Trading Manual USA
Uploaded by
Johnny ChanTrading Manual USA
Uploaded by
Johnny ChanTrading and Capital-Markets
Activities Manual
First Printing, February 1998 Prepared by:
Federal Reserve System
Send comments to:
Director, Division of Banking Supervision
and Regulation
Board of Governors of the Federal
Reserve System
Washington, D.C. 20551
Copies of this manual may be obtained from:
Publications Services
Division of Support Services
Board of Governors of the Federal
Reserve System
Washington, D.C. 20551
Updates are available at an additional charge. For
information about updates or to order by credit card,
call 202-452-3244.
Trading and Capital-Markets Activities Manual
Supplement 8—September 2002
Nature of Changes how a banking organization can mitigate the risk
that may arise if a counterparty claims that a
Trading Activities bank-recommended or -structured derivatives
transaction was unsuitable for it. Other changes
In section 2020.1, ‘‘Counterparty Credit Risk discuss the new-product approval process in
and Presettlement Risk,’’ a new subsection on banking organizations, including the role of
off-market or prefunded derivatives transactions in-house or outside legal counsel in defining and
has been added to provide examples of deriva- approving new products. The examination
tives transactions that are the functional equiva- objectives and examination procedures, sections
lent of extensions of credit to counterparties and 2070.2 and 2070.3, respectively, have also been
to describe the risks associated with them. The updated.
discussion of assessment of counterparty credit
risk has been revised to specify that banking
Capital-Markets Activities
organizations should understand and confirm
with their counterparties the business purpose of Section 3040.1, ‘‘Equity Investment and Mer-
derivatives transactions. chant Banking Activities,’’ has been completely
A more detailed discussion of contingency revised. The accounting, valuation, and risk
funding plans has been added to section 2030.1, management of equity investments in banking
‘‘Liquidity Risk.’’ The characteristics of effec- organizations are summarized. In addition, the
tive contingency funding plans, such as forming section explains the legal and regulatory com-
a crisis-management team and establishing action pliance requirements for these transactions—
plans for different levels of liquidity stress, are including the January 2002 rule establishing
described. Specific information on contingency minimum regulatory capital requirements for
liquidity for bank holding companies is also equity investments in nonfinancial companies.
provided. Examination objectives and examination proce-
Section 2070.1, ‘‘Legal Risk,’’ has been reor- dures, sections 3040.2 and 3040.3, respectively,
ganized and updated. A new subsection describes have been added.
Filing Instructions
Remove pages Insert pages
2020.1, pages 8.1–8.2 2020.1, pages 8.1–8.2
pages 11–13 pages 11–15
2030.1, pages 1–2 2030.1, pages 1–2, 2.1–2.3
2070.1, pages 1–6 2070.1, pages 1–7
2070.2, page 1 2070.2, page 1
2070.3, pages 1–3 2070.3, pages 1–3
3040.1, pages 1–14 3040.1, pages 1–19
3040.2, page 1
3040.3, pages 1–5
Subject Index, pages 1–7 Subject Index, pages 1–7
Trading and Capital-Markets Activities Manual September 2002
Page 1
Trading and Capital-Markets Activities Manual
Supplement 7—April 2002
Nature of Changes its affiliates are subject to the market-terms
requirement of section 23B.
Section 3000.1, ‘‘Investment Securities and End-
User Activities,’’ has been revised to explain In Section 3020.1, ‘‘Securitization and
recent interpretations of sections 23A and 23B Secondary-Market Credit Activities,’’ the discus-
of the Federal Reserve Act. The internal control sion of risk-based provisions affecting asset
questionnaire, section 3000.4, has also been securitizations has been updated to include a
updated. final rule on the capital treatment of recourse
obligations, residual interests, and direct-credit
• A final rule, effective June 11, 2001, provides substitutes resulting from asset securitizations.
three exemptions from the quantitative limits The new rule treats recourse obligations and
and collateral requirements of section 23A. direct-credit substitutes more consistently than
The exemptions apply to certain loans an the current risk-based capital standards, adds
insured depository institution makes to third new standards for the treatment of residual
parties that use the proceeds to purchase interests, and introduces a ratings-based approach
securities or assets through an affiliate of the to assigning risk weights within a securitization.
depository institution. There is a one-year transition period for apply-
• A final rule, effective June 11, 2001, exempts ing the new rules to existing transactions. All
from section 23A an insured depository insti- transactions settled on or after January 1, 2002,
tution’s purchase of a security from an affili- are subject to the revised rules.
ated broker-dealer registered with the Securi- Revisions to section 3040.1, ‘‘Equity Invest-
ties and Exchange Commission (SEC), ment and Merchant Banking Activities,’’ incor-
provided several conditions are met. Among porate a final rule establishing special minimum
other conditions, the purchased security must regulatory capital requirements for equity invest-
have a ready market, as defined by the SEC, ments in nonfinancial companies. The new
and a publicly available market quotation. requirements, effective April 1, 2002, impose a
• An interim rule, effective January 1, 2002, series of marginal capital charges on covered
confirms that (1) derivative transactions equity investments. The charges increase with
between an insured depository institution and the level of a banking organization’s overall
its affiliates and (2) intraday extensions of exposure to equity investments relative to tier 1
credit by an insured depository institution to capital.
Filing Instructions
Remove pages Insert pages
2120.1, pages 1–2 2120.1, pages 1–2
pages 7–8 pages 7–8
2120.2, page 1 2120.2, page 1
2120.3, page 1 2120.3, page 1
2120.4, page 1 2120.4, page 1
2120.5, pages 1–3 2120.5, pages 1–3
3000.1, pages 1–8 3000.1, pages 1–8, 8.1
pages 15–19 pages 15–20
Trading and Capital-Markets Activities Manual April 2002
Page 1
Supplement 7—April 2002
Remove pages Insert pages
3000.4, pages 1–3 3000.4, pages 1–3
3020.1, pages 7–10 3020.1, pages 7–10
pages 10.1–10.2 pages 10.1–10.4
pages 13–14 pages 13–14
3040.1, pages 1–2 3040.1, pages 1–2
pages 5–6 pages 5–6, 6.1–6.3
4020.1, pages 1–2 4020.1, pages 1–2
Subject Index, pages 1–7 Subject Index, pages 1–7
April 2002 Trading and Capital-Markets Activities Manual
Page 2
Trading and Capital-Markets Activities Manual
Supplement 6—September 2001
Nature of Changes Standards No. 140 (FAS 140). Section 2120.1
was further corrected to replace a reference to
Sections 2120.1, ‘‘Accounting,’’ and 3020.1, Accounting Principles Board (APB) Opinion
‘‘Securitization and Secondary-Market Credit No.16 with Statement of Financial Accounting
Activities,’’ have been corrected to remove ref- Standards No. 141 (FAS 141), ‘‘Business Com-
erences to Statement of Financial Accounting binations.’’ References to FAS 125 have also
Standards No. 125 (FAS 125), which has been been removed from the instrument profiles (sec-
replaced by Statement of Financial Accounting tions 4010.1 through 4255.1 and section 4353.1).
Filing Instructions
Remove pages Insert pages
2120.1, pages 3–12 2120.1, pages 3–12
3020.1, pages 3–4 3020.1, pages 3–4
pages 9–10 pages 9–10
pages 10.1–10.2 pages 10.1–10.2
4010.1, pages 3–4 4010.1, pages 3–4
4015.1, pages 3–4 4015.1, pages 3–4
4020.1, pages 3–4 4020.1, pages 3–4
4025.1, pages 1–3 4025.1, pages 1–3
4030.1, pages 1–3 4030.1, pages 1–3
4035.1, page 3 4035.1, page 3
4040.1, pages 9–10 4040.1, pages 9–10
4045.1, pages 5–6 4045.1, pages 5–6
4050.1, pages 3–5 4050.1, pages 3–5
4055.1, pages 1–2 4055.1, pages 1–2
4105.1, pages 5–7 4105.1, pages 5–7
4110.1, pages 13–14 4110.1, pages 13–14
4205.1, pages 1–3 4205.1, pages 1–3
4210.1, page 3 4210.1, page 3
4215.1, pages 3–4 4215.1, pages 3–4
Trading and Capital-Markets Activities Manual September 2001
Page 1
Supplement 6—September 2001
Remove pages Insert pages
4220.1, pages 3–4 4220.1, pages 3–4
4225.1, pages 1–2 4225.1, pages 1–2
4230.1, pages 3–4 4230.1, pages 3–4
4235.1, pages 3–4 4235.1, pages 3–4
4240.1, page 3 4240.1, page 3
4245.1, pages 1–3 4245.1, pages 1–3
4250.1, pages 3–4 4250.1, pages 3–4
4255.1, pages 3–4 4255.1, pages 3–4
4353.1, pages 3–4 4353.1, pages 3–4
pages 9–10 pages 9–10
September 2001 Trading and Capital-Markets Activities Manual
Page 2
Trading and Capital-Markets Activities Manual
Supplement 5—April 2001
Nature of Changes regulator of securities firms. Section 2140.1,
‘‘Regulatory Compliance,’’ has been revised to
incorporate these provisions of the GLB Act.
Trading Activities
Section 2120.1, ‘‘Accounting,’’ has been revised
to incorporate the following recent guidance Capital-Markets Activities
from the Financial Accounting Standards Board:
Statement of Financial Accounting Standards New information on the valuation of retained
(SFAS) No. 133, ‘‘Accounting for Derivative interests, including SR-99-37 and its related
Instruments and Hedging Activities,’’ and SFAS interagency guidance, has been added to section
No. 140, ‘‘Accounting for Transfers and Servic- 3020.1, ‘‘Securitization and Secondary-Market
ing of Financial Assets and Extinguishments of Credit Activities.’’ The subsection on internal
Liabilities." (SFAS 140 supersedes SFAS 125, controls has also been expanded to include the
which had the same title). The accounting treat- minimum requirements for management infor-
ment for securitizations, repurchase agreements, mation systems reports on securitization
derivative instruments, and foreign-currency activities.
instruments has been updated. The discussion A new section 3040.1, ‘‘Equity Investment
on accounting for derivatives includes informa- and Merchant Banking Activities,’’ has been
tion on fair-value, cash-flow, and foreign- added. The new section incorporates the super-
currency hedges. The examination objectives, visory letter on these activities (SR-00-9) that
examination procedures, internal control ques- was formerly in section 4360.1. The section also
tionnaire, and appendix on financial statement provides new guidance on merchant banking
disclosures, sections 2120.2, 2120.3, 2120.4, activities of financial holding companies, includ-
and 2120.5, respectively, have also been updated. ing investment limitations, cross-marketing limi-
In section 2130.1, ‘‘Regulatory Reporting,’’ tations, and special rules for private equity
references to the obsolete Monthly Consolidated funds.
Foreign Currency Report (FFIEC form 035)
have been removed, and the guidance on insti-
tutions that are required to file the FR Y-20 Instrument Profiles
report has been revised. The examination objec-
tives, examination procedures, internal control The ‘‘Accounting Treatment’’ subsections in the
questionnaire, and appendix on reports for trad- instrument profiles have been revised to delete
ing instruments, sections 2130.2, 2130.3, 2130.4, references to obsolete accounting standards and
and 2130.5, respectively, have also been updated. add references to SFAS 133 and SFAS 140.
The Gramm-Leach-Bliley Act (GLB Act), Section 4350.1, ‘‘Credit Derivatives,’’ was fur-
enacted in 1999, removed some restrictions that ther revised to expand the risk-based capital
were formerly applicable to section 20 subsidi- weighting guidance. In section 4353.1, ‘‘Collat-
aries engaged in underwriting, dealing, and eralized Loan Obligations,’’ more detailed infor-
other related activities. Under the GLB Act, mation was provided on the risk-based capital
banking regulators are also required to rely to weighting of three types of transactions for
the greatest extent possible on the functional synthetic collateralized loan obligations.
Filing Instructions
Remove Insert
Tab Section Title Pages Pages
Contents Table of Contents 1 1
Trading and Capital-Markets Activities Manual April 2001
Page 1
Supplement 5—April 2001
Remove Insert
Tab Section Title Pages Pages
2000
2120.1 Accounting 1–13 1–13
2120.2 Accounting—Examination Objectives 1 1
2120.3 Accounting—Examination Procedures 1 1
2120.4 Accounting—Internal Control Questionnaire 1 1
2120.5 Accounting—Related Financial Statement 1–3 1–3
Disclosures
2130.1 Regulatory Reporting 1 1
2130.2 Regulatory Reporting—Examination 1 1
Objectives
2130.3 Regulatory Reporting—Examination 1 1
Procedures
2130.4 Regulatory Reporting—Internal Control 1 1
Questionnaire
2130.5 Regulatory Reporting—Reports for Trading 1–7 1–7
Instruments
2140.1 Regulatory Compliance 1–3 1–3
3000
3020.1 Securitization and Secondary-Market Credit 3–4 3–4, 4.1
Activities 7–10 7–10
10.1–10.2
53 53–67
3040.1 Equity Investment and Merchant Banking 1–14
Activities
4000
4010.1 Commercial Paper 1–4 1–4
4015.1 Repurchase Agreements 1–4 1–4
4020.1 U.S. Treasury Bills, Notes, and Bonds 1–3 1–4
4025.1 U.S. Treasury STRIPS 1–3 1–3
April 2001 Trading and Capital-Markets Activities Manual
Page 2
Supplement 5—April 2001
Remove Insert
Tab Section Title Pages Pages
4030.1 Treasury Inflation-Indexed Securities 1–3 1–3
4035.1 U.S. Government Agency Securities 1–3 1–3
4040.1 Structured Notes 9–10 9–10
4045.1 Corporate Notes and Bonds 5–6 5–6
4050.1 Municipal Securities 3–5 3–5
4055.1 Eurodollar Certificates of Deposit 1–2 1–2
4105.1 Asset-Baked Securities and Asset-Backed 3–7 3–7
Commercial Paper
4110.1 Residential Mortgage-Backed Securities 13–14 13–14
4205.1 Australian Commonwealth Government Bonds 1–3 1–3
4210.1 Canadian Government Bonds 3 3
4215.1 French Government Bonds and Notes 3–4 3–4
4220.1 German Government Bonds and Notes 3–4 3–4
4225.1 Irish Government Bonds 1–3 1–3
4230.1 Italian Government Bonds and Notes 3–4 3–4
4235.1 Japanese Government Bonds and Notes 3–4 3–4
4240.1 Spanish Government Bonds 3 3
4245.1 Swiss Government Notes and Bonds 1–3 1–3
4250.1 United Kingdom Government Bonds 3–4 3–4
4255.1 Brady Bonds and Other Emerging-Markets 3–4 3–4
Bonds
4305.1 Foreign Exchange 7 7
4310.1 Forwards 3–5 3–4
4315.1 Forward Rate Agreements 3–4 3–4
4320.1 Financial Futures 5–7 5–7
Trading and Capital-Markets Activities Manual April 2001
Page 3
Supplement 5—April 2001
Remove Insert
Tab Section Title Pages Pages
4325.1 Interest-Rate Swaps 9–12 9–12
4330.1 Options 7–9 7–9
4335.1 Currency Swaps 5 5
4340.1 Swaptions 3–4 3–4
4345.1 Equity Derivatives 3–4 3–4
4350.1 Credit Derivatives 9–10 9–10
4353.1 Collateralized Loan Obligations 9–11 9–17
4355.1 Commodity-Linked Transactions 5–6 5–6
4360.1 Equity Investment and Merchant Banking 1–11
Activities
Index
Subject Index 1–6 1–7
April 2001 Trading and Capital-Markets Activities Manual
Page 4
Trading and Capital-Markets Activities Manual
Supplement 4—September 2000
Equity Investments and Merchant merchant banking authority to financial holding
Banking companies.
The new section outlines sound practices for
The Federal Reserve’s supervisory letter equity investments and merchant banking,
SR-00-9, issued June 22, 2000, has been added appropriate disclosure practices for institutions
as a new instrument profile, section 4360.1. engaging in these activities, and additional risk-
The section provides guidance for managing management issues for institutions engaging in
the risks of equity investments and merchant transactions with portfolio companies. A final
banking activities, which have become impor- rule on the conduct of equity investment and
tant sources of earnings at some financial insti- merchant banking activities is forthcoming and
tutions. Furthermore, the recently enacted will be included in a future update to this
Gramm-Leach-Bliley Act provides additional manual.
Filing Instructions
Remove Insert
Tab Section Title Pages Pages
Contents
Table of Contents 1 1
4000
4360.1 Equity Investment and Merchant Banking 1–11
Activities
Index
Subject Index 1–7 1–6
Trading and Capital-Markets Activities Manual September 2000
Page 1
Trading and Capital-Markets Activities Manual
Supplement 3—April 2000
Capital Adequacy Accounting
A subsection on the capital treatment of syn- ‘‘Accounting,’’ section 2120.1, was revised in the
thetic collateralized loan obligations (CLOs) has ‘‘Netting or Offsetting Assets and Liabilities’’
been added to section 2110.1, ‘‘Capital subsection to clarify the conditions necessary
Adequacy.’’ The use of credit derivatives to for a master netting arrangement to exist and to
synthetically replicate CLOs has raised ques- add information from the Financial Accounting
tions about how to calculate their leverage and Standards Board’s Interpretation 41. A new
risk-based capital ratios. The new material dis- subsection also provides guidance on account-
cusses supervisory and examination consider- ing for derivative instruments under FASB State-
ations for three types of synthetic CLO transac- ment of Financial Accounting Standard No. 133
tions in banking organizations: (1) the entire (SFAS 133), which is effective for fiscal years
notional amount of the reference portfolio is beginning after June 15, 2000. SFAS 133
hedged, (2) a high-quality senior risk position in requires banking organizations to recognize all
the reference portfolio is retained, and (3) a derivatives on their balance sheets as assets or
first-loss position is retained. liabilities, and to report them at their fair value.
FILING INSTRUCTIONS
Remove Insert
Tab Section Title Pages Pages
2000
2110.1 Capital Adequacy 1–24 1–29
2120.1 Accounting 11–12 11–13
Index
Subject Index 1–7 1–7
Trading and Capital-Markets Activities Manual April 2000
Page 1
Trading and Capital-Markets Activities Manual
Supplement 2—September 1999
Nature of Changes Capital Adequacy
A new subsection on assessing capital adequacy
This supplement reflects new or revised statu- at large, complex banking organizations has
tory and regulatory provisions and new or revised been added to section 2110.1, ‘‘Capital
supervisory instructions or guidance issued by Adequacy.’’ The new guidance outlines the fun-
the Division of Banking Supervision and Regu- damental elements of a sound internal analysis
lation since the publication of the March 1999 of capital adequacy, describes the risks that
supplement. should be addressed in this analysis, and dis-
cusses the examiner’s review of an institution’s
capital adequacy analysis. Other revisions were
made to expand the guidance on market-risk
measure, including the use of internal models
Counterparty Credit Risk and qualitative and quantitative requirements for
market-risk management.
Section 2020.1, ‘‘Counterparty Credit Risk and
Presettlement Risk,’’ has been revised to add a
list of conditions examiners should use when Accounting
evaluating credit-risk management in banking
institutions, as provided in SR-99-3 (February 1, In section 2120.1, ‘‘Accounting,’’ the description
1999). The guidance on collateral arrangements of the Statement of Financial Accounting Stan-
has been expanded to incorporate recent recom- dard No. 133, ‘‘Accounting for Derivative
mendations from the central banks of the Group Instruments and Hedging Activities,’’ has been
of Ten countries on over-the-counter derivatives updated. The Financial Accounting Standards
settlement procedures, as well as market-practice Board has delayed the statement’s effective date
recommendations from the 1999 collateral to fiscal years beginning after June 15, 1999.
review by the International Swaps and Deriva- A reference to an outdated Federal Reserve
tives Association. The examination objectives, policy statement on securities activities has been
examination procedures, and internal control removed. The appendix on financial-statement
questionnaire (sections 2020.2, 2020.3, and disclosures, section 2120.5, has also been
2020.4, respectively) have also been updated. updated.
Filing Instructions
Remove Insert
Tab Section Title Pages Pages
2000
2020.1 Counterparty Credit Risk and Presettlement 1–8 1–8
Risk 8.1–8.2
2020.2 Counterparty Credit Risk and Presettlement 1 1
Risk—Examination Objectives
2020.3 Counterparty Credit Risk and Presettlement 1–2 1–2
Risk—Examination Procedures
2020.4 Counterparty Credit Risk and Presettlement 1–2 1–2
Risk—Internal Control Questionnaire
Trading and Capital-Markets Activities Manual September 1999
Page 1
Supplement 2—September 1999
Remove Insert
Tab Section Title Pages Pages
2110.1 Capital Adequacy 1–16 1–24
2120.1 Accounting 1–6 1–6
9–12 9–12
2120.5 Accounting—Appendix: Related 3 3
Financial-Statement Disclosures
Index
Subject Index 1–7 1–7
September 1999 Trading and Capital-Markets Activities Manual
Page 2
Trading and Capital-Markets Activities Manual
Supplement 1—March 1999
This supplement reflects new or revised statu- the Division of Banking Supervision and Regu-
tory and regulatory provisions and new or revised lation since the publication of the manual in
supervisory instructions or guidance issued by February 1998.
LIST OF CHANGES
Counterparty Credit Risk disruptions of 1998. A subsection on nondeliv-
erable forwards and the need for explicit docu-
Section 2020.1, Counterparty Credit Risk and mentation of these contracts is also added. The
Presettlement Risk, has been revised to incorpo- examination objectives and examination proce-
rate the supervisory guidance on counterparty dures (sections 2070.2 and 2070.3, respectively)
credit risk management provided in SR-99-3 have been updated.
(February 1, 1999). Specific guidance on the
calculation of potential future exposure, exposure-
monitoring and limit systems, the importance of Capital Adequacy
stress testing and scenario analysis, and the
interrelationship between credit and market risk, Section 2110.1, Capital Adequacy, has been
is included. Additional guidance on credit updated to reflect regulatory changes to the
enhancements, including collateral, close-out definition of tier 1 and tier 2 capital and to
provisions, and margining requirements, is pro- include a revised discussion of the regulatory
vided. The section discusses in detail the need treatment of credit derivatives.
for robust counterparty credit risk management
policies and internal controls to ensure that
existing practice conforms to stated policies. Accounting
The unique risks posed by institutional investors
and hedge funds are detailed in a separate In section 2120.1, Accounting, a brief descrip-
subsection, which includes a discussion of the tion of the Statement of Financial Accounting
January 1999 report of the Basle Committee on Standards No. 133 (SFAS 133) for derivatives
Banking Supervision on the risks posed by has been added. SFAS 133 is effective for fiscal
hedge funds to creditors and the accompanying years beginning after June 15, 1999, with an
sound practices standards for interactions with effective date of January 1, 2000, for most
hedge funds. The examination objectives, banks. The description of SFAS 133 will be
examination procedures, and internal control expanded in subsequent revisions to the manual.
questionnaire (sections 2020.2, 2020.3, and
2020.4, respectively) have also been updated.
Securities
In section 2021.1, Counterpary Credit Risk and
Settlement Risk, a discussion of the Board’s Section 3000.1, Investment Securities and End-
June 1998 Policy Statement on Privately Oper- User Activities, has been revised to reflect the
ated Multilateral Settlement Systems provides Policy Statement on Investment Securities and
guidance on the additional settlement risks posed End-User Derivatives Activities, published by
by these systems. the Federal Financial Institutions Examination
Council, and the recission of the high-risk test
for mortgage-derivative products.
Legal Risk
Section 2070.1, Legal Risk, has been updated to Interest-Rate Risk
include a discussion on the importance of prop-
erly and accurately defining the trigger events In section 3010.1, Interest-Rate Risk Manage-
that provide for payments between counterpar- ment, a discussion of an examination scope for
ties, in light of experiences during the market noncomplex institutions has been revised to
Trading and Capital-Markets Activities Manual March 1999
Page 1
Supplement 1—March 1999
delete specific criteria previously used to iden- obligations (CLOs) has been added as section
tify institutions in which only baseline exami- 4353.1. CLOs are securitizations of portfolios of
nation procedures were necessary. The revised commercial and industrial loans through a
focus is on the overall risk profile of the indi- bankruptcy-remote special-purpose vehicle that
vidual institution in lieu of dependence on strict issues asset-backed securities in one or more
quantitative criteria. classes (or tranches). Alternatively, CLOs may
be synthetically created through the use of credit
derivatives.
Collateralized Loan Obligations
A new product profile on collateralized loan
FILING INSTRUCTIONS
Remove Insert
Tab Section Title Pages Pages
Preface 1–2 1–2
Contents Table of Contents 1 1
2000
2020.1 Counterparty Credit Risk and Presettlement 1–9 1–13
Risk
2020.2 Counterparty Credit Risk and Presettlement 1 1
Risk—Examination Objectives
2020.3 Counterpart Credit Risk and Presettlement 1–2 1–2
Risk—Examination Procedures
2020.4 Counterparty Credit Risk and Presettlement 1–2 1–2
Risk—Internal Control Questionnaire
2021.1 Counterparty Credit Risk and Settlement 1–4 1–5
Risk
2070.1 Legal Risk 1–2 1–2, 2.1
5–6 5–6
2070.2 Legal Risk—Examination Objectives 1 1
2070.3 Legal Risk—Examination Procedures 1–3 1–3
2100.1 Financial Performance 7–8 7–8
2110.1 Capital Adequacy 1–4 1–4
7–16 7–16
2120.1 Accounting 11–12 11–12
March 1999 Trading and Capital-Markets Activities Manual
Page 2
Supplement 1—March 1999
Remove Insert
Tab Section Title Pages Pages
3000
3000.1 Investment Securities and End-User Activities 5–6 5–6, 6.1
17–19 17–19
3010.1 Interest-Rate Risk Management 17 17
3020.1 Securitization and Secondary-Market Credit 1–2 1–2
Activities
4000
4010.1 Commercial Paper 1–2 1–2
4040.1 Structured Notes 1–2 1–2
4353.1 Collateralized Loan Obligations 1–11
Index
Subject Index 1–5 1–7
Trading and Capital-Markets Activities Manual March 1999
Page 3
Preface
USING THIS MANUAL • examination objectives
• examination procedures
This manual seeks to provide the examiner with • internal control questionnaire
guidance for reviewing capital-markets and trad-
ing activities at all types and sizes of financial The focus of the examination objectives,
institutions. The manual will be updated peri- examination procedures, and internal control
odically as products and activities evolve. questionnaires is to provide examiners with a
The manual codifies current procedures used practical guide to examining the core areas of
in the review of capital-markets and trading any trading operation. Examination objectives
activities. It discusses the risks involved in describe the goals that should be of primary
various activities, risk-management and interest to the examiner and determine the scope
-measurement techniques, appropriate internal of the examination for the specific area of
controls, and the examination process from the interest. The examination procedures include
following perspectives: procedures to be performed during a compre-
hensive examination. In some instances, not all
• Global applicability. The manual is not di- the procedures may apply to all financial insti-
rected at trading at any one type of institution tutions. Thus, examiners have the flexibility,
(commercial bank, branch/agency, other) but depending on the characteristics of the particular
is meant to apply to capital-markets and institution under examination, to determine the
trading activities at all financial institutions to examination scope and procedures. The materi-
be examined. ality and significance of a given area of opera-
• Portfolio. The manual attempts to broaden our tions are an examiner’s primary considerations
review of trading operations from a product- when deciding the scope of the examination
by-product approach to a portfolio and and the procedures to be performed. Examiner
functional-activity approach. This method bet- flexibility results in examinations tailored to
ter reflects the multiple uses of financial the operations of the banking institution. After
instruments by institutions, their relationship determining the proper objectives and pro-
to other instruments and activities on or off the cedures, the examiner will have an organized
balance sheet, and attendant correlations. approach to examining the institution’s trading
processes. Core topics include the following:
• Types of risk. The manual identifies the range
of risks—market, credit, liquidity, opera- • market risk
tional, legal, and other risks—relevant to the • credit risk
review of capital-markets and trading activi-
• settlement risk
ties, and discusses their management on a
functional and legal-entity basis. • liquidity risk
• operations and systems risk
The manual is divided into four basic sec- • legal risk
tions. The first section consists of broad intro- • financial performance
ductory remarks regarding the examination of • capital adequacy of trading activities
most capital-markets and trading activities, • accounting
including important considerations in preparing • regulatory reporting
for the examination and review of capital- • regulatory compliance
markets activities. It also discusses the impor- • ethics
tance of examiner review of the management
organization of the activity to be examined. The third section of this manual offers super-
The second section presents supervisory guid- visory guidance regarding various banking
ance regarding trading and dealer operations at activities and functions that are not trading-
banking organizations and specifically details related but are directly linked with capital-
certain aspects of the examination process for markets and Treasury operations. While tar-
these operations. In general, the discussion of geted primarily at larger institutions, the general
each topic has the following four subsections: principles identified in this section are applica-
ble to activities at institutions of all sizes. This
• discussion of the general topic section presents the latest Federal Reserve
Trading and Capital-Markets Activities Manual March 1999
Page 1
Preface
supervisory guidance on issues such as interest- • general description
rate risk management within the banking book, • characteristics and features
securitization and secondary-market credit • uses
activities, securities and end-user derivative • description of the instrument’s market
activities, and other topics. In some cases, the • pricing conventions
guidance consists of Federal Reserve super- • hedging issues
vision and regulation (SR) letters on specific • discussion of the risks involved
topics. In others, formal examination-manual • accounting treatment
treatments are presented that include exam pro- • risk-based capital considerations
cedures and internal control questionnaires. • bank-eligibility requirements
The fourth section of this manual presents • references for further information
profiles of specific financial instruments com-
monly encountered in capital-markets and trad- When assigned to review a particular product,
ing activities. An examiner’s understanding of the examiner should first review the appropriate
these instruments is crucial to successful imple- instrument profile to become familiar with the
mentation of a capital-markets examination. characteristics of and the marketplace for the
While the write-ups are not intended to provide product. The examination objectives, examina-
in-depth and fully comprehensive coverage of tion procedures, and internal control question-
each instrument, they do present basic instru- naires will often be applicable across any num-
ment characteristics and examination consider- ber of instruments and products. Therefore,
ations. In general, each instrument profile con- coordination with examiners who are reviewing
tains discussions in the following areas: other products is essential.
March 1999 Trading and Capital-Markets Activities Manual
Page 2
Table of Contents
Section Section
1000 EXAMINATION POLICY 4010 Commercial Paper
4015 Repurchase Agreements
1000 Preparation for Examination 4020 U.S. Treasury Bills, Notes, and Bonds
1010 Organizational Structure 4025 U.S. Treasury STRIPS
4030 Treasury Inflation-Indexed Securities
4035 U.S. Government Agency Securities
2000 TRADING ACTIVITIES 4040 Structured Notes
4045 Corporate Notes and Bonds
2000 Overview of Risk Management in 4050 Municipal Securities
Trading Activities 4055 Eurodollar Certificates of Deposit
2010 Market Risk 4105 Asset-Backed Securities and
2020 Counterparty Credit Risk and Asset-Backed Commercial Paper
Presettlement Risk 4110 Residential Mortgage–Backed
2021 Counterparty Credit Risk and Securities
Settlement Risk 4205 Australian Commonwealth
2030 Liquidity Risk Government Bonds
2040 Operations and Systems Risk 4210 Canadian Government Bonds
(Management Information Systems) 4215 French Government Bonds
2050 Operations and Systems and Notes
Risk (Front-Office Operations) 4220 German Government Bonds
2060 Operations and Systems Risk and Notes
(Back-Office Operations) 4225 Irish Government Bonds
2070 Legal Risk 4230 Italian Government Bonds
2100 Financial Performance and Notes
2110 Capital Adequacy 4235 Japanese Government Bonds
2120 Accounting and Notes
2130 Regulatory Reporting 4240 Spanish Government Bonds
2140 Regulatory Compliance 4245 Swiss Government Notes
2150 Ethics and Bonds
4250 United Kingdom Government
3000 CAPITAL-MARKETS Bonds
ACTIVITIES 4255 Brady Bonds and Other
Emerging-Markets Bonds
3000 Investment Securities and 4305 Foreign Exchange
End-User Activities 4310 Forwards
3010 Interest-Rate Risk Management 4315 Forward Rate Agreements
3020 Securitization and Secondary-Market 4320 Financial Futures
Credit Activities 4325 Interest-Rate Swaps
3030 Futures Brokerage Activities and 4330 Options
Futures Commission Merchants 4335 Currency Swaps
3040 Equity Investment and Merchant 4340 Swaptions
Banking Activities 4345 Equity Derivatives
4350 Credit Derivatives
4353 Collateralized Loan Obligations
4000 INSTRUMENT PROFILES 4355 Commodity-Linked Transactions
4000 Introduction
4005 Federal Funds SUBJECT INDEX
Trading and Capital-Markets Activities Manual April 2001
Page 1
Preparation for Examination
Section 1000.1
The globalization of markets, increased transac- tutions to manage risks by portfolio and to
tion volume and volatility, and the introduction consider exposures in relationship to the insti-
of complex products and trading strategies have tution’s global strategy and risk tolerance.
led capital-markets and trading activities to take A financial institution’s risk-management pro-
on an increasingly important role at financial cess should not only be assessed by business
institutions over the last decade. These activities line, but also in the context of the global,
include the use of a range of financial products consolidated institution. A review of the global
and strategies, from the most liquid fixed- organization may reveal risk concentrations not
income securities to complex derivative instru- readily identifiable from the limited view of a
ments. The risk dimensions of these products branch, agency, Edge Act institution, nonbank
and strategies should be fully understood, moni- subsidiary, or head office on a stand-alone basis.
tored, and controlled by bank management. The consolidation of risk information also allows
Accordingly, adequate risk-management sys- the institution to identify, measure, and control
tems and controls at financial institutions are its risks, while giving the necessary consider-
essential to prevent losses and protect capital. ation to the breakdown of exposure by legal
The role of regulators in supervising capital- entity. Sometimes, if applicable rules and laws
markets and trading activities is to evaluate allow, identified risks at a branch or subsidiary
management’s ability to identify, measure, moni- may be compensated for by offsetting exposures
tor, and control the risks involved in these at another related institution. However, this
activities and to ensure that institutions have management of risks across separate entities
sufficient capital to support the risks they take. must be done in a way that is consistent with the
The level of risk an institution may reasonably authorities granted to each entity. Some finan-
assume through capital-markets and trading cial institutions and their subsidiaries may not
activities should be determined by the board of be permitted to hold, trade, deal, or underwrite
directors’ stated tolerance for risk, the ability of certain types of financial instruments, including
senior management to effectively govern these some of those instruments discussed in the 4000
operations, and the capital position of the sections of this manual, unless they have spe-
institution. cifically received regulatory approval. Further-
more, conditions and commitments may be
OVERVIEW OF RISK attached to regulatory approvals to engage in
certain capital-markets activities. Examiners
For capital-markets and trading activities, risk is should ensure that financial institutions have the
generally defined as the potential for loss on an proper regulatory authority for the activities
instrument, portfolio, or activity. Thus, the risks they engage in and that activities are conducted
referred to in this manual will be discussed in consistent with their specific regulatory approvals.
terms of the impact of some event on value Ideally, an institution should be able to iden-
(value-at-risk) and income (earnings-at-risk) tify the relevant generic risks and should have
from the instrument, activity, or portfolio being measurement systems in place to conceptualize,
addressed. quantify, and control these risks on an insti-
Risk management is the process by which tutional level using a common measurement
managers identify, assess, monitor, and control framework. However, it is recognized that not
all risks associated with a financial institution’s all institutions have an integrated risk-
activities. The increasing complexity of the management system that aggregates all business
financial industry and the range of financial activities. In addition, risk-management meth-
instruments have made risk management more odologies in the marketplace and an institution’s
difficult to accomplish and to evaluate. In more scope of business are continually evolving, mak-
sophisticated institutions, the role of risk man- ing risk management a dynamic process. None-
agement is to identify the risks associated with theless, an institution’s risk-management system
particular business activities and to aggregate should always be able to identify, aggregate, and
summary data into generic components, ulti- control all risks posed by capital-markets and
mately allowing exposures to be evaluated on a trading activities that could have a significant
common basis. This methodology enables insti- impact on capital or equity.
Trading and Capital-Markets Activities Manual February 1998
Page 1
1000.1 Preparation for Examination
Examiners need to determine the ability of the measurement models, and system of internal
institution’s risk-management system to mea- controls. Furthermore, the examiner must assess
sure and control risks. The assessment of risk- the qualitative and quantitative assumptions
management systems and controls should be implicit in the overall risk-management sys-
performed by type of instrument and type of tem and the effectiveness of the institution’s
risk. Some of the risks inherent in the trading approach to controlling risks. In addition, the
process are described below: examiner must determine that the management
information system and other forms of commu-
• Market (price) risk is the risk that the value of nication are adequate for the institution’s level
a financial instrument or a portfolio of finan- of business activity.
cial instruments will change as a result of a Banking supervision is a dynamic process and
change in market conditions (for example, this is especially evident in the oversight of
interest-rate movement). capital-markets and trading activities. As capital
• Funding-liquidity risk refers to the ability to markets, financial instruments, and secondary-
meet investment and funding requirements market activities continue to expand and
arising from cash-flow mismatches. develop, they have an increasingly significant
• Market-liquidity risk refers to the risk of being impact on the safety and soundness of financial
unable to close out open positions quickly institutions. Consequently, it has become equally
enough and in sufficient quantities at a reason- necessary for bank supervisors to focus their
able price to avoid adverse financial impacts. attention on the capital-markets and trading
• Counterparty credit risk is the risk that a activities arena. Policies and practices for evalu-
counterparty to a transaction will fail to per- ating the exposures, management tools, and
form according to the terms and conditions of controls employed by banking institutions have
the contract, thus causing the holder of the had to be constructed and adapted to keep pace
claim to suffer a loss in cash flow or market with changes in the industry. In this context,
value. the manual encourages the examiner to ask the
• Clearing/settlement credit risk is (1) the risk following basic questions:
that a counterparty who has received a pay-
ment or delivery of assets defaults before • Are the tools employed by management to
delivery of the asset or payment or (2) the risk measure and monitor risk exposure adequate?
that technical difficulties interrupt delivery or • Is the level of risk exposure appropriate given
settlement despite the counterparty’s ability or the financial institution’s size, sophistication,
willingness to perform. and financial condition?
• Operations and systems risk is the risk of • Are the risks in the institution’s portfolio
human error or fraud or the risk that systems of products and activities recognized, under-
will fail to adequately record, monitor, and stood, measured, and managed?
account for transactions or positions. • Are the activities conducted consistent with
• Legal risk is the risk that a transaction cannot the goals and risk tolerance of senior manage-
be consummated because of some legal bar- ment and the board of directors?
rier, such as inadequate documentation, a
regulatory prohibition on a specific counter- To prepare for the on-site portion of the
party, and nonenforceability of bilateral and examination of any capital-markets or trading
multilateral close-out netting and collateral activity, a preliminary overview of the range of
arrangements in bankruptcy. products and activities of the institution should
• Reputational risk is the risk arising from be developed. This overview will help examin-
negative public opinion regarding an institu- ers formulate a scope and objective for the
tion’s products or activities. upcoming exam that is consistent with the types
and levels of risk exposure assumed by the
The examiner must be prepared to identify institution.
and evaluate exposures that arise out of any part
of a capital-markets operation. To that end, the
examiner must become familiar with the insti-
tution’s overall reporting structure and segre- PREEXAMINATION REVIEW
gation of duties, range of business activities,
global risk-management framework, risk- The review of trading activities is generally
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Preparation for Examination 1000.1
conducted on the basis of a financial institu- • equity-based products and activities including
tion’s organizational structure. These structures equity options, warrants, and swaps
may vary widely depending on the size and • commodity-based products and activities
sophistication of the institution, the markets and including commodity futures, options, and
geographies in which it competes, and the forwards
objectives and strategies of its management and
board of directors. Other capital-markets activities, such as asset
Many banks and bank holding companies securitization or secondary-market credit
have several subsidiaries that conduct business activities may be assessed by specific activity,
independent of affiliated entities, and some function, or product.
branches and agencies may operate autono- To prepare examiners for their assignments,
mously. The overlap of business lines, sharing the following initial procedures should be fol-
of information and personnel, and transaction lowed to achieve the required scope and cover-
netting agreements that exist among affiliated age of the institution’s activities.
legal entities force examiners to go beyond the
basic business-unit review and focus on func- • Determine the extent of work performed dur-
tional exposures within the global institution. It ing the past year by auditors and regulatory
is also important for an examiner to ensure that agencies (these would include, but not be
an institution respects divisions between legal limited to, the institution’s internal auditors,
entities, such as firewall and bank/nonbank the various exchanges, the Securities and
separations. For example, while a bank holding Exchange Commission, the Commodity
company must be aware of the level of its Futures Trading Commission, the National
consolidated risk, it cannot ignore legal bound- Association of Securities Dealers, the National
aries completely in the management of that risk. Futures Association, and the Internal Revenue
Exposure in the bank is not automatically hedged Service).
by offsetting positions in the bank holding • Review deficiencies identified by audit reports
company and vice versa. In some cases, trans- and reports of examination.
actions may be offset by a transaction between • Obtain a listing of the names, qualifications,
these affiliates which may, however, be subject functions, and positions of key trading and
to other regulatory requirements. Bank holding front- and back-office personnel, and a current
companies should manage and control risk organizational chart. This material should be
exposures on a consolidated basis, while recog- available in prior examination and inspection
nizing legal distinctions among subsidiaries. reports.
Examiners should always maintain a view of • Evaluate the volume of transactions and the
the ‘‘big picture’’ impact of capital-markets dollar value of positions held in each trading
and trading activities on consolidated risk product and activity. These data may be found
exposure. in various regulatory reports.
The examiner team should meet before the • Using the audit findings on the effectiveness
examination begins to summarize the institu- of controls over capital-markets and trading
tion’s status and assign responsibilities for com- activities, evaluate the examination scope to
pleting preparatory work. Generally, examina- assess organizational and reporting changes,
tion assignments may be segregated based on identify perceived weaknesses, and highlight
products, activities, or functions. For example, patterns of error.
for trading operations, examiners may be given
administrative responsibility for the following
areas of review:
BACKGROUND REVIEW
• interest-rate products including fixed-income
securities, swaps, futures, forward-rate agree- Specific items which should be reviewed during
ments (FRAs), options, caps, and floors the preexamination process for capital-markets
• currency-related activities including customer- and trading activities include the following:
driven and discretionary foreign-exchange
(FX) trading, cross-currency transactions, and • Regulatory reports. During the planning stages
currency derivatives (for example, currency of an examination, the examiners may esti-
options, forwards, futures, and swaps) mate activity volumes and diversity of instru-
Trading and Capital-Markets Activities Manual February 1998
Page 3
1000.1 Preparation for Examination
ments and activities from periodical regula- risk control. The following is a brief list of core
tory reports. This information will help in the requests to be made in the first-day letter:
development of an examination scope and
objective, as well as in the determination of • a copy of the organization charts (including
staffing and resource requirements. name and title of managers) for the capital-
• Prior report of examination. The findings and markets or global-trading operations to be
conclusions of the prior examination are assessed, including functional and legal-entity
invaluable to the preparation of the scope and organization
objectives of the current examination. Exami- • a copy of the institution’s written risk-
nation reports provide insight into bank man- management policies and procedures that out-
agement’s policies and practices in measuring line the instruments traded, their associated
and managing risk, the extent of risk exposure risks, and the monitoring of the risks
in a given product and/or activity, and the • a copy of established limits for each principal
overall adequacy of the trading-activity con- type of risk as well as documentation indicat-
trol environment. ing periodic approval by the board of directors
• Audit reports. Internal and external audits are • general-ledger and subsidiary-ledger accounts
often focused on the activities of individual identifying the range and level of activity as of
business units and may not encompass aggre- the examination date
gate exposures and controls. Nevertheless, • management information reports used in the
they are useful in identifying exceptions to global, functional, or legal-entity oversight of
internal policies and specific violations such market- and credit-risk management
as limit exceptions. Management’s responses • detailed information on transactions that are
to audit findings are also useful in identifying unique or uncommon
corrective actions and the direction of the unit. • copies of management reports issued in con-
• Correspondence since the last examination. nection with the bank’s new financial products
An additional resource that should be re- that were put in place since the last examina-
viewed before an examination is the corre- tion indicating the office at which such activ-
spondence file. This will contain important ity is conducted, the lines and limits estab-
information such as management’s response lished for each activity, and the perceived
to the prior examination findings, any appli- risks associated with each activity
cations submitted to the Federal Reserve (for • a description of the scope and frequency of
additional powers, mergers, and acquisitions), internal and external audits of the institution’s
and any supervisory action or agreement that capital-markets and trading activities and cop-
may exist. ies of audits, including working papers, con-
• Outstanding applications. The examiner-in- ducted of capital-markets operations since the
charge should inquire about the status of any last examination
outstanding applications before the Federal
Reserve Board that may suggest expansion in The first-day letter to an institution that
the capital-markets and trading activities of engages in capital-markets or trading activities
the banking institution. and the use of derivatives usually will be much
more precise and comprehensive than this list,
depending on the institution’s range of products
and activities. Significantly more detail should
FIRST-DAY LETTER be requested relative to the objectives of the
trading operations, the activities in which the
In preparation for an on-site examination, exam- institution engages, the products it uses, and the
iners will often need to customize the first-day- risk-management methods and reports it relies
letter questionnaire to reflect the specific focus on. The first-day letter should also include
of the capital-markets review. The focus will requests for detailed information related to the
reflect the range of products and activities of the areas highlighted in the market, credit, liquidity,
institution as well as management’s approach to and operational risk sections of this manual.
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Organizational Structure
Section 1010.1
Obtaining an overview of the organization, man- entities. Other organizational structures include
agement structure, product universe, and control branches, agencies, subsidiaries, joint ventures,
environment of a financial institution’s capital- or portfolio investment partnerships. Some of
markets and trading activities is a critical initial these entities may be registered with regulatory
step in the examination process. This overview agencies such as the Securities and Exchange
can be developed by applying the examination Commission (SEC), National Association of
procedures listed in this manual, which enable Securities Dealers (NASD), and Commodity
the examination team to understand the institu- Futures Trading Commission (CFTC) and may
tion’s legal-entity and managerial structures and have affiliations with, or membership in, stock
the scope and location of its activities, and to and commodities exchanges worldwide. These
evaluate policies, procedures, and actual prac- organizations may impose constraints on the
tices. An overview also helps the examiner to activities of an institution, and the examination
identify broad internal control processes and team should be aware of the scope, conclusions,
gain insight into how effectively they cover and timing of any examinations, inspections,
trading activities. Finally, the overview helps and reviews conducted by other regulatory
identify significant changes in operations and bodies.
the rationale for those changes. Depending on the powers granted to it by the
Evaluating the capital-markets, trading, and country having jurisdiction, a diversified multi-
marketing activities conducted by the financial national banking organization may use a variety
institution can be a complicated task that may be of functional management structures which cross
compounded by the lack of a clear distinction legal-entity boundaries to invest, trade, under-
between bank and nonbank powers granted to an write, or deal in trading products. Functional
institution. A number of institutions will shift management lines may be introduced to facili-
positions among legal entities to facilitate risk tate decision making. An institution may clear
management along product or geographic- its own trading products, provide clearing
market lines. Therefore, the overview or orga- services for customers, or maintain clearing
nizational structure is central in evaluating and settlement relationships with correspondent
whether the financial institution has separated financial institutions. The examiner should
activities as required by law and regulation. review these operations as well as the reasons
The examiner-in-charge is responsible for and results of significant reorganizations, par-
evaluating the organizational structure, activi- ticularly if the entities have exceptional earnings
ties, overall risk-management system, and con- profiles.
trols of the global-trading and capital-markets
To manage and control activities on a global
operations at the highest organizational level. In
basis, a financial institution should have pro-
a U.S. financial institution, this would generally
grams established to identify where it conducts
be the bank holding company level. Examiners
activities both by business entity and by legal
should be aware that organization and struc-
ture can differ significantly among financial entity. These programs should document how
institutions. activities are monitored on an ongoing basis and
reported to senior management. The examiner
should review the adequacy of the management
information system from a reporting and auto-
OPERATIONAL AND LEGAL mation perspective. The most recent internal
STRUCTURE OF THE FIRM and external audit reports covering the banking
AND ITS CAPITAL-MARKETS institution’s capital-markets and trading activi-
ACTIVITIES ties should be evaluated to identify any defi-
ciencies related to organizational structure and
The ownership structure includes the geographic separation of duties. For additional guidance,
locations and legal-entity divisions of an insti- examiners should refer to the Bank Holding
tution’s relevant banking and nonbanking opera- Company Examination Manual, specifically sec-
tions, including holding companies, significant tion 2185.0 on nonbank section 20 subsidiaries
affiliated entities, and separately capitalized units engaged in dealing and underwriting and the
such as section 20 or limited purpose ‘‘venture’’ 3000 sections on nonbank activities, including
Trading and Capital-Markets Activities Manual February 1998
Page 1
1010.1 Organizational Structure
securities brokerage, foreign-exchange advisory, gories of risk, locations, and activities, or by
futures commission merchant, primary dealer, functional department, specific product, or port-
and a wide range of other underwriting and folio. Global risk-management reports should
dealing activities. clearly describe the elements of risk; provide a
quantifiable description of the amount of capital
allocated to capital-markets and trading activi-
Risk-Management Organization ties; and identify limits on market, credit, and
operational risks. Examiners should be aware
Risk management is the process of monitoring, that a global approach to risk analysis can fail
controlling, and communicating to senior man- to identity specific risk levels in specific prod-
agement and the board of directors the nature ucts, functions, or activities. Conversely, func-
and extent of risk from capital-markets and tional decentralized approaches can miss con-
trading activities. The board of directors has solidated risks. Risk-analysis methods which
a regulatory mandate to set and periodically incorporate aspects of both approaches are
approve an institution’s limit levels, given its more effective.
tolerance for risk. Senior management should Financial institutions should have highly quali-
regularly evaluate the risk-management proce- fied personnel throughout their capital-markets
dures in place to ensure they are appropriate and and trading teams, including those in functions
sound. Senior management should also foster responsible for risk management and internal
and participate in active discussions with the control. The personnel of independent risk-
board of directors, staff of risk-management management functions should have a complete
functions, and traders regarding procedures for understanding of the risk associated with all
measuring and managing risk. Management must on- and off-balance-sheet instruments that are
also ensure that capital-markets and trading transacted. Accordingly, compensation policies
activities are allocated sufficient resources to for these individuals should be adequate to
manage and control risks. attract and retain qualified personnel. As a
Personnel responsible for the risk-management matter of general policy, compensation policies,
function should be separate from trading-floor especially in the risk-management, control, and
personnel. In contrast to the measurement and senior-management functions, should be struc-
assessment of risk exposures, the day-to-day tured to avoid potential incentives for excessive
management of exposures by trading staff may risk taking that can occur if, for example,
follow a decentralized, product- or portfolio- salaries are tied too closely to the profitability of
specific approach. Therefore, an independent capital-markets and trading activities.
system for reporting exposures to both senior-
level management and the board of directors
is an important element in the overall risk-
management process. BUSINESS LINES AND SERVICES
A review of the structure of managerial
reporting lines is helpful in determining the Financial institutions identify primary business
financial institution’s capacity to identify and lines in a variety of ways. In trading operations,
manage risk. The reporting lines may be struc- the transaction activity of different instruments
tured by legal entity, by functional lines of may be subdivided into financial engineering,
responsibility, or along business or profit-center sales and distribution, underwriting, market mak-
lines. The examiner should request the organi- ing, proprietary trading and advisory services,
zation chart to identify overlaps in the legal and and others. The grouping of activities may
operational structures and should cite possible provide insight into the market strategy or com-
violations of section 20 firewall provisions or petitive advantage of an institution, its capital
other regulations which require strict separation and risk-limit allocation, and its concentration
of activities. Examiners should be aware of of risk. Transaction-activity groupings may help
special conditions appearing in authorizations to identify the managerial and operational syn-
for the board of directors. Potential conflicts ergy between business and product lines and
of interest of board members should also be between affiliated entities.
evaluated. Institutions may specialize in trading specific
Risk management can be performed globally, types of instruments and offer services tailored
concentrating on the institution’s generic cate- to their customers. The degree of diversity in the
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Organizational Structure 1010.1
range of business lines and services is a measure with any nonbank securities regulators (for
of the banking organization’s capacity to estab- example, provisions such as NASD Series 7 or
lish a presence in those markets. Diversity of CFTC commodity or exchange requirements
business lines can be an early indicator of such as ‘‘registered principal’’). The reviews
potential imbalances in an institution’s resource should indicate whether management or trading
allocation, such as too broad a range of unsu- and sales personnel have been cited for viola-
pervised activities or dependence on too narrow tions of securities laws, mentioned in criminal
a range of activities. referrals to state or federal officials and are
Products and services that an institution has currently or have been under statutory super-
begun offering or discontinued since the previ- vision or periods of disqualification under
ous examination should be identified. Business NASD, New York Stock Exchange (NYSE), or
strategies which discuss any planned or recent other self-regulatory organization (SRO) rules.
changes to the business should be reviewed. A The review should indicate whether manage-
restructuring in business lines and services might ment or trading and sales personnel are allowed
be used to camouflage problems such as recog- to trade for their own accounts. Policies directed
nizing illegal profits or incurring large losses or at the personal-investment activities of staff, as
breaches of internal limits, controls, regulations, well as the areas responsible for monitoring and
or banking and securities laws. The examiner controlling them, should be identified. The com-
should refer all exceptional or unusual findings pensation structure of key principals, including
to the examiner-in-charge. Initiation of new current and deferred salary, bonus, commission,
products or new business initiatives should be equity participation, or other remuneration,
formally approved by the board of directors should be described. Loans between the insti-
after thorough research into all relevant aspects tution and key management should also be
of the product. identified. Compensation practices should be
Banking regulations provide for limitations reviewed to determine that the independence of
and restrictions on permissible activities for those involved in risk-management oversight
banking organizations and their nonbank subsid- is not compromised by direct benefit from the
iaries. A review of specific products and ser- profits of the risk-taking function. Finally, the
vices is an additional check for identifying the profiles section should comment on the reasons
banking organization’s adherence to applicable for resignations or reassignments of key manag-
legal or regulatory requirements. To ensure the ers, traders, and salespeople.
adequacy of internal accounting, clearing, and The growing level of sophistication of capital
settlement of transactions, banking institu- markets requires experienced management with
tions should document the methods used to appropriate credentials to understand complex
collect and monitor information on all traded trading instruments and their associated risk-
instruments. management techniques. The level of experi-
ence required to understand quantitative analy-
sis and advanced risk-based sensitivity analysis
should be commensurate with the sophistication
MANAGEMENT AND of the firm’s activities.
COMPENSATION STRUCTURE Any deficiencies in management’s capacity to
understand and control the instruments or the
Capital-markets and trading management struc- types of risk associated with them are cause for
tures may be organized by legal entity, business regulatory concern. However, the determination
line, profit center, or a combination thereof. of deficiencies must be based on a fair and
Regulatory conditions as well as safe-and-sound impartial assessment of the products traded and
banking practices often require the separation of the institution’s future business plans.
managerial duties. Overlaps should be reviewed
for compliance with regulations, ethical stan-
dards, and safety-and-soundness concerns.
Background reviews include the evaluation of GENERAL POLICIES AND
management expertise and character. Resumes PROCEDURES
should be reviewed to determine whether key
managers in trading, sales, operations, and com- The adequacy of policies and procedures for
pliance have been or are currently registered capital-markets and trading activities should be
Trading and Capital-Markets Activities Manual February 1998
Page 3
1010.1 Organizational Structure
evaluated against the complexity and volume of onciliations and accounting procedures includ-
financial transactions. Policies and procedures ing a chart of accounts.
should be written and include, at a minimum, a Policies and procedures should require that
mission statement, limits approved by the board capital-markets and trading activities are under
of directors, procedures for reviewing limits, a senior management review and subject to peri-
list of traders and their assignments, the organi- odic audit. An internal audit department should
zation’s structure and responsibilities, permis- be organizationally and functionally separate
sible activities, an approved list of brokers, from trading-management oversight and should
counterparties, dealing guidelines, and an report to the board of directors of the institution.
explicit dispute-resolution methodology. Further- In institutions that are more active in trading,
more, the institution should have a code of other organizational units should provide an
ethics for employees, a policy for personal independent assessment of the profitability and
trading, investment guidelines, a detailed risk inherent in these activities.
description of transaction processing, and rec-
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Overview of Risk Management in Trading Activities
Section 2000.1
Risk is an inevitable component of intermedia- must determine that the computer system, man-
tion and trading activity. Given the fundamental agement information reports, and other forms of
trade-off between risks and returns, the objec- communication are adequate and accurate for
tive of regulators is to determine when risk the level of business activity of the institution.
exposures either become excessive relative to
the financial institution’s capital position and
financial condition or have not been identified to
the extent that the situation represents an unsafe GLOBAL RISK-MANAGEMENT
and unsound banking practice. FRAMEWORK
Determination of whether the institution’s
risk-management system can measure and con- The primary goal of risk management is to
trol its risks is of particular importance. The ensure that a financial institution’s trading,
primary components of a sound risk-management position-taking, credit extension, and opera-
process are a comprehensive risk-measurement tional activities do not expose it to losses that
approach; a detailed structure of limits, guide- could threaten the viability of the firm. Global
lines, and other parameters used to govern risk risk management is ultimately the responsibility
taking; and a strong management information of senior management and the board of direc-
system for monitoring and reporting risks. These tors; it involves setting the strategic direction of
components are fundamental to both trading and the firm and determining the firm’s tolerance for
nontrading activities. Moreover, the underlying risk. The examiner should verify that the risk
risks associated with these activities, such as management of capital-markets and trading
market, credit, liquidity, operations, and legal activities is embedded in a strong global (firm-
risks, are not new to banking, although their wide) risk-management system, and that senior
measurement can be more complex for trading management and the directors are actively in-
activities than for lending activities. Accord- volved in overseeing the risk management of
ingly, the process of risk management for capital- capital-markets products.
markets and trading activities should be inte-
grated into the institution’s overall risk-
management system to the fullest extent possible Role of Senior Management
using a conceptual framework common to the and the Board of Directors
financial institution’s other business activities.
Such a common framework enables the institu- Senior management and the board of directors
tion to consolidate risk exposure more effec- have a responsibility to fully understand the
tively, especially since the various individual risks involved in the institution’s activities,
risks involved in capital-markets and trading question line management about the nature and
activities can be interconnected and may tran- management of those risks, set high standards
scend specific markets. for prompt and open discussion of internal
The examiner must apply a multitude of control problems and losses, and engage man-
analyses to appropriately assess the risk- agement in discussions regarding the events or
management system of an institution. The developments that could expose the firm to
assessment of risk-management systems and substantial loss. The commitment to risk man-
controls may be performed in consideration of agement in any organization should be clearly
the type of risk, the type of instrument, or by delineated in practice and codified in written
function or activity. The examiner must become policies and procedures approved by the board
familiar with the institution’s range of business of directors. These policies should be consistent
activities, global risk-management framework, with the financial institution’s broader business
risk-measurement models, and system of inter- strategies and overall willingness to take risk.
nal controls. Furthermore, the examiner must Accordingly, the board of directors should be
assess the qualitative and quantitative assump- informed regularly of the risk exposure of the
tions implicit in the risk-management system institution and should regularly reevaluate the
as well as the effectiveness of the institution’s organization’s exposure and its risk tolerance
approach to controlling risks. The examiner regarding these activities. Middle and senior
Trading and Capital-Markets Activities Manual February 1998
Page 1
2000.1 Overview of Risk Management in Trading Activities
management, including trading and control staff, adequately identifies the major risks to which
should be well versed in the risk-measurement the institution is exposed. The global risk-
and risk-management methodology of the finan- management system should cover all areas of
cial institution. the institution, including ‘‘special portfolios’’
Senior management is responsible for ensur- such as exotic currency and interest-rate options
ing that adequate policies and procedures for or specially structured derivatives. At a mini-
conducting long-term and day-to-day activities mum, the global risk-management system should
are in place. This responsibility includes ensur- provide for the separate institution-wide mea-
ing clear delineations of responsibility for man- surement and management of credit, market,
aging risk, adequate systems for measuring risk, liquidity, legal, and operational risk.
appropriately structured limits on risk taking, The evaluation of the firm’s institution-wide
effective internal controls, and a comprehensive risk relative to the firm’s capital, earnings
risk-reporting process. capacity, market liquidity, and professional and
The risk-management mandate from senior technological resources is an essential responsi-
management and the board of directors should bility of senior management. The examiner
include— should also verify that senior management over-
sees each of the major risk categories (credit,
• identifying and assessing risks market, liquidity, operational, and legal risk).
• establishing policies, procedures, and risk Examiners should ascertain whether the finan-
limits cial institution has an effective process to evalu-
• monitoring and reporting compliance with ate and review the risks involved in products
limits that are (1) either new to the firm or new to the
• delineating capital allocation and portfolio marketplace and (2) of potential interest to the
management firm. In general, a bank should not trade a
• developing guidelines for new products and product until senior management and all rele-
including new exposures within the current vant personnel (including those in risk manage-
framework ment, internal control, legal, accounting, and
• applying new measurement methods to exist- audit) understand the product and are able to
ing products integrate the product into the financial institu-
tion’s risk-measurement and control systems.
The limit structure should reflect the risk- Examiners should determine whether the finan-
measurement system in place, as well as the cial institution has a formal process for review-
financial institution’s tolerance for risk, given its ing new products and whether it introduces new
risk profile, activities, and management’s objec- products in a manner that adequately limits
tives. The limit structure should also be consis- potential losses.
tent with management’s experience and the Financial institutions active in the derivatives
overall financial strength of the institution. markets generate many new products that are
In addition, senior management and the board variants of existing instruments they offer. In
of directors are responsible for maintaining the evaluating whether these products should be
institution’s activities with adequate financial subject to the new-product-evaluation process,
support and staffing to manage and control the examiners should consider whether the firm has
risks of its activities. Highly qualified personnel adequately identified and aggregated all signifi-
must staff not only front-office positions such as cant risks. In general, all significant structural
trading desks, relationship or account officers, variations in options products should receive
and sales, but also all back-office functions some form of new-product review, even when
responsible for risk management and internal the firm is dealing in similar products.
control.
ORGANIZATIONAL STRUCTURE
Comprehensiveness of the OF RISK MANAGEMENT
Risk-Management System
Examiners should evaluate the company’s orga-
The examiner should verify that the global risk- nizational structure and job descriptions to make
management system is comprehensive and sure that there is a clear understanding of the
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Overview of Risk Management in Trading Activities 2000.1
appropriate personnel interaction required to occur in the normal course of business can be
control risk. In particular, measuring and setting accomplished through either centralized or
parameters for the total amount of various risks decentralized structures. The choice of approach
facing the institution are distinct functions that should reflect the organization’s risk profile,
should be clearly separated from the day-to-day trading philosophy, and strategy. In a highly
management of risks associated with the normal decentralized structure, examiners should ascer-
flow of business. Normally, these parameters tain that adequate controls are in place to ensure
should be managed independently by senior the integrity of the aggregate information pro-
management, with approval from the institu- vided to senior management and the board of
tion’s board of directors. directors.
The trading-risk-management role within an Trading positions must be accurately trans-
organization includes defining trading-risk- mitted to the risk-measurement systems. The
management policies, setting uniform standards appropriate reconciliations should be performed
of risk assessment and capital allocation, pro- to ensure data integrity across the full range of
viding senior management with global risk products, including new products that may be
reporting and evaluation, monitoring compli- monitored apart from the main processing net-
ance with limits, and assisting in strategic plan- works. Management reports should be reviewed
ning related to risk management. to determine the frequency and magnitude of
In some organizations, risk management has a limit excesses over time. Traders, risk manag-
control or policing function; in others, it is a ers, and senior management should be able to
counselor to the trading-operations area. Regard- define constraints on trading and justify identi-
less of how it is implemented, the risk- fied excesses. The integrity of the management
management function should have reporting lines information system is especially important in
that are fully independent of the trading groups. this regard (See section 2040.1, ‘‘Operations
When defining an institution’s exposures, risk and Systems Risk (Management Information
managers must address all risks, those that are Systems)’’.) Examiners should also review and
easily quantifiable and those that are not. Many assess the compensation arrangements of risk-
trading risks lend themselves to common management staff to ensure that there are no
financial-estimation methods. Quantifiable risks incentives which may conflict with maintaining
related to price changes should be applied con- the integrity of the risk-control system.
sistently to derive realistic estimates of market
exposure. Consequently, examiners must subjec-
tively and pragmatically evaluate an institu-
tion’s risk related to capital-markets and trading Measurement of Risks
activities.
The risk measurement and management of an The increasing globalization and complexity of
institution will only be as strong as its internal capital markets and the expanding range of
control system. Effective internal control mecha- esoteric financial instruments have made trading-
nisms for monitoring risk require that risk man- risk management more difficult to accomplish
agers maintain a level of independence from the and evaluate. Fortunately, a number of com-
trading and marketing functions—a requirement monly used risk-measurement systems have been
not only for the development of the conceptual developed to assist financial institutions in evalu-
framework applied but for determining the appli- ating their unique combinations of risk expo-
cable parameters used in daily evaluations of sures. These systems all aim to identify the risks
market risks. This function would be respon- associated with particular business activities and
sible for measuring risk, setting risk parameters, group them into generic components, resulting
identifying risk vulnerabilities, monitoring risk in a single measure for each type of risk. These
limits, and evaluating or validating pricing and systems also allow institutions to manage risks
valuation models. Examiners should ascertain on a portfolio basis and to consider exposures in
that the financial institution has some form of relation to the institution’s global strategy and
independent risk management and that manage- risk profile.
ment information is comprehensive and reported Managing the residual exposure or net posi-
to senior management on a frequency commen- tion of a portfolio, instead of separate transac-
surate with the level of trading activity. tions and positions, provides two important
The day-to-day management of risks that benefits: a better understanding of the port-
Trading and Capital-Markets Activities Manual February 1998
Page 3
2000.1 Overview of Risk Management in Trading Activities
folio’s exposure and more efficient hedging. A often lead to improvements in procedures, data
market maker’s portfolio benefits from econo- processing systems, and contingency plans that
mies of scale in market-risk management significantly reduce operational risk.
because large portfolios tend to contain natu- Examiners should ascertain whether manage-
rally offsetting positions, which may signifi- ment has considered the largest losses which
cantly reduce the overall market risk. Hedging might arise during adverse events, even sce-
the residual risk of the net portfolio position narios which the financial institution may con-
rather than individual transactions greatly sider fairly remote possibilities. The evaluation
reduces transactions costs. A portfolio-focused of worst-case scenarios does not suggest that the
management approach reduces the complexity limits themselves must reflect the outcomes of a
of position tracking and management. worst-case scenario or that the financial institu-
All major risks should be measured explicitly tion would be imprudent to assume risk posi-
and consistently and integrated into the firm- tions that involve large losses if remote events
wide risk-management system. Systems and were to occur. However, financial institutions
procedures should recognize that measurement should have a sense of how large this type of
of some types of risk is an approximation and risk might be and how the institution would
that some risks, such as the market liquidity of a manage its positions if such an event occured.
marketable instrument, can be very difficult to Evaluation of such scenarios is crucial to risk
quantify and can vary with economic and mar- management since significant deviations from
ket conditions. Nevertheless, at a minimum, the past experience do occur, such as the breakdown
vulnerabilities of the firm to these risks should in 1992 and 1993 of the traditionally high
be explicitly assessed on an ongoing basis in correlation of the movements of the dollar and
response to changing circumstances. other European currencies of the European
Sound risk-measurement practices include the monetary system.
careful and continuous identification of possible An institution’s exposures should be moni-
events or changes in market behavior that could tored against limits by control staff who are fully
have a detrimental impact on the financial insti- independent of the trading function. The process
tution. The financial institution’s ability to with- for approving limit excesses should require that,
stand economic and market shocks points to the before exceeding limits, trading personnel
desirability of developing comprehensive and obtain at least oral approval from senior man-
flexible data-management systems. agement independent of the trading area. The
organization should require written approval of
limit excesses and maintenance of such docu-
Risk Limits mentation. Limits need not be absolute; how-
ever, appropriate dialogue with nontrading senior
The risk-management system should include a management should take place before limits are
sound system of integrated institution-wide risk exceeded. Finally, senior management should
limits that should be developed under the direc- properly address repeated limit excesses and
tion of and approved by senior management and divergences from approved trading strategies.
the board of directors. The established limits
Procedures should address the frequency of
structure should apply to all risks arising from
limit review, method of approval, and authority
an institution’s activities. For credit and market
required to change limits. Relevant management
risk, in particular, limits on derivatives should
reports and their routing through the organiza-
be directly integrated with institution-wide lim-
tion should be delineated.
its on those risks as they arise in all other
activities of the firm. When risks are not quan-
tifiable, management should demonstrate an Maintenance Issues
awareness of their potential impact.
In addition to credit risk and market risk, Complex instruments require sound analytical
limits or firm guidelines should be established to tools to assess their risk. These tools are
address liquidity and funding risk, operational grounded in rigorous financial theory and math-
risk, and legal risk. Careful assessment of ematics. As an institution commits more resources
operational risk by the financial institution is to structured products, complex cash instru-
especially important, since the identification of ments, or derivatives, existing staff will be
vulnerabilities in the operational process can required to develop an understanding of the
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Overview of Risk Management in Trading Activities 2000.1
methodologies applied. Institutions should not plex products. Internal auditors should also
create an environment in which only trading test compliance with risk limits and evaluate
staff can evaluate market risk; information on the reliability and timeliness of information
new products and their attendant risks should be reported to the financial institution’s senior man-
widely disseminated. agement and the board of directors. Internal
Concurrent with the review of the existing auditors are also expected to evaluate the inde-
risk-management framework, the resources pro- pendence and overall effectiveness of the finan-
vided to maintain the integrity of the risk- cial institution’s risk-management functions.
measurement system should be evaluated. The level of confidence that examiners place
Limits should be reviewed at least annually. in the audit work, the nature of the audit
Assumptions underlying the established limits findings, and management’s response to those
should be reviewed in the context of changes in findings will influence the scope of the current
strategy, the risk tolerance of the institution, or examination. Even when the audit process and
market conditions. Automated systems should findings are satisfactory, examiners should test
be upgraded to accommodate increased volumes critical internal controls, including the revalua-
and added financial complexity, either in apply- tion process, the credit-approval process, and
ing new valuation methodologies or implement- adherence to established limits. Significant
ing tools to evaluate new products. Products changes in product lines; modeling; or risk-
that are recorded ‘‘off-line,’’ that is, not on the management methodologies, limits, and internal
mainframe or LAN (linked personal computers), controls should receive special attention. Sub-
should provide automated data feeds to the stantial changes in earnings from capital-markets
risk-measurement systems to reduce the inci- and trading activities, in the size of positions, or
dence of manual error. the value-at-risk associated with these activities
should also be investigated during the examina-
tion. These findings and evaluations and other
Internal Controls and Audits factors, as appropriate, should be the basis for
decisions to dedicate greater resources to exam-
A review of internal controls has long been ining the trading functions.
central to the examination of capital-markets
and trading activities. The examiner should
review the system of internal controls to ensure
that they promote effective and efficient opera-
SOUND PRACTICES
tions; reliable financial and regulatory reporting; Capital-markets and trading operations vary sig-
and compliance with relevant laws and regu- nificantly among financial institutions, depend-
lations, safe and sound banking practices, and ing on the size of the trading operation, trading
policies of the board of directors and manage- and management expertise, organizational struc-
ment. Evaluating the ability of internal controls tures, the sophistication of computer systems,
to achieve these objectives involves understand- the institution’s focus and strategy, historical
ing and documenting adherence to control and expected income, past problems and losses,
activities such as approvals, verifications, and risks, and types and sophistication of the trading
reconciliations. products and activities. As a result, the risk-
When evaluating internal controls, examiners management practices, policies, and procedures
should consider the frequency, scope, and find- expected in one institution may not be necessary
ings of internal and external audits and the in another. With these caveats in mind, a list of
ability of those auditors to review the capital- sound practices for financial institutions actively
markets and trading activities. Internal auditors engaged in capital-markets and trading opera-
should audit and test the risk-management pro- tions follows:
cess and internal controls periodically, with the
frequency based on a careful risk assessment. • Every organization should have a risk-
Adequate test work should be conducted to management function that is independent of
re-create summary risk factors in management its trading staff.
reports from exposures in the trading position. • Every organization should have a risk-
This may include validation of risk-measurement management policy that is approved by the
algorithms independent of the trading or control board of directors annually. The policy should
functions with special emphasis on new, com- outline products traded, parameters for risk
Trading and Capital-Markets Activities Manual February 1998
Page 5
2000.1 Overview of Risk Management in Trading Activities
activities, the limit structure, over-limit- • Counterparty credit exposure on derivative
approval procedures, and frequency of review. transactions should be measured on a
In addition, every organization should have a replacement-cost and potential-exposure basis.
process to periodically review limit policies, Every organization should perform a periodic
pricing assumptions, and model inputs under assessment of credit exposure to redefine
changing market conditions. In some markets, statistical parameters used to derive potential
frequent, high-level review of such factors exposure.
may be warranted. • With regard to credit risk, any organization
• Every organization should have a new-product that employs netting should have a policy
policy that requires review and approval by all related to netting agreements. Appropriate
operational areas affected by such transactions legal inquiry should be conducted to deter-
(for example, risk management, credit man- mine enforceability by jurisdiction and coun-
agement, trading, accounting, regulatory terparty type. Netting should be implemented
reporting, back office, audit, compliance, and only when legally enforceable.
legal). This policy should be evidenced by an • Every organization should have middle and
audit trail of approvals before a new product is senior management inside and outside the
introduced. trading room who are familiar with the stated
• Every organization should be able to aggre- philosophy on market and credit risk. Also,
gate each major type of risk on a single pricing methods employed by the traders
common basis, including market, credit, and should be well understood.
operational risks. Ideally, risks would be evalu- • Every organization should be cognizant of
ated within a value-at-risk framework to deter- nonquantifiable risks (such as operational
mine the overall level of risk to the institution. risks), have an approach to assessing them,
The risk-measurement system should also per- and have guidelines and trading practices to
mit disaggregation of risk by type and by control them.
customer, instrument, or business unit to • Every organization with a high level of trad-
effectively support the management and con- ing activity should be able to demonstrate that
trol of risks. it can adjust strategies and positions under
• Every organization should have a methodol- rapidly changing market conditions and crisis
ogy to stress test the institution’s portfolios situations on a timely basis.
with respect to key variables or events to • For business lines with high levels of activity,
create plausible worst-case scenarios for risk management should be able to review
review by senior management. The limit struc- exposures on an intraday basis.
ture of the institution should consider the • Management information systems should pro-
results of the stress tests. vide sufficient reporting for decision making
• Every organization should have an integrated on market and credit risks, as well as opera-
management information system that controls tional data including profitability, unsettled
market risks and provides comprehensive items, and payments.
reporting. The sophistication of the system • A periodic compliance review should be con-
should match the level of risk and complexity ducted to ensure conformity with federal,
of trading activity. Every institution should state, and foreign securities laws and regula-
have adequate financial applications in place tory guidelines.
to quantify and monitor risk positions and to • Every institution should have a compensation
process the variety of instruments currently system that does not create incentives which
in use. A minimum of manual intervention may conflict with maintaining the integrity of
should be required to process and monitor the risk-control system.
transactions. • Auditors should perform a comprehensive
• Risk management or the control function review of risk management annually, empha-
should be able to produce a risk-management sizing segregation of duties and validation of
report that highlights positions, limits, and data integrity. Additional test work should be
excesses on a basis commensurate with trad- performed when numerous new products or
ing activity. This report should be sent to models are introduced. Models used by both
senior management, reviewed, signed, and the front and back offices should be reassessed
returned to control staff. periodically to ensure sound results.
February 1998 Trading and Capital-Markets Activities Manual
Page 6
Market Risk
Section 2010.1
Market risk is the potential that changes in the tional elements such as stop-loss limits and
market prices of an institution’s holdings may other trading guidelines that may play an impor-
have an adverse effect on its financial condition. tant role in controlling risk at the trader and
The four most common market-risk factors are business-unit level. All limits should be appro-
interest rates, foreign-exchange rates, equity priately enforced and adequate internal controls
prices, and commodity prices. The market risk should exist to ensure that any exceptions to
of both individual financial instruments and limits are detected and adequately addressed by
portfolios of instruments can be a function of management.
one, several, or all of these basic factors and, in
many cases, can be significantly complex. The
market risks arising from positions with options,
either explicit or embedded in other instruments,
TYPES OF MARKET RISKS
can be especially complex and difficult to man-
age. Institutions should ensure that they ade- Interest-Rate Risk
quately measure, monitor, and control the mar-
ket risks involved in their trading activities. Interest-rate risk is the potential that changes in
interest rates may adversely affect the value of a
The measurement of market risk should take
financial instrument or portfolio, or the condi-
due account of hedging and diversification effects
tion of the institution as a whole. Although
and should recognize generally accepted mea-
interest-rate risk arises in all types of financial
surement techniques and concepts. Although
instruments, it is most pronouced in debt instru-
several types of approaches are available for
ments, derivatives that have debt instruments
measuring market risk, institutions have increas-
as their underlying reference asset, and other
ingly adopted the ‘‘value-at-risk’’ approach for
derivatives whose values are linked to market
their trading operations. Regardless of the spe-
interest rates. In general, the values of longer-
cific approach used, risk measures should be
term instruments are often more sensitive to
sufficiently accurate and rigorous to adequately
interest-rate changes than the values of shorter-
reflect all of an institution’s meaningful market-
term instruments.
risk exposure and should be adequately incor-
Risk in trading activities arises from open or
porated into the risk-management process.
unhedged positions and from imperfect correla-
Risk monitoring is the foundation of an effec- tions between offsetting positions. With regard
tive risk-management process. Accordingly, in- to interest-rate risk, open positions arise most
stitutions should ensure that they have adequate often from differences in the maturities or
internal reporting systems that address their repricing dates of positions and cash flows that
market-risk exposures. Regular reports with are asset-like (i.e., ‘‘longs’’) and those that are
appropriate detail and frequency should be pro- liability-like (i.e., ‘‘shorts’’). The exposure that
vided to the various levels of trading operations such ‘‘mismatches’’ represent to an institution
and senior management, from individual traders depends not only on each instrument’s or posi-
and trading desks to business-line management tion’s sensitivity to interest-rate changes and the
and senior management and, ultimately, the amount held, but also on how these sensitivities
board of directors. are correlated within portfolios and, more
A well-constructed system of limits and poli- broadly, across trading desks and business lines.
cies on acceptable levels of risk exposure is a In sum, the overall level of interest-rate risk in
particularly important element of risk control in an open portfolio is determined by the extent to
trading operations. Financial institutions should which the risk characteristics of the instruments
establish limits for market risk that relate to their in that portfolio interact.
risk measures and are consistent with maximum Imperfect correlations in the behavior of off-
exposures authorized by their senior manage- setting or hedged instruments in response to
ment and board of directors. These limits can changes in interest rates—both across the yield
be allocated to business units, product lines, or curve and within the same maturity or repricing
other appropriate organizational units and should category—can allow for significant interest-rate
be clearly understood by all relevant parties. In risk exposure. Offsetting positions with different
practice, some limit systems often include addi- maturities, although theoretically weighted to
Trading and Capital-Markets Activities Manual February 1998
Page 1
2010.1 Market Risk
create hedged positions, may be exposed to markets pose particular challenges to the effec-
imperfect correlations in the underlying refer- tiveness of foreign-currency hedging strategies.
ence rates. Such ‘‘yield curve’’ risk can arise in
portfolios in which long and short positions of
different maturities are well hedged against a
change in the overall level of interest rates, but
Equity-Price Risk
not against a change in the shape of the yield
Equity-price risk is the potential for adverse
curve when interest rates of different maturities
changes in the value of an institution’s equity-
change by varying amounts.
related holdings. Price risks associated with
Imperfect correlation in rates and values of equities are often classified into two categories:
offsetting positions within a maturity or repric- general (or undiversifiable) equity risk and spe-
ing category can also be a source of significant cific (or diversifiable) equity risk.
risk. This ‘‘basis’’ risk exists when offseting ‘‘General equity-price risk’’ refers to the sen-
positions have different and less than perfectly sitivity of an instrument’s or portfolio’s value to
correlated coupon or reference rates. For exam- changes in the overall level of equity prices. As
ple, three-month interbank deposits, three- such, general risk cannot be reduced by diver-
month Eurodollars, and three-month Treasury sifying one’s holdings of equity intruments.
bills all pay three-month interest rates. However, Many broad equity indexes, for example, prima-
these three-month rates are not perfectly corre- rily involve general market risk.
lated with each other, and spreads between their Specific equity-price risk refers to that portion
yields may vary over time. As a result, three- of an individual equity instrument’s price vola-
month Treasury bills, for example, funded by tility that is determined by the firm-specific
three-month Eurodollar deposits, represent an characteristics. This risk is distinct from market-
imperfectly offset or hedged position. One vari- wide price fluctuations and can be reduced by
ant of basis risk that is central to the manage- diversification across other equity instruments.
ment of global trading risk is ‘‘cross-currency By assembling a portfolio with a sufficiently
interest-rate risk,’’ that is, the risk that compa- large number of different securities, specific risk
rable interest rates in different currency markets can be greatly reduced because the unique
may not move in tandem. fluctuations in the price of any single equity will
tend to be canceled out by fluctuations in the
opposite direction of prices of other securities,
Foreign-Exchange Risk leaving only general-equity risk.
Foreign-exchange risk is the potential that move-
ments in exchange rates may adversely affect Commodity-Price Risk
the value of an institution’s holdings and, thus,
its financial condition. Foreign-exchange rates Commodity-price risk is the potential for ad-
can be subject to large and sudden swings, and verse changes in the value of an institution’s
understanding and managing the risk associated commodity-related holdings. Price risks associ-
with exchange-rate volatility can be especially ated with commodities differ considerably from
complex. Although it is important to acknowl- interest-rate and foreign-exchange-rate risk and
edge exchange rates as a distinct market-risk require even more careful monitoring and man-
factor, the valuation of foreign-exchange instru- agement. Most commodities are traded in mar-
ments generally requires knowledge of the be- kets in which the concentration of supply can
havior of both spot exchange rates and interest magnify price volatility. Moreover, fluctuations
rates. Any forward premium or discount in the in market liquidity often accompany high price
value of a foreign currency relative to the volatility. Therefore, commodity prices gener-
domestic currency is determined largely by ally have higher volatilities and larger price
relative interest rates in the two national discontinuities than most commonly traded
markets. financial assets. An evaluation of commodity-
As with all market risks, foreign-exchange price risk should be performed on a market-by-
risk arises from both open or imperfectly offset market basis and include not only an analysis of
or hedged positions. Imperfect correlations historical price behavior, but also an assessment
across currencies and international interest-rate of the structure of supply and demand in the
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Market Risk 2010.1
marketplace to evaluate the potential for unusu- Adequate controls should be imposed on all
ally large price movements. elements of the process for market-risk measure-
ment and monitoring, including the gathering
and transmission of data on positions, market
factors and market conditions, key assumptions
OPTIONS and parameters, the calculation of the risk mea-
sures, and the reporting of risk exposures through
Exposure to any and all of the various types of appropriate chains of authority and responsibil-
market risk can be significantly magnified by the ity. Moreover, all of these elements should be
presence of explicit or embedded options in subject to internal validation and independent
instruments and portfolios. Moreover, assessing review.
the true risk profile of options can be complex. In most institutions, computer models are
Under certain conditions, the significant lever- used to measure market risk. Even within a
age involved in many options can translate small single organization, a large number of models
changes in the underlying reference instrument may be used, often serving different purposes.
into large changes in the value of the option. For example, individual traders or desks may
Moreover, an option’s value is, in part, highly use ‘‘quick and dirty’’ models that allow speedy
dependent on the likelihood or probability that it evaluation of opportunities and risks, while
may become profitable to exercise in the future. more sophisticated and precise models are
In turn, this probability can be affected by needed for daily portfolio revaluation and for
several factors including the time to expiration systematically evaluating the overall risk of the
of the option and the volatility of the underlying institution and its performance against risk lim-
reference instrument. Accordingly, factors other its. Models used in the risk-measurement and
than changes in the underlying reference instru- front- and back-office control functions should
ment can lead to changes in the value of the be independently validated by risk-management
option. For example, as the price variability of staff or by internal or outside auditors.
the reference instrument increases, the probabil- Examiners should ensure that institutions have
ity that the option becomes profitable increases. internal controls to check the adequacy of the
Therefore, a change in the market’s assessment valuation parameters, algorithms, and assump-
of volatility can affect the value of an option tions used in market-risk models. Specific con-
even without any change in the current price of siderations with regard to the oversight of mod-
the underlying asset. els used in trading operations and the adequacy
The presence of option characteristics is a of reporting systems are discussed in sections
major complicating factor in managing the mar- 2100 and 2110, ‘‘Financial Performance’’ and
ket risks of trading activities. Institutions should ‘‘Capital Adequacy of Trading Activities,’’
ensure that they fully understand, measure, and respectively.
control the various sources of optionality influ-
encing their market-risk exposures. Measure-
ment issues arising from the presence of options Basic Measures of Market Risk
are addressed more fully in the instrument
profile on options (section 4330.1). Nominal Measures
Nominal or notional measurements are the most
basic methodologies used in market-risk man-
MARKET-RISK MEASUREMENT agement. They represent risk positions based on
the nominal amount of transactions and hold-
There are a number of methods for measuring ings. Typical nominal measurement methods
the various market risks encountered in trading may summarize net risk positions or gross risk
operations. All require adequate information on positions. Nominal measurements may also be
current positions, market conditions, and instru- used in conjunction with other risk-measurement
ment characteristics. Regardless of the methods methodologies. For example, an institution may
used, the scope and sophistication of an institu- use nominal measurements to control market
tion’s measurement systems should be commen- risks arising from foreign-exchange trading while
surate with the scale, complexity, and nature of using duration measurements to control interest-
its trading activities and positions held. rate risks.
Trading and Capital-Markets Activities Manual February 1998
Page 3
2010.1 Market Risk
For certain institutions with limited, noncom- U.S. Treasury security. The institution can then
plex risk profiles, nominal measures and con- aggregate the instruments and evaluate the risk
trols based on them may be sufficient to ade- as if the instruments were a single position in the
quately control risk. In addition, the ease of common base.
computation in a nominal measurement system While basic factor-sensitivity measures can
may provide more timely results. However, provide useful insights, they do have certain
nominal measures have several limitations. limitations—especially in measuring the expo-
Often, the nominal size of an exposure is an sure of complex instruments and portfolios. For
inaccurate measure of risk since it does not example, they do not assess an instrument’s
reflect price sensitivity or price volatility. This is convexity or volatility and can be difficult to
especially the case with derivative instruments. understand outside of the context of market
Also, for sophisticated institutions, nominal mea- events. Examiners should ensure that factor-
sures often do not allow an accurate aggregation sensitivity measures are used appropriately and,
of risks across instruments and trading desks. where necessary, supported with more sophisti-
cated measures of market-risk exposure.
Factor-Sensitivity Measures
Basic factor-sensitivity measures offer a some- Basic Measures of Optionality
what higher level of measurement sophistication
than nominal measures. As the name implies, At its most basic level, the value of an option
these measures gauge the sensitivity of the value can generally be viewed as a function of the
of an instrument or portfolio to changes in a price of the underlying instrument or reference
primary risk factor. For example, the price value rate relative to the exercise price of the option,
of a basis point change in yield and the concept the volatility of the underlying instrument or
of duration are often used as factor-sensitivity reference rate, the option contract’s time to
measures in assessing the interest-rate risk of expiration, and the level of market interest rates.
fixed-income instruments and portfolios. Beta, Institutions may use simple measures of each of
or the measure of the systematic risk of equities, these elements to identify and manage the mar-
is often considered a first-order sensitivity mea- ket risks of their option positions, including the
sure of the change in an equity-related instru- following:
ment or portfolio to changes in broad equity
indexes. • ‘‘Delta’’ measures the degree to which the
Duration provides a useful illustration of a option’s value will be affected by a (small)
factor-sensitivity measure. Duration measures change in the price of the underlying
the sensitivity of the present value or price of a instrument.
financial instrument with respect to a change in • ‘‘Gamma’’ measures the degree to which the
interest rates. By calculating the weighted aver- option’s delta will change as the instrument’s
age duration of the instruments held in a port- price changes; a higher gamma typically
folio, the price sensitivity of different instru- implies that the option has greater value to its
ments can be aggregated using a single basis holder.
that converts nominal positions into an overall • ‘‘Vega’’ measures the sensitivity of the option
price sensitivity for that portfolio. These port- value to changes in the market’s expectations
folio durations can then be used as the primary for the volatility of the underlying instrument;
measure of interest-rate risk exposure. a higher vega typically increases the value of
Alternatively, institutions can express the basic the option to its holder.
price sensitivities of their holdings in terms of • ‘‘Theta’’ measures how much an option’s
one representative instrument. Continuing the value changes as the option moves closer to its
example using duration, an institution may con- expiration date; a higher theta is typically
vert its positions into the duration equivalents of associated with a higher option value to its
one reference instrument such as a four-year holder.
U.S. Treasury, three-month Eurodollar, or some • ‘‘Rho’’ measures how an option’s value
other common financial instrument. For exam- changes in response to a change in short-term
ple, all interest-rate risk exposures might be interest rates; a higher rho typically is associ-
converted into a dollar amount of a ‘‘two-year’’ ated with a lower option value to its holder.
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Market Risk 2010.1
Measurement issues arising from the presence term movements in the prices of many financial
of options are addressed more fully in the instruments are not normally distributed, in
instrument profile on options (section 4330.1). particular, that the probability of extreme move-
ments is considerably higher than would be
predicted by an application of the normal distri-
bution. Accordingly, more sophisticated institu-
Scenario Simulations tions use more complex volatility-measurement
techniques to define appropriate scenarios.
Another level of risk-exposure measurement is A particularly important consideration in con-
the direct estimation of the potential change in ducting scenario simulations is the interactions
the value of instruments and portfolios under and relationships between positions. These
specified scenarios of changes in risk factors. On interrelationships are often identified explicitly
a simple basis, changes in risk factors can be with the use of correlation coefficients. A cor-
applied to factor-sensitivity measures such as relation coefficient is a quantitative measure of
duration or the present value of a basis point the extent to which changes in one variable are
to derive a change in value under the selected related to another. The magnitude of the coeffi-
scenario. These scenarios can be arbitrarily cient measues the likelihood that the two vari-
determined or statistically inferred either from ables will move together in a linear relationship.
analyzing historical data on changes in the Two variables (that is, instrument prices) whose
appropriate risk factor or from running multiple movements correspond closely would have a
forecasts using a modeled or assumed stochastic correlation coefficient close to 1. In the case
process that describes how a risk factor may of inversely related variables, the correlation
behave under certain circumstances. In statisti- coefficient would be close to −1.
cal inference, a scenario is selected based on the Conceptually, using correlation coefficients
probability that it will occur over a selected time allows an institution to incorporate multiple risk
horizon. A simple statistical measure used to factors into a single risk analysis. This is impor-
infer such probabilities is the standard deviation. tant for instruments whose value is linked to
Standard deviation is a summary measure of more than one risk factor, such as foreign-
the dispersion or variability of a random vari- exchange derivatives, and for measuring the risk
able such as the change in price of a financial of a trading portfolio. The use of correlations
instrument. The size of the standard deviation, allows the institution to hedge positions—to
combined with some knowledge of the type of partially offset long positions in a particular
probability distribution governing the behavior currency/maturity bucket with short positions in
of a random variable, allows an analyst to a different currency/maturity bucket—and to
quantify risk by inferring the probability that a diversify price risk for the portfolio as a whole
certain scenario may occur. For a random vari- in a unitary conceptual framework. The degree
able with a normal distribution, 68 percent of the to which individual instruments and positions
observed outcomes will fall within plus or are correlated determines the degree of risk
minus one (±1) standard deviation of the aver- offset or diversification. By fully incorporating
age change, 90 percent within 1.65 standard correlation, an institution may be able to express
deviations, 95 percent within 1.96 standard all positions, across all risk factors, as a single
deviations, and 99 percent within 2.58 standard risk figure.
deviations. Assuming that changes in risk fac-
tors are normally distributed, calculated stan-
dard deviations of these changes can be used to
specify a scenario that has a statistically inferred Value-at-Risk
probability of occurrence (for example, a sce-
nario that would be as severe as 95 percent or Value-at-risk (VAR) is the most common mea-
99 percent of all possible outcomes). An alter- surement technique used by trading institutions
native to such statistical inference is to use to summarize their market-risk exposures. VAR
directly observed historical scenarios and is defined as the estimated maximum loss on an
assume that their future probability of occur- instrument or portfolio that can be expected over
rence is the same as their historical frequency of a given time interval at a specified level of
occurrence. probability. Two basic approaches are generally
However, some technicians contend that short- used to forecast changes in risk factors for a
Trading and Capital-Markets Activities Manual February 1998
Page 5
2010.1 Market Risk
desired probability or confidence interval. One closing out or hedging positions may be impos-
involves direct specification of how market sible except at extremely unfavorable prices, in
factors will act using a defined stochastic pro- which case positions may be held for longer
cess and Monte Carlo techniques to simulate than envisioned. This unexpected lengthening of
multiple possible outcomes. Statistical inference the holding period will cause a portfolio’s risk
from these multiple outcomes provides expected profile to be much greater than expected because
values at some confidence interval. An alter- the likelihood of a large price change increases
native approach involves the use of historical with time (holding period), and the risk profile
changes in risk factors and parameters observed of some instruments, such as options, changes
over some defined sample period. Under this substantially as their remaining time to maturity
alternative approach, forecasts can be derived decreases.
using either variance-covariance or historical-
simulation methodologies. Variance-covariance
estimation uses standard deviations and corre-
lations of risk factors to statistically infer the
Stress Testing
probability of possible scenarios, while the
The underlying statistical methods used in daily
historical-simulation method uses actual distri-
risk measurements summarize exposures that
butions of historical changes in risk factors to
reflect the most probable market conditions.
estimate VAR at the desired confidence interval.
Market participants should periodically perform
Some organizations allocate capital to various
simulations to determine how their portfolios
divisions based on an internal transfer-pricing
will perform under exceptional conditions. The
process using measures of value-at-risk. Rates
framework of this stress testing should be
of return from each business unit are measured
detailed in the risk-management policy state-
against this capital to assess the unit’s efficiency
ment, and senior management should be regu-
as well as to determine future strategies and
larly apprised of the findings. Assumptions
commitments to various business lines. In addi-
should be critically questioned and input
tion, as explained in the section on capital
parameters altered to reflect changing market
adequacy, the internal value-at-risk models are
conditions.
used for risk-based capital purposes.
The examiner should review available simu-
Assumptions about market liquidity are likely
lations to determine the base case, as well as
to have a critical effect on the severity of
review comparable scenarios to determine
conditions used to estimate risk. Some institu-
whether the resulting ‘‘worst case’’ is suffi-
tions may estimate exposure under the assump-
ciently conservative. Similar analyses should be
tion that dynamic hedging or other rapid port-
conducted to derive worst-case credit exposures.
folio adjustments will keep risk within a given
Nonquantifiable risks, such as operational and
range even when significant changes in market
legal risks, constraints on market or product
prices occur. Dynamic hedging depends on
liquidity, and the probability of discontinuities
the existence of sufficient market liquidity to
in various trading markets, are important
execute the desired transactions at reasonable
considerations in the review process. Concerns
costs as underlying prices change. If a market-
include unanticipated political and economic
liquidity disruption were to occur, the difficulty
events which may result in market disruptions or
of executing transactions would cause the actual
distortions. This overall evaluation should include
market risk to be higher than anticipated.
an assessment of the institution’s ability to alter
To recognize the importance of market-
hedge strategies or liquidate positions. Addi-
liquidity assumptions, measures such as value-
tional attention should be committed to evaluat-
at-risk should be estimated over a number of
ing the frequency of stress tests.
different time horizons. The use of a short time
horizon, such as a day, may be useful for
day-to-day risk management. However, prudent
managers will also estimate risk over longer MARKET-RISK LIMITS
horizons, since the use of a short horizon relies
on an assumption that market liquidity will Market-risk limits are one of the most funda-
always be sufficient to allow positions to be mental controls over the risks inherent in an
closed out at minimal losses. In a crisis, the institution’s trading activities. Banks should
firm’s access to markets may be so impaired that establish limits for market risk that relate to their
February 1998 Trading and Capital-Markets Activities Manual
Page 6
Market Risk 2010.1
risk measures and are consistent with maximum tion of excessive losses in a position. Typi-
exposures authorized by their senior manage- cally, if these limits are reached, a senior
ment and board of directors. These limits should management response is required to hedge or
be allocated to business units and individual liquidate a position. These limits are usually
traders and be clearly understood by all relevant more restrictive than overall position limits.
parties. Internal controls should ensure that Typical stop-loss limits are retrospective and
exceptions to limits are detected and adequately cover cumulative losses for a day, week, or
addressed by management. In practice, some month.
limit systems include additional elements, such • Value-at-risk limits. Management may place
as stop-loss limits and trading guidelines, that limits on the extent to which the value of a
may play an important role in controlling risk at portfolio is affected by changes in underlying
the trader and business-unit level. Examiners risk factors. Limits can be specified as the
should include these elements in their review of maximum loss for a specified scenario (for
the limit system. Other institutions may have example, a 100 basis point change in rates) or
several levels of limits informally allocated by for scenarios defined at some specified confi-
product or by staff. For example, policy guide- dence level derived from internal VAR mea-
lines may give head traders substantial discre- sures (for example, 99 percent of possible
tion in allocating limits among staff. Some occurrences over a one-day time horizon).
institutions that permit traders to take positions Generally, measures of sensitivity are based
in multiple instruments may apply limits broadly on historical volatilities of risk.
across the organization, with sublevels of advi-
• Maturity gap limits. These limits enable an
sory limits when gross exposures exceed a given
institution to control the risk of adverse
percentage, such as 75 percent, of overall levels.
changes in rates for the periods designated in
When analyzing an institution’s limits, exam-
the institution’s planning time horizon. Limits
iners should evaluate the size of limits against
might range from stated absolute amounts for
the institution’s financial strength. The risks
each time frame to weighted limits that em-
resulting from full utilization of an institution’s
phasize increasing rate-movement exposure
limits should not compromise its safety and
applicable to the relative distance into the
soundness. Examiners should also evaluate the
future in which the gap appears. In addition,
percentage of limit use over time. Excessively
these limits should specify the maximum
large limits may circumvent normal reporting
maturity of the specific instrument or combi-
lines; an increase in activity or position may not
nation of instruments. Typically, institutions
be properly highlighted to senior management.
employ maturity gap limits to control risks
Conversely, overly restrictive limits which are
arising from nonparallel shifts in yield curves
frequently exceeded may undermine the disci-
and forward curves.
pline of the limit structure in place. Finally,
examiners should evaluate profitability along • Limits on options positions. An institution
with position taking. Institutions should be able should place unique limits on options posi-
to explain abnormal daily profits or losses given tions to adequately control trading risks.
the size of their positions. Options limits should include limits which
The following is a summary of limits fre- address exposures to small changes in the
quently used by financial institutions: price of the underlying instrument (delta), rate
of change in the price of the underlying
• Limits on net and gross positions. Limits may instrument (gamma), changes in the volatility
be placed on gross positions, net positions, or of the price of the underlying instrument
both. Limits on gross positions restrict the size (vega), changes in the option’s time to expi-
of a long or short position in a given instru- ration (theta), and changes in interest rates
ment. Limits on net positions, on the other (rho).
hand, attempt to recognize the natural offset of • Limits for volatile or illiquid markets. Man-
long and short positions. Institutions generally agement may choose to limit trading in espe-
should employ both types of limits in their cially volatile markets, in which losses could
risk management. accumulate quickly, or in illiquid markets, in
• Maximum allowable loss (‘‘stop-loss’’). Lim- which management may be forced to take a
its may be established to avoid the accumula- loss to close a position it cannot offset.
Trading and Capital-Markets Activities Manual February 1998
Page 7
Market Risk
Examination Objectives Section 2010.2
1. To evaluate the organizational structure of understand the potential market exposures
the market-risk-management function. of the capital-markets and trading activities
2. To evaluate the adequacy of internal market- of the institution.
risk-management policies and procedures 7. To ensure that business-level management
for capital-markets and trading activities has formulated contingency plans for
and to determine that actual operating prac- illiquid market conditions.
tices reflect such policies. 8. To review management information sys-
3. To identify the market risks of the insti- tems for comprehensive coverage of market
tution. risks.
4. To determine if the institution’s market-risk- 9. To assess the effectiveness of the global
measurement system has been correctly risk-management system and determine if it
implemented and adequately measures the can evaluate market, liquidity, credit, opera-
institution’s market risks. tional, and legal risks and that management
5. To determine how the institution measures at the highest level is aware of the institu-
nonstandard products such as exotic options, tion’s global exposure.
structured financings, and certain mortgage- 10. To recommend corrective action when poli-
backed securities. cies, procedures, practices, internal con-
6. To determine if senior management and the trols, or management information systems
board of directors of the financial institution are found to be deficient.
Trading and Capital-Markets Activities Manual February 1998
Page 1
Market Risk
Examination Procedures Section 2010.3
These procedures list processes and activities and limits. Determine whether the risk-
that may be reviewed during a full-scope exami- measurement model and methodology
nation. The examiner-in-charge will establish adequately address all identified market
the general scope of examination and work with risks and are appropriate for the institu-
the examination staff to tailor specific areas for tion’s activities.
review as circumstances warrant. As part of this b. Review contingency market-risk plans
process, the examiner reviewing a function or for adequacy.
product will analyze and evaluate internal audit c. Check that limits are in place for market
comments and previous examination work- exposures before transacting a deal. If
papers to assist in designing the scope of exami- the financial institution relies on one-off
nation. In addition, after a general review of a approvals, check that the approval pro-
particular area to be examined, the examiner cess is well documented.
should use these procedures, to the extent they d. Review accounting and revaluation poli-
are applicable, for further guidance. Ultimately, cies and procedures. Determine that
it is the seasoned judgment of the examiner and revaluation procedures are appropriate.
the examiner-in-charge that determines which 4. Determine the credit rating and market
procedures are warranted in examining any acceptance of the financial institution as a
particular activity. counterparty in the markets.
5. Obtain all management information analyz-
1. Review the market-risk-management ing market risk.
organization. a. Determine the comprehensiveness, accu-
a. Check that the institution has a market- racy, and integrity of analysis.
risk-management function with sepa- b. Review valuation and simulation meth-
rate reporting lines from traders and ods in place.
marketers. c. Review stress tests, analyzing changes in
b. Determine if market-risk-control person- market conditions.
nel have sufficient credibility in the finan- d. Determine whether the management
cial institution to question traders’ and information reports accurately reflect
marketers’ decisions. risks and that reports are provided to the
c. Determine if market-risk management is appropriate level of management.
involved in new-product discussions. 6. Determine if any recent market disruptions
2. Identify the institution’s capital-markets and have affected the institution’s trading activi-
trading activities and the related balance- ties. If so, determine the institution’s market
sheet and off-balance-sheet instruments. response.
Obtain copies of all risk-management 7. Establish that the financial institution is
reports prepared by the institution. following its internal policies and proce-
a Define the use and purpose of the insti- dures. Determine whether the established
tution’s capital-markets products. limits adequately control the range of mar-
b. Define the institution’s range, scope, and ket risks. Determine whether management
size of risk exposures. Determine the is aware of limit excesses and takes appro-
products in which the institution makes priate action when necessary.
markets. Determine the hedging instru- 8. Determine whether the institution has estab-
ments used to hedge these products. lished an effective audit trail that summa-
c. Evaluate market-risk-control personnel’s rizes exposures and management approvals
demonstrated knowledge of the products with the appropriate frequency.
traded by the financial institution and 9. Determine whether management considered
their understanding of current and poten- the full range of exposures when establish-
tial exposures. ing capital-at-risk exposures.
3. Obtain and evaluate the adequacy of risk- a. Determine if the financial institution
management policies and procedures for established capital-at-risk limits which
capital-markets and trading activities. address both normal and distressed mar-
a. Review market-risk policies, procedures, ket conditions.
Trading and Capital-Markets Activities Manual February 1998
Page 1
2010.3 Market Risk: Examination Procedures
b. Determine if senior management and the 11. Based on information provided, determine
board of directors are advised of market- the institution’s exposure from dynamic
risk exposures in times of market dis- hedging strategies during times of market
ruption and under normal market disruption.
conditions. 12. Recommend corrective action when poli-
10. Determine that business managers have cies, procedures, practices, internal con-
developed contingency plans which outline trols, and management information systems
actions to be taken in times of market are found to be deficient.
disruption to minimize losses as well as the
potential damage to the institution’s market-
making reputation.
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Market Risk
Internal Control Questionnaire Section 2010.4
1. Review the market-risk-management h. Do the policies authorize the use of
organization. appropriate hedging instruments?
a. Does the institution have a market-risk- i. Do the policies address the use of
management function with separate dynamic hedging strategies?
reporting lines from traders and j. Do the policies establish market-risk lim-
marketers? its which consider bid/ask spreads for the
b. Do market-risk-control personnel have full range of products in normal mar-
sufficient credibility in the financial kets?
institution to question traders’ and mar- k. Do the policies provide an explanation of
keters’ decisions? the board of directors’ and senior man-
c. Is market-risk management involved in agement’s philosophy regarding illiquid
new-product discussions in the financial markets?
institution? l. Do the policies establish market-risk lim-
2. Identify the institution’s capital-markets and its which consider bid/ask spreads in
trading activities and the related balance- distressed markets? How do the policies
sheet and off-balance-sheet instruments reflect liquidity concerns?
and obtain copies of all risk-management m. Are limits in place for market exposures
reports prepared. before transacting a deal? If the financial
a. Do summaries identify all the institu- institution relies on one-off approvals, is
tion’s capital-markets products? the approval process well documented?
b. Define the role that the institution takes 4. If the financial institution has recently
for the range of capital-markets prod- experienced a ratings downgrade, ascertain
ucts. Determine the hedging instruments the impact of the credit-rating downgrade.
used to hedge these products. Is the What has been the market response to the
institution an end-user, dealer, market financial institution as a counterparty in the
maker? In what products? markets? Have instances in which the insti-
c. Do market-risk-control personnel dem- tution provides collateral to its counterpar-
onstrate knowledge of the products traded ties significantly increased?
by the financial institution? Do they 5. Obtain all management information analyz-
understand the current and potential ing market risk.
exposures to the institution? a. Is management information comprehen-
3. Does the institution have comprehensive, sive and accurate, and is the analysis
written risk-management policies and pro- sound?
cedures for capital-markets and trading b. Are the simulation assumptions for a
activities? normal market scenario reasonable?
a. Have limits been approved by the board c. Are stress tests analyzing changes in
of directors? market condition appropriate? Are the
b. Have policies, procedures, and limits market assumptions reasonable?
been reviewed and reapproved within the d. Do management information reports
last year? accurately reflect risks? Are reports
c. Are market-risk policies, procedures, and provided to the appropriate level of
limits clearly defined? management?
d. Are the limits appropriate for the insti- 6. If there have been any recent market dis-
tution and the level of capital-markets ruptions affecting the institution’s trading
and trading activity? activities, what has been the institution’s
e. Do the limits adequately distinguish market response?
between trades used to manage the insti- 7. Is the financial institution following its
tution’s asset-liability mismatch position internal policies and procedures? Do the
and discretionary trading activity? established limits adequately control the
f. Are there contingency market-risk plans? range of market risks? Are the limits appro-
g. Are there appropriate accounting and priate for the institution’s level of activity?
revaluation policies and procedures? Is management aware of limit excesses?
Trading and Capital-Markets Activities Manual February 1998
Page 1
2010.4 Market Risk: Internal Control Questionnaire
Does management take appropriate action market disruptions occur? Are manage-
when necessary? ment’s activities in times of market disrup-
8. Has the institution established an effective tions prudent?
audit trail that summarizes exposures and a. Do opportunities for liquidation or
management approvals with the appropriate unwinding of transactions exist?
frequency? Are risk-management, revalua- b. Is the depth (volume, size, number of
tions, and close-out valuation reserves sub- market makers) of the market such that
ject to audit? undue risk is not being taken?
9. Has management considered possible mar- c. If executed on an exchange, is the open
ket disruptions when establishing capital-at- interest in the contract sufficient to
risk exposures? ensure that management would be
a. Has the financial institution established capable of hedging or closing out
capital-at-risk limits which address both open positions in one-way directional
normal and distressed market condi- markets?
tions? Are these limits aggregated on a d. Can management execute transactions in
global basis? large enough size to hedge and/or close
b. Are senior management and the board of out market-risk exposures without result-
directors advised of market-risk expo- ing in significant price adjustments?
sures in illiquid markets? 11. Has management determined the institu-
10. Have business managers developed contin- tion’s exposure to dynamic hedging strate-
gency plans which outline actions to be gies during times of market disruption?
taken to minimize losses as well as to 12. Does the institution have a methodology for
minimize the potential damage to the insti- addressing difficult-to-value products or
tution’s market-making reputation when positions?
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Counterparty Credit Risk and Presettlement Risk
Section 2020.1
Broadly defined, credit risk is the risk of eco- ciated with some derivative instruments, banks
nomic loss from the failure of an obligor to should ensure that they fully assess the presettle-
perform according to the terms and conditions ment credit risks involved with such instru-
of a contract or agreement. Credit risk exists in ments. This section discusses the nature of the
all activities that depend on the performance of credit risks involved in trading activities and
issuers, borrowers, or counterparties, and virtu- reviews basic credit-risk-management issues.
ally all capital-markets and trading transactions Settlement risk is the risk of loss when an
involve credit exposure. Over-the-counter (OTC) institution meets its obligation under a contract
derivative transactions such as foreign exchange, (through either an advance of funds or securi-
swaps, and options can involve particularly ties) before the counterparty meets its obliga-
large and dynamic credit exposures. Accord- tion. Failures to perform at settlement can arise
ingly, institutions should ensure that they iden- from counterparty default, operational prob-
tify, measure, monitor, and control all of the lems, market liquidity constraints, and other
various types of credit risks encountered in their factors. Settlement risk exists from the time an
trading of both derivative and nonderivative outgoing payment instruction cannot be recalled
products. until the incoming payment is received with
Credit risk should be managed through a finality. This risk exists with any traded product
formal and independent process guided by and is greatest when delivery is made in differ-
appropriate policies and procedures. Measure- ent time zones. Issues and examination proce-
ment systems should provide appropriate and dures regarding settlement risk are discussed at
realistic estimates of the credit-risk exposure length in section 2021.1.
and should use generally accepted measurement
methodologies and techniques. The develop-
ment of customer credit limits and the monitor- CREDIT-RISK-MANAGEMENT
ing of exposures against those limits is a critical ORGANIZATION
control function and should form the backbone
of an institution’s credit-risk-management pro- An institution’s process and program for man-
cess. The most common forms of credit risks aging credit risks should be commensurate with
encountered in trading activities are issuer credit the range and scope of its activities. Institutions
risk and counterparty credit risk. Issuer risk is with relatively small trading operations in non-
the risk of default or credit deterioration of an complex instruments may not need the same
issuer of instruments that are held as long level of automated systems and policies, or the
positions in trading portfolios. While the short same level of highly skilled staff, as firms that
time horizon of trading activities limits much of make markets in a variety of cash and derivative
the issuer credit risk for relatively high-quality products.
and liquid instruments, other less-liquid instru- Credit-risk management should begin at the
ments such as loans, emerging-market debt, and highest levels of the organization, with credit-
below-investment-quality debt instruments, may risk policies approved by the board of directors,
be the source of significant issuer credit risk. the formation of a credit-risk policy committee
Counterparty risks, the most significant credit of senior management, a credit-approval pro-
risks faced in trading operations, consist of both cess, and credit-risk management staff who
‘‘presettlement’’ risk and ‘‘settlement’’ risk. Pre- measure and monitor credit exposures through-
settlement risk is the risk of loss due to a out the organization. Although the organiza-
counterparty’s failure to perform on a contract tional approaches used to manage credit risk
or agreement during the life of a transaction. For may vary, the credit-risk management of trading
most cash instruments, the duration of this risk activities should be integrated into the overall
exposure is limited to the hours or days from the credit-risk management of the institution to the
time a transaction is agreed upon until settle- fullest extent practicable. With regard to poli-
ment. However, in the case of many derivative cies, most complex banking organizations appear
products, this exposure can often exist for a to have extensive written policies covering their
period of several years. Given this potentially assessment of counterparty creditworthiness for
longer-term exposure and the complexity asso- both the initial due-diligence process (that is,
Trading and Capital-Markets Activities Manual September 1999
Page 1
2020.1 Counterparty Credit Risk and Presettlement Risk
before conducting business with a customer) surement and evaluation of both on- and
and ongoing monitoring. However, examiners off-balance-sheet exposures, including poten-
should focus particular attention on how such tial future exposure; adequate stress testing;
policies are structured and implemented. reliance on collateral and other credit enhance-
Typically, credit-risk management in trading ments; and the monitoring of exposures against
operations consists of (1) developing and meaningful limits;
approving credit-exposure measurement stan- • employ policies that are sufficiently calibrated
dards, (2) setting counterparty credit limits, to the risk profiles of particular types of
(3) monitoring credit-limit usage and reviewing counterparties and instruments to ensure ade-
credits and concentrations of credit risk, and quate credit-risk assessment, exposure mea-
(4) implementing minimum documentation stan- surement, limit setting, and use of credit
dards. In general, staff responsible for approving enhancements;
exposures should be segregated from those • ensure that actual business practices conform
responsible for monitoring risk limits and mea- with stated policies and their intent; and
suring exposures. Traders and marketers should
• are moving in a timely fashion to enhance
not be permitted to assume risks without ade-
their measurement of counterparty-credit-risk
quate institutional credit-risk controls.
exposures, including refining potential future
Institutions with very large trading operations
exposure measures and establishing stress-
often have a credit function in the trading area;
testing methodologies that better incorporate
staff in this area develop a high level of exper-
the interaction of market and credit risks.
tise in trading-product credit analysis and meet
the demand for rapid credit approval in a trading
To adequately evaluate these conditions, exam-
environment. To carry out these responsibilities
iners should conduct sufficient and targeted
without compromising internal controls, the
transaction testing. See SR-99-3 (February 1,
credit-risk-management function must be inde-
1999).
pendent of these marketing and trading person-
nel who are directly involved in the execution of
the transactions. While the credit staff in the
trading area may possess great expertise in
trading-product credit analysis, the persons CREDIT-RISK MEASUREMENT
responsible for the institution’s global credit
function should have a solid understanding of Appropriate measurement of exposures is essen-
the measurement of credit-risk exposures in tial for effective credit-risk management in trad-
trading products and the techniques available to ing operations. For most cash instruments, pre-
manage those exposures. The examiner’s review settlement credit exposure is measured as current
of credit-risk management in trading activities carrying value. However, in the case of many
should evaluate the quality and timeliness of derivative contracts, especially those traded in
information going to the global credit function OTC markets, presettlement exposure is mea-
and the way that information is integrated into sured as the current value or replacement cost of
global exposure reports. the position, plus an estimate of the institution’s
Examiners should evaluate whether banking potential future exposure to changes in the
institutions— replacement value of that position over the term
of the contract. The methods used to measure
• devote sufficient resources and adequate atten- counterparty credit risk should be commensu-
tion to the management of the risks involved rate with the volume and level of complexity of
in growing, highly profitable, or potentially the instruments involved. Importantly, measure-
high-risk activities and product lines; ment systems should use techniques that present
• have internal audit and independent risk- a relevant picture of the true nature of the credit
management functions that adequately focus exposures involved. Some techniques used to
on growth, profitability, and risk criteria in measure presettlement risk can generate very
targeting their reviews; large exposure estimates that, by definition, are
• achieve an appropriate balance among all unlikely to materialize. Unrealistic measures of
elements of credit-risk management, includ- credit exposure suggest important flaws in the
ing both qualitative and quantitative assess- institution’s risk-management process and should
ments of counterparty creditworthiness; mea- receive special examiner attention.
September 1999 Trading and Capital-Markets Activities Manual
Page 2
Counterparty Credit Risk and Presettlement Risk 2020.1
Presettlement Risk by the purchaser to the writer of the option. The
value of the purchased option may be reduced as
Presettlement credit exposure for cash instru- a result of market movements, but cannot become
ments is measured as the current carrying value, negative. The seller or writer of an option
which for trading operations is the market value receives a premium, usually at inception, and
or fair value of the instrument. Market values must deliver the underlying at exercise. There-
can be obtained from direct market quotations fore, the party that buys the option contract will
and pricing services or, in the case of more always have credit exposure when the option is
complex instruments, may be estimated using in the money, and the party selling the option
generally accepted valuation techniques. For contract will have none, except for settlement
derivative contracts, credit exposure is mea- risk while awaiting payment of the premium.
sured as the current value or replacement cost of
the position, plus an estimate of the institution’s
potential future exposure to changes in that Potential Future Exposure
replacement value in response to market price
changes. Together, replacement cost and esti- Potential future exposure is an estimate of the
mated potential future exposure make up the risk that subsequent changes in market prices
loan-equivalent value of a derivative contract. could increase credit exposure. In measuring
potential exposure, institutions attempt to deter-
For derivative contracts, presettlement expo- mine how much a contract can move into the
sure to a counterparty exists whenever a con- money for the institution and out of the money
tract’s replacement cost has positive value to the for the counterparty over time. Given the impor-
institution (‘‘in the money’’) and negative value tant interrelationships between the market-risk
to the counterparty (‘‘out of the money’’). The and credit-risk exposures involved in banks’
current replacement cost of the contract is its derivative activities that have been emphasized
mark-to-market value. If a counterparty defaults over the past two years of financial-market
on a transaction before settlement or expiration turbulence, examiners should be alert to situa-
of the deal, the other counterparty has an imme- tions in which banks may need to enhance their
diate exposure which must be filled. If the current computations of potential future expo-
contract is in the money for the nondefaulting sures and loan equivalents used to measure and
party, then the nondefaulting counterparty has monitor their derivative counterparty credit
suffered a credit loss. Thus, all deals with a exposure.
positive mark-to-market value represent actual Estimating potential exposure can be subjec-
credit exposure. The replacement cost of deriva- tive, and firms approach its measurement in
tive contracts is usually much smaller than the several different ways. One technique is to use
face or notional value of derivative transactions. ‘‘rules of thumb’’ or factors, such as percentages
Some derivatives involving firm commit- of the notional value of the contract, similar to
ments, such as swaps, initially have a zero net the ‘‘add-on’’ factors used in bank risk-based
present value and, therefore, no replacement capital. Institutions using such an approach
cost at inception. At inception, the only potential should be able to demonstrate that the rules of
for credit exposure these contracts have is what thumb or factors provide adequate estimates of
can arise from subsequent changes in the market potential exposure. For example, differences in
price of the instrument, index, or interest rate the add-ons used for different instruments should
underlying them. Once market prices move to reflect differences in the volatility of the under-
create a positive contract value, the contract has lying instruments and in the tenor (or maturity)
the current credit-risk exposure of its replace- across instruments, and should be adjusted peri-
ment cost as well as the potential credit expo- odically to reflect changes in market conditions
sure that can arise from subsequent changes in and the passage of time.
market prices. A more sophisticated and complex practice of
Options and derivative contracts which con- measuring the potential exposure of derivatives
tain options (for example, swaptions and rate- is to statistically estimate the maximum prob-
protection agreements) face both current and able value that the derivative contract might
potential credit exposure. However, a difference reach over a specified time horizon, which
with option contracts is that they have a positive sometimes may be the life of the contract. This
value at inception reflected by the premium paid is often done by estimating the highest value the
Trading and Capital-Markets Activities Manual September 1999
Page 3
2020.1 Counterparty Credit Risk and Presettlement Risk
contract will achieve within some confidence the underlying instrument or risk factor. Some
interval (for example, 95, 97.5, or 99 percent institutions measure the ‘‘expected’’ exposure of
confidence) based on the estimated distribution a contract in addition to its maximum probable
of the contract’s possible values at each point in exposure. The expected exposure is the mean of
time over the time horizon, given historical all possible probability-weighted replacement
changes in underlying risk factors. The specified costs estimated over the specified time horizon.
percentile or confidence level of the distribution This calculation may reflect a good estimate of
represents the maximum expected value of the present value of the positive exposure that is
the contract at each point over the time horizon. likely to materialize. As such, expected expo-
The time horizon used to calculate potential sure can be an important measure for use in an
future exposure can vary depending on the institution’s internal pricing, limit-setting, and
bank’s risk tolerance, collateral protection, and credit-reserving decisions. However, expected
ability to terminate its credit exposure. Some exposure is by definition lower than maximum
institutions may use a time horizon equal to the probable exposure and may underestimate
life of the respective instrument. While such a potential credit exposure. For this reason,
time horizon may be appropriate for unsecured expected exposure estimates are not frequently
positions, for collateralized exposures, the use used as loan-equivalent amounts in assessing
of lifetime, worst-case estimates of potential capital adequacy from either an internal or
future exposure may be ineffective in measuring regulatory basis.
the true nature of counterparty risk exposure— Statistically generated measures of future
especially given the increasing volatility and exposure use sophisticated risk-measurement
complexity of financial markets and derivatives models that, in turn, involve the use of important
instruments. While life-of-contract potential assumptions, parameters, and algorithms. Insti-
future exposure measures provide an objective tutions using such techniques should ensure that
and conservative long-term exposure estimate, appropriate controls are in place regarding the
they bear little relationship to the actual credit development, use, and periodic review of the
exposures banks typically incur in the case of models and their associated assumptions and
collateralized relationships. In such cases, a parameters. The variables and models used for
bank’s actual credit exposure is the potential both replacement cost and potential exposure
future exposure from the time a counterparty should be approved and tested by the credit-risk-
fails to meet a collateral call until the time the management function and should be subject to
bank liquidates its collateral—a period which is audit by independent third parties with adequate
typically much shorter than the contract’s life. technical qualifications. The data-flow process
For some institutions, more realistic measures of should also be subject to audit to ensure data
collateralized exposures in times of market stress integrity. Equally important are the approval and
are needed. These measures should take into testing of information systems that report posi-
account the shorter time horizons over which tions. The functions responsible for managing
action can be taken to mitigate losses. They credit risk should validate any modifications to
should also incorporate estimates of collateral- models made to accommodate new products or
recovery rates given the impact of potential variations on existing products.
market events on the liquidity of collateral
values.
Institutions with vigorous monitoring systems Aggregate Exposures
can employ additional credit-risk-measurement
methodologies that will tend to generate more In measuring aggregate presettlement credit-risk
precise and often smaller reported exposure exposures to a single counterparty, institutions
levels. Some institutions already calculate such may use either a transactions approach or a port-
measures by assessing the worst-case value of folio approach. Under a transactions approach,
positions over a time horizon of one or two the loan-equivalent amounts for each derivative
weeks—their estimate of a reasonable liquida- contract with a counterparty are added together.
tion period in times of stress. Other institutions Some institutions may take a purely transac-
are moving to build the capability of estimating tional approach to aggregation and do not incor-
portfolio-based potential future exposures by porate the netting of long and short derivatives
any one of several different time horizons or contracts, even when legally enforceable bilat-
buckets, owing to the liquidity and breadth of eral netting agreements are available. In such
September 1999 Trading and Capital-Markets Activities Manual
Page 4
Counterparty Credit Risk and Presettlement Risk 2020.1
cases, simple sum estimates of positive expo- model-review processes and data integrity
sures may seriously overestimate true credit checks. Examiners should be aware that some
exposure, and examiners should monitor and banks may need to develop more meaningful
encourage an institution’s movement toward measures of credit-risk exposures under volatile
more realistic measures of counterparty expo- market conditions by developing and implement-
sure. When they exist, legally enforceable close- ing timely and plausible stress tests of counter-
out netting agreements should be factored into party credit exposures. Stress testing should
these measurements, whatever approach is used evaluate the impact of large market moves on
to obtain them. Master close-out netting agree- the credit exposure to individual counterparties
ments are bilateral contracts intended to reduce and on the inherent liquidation effects. Stress
presettlement credit risk in the event that a testing also should consider liquidity impacts on
counterparty becomes insolvent before settle- underlying markets and positions, and their
ment. Upon default, the nondefaulting party nets effect on the value of any collateral received.
gains and losses with the defaulting counter- Moreover, stress-testing results should be incor-
party to a single payment for all covered trans- porated in senior management reports and pro-
actions. All credit-risk-exposure measures should vide sufficient information to trigger risk-
fully reflect the existence of such legally binding reducing actions when necessary. Simply
netting agreements as well as any other credit applying higher confidence intervals or longer
enhancements. time horizons to potential future exposure mea-
Some financial institutions measure potential sures may not capture the market and exposure
credit-risk exposures on a portfolio basis, where dynamics under turbulent market conditions,
information systems allow and incorporate net- particularly as they relate to the interaction
ting (both within and across products, business between market, credit, and liquidity risk.
lines, or risk factors) and portfolio correlation Examiners should determine whether stress test-
effects to construct a more comprehensive coun- ing has led to risk-reducing actions or a redefi-
terparty exposures measure. The portfolio nition of the institution’s risk appetite under
approach recognizes the improbability that all appropriate circumstances.
transactions with a given counterparty will reach
their maximum potential exposure at the same
time as is implicitly assumed under the transac- Global Exposures
tions approach. The portfolio approach uses
simulation modeling to calculate aggregate While an institution may use various methods to
exposures through time for each counterparty. measure the credit exposure of specific types of
As discussed in section 2070.1, ‘‘Legal Risk,’’ instruments, credit exposures for both loans and
gains and losses may be offset in measuring capital-markets products should be consolidated
potential credit-risk exposure with the portfolio by counterparty to enable senior management to
approach. If legally enforceable netting is not in evaluate the overall counterparty credit risk. To
place, then the sum of contracts with positive obtain an aggregate, institution-wide credit
value under the simulation should be used as a exposure for a customer in the global credit-risk-
measure of potential exposure. Contracts with management system, many institutions use the
negative value should only be considered as an risk in commercial loans as a base and convert
offset for gains when netting is deemed to be credit-risk exposures in capital-markets instru-
legally enforceable. If executed correctly, the ments, both on- and off-balance-sheet, to the
portfolio approach may provide a more realistic same base using loan-equivalent amounts.
measurement of potential credit exposure for the Together these two measures can be added to
portfolio than simply summing the potential any other credit exposures to get the total credit
worst-case exposures for each instrument in the exposure to a given counterparty.
portfolio. Whatever approach is used, the credit-
risk-management function should clearly define
the measurement aggregation methodology and
apply it consistently across all instruments and CREDIT ENHANCEMENTS
types of capital-markets exposures.
In addition, examiners should ensure that an As the derivatives market has expanded so has
institution has adequate internal controls gov- the number of market participants with lower
erning exposure estimation, including robust credit ratings. Accordingly, institutions have
Trading and Capital-Markets Activities Manual September 1999
Page 5
2020.1 Counterparty Credit Risk and Presettlement Risk
increased the use of credit enhancements in the liquid assets (initial margin) and often involves
derivatives marketplace. Some of the more com- calls for additional collateral based on a periodic
mon credit enhancements include the following: marking to market of the position. This type of
arrangement is intended to reduce the frequency
• Collateral arrangements in which one or both of collateral movements and protect the institu-
counterparties agree to pledge collateral, usu- tion against unanticipated swings in credit
ally consisting of cash or liquid securities, to exposure. Collateral agreements can require
secure credit exposures arising from deriva- either one or both counterparties to pledge
tive transactions. collateral. Increasingly, collateral arrangements
• Special-purpose vehicles (SPVs) that can be are being formed bilaterally, where either coun-
separately capitalized subsidiaries or specially terparty may be asked to post collateral, depend-
designed collateral programs organized to ing on whose position is out of the money.
obtain a triple A counterparty credit rating. The use of collateral raises several important
• Mark-to-market cash settlement in which coun- considerations. Similar to other credit enhance-
terparties periodically mark transactions to ments, collateralization mitigates but does not
market and make cash payments equal to their eliminate credit risk. To the extent that collateral
net present value, thus reducing any exposure is sufficient, credit risk is transferred from the
to a preset threshold. counterparty to the obligor of the collateral
• Option-to-terminate or ‘‘close out’’ contracts instrument. However, institutions should ensure
which give either counterparty, after an agreed- that overreliance on collateralization does not
upon interval, the option to instruct the other compromise other elements of sound counter-
party to cash settle and terminate a transaction party credit risk management, such as the due-
based on the transaction’s net present value as diligence process. In addition, collateralization
quoted by agreed-upon reference dealers. The may reduce credit risk at the expense of increas-
existence of the option allows both parties to ing other risks, such as legal, operational, and
view the transaction as having a maturity liquidity risk. For instance, heavy reliance on
which is effectively reduced to the term of the collateral-management systems poses increased
option. operational risk. Collateral agreements must be
• Material-change triggers that convey the right monitored, the collateral posted must be tracked
to change the terms of or terminate a contract and marked to market, and the physical safe-
if a prespecified credit event occurs such as a keeping of the collateral must be ensured. Finally,
rating downgrade, failure to pay or deliver, an the use of collateral is potentially more costly
adverse change in the counterparty’s financial than other forms of credit enhancements, in part
standing, or a merger event. Credit events may because it requires a substantial investment in
trigger the termination of a contract, the systems and back-office support.
imposition of a collateral requirement, or The fundamental aspects of a collateral rela-
stricter collateral terms. tionship are usually specified in a security agree-
ment or in the credit annex of a master netting
Credit enhancements and other nonprice terms agreement. The calculation of required collat-
should be tailored to the counterparty and closely eral is usually based on the net market value of
linked to assessments of counterparty credit the portfolio. The amount of required collateral
quality. and appropriate margin levels are largely deter-
mined by the volatility of the underlying port-
folio, the frequency of collateral calls, and the
type of counterparty. In general, the higher the
Collateral Arrangements volatility of an underlying portfolio, the greater
the amount of collateral and margin required.
Collateral arrangements are becoming an increas- Frequent collateral calls will result in smaller
ingly common form of credit enhancement in amounts of margin and collateral posted. Insti-
the derivatives market. There are generally two tutions should be aware that if volatility increases
types of collateral arrangements. In the first beyond what is covered in the predetermined
type, the counterparty does not post collateral margin level, credit exposure to a counterparty
until exposure has exceeded a prespecified may be greater than originally anticipated. For
amount (threshold). The second type of collat- this reason, institutions generally revalue both
eral arrangement requires an initial pledge of the portfolio and the collateral regularly.
September 1999 Trading and Capital-Markets Activities Manual
Page 6
Counterparty Credit Risk and Presettlement Risk 2020.1
The amount of collateral and margining levels valuation disputes, the party holding the collat-
also should be based on the type of counterparty eral, the window of time allowed for moving
involved. Policies should not be overly broad so collateral, trigger thresholds, closeout rights,
as to compromise the risk-reducing nature of and rehypothecation. In addition, these policies
collateral agreements with certain types of coun- and procedures should address the process of
terparties. Indeed, policies governing collateral overriding credit limits, making margin calls,
arrangements should specifically define those and waiving margin requirements.
cases in which initial and variation margin is In September 1998, the Committee of Pay-
required, and should explicitly identify situa- ment and Settlement Systems and the Euro-
tions in which lack of transparency, business- currency Standing Committee (now the Com-
line risk profiles, and other counterparty charac- mittee on the Global Financial System) of the
teristics merit special treatment. When central banks of the Group of Ten countries
appropriate to the risk profile of the counter- published a report entitled ‘‘OTC Derivatives
party, policies should specify when margining Settlement Procedures and Counterparty Risk
requirements based on estimates of potential Management’’ that recommended that deriva-
future exposures might be warranted. tives counterparties carefully assess the liquid-
Securities that are posted as collateral are ity, legal, custody, and operational risks of using
generally subject to haircuts, with the most collateral. The report made the following spe-
liquid and least volatile carrying the smallest cific recommendations to counterparties:
haircuts. Acceptable forms of collateral tradi-
tionally include cash and U.S. Treasury and • Counterparties should review the backlogs of
agency securities. However, letters of credit, unsigned master agreements and outstanding
Eurobonds, mortgage-backed securities, equi- confirmations and take appropriate steps to
ties, and corporate bonds are increasingly being manage the risks effectively.
considered acceptable collateral by some market • Counterparties should assess the potential for
participants. Institutions that actively accept col- reducing backlogs and associated risks through
lateral should ensure that haircuts for instru- use of existing or new systems for the elec-
ments accepted as collateral are reviewed at tronic exchange or matching of confirmations.
least annually to reflect their volatility and
liquidity. • Counterparties should assess the potential for
Collateral arrangements sometimes include clearinghouses for OTC derivatives to reduce
rehypothecation rights, in which a counterparty credit risks and other counterparty risks, tak-
repledges collateral to a third party. Institutions ing into account the effectiveness of the clear-
with rehypothecation rights may be exposed to inghouse’s risk-management procedures and
the risk that the third party holding the rehypoth- the effects on contracts that are not cleared.
ecated collateral may fail to return the collateral
or may return a different type of collateral. In March 1999, the International Swaps and
Institutions should ensure that they review the Derivatives Association (ISDA) published its
legal issues arising from collateral arrangements 1999 collateral review. The ISDA collateral
carefully, especially when rehypothecation rights review was an assessment of the effectiveness of
are involved and when different locales can existing collateral-management practices and rec-
claim jurisdiction over determining the effective- ommendations for improvements in those prac-
ness of security interests. Rehypothecation of tices. Among the market-practice recommenda-
collateral may have an impact on a counterpar- tions for counterparties arising from the ISDA
ty’s right to set off the value of the collateral collateral review were the following:
against amounts owed by a defaulting counter-
party. In addition, institutions should review the • Counterparties should understand the role of
laws of jurisdictions to which they are poten- collateral as a complement to, not a replace-
tially subject to determine the potential effects ment for, credit analysis tailored to the risk
of stays and the competing claims of other profile presented by the counterparty, type of
creditors on the enforcement of security interests. transaction, size of potential future exposure,
Institutions with collateralization programs term of risk, and other relevant factors.
should establish policies and procedures that • Counterparties should assess the secondary
address position and collateral revaluations, the risks of collateralization, for example:
frequency of margin calls, the resolution of — Legal risk. The risk that close-out netting
Trading and Capital-Markets Activities Manual September 1999
Page 7
2020.1 Counterparty Credit Risk and Presettlement Risk
provisions under a master agreement are counterparty-specific situations and risk pro-
not enforceable upon the counterparty’s files. For example, close-out provisions based
insolvency, thus allowing the bankruptcy on annual events or material-change triggers
representative to ‘‘cherry pick’’ and repu- based on long-term performance may prove
diate contracts. ineffective for counterparties whose risk profiles
— Operational risk. The risk that deficiencies can change rapidly.
in information systems or internal controls In evaluating an institution’s management of
could result in losses. its collateral arrangements and other credit en-
— Credit risk. Replacement-cost risk when a hancements, examiners should assess not only
counterparty defaults prior to settlement, the adequacy of policies but should determine
and settlement risk whether internal controls are sufficient to ensure
— Correlation risk. Default may be highly that practices comply with these policies.
correlated with the market value of the Accordingly, in reviewing targeted areas dealing
contract, as was the case with dollar- with counterparty credit risk management,
denominated instruments held by counter- examiners should identify the types of credit
parties in emerging-market countries. enhancements and contractual covenants used
— Liquidity risk. Close-out provisions trig- by an institution and determine whether the
gered by a ratings downgrade may create institution has sufficiently assessed their
substantial liquidity demands at a time adequacy relative to the risk profile of the
when meeting those demands is particu- counterparty. Finally, examiners should be alert
larly costly. to situations in which collateralized exposures
• Counterparties should centralize and automate may be mis-estimated, and they should encour-
the collateral function and reconciliation pro- age management at these institutions to enhance
cedures and impose a rigorous control envi- their exposure-measurement systems and
ronment. collateral-protection programs accordingly.
• Counterparties should coordinate the collat-
eral, payments, and settlement functions in
order to maximize information flows regard-
ing counterparties and markets in stress situ-
ations. COUNTERPARTY ASSESSMENT
• Counterparties should consider the use of a
As with traditional banking transactions, an
wider range of assets as collateral and accept
independent credit function should conduct an
cash when a collateral-delivery failure occurs.
internal credit review before engaging in trans-
(Counterparties often do not wish to accept
actions with a prospective counterparty. Credit
cash because of the costs of reinvestment.)
guidelines should be employed to ensure that
• Counterparties should establish clear internal limits are approved for only those counterparties
policies and methodologies for setting initial that meet the appropriate credit criteria, incor-
margins based on the volatility of the value of porating any relevant credit support. The credit-
the derivative position. risk-management function should verify that
• When setting haircut levels, counterparties limits are approved by credit specialists with
should ensure that appropriate asset price sufficient signing authority.
volatility measures are considered over the
The quick credit-approval process often
appropriate timeframe.
required in trading operations may lead financial
• Counterparties should ensure that collateral
institutions to conduct only summary financial
agreements address the potential for changes
analysis. Institutions should ensure that the level
in credit quality over the course of the trans-
of financial analysis is adequate and that all
action.
transactions have formal credit approval. If the
credit officers prefer not to establish a formal
line for a new relationship, a transaction-specific
Other Credit Enhancements written approval should be given based on the
potential exposure from the transaction. In mak-
Adequate polices should also govern the use of ing such one-off approvals, credit officers and
material-change triggers and close-out provi- credit-risk management should keep settlement
sions, which should take into account risks in mind.
September 1999 Trading and Capital-Markets Activities Manual
Page 8
Counterparty Credit Risk and Presettlement Risk 2020.1
Broad policies that were structured in the ency may hinder market discipline on the risk-
interests of flexibility to apply to all types of taking activities of counterparties—which may
counterparties may prove inadequate for direct- have been the case with hedge funds. Banking
ing bank staff in the proper review of the risks organizations should also understand their conter-
posed by specific types of counterparties. The parties’ business purpose for entering into
assessment of counterparties based on simple derivatives transactions with the institution.
balance-sheet measures and traditional assess- Understanding the underlying business rationale
ments of financial condition may be adequate for the transaction allows the institution to
for many types of counterparties. However, evaluate the credit, legal, and reputational risks
these assessments may be entirely insufficient that may arise if the counterparty has entered
for those counterparties whose off-balance-sheet into the transaction to evade taxes, hide losses,
positions are a source of significant leverage and or circumvent legal or regulatory restrictions.
whose risk profiles are narrowly based on con- Even when credit-risk assessment policies
centrated business lines, such as with hedge appear to be sufficiently defined, examiners
funds and other institutional investors. should place increasing emphasis on ensuring
General policies calling for annual counter- that existing practice conforms with both the
party credit reviews are another example of stated objectives and intent of the organization’s
broad policies that may compromise the integ- established policies. Quite often, in highly com-
rity of the assessment of individual counterpar- petitive and fast-moving transaction environ-
ties or types of counterparties—especially in ments, examiners found that the analyses speci-
cases when a counterparty’s risk profile can fied in policies, such as the review of a
change significantly over much shorter time counterparty’s ability to manage the risks of its
horizons. Moreover, credit-risk assessment poli- business, were not done or were executed in a
cies should properly define the types of analysis perfunctory manner.
to be conducted for particular types of counter- Necessary internal controls for ensuring that
parties, based on the nature of their risk profile. practices conform with stated policies include
In addition to customizing fundamental analyses actively enforced documentation standards and
based on the industry and business-line charac- periodic independent reviews by internal audi-
teristics of a counterparty, stress testing may be tors or other risk-control units. Examiners should
needed when a counterparty’s creditworthiness evaluate an institution’s documentation stan-
may be adversely affected by short-term fluctua- dards and determine if internal reviews are
tions in financial markets—especially when adequately conducted for business lines, prod-
potential credit exposure to a counterparty ucts, exposures to particular groups of counter-
increases when credit quality deteriorates. parties, and individual customers that exhibit
A key responsibility of examiners has always significant growth or above-normal profitability.
been to identify areas where bank practices may As always, examiners should evaluate the integ-
not conform to stated policies. These efforts are rity of these internal controls through their own
made especially difficult when bank policies transaction testing of such situations, using tar-
lack sufficient granularity, or specificity, to prop- geted examinations and reviews. Testing should
erly focus bank-counterparty risk assessments. include robust sampling of transactions with an
Accordingly, examiners should ensure that a institution’s major counterparties in the targeted
bank’s counterparty credit-risk assessment poli- area, as well as sufficient stratification to ensure
cies are sufficiently defined to adequately address that practices involving smaller relationships
the risk profiles of specific types of counterpar- also adhere to stated policies.
ties and instruments. Policies should specify In stratifying samples and selecting counter-
(1) the types of counterparties that may require parties and transactions on which to base tar-
special consideration; (2) the types and fre- geted testing of practices and internal controls,
quency of information to be obtained from such examiners should incorporate measures of
counterparties; (3) the types and frequency of potential future exposure, regardless of whether
analyses to be conducted, including the need for such exposures are collateralized. As evidenced
and type of any stress-testing analysis; and by banks’ experience with hedge-fund relation-
(4) how such information and analyses appro- ships in 1998, meaningful counterparty credit
priately address the risk profile of the particular risks during periods of stress can go undetected
type of counterparty. This definition in policy is if only unsecured exposures are used in transac-
particularly important when limited transpar- tion testing.
Trading and Capital-Markets Activities Manual September 2002
Page 8.1
2020.1 Counterparty Credit Risk and Presettlement Risk
OTC and Exchange-Traded
Instruments
Assessing the financial health of counterparties
is a critical element in effectively identifying
and managing credit-risk exposures. Before con-
ducting transactions, institutions should conduct
due-diligence assessments of their potential
credit-risk exposure to all of the parties that
might be involved in the transaction. For OTC
transactions, this generally involves a single
counterparty. For exchange-traded instruments,
involved parties may include brokers, clearing
firms, and the exchange’s clearinghouse. In
exchange-traded transactions, the clearinghouse
guarantees settlement of all transactions.
An institution’s policies should clearly iden-
tify criteria for evaluating and approving both
OTC counterparties and, for exchange-traded
instruments, all entities related to a transaction.
For counterparties, brokers, and dealers, the
approval process should include a review of
their financial statements and an evaluation of
the counterparty’s ability to honor its commit-
ments. An inquiry into the general reputation of
the counterparty, dealer, or broker is also appro-
priate. At a minimum, institutions should con-
sider the following in establishing relationships
with counterparties and the dealers and brokers
used to conduct exchange-traded transactions:
• the ability of the counterparty; broker; and
clearinghouse and its subsidiaries, affiliates, or
members to fulfill commitments as evidenced
by capital strength, liquidity, and operating
results
• the entity’s general reputation for financial
stability and fair and honest dealings with
customers
• a counterparty’s ability to understand and
manage the risks inherent in the product or
transaction
• information available from state or federal
regulators, industry self-regulatory organiza-
tions, and exchanges concerning any formal
September 2002 Trading and Capital-Markets Activities Manual
Page 8.2
Counterparty Credit Risk and Presettlement Risk 2020.1
enforcement actions against the counterparty, COUNTERPARTY CREDIT RISK
dealer, broker, its affiliates, or associated LIMITS
personnel
With regard to exchange-traded transactions, Exposure-monitoring and limit systems are criti-
institutions should assure themselves that suffi- cal to the effective management of counterparty
cient safeguards and risk-management practices credit risk. Examiners should focus special
are in place at the involved entities to limit attention on the policies, practices, and internal
potential presettlement and settlement risk controls of banking institutions. An effective
exposure. Exchange clearinghouses generally exposure-monitoring system consists of estab-
use a variety of safeguards to limit the like- lishing meaningful limits on the risk exposures
lihood of defaults by clearing members and an institution is willing to take, independent
ensure that there are adequate resources to meet ongoing monitoring of exposures against such
any losses should a default occur. These safe- limits, and adequate controls to ensure that
guards can include (1) financial and operating reporting and meaningful risk-reducing action
requirements for clearinghouse membership, takes place when limits are exceeded. Since an
(2) margin requirements that collateralize cur- effective exposure-monitoring and limit process
rent or potential future exposures and periodic depends on meaningful exposure-measurement
settlements of gains and losses that are struc- methodologies, examiners should closely evalu-
tured to limit the buildup of these exposures, ate the integrity of these systems at institutions
(3) procedures that authorize resolution of a that may have inadequate exposure-measurement
clearing member’s default through close-out of systems—especially regarding the estimation of
its proprietary positions and transfer or close-out potential future exposures. Overly conservative
of its client’s positions, and (4) the maintenance measures or other types of less-than-meaningful
of supplemental clearinghouse resources (for exposure measurements can easily compromise
example, capital, asset pools, credit lines, guar- well-structured policies and procedures. Such
antees, or the authority to make assessments on situations can lead to limits being driven prima-
nondefaulting members) to cover losses that rily by customer demand and used only to define
may exceed the value of a defaulting member’s and monitor customer facilities, instead of using
margin collateral and to provide liquidity during limits as strict levels, defined by credit manage-
the time it takes to realize the value of that ment, for initiating exposure-reducing actions.
margin collateral. Institutions should assure Limits should be set on the amounts and types
themselves of the adequacy of these safeguards of transactions authorized for each entity before
before conducting transactions on exchanges. execution of any trade. Distinct limits for pre-
Due diligence is especially important when settlement and settlement risk should be estab-
dealing with foreign exchanges; institutions lished and periodically reviewed and recon-
should be cognizant of differences in the regu- firmed. Both overall limits and product sublimits
latory and legal regimes in these markets. Sub- may be established. For example, a customer
stantial differences exist across countries, may be assigned a foreign-exchange trading
exchanges, and clearinghouses in fundamental line, while interest-rate or cross-currency swaps
areas such as mutualization of risk, legal rela- are approved against the general line on a
tionships between the clearinghouse and its transaction-by-transaction basis. In some cases,
members, legal relationships between the clear- the approach to assigning sublimits reflects the
inghouse and customers, procedures in the event pace of transactions in the marketplace as well
of default, and segregation of customer funds. as the amount of credit risk (largely a reflection
These considerations are particularly important of tenor). The sum of product-specific sublimits
for institutions such as futures commission mer- may well exceed the aggregate limit, reflecting
chants (FCMs) that conduct trades for customers.1 management’s experience that all sublimits are
not used simultaneously. In such cases, how-
ever, the organization should have sufficient
monitoring of global credit exposures to detect a
breach of the global limit.
1. See section 3030.1, ‘‘Futures Brokerage Activities and
The frequency with which credit exposures
Futures Commission Merchants,’’ as well as the Federal are monitored depends on the size of the trading
Reserve’s Bank Holding Company Supervision Manual. and derivatives portfolios and on the nature of
Trading and Capital-Markets Activities Manual March 1999
Page 9
2020.1 Counterparty Credit Risk and Presettlement Risk
the trading activities. Active dealers should have risk-management systems and capabilities and
counterparty credit exposure monitored daily. its internal control environment to make effec-
Irrespective of how credit exposure is moni- tive decisions regarding the level of risk they are
tored, the replacement cost should be calculated willing to assume. Institutions should be cau-
daily and compared to the approved potential tioned to obtain supporting documentation for
exposure figure for validity. the claims of fund managers.
Unusual market movements may lead to rapid Counterparty credit risk management should
accumulation of credit exposure. The creditwor- emphasize comprehensive stress testing across a
thiness of counterparties can also change. variety of scenarios, with particular focus on
Between its regular reviews of credit exposures, possible asset or position concentrations. Insti-
the institution should have a mechanism that tutions should also determine the investor’s or
guarantees timely recognition of either unusual fund’s ability to stress test its portfolio. In
credit-exposure buildups or credit deterioration limiting counterparty credit risks through the
in a counterparty. For institutions that are deal- use of collateral and other credit enhancements,
ers in these markets, the monitoring should be it should be recognized that standard arrange-
very frequent, and regular reviews should be ments that may be suitable for most counterpar-
conducted with the same frequency as for other ties may not be suitable for counterparties that
significant credit customers. have the potential to quickly change their port-
Management should have procedures for con- folios, such as hedge funds. For example, 12-
trolling credit-risk exposures when they become month rolling average close-out provisions may
large, a counterparty’s credit standing weakens, be inappropriate for counterparties engaged in
or the market comes under stress. Management active trading, where a prior month’s gains can
should show clear ability to reduce large posi- mask serious losses in the current month. Insti-
tions. Common ways of reducing exposure tutions that deal with institutional investors and
include halting any new business with a coun- hedge funds should have the policies, proce-
terparty and allowing current deals to expire, dures, and internal controls in place to ensure
assigning transactions to another counterparty, that these exposures are measured, monitored,
and restructuring the transaction to limit poten- and controlled by management on an on-going
tial exposure or make it less sensitive to market basis.
volatility. Institutions can also use many of the The Basle Committee on Banking Supervi-
credit enhancement tools mentioned earlier to sion released a report that analyzed the risks
manage exposures that have become uncomfort- posed by hedge funds to creditors and published
ably large. sound practices standards for interactions with
hedge funds. The sound practices standards
identified areas in which bank practices could be
enhanced, including—
INSTITUTIONAL INVESTORS
AND HEDGE FUNDS • establishing clear policies and procedures that
define the bank’s risk appetite and drive the
Examiners should pay increasing attention to the process for setting credit standards;
appropriateness, specificity, and rigor of the • obtaining adequate information on which to
policies, procedures, and internal controls that base sound judgments of counterparty credit
institutions use in assessing, measuring, and quality;
limiting the counterparty credit risks arising • performing adequate due diligence, including
from their trading and derivative activities with setting standards for risk management by
institutional investors in general, and particu- counterparties that are commensurate with the
larly with hedge funds. In the area of counter- level of sophistication and complexity of their
party assessment, institutions doing business activities;
with institutional investors and hedge funds • developing meaningful limits for derivatives
should have sufficient information on which to counterparties and more accurate measures of
assess the counterparty and its inherent risks, potential future exposure;
including information on total leverage, both • adequately assessing and measuring unse-
on- and off-balance-sheet, and firm strategies. cured exposures under collateralized deriva-
Banks should conduct in-depth due-diligence tives transactions, and setting meaningful
reviews of the effectiveness of a counterparty’s credit limits based on such assessments;
March 1999 Trading and Capital-Markets Activities Manual
Page 10
Counterparty Credit Risk and Presettlement Risk 2020.1
• adequately stress-testing counterparty credit processing an agent’s trades for an unnamed
risk under a variety of scenarios that take into counterparty. An effective and efficient back-
account liquidity effects, and incorporating office process helps to ensure that the institution
results into management decisions about risk is aware of the size of such exposures on a
taking and limit setting; timely basis.
• closely linking nonprice terms, including col- Similarly, institutions often manage the settle-
lateral arrangements and termination provi- ment process with unnamed counterparties more
sions, to assessments of counterparty credit closely than they do with traditional trading
quality; and counterparties. Institutions often set settlement
• timely monitoring counterparty transactions limits with unnamed counterparties so that large
and credit exposures, including frequently sums are not settled on a single day. Institu-
reassessing banks’ large exposures, counter- tions sometimes develop procedures that ensure
party leverage, and concentration of counter- management is made immediately aware of
party activities and strategies. settlement failures by unnamed counterparties.
OFF-MARKET OR PREFUNDED
UNNAMED COUNTERPARTIES DERIVATIVES TRANSACTIONS
Institutions that deal in products such as foreign
Banking organizations may enter into off-
exchange, securities, and derivatives sometimes
market or prefunded derivatives contracts that
face situations in which they are unaware of a
are the functional equivalent of extensions of
counterparty’s identity. Investment advisers or
credit to trading counterparties. However, the
agents typically conduct trades on behalf of their
business or legal structure of some of these
investment-management clients and do not pro-
transactions may not readily convey their eco-
vide the names of the ultimate counterparty on
nomic function. Institutions should ensure that
the grounds of confidentiality. In this situation,
off-market or prefunded transactions are recog-
the dealing institution will most likely never
nized appropriately as credit extensions and
know the identity of its counterparties.
represented accurately and adequately in the
Because institutions may not be able to assess
institution’s internal risk-management processes,
the creditworthiness of unnamed counterparties
regulatory reports, and published financial state-
in advance, institutions should develop policies
ments. Moreover, since off-market or prefunded
and procedures that define the conditions under
transactions may have the potential to obscure
which such transactions can be conducted.
the true nature of a counterparty’s assets, liabili-
Exposures arising from these transactions should
ties, income, or expenses, these transactions
be closely monitored and controlled. Given the
may expose the originating banking organiza-
potential reputational risks involved, trans-
tion to increased reputational, legal, or credit
actions with unnamed counterparties should be
risk. Accordingly, banking organizations should
restricted to reputable agents and firms. Institu-
have formal policies, procedures, and internal
tions with significant relationships with invest-
controls for assessing the business purpose and
ment advisers who trade on behalf of undis-
appropriateness of off-market or prefunded trans-
closed counterparties may wish to establish
actions with customers.2
agency agreements with those advisers. These
agreements can provide for a series of represen-
tations and warranties from the investment
adviser on a variety of issues, including Typical Off-Market or Prefunded
compliance with local and national laws and Derivatives Transactions
regulations, particularly on money-laundering
regulations. Off-market or prefunded derivatives transac-
Techniques used to reduce credit exposure to tions involve an up-front extension of credit to
undisclosed counterparties include setting limits the counterparty, either in the form of new
on the aggregate amount of business or on the
2. See the committee letter ‘‘Historical-Rate Rollovers: A
types of instruments or transactions conducted Dangerous Practice’’ (December 26, 1991), Foreign Exchange
with unnamed counterparties. In addition, insti- Committee, Federal Reserve Bank of New York
tutions often pay particular attention when (www.newyorkfed.org/fxc/fx26.html).
Trading and Capital-Markets Activities Manual September 2002
Page 11
2020.1 Counterparty Credit Risk and Presettlement Risk
money or as a rollover of existing debt. Examples side of the swap are paid on a traditional swap
of some off-market or prefunded derivatives schedule. This is the functional equivalent of a
transactions are described below. variable-rate loan.
Historical-Rate Rollovers Deep-in-the-Money Options
Often, historical-rate rollovers involve a deal- Sales of deep-in-the-money options can gener-
er’s extension of a forward foreign-exchange ate large up-front premiums for the option seller.
contract, on behalf of the customer, at off- Deep-in-the-money options are functionally
market rates. In a typical rollover, the customer equivalent to loans to the seller because the
will ask the dealer to apply the historical rate of option is almost certain to be exercised by the
a maturing contract to the spot end of a new pair buyer.
of contracts, which in effect extends the matur-
ing contract and defers any gains or losses on it. Zero-Coupon Swaps
Historical-rate rollovers virtually always involve
the extension of credit from one party to the A zero-coupon swap is an interest-rate swap
other. If the customer has a loss on the maturing agreement with the fixed-rate side based on a
contract, the rollover would in effect represent a zero-coupon bond. With the agreement of the
loan by the dealer to the customer. If the counterparty, the swap agreement may call for a
customer has a profit, the dealer would in effect single fixed payment at maturity by the holder of
be borrowing from the customer. The resulting the zero. The payments on the other side may
loan or borrowing amount and associated follow typical swap interim-payment schedules.
interest-rate charges are typically built into the Because of the payment mismatch, a zero-
forward points the dealer quotes to the customer. coupon swap exposes one counterparty to sig-
nificant credit risk and is the functional equiva-
lent of a loan to the holder of the zero.
Off-Market Swap Transactions
In off-market swap transactions, the contractual Reverse Zero-Coupon Swaps
market rates (for example, the interest rate or
currency-exchange rate) used in the swap trans- In a reverse zero-coupon swap, one counterparty
action are varied from current market levels. makes a zero-coupon payment up front, and the
This necessitates payment at the commencement other counterparty pays interest and principal
of the transaction, by one counterparty to the payments over time. Like a zero-coupon swap,
other, to compensate for the off-market coupon. this is the functional equivalent of a term loan
from the counterparty making the up-front
payment.
Prepaid Swaps
A prepaid swap is generally a physical- Specific Risks with Off-Market or
commodity forward contract featuring an up-front Prefunded Derivatives Transactions
buyer payment that is equal to the present value
of future commodity deliveries. The commodity Credit Risk
deliveries may be priced at the spot prices in
effect on each delivery date, making the trans- Off-market and prefunded derivative transac-
action a loan secured by an obligation to deliver tions may expose a banking organization to
the commodity at future market prices. Alterna- significant credit risk. Therefore, institutions
tively, the contract may call for delivery of should adopt written credit policies and proce-
specific quantities of the commodity on each dures guiding the use of these transactions.
delivery date, in effect fixing future delivery Off-market and prefunded transactions should
prices. A prepaid swap can also be an annuity- be treated as credit extensions for purposes of
like transaction in which the present value of the lending institution’s credit-approval, risk-
future payments on one side of a swap is paid up measurement, monitoring, and control systems.
front, while (variable) payments on the other Conversely, they should be appropriately recog-
September 2002 Trading and Capital-Markets Activities Manual
Page 12
Counterparty Credit Risk and Presettlement Risk 2020.1
nized as a financing by the borrowing counter- including the appropriate representation and
party. Failure to recognize the transaction as a accounting of the transaction on the books and
credit extension or borrowing could threaten records of both counterparties. These policies
centralized control over the management of and procedures may include—
credit risk. Lending institutions should also
consider establishing transaction sizes, maturity • written documentation from senior manage-
limits, and collateral guidelines for these types ment of the counterparty requesting the off-
of nontraditional transactions. Procedures for market or prefunded transaction, explaining
obtaining appropriate sign-off from the finance the reason for the request, and confirming that
function to ensure proper accounting for the the request is a request for an extension of
transaction should also be in place. credit that is consistent with the firm’s internal
policies;
• written documentation from senior manage-
Reputational Risk ment in the appropriate credit, finance, and
accounting functions of the banking organiza-
Banking organizations should establish written tion, explaining the reason for the transaction
policies and procedures for assessing the appro- and the accounting that will be followed to
priateness of and for approving off-market or reflect the transaction on the institution’s
prefunded derivatives transactions with a cus- books; and
tomer. These policies should consider the • written confirmation to senior management of
sophistication of the customer, the reason for the the counterparty, confirming the particulars of
transaction, whether the customer understands the transaction and explicitly stating the
the risks in the transaction, whether the transac- implied loan amount and pricing terms.
tion is consistent with the customer’s internal
policies, and whether it has been approved at
appropriate levels in the customer’s organiza- BLOCK TRADES WITH
tion. Transactions generating significant profits
or losses, nontraditional transactions, and trans-
INVESTMENT ADVISERS
actions or patterns of activity that may not be Frequently, investment advisers or agents will
compatible with a customer’s business lines or bundle together trades for several clients, par-
risk profile should be referred to senior manage- ticularly in the case of mutual funds and hedge
ment of both the banking organization and the funds.3 Most of these trades are accompanied
counterparty. Importantly, in marketing off- by information about how the trade should be
market or prefunded transactions, institutions allocated among the funds for which it was
should ensure that the transactions are presented executed, or they are subject to standing alloca-
and described in a manner consistent with their tion information. Occasionally, investment
true economic substance. advisers may fail to give institutions timely
allocation information. Institutions should be
concerned that such delays do not become
Legal Risk habitual. When significant investment-adviser
relationships exist, institutions should adopt poli-
Even if a banking organization properly markets cies requiring that all transactions be allocated
an off-market or prefunded derivatives transac- within some minimum period (for example, by
tion, the organization may be faced with repu- the end of the business day). The credit depart-
tational and legal risk exposure if its counter- ment should be promptly notified of any excep-
party mischaracterizes the transaction in tions to such policies.
regulatory or public reports. Failure to ensure Many institutions track the allocation arrange-
that management of both counterparties under- ments made by investment advisers. While late
stand and sign off on a transaction increases the
risk that the transaction may be mischaracter- 3. The Securities and Exchange Commission, in a number
ized. To manage this risk, banking organizations of no-action letters, has permitted this practice as long as the
should adopt specific written policies and pro- adviser does not favor any one client over another, has a
written allocation statement before the bundled order was
cedures to ensure that the senior management of placed, and receives the client’s written approval. See the
the banking organization and the counterparty following SEC letters: SMC Capital, Inc. (September 5, 1995)
fully understand and approve of the transaction, and Western Capital Management, Inc. (August 11, 1977).
Trading and Capital-Markets Activities Manual September 2002
Page 13
2020.1 Counterparty Credit Risk and Presettlement Risk
allocations or frequent changes to allocation The sophistication of an institution’s collateral-
arrangements are often symptomatic of back- management system should reflect the size of
office problems at the investment adviser, they the collateral program, frequency of collateral
could also indicate that the investment adviser is revaluations and associated credit-exposure cal-
engaging in unfair allocation. culations, nature of collateral-posting events,
Sometimes the allocations provided by invest- and location of the collateral. The most effective
ment advisers include counterparties that may collateral-management systems are global and
not have established credit lines with the insti- have the ability to identify, post, value, stress-
tution. Institutions should try to minimize such test, and monitor collateral. When collateral-
situations and may wish to limit the percentage management systems are able to feed data into
of any trade that can be allocated to counterpar- the front-office’s credit-line-availability system,
ties that do not have an existing credit line with an institution can factor collateral into credit-
the institution. approval decisions and, consequently, have a
more accurate picture of unsecured credit risk.
Institutions often maintain databases that detail
the extent to which netting is applicable for a
MANAGEMENT INFORMATION given counterparty. Depending on whether net-
SYSTEMS ting is applicable, obligations are presented on a
net or gross basis in credit-monitoring reports.
Management information systems (MIS) used to Credit MIS should furnish adequate reports to
control counterparty credit risk include systems credit personnel and business-line management.
to monitor exposure levels; track customer lim- Daily reports should address significant counter-
its and limit excesses; and, when used, value and party line usage and exceptions to limits. Less
track collateral. Important inputs to these sys- frequent reports on the maturity or tenor of
tems include transaction data, current market credit exposures, sector and industry concentra-
values, and estimated potential credit exposures. tions, trends in counterparty exposures, trends in
The primary purpose of these systems is to limit excesses, ‘‘watch lists,’’ and other pertinent
provide comprehensive, accurate, and timely reports are also appropriate. Periodic summary
credit information to credit-risk-management reports on credit exposures should also be pre-
personnel; front-office personnel; business-line sented to senior management and the board.
and other senior management; and, ultimately,
the board of directors. Institutions should ensure
that their credit MIS are adequate for the range
and scope of their trading and derivative activi- DOCUMENTATION OF POLICIES
ties and that there are appropriate controls in AND PROCEDURES
place to ensure the integrity of these systems. As
part of the normal audit program, internal audit Current and sufficient documentation is critical
should review credit MIS to ensure their to the effective operation of a credit-risk-
integrity. management program and is necessary to ensure
A critical element of MIS is their timeliness that the program is consistent with the stated
in reflecting credit exposures. For derivative intentions of senior management and the board.
contracts, institutions should be able to update The institution’s credit-policy manual is an
the current market values and potential credit important tool for both auditors and examiners,
exposures of their holdings throughout the life as well as an important resource for resolving
of a contract. The frequency of updates for any disputes between credit-risk management
credit-risk-management purposes often depends and traders or marketers.
on the complexity of the product and the volume All policies and procedures specific to credit-
of trading activity. More sophisticated systems risk management for trading should be added to
provide intraday exposure numbers that enable the financial institution’s overall credit-policy
the front office to determine, without any addi- manual. Procedures should include limit-
tional calculations, whether a proposed deal will approval procedures, limit-excess and one-off
cause a credit excess. approval procedures, exposure-measurement
Institutions that use collateral to manage credit methodologies, and procedures for accommodat-
risk usually maintain collateral-management sys- ing new products and variations on existing
tems for valuation and monitoring purposes. products. Policies should also address the meth-
September 2002 Trading and Capital-Markets Activities Manual
Page 14
Counterparty Credit Risk and Presettlement Risk 2020.1
odologies for assessing credit-loss reserves for the available limit to a counterparty before
trading operations. When established, such entering into a deal. Signed over-limit or one-
reserves should take into account both current off approvals should also be tracked down and
and potential future exposure. Credit-approval kept in a file for historical records. A log should
documentation should also be closely tracked by be maintained for all missing signed approvals,
the credit-risk-management function. All limit and approvals for new products should be
approvals should be filed by counterparty and maintained.
made available to traders so that they know
Trading and Capital-Markets Activities Manual September 2002
Page 15
Counterparty Credit Risk and Presettlement Risk
Examination Objectives Section 2020.2
1. To evaluate the organizational structure of procedures, and legal and operational sup-
the credit-risk-management function. port relating to the institution’s use of credit
2. To evaluate the adequacy of internal credit- enhancements.
risk-management policies and procedures 11. To determine if the institution has imple-
relating to the institution’s capital-markets mented adequate policies and procedures
and trading activities and to determine that that are sufficiently calibrated to the risk
sufficient resources and adequate attention profiles of particular types of counterparties
are devoted to the management of the risks and instruments to ensure adequate credit-
involved in growing, highly profitable, or risk assessment, exposure measurement,
potentially high-risk activitivies and prod- limit setting, and use of credit enhancements.
uct lines. 12. To ensure the comprehensiveness, accuracy,
3. To ensure that actual operating practices and integrity of management information
reflect such policies. systems that analyze credit exposures and
4. To identify the credit risks of the institution. to ensure that the methodology and auto-
5. To determine if the institution’s credit-risk- mated processing can accommodate net-
measurement system has been correctly ting and other legal offset agreements, if
implemented and adequately measures the applicable.
institution’s credit risks.
13. To determine if the institution’s credit-risk-
6. To determine if the institution’s credit-risk-
management system has been correctly
management processes achieve an appropri-
implemented and adequately measures the
ate balance among all elements of credit-
institution’s exposures.
risk management, including both qualitative
and quantitative assessments of counter- 14. To determine if the institution has an effec-
party creditworthiness; measurement and tive global risk-management system that
evaluation of both on- and off-balance-sheet can aggregate and evaluate market, liquid-
exposures, including potential future expo- ity, credit, settlement, operational, and legal
sure; adequate stress testing; reliance on risks, and that management at the highest
collateral and other credit enhancements; level is aware of the institution’s global
and the monitoring of exposures against exposure.
meaningful limits. 15. To determine if the institution is moving in
7. To determine how the institution measures a timely fashion to enhance its measure-
difficult-to-value exposures. ment of counterparty-credit-risk exposures,
8. To determine if senior management and the including the refinement of potential future
board of directors of the institution under- exposure measures and the establishment of
stand the potential credit exposures of the stress-testing methodologies that better in-
capital-markets and trading activities of the corporate the interaction of market and
institution. credit risks.
9. To ensure that business-level management 16. To recommend corrective action when poli-
has formulated contingency plans in the cies, procedures, practices, internal con-
event of credit deterioration and associated trols, or management information systems
market disruptions. are found to be deficient.
10. To evaluate the adequacy of the policies,
Trading and Capital-Markets Activities Manual September 1999
Page 1
Counterparty Credit Risk and Presettlement Risk
Examination Procedures Section 2020.3
These procedures are processes and activities gies used to measure current exposure
that may be considered in reviewing the credit- and potential exposure.
risk-management of trading and derivative b. Review credit-administration procedures.
operations. The examiner-in-charge will estab- • Determine how frequently counter-
lish the general scope of examination and work party credit conditions are analyzed
with the examination staff to tailor specific areas and lines reviewed. This should be
for review as circumstances warrant. As part of done no less frequently than annually.
this process, the examiner reviewing a function • Assess whether management has dem-
or product will analyze and evaluate internal onstrated an ability to identify down-
audit comments and previous examination work- grades in creditworthiness between
papers to assist in designing the scope of the reviews.
examination. In addition, after a general review • Determine if credit-risk-management
of a particular area to be examined, the examiner staff demonstrate an ability to work
should use these procedures, to the extent they out of positions with counterparties
are applicable, for further guidance. Ultimately, whose credit quality has deteriorated.
it is the seasoned judgment of the examiner and • Check that limits are in place for
the examiner-in-charge as to which procedures counterparties before transacting a deal.
are warranted in examining any particular If the institution relies on one-off
activity. approvals, check that the approval pro-
cess is as formal as that for counter-
1. Review the credit-risk-management party limits.
organization. c. Review contingency credit-risk plans for
a. Check that the institution has a credit- adequacy.
risk-management function with a sepa- d. Review accounting and revaluation
rate reporting line from traders and policies and procedures. Determine that
marketers. revaluation procedures are appropriately
b. Determine if credit-risk-control person- controlled.
nel have sufficient authority in the insti- e. Determine the extent to which manage-
tution to question traders’ and marketers’ ment relies on netting agreements. Deter-
decisions. mine if aggregation of exposure assumes
c. Determine if credit-risk management is netting, and check that netting agree-
involved in new-product discussions in ments are in place and that legal research
the institution. is performed to justify management’s
2. Identify the institution’s capital-markets and confidence in the enforceability of the
trading activities and the related balance- netting agreements.
sheet and off-balance-sheet instruments. 4. Determine the credit rating and market
Obtain copies of all risk-management reports acceptance of the institution as a counter-
prepared by the institution. Using this party in the markets.
information, evaluate credit-risk-control per- 5. Obtain all management information analyz-
sonnel’s demonstrated knowledge of the ing credit risk.
products traded by the institution and their a. Determine the comprehensiveness, accu-
understanding of current and potential racy, and integrity of analysis.
exposures. b. Review valuation and simulation meth-
3. Obtain and evaluate the adequacy of risk- ods in place.
management policies and procedures for c. Review stress tests analyzing changes in
capital-markets and trading activities. credit quality, including deterioration of
a. Review credit-risk policies, procedures, credit due to changing macroeconomic
and limits. Determine whether the risk- conditions. Review stress-testing meth-
measurement model and methodology odologies to determine the extent to
adequately address all identified credit which they incorporate both credit and
risks and are appropriate for the institu- market risk.
tion’s activities. Review the methodolo- d. Review potential future exposure calcu-
Trading and Capital-Markets Activities Manual September 1999
Page 1
2020.3 Counterparty Credit Risk and Presettlement Risk: Examination Procedures
lations to determine whether they reflect tion’s use of credit enhancements.
realistic measures of exposure in both a. Review collateralization policies and
normal and stressed markets. procedures.
e. Determine whether the management • Determine the frequency of margin
information reports accurately reflect calls and portfolio and collateral
risks and whether reports are provided to revaluations.
the appropriate levels of management. • Ensure that legal agreements are in
6. Determine if any of the institution’s coun- place and that the fundamental aspects
terparties have recently experienced credit of collateral relationships are specified
downgrades or deteriorations and whether in the agreements.
the institution’s trading activities have been • Review the policies for determining
affected. If so, determine the institution’s the types of acceptable collateral, hair-
response. cuts on the collateral, and margin
7. Review documentation that evidences credit- requirements.
risk management’s adherence to its program. b. Determine whether the institution has
a. Obtain copies of written approvals for rehypothecation rights. Determine
limit excesses or one-off approvals. whether appropriate policies and pro-
Determine the timeliness of these cedures are in place to manage the
approvals. risks associated with collateral
b. Select a sample of master agreements rehypothecation.
to ensure that each counterparty with c. Ensure that collateral-management sys-
whom management nets exposure for tems and operational internal controls
risk-management purposes has signed a are fully documented and able to support
master agreement. Review the master the institution’s credit enhancement
agreement aging report of unsigned activity.
master agreements to ensure adequate 13. Determine whether policies and procedures
chasing procedures are in place. reflect the risk profiles of particular coun-
8. Establish that the institution is following its terparties and instruments. If the institution
internal policies and procedures. Determine trades with institutional investors, hedge
whether the established limits adequately funds, or unnamed counterparties, deter-
control the range of credit risks. Determine mine if the institution has an overall limit on
that the limits are appropriate for the insti- trading with these types of counterparties.
tution’s level of activity. Determine whether 14. Determine whether appropriate policies and
management is aware of limit excesses and procedures are in place if the institution
takes appropriate action when necessary. engages in block trades with investment
9. Determine whether the internal-audit and advisors.
independent risk-management functions a. Determine if the institution has a policy
adequately focus on growth, profitability, that all trades not allocated at the time of
and risk criteria in targeting their reviews. the trade must be allocated by the end of
10. Determine whether the institution has the trading day. Determine whether
established an effective audit trail that exceptions to such a policy are moni-
summarizes exposures and management tored by the credit area.
approvals with the appropriate frequency. b. Determine how the institution deals with
11. Determine that business managers have investment advisors who are habitually
developed contingency plans which reflect late with allocation information.
actions to be taken in times of market c. Determine whether the institution limits
disruption (and major credit deteriorations) the percentage of a block trade that can
to minimize losses as well as the potential be allocated to counterparties without
damage to the institution’s market-making credit lines.
reputation. These should include controls 15. Recommend corrective action when poli-
over the settlement process. cies, procedures, practices, internal con-
12. Obtain and evaluate the adequacy of poli- trols, or management information systems
cies and procedures relating to the institu- are found to be deficient.
September 1999 Trading and Capital-Markets Activities Manual
Page 2
Counterparty Credit Risk and Presettlement Risk
Internal Control Questionnaire Section 2020.4
1. Review the credit-risk-management • Can management identify downgrades
organization. in creditworthiness between reviews?
a. Does the institution have a credit-risk- • Has credit-risk-management staff
management function with a separate demonstrated an ability to work out of
reporting line from traders and marketers? positions with counterparties whose
b. Do credit-risk-control personnel have credit quality has deteriorated?
sufficient credibility in the institution to • Are limits in place for counterparties
question traders’ and marketers’ before transacting a deal? If the insti-
decisions? tution relies on one-off approvals, is
c. Is credit-risk management involved in the approval process as formal as that
new-product discussions in the for counterparty limits?
institution? c. Have limits been approved by the board
2. Identify the institution’s capital-markets and of directors?
trading activities and the related balance- d. Have policies, procedures, and limits
sheet and off-balance-sheet instruments and been reviewed and reapproved within the
obtain copies of all risk-management reports last year?
prepared. e. Are credit-risk policies, procedures, and
a. Do summaries identify all the institu- limits clearly defined?
tion’s capital-markets products? f. Are the credit limits appropriate for the
b. Define the role that the institution takes institution and its level of capital?
for the range of capital-markets prod- g. Are there contingency credit-risk plans?
ucts. Determine the instruments used to h. Are there appropriate accounting and
hedge these products. Is the institution revaluation policies and procedures?
an end-user, dealer, or market maker? If i. Does management rely on netting
so, in what products? agreements?
c. Do credit-risk-control personnel demon- • Does aggregation of exposure assume
strate knowledge of the products traded netting?
by the institution? Do they understand • Are netting agreements in place and
the current and potential exposures to the has legal research been performed
institution? to justify management’s confidence
3. Does the institution have comprehensive, in the enforceability of the netting
written risk-management policies and pro- agreements?
cedures for capital-markets and trading 4. Has there been a credit-rating downgrade
activities? for the examined institution? What has been
a. Review credit-risk policies and the market response to the financial institu-
procedures. tion as a counterparty in the markets?
• Do the risk-measurement model and 5. Obtain all management information analyz-
methodology adequately address all ing credit risk.
identified credit risks? Are the risk- a. Is management information comprehen-
measurement model and methodology sive and accurate and is the analysis
appropriate for the institution’s sound?
activities? b. Are the simulation assumptions for a
• Do the policies explain the board of normal market scenario reasonable?
directors’ and senior management’s c. Are stress tests analyzing changes in
philosophy regarding illiquid markets credit quality appropriate? Are the mar-
and credit events (downgrades/ ket assumptions reasonable given credit
deteriorations)? deterioration of concentrations? Do stress-
b. Review credit-administration procedures. testing methodologies incorporate both
• Are counterparty credit conditions credit and market risk?
analyzed and lines reviewed with d. Are calculations of potential future
adequate frequency? (This should be exposure realistic in both normal and
done no less frequently than annually.) stressed markets?
Trading and Capital-Markets Activities Manual September 1999
Page 1
2020.4 Counterparty Credit Risk and Presettlement Risk: Internal Control Questionnaire
e. Do management information reports c. Does the institution have policies speci-
accurately reflect risks? Are reports fying the types of acceptable collateral,
provided to the appropriate levels of haircuts on the collateral, and margin
management? requirements? How often are these poli-
6. Have any of the institution’s counterparties cies reviewed by management?
recently experienced credit downgrades or d. Does the institution have rehypotheca-
deteriorations? If so, how have the institu- tion rights?
tion’s trading activities been affected and • Does the institution have policies and
what was the institution’s response? procedures in place to manage the risk
7. Review documentation that evidences credit that a third party holding rehypoth-
management’s adherence to its program. ecated collateral may fail to return the
a. Does the institution maintain copies of collateral or may return a different
written approvals for limit excesses or type of collateral?
one-off approvals? Are these prepared in • Does the institution have measures in
a timely manner? place to protect its security interest in
b. Obtain a sample of master agreements. the rehypothecated collateral?
Are they appropriately signed? Are they e. Do material-change triggers and close-
signed in a timely manner? Does the out provisions take into account
institution have an appropriate chasing counterparty-specific situations and risk
process to follow up on unsigned master profiles?
agreements? f. Are the collateral-management system
8. Is the institution following its internal poli- and operational environment able to
cies and procedures? Do the established support the institution’s collateral
limits adequately control the range of credit activity?
risks? Are the limits appropriate for the 13. Does the institution trade with institu-
institution’s level of activity? Is manage- tional investors, hedge funds, or unnamed
ment aware of limit excesses? Does man- counterparties?
agement take appropriate action when
a. Does the institution place an overall limit
necessary?
on trading with these types of
9. Do the internal audit and independent risk-
counterparties?
management functions adequately focus on
growth, profitability, and risk criteria in b. Are credit officers aware of all cases
targeting their reviews? in which a counterparty’s identity is
10. Has the institution established an effective unknown?
audit trail that summarizes exposures and 14. Does the institution engage in block trades
management approvals with the appropriate with investment advisors?
frequency? Are risk-management, revalua- a. Does the institution have a policy that all
tions, and closeout valuation reserves sub- trades not allocated at the time of the
ject to audit? trade must be allocated by the end of the
11. If any recent market disruptions affected the trading day? Are exceptions to the policy
institution’s trading activities, what has been monitored closely by the credit area?
the institution’s market response? b. How does the institution deal with invest-
12. Does the institution have comprehensive ment advisors who are habitually late
written policies and procedures relating to with allocation information?
its use of credit enhancements? c. Does the institution limit the percentage
a. Does the institution revalue collateral of a block trade that can be allocated to
and positions with adequate frequency? counterparties without credit lines?
b. Are the fundamental aspects of collateral 15. Do policies and procedures generally reflect
relationships reflected in legal the risk profiles of particular counter-
agreements? parties and instruments?
September 1999 Trading and Capital-Markets Activities Manual
Page 2
Counterparty Credit Risk and Settlement Risk
Section 2021.1
Settlement risk is the risk of loss when an banks of the Group of Ten Countries, ‘‘Settle-
institution meets its payment obligation under a ment in Foreign Exchange Transactions,’’ which
contract (through either an advance of funds or was prepared under the auspices of the Bank for
securities) before its counterparty meets a coun- International Settlements. In addition, the Board
terpayment or delivery obligation. Failures to issued a policy statement, effective January 4,
perform at settlement can arise from counter- 1999, that addresses risks relating to private
party default, operational problems, market multilateral settlement systems (63 FR 34888,
liquidity constraints, and other factors. Settle- June 26, 1998).
ment risk exists for any traded product and is
greatest when delivery is made in different time
zones. For banking institutions, foreign-exchange SETTLEMENT-RISK-
(FX) transactions are, perhaps, the greatest MANAGEMENT ORGANIZATION
source of settlement-risk exposure. For large,
money-center institutions, FX transactions can An institution’s process and program for man-
involve sizable credit exposures amounting to aging its settlement risks should be commensu-
tens of billions of dollars each day. Accordingly, rate with the range and scope of its activities.
although the following general guidance can be Institutions with relatively small trading opera-
applied to the settlement of all types of traded tions in noncomplex instruments may not need
instruments, it focuses primarily on the settle- the same level of automated systems, policies,
ment risks involved in FX transactions. and staff skills as do firms that are heavily
Settlement risk has a number of dimensions engaged in FX transactions and other trading
that extend beyond counterparty credit risk to activities.
include liquidity, legal, operational, and system- The management of settlement risk should
atic risks. Even temporary delays in settlement begin at the highest levels of the organization,
can expose a receiving institution to liquidity with senior management exercising appropriate
pressures if unsettled funds are needed to meet oversight of settlement exposures. Although the
obligations to other parties. Such liquidity specific organizational approaches may vary
exposure can be severe if the unsettled amounts across institutions, managing settlement risk for
are large and alternative sources of funds must FX and other trading activities should be inte-
be raised at short notice in turbulent or unrecep- grated into the overall risk management of the
tive markets. In an extreme example, the finan- institution to the fullest extent practicable. Set-
cial failure of a counterparty can result in the tling transactions can involve many different
loss of the entire amount of funds. functional areas of an institution, including trad-
ing, credit, operations, legal, risk assessment,
As with other forms of credit risk, settlement branch management, and correspondent rela-
risk should be managed through a formal and tions. Only senior management can effect the
independent process with adequate senior man- coordination necessary to define, measure, man-
agement oversight and should be guided by age, and limit settlement risks across such varied
appropriate polices, procedures, and exposure functions. Accordingly, senior management
limits. Measurement systems should provide should ensure that they fully understand the
appropriate and realistic estimates of the settle- settlement risks incurred by the institution and
ment exposures and should use generally accepted should clearly define lines of authority and
measurement methodologies and techniques. The responsibility for managing these risks so that
development of customer credit limits and the priorities, incentives, resources, and procedures
monitoring of exposures against those limits is a across different areas can be structured to reduce
critical control function and should form the exposures and mitigate risks. Staff responsible
backbone of an institution’s settlement-risk- for all aspects of settlement-risk management
management process. should be adequately trained.
This section discusses settlement risks involved
in trading activities, especially as they apply to
FX transactions. A primary reference for this Measuring FX Settlement Exposures
material is the 1996 report of the Committee on
Payment and Settlement Systems of the central Settlements generally involve two primary
Trading and Capital-Markets Activities Manual March 1999
Page 1
2021.1 Counterparty Credit Risk and Settlement Risk
events: the transmission of payment orders and The effect of an institution’s internal process-
the actual advance or receipt of funds. In FX ing patterns on its settlement risk should also be
transactions, it is important to distinguish a considered. The interval from the unilateral
payment order, which is an instruction to make cancellation deadline for sold currency until
a payment, from the payment, which involves an final receipt of bought currency is generally
exchange of credits and debits on the accounts referred to as the period of irrevocability. The
of a correspondent bank or the accounts of a full face value of the trade is at risk and the
central bank when an interbank transfer takes exposure on this amount can last overnight and
place. To avoid paying late delivery fees, banks up to one or two full days. If weekends and
try to send their orders to their back office, holidays are included, the exposure can exist for
branch, or correspondent bank on the day of several days. The total exposures outstanding
trade or the next day. Since spot FX transactions during this interval constitutes an institution’s
generally call for settlement on the second day minimum FX settlement exposure.
after the trade, orders are transmitted one or two The process of reconciling payments received
days before settlement. On settlement day, pay- with expected payments can also be a significant
ment orders are routed to the receiving institu- source of settlement-risk exposure. Many insti-
tion through its correspondent or through the tutions may not perform this exercise until the
domestic payment system for actual final pay- day after settlement. During this interval, there
ment. Final payment may also be made through is uncertainty as to whether the institution has
book-entry transfer if the two trading banks use received payments from particular counter-
a common correspondent. parties. This period of uncertainty can create
A bank’s settlement exposure runs from the increased exposure, if it extends past the unilat-
time that its payment order for the currency sold eral cancellation deadline for payments on the
can no longer be recalled or canceled with following day. For example, if an institution is
certainty and lasts until the time that the cur- subject to a unilateral cancellation deadline of
rency purchased is received with finality. In 3:00 a.m. on settlement day and payments from
general, book-entry payments provide some- the prior day’s settlements are not reconciled
what greater flexibility in terms of the ability to until mid-morning on the day following settle-
cancel a transfer because their processing does ment, it may be too late to manage its payments
not rely on domestic payment systems. How- exposure for that following day. In this case, the
ever, even the cancellation of book-entry trans- maximum exposure from the evening of settle-
fers is still subject to restrictions presented by an ment day to morning on the following day can
institution’s internal processing cycles and com- amount to both the receipts expected on settle-
munication networks as well as time zone dif- ment day (since their receipt has not been
ferences between branch locations. In theory, reconciled) and the entire amount of the follow-
institutions may retrieve and cancel payment ing day’s settlements (since they cannot be
orders up until the moment before the funds are recalled.) In effect, an estimation of worst-case
finally paid to a counterparty. However, many or maximum settlement exposures involves add-
institutions have found that operational, eco- ing the exposures outstanding during the period
nomic, and even legal realities may result in of irrevocability to the exposures outstanding
payment orders becoming effectively irrevo- during the period of uncertainty. In a worst-case
cable one or two business days before settlement situation, a bank might find itself in the position
day. of having sent out payments to a counterparty on
Institutions should specifically identify the one day when it had not been paid on the
actual time past which they can no longer stop a previous day.
payment without the permission of a third party. Many institutions commonly define and mea-
This time is termed the unilateral cancellation sure their daily settlement exposures as the total
deadline and should be used as a key parameter receipts coming due that day. In some cases, this
in assessing settlement-risk exposure. The doc- technique may either understate or overstate
umentation covering a correspondent’s ser- exposures. Simple measures using multiples of
vice agreement generally identifies these cutoff daily receipts can also incorrectly estimate risk.
times. In the event of a dispute, a correspondent For example, using simple ‘‘rules of thumb’’ of
is likely to use the contractually agreed-upon two or three days of receipts may not sufficiently
unilateral cancellation deadline as a binding account for the appropriate timing of the settle-
constraint. ment processing across different currencies.
March 1999 Trading and Capital-Markets Activities Manual
Page 2
Counterparty Credit Risk and Settlement Risk 2021.1
Appropriately measuring FX settlement expo- also be broken down into sublimits by product.
sures requires an institution to explicitly identify Sublimits may also be specified by date since
both the unilateral cancellation deadlines and settlement risk tends to be highest on the date of
the reconciliation process times involved in each settlement.
type of currency transaction. Accordingly, any Effective monitoring of exposures is crucial
simple rules used to measure settlement expo- to the management of settlement risk, and insti-
sures should be devised in such a way as to tutions with large settlement exposures should
consider both the unilateral cancellation dead- strive to monitor payment flows on a real-time
lines and the reconciliation process involved in basis. Institutions should look to reduce settle-
settlement. Identifying the duration of the settle- ment risk by arranging with their correspondents
ment process and the related exposures does and counterparties to minimize, as much as
not require real-time tracking of all payments practicable, the timing of an exchange of pay-
and can be accomplished through estimations ments. Collateral arrangements and net settle-
based on standard settlement instructions and an ment agreements are also important settlement-
understanding of the key milestones in the risk-management tools.
settlement process. Institutions should have a The timely reconciliation of nostro accounts
clear means of reflecting this risk in their expo- also helps to mitigate settlement risk. Institu-
sure measurements. tions often assume they have settlement expo-
Explicit consideration of unilateral cancella- sure until they can confirm final receipt of funds
tion deadlines and the reconciliation process can or securities. Timely reconciliation enables an
help an institution identify areas for improve- institution to determine its settlement exposure
ment. If the time from its unilateral cancellation accurately and make informed judgments about
deadline to reconciliation can be reduced to its ability to assume additional settlement risk.
under 24 hours, then an exposure measure of
one day’s receivables may provide a reasonable
approximation of the duration and size of the Procedures
settlement exposure to a counterparty. However,
even then it must be recognized that overnight From time to time, institutions may misdirect
and weekend exposure may remain and that their payments, and funds may fail to arrive in
different currency pairs may require different promptly. While such mistakes may be inadvert-
intervals, which might overlap. ent and corrected within a reasonable time,
institutions should have procedures for quickly
identifying fails, obtaining the funds due, and
Limits taking steps to avoid recurrences. Some institu-
tions deduct fails from counterparty limits and
Institutions should ensure that settlement expo- review a series of fails to determine whether
sures to counterparties are properly limited. FX their pattern suggests that the problem is not
settlement exposures should be subject to an procedural.
adequate credit-control process, including credit
evaluation and review and determination of the
maximum exposure the institution is willing to Netting
take with a particular counterparty bank. The
process is most effective when the counterpar- Banks can reduce the size of their counterparty
ty’s FX settlement exposure limit is subject to exposures by entering into legally binding agree-
the same procedures used to devise limits on ments for the netting of settlement payments.
exposures of similar duration and size to the (Netting of payment obligations should not be
same counterparty. For example, in cases where confused with the more common netting of
the FX settlement exposure to a counterparty mark-to-market credit exposures of outstanding
lasts overnight, the limit might be assessed in contracts such as swaps and forward FX.) Com-
relation to the trading bank’s willingness to lend mon arrangements involving bilateral netting of
fed funds on an overnight basis. settlement flows, including FXNet, ValueNet,
Examiners should verify that the firm has set and Swift Accord, and bilateral agreements
up separate presettlement and settlement lines following IFEMA or other contracts. Legally
for counterparties. Settlement exposures may binding netting arrangements permit banks to
Trading and Capital-Markets Activities Manual March 1999
Page 3
2021.1 Counterparty Credit Risk and Settlement Risk
offset trades against each other so that only the Risk-management measures to mitigate credit
net amount in each currency must be paid or risk include monitoring participants’ financial
received by each bank to its netting counter- condition; setting caps or limits on some or all
parts. Depending on trading patterns, netting can participants’ positions in the system; and requir-
significantly reduce the value of currencies ing collateral, margin, or other security. To
settled. Netting also reduces the number of mitigate liquidity risk, institutions operating mul-
payments to one per currency either to or from tilateral settlement systems may also consider
the counterparty. external liquidity resources and contingency
Netting is most valuable when counterparties arrangements. Liquidity risk also is mitigated by
have a considerable two-way flow of business. timely notification of settlement failures to enable
As a consequence, netting may only be attrac- participants to borrow funds to cover shortfalls.
tive to the most active institutions. To take Operational risks are mitigated by contingency
advantage of risk-reducing opportunities, insti- plans, redundant systems, and backup facilities.
tutions should have a process for identifying Legal risks are mitigated by operating rules and
attractive netting situations that would provide participant agreements, especially when transac-
netting benefits that outweigh the costs involved. tions are not covered by an established body of
Some banks use the procedure of informal law.
payment netting. Based on trading patterns, Large multilateral settlement systems also
back offices of each counterparty will confer by must meet the more comprehensive require-
telephone on the day before settlement and ments of the Lamfalussy Minimum Standards
agree to settle only the net amount of the trades established by the central banks of the Group of
falling due. Since there may not be a legal Ten countries. Under the policy statement, in
opinion underpinning such procedures, institu- determining whether a system must meet the
tions should ensure that they develop a good Lamfalussy Minimum Standards, the Board will
understanding of their ability to manage the consider whether the system settles a high pro-
legal, credit, and liquidity risks of this practice. portion of large-value interbank or other finan-
cial market transactions, has very large liquidity
exposures that have potentially systemic conse-
quences, or has systemic credit exposures rela-
Multilateral Settlement Systems tive to the participants’ financial capacity.
The use of multilateral settlement systems by
institutions raises additional settlement risks Contingency Planning
insofar as the failure of one system participant to
settle its obligations when due can have credit or Contingency planning and stress testing should
liquidity effects on participants that have not be an integral part of the settlement-risk-
dealt with the defaulting participant. The Board’s management process. Contingencies should be
recent Policy Statement on Privately Operated established to span a broad spectrum of stress
Multilateral Settlement Systems provides guid- events, ranging from internal operational diffi-
ance on the risks of these systems. The policy culties to individual counterparty defaults to
statement applies to systems with three or more broad market-related events. Adequate contin-
participants that settle U.S. dollar payments with gency planning in the FX settlement-risk area
an aggregate gross value of more than $5 billion includes ensuring timely access to key infor-
on any one day. However, the principles set mation such as payments made, received, or in
forth in the policy statement can be used to process; developing procedures for obtaining
evaluate risks in smaller systems. information and support from correspondent
The policy statement addresses the credit, institutions; and well-defined procedures for
liquidity, operational, and legal risks of multi- informing senior management about impending
lateral settlement systems and provides risk- problems.
management measures for consideration. The
policy statement is intended to provide a flex-
ible, risk-based approach to multilateral Internal Audit
settlement system risk management and should
not be interpreted as mandating uniform, rigid Institutions should have in place adequate inter-
requirements for all systems under its purview. nal audit coverage of the settlement areas to
March 1999 Trading and Capital-Markets Activities Manual
Page 4
Counterparty Credit Risk and Settlement Risk 2021.1
ensure that operating procedures are adequate to accounting, systems development, and manage-
minimize exposure to settlement risk. The scope ment information systems. In automated FX
of the FX settlement internal audit program settlement processing, the internal audit depart-
should be appropriate to the risks associated ment should have some level of specialization in
with the market environment in which the insti- information technology auditing, especially if
tution operates. The audit frequency should be the institution maintains its own computer
adequate for the relevant risk associated with the facility.
FX settlement area. Most institutions base audit
frequency on a risk-assessment basis, and
examiners should consult with the internal audit
examiner to determine the adequacy of the Management Information Systems
risk-assessment methodology used by the
institution. In larger, more complex institutions, counter-
Audit reports should be distributed to appro- party exposures and positions can run across
priate levels of management, who should take departments, legal entities, and product lines.
appropriate corrective action to address findings Institutions should have clearly defined methods
pointed out by the internal audit department. and techniques for aggregating exposures across
Audit reports should make recommendations for multiple systems. In general, automated aggre-
minimizing settlement risk in cases where weak- gation produces fewer errors and a higher level
nesses are cited. Management should provide of accuracy in a more timely manner than
written responses to internal audit reports, indi- manual methods.
cating its intended action to correct deficiencies The institution should have a contingency
where noted. plan in place to ensure continuity of its FX
When audit findings identify areas for settlement operations if its main production site
improvement in the FX settlement area, other becomes unusable. This plan should be docu-
areas of the institution on which this may mented and supported by contracts with outside
have an impact should be notified. This could vendors, where appropriate. The plan should be
include credit-risk management, reconciliations/ tested periodically.
Trading and Capital-Markets Activities Manual March 1999
Page 5
Liquidity Risk
Section 2030.1
Institutions face two types of liquidity risk in contract early and possibly at a time when the
their capital-markets and trading activities: institution may face other funding and liquidity
‘‘funding-liquidity risk’’ refers to the ability to pressures. Furthermore, early terminations may
meet investment and funding requirements aris- expose additional market positions. Manage-
ing from cash-flow mismatches, and ‘‘market- ment and directors should be aware of these
liquidity risk’’ is the risk that an institution potential liquidity risks and address them in the
cannot easily eliminate or offset a particular liquidity plan and management process. Exam-
position without significantly affecting the iners should consider the extent to which such
previous market price because of inadequate potential obligations could present liquidity risks
market depth or market disruption. Measur- to the institution.
ing, monitoring, and addressing both types of
liquidity-risk exposures are vital activities of a
financial institution. Ultimate responsibility for
setting liquidity policies and reviewing liquidity FUNDING-LIQUIDITY RISK
decisions lies in the financial institution’s
highest level of management, and its decisions Funding-liquidity risk refers to the ability to
should be reviewed periodically by the board of meet investment and funding requirements aris-
directors. ing from cash-flow mismatches. Virtually every
financial transaction or commitment has impli-
In developing guidelines for controlling cations for an institution’s liquidity. Tradi-
liquidity risks, institutions should consider the tionally, funding-liquidity-risk management
possibility that they could lose access to one or focused on the balance-sheet activities of finan-
more markets because of concerns about its own cial institutions; however, the major growth in
creditworthiness, the creditworthiness of a major off-balance-sheet activities in recent years has
counterparty, or generally stressful market con- made liquidity management of these exposures
ditions. At such times, the institution may have increasingly important. Activities such as foreign-
less flexibility in managing its market-, credit-, exchange, securities, and derivatives trading can
and liquidity-risk exposures. Institutions that have an important impact on a financial institu-
make markets in over-the-counter derivatives or tion’s liquidity.
that dynamically hedge their positions require The ability of a financial institution to raise
constant access to financial markets, and that funds in the wholesale marketplace can be
need may increase in times of market stress. The influenced by systemic factors, which affect the
institution’s liquidity plan should reflect the spectrum of market participants, as well as by
institution’s ability to turn to alternative mar- weaknesses confined to the individual institu-
kets, such as futures or cash markets, or to tion, such as a real or perceived decline in its
provide sufficient collateral or other credit credit quality. The perception that a financial
enhancements to continue trading under a broad institution’s credit quality is declining can have
range of scenarios. a dramatic impact on its wholesale funding
Examiners should ensure that financial insti- capabilities. Additionally, customers may wish
tutions that participate in over-the-counter to reduce or eliminate their exposures to the
derivative markets adequately consider the institution by unwinding their in-the-money posi-
potential liquidity risk associated with the early tions. (In this instance, the customers’ in-the-
termination of derivative contracts. Many forms money position refers to contracts with a posi-
of standardized contracts for derivatives trans- tive value to the customer; the position would be
actions allow counterparties to terminate their out-of-the-money to the financial institution.)
contracts early if the institution experiences an While not necessarily obligated to unwind posi-
adverse credit event or its financial condition tions, the institution may feel compelled to
deteriorates. Under conditions of market stress, accommodate its counterparties if it perceives
customers may also ask for the early termination that a continued presence as an active market
of some contracts within the context of the maker is required to avoid damaging its market-
dealer’s market-making activities. In these situ- making reputation. Similarly, to the extent that
ations, an institution that owes money on deriva- the institution has entered into transactions
tive transactions may be required to settle a documented with agreements containing margin
Trading and Capital-Markets Activities Manual September 2002
Page 1
2030.1 Liquidity Risk
or collateralization provisions in favor of the should be available for examiner review. A
counterparty, or has granted the counterparty the more detailed discussion of funding-liquidity
right to terminate the contract under certain risk can be found in the Commercial Bank
conditions, the institution may be legally obli- Examination Manual.
gated to provide cash or cash-equivalent collat-
eral to in-the-money counterparties. Correspond-
ingly, the institution’s ability to collect margin
or collateral from its customers on its in-the- Contingency Funding Plans
money positions may be affected by the ability
of its counterparties to perform. The complexity of large trading portfolios can
make liquidity and cash-flow management
difficult. For example, as market prices change,
required adjustments to hedge ratios, variation
Management Information Systems margin calls, and customers’ exercise of options
may cause a portfolio that is hedged and solvent
Virtually all financial institutions have a staff in a present-value sense to experience, at a
dedicated to measuring and managing the insti- point in time, a shortfall of cash inflows over
tution’s liquidity. Generally, the management outflows—thus creating a liquidity squeeze. Even
information systems designed for liquidity mea- if its portfolio is solvent, a financial institution
surement should relate to the level of the activi- may be unable to borrow to cover the cash-flow
ties of the financial institution. An institution’s asymmetry because the complexity of the port-
investment in information systems designed to folio can obscure its true financial condition
gather liquidity information on balance-sheet from potential lenders, making it appear too
and off-balance-sheet exposures may be substan- risky for lenders to quickly approve an urgent
tial for firms actively involved in the market- request for funds. For a financial institution with
place, especially if these activities are conducted insufficient liquid assets, this cash-flow-
globally. Correspondingly, financial institutions management problem adds to the dimensions
who are primarily end-users of off-balance-sheet over which a portfolio must be managed.
products may have less-sophisticated systems. To address liquidity and cash-flow issues,
Cash-flow projections should always incorpo- senior management is responsible for establish-
rate all significant cash-flow sources and uses ing and implementing a sound funding-liquidity
resulting from on- and off-balance-sheet activi- contingency plan that provides for centralized
ties. For institutions operating in a global envi- and comprehensive policies and procedures;
ronment, these projections should also reflect measurement, monitoring, and reporting of
various foreign-currency funding requirements. exposures; and internal controls. The board of
Management information systems should also directors is responsible for reviewing this plan
be able to project cash flows under a variety of regularly and assessing the institution’s overall
scenarios, including (1) a ‘‘business-as-usual’’ liquidity-risk profile in light of the banking
approach, which establishes the benchmark for organization’s business strategies, liquidity
the ‘‘normal’’ behavior of cash flows of the objectives, and risk appetite.
institution; (2) a liquidity crisis confined to the A liquidity contingency plan should be based
institution; and (3) a systemic liquidity crisis, in on a solid understanding of the institution’s
which liquidity is affected at all financial insti- anticipated sources and uses of funds and on the
tutions. While the magnitude and direction of expected timing of those sources and uses. The
net cash positions can be forecast, it will fluc- composition, size, availability, volatility, and
tuate with changes in the market and activity in term structure of asset-backed liquidity sources
the portfolios. in relation to the institution’s liquidity structure
As in other areas of risk management, and liquidity needs should be gauged. The plan
liquidity-information systems and the liquidity- should reflect an understanding of the increased
management process should be subject to audit. volatility in financial markets and the speed with
The examiner should ensure that the overall which access to financial markets can deteriorate.
liquidity-risk-management process takes into The plan should identify stable, flexible, and
account the risks in trading activities, especially diverse liquidity sources to accommodate sig-
when those activities are substantial, and the nificant fluctuations in asset and liability levels
firm is a market maker. Evidence of analysis as a result of business cycles or unanticipated
September 2002 Trading and Capital-Markets Activities Manual
Page 2
Liquidity Risk 2030.1
stress events. In designing the plan, manage- among responsible staff, management, and the
ment should consider the interrelatedness of board. The crisis-management team should
funding-liquidity risks with credit, market, include top members of management respon-
interest-rate, and operational risks. sible for asset-liability management, as well as
A comprehensive approach formalizes com- highly skilled line management and staff. The
munications between business lines and the team should be designed to maximize the insti-
funding desk, and it explicitly considers fund- tution’s ability to quickly assess an evolving
ing requirements arising from all sources within situation, rapidly decide a course of action,
the institution, including off-balance-sheet obli- implement the actions, monitor changes in the
gations and derivatives transactions. Many forms situation, and take corrective action as needed.
of standardized derivatives contracts allow coun- The responsibilities and authority of each mem-
terparties to request collateral or to terminate ber of the team should be carefully delineated.
contracts early if the institution experiences an Particular attention should be given to the team
adverse credit event or its financial condition member or members responsible for communi-
deteriorates. In addition, under situations of cating with the public, the bank’s counterparties,
market stress, a customer may ask for early major customers, rating agencies, and regula-
termination of some contracts. In these circum- tors. The importance of accurate and consistent
stances, an institution that owes money on information flows cannot be underestimated in a
derivatives transactions may be required to stress scenario.
deliver collateral or settle a contract early— The plan should provide for realistic action
when the institution is also encountering addi- plans that define different levels of liquidity
tional funding and liquidity pressures. The stress. For each level, the plan should evaluate
liquidity plan should consider the extent to funding capacities; specify actions and proce-
which the bank acts as a dealer in asset markets dures to be implemented; identify alternative
or provides payment and settlement services for contingency funding, taking into account the
customers and other banks. possibility that liquidity pressures may have
Potential stress scenarios should be identified, spread to other funding sources; and measure
and funding-liquidity plans should identify the institution’s ability to fund operations over
liquidity sources that could be accessed under an extended period of liquidity stress. In defin-
stress conditions. Stress scenarios should also ing levels of liquidity stress, some institutions
take into account unusual demands on bank develop predefined triggers, while others rely on
liquidity, such as the sudden draw-down of more judgmental warning signals that may or
customer lines of credit or the early termination may not indicate a need to trigger activation of
of derivatives contracts. the contingency plan. Either approach can be
Separate, but integrated and coordinated, con- used in an effective liquidity contingency plan.
tingency plans should be developed for the Triggers or warning signals may include—
parent company, for significant nonbank subsid-
iaries or special-purpose funding vehicles for • a reluctance of traditional funds providers to
which liquidity risk may be substantial, and for continue funding at past levels;
overseas operations that need to address liquid- • smaller deal sizes reflecting funding
ity risk in foreign currencies and under foreign conservatism;
banking systems. Banks may be less well known • rating downgrades or ‘‘watch listings’’ for a
to liability holders in foreign-currency markets. downgrade;
Therefore, in the event of market stress, espe- • stock-price declines;
cially stress related to the bank’s domestic • a difficulty accessing longer-term money (par-
operating environment, these liability holders ticularly over quarter-end reporting dates);
may react strongly to rumors. The bank should • the reluctance of trust managers, money man-
have a contingency plan to mobilize domestic agers, and public entities to place funds with
liquidity and the necessary foreign-exchange the bank;
transactions in sufficient time to meet foreign- • the reluctance of broker-dealers to show the
currency funding requirements. bank’s name in the market, forcing manage-
An effective contingency plan includes a ment to arrange friendly broker-dealer support;
reliable but flexible crisis-management team and • market rumors or concerns that customers
administrative structure, realistic action plans, have expressed to bank staff about the bank’s
and frequent communication and reporting condition;
Trading and Capital-Markets Activities Manual September 2002
Page 2.1
2030.1 Liquidity Risk
• rising funding costs in a stable market; Contingency Liquidity in Bank Holding
• the redemption of CDs before maturity; Companies
• counterparty resistance to bank off-balance-
sheet products; Bank holding companies have a more limited
• counterparties that begin requesting collateral range of asset and liability management options
for credit exposures; and than banks do; thus, their liquidity-risk profile is
• correspondent banks eliminating or decreas- higher. Moreover, management can quickly
ing their credit lines. change a bank holding company’s liquidity
profile by repurchasing stock, paying dividends,
Frequent communication and reporting among or making investments in subsidiaries. Examin-
crisis team members, the board of directors, and ers should establish that the board of directors of
other affected managers optimize the effective- the parent company has a clear, strategic direc-
ness of a contingency plan by ensuring that tion for both the level of liquidity that should be
business decisions are coordinated to minimize maintained at the parent level and the provision
any further disruptions to liquidity. The quality of liquidity to subsidiary banks in times of
of communications and reporting depends on stress.
the quality of the institution’s liquidity metrics Bank holding company liquidity should be
and management information systems. More maintained at levels sufficient to fund holding
frequent and more detailed reporting is advis- company and nonbank affiliate operations for an
able as a stress situation intensifies. Reports that extended period of time in a stress environment
generally should be available include— (that is, when access to normal funding sources
is disrupted), without having a negative impact
• a large-funder report, on insured institution subsidiaries. As they are at
• an asset and liability runoff report, the bank level, the stability, flexibility, and
• reports on performance in relation to liquidity diversity of primary and contingent sources of
limits and benchmarks, and funding liquidity should be identified at the
• cash-flow analyses. holding company level. The impact of bank
holding company liquidity, as well as the com-
The bank should have a good estimate of the position of liquidity sources, on the bank’s
flow-of-funds time line and sequence for the access to the funding markets should be consid-
liquidation of major classes of balance-sheet ered carefully.
assets. These estimates should be realistic under Bank holding companies should develop strat-
the current market environment and be empiri- egies to remedy funding mismatches that may
cally supportable. The bank should have a develop under stress conditions. Strategies may
realistic analysis of cash inflows, outflows, and include limiting parent company funding of
funds availability at various time intervals (for long-term assets and securing reliable, long-
example, at 7, 10, 15, 30, 45, 60, and 90 days). term back-up funding sources. Back-up funding
Potential sources of contingency funding should contracts should be reviewed to determine the
be identified, quantified, and ranked by prefer- extent to which any ‘‘material adverse change’’
ence. The ability of the bank to draw down clauses would constrain the company’s access to
back-up lines of credit in a crisis, and the rights funding if the company’s financial condition
of the lender to deny draw-downs, should be deteriorated. A common stress test is to analyze
fully evaluated. whether the holding company has adequate
Institutions that have significant payment- liquidity to meet its potential debt obligations
system operations should have a formal, written over the next 12 months, in addition to operating
plan in place for managing the risk of both expenses, assuming the company loses access to
intraday and end-of-day funding failures, which the funding market and dividends from
may result if internal systems fail or if the subsidiaries.
systems fail at an institution from which pay-
ments are expected. Clear, formal communica-
tions channels should be established between MARKET-LIQUIDITY RISK
the operations areas handling the payment sys-
tems and the funding area so that the treasury Market-liquidity risk refers to the risk of being
operation is aware of any funding disruption and unable to close out open positions quickly
can respond quickly. enough and in sufficient quantities at a reason-
September 2002 Trading and Capital-Markets Activities Manual
Page 2.2
Liquidity Risk 2030.1
able price. In dealer markets, the size of the
bid/ask spread of a particular instrument pro-
vides a general indication as to the depth of the
market under normal circumstances. However,
disruptions in the marketplace, contraction in
the number of market makers, and the execution
of large block transactions are some factors that
may result in the widening of bid/ask spreads.
Disruptions in various financial markets may
have serious consequences for a financial insti-
tution that makes markets in particular instru-
Trading and Capital-Markets Activities Manual September 2002
Page 2.3
Liquidity Risk 2030.1
ments. These disruptions may be specific to a and exchange-traded instruments can be closed
particular instrument, such as those created by a out, the ability to effectively unwind OTC
sudden and extreme imbalance in the supply and derivative contracts is limited. Many of these
demand for a particular product. Alternatively, contracts tend to be illiquid, since they can
a market disruption may be all-encompassing, generally only be canceled by an agreement
such as the stock market crash of October 1987 with the counterparty. Should the counterparty
and the associated liquidity crisis. refuse to cancel the open contract, the financial
The decision of major market makers to enter institution could also try to arrange an assign-
or exit specific markets may also significantly ment whereby another party is ‘‘assigned’’ the
affect market liquidity, resulting in the widening contract. Contract assignments, however, can be
of bid/ask spreads. The liquidity of certain difficult and cumbersome to arrange. A financial
markets may depend significantly on the active institution’s ability to cancel these financial
presence of large institutional investors; if these contracts is a critical determinant of the degree
investors pull out of the market or cease to trade of liquidity associated with the instruments.
actively, liquidity for other market participants Financial institutions which are market makers,
can decline substantially. therefore, typically attempt to mitigate or elimi-
Market-liquidity risk is also associated with nate market-risk exposures by arranging OTC
the probability that large transactions in particu- contracts with other counterparties executing
lar instruments, by nature, may have a signifi- hedge transactions on the appropriate exchanges,
cant effect on the transaction price. Large trans- or, most typically, a combination of the two.
actions can strain liquidity in markets that are In using these alternative routes, the financial
not deep. Also relevant is the risk of an unex- institution must deal with two or more times the
pected and sudden erosion of liquidity, possibly number of contracts to cancel its risk exposures.
as a result of a sharp price movement or jump While market-risk exposures can be mitigated or
in volatility. This could lead to illiquid markets, completely canceled in this manner, the finan-
in which bid/ask spreads are likely to widen, cial institution’s credit-risk exposure increases
reflecting declining liquidity and further increas- in the process.
ing transaction costs.
Exchange-Traded Instruments
Over-the-Counter Instruments
For exchange-traded instruments, counterparty
Market liquidity in over-the-counter (OTC) credit exposures are assumed by the clearing-
dealer markets depends on the willingness of house and managed through netting and mar-
market participants to accept the credit risk of gin arrangements. The combination of margin
major market makers. Changes in the credit risk requirements and netting arrangements of clear-
of major market participants can have an impor- inghouses is designed to limit the spread of
tant impact on the liquidity of the market. credit and liquidity problems if individual firms
Market liquidity for an instrument may erode or customers have difficulty meeting their obli-
if, for example, a decline in the credit quality gations. However, if there are sharp price changes
of certain market makers eliminates them as in the market, the margin payments that clear-
acceptable counterparties. The impact on market inghouses require to mitigate credit risk can
liquidity could be severe in those OTC markets have adverse effects on liquidity, especially in a
in which a particularly high proportion of activ- falling market. In this instance, market partici-
ity is concentrated with a few market makers. pants may sell assets to meet margin calls,
In addition, if market makers have increased further exacerbating liquidity problems in the
concerns about the credit risk of some of their marketplace.
counterparties, they may reduce their activities Many exchange-traded instruments are liquid
by reducing credit limits, shortening maturities, only for small lots, and attempts to execute a
or seeking collateral for security—thus dimin- large block can cause a significant price change.
ishing market liquidity. Additionally, not all financial contracts listed on
In the case of OTC off-balance-sheet instru- the exchanges are heavily traded. While some
ments, liquid secondary markets often do not contracts have greater trading volume than the
exist. While cash instruments can be liquidated underlying cash markets, others trade infre-
Trading and Capital-Markets Activities Manual February 1998
Page 3
2030.1 Liquidity Risk
quently. Even with actively traded futures or to cover open price-risk exposures exposes the
options contracts, the bulk of trading generally financial institution to increased risk when
occurs in short-dated contracts. Open interest, or hedges cannot be easily adjusted. (Dynamic
the total transaction volume, in an exchange- hedging is not applied to an entire portfolio, but
traded contract, however, provides an indication only to the uncovered risk.) The use of dynamic
of the liquidity of the contract in normal market hedging strategies and technical trading by a
conditions. sufficient number of market participants can
introduce feedback mechanisms that cause price
movements to be amplified and lead to one-way
markets. Some managers may estimate exposure
‘‘Unbundling’’ of Product Risk on the basis of the assumption that dynamic
hedging or other rapid portfolio adjustments will
Both on- and off-balance-sheet products typi-
keep risk within a given range even in the face
cally contain more than one element of market-
of large changes in market prices. However,
risk exposure; therefore, various hedging instru-
such portfolio adjustments depend on the exist-
ments may need to be used to hedge the
ence of sufficient market liquidity to execute
inherent risk in one product. For example, a
the desired transactions, at reasonable costs, as
fixed coupon foreign currency–denominated
underlying prices change. If a liquidity disrup-
security has interest-rate and foreign-exchange
tion were to occur, difficulty in executing the
risks which the financial institution may choose
transactions needed to change the portfolio’s
to hedge. The hedging of the risks of this
exposure will cause the actual risk to be higher
security would likely result in the use of both
than anticipated. Those institutions who have
foreign-exchange and interest-rate contracts.
open positions in written options and, thus, are
Likewise, the hedging of a currency interest-rate
short volatility and gamma will be the most
swap, for example, would require the same.
exposed.
By breaking the market risk of a particular
The complexity of the derivatives strategies
product down into its fundamental elements, or
of many market-making institutions can further
‘‘unbundling’’ the risks, market makers are able
exacerbate the problems of managing rapidly
to move beyond product liquidity to risk liquid-
changing positions. Some financial institutions
ity. Unbundling not only eases the control of
construct complex arbitrage positions, some-
risk, it facilitates the assumption of more risk
times spanning several foreign markets and
than was previously possible without causing
involving legs in markets of very different
immediate market concern or building up unac-
liquidity properties. For example, a dollar-based
ceptable levels of risk. For example, the interest-
institution might hedge a deutschemark convert-
rate risk of a U.S. dollar interest-rate swap can
ible bond for both equities and foreign-exchange
be hedged with other swaps, forward rate agree-
risk and finance the bond with a dollar-
ments (FRAs), Eurodollar futures contracts,
deutschemark bond swap. Such a transaction
Treasury notes, or even bank loans and deposits.
may lock in many basis points in profit for the
The customized swap may appear to be illiquid
institution, but exposes it to considerable liquid-
but, if its component risks are not, then other
ity risk, especially if the arbitrage transaction
market makers would, under normal market
involves a combination of long-term and short-
conditions, be willing and able to provide the
term instruments (for example, if the foreign-
necessary liquidity. Positions, however, can
exchange hedging were done through three-
become illiquid, particularly in a crisis.
month forwards, and the bond had a maturity
over one year). If key elements of the arbitrage
transaction fall away, it may be extremely diffi-
Dynamic Hedging Risks cult for the institution to find suitable instru-
ments to close the gap without sustaining a loss.
Certain unbundled market-risk exposures may Multifaceted transactions can also be par-
tend to be managed as individual transactions, ticularly difficult to unwind. The difficulty of
while other risks may be managed on a portfolio unwinding all legs of the transaction simulta-
basis. The more ‘‘perfectly hedged’’ the trans- neously can temporarily create large, unhedged
actions in the portfolio are, the less the need to exposures for the financial institution. The abil-
actively manage residual risk exposures. Con- ity to control the risk profile of many of these
versely, the use of dynamic hedging strategies transactions lies in the ability to execute trades
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Liquidity Risk 2030.1
more or less simultaneously and continuously in options, change radically as their remaining
multiple markets, some of which may be subject time to maturity decreases.
to significant liquidity risks. Thus, the examiner Market makers should consider the bid/ask
should determine whether senior management is spreads in normal markets and potential bid/ask
aware of multifaceted transactions and can moni- spreads in distressed markets and establish risk
tor exposures to such linked activity, and whether limits which consider the potential illiquidity of
adequate approaches exist to control the associ- the instruments and products. Stress tests evi-
ated risks in a dynamic environment. dencing the ‘‘capital-at-risk’’ exposures under
both scenarios should be available for examiner
review.
Market-Liquidity-Risk Limits
Revaluation Issues
Risk measures under stress scenarios should be
estimated over a number of different time hori- Market makers may establish closeout valuation
zons. While the use of a short time horizon, such reserves covering open positions to take into
as a day, may be useful for day-to-day risk consideration a potential lack of liquidity in the
management, prudent managers will also esti- marketplace upon liquidation, or closing out
mate risk over longer horizons because the use of, market-risk exposures. These ‘‘holdback’’
of such a short horizon assumes that market reserves are typically booked as a contra account
liquidity will always be sufficient to allow posi- for the unrealized gain account. Since transac-
tions to be closed out at minimal losses. How- tions are marked to market, holdback reserves
ever, in a crisis, market liquidity, or the institu- establish some comfort that profits taken into
tion’s access to markets, may be so impaired current earnings will not dissipate over time as a
that closing out or hedging positions may be result of ongoing hedging costs. Holdback
impossible, except at extremely unfavorable reserves may represent a significant portion of
prices, in which case positions may be held for the current mark-to-market exposure of a trans-
longer than envisioned. This unforeseen length- action or portfolio, especially for those transac-
ening of the holding period will cause a port- tions involving a large degree of dynamic hedg-
folio’s risk profile to be much greater than ing. The examiner should ensure, however, that
envisioned in the original risk measure, as the the analysis provided can demonstrate a quan-
likelihood of a large price change (volatility) titative methodology for the establishment of
increases with the horizon length. Additionally, these reserves and that these reserves, if neces-
the risk profiles of some instruments, such as sary, are adequate.
Trading and Capital-Markets Activities Manual February 1998
Page 5
Liquidity Risk
Examination Objectives Section 2030.2
Examination objectives relating to funding- risk exposures of the trading activities of the
liquidity risk are found in the Commercial Bank institution.
Examination Manual. The following examina- 6. To ensure that business-level management
tion objectives relate to the examination of has formulated contingency plans in the
market-risk liquidity. event of sudden illiquid markets.
7. To ensure the comprehensiveness, accuracy,
and integrity of management information
1. To evaluate the organizational structure of systems providing analysis of market-
the risk-management function. liquidity-risk exposures.
2. To evaluate the adequacy of internal poli- 8. To determine if the institution’s liquidity-
cies and procedures relating to the institu- risk-management system has been correctly
tion’s capital-markets and trading activities implemented and adequately measures the
in illiquid markets and to determine that institution’s exposures.
actual operating practices reflect such 9. To determine if the open interest in exchange-
policies. traded contracts is sufficient to ensure that
3. To identify the institution’s exposure and management would be capable of hedging
potential exposure resulting from trading in or closing out open positions in one-way
illiquid markets. directional markets.
4. To determine the institution’s potential 10. To determine if management is aware of
exposure if liquid markets suddenly become limit excesses and takes appropriate action
illiquid. when necessary.
5. To determine if senior management and the 11. To recommend corrective action when poli-
board of directors of the financial institution cies, procedures, practices, or internal con-
understand the potential market-liquidity- trols are found to be deficient.
Trading and Capital-Markets Activities Manual February 1998
Page 1
Liquidity Risk
Examination Procedures Section 2030.3
These procedures represent a list of processes b. Review contingency market-liquidity-
and activities that can be reviewed during a risk plans, if any.
full-scope examination. The examiner-in-charge c. Review accounting and revaluation poli-
will establish the general scope of examination cies and procedures. Determine that
and work with the examination staff to tailor revaluation procedures are appropriate.
specific areas for review as circumstances 4. Determine the credit rating and market
warrant. As part of this process, the examiner acceptance of the financial institution as a
reviewing a function or product will analyze and counterparty in the markets.
evaluate internal-audit comments and previous 5. Obtain all management information analyz-
examination workpapers to assist in designing ing market-liquidity risk.
the scope of examination. In addition, after a a. Determine the comprehensiveness, accu-
general review of a particular area to be exam- racy, and integrity of analysis.
ined, the examiner should use these procedures, b. Review bid/ask assumptions in a normal
to the extent they are applicable, for further market scenario.
guidance. Ultimately, it is the seasoned judg- c. Review stress tests that analyze the wid-
ment of the examiner and the examiner-in- ening of bid/ask spreads and determine
charge as to which procedures are warranted in the reasonableness of assumptions.
examining any particular activity. d. Determine whether the management
Examination procedures relating to funding- information reports accurately reflect
liquidity risk are found in the Commercial Bank risks and that reports are provided to the
Examination Manual. The following examina- appropriate level of management.
tion procedures relate to the examination of 6. Determine if any recent market disruptions
market-liquidity risk. have affected the institution’s trading activi-
ties. If so, determine the institution’s market
1. Review the liquidity-risk-management response.
organization. 7. Establish that the financial institution is
a. Check that the institution has a liquidity- following its internal policies and proce-
risk-management function with a sepa- dures. Determine whether the established
rate reporting line from traders and limits adequately control the range of liquid-
marketers. ity risks. Determine that the limits are
b. Determine if liquidity-risk-control per- appropriate for the institution’s level of
sonnel have sufficient credibility in the activity. Determine whether management is
financial institution to question traders’ aware of limit excesses and takes appropri-
and marketers’ decisions. ate action when necessary.
8. Determine whether the institution has estab-
c. Determine if liquidity-risk management
lished an effective audit trail that summa-
is involved in new-product discussions
rizes exposures and management approvals
in the financial institution.
with the appropriate frequency.
2. Identify the institution’s capital-markets and 9. Determine whether management considered
trading activities and the related balance- potential illiquidity of the markets when
sheet and off-balance-sheet instruments and establishing capital-at-risk exposures.
obtain copies of all risk-management reports a. Determine if the financial institution
prepared by the institution to evaluate established capital-at-risk limits which
liquidity-risk-control personnel’s demon- address both normal and distressed mar-
strated knowledge of the products traded by ket conditions.
the financial institution and their understand-
b. Determine if senior management and the
ing of current and potential exposures.
board of directors are advised of market-
3. Obtain and evaluate the adequacy of risk- liquidity-risk exposures in illiquid mar-
management policies and procedures for kets as well as of potential risk arising as
capital-markets and trading activities. a result of distressed market conditions.
a. Review market-risk policies, procedures, 10. Determine whether business managers have
and limits. developed contingency plans which reflect
Trading and Capital-Markets Activities Manual February 1998
Page 1
2030.3 Liquidity Risk: Examination Procedures
actions to be taken in suddenly illiquid markets resulting from dynamic hedging
markets to minimize losses as well as the strategies.
potential damage to the institution’s market- 12. Recommend corrective action when poli-
making reputation. cies, procedures, practices, internal con-
11. Based on information provided, determine trols, or management information systems
the institution’s exposure to suddenly illiquid are found to be deficient.
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Liquidity Risk
Internal Control Questionnaire Section 2030.4
The internal control questionnaire relating to e. Are the limits appropriate for the insti-
funding-liquidity risk is found in the Commer- tution and its level of capital?
cial Bank Examination Manual. The following f. Are there contingency market-liquidity-
internal control questions relate to the examina- risk plans?
tion of market-risk liquidity. g. Do the policies address the use of
dynamic hedging strategies?
1. Review the liquidity-risk-management 4. Has there been a credit-rating downgrade?
organization. What has been the market response to the
a. Does the institution have a liquidity-risk- financial institution as a counterparty in the
management function that has a sepa- markets? Are instances in which the insti-
rate reporting line from traders and tution provides collateral to its counter-
marketers? parties minimal?
b. Do liquidity-risk-control personnel have 5. Obtain all management information analyz-
sufficient credibility in the financial ing market-liquidity risk.
institution to question traders’ and mar- a. Is management information comprehen-
keters’ decisions? sive and accurate and is the analysis
c. Is liquidity-risk management involved in sound?
new-product discussions in the financial b. Are the bid/ask assumptions in a normal
institution? market scenario reasonable?
2. Identify the institution’s capital-markets and c. Do management information reports
trading activities and the related balance- accurately reflect risks? Are reports
sheet and off-balance-sheet instruments and provided to the appropriate level of
obtain copies of all risk-management reports management?
prepared. 6. If any recent market disruptions affected the
a. Do summaries identify all the institu- institution’s trading activities, what has been
tion’s capital-markets products? the institution’s market response?
b. Define the role that the institution takes 7. Is the financial institution following its
for the range of capital-markets prod- internal policies and procedures? Do the
ucts. Determine the hedging instruments established limits adequately control the
used to hedge these products. Is the range of liquidity risks? Are the limits
institution an end-user, dealer, or market appropriate for the institution’s level of
maker? If so, in what products? activity?
c. Do liquidity-risk-control personnel dem- 8. Has the institution established an effective
onstrate knowledge of the products traded audit trail that summarizes exposures and
by the financial institution? Do they management approvals with the appropriate
understand the current and potential frequency?
exposures to the institution? 9. Has management considered potential illi-
3. Does the institution have comprehensive, quidity of the markets when establishing
written risk-management policies and pro- capital-at-risk exposures?
cedures for capital-markets and trading a. Has the financial institution established
activities? capital-at-risk limits which address both
a. Do the policies provide an explanation of normal and distressed market condi-
the board of directors’ and senior man- tions? Are these limits aggregated on a
agement’s philosophy regarding illiquid global basis?
markets? b. Are senior management and the board of
b. Have limits been approved by the board directors advised of market-liquidity-risk
of directors? exposures in illiquid markets as well as
c. Have policies, procedures, and limits of potential risk arising as a result of
been reviewed and reapproved within the distressed market conditions?
last year? 10. Has management determined the institu-
d. Are market-liquidity-risk policies, proce- tion’s exposure to suddenly illiquid markets
dures, and limits clearly defined? resulting from dynamic hedging strategies?
Trading and Capital-Markets Activities Manual February 1998
Page 1
Operations and Systems Risk
(Management Information Systems) Section 2040.1
Management information systems (MIS) should understood by senior managers and directors,
accumulate, interpret, and communicate infor- who may not have specialized and technical
mation regarding the institution’s positions, prof- knowledge of trading activities and derivative
its, business activities, and inherent risks. The products. Risk exposures arising from various
form and content of management information products within the trading function should be
for trading activities will be a function of the reported to senior managers and directors using
size and complexity of the trading operation and a common conceptual framework for measuring
organization, policies and procedures, and man- and limiting risks.
agement reporting lines. MIS generally take two
forms: computing systems with business appli-
cations and management reporting. For institu- PROFESSIONAL EXPERTISE
tions with trading operations, a computerized
system should be in place. For a small number The trading institution should have personnel
of institutions with limited trading activity, an with sufficient expertise to understand the finan-
elaborate computerized system may not be cost cial instruments and maintain the management
effective. Not all management information sys- information system. Reports should be updated
tems are fully integrated. Examiners should to reflect the changes in the business environ-
expect to see varying degrees of manual inter- ment. Institutions that develop their own appli-
vention and should determine whether the integ- cations should have adequate staff to alter and
rity of the data is preserved through proper test current software. Also, the implementation
controls. The examiner should review and eval- of automated reporting systems is not a substi-
uate the sophistication and capability of the tute for an adequate reconcilement procedure
financial institution’s computer systems and soft- that would ensure the integrity of data inputs.
ware, which should be capable of supporting, The system must be independently audited by
processing, and monitoring the capital-markets personnel with sufficient expertise to perform a
and trading activities of the financial institution. comprehensive review of management report-
An accurate, informative, and timely manage- ing, financial applications, and systems capacity.
ment information system is essential to the
prudent operation of a trading or derivative
activity. Accordingly, the examiner’s assess- COMPUTING SYSTEMS
ment of the quality of the management informa-
tion system is an important factor in the overall Worldwide deregulation of financial markets
evaluation of the risk-management process. combined with the latest tools in information
Examiners should determine the extent to which technologies have brought capital markets
the risk-management function monitors and together so that geographic financial centers are
reports its measure of trading risks to appropri- no longer as important. Access to markets on
ate levels of senior management and the board competitive terms from any location is made
of directors. Exposures and profit-and-loss state- possible by instantaneous worldwide transmis-
ments should be reported at least daily to man- sion of news and market information. To man-
agers who supervise but do not conduct trading age their risk-management process in the current
activities. More frequent reports should be made financial and technological environment, finan-
as market conditions dictate. Reports to other cial institutions are more readily prepared to
levels of senior management and the board may incorporate the latest communications systems
occur less frequently, but examiners should and database management techniques. In addi-
determine whether the frequency of reporting tion, new financial concepts are rapidly becom-
provides these individuals with adequate infor- ing standard practice in the industry, made
mation to judge the changing nature of the possible by powerful computing tools and com-
institution’s risk profile. munications systems.
Examiners should ensure that the manage- Some capital-markets instruments require
ment information systems translate the mea- information technologies that are more complex
sured risk from a technical and quantitative than those used for more traditional banking
format to one that can be easily read and products, such as loans, deposits, and standard
Trading and Capital-Markets Activities Manual February 1998
Page 1
2040.1 Operations and Systems Risk (Management Information Systems)
foreign-exchange transactions. Indeed, a depart- traded instruments used by an institution. The
ment developing specialized trading products group of systems used may be a combination of
and their supporting systems is often viewed by systems purchased from vendors and applica-
senior management as the laboratory for the tions developed in-house by the firm’s software
financial institution. For financial institutions programmers. Standard instructions should be
active in capital markets, conducting business in set within the automated systems. The organi-
a safe and sound manner depends on the suc- zation should identify which instructions may be
cessful integration of management information overridden and under what circumstances.
systems into the daily processes of market- and The organization should give planned
credit-risk management; transaction processing; enhancement or development projects appropri-
settlement; accounting; and financial, regula- ate priority, given management’s stated goals
tory, and management reporting. and capital-markets activity. Third-party ven-
Examiners should evaluate the processes of dors should be provided with adequate lead time
software development, technical specifications, to make changes to existing programs. Sufficient
database management, local area networks, and testing should be performed before system
communication systems. Access to the auto- upgrades are implemented.
mated systems should be adequately protected. When consolidating data derived from mul-
If the organization uses PCs, a written policy to tiple sources, the institution should perform
address access, development, maintenance, and controls and reconciliations that minimize the
other relevant issues should exist. Given the potential for corrupting consolidated data. If
specialized management skills and heightened independent databases are used to support
sophistication in information technologies found subsidiary systems, then reconciliation controls
in many trading rooms, an evaluation of systems should be evident at each point that multiple
management should be incorporated into the data files are brought together. Regardless of the
overall assessment of management and internal combination of automated systems and manual
controls. A full-scope examination of these processes, examiners should ensure that appro-
areas is best performed by specialized electronic priate validation processes are effected to ensure
data processing examiners. However, a general data integrity.
review of these processes must also be incorpo- Not all financial institutions have the same
rated in the financial examination. automation requirements. For institutions with
For examination purposes, the scope of the limited transaction volume, it is not cost effec-
review should be tailored to the functionality of tive to perform risk-management reporting in an
the management information system as opposed automated environment, and most analysis can
to its technical specifications. Functionality refers be handled manually. When volumes increase
to how well the system serves the needs of users such that timely risk monitoring can no longer
in all areas of the institution, including senior be handled manually, then automated applica-
management, risk management, front office, back tions may be appropriate.
office, financial reporting, and internal audit.
The organization should have flow charts or
narratives that indicate the data flow from input
through reporting. The comprehensiveness of MODEL RISK
this information, however, will depend on the
level of reporting necessary for the institution. A key element of the management information
An important aspect of evaluating informa- system of trading operations is models and
tion technology is the degree to which various algorithms used to measure and manage risk.
systems interface. For purposes of this discus- The frequency and extent to which financial
sion, automated systems refers to the collection institutions should reevaluate their models and
of various front-office and control systems. assumptions depend, in part, on the specific risk
Financial institutions relying on a single data- exposures created by their trading activities, the
base of client and transaction files may have pace and nature of market changes, and the pace
stronger controls on data integrity than those of innovation with respect to measuring and
with multiple sources of data. However, rarely managing risks. At a minimum, financial
does a single automated system handle data institutions with significant capital-markets and
entry and all processing and control functions trading activities should review the underlying
relevant to all over-the-counter and exchange- methodologies and assumptions of their models
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Operations and Systems Risk (Management Information Systems) 2040.1
at least annually, and more often as market tions have a process whereby parameters used in
conditions dictate, to ensure that they are appro- valuation models depend on rigorous statistical
priate and consistent for all products. Such methods and are updated to reflect changing
internal evaluations may, in many cases, be market conditions. To the extent possible, the
supplemented with reviews by external auditors results derived from statistical methods should
or other qualified outside parties, such as con- be validated against available market information.
sultants who have expertise with highly techni- Models that incorporate assumptions about
cal models and risk-management techniques. underlying market conditions or price relation-
When introducing a pricing model, it is ships require ongoing monitoring. Input param-
imperative that adequate testing of the algorithm eters such as volatility, correlations between
be performed by systems personnel with appro- market prices, interest rates and currencies, and
priate sign-off by model users (traders, control- prepayment speeds of underlying mortgage pools
lers, and auditors). In practice, pricing models require frequent review. For example, volatility
for the most heavily traded financial instruments quotes may be compared to those in available
are well tested. Financial algorithms for com- published sources, or from implied volatilities
plex, exotic products should be well docu- derived from a pricing model using current
mented as part of the policies and procedures market prices of actively traded exchange-
manual and functional specifications. Hazards listed options. Mortgage securities prepayment
are more likely to arise for instruments that have assumptions can be compared to vectors pro-
nonstandard or option-like features. The use of vided by the dealer community to automated
proprietary models that employ unconventional services or to factors provided by third-party
techniques that are not widely agreed upon by vendors.
market participants should lead to further ques- Examiners should evaluate the ability of an
tioning by examiners. Even the use of standard institution’s model to accommodate changes in
models may lead to errors if the financial tools assumptions and parameters. Institutions should
are not appropriate for a given instrument. conduct ‘‘what-if’’ analyses and tests of the
sensitivity of specific portfolios or their aggre-
gate risk position. Examiners should expect the
NEW PRODUCTS risk-management and measurement system to be
sufficiently flexible to stress test the range of
The development of new products is a key portfolios managed by the institution. Any
feature of capital-markets and trading opera- parameter variations used for stress tests or
tions. The general risks associated with new what-if analyses should be clearly identified.
products should be addressed through the new- These simulations usually summarize the profit
product-approval process. In reviewing financial or loss given a change in interest rates, foreign-
applications, examiners should evaluate whether exchange rates, equity or commodity prices,
the current tools quantify and monitor the range volatility, or time to maturity or expiry.
of relevant exposures. New applications require
special review and additional measures of con-
trol. In the absence of a model that provides a
reasonable simulation of market price, the risk- MANAGEMENT INFORMATION
management, control, and audit areas should be REPORTING
responsible for developing an appropriate valu-
ation methodology. Nonstandard software appli- Management reporting summarizes day-to-day
cations should proceed through the institution’s operations, including risk exposure. The finan-
software development process for testing before cial institution’s goal and market profile will be
implementation. They should not be released reflected in the reporting format and process at
for actual business use until validation and the operational level. These reporting formats
sign-off is obtained from appropriate functional should be evaluated for data integrity and clar-
departments. ity. Examiners should determine if reporting is
sufficiently comprehensive for sound decision
making.
Parameter Selection and Review In addition, reports are used to provide man-
agement with an overall view of business activ-
Examiners should ensure that financial institu- ity for strategic planning. Overall management
Trading and Capital-Markets Activities Manual February 1998
Page 3
2040.1 Operations and Systems Risk (Management Information Systems)
reporting should reflect the organizational struc- reports, the senior managers should be well
ture of the institution and the risk tolerance of aware of potential weaknesses in the data pro-
senior management. Examiners should expect vided. Risk reporting should be assessed and
reports to aggregate data across geographic performed independently of the front office to
locations when appropriate and segregate posi- ensure objectivity and accuracy and to prevent
tions by legal entity when appropriate. Examin- manipulation or fraud. However, if the back
ers may find that periodic reporting is provided office uses databases and software programs that
to management on market-limit and credit-line are independent from those used in the front
utilization. Management uses these to reevaluate office, it needs to perform a periodic reconcili-
the limit structure, relate risks to profitability ation of differences. For financial institutions
over a discrete period, evaluate growing busi- operating in a less automated environment, report
nesses, and identify areas of potential profit. preparation should be evaluated in terms of
Management reporting also should relate risks timeliness and data accuracy. Cross-checking
undertaken to return on capital. In fact, manage- and sign-off by the report preparer and reviewer
ment information systems should allow manage- with appropriate authority should be evident.
ment to identify and address market, credit, and Each financial institution will define the
liquidity risks. See sections 2010.1, 2020.1, and acceptable tradeoff between model accuracy and
2030.1 on market, credit, and liquidity risk, information timeliness. As part of their appraisal
respectively. of risk management, examiners should review
Management reports will usually be gener- the frequency and accuracy of reporting against
ated by control departments within the institu- the institution’s posture in the marketplace,
tion, independent from front-office influence. volume of activity, aggregate range of expo-
When front-office managers have input to sures, and capacity to absorb losses.
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Operations and Systems Risk
(Management Information Systems)
Examination Objectives Section 2040.2
1. To determine the scope and adequacy of the and manual processes are designed with
audit function for management information sufficient audit trails to evaluate and ensure
systems and management reporting. data integrity.
2. To determine if the policies, practices, pro- 8. To ensure that reports are fully described
cedures, and internal controls regarding in functional specifications and are also
management information systems and man- included in the policies and procedures of
agement reporting are adequate. the respective user departments.
3. To ensure that only authorized users are 9. To determine whether management report-
able to gain access to automated systems. ing provides adequate information for stra-
4. To evaluate computer systems, communica- tegic planning.
tions networks, and software applications in
10. To determine that risk-management report-
terms of their ability to support and control
ing summarizes the quantifiable and non-
the capital-markets and trading activities.
quantifiable risks facing the institution.
5. To determine that the functions of auto-
mated systems and reporting processes 11. To determine whether financial perfor-
are well understood by staff and are fully mance reports are accurate and sufficiently
documented. detailed to relate profits to risks assumed.
6. To determine that software applications per- 12. To evaluate summary reports on operations
taining to risk reporting, pricing, and other for adequacy.
applications that depend on modeling are 13. To recommend corrective action when poli-
fully documented and subject to indepen- cies, practices, procedures, internal con-
dent review. trols, or management information systems
7. To determine that the automated systems are deficient.
Trading and Capital-Markets Activities Manual February 1998
Page 1
Operations and Systems Risk
(Management Information Systems)
Examination Procedures Section 2040.3
These procedures represent a list of processes istration. Determine the types of reconcili-
and activities that may be reviewed during a ations performed, frequency of database
full-scope examination. The examiner-in-charge reconciliation, and tolerance for variance.
will establish the general scope of examination The more independent databases are, the
and work with the examination staff to tailor more the potential for data error exists.
specific areas for review as circumstances 7. Determine the extent of data-parameter
warrant. As part of this process, the examiner defaults, for example, standard settlement
reviewing a function or product will analyze and instructions to alleviate manual interven-
evaluate internal-audit comments and previous tion. Determine the extent of manual inter-
examination workpapers to assist in designing vention for transaction processing, financial
the scope of examination. In addition, after a analysis, and management reporting.
general review of a particular area to be exam- 8. Review the policies and procedures manual
ined, the examiner should use these procedures, for reporting requirements for management.
to the extent they are applicable, for further 9. Determine whether the automated and
guidance. Ultimately, it is the seasoned judg- manual process have sufficient audit trails
ment of the examiner and the examiner-in- to evaluate and ensure data integrity for the
charge as to which procedures are warranted in range of functional applications. Determine
examining any particular activity. how control staff validates report content
and whether the report content is well
1. Obtain copies of internal and external audit understood by the preparer.
reports for MIS and management reporting.
10. Determine whether the processing and pro-
Review findings and management’s
duction of reports is segregated from front-
responses to them and determine whether
office staff. When the front office has influ-
appropriate corrective action was taken.
ence, how does management validate
2. Obtain a flow chart of reporting and sys-
summary data and findings?
tems flows and review information to iden-
tify important risk points. Review policies 11. Review the functional applications such as
and procedures for MIS. Review the per- credit administration, trade settlement,
sonal computer policy for the institution, if accounting, revaluation, and risk monitor-
available. ing to determine the combination of auto-
3. Determine the usage of financial applica- mation and manual intervention for man-
tions on terminals that are not part of the agement reporting. Compare findings with
mainframe, minicomputer, or local area net- examiners reviewing specific products or
work. For instance, traders may use their business lines.
own written spreadsheet to monitor risk 12. Determine whether the documentation sup-
exposure or for reconciliation. porting pricing models is adequate. Deter-
4. Obtain an overview of the system’s func- mine whether ‘‘user instructions’’ provide
tional features. Browse the system with the sufficient guidance in model use.
institution’s systems administrator. Deter- 13. Determine whether the range of risk-
mine whether passwords are used and management reports is adequately docu-
access to the automated system is restricted mented in terms of inputs (databases, data-
to approved users. feeds external to the organization, economic
5. Review a list of ongoing or planned man- and market assumptions), computational fea-
agement information systems projects. Deter- tures, and outputs (report formats, defini-
mine whether the priority of projects is tions). Evaluate the documentation for thor-
justified given management’s strategic goals oughness and comprehensiveness.
and recent mix of business activity. 14. Determine whether the range of reports
6. From the systems overview, ascertain the (risk management, financial performance
range of databases in use. Some system and operational controls) provides valid
architecture may use independent databases results to evaluate business activity and for
for front office, back office, or credit admin- strategic planning.
Trading and Capital-Markets Activities Manual February 1998
Page 1
2040.3 Operations and Systems Risk (Management Information Systems): Examination Procedures
15. Recommend corrective action when poli-
cies, practices, procedures, internal con-
trols, or management information systems
are deficient.
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Operations and Systems Risk
(Management Information Systems)
Internal Control Questionnaire Section 2040.4
1. Is the scope of the audit coverage compre- before system upgrades are implemented?
hensive? Are audits for management infor- 9. Do planned enhancement or development
mation systems and reporting available? projects have appropriate priority, given
Are findings discussed with management? management’s stated goals and capital-
Has management implemented timely cor- markets activity?
rective actions for deficiencies? 10. Identify the key databases used for the
2. Do policies and procedures address the range of management reports.
range of system development and technical a. Are direct electronic feeds from external
maintenance at the institution, including the services such as Reuters, Telerate, and
use of outside vendors and consultants? Bloomberg employed? How are incom-
Does the institution have a comprehensive plete datafeeds identified? Can market
personal computer policy? If the organiza- data be overridden by users? How does
tion uses PCs, is there a written policy to the institution ensure the data integrity of
address access, development, maintenance, datafeeds or manually input rates, yields,
and other relevant issues? or prices from market sources?
3. Do the new product policies and procedures
b. Are standard instructions set within the
require notification and sign-off by key
automated systems? Can these be over-
systems development and management
ridden? Under what circumstances?
reporting staff?
4. Are there functional specifications for the c. For merging and combining databases,
systems? Are they adequate for the current how does the institution ensure accurate
range of automated systems at the institu- output?
tion? Do they address both automated and d. What periodic reconciliations are per-
manual input and intervention? formed to ensure data integrity? Is the
5. Does the organization have flow charts or reconciliation clerk sufficiently familiar
narratives that indicate the data flow from with the information to identify ‘‘con-
input through reporting? Is this information taminated’’ data?
comprehensive for the level of reporting 11. Does the institution have a model-validation
necessary for the financial institution? process? Does the organization use consult-
6. Is access to the automated systems ade- ants for model development and validation?
quately protected? Are these consultants used effectively? Are
a. Do access rights, passwords, and logon the yield curve calculations, interpolation
ID’s protect key databases from methods, discount factors, and other param-
corruption? eters used clearly documented and appro-
b. Are ‘‘write or edit’’ commands restricted priate to the instruments utilized? Regard-
to a limited set of individuals? less of the source of the model, how does
c. Are specific functions assigned to a lim- management ensure accurate and consistent
ited set of individuals? Are access rights results?
reviewed periodically? 12. Does the system design account for the
d. Does the system have an audit report for different pricing conventions and accrual
monitoring user access? methods across the range of products in use
e. Is access logon information stored in at the financial institution? Evaluate the
records for audit trail support? range of system limitations for processing
7. Is management information provided from and valuation across the range of products
mainframe, minicomputers, local area net- used by the institution. Assess the pos-
works (multiuser personal computer net- sible impact on accuracy of management
works), or single-user personal computers reporting.
or a combination of the above? 13. Is management reporting prepared on a
8. Are third-party vendors provided with ade- sufficiently independent basis from line man-
quate lead time to make changes to existing agement? Is management reporting ade-
programs? Is sufficient testing performed quate for the volume and complexity of
Trading and Capital-Markets Activities Manual February 1998
Page 1
2040.4 Operations and Systems Risk (Management Information Systems): Internal Control Questionnaire
capital-markets and trading activities for the 15. Do reports segregate positions by legal
types of reports listed below? Are reports entity when appropriate?
complete? Do they have clear formats? 16. Determine whether the system for measur-
Are the data accurate? Are exceptions high- ing and managing risk is sufficiently flex-
lighted? Is appropriate segregation of duties ible to stress test the range of portfolios
in place for report preparation? Are there managed by the institution. Does the system
reports for the following: provide usable and accurate output? If the
a. Market-risk exposure against limits? institution does not perform automated stress
b. Credit-risk exposure against limits? testing, what process is used to minimize
c. Market-liquidity risk exposure against quantifiable risks in adverse markets?
limits? 17. Are parameter variations used for stress
d. Funding-liquidity risk exposure against tests or are ‘‘what if’’ analyses clearly
market demand? identified?
18. Does management reporting relate risks
e. Transaction volumes and business mix? undertaken to return on capital?
f. Profit and loss? 19. Do reports provide information on the busi-
g. Other risk exposures and management ness units that is adequate for sound strate-
information reports? gic planning? Are profitable and unprofit-
14. Do reports reflect aggregation of data across able businesses clearly identified? Does
geographic locations when appropriate? management have adequate information?
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Operations and Systems Risk (Front-Office Operations)
Section 2050.1
The front office is where trading is initiated and bid/ask levels in the marketplace. The difference
the actual trading takes place. It consists of between the bid and the ask is called the spread.
traders, marketing staff, and sometimes other Dealers are not necessarily obliged to make
trading-support staff. Front-office personnel two-way markets. Many market participants are
execute customer orders, take positions, and actively involved in facilitating customer trans-
manage the institution’s market risks. The front actions even though they are not considered
office is usually organizationally and function- market makers. In some cases, these institutions
ally separate and distinct from the back-office act similarly to market makers, hedging incre-
operation, which is part of the institution’s mental transactions derived from their customer
overall operations and control infrastructure. base. In other cases, the institution may mark
The back-office function completes the trad- transactions up from the bid/ask levels in the
ing transactions executed by the front office. marketplace, enter into a transaction with its
(See section 2060, ‘‘Back-Office Operations.’’) customer, and fill the order in the marketplace,
It processes contracts, controls various clearing effectively taking a spread on the transaction.
accounts, confirms transactions, and is typically While it may appear as if the dealer is acting as
responsible for performing trade revaluations. a broker, it should be noted that both the
Additionally, back-office personnel investigate transaction with the customer and the transac-
operational problems which may arise as a result tion with the marketplace are executed with the
of business activities. The back office provides financial institution as principal.
logistical support to the trading room and should A proprietary trader takes on risk on the
be the area where errors are caught and brought institution’s behalf, based on a view of eco-
to the attention of the traders. While the dealing nomic and market perceptions and expectations.
room and back office must cooperate closely to This type of trader will take a position in the
ensure efficiency and prevent problems, their market to profit from price movements and price
duties should be segregated to provide an volatility. Proprietary traders may incur high
appropriate level of independence and control. levels of market risk by managing significant
While the overall size, structure, and sophis- positions which reflect their view of future
tication of an institution’s front office will market conditions. This type of activity requires
vary, the general functions and responsibilities the highest level of experience and sophistica-
described in this section prevail across the tion of all traders in the institution.
majority of financial institutions. The following Intermediaries communicate bid and ask
discussion describes a typical front office, but it levels to potential principals and otherwise
is important to consider individual instrument arrange transactions. These transactions are
profiles and market-specific characteristics in entered into on an ‘‘as agent’’ basis, and do not
conjunction with the review of front-office result in the financial institution acting as a
activities. principal to either counterparty involved in the
transaction. An intermediary typically charges a
fee for its service.
ROLE AND STRUCTURE End-users are purchasers or sellers of prod-
OF THE FRONT OFFICE ucts for investment or hedging purposes. Some-
times an end-user will be a short-term trader, but
The trading operation of a financial institution its volume will usually be lower than that of a
can be categorized by the various roles the front proprietary trader.
office performs in the marketplace. The front An institution may not function in all the
office’s responsibilities may include any combi- above-mentioned roles. Each type of market
nation of the following: market maker (dealer), participant strives to maintain or improve its
proprietary trader, intermediary, and end-user. posture in the market based on its own actual or
A market maker makes two-way markets. perceived competitive advantages. The institu-
When initially contacted, the market maker may tion may also have a sales force or marketing
not know whether the counterparty wishes to staff that receives price quotes from the institu-
buy or sell a particular product. The market tion’s trading staff and represents market oppor-
maker quotes two-way prices, reflective of the tunities to current and potential clients. Usually,
Trading and Capital-Markets Activities Manual February 1998
Page 1
2050.1 Operations and Systems Risk (Front-Office Operations)
marketing staff is paid based on volume or on desired positions, and the likely needs of the
the profit margin for the business developed. initiating trader. The trader assesses the current
Sound business practices dictate that financial status of the market through information
institutions take steps to ascertain the character obtained from other financial institutions, bro-
and financial sophistication of counterparties. kers, or information services, and uses this
These practices include efforts to ensure that the information to anticipate the direction of the
counterparties understand the nature of the trans- market. Upon determining the most favorable
actions into which they are entering. When the rate, the initiating trader closes the transaction
counterparties are unsophisticated, either gen- by signifying a purchase or sale on the quoting
erally or with respect to a particular type of trader’s terms.
transaction, financial institutions should take Before closing the transaction, the traders
additional steps to ensure that they adequately must also ensure that it falls within the institu-
disclose the risks associated with the specific tion’s counterparty credit lines and authorized
type of transaction. Ultimately, counterparties trading limits. A trade is usually completed in a
are responsible for the transactions into which matter of seconds and the commitments entered
they choose to enter. However, when an insti- into are considered firm contracts.
tution recommends specific transactions to an Traders at competing institutions may arrange
unsophisticated counterparty, the institution profit-sharing arrangements or provide other
should ensure that it has adequate information forms of kickbacks without attracting the notice
on which to base its recommendation. of control staff or trading management. To
protect against this occurrence, a daily blotter
(price/rate sheet) or comparable record or data-
base should be maintained. The blotter or data-
Organizational Structure base should be validated against the daily
trading range within a narrow tolerance level.
The organizational structure of the front office
Off-market rates should be recorded in a
is usually a function of the particular roles it
log with appropriate control justification and
performs. In general, the broader the scope of a
sign-off.
financial institution’s trading activities, the more
Time-stamping of trade tickets by the trader
structured the front-office organization. A mar-
or computer system permits comparison between
ket maker of various products can be expected
the market rates recorded on the rate sheet and
to have numerous trading and sales desks, with
the rates at which trades are transacted. This
each business activity managed independently
system not only protects against deliberate trans-
and overseen by the trading manager. Corre-
actions at off-market rates, but it is also useful in
spondingly, traders acting exclusively in a pro-
resolving rate discrepancies in transactions with
prietary capacity may act relatively indepen-
other financial institutions and customers.
dently, reporting only to the trading manager.
Transaction Flow
TRADE CONSUMMATION
Upon execution of the transaction, vital trade
Trading is transacted through a network of information is captured. The form in which
communications links among financial institu- details of trade transactions are captured is
tions and brokers, including telephone lines, contingent on the trading systems of the finan-
telexes, facsimile machines, and other electronic cial institution. When distinct front- and back-
means. The party initiating the transaction con- office transaction systems are used, trade tickets
tacts one or more dealers, typically over taped or initial input forms typically provide the input
telephone lines, to request a ‘‘market,’’ that is, a detail for the back office. These trade tickets are
two-sided quote. More than one institution may usually handwritten by the trader and hand-
be contacted to obtain the most favorable rate or delivered to the back office. When straight-
execute several trades quickly. through or automated processing systems are
The initiating trader does not normally indi- used, trade input is typically performed by the
cate which side of the market he or she is on. In front office. Details are input onto a computer
response, the trader receiving the call considers screen and verified by the back office before
the current market, the institution’s actual and final acceptance. In either case, trade details
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Operations and Systems Risk (Front-Office Operations) 2050.1
should include such basic information as the policies and procedures governing standards for
trade date, time of trade, settlement date, coun- dealing with counterparties. An appropriate level
terparty, instrument, amount, price or rate, and, of due diligence should be performed on all
depending on the instrument, manner and place counterparties with which the institution deals,
of settlement. even if the transactions do not expose the
The trader’s own principal record is the trad- financial institution to much credit risk (for
ing blotter or position book, which is a chrono- example, collateralized transactions).
logical record of deals and a running record of Finally, management should ensure that the
the trader’s position. The blotter may or may not marketing practices of its salespersons are ethi-
be automated, depending on the sophistication cal. Standards addressing the sales of complex
of the computer systems at the institution. products should be established to ensure that
customers are not entering into transactions
about which they have no understanding of the
Transaction Reporting potential risks. Management should remain cog-
nizant of the risk to the institution’s reputation at
Traders track market-risk exposures and profit all times. Once an institution’s reputation is
and loss in the ordinary course of business. damaged, it can be very difficult to restore. (See
These calculations, however, should not form section 2150, ‘‘Ethics.’’)
the basis for official risk or profit-and-loss
reporting. Management information distributed
to senior management should be prepared and
reviewed independent of the trading function. UNACCEPTABLE PRACTICES
Certain trading practices are considered unac-
ceptable and require close supervision to control
TRAINING AND TECHNICAL or prevent. In the foreign-exchange market, in
COMPETENCE which prices will probably change before a
dispute or counterparty can be settled, the prac-
Trading-support functions are technical and tice of brokers’ points has evolved. The use of
require levels of skills and training commensu- brokers’ points involves one side agreeing to the
rate with the type of institution and the type and other’s price in a disputed trade, but with the
variety of products handled. Back-office person- caveat that the discrepancy will be made up in
nel should demonstrate a level of competence so the future. The parties keep an unofficial list of
that they act as a viable check and balance to the owed or lent monies. The party agreeing to the
financial institution’s front-office staff. Addition- other’s price can then call in the favor at a later
ally, financial institutions must be able to attract date. This practice may be used to hide losses
and retain competent personnel, as well as train in a trading portfolio until there are sufficient
them effectively. Finally, a sufficient level of profits to offset them. The practice of brokers’
staffing is required to ensure the timely and points is considered an unsafe and unsound
accurate processing, reporting, controlling, and banking practice, and a financial institution
auditing of trading activities. should have a policy forbidding it.
Another unacceptable practice is adjusted-
price trading. This practice is used to conceal
ETHICS losses in a trading portfolio and involves a
collusive agreement with a securities dealer
The potential risk of trading transactions to a from which the institution previously purchased
financial institution emphasizes the importance a security that has now dropped in value. The
of management’s ascertaining the character of security is resold to the dealer at the institution’s
its potential traders. While there are no guaran- original purchase price, and the institution pur-
tees as to how a particular trader may react to chases other securities from the dealer at an
seriously adverse market conditions, proper per- inflated price. This practice could also involve
sonnel screening, internal controls, and commu- ‘‘cross parking,’’ whereby the collusive parties
nication of corporate policies should reduce the are both attempting to conceal trading losses.
possibility of trading improprieties. Adjusted-price trading is further described in the
Additionally, management should establish Municipal Securities Activities Exam Manual.
Trading and Capital-Markets Activities Manual February 1998
Page 3
2050.1 Operations and Systems Risk (Front-Office Operations)
Transactions involving off-market rates Evaluating the adequacy of internal controls
(including foreign-exchange historical-rate roll- requires sound judgment on the part of the
overs) should be permitted only in limited cir- examiner. The following is a list of some of the
cumstances with strict management oversight. practices examiners should look for.
The use of off-market rates introduces risks
above and beyond those normally faced by • Every organization should have comprehen-
dealing institutions in day-to-day trading activi- sive policies and procedures in place that
ties. Because off-market rates could be used to describe the full range of capital-markets and
shift income from one institution to another or trading activities performed. These docu-
from one reporting period to another, they can ments, typically organized into manuals,
serve illegitimate purposes, such as to conceal should at a minimum include front- and back-
losses, evade taxes, or defraud a trading institu- office operations, reconciliation guidelines and
tion. All financial institutions should have poli- frequency, revaluation guidelines, accounting
cies and procedures for dealing with trades guidelines, descriptions of accounts, broker
conducted at off-market rates. policies, a code of ethics, and the risk-
Customers may give a financial institution the measurement and management methods,
discretionary authority to trade on their behalf. including the limit structure.
This authority should be documented in a writ- • For every institution, existing policies and
ten agreement between the parties that clearly procedures should ensure the segregation of
lists the permissible instruments and financial duties between trading, control, and payment
terms, collateral provisions and monitoring, con- functions.
firmation of trades, reporting to the client, and • The revaluation of positions may be con-
additional rights of both parties. For institutions ducted by traders to monitor positions, by
that have discretionary authority, examiners controllers to record periodic profit and loss,
should ensure that additional policies and pro- and by risk managers who seek to estimate
cedures are in place to prevent excessive trading risk under various market conditions. The
in the client’s account (account churning). Close frequency of revaluation should be driven by
supervision of sales and marketing staff and the level of an institution’s trading activity.
adequate client reporting and notification are Trading operations with high levels of activity
extremely important to ensure that the institu- should perform daily revaluation. Every insti-
tion adheres to the signed agreement. tution should conduct revaluation for profit
From a management standpoint, inappropri- and loss at least monthly; the accounting
ate trading and sales practices can be avoided by revaluation should apply rates and prices from
establishing proper guidelines and limits, enforc- sources independent of trader input.
ing a reporting system that keeps management • Taping of trader and dealer telephone lines
informed of all trading activities, and enforcing facilitates the resolution of disputes and can
the segregation of responsibilities. Experience be a valuable source of information to audi-
has shown that losses can occur when such tors, managers, and examiners.
guidelines are not respected. • Trade tickets and blotters (or their electronic
equivalents) should be created in a timely and
complete manner to allow for easy reconcili-
ation and appropriate position-and-exposure
SOUND PRACTICES monitoring. The volume and pace of trading
may warrant the virtually simultaneous cre-
Capital-markets and trading operations vary sig- ation of records in some cases.
nificantly among financial institutions, depend- • Computer hardware and software applications
ing on the size of the trading operation, trading must accommodate the current and projected
and management expertise, the organizational level of trading activity. Appropriate disaster-
structure, the sophistication of computer sys- recovery plans should be tested regularly.
tems, the institution’s focus and strategy, histori- • Every institution should have a methodology
cal and expected income, past problems and to identify and justify any off-market transac-
losses, risks, and the types and sophistication of tions. Ideally, off-market transactions would
the trading products and activities. As a result, be forbidden.
practices, policies, and procedures expected in • A clear institutional policy should exist con-
one institution may not be necessary in another. cerning personal trading. If personal trading is
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Operations and Systems Risk (Front-Office Operations) 2050.1
permitted at all, procedures should be estab- switches, and relevant credit authorities should
lished to avoid even the appearance of con- be involved.
flicts of interest. • Every institution that uses brokers for foreign-
• Every institution should ensure that manage- exchange transactions should establish a
ment of after-hours and off-premises trading, clear statement forbidding lending or borrow-
if permitted at all, is well documented so that ing brokers’ points as a method to resolve
transactions are not omitted from the auto- discrepancies.
mated blotter or the bank’s records. • Every organization should have explicit com-
• Every institution should ensure that staff is pensation policies to resolve disputed trades
both aware of and complies with internal for all traded products. Under no circum-
policies governing the trader-broker stances should soft-dollar or off-the-books
relationship. compensation be permitted for dispute
• Every institution that uses brokers should resolution.
monitor the patterns of broker usage, be alert • Every institution should have ‘‘know-your-
to possible undue concentrations of business, customer’’ policies, and they should be under-
and review the short list of approved brokers stood and acknowledged by trading and sales
at least annually. staff.
• Every institution that uses brokers should • The designated compliance officer should per-
establish a firm policy to minimize name form a review of trading practices annually.
substitutions of brokered transactions. All such In institutions with a high level of activity,
transactions should be clearly designated as interim reviews may be warranted.
Trading and Capital-Markets Activities Manual February 1998
Page 5
Operations and Systems Risk (Front-Office Operations)
Examination Objectives Section 2050.2
1. To review the organization and range of ing staff is adequate for sound decision
activities of the front office. making.
2. To determine whether the policies, proce- 7. To evaluate the adequacy of the supervision
dures, and internal systems and controls for of trading and marketing personnel.
the front office are adequate and effective 8. To determine that front-office personnel are
for the range of capital-markets products technically competent and well trained, and
used by the financial institution. that ethical standards are established and
3. To determine whether the financial insti- respected.
tution adequately segregates the duties of 9. To ascertain the extent, if any, of unaccept-
personnel engaged in the front office from able business practices.
those involved in the back-office-control 10. To determine that traders and salespeople
function. know their customers and engage in
4. To ascertain that the front office is comply- activities appropriate for the institution’s
ing with policies and established market counterparties.
and counterparty limits. 11. To recommend corrective action when poli-
5. To determine that trade consummation and cies, procedures, practices, internal con-
transaction flow do not expose the financial trols, or management information systems
institution to operational risks. are found to be deficient, or when violations
6. To ensure that management’s reporting to of laws, rulings, or regulations have been
front-office managers, traders, and market- noted.
Trading and Capital-Markets Activities Manual February 1998
Page 1
Operations and Systems Risk (Front-Office Operations)
Examination Procedures Section 2050.3
These procedures represent a list of processes for any counterparties, determine that trans-
and activities that may be reviewed during a actions are appropriately reflected. (See sec-
full-scope examination. The examiner-in-charge tion 2020, ‘‘Counterparty Credit Risk and
will establish the general scope of examination Presettlement Risk.’’)
and work with the examination staff to tailor 3. Ensure that comprehensive policies and pro-
specific areas for review as circumstances cedures covering the introduction of new
warrant. As part of this process, the examiner trading products exist. A full review of the
reviewing a function or product will analyze and risks involved should be performed by all
evaluate internal audit comments and previous relevant parties: trading, credit- and market-
examination workpapers to assist in designing risk management, audit, accounting, legal,
the scope of examination. In addition, after a tax, and operations.
general review of a particular area to be exam-
4. Determine that policies and procedures
ined, the examiner should use these procedures,
adequately address the following:
to the extent they are applicable, for further
guidance. Ultimately, it is the seasoned judg- a. The financial institution complies with
ment of the examiner and the examiner-in- regulatory policy regarding brokers’ points.
charge as to which procedures are warranted in b. The financial institution has policies
examining any particular activity. addressing traders’ self-dealing in com-
modities or instruments closely related to
those traded within the institution. A writ-
ten policy requires senior management to
GENERAL PROCEDURES grant explicit permission for traders to
trade for their personal account, and pro-
1. Obtain the following: cedures are established that permit man-
a. policies and procedures agement to monitor these trading activities.
b. organization chart c. The financial institution does not engage
c. resumes of key trading personnel in adjusted-price trading.
d. systems configuration
d. The financial institution has adequate poli-
e. management information reports
cies regarding off-market-rate transac-
2. Determine the roles of front office in the tions. All requests for the use of off-
marketplace. market rates are referred to management
3. Ensure that the terms under which brokerage for policy and credit judgments as well
service is to be rendered are clear and that as for guidance on appropriate internal
management has the authority to intercede in accounting procedures. Specifically, review
any disputes that may arise. Additionally, and assess the financial institution’s poli-
ensure that any exclusive broker relation- cies and procedures regarding historical-
ships in a single market do not result in an rate rollovers.
overdependence or other vulnerability on the
part of the financial institution. e. Adequate control procedures are in place
for trading that is conducted outside of
normal business hours—either at the office
or at traders’ homes. Personnel permitted
POLICIES AND PROCEDURES to engage in such dealing should be clearly
identified along with the types of autho-
1. Check that procedures clearly indicate under rized transactions. Additionally, proce-
what conditions, if any, market-risk limits dures ensure that off-premises transac-
may be exceeded and what authorizations tions will not exceed risk limits.
must be obtained. (See section 2010, ‘‘Mar- f. The financial institution has adequate pro-
ket Risk.’’) cedures for handling customer stop-loss
2. Check that procedures clearly indicate under orders. Documentation related to both the
what conditions, if any, counterparty risk agreed-on arrangements as well as the
limits may be exceeded and what approvals individual transactions is available for
must be obtained. If netting agreements exist review.
Trading and Capital-Markets Activities Manual February 1998
Page 1
2050.3 Operations and Systems Risk (Front-Office Operations): Examination Procedures
g. The financial institution requires that the recorded by the trader after the deal has been
appropriate level of due diligence be per- completed.
formed on all counterparties with which 2. Ensure that the financial institution has
the institution enters into transactions, established satisfactory controls over trade
even if the transactions do not expose the input.
financial institution to credit risk (for 3. Confirm that a separation of duties exists for
example, delivery versus payment and the revaluation of the portfolio, reconcilia-
collateralized transactions). tion of traders’ positions and profits, and the
h. The marketing practices of the institu- confirmation of trades.
tion’s salespersons are ethical. Standards
address the sales of complex products to
ensure that customers are not entering into TRANSACTION-CONSUMMATION
transactions about which they have no PROCEDURES
understanding of the potential risks.
1. Ensure that traders and marketers check that
TRAINING AND TECHNICAL they are within market- and credit-risk limits
COMPETENCE PROCEDURES before the execution of the transaction.
1. Evaluate key personnel policies and practices
and their effects on the financial institution’s TRANSACTION-FLOW
capital-markets and trading activities. PROCEDURES
a. Evaluate the experience level of senior
personnel. 1. Ensure that trade tickets or input sheets
b. Determine the extent of internal and include all trade details needed to validate
external training programs. transactions.
c. Assess the turnover rate of front-office 2. Ensure that transactions are processed in a
personnel. If the rate has been high, deter- timely manner. Check that some type of
mine the reasons for the turnover and method exists to reconstruct trading history.
evaluate what effect the turnover has 3. Ensure that the transaction-discrepancy pro-
had on the financial institution’s trading cedure is adequate and includes independent
operations. validation of the back office.
d. Review the financial institution’s compen-
sation program for trading activities to
determine whether remuneration is based TRANSACTION REPORTING
on volume and profitability criteria. If so,
determine whether controls are in place to 1. Ensure that management information reports
prevent personnel from taking excessive prepared for front-office management pro-
risks to meet the criteria. vide adequate information for risk moni-
e. Determine the reasons for each trader’s toring, including financial performance and
termination or resignation. transaction detail, to ensure sound decision
2. Determine whether the financial institution making.
has a management succession plan.
3. Evaluate the competence of trading and mar-
keting personnel. Determine whether infor- ETHICS PROCEDURES
mation on the organization, trading strategy,
and goals is well disseminated. 1. Evaluate the level of due diligence per-
4. Determine if management remains informed formed on counterparties.
about pertinent laws, regulations, and account- 2. Evaluate the code of ethics and staff adher-
ing rules. ence to it.
3. Evaluate ‘‘know-your-customer’’ guidelines
SEGREGATION OF DUTIES and staff adherence.
PROCEDURES 4. Evaluate the management of trading and
marketing staff. Evaluate the seriousness of
1. Ensure that all transactions are promptly any ethical lapses.
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Operations and Systems Risk (Front-Office Operations): Examination Procedures 2050.3
CORRECTIVE ACTION management information systems are found
to be deficient, or when violations of laws,
1. Recommend corrective action when policies, rulings, or regulations have been noted.
procedures, practices, internal controls, or
Trading and Capital-Markets Activities Manual February 1998
Page 3
Operations and Systems Risk (Front-Office Operations)
Internal Control Questionnaire Section 2050.4
POLICIES AND PROCEDURES TRANSACTION CONSUMMATION
1. Do policies and procedures establish market- 1. Do traders ensure that transactions are within
risk limits, and do the policies and pro- market- and credit-risk limits before the
cedures clarify the process for obtaining execution of the transaction?
approvals for excessions?
2. Do policies and procedures establish credit-
risk limits, and do the policies and pro-
TRANSACTION FLOW
cedures clarify the process for obtaining 1. Do trade tickets or input sheets include all
approvals for excessions? necessary trade details?
3. Do policies address the approval process for 2. Does the institution have procedures to ensure
new products? the timely processing of all transactions?
4. Is an appropriate level of approval obtained 3. Does the institution have a method with
for off-market transactions and for additional which to resolve trade discrepancies on
credit risk incurred on off-market trades? transactions, regardless of communication
5. Does management make sure that senior medium used?
management is aware of off-market trades 4. Do traders include an adequate amount of
and the special risks involved? trade details on blotters, input sheets, and
6. Does management inquire about a custom- computer screens to enable reconciliation by
er’s motivation in requesting an off-market- the front and back office?
rate trade to ascertain its commercial 5. Do automated systems for input appear
justification? adequate for the volumes and range of prod-
7. Do procedures manuals cover all the securi- ucts transacted by the institution?
ties activities that the financial institution
conducts, and do they prescribe appropriate
internal controls relevant to those functions TRANSACTION REPORTING
(such as revaluation procedures, accounting
and accrual procedures, settlement proce- 1. Are reports prepared for front-office manage-
dures, confirmation procedures, accounting ment to allow the monitoring of market- and
and auditing trails, and procedures for estab- credit-risk limits?
lishing the sequential order and time of
transactions)? TRAINING AND TECHNICAL
COMPETENCE
1. Does the financial institution have a manage-
ROLE OF THE FRONT OFFICE ment succession plan?
2. Does the financial institution have an
1. Do policies clarify the responsibilities of
appropriate program for cross-training of
traders as to market making, dealing, pro-
personnel?
prietary, and intermediary roles?
3. Does the financial institution provide for the
2. Are the financial institution’s dealings with adequate training of front-office personnel?
brokers prudent?
4. Are traders technically competent in their
3. Is the financial institution’s customer base existing positions?
diverse? Is the customer base of high credit
5. Does management remain informed about
and ethical quality?
pertinent laws, regulations, and accounting
rules?
SEGREGATION OF DUTIES ETHICS
1. Is there adequate segregation of duties 1. Is an appropriate level of due diligence
between the front and back office? performed on all counterparties with which
Trading and Capital-Markets Activities Manual February 1998
Page 1
2050.4 Operations and Systems Risk (Front-Office Operations): Internal Control Questionnaire
the front office enters into transactions, 6. Were any unacceptable practices noted by
regardless of collateralization? internal or external auditors? Has manage-
2. Is there a code of ethics? Do traders and ment addressed these actions? From exam-
marketers appear to be familiar with it? iner observation, are there any ongoing
3. Are there ‘‘know-your-customer’’ guide- unacceptable practices? Is management’s
lines? Do traders and marketers appear to be response to deficiencies adequate?
familiar with them? 7. Does the financial institution have discretion-
4. Do internal memos detail any ethical lapses? ary authority over client monies? Are poli-
If so, how were they resolved? Does senior cies and procedures adequate to control
management take its guidance role seriously? excessive trading by sales and marketing
5. Are customer relationships monitored by staff? Is front-office supervision adequate?
senior management in the front office? How Does the back office have additional controls
are customer complaints resolved? Are the to alert senior control staff and the compli-
back office, control staff, and compliance ance department of deficiencies? Is discre-
involved in the process? Are overall controls tionary trading activity included in the insti-
for customer complaints adequate? tution’s audit program?
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Operations and Systems Risk (Back-Office Operations)
Section 2060.1
Operational risks managed outside of the deal- the revaluation process that leads to the mainte-
ing room are potentially more costly than those nance of the subsidiary ledgers and the general
managed inside the dealing room. While the ledger. Another crucial function of the back
function of dealers in the front office is primarily office is accepting or releasing securities, com-
to transact and manage positions, the processing modities, and payments on trades, as well as
of transactions, recording of contracts in the identifying possible mistakes. Clearly, trading
accounting system, and reconciliations and pro- personnel need to be separate from control of
cedures required to avoid errors are functions receipts, disbursements, and custody functions
that must take place outside the dealing room. In to minimize the potential for manipulation. Regu-
conducting these functions, the back office pro- latory reports and management accounting may
vides the necessary checks to prevent unautho- also be the responsibility of the back office.
rized trading. Management responsibilities performed by
Back office, for the purposes of this manual, the back office vary by institution. The evalua-
may represent a single department or multiple tion of transaction exposure against established
units (such as financial control, risk manage- market, liquidity, or credit limits may be per-
ment, accounting, or securities custody), depend- formed by back-office staff or by a separate
ing on the organizational structure of the finan- risk-management function, independent of front-
cial institution. Some institutions have combined office traders and marketers. Risk-management
some of the responsibilities usually found in the reporting may also be performed by back-office
back office into a middle-office function, which staff. Legal documentation, while initiated by
is also independent of dealing activities. internal or external counsel, may be followed up
Close cooperation must exist between the (chased) by back-office staff.
dealing room and the back office to prevent The links between front- and back-office
costly mistakes. An understanding of each role operations may range from totally manual to
and function is important. While their priorities fully computerized systems in which the func-
are different, both functions work toward the tions are directly linked. The complexity of
same goal of proper processing, control, and linking systems should be related to the volume
recording of contracts, which is essential to the and complexity of capital-markets and trading
success of a trading department. activities undertaken. Manual operations are
The back office serves several vital functions. subject to error. However, management should
It records and confirms trades transacted by the not have a false sense of security with auto-
front office and provides the internal control mated systems. Changes in programming codes
mechanism of segregation of duties. The checks installed through the maintenance process, new
and balances provided by the back-office func- financial structures, and improper use of soft-
tion help management supervise the trading ware may lead to computational and processing
activities conducted by the front office. A prop- errors. Regardless of the operational process in
erly functioning back office will help ensure the place, the back-office functions should be sub-
integrity of the financial institution and mini- ject to comprehensive audit.
mize operations, settlement, and legal risks. Operational risk is the risk that deficiencies in
Segregation of front- and back-office duties information systems or internal controls will
minimizes legal violations, such as fraud or result in unexpected loss. Although operational
embezzlement, or violation of regulations. risk is difficult to quantify, it can be evaluated by
Operational integrity is maintained through the examining a series of plausible worst-case or
independent processing of trades, trade confir- what-if scenarios, such as a power loss, dou-
mations, and settlements. The goal is to avoid bling of transaction volume, or a mistake found
potentially costly mistakes such as incorrectly in the pricing software. It can also be assessed
recorded or unrecorded contracts. The back through periodic reviews of procedures, data
office also is responsible for the reconcilement processing systems, contingency plans, and other
of positions and broker statements and may operating practices. These reviews may help
monitor broker relationships with the financial reduce the likelihood of errors and breakdown in
institution. The back-office staff provides an controls, improve the control of risk and the
independent assessment of price quotes used for effectiveness of the limit system, and prevent
Trading and Capital-Markets Activities Manual February 1998
Page 1
2060.1 Operations and Systems Risk (Back-Office Operations)
unsound marketing practices and premature • a market-risk-management system to monitor
adoption of new products or lines of business. the organization’s exposure to market risk,
Considering the extent that capital-markets and written procedures for authorizing trades
activities rely on computerized systems, finan- and excesses of those limits;
cial institutions should have plans that take into • a credit-risk-management system to monitor
account potential problems with their normal the organization’s exposure with customers
processing procedures. and broker-dealers;
Financial institutions should also ensure that • separation of duties and supervision to ensure
trades that are consummated orally are con- that persons executing transactions are not
firmed as soon as possible. Oral transactions involved in approving the accounting method-
conducted via telephone should be recorded and ology or entries (Persons executing transac-
subsequently supported by written or printed tions should not have authority to sign incom-
documents. Examiners should ensure that the ing or outgoing confirmations or contracts,
institution monitors the consistency between the reconcile records, clear transactions, or con-
terms of transactions as they were orally agreed trol the disbursement of margin payments.);
on and as they were subsequently confirmed. • a clearly defined flow of order tickets and
Examiners should also consider the extent confirmations (The flow of order tickets and
to which financial institutions evaluate and con- confirmations should be designed to verify
trol operating risks through the use of internal accuracy and enable reconciliations through-
audits, stress testing, contingency planning, and out the system and to enable the reconcile-
other managerial and analytical techniques. ment of traders’ position reports to those
Financial institutions should have approved poli- positions maintained by an operating unit.);
cies that specify documentation requirements • procedures for promptly resolving failures to
for capital-markets activities as well as formal receive or deliver securities on the date secu-
procedures for saving and safeguarding impor- rities are settled;
tant documents. All policies and procedures
• procedures for someone other than the person
should be consistent with legal requirements and
who executed the contract to resolve customer
internal policies.
complaints;
• procedures for verifying brokers’ reports of
margin deposits and contract positions and for
INTERNAL CONTROLS reconciling such reports to records; and
• guidelines for the appropriate behavior of
Management is responsible for minimizing the dealing and control staff and for the selection
risks inherent in executing financial contracts. and training of competent personnel to follow
Policies and procedures should be established written policies and guidelines.
covering organizational structure, segregation of
duties, operating and accounting system con-
trols, and comprehensive management report-
ing. Formal written procedures should be in TICKET FLOW
place for purchases and sales, processing,
accounting, clearance, and safekeeping activi- Once a transaction has been initiated by the
ties relating to financial contracts transactions. front office, the primary responsibility for pro-
In general, these procedures should be designed cessing trades rests with various back-office
to ensure that all financial contracts are properly personnel. Back-office staff process all pay-
recorded and that senior management is aware ments and delivery or receipt of securities,
of the exposure and gains or losses resulting commodities, and written contracts. Addition-
from these activities. Desirable controls include— ally, the back office is responsible for verifying
the amounts and direction of payments which
• written documentation indicating the range of are made under a range of netting agreements.
permissible products, trading authorities, and After sending the trade tickets to the back
permissible counterparties; office, the traders are removed from the rest of
• written position limits for each type of con- the processing, except to check their daily posi-
tract or risk type established by the board of tions against the records developed separately
directors; by the back office and to verify any periodic
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Operations and Systems Risk (Back-Office Operations) 2060.1
reports it prepared. After receipt of the trade Examiners should determine whether systems
ticket from the front office, back-office person- and processes enable audit and control staff to
nel verify the accuracy of the trade ticket, and adequately monitor dealing activity. Time stamp-
any missing information is obtained and recorded. ing transactions at the time of execution will
A confirming communication will be sent to the enable an institution to validate intraday dealing
counterparty, who, in turn, will respond with an prices and reconstruct trading activity. More-
acceptance communication. The acceptance over, time-stamp sequences of the trade tickets
comunication will either confirm the trade or should closely, if not exactly, match the serial
identify discrepancies for resolution. The trade order for a particular trader or dealer.
is then ready to be processed. It is appropriate to evaluate whether an insti-
Trade processing involves entering the trade tution’s automated systems provide adequate
agreement on the correct form or into an auto- support for its dealing and processing functions.
mated system. When the front office has already Systems that have increased dealing volumes
performed this function, verification of transac- should be examined for downtime, capacity
tion data should be performed. The copy of the constraints, and error rates for transaction
trade agreement to be sent to the counterparty is throughput. Further, institutions that deal in
once more checked against the original ticket, complex derivative products should have auto-
and the trade agreement is transmitted. mated systems commensurate with the analyti-
Other copies of the trade agreement will be cal and processing tasks required.
used for all bookkeeping entries and settlement
during the life of the agreement. For instance,
all contingent liability, general ledger, and sub-
ledger entries will be supported by copies of the TRADE TRANSACTIONS
trade agreement, with the relevant entry high-
lighted on the copy. Likewise, at maturity of Confirmations
an agreement, payment or receipt orders will be
initiated by the relevant trade-agreement Whenever trading transactions are agreed upon,
copies. a confirmation is sent to the counterparty to the
After the trades are recorded on the institu- agreement. A confirmation is the record of the
tion’s books, they will be periodically revalued. terms of a transaction sent out by each party,
Over time, trades will mature or be sold, before the actual settlement of the transaction
unwound, exercised, or expire as worthless, itself. The confirmation contains the exact details
depending on circumstances and instruments. of the transaction and thus serves legal, practi-
Subsequently, these transactions will be removed cal, and antifraud purposes. The confirmation
from the books of the institution, and related can be generated manually or automatically by
deferred accounts will pass through the account- an on-line computer trading system.
ing cycle. The back office should initiate, follow up, and
Financial institutions active in global markets control counterparty confirmations. Usually, an
may permit some traders to transact business incoming confirmation from the counterparty
after normal business hours. This activity should can be compared with a copy of the outgoing
be well defined in the institution’s policies and confirmation. If an incoming confirmation is not
procedures manual, in which trading instru- expected or if the transaction is carried out with
ments should be listed and possible counterpar- commercial customers and individuals, it is wise
ties defined. Supervisory responsibility of after- to send confirmations in duplicate and request a
hours and off-premises trading and the authorities return copy signed or authenticated by the other
for traders should be delineated. party.
A policy should be in place for off-market When a financial institution deals in faster-
transactions, and the organization should review paced markets, such as foreign exchange, or in
trading activity to determine if off-market rates instruments which have very short settlement
are used. Justification for off-market transac- periods, trade validation may be performed
tions should be registered in a log by the back through taped telephone conversations before
office. Frequent use of off-market rates may the exchange, with corroboration of a written or
reflect the extension of credit to a counterparty electronically dispatched confirmation. The use
and should be the subject of further examiner of taped phone conversations can help reduce
inquiry. the number and size of discrepancies and is a
Trading and Capital-Markets Activities Manual February 1998
Page 3
2060.1 Operations and Systems Risk (Back-Office Operations)
useful complement to (as opposed to a substitute and comprehensive explanation for any forms
for) the process of sending out and verifying not used.
confirmations. At a minimum, institutions should
retain the past 90 days of taped phone conver-
sations, but this time frame may need to be
expanded depending on the volume and term of Settlement Process
instruments traded. It is poor practice to rely
solely on telephone verifications because of After an outright or contingent purchase or sale
their ineffectiveness in litigation in some juris- has been made, the transaction must be cleared
dictions. Additionally, certain jurisdictions only and settled through back-office interaction with
recognize physical confirmations. the clearing agent. On the date of settlement
(value date), payments or instruments are
An institution dealing in global markets should exchanged and general-ledger entries are updated.
ensure the adequacy of its confirmations through Depending on the nature of the deal, currency
legal study of the regulations specific to the instruments will be received, paid, or both. The
foreign locales of its counterparties. In all process of paying and receiving must be handled
trading markets, the confirmation should pro- carefully because errors can be extremely costly.
vide a final safeguard against dealing errors or When all the proper information is recorded,
fraud. contracts are placed in ‘‘dead files.’’
All confirmations should be sent to the atten- Settlement is completed when the buyer (or
tion of a department at the counterparty institu- the buyer’s agent) has received the securities or
tion which is independent of the trading room. products, and the seller has been paid. Brokers
Incoming information should be compared in may assign these tasks to a separate organiza-
detail with the outgoing confirmation, and any tion, such as a clearinghouse, but remain respon-
discrepancies should be carefully appraised. sible to their customers for ensuring that the
If the discrepancy is significant, it should be transactions are handled properly. They are also
investigated independently. If the discrepancy is responsible for maintaining accurate accounting
small, a copy of the confirmation may be given records.
to the trader for clarification with the counter- Examiners should review the various methods
party, since the trader will probably have daily of settlement for the range of products covered
contact with the other party. Most importantly, and note any exceptions to commonly accepted
the department should follow up on all these practices. Unsettled items should be monitored
discrepancies and ensure that new confirma- closely by the institution. The handling of prob-
tions are obtained for any agreed-on changes in lems is always a delicate matter, especially when
terms. the cost is considerable. Anything more than a
A strictly controlled confirmation process routine situation should be brought to the atten-
helps to prevent fraudulent trades. For example, tion of the chief dealer and a senior officer in the
in a fraudulent deal, a trader could enter into a back office. Further action should be handled by
contract, mail out the original of a confirmation, management.
and then destroy all copies. This technique Losses may be incurred if a counterparty fails
would enable a trader to build up positions to make delivery. In some cases, the clearing-
without the knowledge of the financial institu- house and broker may be liable for any prob-
tion’s management. If the incoming confirma- lems that occur in completing the transaction.
tion is directed to the trader, it could be destroyed Settlement risk should be controlled through the
as well, and nobody would ever know about the continuous monitoring of movement of the
position. The trader, when closing this position, institution’s money and securities and by the
would make up a ticket for the originally establishment of counterparty limits by the credit
destroyed contract and pass it on together with department. A maximum settlement-risk limit
the offsetting contract so that the position is should be established for each counterparty.
square again. Receipt and verification of the
incoming confirmation by an independent
department would immediately uncover this type Foreign Payments
of fraudulent activity. An additional protection
is the use of serially numbered manifold forms Two control steps are involved when making
for confirmations, with an exact accounting of foreign payments. The first step is internal; each
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Operations and Systems Risk (Back-Office Operations) 2060.1
payment should be carefully checked with the onciled include trader position sheets to the
corresponding contract to ensure the accuracy of general ledger, general ledger to regulatory
the amount, date, and delivery instructions. The reports, broker statements to the general ledger,
second is checking with the dealer responsible and the income statement.
for the currency involved to ensure that cash-
flow figures for the delivery date, excluding
nostro balances, agree with the net of all con- DISCREPANCIES AND DISPUTED
tracts maturing on that day.
TRADES
If the financial institution uses more than one
financial institution abroad for the payment or Any discrepancy in trading transactions must
receipt of a currency, the back office must be brought immediately to the attention of the
ensure that the flow of funds does not leave one appropriate operations manager. All discrepan-
account in overdraft while another account has cies should be entered into a log, which should
excessive balances; this check will avoid unnec- be reviewed regularly by a senior operations
essary overdraft charges. The final check of officer. The log should contain the key financial
flows of foreign funds is made through the terms of the transaction, indicate the disputed
reconciliation of the foreign account. This is items, and summarize the resolution. The coun-
always a retrospective reconciliation because of terparty should receive notice of the final dispo-
the delays in receiving the statement of account. sition of the trade, and an adequate audit trail
Some extra actions that can help prevent prob- of that notice should be on file in the back
lems abroad or resolve them more quickly are office. The institution should have clear and
(1) sending details of expected receipts to the documented policies and procedures regard-
counterparty or correspondent with a request to ing the resolution of disputed trades with
advise if funds are not received, (2) asking counterparties.
the correspondent financial institution to advise
immediately if the account is in overdraft or
if balances are above a certain level, and
(3) establishing a contact person in the corre- Brokers’ Commissions and Fees
spondent bank to be notified if problems arise.
Brokers charge a commission or fee for each
Delivery versus payment. Many foreign secu- transaction they perform. The commission should
rities and U.S. Treasury securities are settled on not be included in the price of the transaction,
a delivery-versus-payment basis, under which and it should be billed separately by the brokers.
counterparties are assured that delivery of a Checking the commissions, initiating the pay-
security from the seller to the buyer will be ments, and reviewing brokers’ statements are
completed if, and only if, the buyer pays the other functions of the back office. To ensure the
seller. integrity of fees and commissions, brokers’
points arrangements and other trader-negotiated
solutions to trade disputes should be avoided.
Reconciliations
REVALUATION
The back office should perform timely reconcili-
ations in conformity with the policies and pro- Revaluation is the process by which financial
cedures of the institution. The minimum appro- institutions update or ‘‘mark to market’’ the
priate frequency for reconciliation will be linked value of their trading-product portfolios. Guide-
to the volume and complexity of the transactions lines for the formal revaluation should be delin-
at the financial institution. The individual eated in written policies and procedures. Weak
responsible for performing the reconcilement of policies and procedures increase the potential
accounts should be independent of the person for fraud and raise doubt about the integrity of
responsible for the input of transaction data. trading profits and a firm’s ability to evaluate
Reconciliations should determine positions risk. A common deficiency of revaluation pro-
held by the front office, as well as provide an cedures is the improper segregation of duties
audit trail detailing reclassified accounts for between traders and control personnel, includ-
regulatory reporting. Typical reports to be rec- ing a disproportionate dependence on trader
Trading and Capital-Markets Activities Manual February 1998
Page 5
2060.1 Operations and Systems Risk (Back-Office Operations)
input and the lack of independent verification of The mark-to-market methodology for risk
pricing parameters. In addition, the use of management may be calculated on the same
inconsistent pricing assumptions and methodolo- basis as the controller’s income-recognition
gies between the trading desk and back office method. Some financial institutions use equiva-
can lead to incorrect financial reporting and lency formulas that convert gross exposures to
evaluations of market risk. standard measures based on the price sensitivity
The determination of current market value is of benchmark securities. In this regard, the
both an intraday activity performed by traders to revaluation process serves as a starting point for
monitor their position as well as a daily activity risk assessment of capital-markets products. The
performed by control staff to determine the assessment of exposures by risk management,
impact on earnings. Discrepancies between trader however, should never be less conservative than
input and independent market rates should be assessment by actual market levels.
resolved and documented. Procedures should be
established for maintaining a discrepancy log
containing the reason for the discrepancy and
the profit-and-loss impact. Significant dis- ACCOUNTING
crepancies should be reported to senior
management. The recording of outstanding transactions allows
Sufficient information regarding the periodic verification of dealer positions, risk control, and
revaluation and resolution of discrepancies recording of profit and loss. Each institution
should be documented and maintained. In addi- should follow guidelines established by industry
tion, any adjustments to the general ledger due practice or the applicable governing bodies,
to changes in revaluation estimates should be including—
clearly recorded and reported to management.
The revaluation process is transparent for • generally accepted accounting principles
securities, futures, and other instruments that are (GAAP)
traded on organized exchanges. Published prices • regulatory accepted principles (RAP)
from exchanges provide an objective check • Federal Reserve Board policy statements
against the price provided by traders, although • Federal Financial Institutions Examination
liquidity considerations make evaluating quoted Council statements
prices more complex. A secondary comfort
level for exchange-traded products is the margin For further discussion, see sections 2120.1,
call in which a position is evaluated at the ‘‘Accounting,’’ and 2130.1, ‘‘Regulatory
posted end-of-day price. Prices of actively traded Reporting.’’
over-the-counter (OTC) products available from
electronic wire services provide a similar check
against trader prices for these products. MANAGEMENT INFORMATION
However, with less actively traded products, REPORTS
especially exotic OTC-traded derivatives and
options, the revaluation process is more com- Management information reports are prepared
plex. The pricing of illiquid instruments has a by the back office and trader-support areas to
greater potential for error or abuse because enable management and trading personnel to
valuation is more subjective. For example, assess the trading position, risk positions, profit
options that are tailored for customer require- and loss, operational efficiency, settlement costs,
ments may have no two-way market, yet still and volume monitoring of the institution. For
must be evaluated at current market value. further discussion, see section 2040.1, ‘‘Man-
While various pricing models exist, all depend agement Information Systems.’’
on critical assumptions and estimates used to
calculate the probable price. Errors can arise
from incorrect estimates or manipulation of
variables and assumptions. One particular vul- DOCUMENTATION AND
nerability concerns the observed volatility of RECORDKEEPING
options. See section 2010.1, ‘‘Market Risk,’’ for
a discussion of problems that can arise with Accurate recording of transactions by back-
measuring volatilities. office personnel is crucial to minimizing the risk
February 1998 Trading and Capital-Markets Activities Manual
Page 6
Operations and Systems Risk (Back-Office Operations) 2060.1
of loss from contractual disputes. Poor docu- ing on the size of the trading operation, trading
mentation can lead to unenforceable transac- and management expertise, organizational struc-
tions. Similarly, poor recordkeeping can render ture, sophistication of computer systems, insti-
audit trails ineffective, and can result in a tution’s focus and strategy, historical and
qualified or adverse opinion by the public expected income, past problems and losses,
accountant, a violation of Federal Reserve Board risks, and types and sophistication of the trading
policy, or loss due to fraud. products and activities. As a result, practices,
An institution should keep confirmations sum- policies, and procedures expected in one insti-
marizing the specific terms of each trade. Addi- tution may not be necessary in another. The
tionally, master agreements should be kept on adequacy of internal controls requires sound
premises or a copy should be available locally judgment on the part of the examiner. The
for examiner reference. For further discussion following is a list of sound back-office opera-
on master agreements, see section 2070.1, ‘‘Legal tions to check for.
Risk.’’
• Every organization should have comprehen-
sive policies and procedures in place that
AUDITS describe the full range of capital-markets and
trading activities performed. These docu-
The scope and frequency of an institution’s ments, typically organized into manuals,
audit program should be designed to review its should at a minimum include front- and back-
internal control procedures and verify that con- office operations; reconciliation guidelines and
trols are, in fact, being followed. Any weak- frequency; revaluation guidelines; accounting
nesses in internal control procedures should be guidelines; descriptions of accounts; broker
reported to management, along with recommen- policies; a code of ethics; and the risk-
dations for corrective action. measurement and risk-management methods,
Audits of capital-markets and trading prod- including the limit structure.
ucts provide an indication of the internal control • For every institution, existing policies and
weaknesses of the financial institution. The procedures should ensure the segregation of
audit function should have a risk-assessment duties between trading, control, and payment
map of the capital-markets and trading function functions.
that identifies important risk points for the • The revaluation of positions may be con-
institution. For back-office operations, the risk ducted by traders to monitor positions, by
assessment may highlight manual processes, controllers to record periodic profit and loss,
complex automated computations, independent and by risk managers who seek to estimate
revaluation, key reconciliations, approval pro- risk under various market conditions. The
cesses, and required investigations or staff frequency of revaluation should be driven by
inquiries. Examiners should review a sample of the level of an institution’s trading activity.
internal auditors’ workpapers and findings to Trading operations with high levels of activity
determine their adequacy. The institution’s man- should perform daily revaluation. Every insti-
agement should review responses to internal tution should conduct revaluation for profit
audit findings. Appropriate follow-up by audi- and loss at least monthly; the accounting
tors should be in evidence to ensure that defi- revaluation should apply rates and prices from
ciencies are, in fact, remedied. Assuming that sources independent of trader input.
examiners are comfortable with the quality of an • The organization should have an efficient
internal audit, they should use audit findings confirmation-matching process that is fully
from internal and external auditors as a starting independent from the dealing function. Docu-
point to evaluate the internal controls of the mentation should be completed and exchanged
institution. as close to completion of a transaction as
possible.
• Computer hardware and software applications
SOUND PRACTICES FOR must have the capacity to accommodate the
BACK-OFFICE OPERATIONS current and projected level of trading activity.
Appropriate disaster-recovery plans should be
Capital-markets and trading operations vary sig- tested regularly.
nificantly among financial institutions, depend- • Auditors should review trade integrity and
Trading and Capital-Markets Activities Manual February 1998
Page 7
2060.1 Operations and Systems Risk (Back-Office Operations)
monitoring on a schedule that conforms with transactions should be clearly designated as
the institution’s appropriate operational-risk switches, and relevant credit authorities should
designation. be involved.
• Every institution should have a method- • Every institution that uses brokers for foreign-
ology to identify and justify any off-market exchange transactions should establish a clear
transactions. statement forbidding lending or borrowing
• A clear institutional policy should exist con- broker’s points as a method to resolve
cerning personal trading. If permitted at all, discrepancies.
procedures should be established to avoid • Every organization should have explicit com-
even the appearance of conflicts of interest. pensation policies to resolve disputed trades
• Every institution should ensure that the man- for all traded products. Under no circum-
agement of after-hours and off-premises trad- stances should soft-dollar or off-the-books
ing, if permitted at all, is well documented so compensation be permitted for dispute resolu-
that transactions are not omitted from the tion.
automated blotter or the bank’s records.
• Every institution should ensure that staff is • Every institution should have ‘‘know-your-
both aware of and complies with internal customer’’ policies, which should be under-
policies governing the trader-broker stood and acknowledged by trading and sales
relationship. staff.
• Every institution that uses brokers should • In organizations that have customers who
monitor the patterns of broker usage, be alert trade on margin, procedures for collateral
to possible undue concentrations of business, valuation and segregated custody accounts
and review the short list of approved brokers should be established.
at least annually. • The designated compliance officer should
• Every institution that uses brokers should perform a review of trading practices annu-
establish a firm policy to minimize name ally. In institutions with a high level of activ-
substitutions of brokered transactions. All ity, interim reviews may be warranted.
February 1998 Trading and Capital-Markets Activities Manual
Page 8
Operations and Systems Risk (Back-Office Operations)
Examination Objectives Section 2060.2
1. To determine whether the policies, proce- 10. To evaluate the process for resolving dis-
dures, practices, and internal systems and puted trades with customers and brokers.
controls for back-office operations are 11. To determine the reasonableness of brokers’
adequate and effective for the range of fees and commissions.
capital-markets products used by the finan- 12. To evaluate the effectiveness of and con-
cial institution. trols on the revaluation process.
2. To determine whether trade-processing per- 13. To review the accounting treatment, report-
sonnel are operating in conformance with ing, and control of deals for adherence to
established policies and procedures. generally accepted accounting principles and
3. To determine whether the financial institu- the institution’s internal chart of accounts
tion adequately segregates the duties of and procedures.
personnel engaged in the front office from
14. To review adherence to regulatory reporting
those involved in the back-office control
instructions.
function (operations, revaluation, account-
ing, risk management, and financial 15. To evaluate the adequacy of management
reporting). information reporting systems on trading
4. To evaluate the adequacy of supervision of activities.
the trade-processing operation. 16. To evaluate the adequacy of documentation
5. To evaluate the sophistication and capabil- and other requirements necessary to accu-
ity of computer systems and software for rately record trading activity, such as signed
the operation and control function. agreements, dealer tickets, and confirmations.
6. To assess the adequacy of confirmation 17. To evaluate the adequacy of audits of capital-
procedures. markets and trading activities.
7. To assess the adequacy of settlement 18. To recommend corrective action when poli-
procedures. cies, procedures, practices, internal con-
8. To evaluate the adequacy and timeliness of trols, or management information systems
the reconciliation procedures of outstanding are found to be deficient, or when violations
trades, positions, and earnings with the of laws, rulings, or regulations have been
front office and the general ledger. noted.
9. To evaluate the process for resolving
discrepancies.
Trading and Capital-Markets Activities Manual February 1998
Page 1
Operations and Systems Risk (Back-Office Operations)
Examination Procedures Section 2060.3
These procedures represent a list of processes j. an approved list of brokers, counterpar-
and activities that may be reviewed during a ties, and an explicit dispute-resolution
full-scope examination. The examiner-in-charge methodology (that is, brokers’ points
will establish the general scope of examination policy)
and work with the examination staff to tailor k. the procedure for addressing disputed
specific areas for review as circumstances war- trades and discrepancies in financial terms
rant. As part of this process, the examiner l. revaluation procedures
reviewing a function or product will analyze and
m. accounting procedures, including a chart
evaluate internal-audit comments and previous
of accounts and booking policies for
examination workpapers to assist in designing
internal transactions and transactions with
the scope of examination. In addition, after a
affiliates
general review of a particular area to be exam-
ined, the examiner should use these procedures, n. guidelines for management information
to the extent they are applicable, for further reporting
guidance. Ultimately, it is the seasoned judg- o. requirements for documentation and
ment of the examiner and the examiner-in- recordkeeping
charge as to which procedures are warranted in p. guidelines for the quality control and stor-
examining any particular activity. age of taped conversations of dealer
transactions
q. guidelines for brokers’ commissions and
GENERAL PROCEDURES fees and their appropriate reconciliations
r. a code of ethics for traders and other
1. Obtain copies of all policies and procedures personnel with insider information, and
governing back-office operations. Policies ‘‘know-your-customer’’ guidelines
and procedures should at a minimum include s. personal-trading guidelines and monitor-
the following. ing procedures
a. the mission statement t. a list of authorized signatures
b. organizational structure and responsibili-
u. the policy for off-market rates which
ties
includes the following:
c permissible activities and off-premises
dealing rules • A letter from someone in senior cus-
d. limits approved by the board of directors tomer management (treasurer or above)
for the full range of activities and risks, should be kept on file explaining (1) that
including intraday and overnight net open the customer will occasionally request
positions, instrument types, contracts, off-market rates, (2) the reasons such
individual traders, settlement, price move- requests will be made, and (3) that such
ment, market liquidity, counterparty, and requests are consistent with the cus-
commodity or product types, if applicable tomer firm’s internal policies. This let-
(For more details on limits, see sec- ter should be kept current.
tions 2010.1, 2020.1, and 2030.1, ‘‘Mar- • The dealer should solicit an explanation
ket Risk,’’ ‘‘Counterparty Credit and Pre- from the customer for each request for
settlement Risk,’’ and ‘‘Liquidity Risk,’’ an off-market-rate deal at the time the
respectively.) request is made.
e. the limit-monitoring process used by back- • Senior management and appropriate
office or risk-management staff indepen- credit officers at the dealer institution
dent of the front office, and limit-excess- should be informed of and approve each
approval procedures transaction and any effective extension
f. a detailed description of transaction- of credit.
processing procedures and flow • A letter should be sent to senior cus-
g. procedures for confirming trades tomer management immediately after
h. procedures for settlement of trades each off-market transaction is executed
i. required reconciliations explaining the particulars of the trade
Trading and Capital-Markets Activities Manual February 1998
Page 1
2060.3 Operations and Systems Risk (Back-Office Operations): Examination Procedures
and explicitly stating the implied loan or SEGREGATION OF DUTIES
borrowing amount.
• Normally, existing forward contracts 1. Ensure that the process of executing trades is
should not be extended for more than separate from that of confirming, reconciling,
three months nor extended more than revaluing, or clearing these transactions or
once; however, any extension of a roll- controlling the disbursement of funds, secu-
over should itself meet the requirements rities, or other payments, such as margins,
above. commissions, and fees.
2. Review the financial institution’s policies to 2. Ensure that individuals initiating transactions
determine whether they are adequate and do not confirm trades, revalue positions,
effective. Does top management have clear approve or make general-ledger entries, or
directives regarding the responsibilities of resolve disputed trades. Additionally, within
management personnel in charge of oversee- the back office, segregation must occur
ing and controlling risk? See sections 2010.1, between reconciling and confirming posi-
2020.1, 2030.1, and 2070.1, ‘‘Market Risk,’’ tions. Accounting entry and payment receipt
‘‘Counterparty Credit and Presettlement and disbursement must also be performed by
Risk,’’ ‘‘Liquidity Risk,’’ and ‘‘Legal Risk,’’ distinct individuals with separate reporting
respectively. lines.
3. Determine whether access to trading prod-
3. Conduct interviews with senior and middle
ucts, trading records, critical forms, and both
management to determine their familiarity
the dealing room and processing areas is
with policy directives in day-to-day situa-
permitted only in accordance with stated
tions. Develop conclusions as to the adequacy
policies and procedures.
of these policies in defining responsibilities
4. Determine whether a unit independent of the
at lower levels of management in addressing
trading room is responsible for reviewing
the nature of the business and the business
daily reports to detect excesses of approved
risks being undertaken, and in defining spe-
trading limits.
cific limitations on all types of transactional
risks and operational failures intended to 5. Review the job descriptions and reporting
protect the organization from unsustainable lines of all trading and supervisory personnel
losses. Are these policies reviewed periodi- to ensure that they support the segregation of
cally to ensure that all risk-bearing busi- duties outlined in the financial institution’s
nesses of the financial institutions come under policies. In addition, during the course of the
directives approved by top management and examination, observe the performance of per-
in light of the financial institution’s profit sonnel to determine whether certain duties
experience? Develop an understanding of the that are supposed to be segregated are truly
degree of commitment of middle and lower- segregated.
level management to the institution’s policy
directives.
a. Evaluate whether management is TICKET-FLOW PROCEDURES
informed about pertinent laws, regula-
tions, and accounting conventions. Evalu- 1. Confirm that the trading tickets or auto-
ate whether training of back-office staff is mated transactions used to record pur-
adequate for the institution’s volume and chases, sales, and trading contracts are well
business mix. controlled. Sequential ticketing may be
b. Evaluate the management-succession plan appropriate to permit reconstruction of trad-
for back-office and control staff. ing history, if required.
2. Verify that trading tickets are verified and
c. Evaluate the impact of staff turnover on
time coded by the front-office personnel.
back-office operations.
3. If risk management is monitored by the
4. Determine the extent to which the financial back office, determine that traders are
institution adheres to its established limits, adhering to stated limits. If limit excesses
policies, and procedures. exist, ensure that management approval has
5. Determine the adherence of key personnel to been obtained and documented before the
established policies, procedures, and limits. occurrence of the limit violation. Determine
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Operations and Systems Risk (Back-Office Operations): Examination Procedures 2060.3
whether the institution maintains adequate ent types of transactions sometimes have
records of limit violations. varying legal or regulatory standards for the
4. Review transactions for any unusual pattern medium of communication that can be used
or activity, such as an increase in volume, (such as telex).
new trading counterparties, or a pattern of 2. Review the confirmation process and
top-price or bottom-price trades relative to follow-up procedures. Determine that person-
the day’s trading range or with the same nel check all incoming confirmations to
counterparties. internal records and immediately record,
5. Determine whether the institution holds col- investigate, and correct any discrepancies. In
lateral for margin trading. Determine whether addition, determine whether—
adequate procedures are in place to monitor a. outgoing confirmations are sent not later
positions against collateral. Ensure that the than one business day after the transaction
margin-monitoring process is wholly inde- date;
pendent of the front office. Review the b. outgoing confirmations contain all rel-
adequacy of procedures for verifying reports evant contract details, and incoming con-
of margin deposits and contract-position firmations are delivered directly to the
valuations (based on outside pricing sources) back office for review;
submitted by brokers and futures commis- c. all discrepancies between an incoming con-
sion merchants. Review procedures for rec- firmation and the financial institution’s
onciling these reports to the financial insti- own records are recorded in a confirmation-
tution’s records. discrepancy register, regardless of disposi-
6. Review the financial institution’s system for tion, and open items are reviewed regu-
ensuring that deals are transacted at market larly and resolved in a timely manner;
rates. d. discrepancies are directed and reviewed
7. Determine whether the institution can iden- for resolution by an officer independent of
tify off-market rates for the range of instru- the trading function;
ments transacted. Determine whether appro- e. all discrepancies requiring corrective action
priate justification for these transactions is are promptly identified and followed up
on file and acknowledged by senior man- on; and
agement. f. any unusual concentrations of discrepan-
8. Review the holdover-trade policy and the cies exist for traders or counterparties.
holdover register’s record of trades made 3. Review confirmation-aging reports to iden-
but not posted to the ledgers at the end of tify trades without confirmations that have
the day, the identification of such contracts been outstanding more than 15 days. (Sig-
as ‘‘holdover’’ items, and their inclusion in nificantly less than 15 days in some markets
trader or trading-office position reports to may be a cause for concern.)
management. 4. Determine whether the information on con-
9. Determine whether all holdover trades are firmations received is verified with the trad-
properly recorded and monitored. In addi- er’s ticket or the contract.
tion, review the financial institution’s hold- 5. Determine whether the institution has
over register and evaluate the reasons for an effective confirmation-matching and
any unusually high incidence of held-over confirmation-chasing process.
deals.
10. Identify transactions undertaken with affili-
ated counterparties to determine whether
such dealings have been transacted at prices SETTLEMENT PROCEDURES
comparable to those employed in deals with
nonaffiliated counterparties. 1. In all instances, particularly those in which
the settlement of trades occurs outside an
established clearing system, review the finan-
cial institution’s settlement controls to deter-
CONFIRMATION PROCEDURES mine whether they adequately limit settle-
ment risk.
1. Determine whether the confirmation process 2. Determine whether the financial institution
is controlled by the back-office area. Differ- uses standardized settlement instructions.
Trading and Capital-Markets Activities Manual February 1998
Page 3
2060.3 Operations and Systems Risk (Back-Office Operations): Examination Procedures
(Their use can significantly reduce both the 2. Confirm that customer complaints are resolved
incidence and size of differences arising from by someone other than the person who
the mistaken settlement of funds.) executed the contract.
3. Review the nostro accounts to determine if 3. Ensure that the institution’s policy prohibits
there are old or numerous outstanding items the use of brokers’ points in the foreign-
which could indicate settlement errors or exchange market and properly controls any
poor procedures. brokers’ switch transactions that are permitted.
4. Determine if the institution prepares adequate 4. Review the trade-investigations log to deter-
aging schedules and if they are appropriately mine the size and amount of outstanding
monitored. disputes, the number resolved and not paid,
5. Determine whether disbursements and the amount paid out in the most recent
receipts have been recalculated to reflect period, and the trend of dispute resolutions
the net amounts for legally binding netting (the institution’s fault versus counterparties’
arrangements. fault).
5. Review the volume of confirmation and settle-
ment discrepancies noted and the correspond-
RECONCILIATION PROCEDURES ing levels of overdraft interest or compen-
sation expenses paid to counterparties to
1. Obtain copies of reconciliations (for trade, determine—
revaluation confirmation, positions) for a. the adequacy of operations staffing (num-
capital-markets products. Verify that bal- ber and skill level),
ances reconcile between appropriate subsid- b. the adequacy of current operating policies
iary controls and the general ledger. Review and procedures, and
the reconciliation process used by the back c. the overall standard of internal controls.
office for its adequacy.
a. Determine the adequacy of the frequency
of the reconciliations in light of the trad-
ing operation. BROKERS’ COMMISSIONS AND
b. Investigate unusual items and any items FEES PROCEDURES
outstanding for an inordinately long period
of time. 1. Evaluate the volume of trading deals trans-
c. Assess the adequacy of the audit trail to acted through brokers.
ensure that balances and accounts have 2. Review brokerage expenses. Determine that
been properly reconciled. at least monthly brokerage expenses are—
d. Determine that reconciliations are main- a. commensurate with the level of trading
tained for an appropriate period of time activity and profits,
before their destruction. b. spread over a fair number of brokers with
2. Determine that timely reconciliations are pre- no evidence of favoring particular brokers,
pared in conformity with applicable policies c. reconciled by personnel independent of
and procedures of the reporting institution traders for accuracy and distribution of
and with regulatory accounting principles. expenses.
3. Determine that the reconcilement of front- 3. Scrutinize transactions for which the broker
office positions is performed by an individual has not assessed the usual fee.
without initial transaction responsibility. 4. Does the financial institution retain informa-
Determine that timely reconciliations are per- tion on and authorizations for all overdraft
formed given capital-markets and trading charges and brokerage bills within the last 12
activity. months and retain all telex tapes or copies
and recorded conversation tapes for at least
90 days? (This retention period may need to
PROCEDURES FOR be considerably longer for some markets.)
DISCREPANCIES AND DISPUTED 5. Review the retention policy for brokers’
TRADES commission and fee reports.
6. Assess that adequate information is obtained
1. Assess the process and procedures for the to substantiate compensated contracts, liqui-
resolution of disputed trades. dation of contracts, and canceled contracts.
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Operations and Systems Risk (Back-Office Operations): Examination Procedures 2060.3
7. Review a sample of brokered transactions d. the names of firms or institutions with
and their documentation. whom employees are authorized to con-
duct business (counterparties)
REVALUATION PROCEDURES 2. Determine whether the institution has a for-
mal record-retention policy and whether it
1. Determine whether revaluation procedures results in an adequate audit trail for internal
address the full range of capital-markets and and external auditors.
trading instruments at the institution.
2. Determine the frequency of revaluation by
product and application (use).
3. Determine the source of market rates and
AUDIT PROCEDURES
whether the selection process is subject to 1. Determine whether the audit program includes
manipulation or override by traders. Deter- a risk assessment of all front- and back-office
mine if trader override is justified and well activities.
documented.
2. Determine whether the audits performed are
4. Evaluate the methodology of revaluing illiq-
comprehensive and address areas of concern
uid or structured products when prices are
with appropriate frequency.
not readily available. If the institution estab-
3. Determine whether audit findings are
lishes reserves for these products, review the
complete.
adequacy of those reserves.
5. Determine whether investment portfolios are 4. Determine whether audit findings are relayed
adequately monitored on a reasonable to the appropriate level of management and
frequency. that there is appropriate follow-up and
response.
5. Determine whether the audit staff is adequately
DOCUMENTATION AND trained to analyze the range of capital-
RECORDKEEPING PROCEDURES markets activities at the financial institution.
1. Determine the adequacy of control on docu-
mentation. Review written documentation for
the following: CORRECTIVE ACTION
a. the types of contracts eligible for purchase
or sale by the financial institution 1. Recommend corrective action when policies,
b. individuals eligible to purchase and sell procedures, practices, internal controls, or
contracts management information systems are found
c. individuals eligible to sign contracts or to be deficient, or when violations of laws,
confirmations rulings, or regulations have been noted.
Trading and Capital-Markets Activities Manual February 1998
Page 5
Operations and Systems Risk (Back-Office Operations)
Internal Control Questionnaire Section 2060.4
POLICIES AND PROCEDURES list of all traders authorized to trade off
premises?
The following questions are appropriate for
policies and operating procedures for capital-
markets and trading activities.
SEGREGATION OF DUTIES
1. Do the policies and procedures have the 1. Does the back office have a current organi-
approval of the board of directors? zation chart? If so, obtain a copy.
2. Do they give sufficiently precise guidance 2. Is the organization chart supplemented by
to officers and employees? position descriptions and summaries of
3. Do they have clear directives regarding the major functions? If so, obtain copies of
responsibilities of management personnel in them.
charge of overseeing and controlling risk? 3. Is there a management-succession plan for
(See sections 2010.1, 2020.1, 2030.1, and back-office and control staff, and is it ad-
2070.1, ‘‘Market Risk,’’ ‘‘Counterparty equate? Is the experience level of personnel
Credit and Presettlement Risk,’’ ‘‘Liquidity commensurate with the institution’s activity?
Risk,’’ and ‘‘Legal Risk,’’ respectively. Is the turnover rate high?
4. Do they appear to be appropriate to man- 4. Compare organizational charts between
agement’s objectives and the needs of the exams. If the turnover rate has been high,
institution’s customers? determine the reasons for the turnover and
5. Do they cover all of the financial institu- evaluate what effect the turnover has had on
tion’s back-office operations and adequately the financial institution’s trading operations.
describe the objectives of these activities? Determine the reasons for each trader’s
6. Are they updated on a timely basis when termination or resignation.
new products are introduced or when exist- 5. Are all employees required to take two
ing products are modified? consecutive weeks of vacation annually? Is
this policy followed?
7. Do they fully describe all the documenta-
6. Does the institution perform background
tion requirements relating to trading
checks on employees?
products?
7. Review the financial institution’s compen-
8. Do they establish parameters which prevent sation program for these activities to deter-
conflicts of interest within the financial mine whether remuneration is based on
institution’s overall trading operations (that volume and profitability criteria. If so, deter-
is, do safeguards prevent insider abuses)? mine whether controls are in place to pre-
9. Do procedures manuals cover all the secu- vent personnel from taking excessive risks
rities activities that the financial institution to meet the criteria.
conducts, and do they prescribe appropriate 8. Is there a list of locations where trading
internal controls relevant to those functions activities are carried out, supplemented by a
(such as revaluation procedures, accounting description of the activities at each location
and accrual procedures, settlement proce- and an explanation of each location’s
dures, confirmation procedures, accounting/ responsibilities with regard to risk manage-
auditing trails, and procedures for establish- ment and control? If so, obtain copies of the
ing the sequential order and time of list and arrange for access to the supplemen-
transactions)? tal information.
10. Do prodedures include a code of ethics? Is 9. Are dealers and position clerks that report to
there a ‘‘know-your-customer’’ guideline at them excluded from the following functions:
the institution? How does the institution a. preparing, validating (officially signing),
ensure compliance? and mailing trading contracts?
11. Are there written procedures to control b. recording trading transactions, maintain-
after-hours trades and trades originating ing position ledgers and maturity files,
outside the trading room (for example, at and preparing daily activity and position
the trader’s home)? Is there an approved reports (except for memorandum records
Trading and Capital-Markets Activities Manual February 1998
Page 1
2060.4 Operations and Systems Risk (Back-Office Operations): Internal Control Questionnaire
used to inform dealers of position TICKET FLOW
information)?
c. periodically revaluing positions and 1. Are tickets prenumbered? If not, are trading
determining gains or losses for official tickets assigned a computer-generated num-
accounting records? ber? Does control over tickets appear rea-
d. settling transactions and other paying or sonable and adequate?
receiving functions, such as issuing or 2. Do tickets clearly define the type of product
receiving, and processing cable or mail (for example, interest-rate swap, OTC bond
transactions, drafts, or bills of exchange? option, or gold bullion)?
3. Do tickets contain all other pertinent infor-
e. receiving counterparty confirmations and
mation to prepare the related contract with-
reconciling them to contracts or broker
out recourse to the dealing room?
statements, following up on outstanding
4. Are trading tickets time and date stamped in
confirmations, and correcting related
the front office? Are dual signatures on the
errors and similar processing functions?
tickets for the trader and back-office
f. operating and reconciling nostro and personnel?
other due-to or due-from accounts related 5. Are there any unusual patterns of activity
to trading activities? (for example, an increase in volume, new
g. preparing, approving, and posting any trading counterparties, a pattern of top-price
other accounting entries? or bottom-price trades relative to the
10. Is management informed about pertinent day’s trading range or with the same
laws, regulations, and accounting conven- counterparties)?
tions? Is training of back-office staff adequate 6. Are reviews of outstanding contracts per-
for the institution’s volume and business formed on a frequency commensurate with
mix? trading activity?
11. Does management have a strategy for the 7. Are trader positions reviewed and approved
back office that parallels that for the by management on a timely basis?
organization? 8. Can the institution identify off-market
12. Is the process of executing trades separate transactions?
from that of confirming, reconciling, revalu- 9. Does the institution ensure that senior cus-
ing, or clearing these transactions or from tomer management is aware of off-market
controlling the disbursement of funds, secu- transactions and the special risks involved?
rities, or other payments, such as margins, Is appropriate justification for these trans-
commissions, or fees? actions on file and acknowledged by senior
management?
13. Are front-office functions segregated from
10. Are holdover trades adequately controlled?
those individuals who confirm trades, revalue
11. Are all holdover trades properly recorded
positions, approve or make general-ledger
and monitored? Can the institution justify
entries, or resolve disputed trades? Addi-
the reasons for any unusually high incidence
tionally, within the back office, are recon-
of held-over deals?
ciling and confirming positions segregated?
Is accounting entry and payment receipt or 12. Does the institution transact trades with
disbursement performed by distinct indi- affiliated counterparties? Are such dealings
viduals with separate reporting lines? transacted at prices comparable to those
employed in deals with nonaffiliated
14. Is access to trading products, trading records, counterparties?
critical forms, and both the dealing room 13. Does the financial institution have specific
and processing areas permitted only in policies for margin lending, and are cus-
accordance with stated policies and tomer requests adequately reviewed and
procedures? authorized? Does it enforce all margin
15. Is a unit independent of the trading room requirements and sell securities if custom-
responsible for reviewing daily reports to ers do not meet margin calls?
detect excesses of approved trading limits? 14. Does the back office monitor collateral
16. From observation, are back-office tasks truly against open positions for margin custom-
segregated from front-office tasks? ers? Is the supervision adequate?
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Operations and Systems Risk (Back-Office Operations): Internal Control Questionnaire 2060.4
15. Are margin requirements on all outstanding communication that can be used (for exam-
contracts for a customer monitored daily? ple, telex)?
In the case of actively trading customers, 10. Does the institution have an effective
are margin requirements checked after cash confirmation-matching and confirmation-
trades? chasing process?
11. Are there procedures to uncover unusually
heavy trading by a single counterparty?
CONFIRMATIONS
SETTLEMENT PROCESS
Review the confirmation process and follow-up
procedures. 1. Do the financial institution’s controls
adequately limit settlement risk?
1. Are all data on incoming and outgoing 2. Are nostro accounts reconciled frequently?
confirmations compared to file copies of Are there old or numerous outstanding items
contracts? Verify that confirmations contain which could indicate settlement errors or
the following information: poor procedures?
a. counterparty 3. How are failed securities trades managed?
b. instrument purchased or sold a. Do procedures promptly resolve transac-
c. trade date tions that are not settled when and as
d. value date agreed on (‘‘fails’’)?
e. maturity or expiry date b. Are stale items valued periodically and, if
f. financial terms any potential loss is indicated, is a par-
g. delivery and payment instructions ticular effort made to clear such items or
h. definition of any applicable market con- to protect the financial institution from
ventions (for example, the interest- loss by other means?
determination methodology) c. Are fail accounts periodically reconciled
i. date of preparation, if different from the to the general ledger, and are any differ-
transaction date ences followed up to a conclusion?
j amount traded 4. Is the back office routinely able to reconcile
k. reference number its cash accounts against securities accepted
or delivered?
2. Are signatures on confirmations verified?
5. Is physical security of trading products
3. Are outgoing confirmations sent not later adequate?
than one business day after the transaction
6. To ensure segregation of duties, are person-
date?
nel responsible for releasing funds specifi-
4. Do outgoing confirmations contain all rel- cally excluded from any confirmation
evant contract details? Are incoming con- responsibilities?
firmations delivered directly to the back 7. Does the institution prepare adequate aging
office for review? schedules? Are they monitored?
5. Does the institution adequately monitor dis- 8. Are netting arrangements correctly reflected
crepancies between an incoming confirma- in disbursements and receipts?
tion and the financial institution’s own
records?
6. Are discrepancies directed to and reviewed RECONCILIATIONS
for resolution by an officer independent of
the trading function? Obtain copies of reconciliations (for trade,
7. Are all discrepancies requiring corrective revaluation confirmation, and positions) for
action promptly identified and followed up traded products. Verify that balances reconcile
on? to appropriate subsidiary controls and the gen-
8. Are there any unusual concentrations of eral ledger. Review the reconciliation process
discrepancies for traders or counterparties? followed by the back office for adequacy.
9. Has the institution conducted adequate
research to determine the standing of legal 1. Are timely reconciliations prepared in con-
or regulatory standards for the medium of formity with applicable policies and proce-
Trading and Capital-Markets Activities Manual February 1998
Page 3
2060.4 Operations and Systems Risk (Back-Office Operations): Internal Control Questionnaire
dures of the reporting institution and regula- 4. Are brokers’ statements reconciled by the
tory accounting principles? back office with the financial institution’s
2. Are unusual items investigated? Are there records before the payment of commissions?
any outstandings? 5. Does the back office routinely report any
3. Is the audit trail adequate to ensure that significant questions or problems in dealing
balances and accounts have been properly with brokers? Are discrepancies on brokers’
reconciled? statements directed to someone outside the
4. Are reconciliations held on file for an appro- trading function for resolution?
priate period of time? 6. Can the institution justify cases in which the
5. Is the reconcilement of front-office positions broker has not assessed the usual fee?
performed by an individual without initial 7. Is an adequate audit trail established for all
transaction responsibility? overdraft charges and brokerage bills within
the last 12 months? Does the process require
retention of all telex tapes or copies and
DISCREPANCIES AND DISPUTED recorded conversation tapes for at least 90
days? (This retention period may need to be
TRADES considerably longer for some markets.)
1. Is the resolution of disputed trades and
determination of compensation for the early
unwinding of contractual obligations of the REVALUATION
financial institution controlled by the back
office? 1. Do the revaluation procedures address the
2. Are the processes and procedures for the full range of capital-markets and trading
resolution of disputed trades effective? instruments at the institution?
3. Are customer complaints resolved by some- 2. Is the frequency of revaluation by product
one other than the person who executed the and application (use) adequate?
contract? 3. Are the source of market rates and the
4. Does the institution’s policy prohibit the use selection process subject to manipulation or
of brokers’ points in the foreign-exchange override by traders? Is trader override justi-
market and control any brokers’ switch trans- fied and well documented?
actions? 4. Are revaluation results discussed with the
5. Is the volume of confirmation and settlement trading management? Is an approval process
discrepancies excessive? in place to ensure agreement of positions and
profit and loss by back- and front-office staff?
BROKERS’ COMMISSIONS AND
FEES PROCEDURES ACCOUNTING
1. Evaluate the volume of trading deals trans- See section 2120.1, ‘‘Accounting.’’
acted through brokers. Are commissions and
fees—
a. commensurate with the level of trading MANAGEMENT INFORMATION
activity and profits? REPORTING
b. spread over a fair number of brokers? Is
there evidence of favoring a particular or See section 2040.1, ‘‘Management Information
group of brokers? Systems.’’
c. reconciled by personnel independent of
traders to determine accuracy and distri-
bution of expenses? DOCUMENTATION AND
2. Are regular statements received from these RECORDKEEPING
brokers?
3. Are incoming brokers’ statements sent directly 1. Is written documentation complete, approved
to the accounting or operations department at the appropriate level (with authorized
and not to trading personnel? signatures), and enforceable?
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Operations and Systems Risk (Back-Office Operations): Internal Control Questionnaire 2060.4
2. Are there procedures in place to ensure 3. Do audit findings summarize all important
compliance with the Financial Recordkeep- areas of concern noted in the workpapers?
ing and Reporting Act of 1978? 4. Are audit findings relayed to the appropriate
level of management? Is appropriate follow-up
and response elicited?
AUDIT 5. Is the audit staff adequately trained to ana-
lyze the range of capital-markets activities at
1. Does the audit program include a risk assess-
the financial institution?
ment of all the front- and back-office
activities? 6. Is there the opportunity for undue influence
2. Are the audits performed comprehensive, to be imposed on audit staff? Is audit staff
and do they address areas of concern with sufficiently independent of control and front-
appropriate frequency? Is the scope adequate office functions?
and clearly stated?
Trading and Capital-Markets Activities Manual February 1998
Page 5
Legal Risk
Section 2070.1
An institution’s trading and capital-markets will prove unenforceable. Many trading activi-
activities can lead to significant legal risks. ties, such as securities trading, commonly take
Failure to correctly document transactions can place without a signed agreement, as each indi-
result in legal disputes with counterparties over vidual transaction generally settles within a very
the terms of the agreement. Even if adequately short time after the trade. The trade confirma-
documented, agreements may prove to be unen- tions generally provide sufficient documentation
forceable if the counterparty does not have the for these transactions, which settle in accor-
authority to enter into the transaction or if the dance with market conventions. Other trading
terms of the agreement are not in accordance activities involving longer-term, more complex
with applicable law. Alternatively, the agree- transactions may necessitate more comprehen-
ment may be challenged on the grounds that the sive and detailed documentation. Such documen-
transaction is not suitable for the counterparty, tation ensures that the institution and its coun-
given its level of financial sophistication, finan- terparty agree on the terms applicable to the
cial condition, or investment objectives, or on transaction. In addition, documentation satisfies
the grounds that the risks of the transaction were other legal requirements, such as the ‘‘statutes of
not accurately and completely disclosed to the frauds’’ that may apply in many jurisdictions.
investor. Statutes of frauds generally require signed, writ-
As part of sound risk management, institu- ten agreements for certain classes of contracts,
tions should take steps to guard themselves such as agreements with a duration of more than
against legal risk. Active involvement of the one year (including both longer-term transac-
institution’s legal counsel is an important ele- tions such as swaps and master or netting
ment in ensuring that the institution has ade- agreements for transactions of any duration).
quately considered and addressed legal risk. An Some states, such as New York, have provided
institution’s policies and procedures should limited exceptions from their statutes of frauds
include appropriate review by in-house or out- for certain financial contracts when other sup-
side counsel as an integral part of the institu- porting evidence, such as confirmations or tape
tion’s trading and capital-markets activities, recordings, is available.
including new-product development, credit
In the over-the-counter (OTC) derivatives
approval, and documentation of transactions.
markets, the prevailing practice has been for
While some issues, such as the legality of a type
institutions to enter into master agreements with
of transaction, may be addressed on a jurisdiction-
each counterparty. Master agreements are also
wide basis, other issues, such as the enforceabil-
becoming common for other types of transac-
ity of multibranch netting agreements covering
tions, such as repurchase agreements. Each mas-
several jurisdictions, may require review of
ter agreement identifies the type of products and
individual contracts.
specific legal entities or branches of the institu-
An institution should have established proce-
tion and counterparty that it will cover. Entering
dures to ensure adequate legal review. For
into a master agreement may help to clarify that
example, review by legal counsel may be
each subsequent transaction with the counter-
required as part of the product-development or
party will be made subject to uniform terms and
credit-approval process. Legal review is also
conditions. In addition, a master agreement that
necessary for an institution to establish the types
includes netting provisions may reduce the
of agreements to be used in documenting trans-
institution’s overall credit exposure to the
actions, including any modifications to standard-
counterparty.
ized agreements that the institution considers
appropriate. The institution should also ensure An institution should specify its documenta-
that prior legal opinions are reviewed periodi- tion requirements for transactions and its proce-
cally to determine if they are still valid. dures for ensuring that documentation is consis-
tent with orally agreed-on terms. Transactions
entered into orally, with documents to follow,
DOCUMENTATION should be confirmed as soon as possible. Docu-
mentation policies should address the terms that
If the terms of a transaction are not adequately will be covered by confirmations for specific
documented, there is a risk that the transaction types of transactions and what transactions are
Trading and Capital-Markets Activities Manual September 2002
Page 1
2070.1 Legal Risk
covered by a master agreement; policies should available or may be artificially maintained at
specify when additional documentation beyond nonmarket rates by a government seeking to
the confirmation is necessary. When master preserve its currency.
agreements are used, policies should cover the Contracts also should be clear as to whether
permissible types of master agreements. Appro- cross-default provisions allow or require the
priate controls should be in place to ensure that close-out of other contracts between the parties.
the confirmations and agreements used satisfy Finally, close-out provisions should be reviewed
the institution’s policies. Additional issues re- to determine what conditions need to be met
lated to the enforceability of the netting provi- before the contract can be finally closed out.
sions of master agreements are discussed below Formalities in some contracts may delay the
in ‘‘Enforceability Issues.’’ close-out period significantly, further injuring a
nondefaulting counterparty.
Trigger Events
Netting
Special attention should be given to the defini-
tion of ‘‘trigger events,’’ which provide for To reduce settlement, credit, and liquidity risks,
payment from one counterparty to another or institutions increasingly use netting agreements
permit a counterparty to close out a transaction or master agreements that include netting pro-
or series of transactions. In the ordinary course visions. ‘‘Netting’’ is the process of combining
of events, contractual disputes can be resolved the payment or contractual obligations of two or
by parties who wish to continue to enter into more parties into a single net payment or obli-
transactions with one another, but these disputes gation. Institutions may have bilateral netting
can become intractable if serious market disrup- agreements covering the daily settlement of
tions occur. Indeed, the 1998 Russian market payments such as those related to check-clearing
crisis raised calls for the establishment of an or foreign-exchange transactions. Bilateral mas-
international dispute-resolution tribunal to handle ter agreements with netting provisions may
the large volume of disputed transactions when cover OTC derivatives or other types of trans-
the Russian government announced its debt actions, such as repurchase agreements.
moratorium and restructuring. The Commodity Futures Trading Commis-
sion (CFTC) has exempted a broad range of
Trigger events need to be clearly and pre-
OTC derivatives from the Commodity Exchange
cisely defined. In the Russian crisis, the trigger
Act, eliminating the risk that instruments meet-
events in some master agreements did not include
ing certain conditions would be found to be
a rescheduling of or moratorium on the payment
illegal off-exchange futures under U.S. law. The
of sovereign debt. Even when sovereign debt is
exemption nevertheless limits the use of multi-
covered by the master agreement, it may be
lateral netting and similar arrangements for
appropriate to specify that not only debt directly
reducing credit and settlement risk, and reserves
issued by the sovereign, but also debt issued
the CFTC’s enforcement authority with respect
through governmental departments and agencies
to fraud and market manipulation.1
or through other capital-raising vehicles, falls
The CFTC’s exemption provides significant
within the scope of the trigger event. Moreover,
comfort with respect to the legality of most OTC
when a trigger event has occurred, but the
derivative instruments within the United States.
contract expires before the expiration of a cure
The risk that a transaction will be unenforceable
period or before the completion of a debt
because it is illegal may be higher in other
restructuring, the nondefaulting party can lose
jurisdictions, however. Jurisdictions outside the
the protection of the contract absent clear pro-
United States also may have licensing or other
visions to the contrary.
requirements that must be met before certain
The occurrence of trigger events also may OTC derivatives or other trading activities can
give rise to disputes regarding the appropriate be legally conducted.
settlement rate at which to close out contracts. It
may be difficult to argue in favor of substitute
settlement rates that were not referenced as a 1. See 17 CFR 35. Instruments covered by the CFTC’s
pricing source in the original documentation. exemption are also excluded from the coverage of state
However, original pricing sources may not be bucket-shop and gambling laws.
September 2002 Trading and Capital-Markets Activities Manual
Page 2
Legal Risk 2070.1
Master Agreements ments covering multiple derivative transactions.
When a bank has undertaken a number of
Master agreements generally provide for routine contracts with a particular counterparty that are
transaction and payment netting and for close- subject to a master agreement, the bank runs the
out netting in the event of a default. Under the risk that, in the event of the counterparty’s
transaction- and payment-netting provisions of failure, the receiver for the counterparty will
such an agreement, all payments for the same refuse to recognize the validity of the netting
date in the same currency for all covered trans- provisions. In such an event, the receiver could
actions are netted, resulting in one payment in ‘‘cherry pick,’’ that is, repudiate individual con-
each currency for any date on which payments tracts under which the counterparty was obli-
are made under the agreement. Close-out netting gated to pay the bank while demanding payment
provisions, on the other hand, generally are on those contracts on which the bank was
triggered by certain default events, such as a obligated to pay the counterparty. The Financial
failure to make payments or insolvency. Such Institutions Reform, Recovery, and Enforcement
events may give the nondefaulting party the Act of 1990 (FIRREA) and amendments to the
right to require early termination and close-out Bankruptcy Code, as well as the payment sys-
of the agreement. Under close-out netting, the tem risk-reduction provisions of the Federal
positive and negative current replacement val- Deposit Insurance Corporation Improvement Act
ues for each transaction under the agreement are (FDICIA), have significantly reduced this risk
netted for the nondefaulting counterparty to for financial institutions in the United States.2
obtain a single sum, either positive or negative. The enforceability of close-out netting remains a
If the sum of the netting is positive (that is, the significant risk in dealing with non-U.S. coun-
transactions under the agreement, taken as a terparties that are chartered or located in juris-
whole, have a positive value to the nondefault- dictions where the legal status of netting agree-
ing counterparty), then the defaulting counter- ments may be less well settled. Significant
party owes that sum to the nondefaulting issues concerning enforcement and collection
counterparty. under netting agreements also arise when the
The results may differ if the net is negative, counterparty is an uninsured branch of a foreign
that is, the contracts have a positive value to the bank chartered in a state, such as New York, that
defaulting counterparty. Some master agree- has adopted a ‘‘ring-fencing’’ statute providing
ments include so-called walk-away clauses, for the separate liquidation of such branches.
under which a nondefaulting counterparty is not In evaluating the enforceability of a netting
required to pay the defaulting counterparty for contract, an institution needs to consider a
the positive value of the netting to the defaulting number of factors. First, the institution needs to
counterparty. The current trend, however, has determine the legal entity that is its counter-
been to require payments of any positive net party. For example, if the bank is engaging in
value to either party, regardless of whether the transactions with a U.S. branch of a foreign
party defaulted. Revisions to the Basel Capital bank, the relevant legal entity generally would
Accord have reinforced this trend by not recog- be the foreign bank itself. Some master agree-
nizing netting agreements that include a walk- ments, however, are designed to permit netting
away clause, as discussed more fully below. of transactions with multiple legal entities. A
further consideration is the geographic coverage
of the agreement. In some instances, bank coun-
Enforceability Issues terparties have structured their netting agree-
ments to cover transactions entered into between
The effectiveness of netting in reducing risk multiple branches of the counterparties in a
depends on both the adequacy and enforceabil- variety of countries, thereby potentially subject-
ity of the legal arrangements in place. The ing the agreements to a variety of legal regimes.
unenforceability of a netting agreement may Finally, the range of transactions to be covered
expose an institution to significant losses if it in a single agreement is an important consider-
relies on the netting agreement to manage its
credit risk or for capital purposes.
2. Risks related to netting enforceability have not been
A major concern for market participants has completely eliminated in the United States. Validation of
been the enforceability in bankruptcy of the netting under FDICIA is limited to netting among entities that
close-out netting provisions of master agree- may be considered to be ‘‘financial institutions.’’
Trading and Capital-Markets Activities Manual September 2002
Page 3
2070.1 Legal Risk
ation. While there is an incentive to cover a • the law of the jurisdiction in which the coun-
broad range of contracts to achieve a greater terparty is chartered and, if a foreign branch of
reduction of credit risk, overinclusion may be a counterparty is involved, then also under the
counterproductive if contracts that could jeop- law of the jurisdiction in which the branch is
ardize the enforceability of the entire agreement located;
are included. Some institutions deal with this • the law that governs the individual transac-
risk by having separate agreements for particu- tions; and
lar products, such as currency contracts, or • the law that governs any contract or agree-
separate master agreements covered by an over- ment necessary to effect the netting.4
all ‘‘master master agreement.’’
Regardless of the scope of a master agree- Under the accord, the bank also must have
ment, clarity is an important factor in ensuring procedures in place to ensure that the legal
the enforceability of netting provisions. The characteristics of netting arrangements are regu-
agreement should clearly specify the types of larly reviewed in light of possible changes in
deals to be netted, mechanisms for valuation and relevant law. To help determine whether to rely
netting, locations covered, and the office through on a netting arrangement, many institutions
which netting will be done. have procedures for internally assessing or ‘‘scor-
ing’’ legal opinions from relevant jurisdictions.
These legal opinions may be prepared by out-
Reliance on Netting Agreements side or in-house counsel. A generic industry or
standardized legal opinion may be used to sup-
While netting agreements have the potential to port reliance on a netting agreement for a
substantially reduce credit risk to a counterparty, particular jurisdiction. The institution should
an institution should not rely on a netting have procedures for review of the terms of
agreement for credit-risk-management purposes individual netting agreements, however, to
unless it has adequate assurances that the agree- ensure that the agreement does not raise issues,
ment would be legally enforceable in the event such as enforceability of the underlying trans-
of a legal challenge. Further, netting will be actions, choice of law, and severability, that are
recognized for capital purposes only if the bank not covered by the general opinion.
has satisfied the requirements set forth in the Institutions also rely on netting arrangements
Basel Capital Accord (the accord). To meet in managing credit risk to counterparties. Insti-
these requirements, the netting contract or agree- tutions may rely on a netting agreement for
ment with a counterparty must create a single internal risk-management purposes only if they
legal obligation, covering all transactions to be have obtained adequate assurances on the legal
netted, such that the bank would have either a enforceability of the agreement in the event of a
claim to receive or an obligation to pay only the legal challenge. Such assurances generally would
net amount of the individual transactions if a be obtained by acquiring legal opinions that
counterparty fails to perform because of default, meet the requirements of the accord.
bankruptcy, liquidation, or other similar circum-
stances.3 Netting contracts that include a walk-
away clause are not recognized for capital pur- Multibranch Agreements
poses under the accord.
To demonstrate that a netting contract meets A multibranch master netting agreement covers
the requirements of the accord, the bank must transactions entered into between multiple
obtain written and reasoned legal opinions that, branches of an institution or its counterparty that
in the event of a legal challenge, the relevant are located in a variety of countries. These
courts and administrative authorities would find agreements may cover branches of the institu-
the bank’s exposure to be the net amount under—
4. A netting contract generally must be found to be
3. The agreement may cover transactions excluded from enforceable in all of the relevant jurisdictions in order for an
the risk-based capital calculations, such as exchange-rate institution to rely on netting under the contract for capital
contracts with an original maturity of 14 calendar days or less purposes. For those jurisdictions in which the enforceability of
or instruments traded on exchanges requiring daily margin. netting may be in doubt, however, an institution may be able,
The institution may consistently choose either to include or in appropriate circumstances, to rely on opinions that the
exclude the mark-to-market values of such transactions when choice of governing law made by the counterparties to the
determining net exposure. agreement will be respected.
September 2002 Trading and Capital-Markets Activities Manual
Page 4
Legal Risk 2070.1
tion or counterparty located in jurisdictions lateral is not required until the level of exposure
where multibranch netting is not enforceable, has reached a certain threshold.
creating the risk that including these branches While collateral may be a useful tool for
may render the entire netting agreement unen- reducing credit exposure, a financial institution
forceable for all transactions. To rely on a should not rely on collateral to manage its credit
netting agreement for transactions in any juris- risk to a counterparty and for risk-based capital
diction, an institution must obtain legal opinions purposes, unless it has adequate assurances that
that conclude (1) that transactions with branches its claim on the collateral will be legally enforce-
in user-unfriendly jurisdictions are severable able in the event the counterparty defaults,
and (2) that the multibranch master agreement particularly for collateral provided by a foreign
would be enforceable, despite the inclusion of counterparty or held by an intermediary outside
these branches. of the United States. To rely on collateral
Currently, the risk-based capital rules do not arrangements where such cross-border issues
specify how the net exposure should be calcu- arise, a financial institution generally should
lated when a branch in a netting-unfriendly obtain written and reasoned legal opinions that
jurisdiction is included in a multibranch master (1) the collateral arrangement is enforceable in
netting agreement. In the meantime, institutions all relevant jurisdictions, including the jurisdic-
are using different practices, which are under tion in which the collateral is located, and (2) the
review with the goal of providing additional collateral will be available to cover all transac-
guidance. Some institutions include the amount tions covered by the netting agreement in the
owed by branches of the counterparty in netting- event of the counterparty’s default.
unfriendly jurisdictions when calculating the
global net exposure. Others completely sever
these amounts from calculations, as if transac- Operational Issues
tions with these branches were not subject to the
netting agreement. With respect to transaction The effectiveness of netting in reducing risks
with branches in netting-unfriendly jurisdic- also depends on how the arrangements are
tions, some institutions add on the amounts they implemented. The institution should have pro-
owe in such jurisdictions (which are liabilities) cedures to ensure that the operational implemen-
to account for the risk of double payment,5 tation of a netting agreement is consistent with
while other institutions add on the amounts its provisions.
owed to them in such jurisdictions (which are Netting agreements also may require that
assets). The approach an institution uses should some of a financial institution’s systems be
reflect the specifics of the legal opinions it adapted. For example, the interface between the
receives concerning the severability of transac- front-office systems and back-office payment
tions in netting-unfriendly jurisdictions. and receipt functions needs to be coordinated to
allow trading activity to take place on a gross
basis while the ultimate processing of payments
Collateral Agreements and receipts by the back-office is on a net basis.
In particular, an internal netting facility needs
Financial institutions are increasingly using col- to—
lateral agreements in connection with OTC
derivatives transactions to limit their exposure • segregate deals to be netted,
to the credit risk of a counterparty. Depending • compute the net amounts due to each party,
on the counterparties’ relative credit strength,
• generate trade confirmations on the trade date
requirements for posting collateral may be
for each trade,
mutual or imposed on only one of the counter-
parties. Under most agreements, posting of col- • generate netted confirmations shortly after the
agreed-on netting cut-off time,
• generate net payment and receipt messages,
5. The risk of double payment is the risk that the institution • generate appropriate nostro and accounting
must make one payment to a counterparty’s main receiver entries, and
under a multibranch master agreement and a second payment
to the receiver of the counterparty’s branch in the netting-
• provide for the cancellation of any gross
unfriendly jurisdiction for transactions entered into in that payment or receipt messages in connection
jurisdiction. with the netted trades.
Trading and Capital-Markets Activities Manual September 2002
Page 5
2070.1 Legal Risk
Nondeliverable Forwards the risk that a legal challenge could result in a
court finding that the contract is ultra vires and
An area of growing concern for legal practitio- therefore unenforceable. Significant losses in
ners has been the documentation of nondeliver- OTC derivatives markets resulted from a finding
able forward (NDF) foreign-exchange transac- that swap agreements with municipal authorities
tions. The NDF market is a small portion of the in the United Kingdom were ultra vires. Issues
foreign-exchange market, but is a large part of concerning the authority of municipal and other
the market for emerging-country currencies. An government units to enter into derivatives con-
NDF contract uses an indexed value to represent tracts have been raised in some U.S. jurisdic-
the value of a currency that cannot be delivered tions, as well. Other types of entities, such as
due to exchange restrictions or the lack of pension plans and insurance companies, may
systems to properly account for the receipt of need specific regulatory approval to engage in
the currency. NDF contracts are settled net in the derivatives transactions.
settlement currency, which is a hard currency A contract may be unenforceable in some
such as U.S. dollars or British pounds sterling. circumstances if the person entering into the
An NDF contract must be explicitly identified contract on behalf of the counterparty is not
as such—foreign-exchange contracts are pre- authorized to do so. Many entities, including
sumed to be deliverable. The index should be corporations, have placed more extensive restric-
clearly defined, especially for countries in which tions on the authority of the corporation or its
dual exchange rates exist, that is, the official employees to enter into certain types of deriva-
government rate versus the unofficial ‘‘street’’ tives and securities transactions.
rate. To address issues related to counterparty
NDF contracts often provide for cancellation authority, an institution’s procedures should pro-
if certain disruption events specified in the vide for an analysis, under the law of the
master agreement occur. Disruption events can counterparty’s jurisdiction, of the counterparty’s
include sovereign events (the nationalization of power to enter into and the authority of a trading
key industries or defaults on government obli- representative of the counterparty to bind the
gations), new exchange controls, the inability to counterparty to particular transactions. It also is
obtain valid price quotes with which to deter- common to look at whether boards of directors
mine the indexed value of the contract, or or trustees are authorized to enter into specific
a benchmark-obligation default. Under a types of transactions. Depending on the proce-
benchmark-obligation default, a particular issue dures of the particular institution, issues relating
is selected and, if that issue defaults during the to counterparty capacity may be addressed in the
term of the contract, the contract is cancelled. context of the initial credit-approval process or
Cancellation events should be specifically through a more general review of classes of
described in order to minimize disputes about counterparties.
whether an event has occurred. In addition,
overly broad disruption events could cause the
cancellation of a contract that both counterpar- Suitability
ties wish to execute.
The International Swaps and Derivatives A counterparty on the losing end of a derivatives
Association (ISDA) has established an NDF transaction may claim that a banking organiza-
project to develop standard documentation for tion recommended or structured an unsuitable
these transactions. The ISDA documentation transaction, given the counterparty’s level of
establishes definitions that are unique to NDF financial sophistication, financial condition, or
transactions and provides sample confirmations investment objectives, or it may claim that the
that can be adapted to reflect disruption events. transaction and its risks were inaccurately or
incompletely disclosed. Banking organizations
that recommend or structure derivatives transac-
LEGAL ISSUES tions for clients, especially transactions contain-
ing nonstandard terms, should make reasonable
Capacity efforts to know their counterparties in order to
avoid such claims. Moreover, banking organiza-
If a counterparty does not have the legal author- tions should fully explain to counterparty per-
ity to enter into a transaction, the institution runs sonnel with the requisite knowledge and expe-
September 2002 Trading and Capital-Markets Activities Manual
Page 6
Legal Risk 2070.1
rience to evaluate a transaction what the structure keted to institutional customers being made
and risks of any derivatives transaction are. available to retail customers) and existing prod-
Banking organizations should also understand ucts that have been significantly modified. The
their counterparties’ business purpose for enter- definition of a new product should be consistent
ing into derivatives transactions with the insti- with the size, complexity, and sophistication of
tution. Understanding the underlying business the institution. Small changes in the payment
rationale for the transaction allows the institu- formulas or other terms of products can greatly
tion to evaluate the credit, legal, and reputa- alter their risk profiles and justify designation as
tional risks that may arise if the counterparty has a new product.
entered into the transaction to evade taxes, hide The authority of the bank to enter into the
losses, or circumvent legal or regulatory new or modified transaction or market the new
restrictions. product in all relevant jurisdictions should be
established, and any limitations on that authority
fully reviewed. Legal review is also necessary
New-Product Approval for an institution to establish the types of agree-
ments to be used in documenting the transac-
Legal counsel, either in-house or outside, should tion, including any modifications to standard-
be involved in the new-product approval pro- ized documentation. The institution should
cess. New-product reviews should include prod- ensure that prior legal opinions and standard
ucts being offered for the first time in a new agreements are reviewed periodically and that
jurisdiction or to a new category of counterpar- they reflect changes in law or the manner in
ties (for example, a product traditionally mar- which transactions are structured.
Trading and Capital-Markets Activities Manual September 2002
Page 7
Legal Risk
Examination Objectives Section 2070.2
1. To determine if the institution’s internal poli- of the bank are effectively implementing the
cies and procedures adequately identify provisions of netting agreements.
potential legal risks and ensure appropriate 5. To determine whether the unique risks of
legal review of documentation, counterpar- nondeliverable forward (NDF) contracts have
ties, and products. been considered and reflected in the institu-
2. To determine whether appropriate documen- tion’s policies and procedures, if appropriate.
tation requirements have been established 6. To determine whether the institution’s inter-
and that procedures are in place to ensure that nal policies and procedures adequately address
transactions are documented promptly. the need to review the suitability of transac-
3. To determine whether adequate assurances tions for a counterparty.
of legal enforceability have been obtained 7. To determine whether the institution’s inter-
for netting agreements or collateral arrange- nal policies and procedures adequately address
ments relied on for risk-based capital pur- the approval of new products, including a
poses or credit-risk management. requirement for appropriate reviews by legal
4. To determine whether the operational areas counsel.
Trading and Capital-Markets Activities Manual September 2002
Page 1
Legal Risk
Examination Procedures Section 2070.3
Examiners should use the following guidelines completed and pending documentation?
to assist in their review of the institution’s How does the institution follow up on
trading activities with respect to legal risk. This outstanding documentation?
should not be considered to be a complete g. What controls does the institution have in
checklist of subjects to be examined. place pending execution of required docu-
mentation, for example, legal-approval
1. Obtain copies of policies and procedures that requirements? (Documentation has not
outline appropriate legal review for new been executed until it has been signed by
products. appropriate personnel of both parties to
a. Does the institution require legal review the transaction.)
of new products, including significant h. In practice, is required documentation
revisions or modifications to existing executed in a timely manner?
products, as part of the product-review i. Who has the authority to approve excep-
process? tions to existing documentation
b. Do the procedures provide for review requirements?
of existing products offered in new juris- j. Do the procedures ensure that documen-
dictions or to new classes of counterparties? tation is reviewed for consistency with the
2. Obtain copies of policies and procedures institution’s policies?
that outline review requirements for new k. Who reviews documentation?
counterparties. l. Does the institution specify the terms to
a. Does the institution require review of new be covered by confirmations for differ-
counterparties to ensure that the counter- ent types of transactions, including
party has adequate authority to enter into transactions that are subject to master
proposed transactions? agreements?
b. Do the institution’s procedures include an m. If the institution engages in nondeliver-
assessment of the suitability of any trans- able forward (NDF) transactions, does the
actions recommended to or structured by documentation address the index to be
the institution for the counterparty? used and clearly specify that the contract
c. Do the institution’s procedures ensure fur- is for a nondeliverable currency? Are
ther review of counterparty authority if disruption events, if any, specifically
new types of transactions are entered into? described?
3. Obtain copies of policies and procedures that 4. Obtain copies of policies and procedures
establish documentation requirements. concerning the review of the enforceability
of netting agreements and master agreements
a. Has the institution established documen-
with netting provisions.
tation requirements for all types of trans-
actions in the trading area? a. Does the institution have procedures to
ensure that legal opinions have been
b. When are master agreements required for
obtained addressing the enforceability of a
over-the-counter (OTC) derivative or other
netting agreement under the laws of all
transactions with a counterparty?
relevant jurisdictions before relying on
c. Does the institution require legal review the netting agreement for capital purposes
for new agreement forms, including net- or in managing credit exposure to the
ting agreements and master agreements counterparty?
with netting provisions? b. Do the procedures include guidelines for
d. Who has authority to approve the use of determining the relevant jurisdictions for
new agreement forms, including new mas- which opinions should be obtained? Opin-
ter agreement forms or agreement terms? ions should cover the enforceability of
e. How does the institution ensure that docu- netting under (1) the law of the jurisdic-
ments are executed in a timely manner for tion in which the counterparty is char-
new counterparties and new products? tered, (2) the law of any jurisdiction in
f. Does the institution have an adequate which a branch of the counterparty that is
document-management system to track a party to the agreement is located, (3) the
Trading and Capital-Markets Activities Manual September 2002
Page 1
2070.3 Legal Risk: Examination Procedures
law that governs any individual trans- enforceability of collateral arrangements
action under the netting agreement, and must be obtained before the institution
(4) the law that governs the netting relies on such arrangements for risk-
agreement itself. based capital or credit-risk-management
c. When generic or industry opinions are purposes?
relied on, do the procedures of the insti- b. Who reviews the above opinions?
tution ensure that individual agreements c. Who determines when a collateral arrange-
are reviewed for additional issues that ment may be relied on by the institution
might be raised? for credit-risk-management or risk-based
d. Does the institution have procedures for capital purposes?
evaluating or ‘‘scoring’’ the legal opinions d. Do the procedures ensure that legal opin-
it receives concerning the enforceability ions relied on by the institution are
of netting agreements? reviewed periodically?
e. Who reviews the above opinions? How 6. Obtain samples of master agreements, con-
do they communicate their views on firmations for transactions under such agree-
the enforceability of netting under an ments, and related legal opinions.
agreement? a. Does the institution maintain in its files
f. Who determines when master netting the master agreements, legal opinions, and
agreements will be relied on for risk- related documentation and translations
based capital and credit-risk-management relied on for netting purposes?
purposes? b. Have the master agreements and confir-
g. Who determines whether certain transac- mations been executed by authorized
tions should be excluded from the net- personnel?
ting, such as transactions in connection c. Have master agreements been executed by
with a branch in a netting-unfriendly counterparty personnel that the institution
jurisdiction? has determined are authorized to execute
h. When the institution nets transactions for such agreements?
capital purposes, are any transactions that d. Does the institution maintain records evi-
are not directly covered by a close-out dencing that master agreements and
netting provision of a master agreement related legal opinions have been reviewed
included? If so, does the institution obtain in accordance with the institution’s poli-
legal opinions supporting the inclusion of cies and procedures?
such transactions? For example, if the 7. Obtain copies of the institution’s policies and
institution includes in netting calculations procedures concerning the implementation of
foreign-exchange transactions between netting agreements.
branches of the institution or counterparty a. Do the procedures ensure that the terms of
not covered by a master agreement, ask netting agreements are accurately and
counsel if the institution has an agree- effectively acted on by the trading, credit,
ment and legal opinion that support this and operations or payments-processing
practice. areas of the institution?
i. Does the institution have procedures to b. Does the institution have adequate con-
ensure that the legal opinions on which it trols over the operational implementation
relies are periodically reviewed? of its master netting agreements?
j. Does the institution have procedures in c. Who determines whether specific transac-
place to ensure that existing master agree- tions are to be netted for risk-based capital
ments are regularly monitored to deter- and credit-risk-management purposes?
mine whether they meet the requirements d. When is legal approval for the netting
for recognition under the institution’s net- of particular transactions under a netting
ting policies? agreement required?
5. Obtain copies of policies and procedures e. How are the relevant details of netting
concerning the review of the enforceability agreements communicated to the trading,
of collateral arrangements. credit, and payments areas?
a. Does the institution have guidelines that f. How does each area incorporate relevant
establish when and from what jurisdic- netting information into its systems?
tions legal opinions concerning the g. What mechanism does the institution have
September 2002 Trading and Capital-Markets Activities Manual
Page 2
Legal Risk: Examination Procedures 2070.3
to link netting information with credit- calculations, what method does the insti-
exposure information and to monitor tution use to calculate net exposure under
netting information in relation to credit- the agreement for capital purposes, and is
exposure information? that method used consistently?
h. Do periodic settlement amounts reflect k. If a master agreement includes transac-
payments or deliveries netted in accor- tions that do not qualify for netting, such
dance with details of netting agreements? as transactions in a netting-unfriendly
i. How does the institution calculate its credit jurisdiction, how does the institution deter-
exposure to each counterparty under the mine what method to use to calculate net
relevant master netting agreements? exposure under the agreement for capital
j. If the master agreement includes transac- purposes?
tions excluded from risk-based capital
Trading and Capital-Markets Activities Manual September 2002
Page 3
Financial Performance
Section 2100.1
The evaluation of financial performance, or time decay, or other appropriate factors. Similar
profitability analysis, is a powerful and neces- methodologies for allocating reserves should
sary tool for managing a financial institution and also be established where appropriate.
is particularly important in the control and Proper segregation of duties and clear report-
operation of trading activities. Profitability analy- ing lines help ensure the integrity of profitability
sis identifies the amount and variability of earn- and performance reports. Accordingly, the mea-
ings, evaluates earnings in relation to the nature surement and analysis of financial performance
and size of risks taken, and enables senior and the preparation of management reports are
management to judge whether the financial per- usually the responsibility of a financial-control
formance of business units justifies the risks or other nontrading function. This responsibility
taken. Moreover, profitability analysis is often includes revaluing or marking to market the
used to determine individual or team compen- trading portfolio and identifying the various
sation for marketing, trading, and other business- sources of revenue. Some banks have begun to
line staff engaged in trading activities. The place operations and some other control staff in
following four elements are necessary to effec- the business line, with separate reporting to the
tively assess and manage the financial perfor- business head. Examiners should satisfy them-
mance of trading operations: selves that duties are adequately segregated and
that the operations staff is sufficiently indepen-
• valuing or marking positions to market prices dent from trading and risk-taking functions.
• assigning appropriate reserves for activities
and risks
• reporting results through appropriate chains of
command VALUATION
• attributing income to various sources and
products The valuation process involves the initial and
ongoing pricing or ‘‘marking to market’’ of
Valuation of the trading portfolio is critical to positions using either observable market prices
effective performance measurement since the or, for less liquid instruments, fair-value pricing
accuracy and integrity of performance reports conventions and models. An institution’s writ-
are based primarily on the market price or fair ten policies and procedures should detail the
value of an institution’s holdings and the pro- range of acceptable practices for the initial
cess used to determine those prices. The valua- pricing, daily mark-to-market, and periodic
tion process is often complex, as the pricing of independent revaluation of trading positions. At
certain financial instruments can require the use a minimum, the bank’s policies should specifi-
of highly sophisticated pricing models and other cally define the responsibilities of the partici-
estimators of fair value. The chief financial pants involved in the trading function (for exam-
officer (CFO) and other senior officers of the ple, trading operations, financial-control, and
bank must receive comprehensive and accurate risk-management staff) to ensure reliable and
information on capital-markets and trading consistent financial reporting. Pricing method-
activities to accurately measure financial perfor- ologies should be clearly defined and docu-
mance, assess risks, and make informed busi- mented to ensure that they are consistently
ness decisions. Internal profitability reports applied across financial products and business
should indicate to the CFO and other senior lines. Proper controls should be in place to
management the sources of capital-markets and ensure that pricing feeds are accurate, timely,
trading income, and assign profits and losses to and not subject to unauthorized revisions.
the appropriate business units or products (for Additionally, the firm should have comprehen-
example, foreign exchange, corporate bond trad- sive policies and procedures specifically for
ing or interest-rate swaps). To prepare these creating, validating, revising, and reviewing the
reports, an institution should specify its meth- pricing models used in the valuation process.
odologies for attributing both earnings and risks Inadequate policies and procedures raise doubts
to their appropriate sources such as interest about the institution’s trading profits and its
income, bid/offer spreads, customer mark-up, ability to manage the risks of its trading activities.
Trading and Capital-Markets Activities Manual February 1998
Page 1
2100.1 Financial Performance
Initial Pricing monthly. In these cases, written policies should
specify which types of transactions, if any, are
The initial pricing of positions or transactions is exempt from daily revaluation and how often
generally the responsibility of the trader who these transactions must be marked to market.
originates the deal, although a marketer will
often be involved in the process. For those
instruments that trade in fairly liquid markets,
the price is usually based on the quoted bid/offer Independent Price Testing and
price plus an origination ‘‘value-added’’ spread Revaluation
that may include, for example, a credit premium
or estimated hedge cost, depending on the char- In addition to the mark-to-market process per-
acteristics of the product. The prices of less formed daily, banks should perform an indepen-
liquid instruments are generally priced at theo- dent review and revaluation of the trading port-
retical market prices, usually determined by folio periodically to verify that trading positions
pricing models. Regardless of the type of trans- reflect fair value, check the reasonableness of
action, an independent control function should pricing inputs, and assess profitability. The
review all new-deal pricing for reasonableness review must be performed by a control function
and ensure that pricing mechanics are consistent that is independent from the trading func-
with those of existing transactions and approved tion. Usually this independent revaluation pro-
methodologies. Significant differences, as defined cess is performed monthly; however, it may be
in written policies, should be investigated by the prudent to independently revalue certain illiquid
control function. and harder-to-price transactions, and transac-
tions that are not marked to market daily, more
frequently.
The scope of the testing process will differ
Daily Mark-to-Market Process across institutions depending on the size and
sophistication of the trading activities con-
Trading accounts should be revalued, or ‘‘marked ducted. In many institutions, revaluation of an
to market,’’ at least daily to reflect fair value and entire portfolio of relatively simple, generic
determine the profit or loss on the portfolio for instruments may be too time consuming to be
financial-reporting and risk-management pur- efficient, and price validation may be conducted
poses. Trading positions are usually marked to on a sampling basis. In contrast, more complex
market as of the close of business using inde- transactions may be revalued in their entirety.
pendent market quotes. Most institutions are Alternatively, an institution may choose to
able to determine independent market prices revalue holdings based on materiality (for exam-
daily for most positions, including many exotic ple, all transactions over a dollar threshold). An
and illiquid products. Many complex instru- institution’s policies should clearly define the
ments can be valued using the independent scope of its periodic valuation-testing process,
market prices of various elementary components and reasonable justification should be provided
or risk factors. Automatic pricing feeds should for excluding certain transactions from the test-
be used to update positions whenever feasible. ing process.
When automatic pricing feeds are not feasible, a If the value of the portfolios as determined by
separate control function (for example, the the periodic (for example, monthly) independent
middle- or back-office function) should be re- revaluation is significantly different from the
sponsible for inputting appropriate pricing data book value of these portfolios, further investi-
or parameters into the appropriate accounting gation is warranted. The materiality threshold
and measurement systems, even though traders for investigation should be specifically defined
may have some responsibility for determining in written policies (such as ‘‘all discrepancies
those prices and parameters. above $x thousand must be investigated to
Daily revaluation may not be feasible for determine the source of the difference’’). When
some illiquid instruments, particularly those that the reason for the discrepancy is discovered, the
are extremely difficult to model or not widely institution should determine whether the finan-
traded. Institutions may revalue these types of cial reports need to be adjusted. Based on the
transactions less often, possibly weekly or magnitude and pattern of the pricing inconsis-
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Financial Performance 2100.1
tencies, changes to the pricing process or pricing Also, some organizations may value positions
models may be required. on the conservative side of midmarket by taking
Results of the month-end valuation process a discount or adding a premium to the midmar-
should be formally documented in sufficient ket price to act as a ‘‘holdback reserve.’’ Firms
detail to provide a complete audit trail. In that use a conservative midmarket valuation
addition, a summary of the results of the inde- system may mark all positions in this manner or
pendent revaluation should be communicated to may only value some less liquid positions this
appropriate management and control functions. way. Bank policies should clearly specify which
Reports should be generated to inform manage- valuation methodologies are appropriate for dif-
ment of the results of the periodic price-testing ferent types of transactions.
process and include, at a minimum, the scope of The bid/offer price should be considered a
the testing process, any material discrepancies limit on instrument values, net of any reserves.
between the independent valuations and the Net instrument values recorded on the books at
reported valuations, and any actions taken in market value should not be below or above the
response to them. market’s bid/offer price, as these are the values
at which a position can be closed. Some insti-
tutions have automated programs that use prices
obtained from traders to check whether the fair
Liquid Instruments and Transactions values recorded on the firm’s financial state-
ments fall within the bid/offer price. While these
For transactions that trade on organized programs can help ensure appropriate pricing
exchanges or in liquid over-the-counter (OTC) regardless of the specific method used, a firm
markets, market prices are relatively easy to should still have a sound, independent daily
determine. Trading positions are simply updated revaluation that does not rely solely on traders
to reflect observable market prices obtained marking their positions to market.
from either the exchange on which the instru-
ment is listed or, in the case of OTC transac- Whether bid/offer or midmarket pricing is
tions, from automated pricing services or as used, it is important that banks use consistent
quotes from brokers or dealers that trade the time-of-day cut-offs when valuing transactions.
product. When observable market prices are For example, instruments and their related
available for a transaction, two pricing method- hedges should be priced as of the same time
ologies are primarily used—bid/offer or midmar- even if the hedging item trades on an exchange
ket. Bid/offer pricing involves assigning the with a different closing time than the exchange
lower of bid or offer prices to a long position on which the hedged item trades. Also, all
and the higher of bid or offer prices to short instruments in the same trading portfolio should
positions. Midmarket pricing involves assigning be valued at the same time even if they are
the price that is midway between bid and offer traded at different locations. Price quotes should
prices. Most institutions use midmarket pricing be current as of the time of pricing and should
schemes, although some firms may still use be consistent with other trades that were trans-
bid/offer pricing for some products or types of acted close to the same time.
trading. Midmarket pricing is the method rec- For liquid exchange-traded or OTC products,
ommended by the accounting and reporting the monthly revaluation process may simply
subcommittee of the Group of Thirty’s Global entail a comparison of book values with
Derivatives Study Group, and is the method exchange or broker-dealer quotations. In these
market practitioners currently consider the most cases, it should be known whether the party
sound. providing the valuation is a counterparty to the
Some institutions may use bid/offer pricing transaction that generated the holding or is being
for some transactions and midmarket pricing for paid for providing the valuation as an indepen-
others. For example, bid/offer pricing may be dent pricing service. Firms should be aware that
used for proprietary and arbitrage transactions in broker-dealer quotes may not necessarily be the
which the difference between bid and offer same values used by that dealer for its internal
prices and the midmarket price is assumed not to purposes and may not be representative of other
be earned. Midmarket pricing may be used for ‘‘market’’ or model-based valuations. Therefore,
transactions in which the firm is a market maker, institutions should satisfy themselves that the
and the bid/offer to midmarket spread is earned. external valuations provided are appropriate.
Trading and Capital-Markets Activities Manual February 1998
Page 3
2100.1 Financial Performance
Illiquid Instruments and Transactions again, pricing models may be used for this
purpose.
Illiquid, nontraditional, and user-specific or cus- When conducting the monthly revaluation,
tomized transactions pose particular pricing chal- the validity of portfolio prices can be tested by
lenges because independent third-party prices reviewing them for historical consistency or by
are generally unavailable. For illiquid products comparing actual close-out prices or the perfor-
that are traded on organized exchanges, but mance of hedge positions to model predictions.
where trades occur infrequently and available In some instances, controllers may run parallel
quotes are often not current, mark-to-market pricing models as a check on the valuations
valuations based on the illiquid market quotes derived by trader models. This method is usu-
may be adjusted by a holdback reserve that is ally only used for the more exotic, harder-to-
created to reflect the product’s reduced liquidity price products.
(see ‘‘Holdback Reserves’’ below). For illiquid
OTC transactions, broker quotes may be avail-
able, albeit infrequently. When broker quotes Pricing Models
are available, the bank may use several quotes to
determine a final representative valuation. For Pricing models can either be purchased from
example, they may compute a simple average of vendors or developed internally and they can be
quotes or eliminate extreme prices and average mainframe or PC-based. Internally developed
the remaining quotes. In such cases, internal models are either built from scratch or devel-
policies should clearly identify the methodology oped using existing customized models that
to be used. traders modify and manipulate to incorporate
When the middle or back office is responsible the specific characteristics of a transaction.
for inputting broker quotes directly, the traders The use of pricing models introduces the
should also be responsible for reporting their potential for model risk into the valuation pro-
positions to the middle- or back-office function cess. Model risk is the risk that faulty pricing
as an added control. Any differences in pricing models will result in inaccurate valuations of
should be reconciled. When brokers are respon- holdings, which results in trading losses to the
sible for inputting data directly, it is crucial that institution. Model risk can result from inad-
these data are verified for accuracy and appro- equate development or application of a model,
priateness by the middle or back office. the assumptions used in running a model, or the
For many illiquid or customized transactions, specific mathematical algorithms on which a
such as highly structured or leveraged instru- model is based. Accordingly, effective policies
ments and more complex, nonstandard notes or and procedures related to model development,
securities, reliable independent market quotes model validation and model control are neces-
are usually not available, even infrequently. In sary to limit model risk. At a minimum, policies
such instances, other valuation techniques must for controlling model risk should address the
be used to determine a theoretical, end-of-day institution’s process for developing, implement-
market value. These techniques may involve ing, and revising pricing models. The responsi-
assuming a constant spread over a reference rate bilities of staff involved in the model-
or comparing the transaction in question with development and model-validation process
similar transactions that have readily available should be clearly defined.
prices (for example, comparable or similar trans- In some institutions, only one department or
actions done with different counterparties). More group may be authorized to develop pricing
likely, though, pricing models will be used to models. In others, model development may be
price these types of customized transactions. initiated in any of several areas related to
Even when exchange prices exist for a financial trading. Regardless of the bank function respon-
instrument, market anomalies in the pricing may sible for model development and control, insti-
exist, making consistent pricing across the tutions should ensure that modeling techniques
instrument difficult. For example, timing and assumptions are consistent with widely
differences may exist between close of the cash acceptable financial theories and market prac-
market and futures markets causing a diver- tices. When modeling activities are conducted in
gence in pricing. In these cases, it may be separate business units or are decentralized,
appropriate to use theoretical pricing, and business-unit polices governing model develop-
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Financial Performance 2100.1
ment and use should be consistent with overall review process should be performed by a group
corporate polices on model-risk management. independent from the traders, such as a control
As part of these policies, institutions should or risk-analysis function. As appropriate, model
ensure that models are properly documented. reviews should consider changes in the types of
Documentation should be created and main- transactions handled by the model, as well as
tained for all models used, and a model- changes in generally accepted modeling conven-
inventory database should be maintained on a tions and techniques. Model reviews should
corporate-wide or business-line basis. incorporate an investigation of actual verses
Before models are authorized for use, they expected performance and fully incorporate
should be validated by individuals who are not assessment of any hedging activity. Significant
directly involved in the development process or deviation in expected versus actual performance
do not have methodological input to the model. and unexplainable volatility in the profits and
Ideally, models should be validated by an inde- losses of trading activities may indicate that
pendent financial-control or risk-management market-defined hedging and pricing relation-
function. Independent model validation is a key ships are not being adequately captured in a
control in the model-development process and model. The model-review process should be
should be specifically addressed in a firm’s clearly defined and documented, and these poli-
policies. Management should be satisfied that cies should be communicated to the appropriate
the underlying methodologies for all models are parties throughout the organization.
conceptually sound, mathematically and statis- In addition to the periodic scheduled reviews,
tically correct, and appropriate for the model’s models should always be reviewed when new
purpose. Pricing methodologies should be con- products are introduced or changes in valuations
sistent across business lines. In addition, the are proposed. Model review may also be
technical expertise of the model validators should prompted by a trader who feels that a model
be sufficient to ensure that the basic approach of should be updated to reflect the significant
the model is appropriate. development or maturing of a market. In some
All model revisions should be performed in a cases, models may start out as a PC-based
controlled environment, with changes either spreadsheet model and are subsequently trans-
made or verified by a control function. When formed to a mainframe model. Whenever this
traders are able to make changes to models occurs, the model should be reviewed and any
outside of a controlled environment, an inappro- resulting changes in valuation should be moni-
priate change may result in inaccurate valuation. tored. Banks should continually monitor and
Under no circumstances should traders be able compare their actual cash flows versus model
to determine valuations of trading positions by projections, and significant discrepancies should
making changes to a model unless those changes prompt a model review.
are subject to the same review process as a new
type of transaction. Accordingly, written poli-
cies should specify when changes to models are Pricing-Model Inputs
acceptable and how those revisions should be
accomplished. Controls should be in place to Pricing models require various types of inputs,
prevent inappropriate changes to models by including hard data, readily observable param-
traders or other unauthorized personnel. For eters such as spot or futures prices, and both
example, models can be coded or date marked quantitatively and qualitatively derived assump-
so that it is obvious when changes are made to tions. All inputs should be subject to controls
those models. Rigorous controls on spreadsheet- that ensure that they are reasonable and consis-
based models should ensure their integrity and tent across business lines, products, and geo-
prevent unauthorized revisions. The control func- graphic locations. Assumptions and inputs
tion should maintain copies of all models used regarding expected future volatilities and corre-
by the traders in case those used on the trading lations, and the specification of model-risk fac-
floor are corrupted. tors such as yield curves, should be subject to
Models should be reviewed or reassessed at specific control and oversight. Important consid-
some specified frequency, with the most impor- erations in each of these areas are as follows:
tant or complex models reviewed at least once a
year. In addition, models should be reviewed • Volatilities. Both historically determined and
whenever major changes are made to them. The implied volatilities should be derived using
Trading and Capital-Markets Activities Manual February 1998
Page 5
2100.1 Financial Performance
generally accepted and appropriately docu- ated by a transaction and then release the reserve
mented techniques. Implied volatilities should into income over time. By deferring a portion of
be reviewed for reasonableness and derived the profits or losses, holdback reserves may
from closely related instruments. avoid earnings overstatement and more accu-
• Correlations. Correlations should be well rately match revenues and expenses.
documented and estimated as consistently as Reserving methodologies and the types of
practicable across products and business lines. reserves created vary among institutions. Even
If an institution relies on broker quotes, it within firms, the reserving concept may not be
should have an established methodology for consistent across business lines, or the concept
determining the input to be used from multiple may not be applied consistently. At a minimum,
quotes (such as the average or median). policies regarding holdback reserves should
• Risk factors. Pricing models generally decom- define (1) the universe of risks and costs that are
pose instruments into elementary components, to be considered when creating holdback reserves,
such as specific interest rates, currencies, (2) the methodologies to be used to calculate
commodities, and equity types. Interest rates them, and (3) acceptable practices for recogniz-
and yield curves are particularly important ing the reserves into the profits and losses of the
pricing-model-risk factors. Institutions should institution.
ensure that the risk factors in general, and the General policies for holdback reserves should
yield curves in particular, used in pricing be developed by a group independent from the
instruments are sufficiently robust (have suf- business units, such as the financial-control area.
ficient estimation points). Moreover, the same This group may also be responsible for devel-
types of yield curves (spot, forward, yield-to- oping and implementing the policy. Alterna-
maturity) should be used to price similar tively, individual business lines may be given
products. responsibility for developing an implementation
policy. If implementation policies are developed
During the periodic revaluation process, many by individual business lines, they should be
institutions may perform a formal verification of periodically reviewed and approved by an inde-
model-pricing inputs, including volatilities, cor- pendent operating group. Most importantly, the
relation matrices, and yield curves. traders or business units should not be able to
determine the level of holdback reserves and,
hence, be able to determine the fair value of
HOLDBACK RESERVES trading positions. In general, reserving policies
should be formula-based or have well-specified
Mark-to-market gains and losses on trading and procedures to limit subjectivity in the determi-
derivatives portfolios are recognized in the unit’s nation of fair value. Reserve policies should be
profits and losses and incorporated into the reviewed periodically and revised as necessary.
value of trading assets and liabilities. Often a
bank will ‘‘hold back,’’ or defer, the recognition
of a certain portion of first-day profits on a Reserve Adequacy
transaction for some period of time. Holdback
reserves are usually taken to reflect uncertainty An insufficient level of holdback reserves may
about the pricing of a transaction or the risks cause current earnings to be overstated. How-
entailed in actively managing the position. These ever, excess holdback reserves may cause cur-
reserves represent deferred gains that may or rent earnings to be understated and subject to
may not be realized, and they are usually not manipulation. Accordingly, institutions should
released into income until the close or maturity develop policies detailing acceptable practices
of the contract. for the creation, maintenance, and release of
Holdback reserves can also be taken to better holdback reserves. The level of holdback
match trading revenues with expenses. Certain reserves should be periodically reviewed for
costs associated with derivatives transactions, appropriateness and reasonableness by an inde-
such as credit, operational, and administrative pendent control function and, if deemed neces-
costs, may be incurred over the entire lives of sary, the level should be adjusted to reflect
the instruments involved. In an effort to match changing market conditions. Often, the reason-
revenue with expenses, an institution may defer ableness of reserves will be checked in conjunc-
a certain portion of initial profit or loss gener- tion with the month-end revaluation process.
February 1998 Trading and Capital-Markets Activities Manual
Page 6
Financial Performance 2100.1
Creating Reserves For new models, reserves are usually based on
an assessment of the level of model sophisti-
All holdback reserves should be recognized in cation.
the internal reports and financial statements of
the institution, whether they are represented as
‘‘pricing adjustments’’ or as a specified hold- Recording Reserves
back of a transaction’s profit or loss. Any type of
holdback reserve that is not recorded in the Holdback reserves may be separately recorded
financial records should be avoided. Reserves in the general-ledger accounts of each business
may be taken either on a transaction-by- entity, or they may be tracked on a corporate-
transaction basis or on an overall portfolio basis. wide basis. These reserves are usually recorded
Written policies should clearly specify the types on the general-ledger account as a contra trading
of holdback reserves that are appropriate for asset (representing a reduction in unrealized
different portfolios and transactions. gains), but some banks record them as a liability.
While holdback reserves may be created for a Alternatively, reserves for some risks may be
variety of risks and costs, the following are the recorded as a contra asset and reserves for other
most common types: risks recorded as a liability. Holdback reserves
can be netted against ‘‘trading assets,’’ included
• Administrative-cost reserves. These reserves in ‘‘other liabilities,’’ or disclosed separately in
are intended to cover the estimated future the published financial statements. Institutions
costs of maintaining portfolio positions to should ensure that they have clear policies
maturity. Administrative-cost reserves are typi- indicating the method to be used in portraying
cally determined as a set amount per transac- reserves in reports and financial statements.
tion based on historical trends.
• Credit-cost reserves. These reserves provide
for the potential change in value associated Releasing Reserves
with general credit deterioration in the port-
folio and with counterparty defaults. They are An institution’s policies should clearly indicate
typically calculated by formulas based on the the appropriate procedure for releasing reserves
counterparty credit rating, maturity of the as profits or losses. Holdback reserves created as
transaction, collateral, netting arrangements, a means of matching revenues and expenses are
and other credit factors. usually amortized into income over the lives of
• Servicing-cost reserves. These reserves pro- the individual derivative contracts. Reserves
vide for anticipated operational costs related that are created to reflect the risk that recognized
to servicing the existing trading positions. gains may not be realized due to mispricing or
• Market-risk reserves. These reserves are cre- unexpected hedging costs are usually released in
ated to reflect a potential loss on the open risk their entirety at the close or maturity of the
position given adverse market movements and contract, or as the portfolio changes in structure.
an inability to hedge (or the high cost of If reserves are amortized over time, a straight-
hedging) the position. This includes dynamic line amortization schedule may be followed,
hedging costs for options. with reserves being released in equal amounts
• Liquidity-risk reserves. These reserves are over the life of the transaction or the life of the
usually a subjective estimate of potential risk. Alternatively, individual amortization sched-
liquidity losses (given an assumed change in ules may be determined for each transaction.
value of a position) due to the bank’s inability
to obtain bid/offer in the market. They are
intended to cover the expected cost of liqui- INCOME ATTRIBUTION
dating a particular transaction or portfolio or
of arranging hedges that would eliminate any Profits and losses (P&L’s) from trading accounts
residual market risk from that transaction or can arise from several factors. Firms attempt to
portfolio. determine the underlying reasons for value
• Model-risk reserves. These reserves are cre- changes in their trading portfolios by attributing
ated for the expected profit and loss impact of the profits and losses on each transaction to
unforeseen inaccuracies in existing models. various sources. For example, profits and losses
Trading and Capital-Markets Activities Manual March 1999
Page 7
2100.1 Financial Performance
can be attributed to the ‘‘capture’’ of the bid/ and proprietary trading desk, as well as to
offer spread—the primary aim of market mak- holdback reserves. Any balance in the first-day
ing. Another example is the attribution of profit profit may then be assigned to the business or
to ‘‘origination,’’ the difference between the fair product line that acquired the position. As the
value of the created instrument and the con- position is managed over time, subsequent P&L
tracted transaction price. Profit and loss can also attributions are made based on the effectiveness
result from proprietary position-taking. Proper of a trading desk’s management of the position.
attribution of trading revenues is crucial to In turn, the trading desk may further attribute
understanding the risk profile of trading activi- P&L to risk sources and other factors such as
ties. The ability of an institution to accurately spread movements, tax sensitivity, time decay,
determine the sources of daily P&L on different or basis carry. Many trading desks go on to
types of financial instruments is considered a break out their daily P&L with reference to the
key control to ensure that trading-portfolio valu- actual risks being managed—for example delta,
ations are reasonable. The discipline of measur- gamma, theta, rho, and vega. Institutions should
ing and attributing P&L performance also ensure that they provide an independent review
ensures that risks are accurately measured and for the reasonableness of all revenue splits.
monitored.
The income-attribution process should be car-
ried out by a group independent from the trad- Unexplained Profits and Losses
ers; in most larger institutions, attribution is the
responsibility of the risk-management or middle- Unexplained profits and losses is defined as the
office function. The designated group is respon- difference between actual P&L and explained
sible for conducting analysis of the institution’s P&L. If the level of unexplained P&L is con-
transactions and identifying the various sources sidered significant, the control function should
of trading P&L for each product or business investigate the reason for the discrepancy. It
line. These analyses may cover only certain may be necessary to make changes to the pricing
types of transactions, but increasingly they are process as a result of the investigation. For
being applied to all products. The income- example, models may be modified or the choice
attribution process should be standardized and of pricing inputs, such as volatilities and corre-
consistently applied across all business units. lations, may be challenged. The level of unex-
The goal of income-attribution analyses is to plained P&L considered significant will vary
attribute, or ‘‘explain,’’ as much of the daily among institutions, with some firms specifically
trading P&L as possible. A significant level of defining a threshold for investigation (for exam-
‘‘unexplained’’ P&L or an unusual pattern of ple, ‘‘unexplained P&L above $x thousand dol-
attribution may indicate that the valuation pro- lars will be investigated’’). Some institutions
cess is flawed, implying that the bank’s reported permit risk-control units to decide what is sig-
income may be either under- or overstated. It nificant on a case-by-case basis. Alternatively,
may also point to unexplained risks that are not management ‘‘triggers,’’ such as contract limits,
adequately identified and estimated. may identify particular movements in P&L that
should be reviewed.
Explained Profits and Losses
REPORTS TO MANAGEMENT
Profits and losses that can be attributed to a risk AND DISCLOSURES TO
source are considered ‘‘explained P&L.’’ Insti- CUSTOMERS
tutions with significant trading activities should
ensure they have appropriate methodologies and Reports to Management
policies to attribute as much revenue as practi-
cable. For example, some institutions may define An independent control function should prepare
first-day profit as the difference between the daily P&L breakout reports and official month-
midmarket or bid/offer price and the price at end P&L breakout reports that are distributed to
which the transaction was executed. This senior management. Daily reports that identify
first-day profit may then be allocated among the profits and losses of new deals should be
sources such as the sales desk, origination desk, provided to appropriate management and staff,
March 1999 Trading and Capital-Markets Activities Manual
Page 8
Financial Performance 2100.1
including trading-desk managers. These reports of-day mark-to-market values for the firm’s own
should include P&L explanations by source and reports and financial records, usually at midmar-
risks for each trading book. New-deal reports ket. Holdback reserves are generally not included
may also be generated periodically to provide in the valuation given to customers. In all cases,
information on all new deals transacted during price quotes should be accompanied by infor-
the period. This information may include the mation that describes how the value was derived.
customer names, maturities, notional amounts, If internally validated models are used to deter-
portfolio values, holdback reserves, and new- mine a transaction value, this fact should be
deal profits and losses. At a minimum, senior made clear and the underlying valuation assump-
management should receive the formal month- tions provided.
end P&L explanation reports. In making any price quotes, institutions should
include a disclaimer stating the true nature of
any quote—such as ‘‘indication only’’ or ‘‘trans-
Providing Valuations to Customers action price.’’ Disclosures should state the char-
acteristics of any valuation provided (for exam-
Trading institutions are often asked to provide ple, midmarket, indicative, or firm price). In
valuations of transacted products to their cus- markets that have specific conventions for
tomers. Quotes may be provided on a daily, determining valuations, firms should usually
weekly, monthly, or less frequent basis at the supply valuations using those conventions unless
customer’s request. Even when valuations are otherwise agreed to by the customer.
not requested by the client, sales personnel may Although traders and marketers should receive
follow the clients’ positions and notify them of and review all valuations distributed to custom-
changes in the valuation of their positions due to ers, customer valuations should be provided
market movements. Some firms will provide primarily by a back- or middle-office function to
quotes for all of the positions in their customers’ maintain segregation from the front office.
portfolios—not just the transactions executed Internal auditors may review valuations pro-
with the firm. Firms may also formally offer to vided to clients to ensure consistency with the
give valuations to certain customers for certain values derived from the independent pricing
lower-risk products. models and consistency with internal mark-to-
Generally, price quotes are taken from the market processes.
same systems or models used to generate end-
Trading and Capital-Markets Activities Manual February 1998
Page 9
Financial Performance
Examination Objectives Section 2100.2
1. To review the institution’s internal reporting a. reasonableness,
of revenues and expenses to ensure that these b. consistency,
reports are prepared in a manner that accu- c. consistency with management’s stated
rately measures capital-markets and trading strategy and budget assumptions,
results and are generally consistent with d. the trend in earnings,
industry norms. e. the volatility of earnings, and
2. To review management information reports f. the risk-reward profile of specific products
for content, clarity, and consistency. To ensure and business units.
that reports contain adequate and accurate 5. To review management’s monitoring of
financial data for sound decision making, capital-markets and trading volumes.
particularly by the chief financial officer and 6. To assess whether the institution’s market-
other senior management. risk-measuring system adequately captures
and reports to senior management the major
3. To assess whether the institution adequately risks of the capital-markets and trading
attributes income to its proper sources and activities.
risks. To assess whether the allocation meth- 7. To determine the extent that capital-markets
odology is sufficient. and trading activities contribute to the overall
4. To review the level of profits, risk positions, profitability and risk profile of the institution.
and specific types of transactions that result 8. To recommend corrective action when poli-
in revenues or losses (by month or quarter) cies, procedures, practices, or internal reports
since the prior examination to ascertain— or controls are found to be deficient.
Trading and Capital-Markets Activities Manual February 1998
Page 1
Financial Performance
Examination Procedures Section 2100.3
These procedures represent a list of processes reflect all significant income and expenses
and activities that may be reviewed during a contributing to a business line or group’s
full-scope examination. The examiner-in-charge internally reported income.
will establish the general scope of examination 5. Check whether internal reporting practices
and work with the examination staff to tailor are in line with industry norms and identify
specific areas for review as circumstances war- the rationale for any significant differences.
rant. As part of this process, the examiner 6. Check whether amortization and deprecia-
reviewing a function or product will analyze and tion costs and other overhead costs are
evaluate internal-audit comments and previous appropriately allocated among the appropri-
examination workpapers to assist in designing ate business areas.
the scope of examination. In addition, after a 7. Determine whether reserves for credit risk
general review of a particular area to be exam- and other risks are sufficient to cover any
ined, the examiner should use these procedures, reasonably expectable losses and costs.
to the extent they are applicable, for further 8. Review the institution’s progress in imple-
guidance. Ultimately, it is the seasoned judg- menting or updating the methodology for
ment of the examiner and the examiner-in- attributing income to the appropriate sources.
charge as to which procedures are warranted in 9. Analyze the quality of earnings. Review the
examining any particular activity. level of profits and specific types of trans-
actions that result in revenues or losses (by
1. Obtain all profitability reports which are month or quarter) since the prior examina-
relevant to each business line or group. For tion to determine—
each line or group, identify the different a. reasonableness,
subcategories of income that are used in b. consistency,
internal profit reports.
c. consistency with management’s stated
2. Assess the institution’s methodology for
strategy and budgeted levels,
attributing income to its sources. Check
d. the trend in earnings,
whether the allocation methodology makes
sufficient deductions or holdbacks from the e. the volatility of earnings, and
business line to account for the efforts of f. the risk/reward profile of specific prod-
sales, origination, and proprietary trading, ucts or business units.
and whether it properly adjusts for hedging 10. Review the volume of transactions and
costs, credit risks, liquidity risks, and other positions taken by the institution for reason-
risks incurred. An adequate methodology ableness, and check that the institution has a
should cover each of these factors, but an system for effectively monitoring its capital-
institution need not make separate reserve markets and trading volumes.
categories for each risk incurred. However, 11. Determine whether the market-risk-
such institutions should be making efforts to measuring system provides the chief finan-
allocate income more precisely among these cial officer and other senior management
different income sources and risks. with a clear vision of the financial institu-
3. Review management information reports tion’s market portfolio and risk profile.
for content, clarity, and consistency. Deter- 12. Determine the extent that trading activities
mine if reports contain adequate financial contribute to the overall profitability of the
data for sound decision making. institution. Determine how the trend has
4. Review internal trading-income reports to changed since the prior examination.
ensure that they accurately reflect the earn- 13. Recommend corrective action when meth-
ings results of the business line or group. odologies, procedures, practices, or internal
Check whether internal profitability reports reports or controls are found to be deficient.
Trading and Capital-Markets Activities Manual February 1998
Page 1
Financial Performance
Internal Control Questionnaire Section 2100.4
1. How does the institution define trading the business unit overly dependent on
income? Does it cover interest, overhead, income generated from one particular
and other expenses related to the business customer or related group of customers?
line in that line’s income reports? Do inter- How diverse is the generation of product
nal income reports accurately reflect the and customer profitability?
results of the business line? Is the break- c. Is the institution taking an undue amount
down of business-line income into compo- of credit risk or market risk to generate
nents sufficient to identify the main sources its profits? Is the institution ‘‘intermedi-
of profitability and expenses? What varia- ating’’ in transactions for a credit
tions are there from the general market ‘‘spread’’? What is the credit quality of
practice for internal reporting of business- the customers in which the institution is
line income? taking credit risk in the trading unit?
2. What is the methodology for allocating 6. How does the institution monitor and con-
income to its sources? Do the allocations trol its business-line and overall volume of
make sufficient deductions or holdbacks to capital-markets and trading activities?
account for the efforts of sales, origination,
7. Does the market-risk-measuring system
and proprietary trading? Do they properly
adequately capture and report to the chief
adjust for hedging costs, credit risks, liquid-
financial officer and senior management the
ity risks, and other risks incurred?
major risks from the capital-markets and
3. What steps is the institution taking to
trading activities?
enhance its income-allocation system?
4. How frequently are earnings reported to 8. Does the market-risk-measuring system pro-
middle and senior management? Are the vide the chief financial officer and other
reports comprehensive enough for the level senior management with a clear vision of
of activity? Can they be used for planning the financial institution’s market portfolio
and trend analysis? How often and under and risk profile? How does management
what circumstances are these reports sent to compare the profitability of business lines
the chief financial officer, the president, and with the underlying market risks?
members of the board of directors? 9. What is the contribution of trading activities
5. Evaluate the sources of earnings. Are earn- to the overall profitability of the institution?
ings highly volatile? What economic events How has the trend changed since the prior
or market conditions led to this volatility? examination?
a. Are there any large, nonrecurring income/ 10. Evaluate the earnings of new-product or
expense items? If so, why? new-business initiatives. What is the earn-
b. Is profitability of the business unit ings performance and risk profile for these
dependent on income generated from areas? What are management’s goals and
one particular product? Is profitability of plans for these areas?
Trading and Capital-Markets Activities Manual February 1998
Page 1
Capital Adequacy
Section 2110.1
As with all risk-bearing activities, the risk requirements generally sensitive to differences
exposures a banking organization assumes in its in risk profiles among banking organizations;
trading, derivative, and capital-markets activi- (2) factor off-balance-sheet exposures into the
ties should be fully supported by an adequate assessment of capital adequacy; (3) minimize
capital position. Accordingly, banking organiza- disincentives to holding liquid, low-risk assets;
tions should ensure that their capital positions and (4) achieve greater consistency in the evalu-
are sufficiently strong to support all trading and ation of the capital adequacy of major banks
capital-markets risks on a fully consolidated throughout the world. The risk-based capital
basis and that adequate capital is maintained in measure focuses primarily on the credit risk
all affiliated entities engaged in these activities. associated with the nature of banking organiza-
Institutions with significant trading activities tions’ on- and off-balance-sheet exposures and
should have reasonable methods to measure the on the type and quality of their capital. It
risks of their activities and allocate capital provides a definition of capital and a framework
against the economic substance of those risks. for calculating risk-weighted assets by assigning
To that extent, regulatory capital requirements assets and off-balance-sheet items to broad cate-
should be viewed as minimum requirements, gories of credit risk. A banking organization’s
and those institutions exposed to a high or risk-based capital ratio is calculated by dividing
inordinate degree of risk or forms of risk that its qualifying capital by its risk-weighted assets.
may not be fully addressed in regulatory require- The risk-based capital measure sets forth mini-
ments are expected to operate above minimum mum supervisory capital standards that apply to
regulatory standards consistent with the eco- all banking organizations on a consolidated
nomic substance of the risks entailed. basis.
As the baseline for capital-adequacy assess- The risk-based capital ratio focuses princi-
ment, bank supervisors first consider an organi- pally on broad categories of credit risk. For most
zation’s risk-based capital ratio; that is, the ratio banking organizations, the ratio does not incor-
of qualifying capital to assets and off-balance- porate other risk factors that may affect the
sheet items that have been ‘‘risk weighted’’ organization’s financial condition. These factors
according to perceived credit risk. Supervisors may include overall interest-rate exposure;
also focus on the tier 1 leverage ratio to help liquidity, funding, and market risks; the quality
assess capital adequacy. For banking organiza- and level of earnings; investment or loan port-
tions with significant trading activities, the risk- folio concentrations; the effectiveness of loan
based capital ratio also takes into account an and investment policies; the quality of assets;
institution’s exposure to market risk.1 and management’s ability to monitor and con-
trol financial and operating risks. An overall
assessment of capital adequacy must take into
RISK-BASED CAPITAL MEASURE account these other factors and may differ sig-
nificantly from conclusions that might be drawn
The principal objectives of the risk-based capital solely from the level of an organization’s risk-
measure 2 are to (1) make regulatory capital based capital ratio.
1. The market-risk capital rules are mandatory for certain
banking organizations with significant exposure to market risk Definition of Capital
beginning no later than January 1, 1998. See ‘‘Market-Risk
Measure,’’ below.
2. The risk-based capital measure is based on a framework For risk-based capital purposes, a banking orga-
developed jointly by supervisory authorities from the G-10 nization’s capital consists of two major compo-
countries. The Federal Reserve implemented the risk-based
measure in January 1989. This section provides a brief
nents: core capital elements (tier 1 capital) and
overview of the current risk-based capital measure. More supplementary capital elements (tier 2 capital).
detailed discussions can be found in the Federal Reserve’s Core capital elements include common equity
Commercial Bank Examination Manual. Specific guidelines including capital stock, surplus, and undivided
for calculating the risk-based capital ratio are found in
Regulation H (12 CFR 208, appendixes A and E) for state
profits; qualifying noncumulative perpetual pre-
member banks and in Regulation Y (12 CFR 225, appendixes ferred stock (or, for bank holding companies,
A and E) for bank holding companies. cumulative perpetual preferred stock, the aggre-
Trading and Capital-Markets Activities Manual April 2000
Page 1
2110.1 Capital Adequacy
gate of which may not exceed 25 percent of which most market judgments of capital ade-
tier 1 capital); and minority interest in the equity quacy are made.
accounts of consolidated subsidiaries. Tier 1 Consideration of the capacity of an institu-
capital is generally defined as the sum of core tion’s capital structure to absorb losses should
capital elements less goodwill, unrealized hold- also take into account how that structure could
ing losses in the available-for-sale equity port- be affected by changes in the institution’s per-
folio, and other intangible assets that do not formance. For example, an institution experienc-
qualify within capital, as well as any other ing a net operating loss—perhaps because of
investments in subsidiaries that the Federal realization of unexpected losses—will face not
Reserve determines should be deducted from only a reduction in its retained earnings, but also
tier 1 capital. Tier 1 capital represents the possible constraints on its access to capital
highest form of capital, namely permanent markets. These constraints could be exacerbated
equity. Tier 2 capital consists of a limited should conversion options be exercised to the
amount of the allowance for loan and lease detriment of the institution. A decrease in com-
losses, perpetual preferred stock that does not mon equity, the key element of tier 1 capital,
qualify as tier 1 capital, mandatory convertible may have further unfavorable implications for
securities and other hybrid capital instruments, an organization’s regulatory capital position.
long-term preferred stock with an original term The eligible amounts of most types of tier 1
of 20 years or more, and limited amounts of preferred stock and tier 2 or tier 3 capital ele-
term subordinated debt, intermediate-term pre- ments may be reduced, because current capital
ferred stock, and unrealized holding gains on regulations limit the amount of these elements
qualifying equity securities. See section 3020.1, that can be included in regulatory capital to
‘‘Assessment of Capital Adequacy,’’ in the Com- a maximum percentage of tier 1 capital. Such
mercial Bank Examination Manual for a com- adverse magnification effects could be further
plete definition of capital elements. accentuated should adverse events take place at
Capital investments in unconsolidated bank- critical junctures for raising or maintaining capi-
ing and finance subsidiaries and reciprocal hold- tal, for example, as limited-life capital instru-
ings of other banking organizations’ capital ments are approaching maturity or as new capi-
instruments are deducted from an organization’s tal instruments are being issued.
capital. The sum of tier 1 and tier 2 capital less
any deductions makes up total capital, which is
the numerator of the risk-based capital ratio. Risk-Weighted Assets
In assessing an institution’s capital adequacy,
supervisors and examiners should consider the Each asset and off-balance-sheet item is assigned
capacity of the institution’s paid-in equity and to one of four broad risk categories based on the
other capital instruments to absorb economic obligor or, if relevant, the guarantor or type of
losses. In this regard, it has been the Federal collateral. The risk categories are zero, 20, 50,
Reserve’s long-standing view that common and 100 percent. The standard risk category,
equity (that is, common stock and surplus and which includes the majority of items, is 100 per-
retained earnings) should be the dominant com- cent. The appropriate dollar value of the amount
ponent of a banking organization’s capital struc- in each category is multiplied by the risk weight
ture and that organizations should avoid undue associated with that category. The weighted
reliance on non-common-equity capital ele- values are added together and the resulting sum
ments.3 Common equity allows an organization is the organization’s risk-weighted assets, the
to absorb losses on an ongoing basis and is denominator of the risk-based capital ratio.4
permanently available for this purpose. Further, Off-balance-sheet items are incorporated into
this element of capital best allows organizations the risk-based capital ratio by first being con-
to conserve resources when they are under stress verted into a ‘‘credit-equivalent’’ amount. To
because it provides full discretion in the amount accomplish this, the face amount of the item is
and timing of dividends and other distributions. multiplied by a credit conversion factor (zero,
Consequently, common equity is the basis on 20, 50, or 100 percent). The credit-equivalent
3. The Basel Committee on Banking Supervision affirmed
this view in a release issued in October 1998, which stated that 4. See the Commercial Bank Examination Manual for a
common shareholders’ funds are the key element of capital. complete discussion of risk-weighted assets.
April 2000 Trading and Capital-Markets Activities Manual
Page 2
Capital Adequacy 2110.1
amount is then assigned to a risk category in the the form of tier 1 capital. Organizations that
same manner as on-balance-sheet items. For do not meet the minimum ratios, or that are
over-the-counter derivative transactions, the considered to lack sufficient capital to support
credit-equivalent amount is determined by mul- their activities, are expected to develop and
tiplying the notional principal amount of the implement capital plans acceptable to the Fed-
underlying contract by a credit-conversion fac- eral Reserve for achieving adequate levels of
tor and adding the resulting product (which is an capital.
estimate of potential future exposure) to the
positive mark-to-market value of the contract
(which is the current exposure). A contract with
a negative mark-to-market value is treated as TIER 1 LEVERAGE RATIO
having a current exposure of zero. (See ‘‘Credit-
Equivalent Computations for Derivative Con- The principal objective of the tier 1 leverage
tracts’’ below.) measure is to place a constraint on the maximum
The primary determinant of the appropriate degree to which a banking organization can
risk category for a particular off-balance-sheet leverage its equity capital base.6 A banking
item is the obligor. Collateral or guarantees organization’s tier 1 leverage ratio is calculated
may be used to a limited extent to assign an by dividing its tier 1 capital by its average total
item to a lower risk category than would be consolidated assets. Generally, average total con-
available to the obligor. The forms of collateral solidated assets are defined as the quarterly
generally recognized for risk-based capital average total assets reported on the organiza-
purposes are cash on deposit in the lending tion’s most recent regulatory reports of financial
institution; securities issued or guaranteed condition, less goodwill, certain other intangible
by central governments of the Organization assets, investments in subsidiaries or associated
for Economic Cooperation and Development companies, and certain excess deferred-tax assets
(OECD) countries,5 U.S. government agencies, that are dependent on future taxable income.
or U.S. government–sponsored agencies; and The Federal Reserve has adopted a minimum
securities issued by multilateral lending institu- tier 1 leverage ratio of 3 percent for the most
tions or regional development banks in which highly rated banks. A state member bank oper-
the U.S. government is a shareholder or contrib- ating at or near this level is expected to have
uting member. The only guarantees recognized well-diversified risk, including no undue interest-
are those provided by central or state and local rate-risk exposure; excellent asset quality; high
governments of the OECD countries, U.S. gov- liquidity; good earnings; and in general be
ernment agencies, U.S. government–sponsored considered a strong banking organization rated
agencies, multilateral lending institutions or a composite 1 under the CAMELS rating sys-
regional development banks in which the United tem for banks. Other state member banks are
States is a shareholder or contributing member, expected to have a minimum tier 1 leverage
U.S. depository institutions, and foreign banks. ratio of 4 percent. Bank holding companies rated
Banking organizations are expected to meet a composite 1 under the BOPEC rating system
a minimum ratio of capital to risk-weighted and those that have implemented the Board’s
assets of 8 percent, with at least 4 percent taking risk-based capital measure for market risk must
maintain a minimum tier 1 leverage ratio of
5. OECD countries are defined to include all full members 3 percent. Other bank holding companies are
of the Organization for Economic Cooperation and Develop- expected to have a minimum tier 1 leverage
ment regardless of entry date, as well as countries that have
concluded special lending arrangements with the International
ratio of 4 percent. In all cases, banking organi-
Monetary Fund (IMF) associated with the IMF’s General zations should hold capital commensurate with
Arrangements to Borrow, but excludes any country that has the level and nature of all risks to which they are
rescheduled its external sovereign debt within the previous exposed.
five years. As of May 1999, the OECD countries were
Australia, Austria, Belgium, Canada, the Czech Republic,
Denmark, Finland, France, Germany, Greece, Hungary, Ice-
land, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, the 6. The tier 1 leverage measure, intended to be a supplement
Netherlands, New Zealand, Norway, Poland, Portugal, Spain, to the risk-based capital measure, was adopted by the Federal
Sweden, Switzerland, Turkey, the United Kingdom, and the Reserve in 1990. Guidelines for calculating the tier 1 leverage
United States. Saudi Arabia has concluded special lending ratio are found in Regulation H (12 CFR 208, appendix B) for
arrangements with the IMF associated with the IMF’s General state member banks and in Regulation Y (12 CFR 225,
Arrangements to Borrow. appendix D) for bank holding companies.
Trading and Capital-Markets Activities Manual April 2000
Page 3
2110.1 Capital Adequacy
CREDIT-EQUIVALENT receipt and payment of cash variation margin
COMPUTATIONS FOR may be excluded from the risk-based ratio
DERIVATIVE CONTRACTS calculation. Gold contracts are accorded the
same treatment as exchange-rate contracts except
that gold contracts with an original maturity of
Applicable Derivative Contracts 14 or fewer calendar days are included in the
Credit-equivalent amounts are computed for risk-based ratio calculation. Over-the-counter
each of the following off-balance-sheet contracts: options purchased are included and treated in
the same way as other derivative contracts.
• interest-rate contracts
— single-currency interest-rate swaps
— basis swaps Calculation of Credit-Equivalent
— forward rate agreements Amounts
— interest-rate options purchased (including
caps, collars, and floors purchased) The credit-equivalent amount of a derivative
— any other instrument linked to interest rates contract (excluding credit derivatives) that is not
that gives rise to similar credit risks (includ- subject to a qualifying bilateral netting contract
ing when-issued securities and forward is equal to the sum of—
forward deposits accepted)
• exchange-rate contracts • the current exposure (sometimes referred to as
— cross-currency interest-rate swaps the replacement cost) of the contract and
— forward foreign-exchange-rate contracts • an estimate of the potential future credit
— currency options purchased exposure of the contract.
— any other instrument linked to exchange
rates that gives rise to similar credit risks The current exposure is determined by the
• equity derivative contracts mark-to-market value of the contract. If the
— equity-linked swaps mark-to-market value is positive, then the cur-
— equity-linked options purchased rent exposure is equal to that mark-to-market
— forward equity-linked contracts value. If the mark-to-market value is zero or
— any other instrument linked to equities that negative, then the current exposure is zero.
gives rise to similar credit risks Mark-to-market values are measured in dollars,
• commodity (including precious metal) deriva- regardless of the currency or currencies speci-
tive contracts fied in the contract, and should reflect changes in
— commodity-linked swaps the relevant rates, as well as in counterparty
— commodity-linked options purchased credit quality.
— forward commodity-linked contracts The potential future credit exposure of a
— any other instrument linked to commodi- contract, including a contract with a negative
ties that gives rise to similar credit risks mark-to-market value, is estimated by multiply-
• credit derivatives ing the notional principal amount of the contract
— credit-default swaps by a credit-conversion factor. Banking organi-
— total-rate-of-return swaps zations should use, subject to examiner review,
— other types of credit derivatives the effective rather than the apparent or stated
notional amount in this calculation. The conver-
sion factors (in percent) are in table 1. The
Exceptions Board has noted that these conversion factors,
which are based on observed volatilities of the
Exchange-rate contracts with an original matu- particular types of instruments, are subject to
rity of 14 or fewer calendar days and derivative review and modification in light of changing
contracts traded on exchanges that require daily volatilities or market conditions.
April 2000 Trading and Capital-Markets Activities Manual
Page 4
Capital Adequacy 2110.1
Table 1—Conversion-Factor Matrix
Foreign-
exchange
rate and Precious Other
Remaining maturity Interest rate gold Equity metals commodity
One year or less 0.0 1.0 6.0 7.0 10.0
Over one to five years 0.5 5.0 8.0 7.0 12.0
Over five years 1.5 7.5 10.0 8.0 15.0
For a contract that is structured such that on or commodity contracts is subject to the same
specified dates any outstanding exposure is conversion factors as a commodity, excluding
settled and the terms are reset so that the market precious metals.
value of the contract is zero, the remaining No potential future credit exposure is calcu-
maturity is equal to the time until the next reset lated for a single-currency interest-rate swap in
date. For an interest-rate contract with a remain- which payments are made based on two floating-
ing maturity of more than one year that meets rate indexes, so-called floating/floating or basis
these criteria, the minimum conversion factor is swaps. The credit exposure on these contracts is
0.5 percent. evaluated solely on the basis of their mark-to-
For a contract with multiple exchanges of market values.
principal, the conversion factor is multiplied by Examples of the calculation of credit-
the number of remaining payments in the con- equivalent amounts for selected instruments are
tract. A derivative contract not included in the in table 2.
definitions of interest-rate, exchange-rate, equity,
Table 2—Calculating Credit-Equivalent Amounts for Derivative Contracts
Notional Potential Mark- Current Credit-
principal Conversion exposure to- exposure equivalent
Type of Contract amount factor (dollars) market (dollars) amount
(1) 120-day forward
foreign exchange 5,000,000 .01 50,000 100,000 100,000 150,000
(2) 4-year forward
foreign exchange 6,000,000 .05 300,000 −120,000 0 300,000
(3) 3-year single-
currency fixed- and
floating-interest-rate
swap 10,000,000 .005 50,000 200,000 200,000 250,000
(4) 6-month oil swap 10,000,000 .10 1,000,000 −250,000 0 1,000,000
(5) 7-year cross-
currency floating
and floating-
interest-rate swap 20,000,000 .075 1,500,000 −1,500,000 0 1,500,000
TOTAL 2,900,000 + 300,000 3,200,000
Trading and Capital-Markets Activities Manual April 2000
Page 5
2110.1 Capital Adequacy
Avoidance of Double Counting Netting of Swaps and Similar
Contracts
In certain cases, credit exposures arising from
derivative contracts may be reflected, in part, on Netting refers to the offsetting of positive and
the balance sheet. To avoid double counting negative mark-to-market values in the determi-
these exposures in the assessment of capital nation of a current exposure to be used in the
adequacy and, perhaps, assigning inappropriate calculation of a credit-equivalent amount. Any
risk weights, examiners may need to exclude legally enforceable form of bilateral netting
counterparty credit exposures arising from the (that is, netting with a single counterparty) of
derivative instruments covered by the guidelines derivative contracts is recognized for purposes
from balance-sheet assets when calculating a of calculating the credit-equivalent amount pro-
banking organization’s risk-based capital ratios. vided that—
This exclusion will eliminate the possibility that
an organization could be required to hold capital • the netting is accomplished under a written
against both an off-balance-sheet and on-balance- netting contract that creates a single legal
sheet amount for the same item. This treatment obligation, covering all included individual
is not accorded to margin accounts and accrued contracts, with the effect that the organization
receivables related to interest-rate and exchange- would have a claim to receive, or an obliga-
rate contracts. tion to receive or pay, only the net amount of
The aggregate on-balance-sheet amount the sum of the positive and negative mark-to-
excluded from the risk-based capital calculation market values on included individual con-
is equal to the lower of— tracts if a counterparty, or a counterparty to
whom the contract has been validly assigned,
• each contract’s positive on-balance-sheet fails to perform due to default, insolvency,
amount or liquidation, or similar circumstances;
• its positive market value included in the off-
balance-sheet risk-based capital calculation. • the banking organization obtains written and
reasoned legal opinions that in the event of a
For example, a forward contract that is marked legal challenge—including one resulting from
to market will have the same market value on default, insolvency, liquidation, or similar
the balance sheet as is used in calculating the circumstances—the relevant court and admin-
credit-equivalent amount for off-balance-sheet istrative authorities would find the banking
exposures under the guidelines. Therefore, the organization’s exposure to be such a net
on-balance-sheet amount is not included in the amount under—
risk-based capital calculation. When either the — the law of the jurisdiction in which the
contract’s on-balance-sheet amount or its mar- counterparty is chartered or the equivalent
ket value is negative or zero, no deduction from location in the case of noncorporate
on-balance-sheet items is necessary for that entities, and if a branch of the counterparty
contract. is involved, then also under the law of
If the positive on-balance-sheet asset amount the jurisdiction in which the branch is
exceeds the contract’s market value, the excess located;
(up to the amount of the on-balance-sheet asset) — the law that governs the individual con-
should be included in the appropriate risk- tracts covered by the netting contract; and
weight category. For example, a purchased — the law that governs the netting contract;
option will often have an on-balance-sheet
amount equal to the fee paid until the option • the banking organization establishes and main-
expires. If that amount exceeds market value, tains procedures to ensure that the legal char-
the excess of carrying value over market value acteristics of netting contracts are kept under
would be included in the appropriate risk-weight review in light of possible changes in relevant
category for purposes of the on-balance-sheet law; and
portion of the calculation. • the banking organization maintains documen-
tation in its files that is adequate to support the
netting of rate contracts, including a copy of
the bilateral netting contract and necessary
legal opinions.
April 2000 Trading and Capital-Markets Activities Manual
Page 6
Capital Adequacy 2110.1
A contract containing a walkaway clause is not ognized through the application of a formula
eligible for netting for purposes of calculating that results in an adjusted add-on amount (Anet).
the credit-equivalent amount. The formula, which employs the ratio of net
By netting individual contracts for the pur- current exposure to gross current exposure
pose of calculating credit-equivalent amounts of (NGR), is expressed as:
derivative contracts, a banking organization rep-
resents that it has met the requirements of the Anet = (0.4 × Agross) + 0.6(NGR × Agross)
risk-based measure of the capital adequacy
guidelines for bank holding companies and that The NGR may be calculated in accordance
all the appropriate documents are in the organi- with either the counterparty-by-counterparty
zation’s files and available for inspection by approach or the aggregate approach. Under the
the Federal Reserve. The Federal Reserve may counterparty-by-counterparty approach, the NGR
determine that a banking organization’s files are is the ratio of the net current exposure for a
inadequate or that a netting contract, or any of netting contract to the gross current exposure of
its underlying individual contracts, may not be the netting contract. The gross current exposure
legally enforceable. If such a determination is is the sum of the current exposures of all
made, the netting contract may be disqualified individual contracts subject to the netting con-
from recognition for risk-based capital pur- tract. Net negative mark-to-market values for
poses, or underlying individual contracts may be individual netting contracts with the same coun-
treated as though they are not subject to the terparty may not be used to offset net positive
netting contract. mark-to-market values for other netting con-
The credit-equivalent amount of contracts tracts with the same counterparty.
that are subject to a qualifying bilateral netting Under the aggregate approach, the NGR is
contract is calculated by adding— the ratio of the sum of all the net current
exposures for qualifying bilateral netting con-
• the current exposure of the netting contract tracts to the sum of all the gross current expo-
(net current exposure) and sures for those netting contracts (each gross
• the sum of the estimates of the potential future current exposure is calculated in the same
credit exposures on all individual contracts manner as in the counterparty-by-counterparty
subject to the netting contract (gross potential approach). Net negative mark-to-market values
future exposure) adjusted to reflect the effects for individual counterparties may not be used to
of the netting contract. offset net positive current exposures for other
counterparties.
The net current exposure of the netting contract A banking organization must consistently use
is determined by summing all positive and either the counterparty-by-counterparty approach
negative mark-to-market values of the indi- or the aggregate approach to calculate the NGR.
vidual contracts included in the netting contract. Regardless of the approach used, the NGR
If the net sum of the mark-to-market values is should be applied individually to each qualify-
positive, then the current exposure of the netting ing bilateral netting contract to determine the
contract is equal to that sum. If the net sum of adjusted add-on for that netting contract.
the mark-to-market values is zero or negative, In the event a netting contract covers con-
then the current exposure of the netting contract tracts that are normally excluded from the risk-
is zero. The Federal Reserve may determine that based ratio calculation—for example, exchange-
a netting contract qualifies for risk-based capital rate contracts with an original maturity of 14 or
netting treatment even though certain individual fewer calendar days or instruments traded on
contracts may not qualify. In these instances, the exchanges that require daily payment of cash
nonqualifying contracts should be treated as variation margin—an institution may elect to
individual contracts that are not subject to the either include or exclude all mark-to-market
netting contract. values of such contracts when determining net
Gross potential future exposure or Agross is current exposure, provided the method chosen is
calculated by summing the estimates of poten- applied consistently.
tial future exposure for each individual contract Examiners are to review the netting of off-
subject to the qualifying bilateral netting con- balance-sheet derivative contractual arrange-
tract. The effects of the bilateral netting contract ments used by banking organizations when
on the gross potential future exposure are rec- calculating or verifying risk-based capital ratios
Trading and Capital-Markets Activities Manual April 2000
Page 7
2110.1 Capital Adequacy
to ensure that the positions of such contracts are to the obligor of the reference asset or any
reported gross unless the net positions of those collateral. On the other hand, a bank that owns
contracts reflect netting arrangements that comply the underlying asset upon which effective credit
with the netting requirements listed previously. protection has been acquired through a credit
derivative may, under certain circumstances,
assign the unamortized portion of the underlying
CAPITAL TREATMENT OF asset to the risk category appropriate to the
guarantor (for example, the 20 percent risk
CREDIT DERIVATIVES category if the guarantor is an OECD bank).9
Credit derivatives are off-balance-sheet arrange- Whether the credit derivative is considered an
ments that allow one party (the beneficiary) to eligible guarantee for purposes of risk-based
transfer credit risk of a reference asset—which capital depends on the degree of credit protec-
the beneficiary may or may not own—to another tion actually provided, which may be limited
party (the guarantor). Many banks increasingly depending on the terms of the arrangement. For
use these instruments to manage their overall example, a relatively restrictive definition of a
credit-risk exposure. In general, credit deriva- default event or a materiality threshold that
tives have three distinguishing features: requires a comparably high percentage of loss to
occur before the guarantor is obliged to pay
1. the transfer of the credit risk associated with could effectively limit the amount of credit risk
a reference asset through contingent pay- actually transferred in the transaction. If the
ments based on events of default and, usu- terms of the credit derivative arrangement sig-
ally, the prices of instruments before, at, and nificantly limit the degree of risk transference,
shortly after default (reference assets are then the beneficiary bank cannot reduce the risk
most often traded sovereign and corporate weight of the ‘‘protected’’ asset to that of the
debt instruments or syndicated bank loans) guarantor. On the other hand, even if the transfer
2. the periodic exchange of payments or the of credit risk is limited, a banking organization
payment of a premium rather than the pay- providing limited credit protection through a
ment of fees customary with other off- credit derivative should hold appropriate capital
balance-sheet credit products, such as letters against the underlying exposure while the orga-
of credit nization is exposed to the credit risk of the
3. the use of an International Swap Derivatives reference asset.
Association (ISDA) master agreement and Banking organizations providing a guarantee
the legal format of a derivatives contract through a credit derivative may mitigate the
credit risk associated with the transaction by
For risk-based capital purposes, total-rate-of- entering into an offsetting credit derivative with
return swaps and credit-default swaps generally another counterparty, a so-called ‘‘back-to-
should be treated as off-balance-sheet direct back’’ position. Organizations that have entered
credit substitutes.7 The notional amount of a into such a position may treat the first credit
contract should be converted at 100 percent to derivative as guaranteed by the offsetting trans-
determine the credit-equivalent amount to be action for risk-based capital purposes. Accord-
included in the risk-weighted assets of a guar- ingly, the notional amount of the first credit
antor.8 A bank that provides a guarantee through derivative may be assigned to the risk category
a credit derivative transaction should assign its appropriate to the counterparty providing credit
credit exposure to the risk category appropriate protection through the offsetting credit deriva-
tive arrangement (for example, to the 20 percent
7. Unlike total-rate-of-return swaps and credit-default risk category if the counterparty is an OECD
swaps, credit-linked notes are on-balance-sheet assets or bank).
liabilities. A guarantor bank should assign the on-balance- In some instances, the reference asset in the
sheet amount of the credit-linked note to the risk category
appropriate to either the issuer or the reference asset, which-
credit derivative transaction may not be iden-
ever is higher. For a beneficiary bank, cash consideration tical to the underlying asset for which the
received in the sale of the note may be considered as collateral
for risk-based capital purposes.
8. A guarantor bank that has made cash payments repre- 9. In addition to holding capital against credit risk, a bank
senting depreciation on reference assets may deduct such that is subject to the market-risk rule (see ‘‘Market-Risk
payments from the notional amount when computing credit- Measure,’’ below) must hold capital against market risk for
equivalent amounts for capital purposes. credit derivatives held in its trading account.
April 2000 Trading and Capital-Markets Activities Manual
Page 8
Capital Adequacy 2110.1
beneficiary has acquired credit protection. For est risk category appropriate to the assets in the
example, a credit derivative used to offset the basket. In addition to holding capital against
credit exposure of a loan to a corporate cus- credit risk, a bank that is subject to the market-
tomer may use a publicly traded corporate bond risk rule (see below) must hold capital against
of the customer as the reference asset, whose market risk for credit derivatives held in its
credit quality serves as a proxy for the on- trading account. (For a description of market-
balance-sheet loan. In such a case, the under- risk capital requirements, see SR-97-18).
lying asset will still generally be considered
guaranteed for capital purposes as long as
both the underlying asset and the reference asset CAPITAL TREATMENT OF
are obligations of the same legal entity and
have the same level of seniority in bankruptcy.
SYNTHETIC COLLATERALIZED
In addition, banking organizations offsetting LOAN OBLIGATIONS
credit exposure in this manner would be obli-
Credit derivatives can be used to synthetically
gated to demonstrate to examiners that there
replicate collateralized loan obligations (CLOs).
is a high degree of correlation between the
Banking organizations can use CLOs and their
two instruments; the reference instrument is
synthetic variants to manage their balance sheets
a reasonable and sufficiently liquid proxy for
and, in some instances, transfer credit risk to the
the underlying asset so that the instruments
capital markets. These transactions allow eco-
can be reasonably expected to behave similarly
nomic capital to be allocated more efficiently,
in the event of default; and, at a minimum, the
resulting in, among other things, improved share-
reference asset and underlying asset are subject
holders’ returns. A CLO is an asset-backed
to mutual cross-default provisions. A banking
security that is usually supported by a variety of
organization that uses a credit derivative which
assets, including whole commercial loans,
is based on a reference asset that differs from the
revolving credit facilities, letters of credit, bank-
protected underlying asset must document the
er’s acceptances, or other asset-backed securi-
credit derivative being used to offset credit risk
ties. In a typical CLO transaction, the sponsor-
and must link it directly to the asset or assets
ing banking organization transfers the loans and
whose credit risk the transaction is designed to
other assets to a bankruptcy-remote special-
offset. The documentation and the effectiveness
purpose vehicle (SPV), which then issues asset-
of the credit derivative transaction are subject
backed securities consisting of one or more
to examiner review. Banking organizations
classes of debt. The CLO enables the sponsoring
providing credit protection through such
institution to reduce its leverage and risk-based
arrangements must hold capital against the risk
capital requirements, improve its liquidity, and
exposures that are assumed.
manage credit concentrations.
Some credit derivative transactions provide
The first synthetic CLO issued in 1997 used
credit protection for a group or basket of refer-
credit-linked notes (CLNs).10 Rather than trans-
ence assets and call for the guarantor to absorb
ferring assets to the SPV, the sponsoring bank
losses on only the first asset in the group that
issued CLNs to the SPV, individually referenc-
defaults. Once the first asset in the group defaults,
ing the payment obligation of a particular com-
the credit protection for the remaining assets
pany or ‘‘reference obligor.’’ In that particular
covered by the credit derivative ceases. If
transaction, the notional amount of the CLNs
examiners determine that the credit risk for the
issued equaled the dollar amount of the refer-
basket of assets has effectively been transferred
ence assets the sponsor was hedging on its
to the guarantor and the beneficiary banking
balance sheet. Since that time, other structures
organization owns all of the reference assets
have evolved that also use credit-default swaps
included in the basket, then the beneficiary may
to transfer credit risk and create different levels
assign the asset with the smallest dollar amount
of risk exposure, but that hedge only a portion of
in the group—if less than or equal to the
the notional amount of the overall reference
notional amount of the credit derivative—to
the risk category appropriate to the guarantor.
Conversely, a banking organization extending 10. CLNs are obligations whose principal repayment is
conditioned upon the performance of a referenced asset or
credit protection through a credit derivative on a portfolio. The assets’ performance may be based on a variety
basket of assets must assign the contract’s of measures, such as movements in price or credit spread, or
notional amount of credit exposure to the high- the occurrence of default.
Trading and Capital-Markets Activities Manual April 2000
Page 9
2110.1 Capital Adequacy
portfolio. In most traditional CLO structures, folio, an SPV acquires the credit risk on a
assets are actually transferred into the SPV. In reference portfolio by purchasing CLNs issued
synthetic securitizations, the underlying expo- by the sponsoring banking organization. The
sures that make up the reference portfolio remain SPV funds the purchase of the CLNs by issuing
in the institution’s banking book. The credit risk a series of notes in several tranches to third-
is transferred into the SPV through credit- party investors. The investor notes are in effect
default swaps or CLNs. In this way, the institu- collateralized by the CLNs. Each CLN repre-
tion is able to avoid sensitive client-relationship sents one obligor and the bank’s credit-risk
issues arising from loan-transfer notification exposure to that obligor, which may take the
requirements, loan-assignment provisions, and form of, for example, bonds, commitments,
loan-participation restrictions. Client confiden- loans, and counterparty exposures. Since the
tiality also can be maintained. noteholders are exposed to the full amount of
Under the risk-based capital guidelines, cor- credit risk associated with the individual refer-
porate credits are typically assigned to the ence obligors, all of the credit risk of the
100 percent risk category and are assessed reference portfolio is shifted from the sponsor-
8 percent capital. In the case of high-quality ing bank to the capital markets. The dollar
investment-grade corporate exposures, the 8 per- amount of notes issued to investors equals the
cent capital requirement may exceed the eco- notional amount of the reference portfolio. If
nomic capital that a bank sets aside to cover the there is a default of any obligor linked to a CLN
credit risk of the transaction. Clearly, one of the in the SPV, the institution will call the individual
motivations behind CLOs and other securitiza- note and redeem it based on the repayment
tions is to more closely align the sponsoring terms specified in the note agreement. The term
institution’s regulatory capital requirements with of each CLN is set such that the credit exposure
the economic capital required by the market. to which it is linked matures before the maturity
The introduction of synthetic CLOs has raised of the CLN. This ensures that the CLN will be in
questions about their treatment for purposes of place for the full term of the exposure to which
calculating the leverage and risk-based capital it is linked.
ratios of the Federal Reserve and other banking An investor in the notes issued by the SPV is
agencies.11 In this regard, supervisors and exposed to the risk of default of the underlying
examiners should consider the capital treatment reference assets, as well as to the risk that the
of synthetic CLOs from the perspective of both sponsoring institution will not repay principal at
investors and sponsoring banking organizations the maturity of the notes. Because of the linkage
for three types of transactions: (1) the sponsor- between the credit quality of the sponsoring
ing banking organization, through a synthetic institution and the issued notes, a downgrade of
CLO, hedges the entire notional amount of a the sponsor’s credit rating most likely will result
reference asset portfolio; (2) the sponsoring in the notes also being downgraded. Thus, a
banking organization hedges a portion of the banking organization investing in this type of
reference portfolio and retains a high-quality, synthetic CLO should assign the notes to the
senior risk position that absorbs only those higher of the risk categories appropriate to the
credit losses in excess of the junior-loss posi- underlying reference assets or the issuing entity.
tions; and (3) the sponsoring banking organiza- For purposes of risk-based capital, the spon-
tion retains a subordinated position that absorbs soring banking organizations may treat the cash
first losses in a reference portfolio. Each of these proceeds from the sale of CLNs that provide
transactions is explained more fully below. protection against underlying reference assets as
cash collateralizing these assets.12 This treat-
ment would permit the reference assets, if car-
Entire Notional Amount of the ried on the sponsoring institution’s books, to be
Reference Portfolio Hedged
12. The CLNs should not contain terms that would signifi-
In a synthetic securitization that hedges the cantly limit the credit protection provided against the under-
lying reference assets, for example, a materiality threshold
entire notional amount of the reference port- that requires a relatively high percentage of loss to occur
before CLN payments are adversely affected, or a structuring
of CLN post-default payments that does not adequately pass
11. For more information, see SR-99-32, ‘‘Capital Treat- through credit-related losses on the reference assets to inves-
ment for Synthetic Collateralized Obligations.’’ tors in the CLNs.
April 2000 Trading and Capital-Markets Activities Manual
Page 10
Capital Adequacy 2110.1
assigned to the zero percent risk category to the There may be several levels of loss in this
extent that their notional amount is fully collat- type of synthetic securitization. The first-loss
eralized by cash. This treatment may be applied position may be a small cash reserve, sufficient
even if the cash collateral is transferred directly to cover expected losses, that accumulates over
into the general operating funds of the institu- a period of years and is funded from the excess
tion and is not deposited in a segregated account. of the SPV’s income (that is, the yield on the
The synthetic CLO would not confer any bene- Treasury securities plus the credit-default-swap
fits to the sponsoring banking organization for fee) over the interest paid to investors on the
purposes of calculating its tier 1 leverage ratio notes. The investors in the SPV assume a
because the reference assets remain on the second-loss position through their investment in
organization’s balance sheet. the SPV’s senior and junior notes, which tend to
be rated AAA and BB, respectively. Finally, the
sponsoring banking organization retains a high-
High-Quality, Senior Risk Position in quality, senior risk position that would absorb
the Reference Portfolio Retained any credit losses in the reference portfolio that
exceed the first- and second-loss positions. Typi-
In some synthetic CLOs, the sponsoring bank- cally, no default payments are made until the
ing organization uses a combination of credit- maturity of the overall transaction, regardless of
default swaps and CLNs to essentially transfer when a reference obligor defaults. While opera-
the credit risk of a designated portfolio of its tionally important to the sponsoring banking
credit exposures to the capital markets. This organization, this feature has the effect of ignor-
type of transaction allows the sponsoring insti- ing the time value of money. Thus, when the
tution to allocate economic capital more effi- reference obligor defaults under the terms of the
ciently and to significantly reduce its regulatory credit derivative and the reference asset falls
capital requirements. In this structure, the spon- significantly in value, the sponsoring banking
soring banking organization purchases default organization should, in accordance with gener-
protection from an SPV for a specifically iden- ally accepted accounting principles, make
tified portfolio of banking-book credit expo- appropriate adjustments in its regulatory reports
sures, which may include letters of credit and to reflect the estimated loss relating to the time
loan commitments. The credit risk on the iden- value of money.
tified reference portfolio (which continues to For risk-based capital purposes, banking
remain in the sponsor’s banking book) is trans- organizations investing in the notes must assign
ferred to the SPV through the use of credit- them to the risk weight appropriate to the
default swaps. In exchange for the credit pro- underlying reference assets.14 A banking orga-
tection, the sponsoring institution pays the SPV nization sponsoring such a transaction must
an annual fee. The default swaps on each of the include in its risk-weighted assets its retained
obligors in the reference portfolio are structured senior exposures in the reference portfolio, to
to pay the average default losses on all senior the extent these are held in its banking book.
unsecured obligations of defaulted borrowers. The portion of the reference portfolio that is
To support its guarantee, the SPV sells CLNs to collateralized by the pledged Treasury securities
investors and uses the cash proceeds to purchase may be assigned a zero percent risk weight. The
Treasury notes from the U.S. government. The remainder of the portfolio should be risk
SPV then pledges the Treasuries to the sponsor- weighted according to the obligor of the expo-
ing banking organization to cover any default sures, unless certain stringent minimum condi-
losses.13 The CLNs are often issued in multiple tions are met. When the sponsoring institution
tranches of differing seniority and in an aggre- has virtually eliminated its credit-risk exposure
gate amount that is significantly less than the to the reference portfolio through the issuance of
notional amount of the reference portfolio. The CLNs, and when the other stringent minimum
amount of notes issued typically is set at a level
sufficient to cover some multiple of expected
losses, but well below the notional amount of 14. Under this type of transaction, if a structure exposes
the reference portfolio being hedged. investing banking organizations to the creditworthiness of a
substantive issuer (for example, the sponsoring institution),
then the investing institutions should assign the notes to the
13. The names of corporate obligors included in the refer- higher of the risk categories appropriate to the underlying
ence portfolio may be disclosed to investors in the CLNs. reference assets or the sponsoring institution.
Trading and Capital-Markets Activities Manual April 2000
Page 11
2110.1 Capital Adequacy
requirements are met, the institution may assign adequacy. A failure on the part of the sponsoring
the uncollateralized portion of its retained senior banking organization to require the investors in
position in the reference portfolio to the 20 per- the CLNs to absorb the credit losses that they
cent risk weight. To the extent that the reference contractually agreed to assume may be consid-
portfolio includes loans and other balance-sheet ered an unsafe and unsound banking practice. In
assets in the banking book, a banking organiza- addition, this failure generally would constitute
tion that sponsors this type of synthetic securi- ‘‘implicit recourse’’ or support to the transaction
tization would not realize any benefits with that would result in the sponsoring banking
respect to the determination of its leverage ratio. organization losing the preferential capital treat-
The stringent minimum requirements, which ment on its retained senior position.
are discussed more fully in the annex to SR-99- If an organization sponsoring a synthetic
32, include (1) the probability of loss on the securitization does not meet the stringent mini-
retained senior position is extremely low due to mum criteria outlined in SR-99-32, it still may
the high credit quality of the reference portfolio reduce the risk-based capital requirement on the
and the amount of prior credit protection; senior risk position retained in the banking book
(2) market discipline is injected into the process by transferring the remaining credit risk to a
through the sale of CLNs into the market, the third-party OECD bank through the use of a
most senior of which must be rated AAA by a credit derivative. Provided the credit derivative
nationally recognized credit rating agency; and transaction qualifies as a guarantee under the
(3) the sponsoring institution performs rigorous risk-based capital guidelines, the risk weight on
and robust stress testing and demonstrates that the senior position may be reduced from 100 per-
the level of credit enhancement is sufficient to cent to 20 percent. Institutions may not enter
protect itself from losses under scenarios appro- into nonsubstantive transactions that transfer
priate to the specific transaction. The Federal banking-book items into the trading account to
Reserve may impose other requirements as obtain lower regulatory capital requirements.15
deemed necessary to ensure that the sponsoring
institution has virtually eliminated all of its
credit exposure. Furthermore, supervisors and Retention of a First-Loss Position
examiners retain the discretion to increase the
risk-based capital requirement assessed against In certain synthetic transactions, the sponsoring
the retained senior exposure in these struc- banking organization may retain the credit risk
tures, if the underlying asset pool deteriorates associated with a first-loss position and, through
significantly. the use of credit-default swaps, pass the second-
Based on a qualitative review, Federal Reserve and senior-loss positions to a third-party entity,
staff will determine on a case-by-case basis most often an OECD bank. The third-party
whether the senior retained portion of a spon- entity, acting as an intermediary, enters into
soring banking organization’s synthetic securi- offsetting credit-default swaps with an SPV, thus
tization qualifies for the 20 percent risk weight. transferring its credit risk associated with the
The sponsoring institution must be able to dem- second-loss position to the SPV.16 As described
onstrate that virtually all of the credit risk of the in the second transaction type described above,
reference portfolio has been transferred from the the SPV then issues CLNs to the capital markets
banking book to the capital markets. As is the for a portion of the reference portfolio and
case with organizations engaging in more tradi- purchases Treasury collateral to cover some
tional securitization activities, examiners must
carefully evaluate whether the institution is fully
capable of assessing the credit risk it retains in 15. For instance, a lower risk weight would not be applied
its banking book and whether it is adequately to a nonsubstantive transaction in which the sponsoring
capitalized given its residual risk exposure. institution enters into a credit derivative to pass the credit risk
of the senior retained portion held in its banking book to an
Supervisors will require the sponsoring organi- OECD bank, and then enters into a second credit derivative
zation to maintain higher levels of capital if it is transaction with the same OECD bank in which it reassumes
not deemed to be adequately capitalized given into its trading account the credit risk initially transferred.
the retained residual risks. In addition, an insti- 16. Because the credit risk of the senior position is not
transferred to the capital markets but, instead, remains with
tution sponsoring synthetic securitizations must the intermediary bank, the sponsoring banking organization
adequately disclose to the marketplace the effect should ensure that its counterparty is of high credit quality, for
of the transaction on its risk profile and capital example, at least investment grade.
April 2000 Trading and Capital-Markets Activities Manual
Page 12
Capital Adequacy 2110.1
multiple of expected losses on the underlying depending on whether the reference portfolio
exposures. consists primarily of loans to private obligors, or
Two alternative approaches could be used to undrawn long-term commitments. These com-
determine how the sponsoring banking organi- mitments generally have an effective risk-based
zation should treat the overall transaction for capital requirement that is one-half the require-
risk-based capital purposes. The first approach ment for loans, since they are converted to an
employs an analogy to the low-level capital rule on-balance-sheet credit-equivalent amount using
for assets sold with recourse. Under this rule, a the 50 percent conversion factor. If the reference
transfer of assets with recourse that is contrac- pool consists primarily of drawn loans to com-
tually limited to an amount less than the effec- mercial obligors, then the capital requirement on
tive risk-based capital requirements for the trans- the senior-loss position would be significantly
ferred assets is assessed a total capital charge higher than if the reference portfolio contained
equal to the maximum amount of loss possible only undrawn long-term commitments. As a
under the recourse obligation. If this rule was result, the capital charge for the overall transac-
applied to a sponsoring banking organization tion could be greater than the dollar-for-dollar
retaining a one percent first-loss position on a capital requirement set forth in the first approach.
synthetically securitized portfolio that would Sponsoring institutions are required to hold
otherwise be assessed 8 percent capital, the capital against a retained first-loss position in a
organization would be required to hold dollar- synthetic securitization. The capital should equal
for-dollar capital against the one percent first- the higher of the two capital charges resulting
loss risk position. The sponsoring institution from the sponsoring institution’s application of
would not be assessed a capital charge against the first and second approaches outlined above.
the second and senior risk positions.17 Further, although the sponsoring banking orga-
The second approach employs a literal read- nization retains only the credit-risk associated
ing of the capital guidelines to determine the with the first-loss position, it still should con-
sponsoring banking organization’s risk-based tinue to monitor all the underlying credit expo-
capital charge. In this instance, the one percent sures of the reference portfolio to detect any
first-loss position retained by the sponsoring changes in the credit-risk profile of the counter-
institution would be treated as a guarantee, that parties. This is important to ensure that the
is, a direct credit substitute, which would be institution has adequate capital to protect against
assessed an 8 percent capital charge against its unexpected losses. Examiners should determine
face value of one percent. The second-loss whether the sponsoring bank has the capability
position, which is collateralized by Treasury to assess and manage the retained risk in its
securities, would be viewed as fully collateral- credit portfolio after the synthetic securitization
ized and subject to a zero percent capital charge. is completed. For risk-based capital purposes,
The senior-loss position guaranteed by the banking organizations investing in the notes
intermediary bank would be assigned to the must assign them to the risk weight appropriate
20 percent risk category appropriate to claims to the underlying reference assets.19
guaranteed by OECD banks.18 It is possible that
this approach may result in a higher risk-based
capital requirement than the dollar-for-dollar
capital charge imposed by the first approach— ASSESSING CAPITAL
ADEQUACY AT LARGE,
COMPLEX BANKING
17. A banking organization that sponsors this type of
synthetic securitization would not realize any benefits in the
ORGANIZATIONS
determination of its leverage ratio since the reference assets
themselves remain on the sponsoring institution’s balance Supervisors should place increasing emphasis
sheet. on banking organizations’ internal processes for
18. If the intermediary is a banking organization, then it
could place both sets of credit-default swaps in its trading
account and, if subject to the Federal Reserve’s market-risk
capital rules, use its general market-risk model and, if 19. Under this type of transaction, if a structure exposes
approved, specific-risk model to calculate the appropriate investing banking organizations to the creditworthiness of a
risk-based capital requirement. If the specific-risk model has substantive issuer (for example, the sponsoring institution),
not been approved, then the sponsoring banking organization then the investing institutions should assign the notes to the
would be subject to the standardized specific-risk capital higher of the risk categories appropriate to the underlying
charge. reference assets or the sponsoring institution.
Trading and Capital-Markets Activities Manual April 2000
Page 13
2110.1 Capital Adequacy
assessing risks and for ensuring that capital, the results of this evaluation in the examination
liquidity, and other financial resources are ade- or inspection report.
quate in relation to the organization’s overall For those banking organizations actively
risk profiles. This emphasis is necessary in part involved in complex securitizations, other
because of the greater scope and complexity of secondary-market credit activities, or other com-
business activities, particularly those related to plex transfers of risk, examiners should expect
ongoing financial innovation, at many banking a sound internal process for capital adequacy
organizations. In this setting, one of the most analysis to be in place immediately as a matter
challenging issues bankers and supervisors face of safe and sound banking. Secondary-market
is how to integrate the assessment of an institu- credit activities generally include loan syndica-
tion’s capital adequacy with a comprehensive tions, loan sales and participations, credit deriva-
view of the risks it faces. Simple ratios— tives, and asset securitizations, as well as the
including risk-based capital ratios—and tradi- provision of credit enhancements and liquidity
tional ‘‘rules of thumb’’ no longer suffice in facilities to such transactions. These activi-
assessing the overall capital adequacy of many ties are described further in SR-97-21, ‘‘Risk
banking organizations, especially large institu- Management and Capital Adequacy of Expo-
tions and others with complex risk profiles, such sures Arising from Secondary-Market Credit
as those that are significantly engaged in secu- Activities.’’
ritizations or other complex transfers of risk. Examiners should evaluate whether an orga-
Consequently, supervisors and examiners nization is making adequate progress in assess-
should evaluate internal capital-management pro- ing its capital needs on the basis of the risks
cesses to judge whether they meaningfully tie arising from its business activities, rather than
the identification, monitoring, and evaluation focusing its internal processes primarily on
of risk to the determination of an institution’s compliance with regulatory standards or com-
capital needs. The fundamental elements of a parisons with the capital ratios of peer institu-
sound internal analysis of capital adequacy tions. In addition to evaluating an organization’s
include measuring all material risks, relating current practices, supervisors and examiners
capital to the level of risk, stating explicit capital should take account of plans and schedules to
adequacy goals with respect to risk, and assess- enhance existing capital-assessment processes
ing conformity to an institution’s stated objec- and related risk-measurement systems, with
tives. It is particularly important that large appropriate sensitivity to transition timetables
institutions and others with complex risk pro- and implementation costs. Evaluation of adher-
files be able to assess their current capital ence to schedules should be part of the exam-
adequacy and future capital needs systemati- ination and inspection process. Regardless of
cally and comprehensively, in light of their risk planned enhancements, supervisors should expect
profiles and business plans. For more informa- current internal processes for capital adequacy
tion, see SR-99-18, ‘‘Assessing Capital Ade- assessment to be appropriate to the nature, size,
quacy in Relation to Risk at Large Banking and complexity of an organization’s activities,
Organizations and Others with Complex Risk and to its process for determining the allowance
Profiles.’’ for credit losses.
The practices described in this subsection The results of the evaluation of internal pro-
extend beyond those currently followed by most cesses for assessing capital adequacy should
large banking organizations to evaluate their currently be reflected in the institution’s ratings
capital adequacy. Therefore, supervisors and for management. Examination and inspection
examiners should not expect these institutions reports should contain a brief description of the
to immediately have in place a comprehensive internal processes involved in internal analysis
internal process for assessing capital adequacy. of the adequacy of capital in relation to risk, an
Rather, examiners should look for efforts to assessment of whether these processes are ade-
initiate such a process and thereafter make quate for the complexity of the institution and its
steady and meaningful progress toward a com- risk profile, and an evaluation of the institution’s
prehensive assessment of capital adequacy. efforts to develop and enhance these processes.
Examiners should evaluate an institution’s Significant deficiencies and inadequate progress
progress at each examination or inspection, in developing and maintaining capital-assessment
considering progress relative to both the institu- procedures should be noted in examination and
tion’s former practice and its peers, and record inspection reports. As noted above, examiners
April 2000 Trading and Capital-Markets Activities Manual
Page 14
Capital Adequacy 2110.1
should expect those institutions already engaged to ensure objectivity and consistency and that
in complex activities involving the transfer of all material risks, both on- and off-balance-
risk, such as securitization and related activi- sheet, are adequately addressed.
ties, to have sound internal processes for ana- Banking organizations should conduct
lyzing capital adequacy in place immediately as detailed analyses to support the accuracy or
a fundamental component of safe and sound appropriateness of the risk-measurement tech-
operation. As these processes develop and niques used. Similarly, inputs used in risk
become fully implemented, supervisors and measurement should be of good quality.
examiners should also increasingly rely on Those risks not easily quantified should be
internal assessments of capital adequacy as an evaluated through more subjective, qualita-
integral part of an institution’s capital adequacy tive techniques or through stress testing.
rating. If these internal assessments suggest that Changes in an institution’s risk profile should
capital levels appear to be insufficient to support be incorporated into risk measures on a
the risks taken by the institution, examiners timely basis, whether the changes are due to
should note this finding in examination and new products, increased volumes or changes
inspection reports, discuss plans for correcting in concentrations, the quality of the bank’s
this insufficiency with the institution’s directors portfolio, or the overall economic environ-
and management, and initiate supervisory actions, ment. Thus, measurement should not be ori-
as appropriate. ented to the current treatment of these trans-
actions under risk-based capital regulations.
When measuring risks, institutions should
perform comprehensive and rigorous stress
Fundamental Elements of a Sound tests to identify possible events or changes in
Internal Analysis of Capital Adequacy markets that could have serious adverse
effects in the future. Institutions should also
Because risk-measurement and -management give adequate consideration to contingent
issues are evolving rapidly, it is currently neither exposures arising from loan commitments,
possible nor desirable for supervisors to pre- securitization programs, and other transac-
scribe in detail the precise contents and structure tions or activities that may create these
of a sound and effective internal capital- exposures for the bank.
assessment process for large and complex insti- 2. Relating capital to the level of risk. The
tutions. Indeed, the attributes of sound practice amount of capital held should reflect not only
will evolve over time as methodologies and the measured amount of risk, but also an
capabilities change, and will depend signifi- adequate ‘‘cushion’’ above that amount to
cantly on the individual circumstances of each take account of potential uncertainties in risk
institution. Nevertheless, a sound process for measurement. A banking organization’s capi-
assessing capital adequacy should include four tal should reflect the perceived level of pre-
fundamental elements: cision in the risk measures used, the poten-
tial volatility of exposures, and the relative
1. Identifying and measuring all material risks. importance to the institution of the activities
A disciplined risk-measurement program producing the risk. Capital levels should also
promotes consistency and thoroughness in reflect that historical correlations among
assessing current and prospective risk pro- exposures can rapidly change. Institutions
files, while recognizing that risks often can- should be able to demonstrate that their
not be precisely measured. The detail and approach to relating capital to risk is concep-
sophistication of risk measurement should be tually sound and that outputs and results are
appropriate to the characteristics of an insti- reasonable. An institution could use sensitiv-
tution’s activities and to the size and nature ity analysis of key inputs and peer analysis in
of the risks that each activity presents. At a assessing its approach. One credible method
minimum, risk-measurement systems should for assessing capital adequacy is for an insti-
be sufficiently comprehensive and rigorous tution to consider itself adequately capital-
to capture the nature and magnitude of risks ized if it meets a reasonable and objectively
faced by the institution, while differentiating determined standard of financial health, tem-
risk exposures consistently among risk cate- pered by sound judgment—for example, a
gories and levels. Controls should be in place target public-agency debt rating or even a
Trading and Capital-Markets Activities Manual April 2000
Page 15
2110.1 Capital Adequacy
statistically measured maximum probability to maintain its overall desired capacity to
of becoming insolvent over a given time absorb potential losses. Failure to recognize
horizon. In effect, this latter method is the this relationship could lead an institution
foundation of the Basel Accord’s treatment to overestimate the strength of its capital
of capital requirements for market foreign- position.
exchange risk. 4. Assessing conformity to the institution’s
3. Stating explicit capital adequacy goals with stated objectives. Both the target level and
respect to risk. Institutions need to establish composition of capital, along with the pro-
explicit goals for capitalization as a standard cess for setting and monitoring such targets,
for evaluating their capital adequacy with should be reviewed and approved periodi-
respect to risk. These target capital levels cally by the institution’s board of directors.
might reflect the desired level of risk cover-
age or, alternatively, a desired credit rating
for the institution that reflects a desired Risks Addressed in a Sound Internal
degree of creditworthiness and, thus, access Analysis of Capital Adequacy
to funding sources. These goals should be
reviewed and approved by the board of Sound internal risk-measurement and capital-
directors. Because risk profiles and goals assessment processes should address the full
may differ across institutions, the chosen range of risks faced by an institution. The four
target levels of capital may differ signifi- risks listed below do not represent an exhaustive
cantly as well. Moreover, institutions should list of potential issues that should be addressed.
evaluate whether their long-run capital tar- The capital regulations of the Federal Reserve
gets might differ from short-run goals, based and other U.S. banking agencies refer to many
on current and planned changes in risk pro- specific factors and other risks that institutions
files and the recognition that accommodating should consider in assessing capital adequacy.
new capital needs can require significant lead
time. • Credit risk. Internal credit-risk-rating systems
In addition, capital goals and the monitor- are vital to measuring and managing credit
ing of performance against those goals should risk at large banking organizations. Accord-
be integrated with the methodology used to ingly, a large institution’s internal ratings
identify the adequacy of the allowance for system should be adequate to support the
credit losses (the allowance). Although both identification and measurement of risk for its
the allowance and capital represent the abil- lending activities and adequately integrated
ity to absorb losses, insufficiently clear dis- into the institution’s overall analysis of capital
tinction of their respective roles in absorbing adequacy. Well-structured credit-risk-rating
losses can distort analysis of their adequacy. systems should reflect implicit, if not explicit,
For example, an institution’s internal stan- judgments of loss probabilities or expected
dard of capital adequacy for credit risk could loss, and should be supported where possible
reflect the desire that capital absorb ‘‘unex- by quantitative analyses. Definitions of risk
pected losses,’’ that is, some level of poten- ratings should be sufficiently detailed and
tial losses in excess of that level already descriptive, applied consistently, and regularly
estimated as being inherent in the current reviewed for consistency throughout the insti-
portfolio and reflected in the allowance.20 In tution. SR-98-25, ‘‘Sound Credit-Risk Man-
this setting, an institution that does not main- agement and the Use of Internal Credit-Risk
tain its allowance at the high end of the range Ratings at Large Banking Organizations,’’
of estimated credit losses would require more discusses the need for banks to have suffi-
capital than would otherwise be necessary ciently detailed, consistent, and accurate risk
ratings for all loans, not only for criticized or
20. In March 1999, the banking agencies and the Securities
problem credits. It describes an emerging
and Exchange Commission issued a joint interagency letter to sound practice of incorporating such ratings
financial institutions stressing that depository institutions information into internal capital frameworks,
should have prudent and conservative allowances that fall recognizing that riskier assets require higher
within an acceptable range of estimated losses. The Federal
Reserve has issued additional guidance on credit-loss allow-
capital levels.
ances to supervisors and bankers in SR-99-13, ‘‘Recent Banking organizations should also take full
Developments Regarding Loan-Loss Allowances.’’ account of credit risk arising from securitiza-
April 2000 Trading and Capital-Markets Activities Manual
Page 16
Capital Adequacy 2110.1
tion and other secondary-market credit activi- the importance of assessing interest-rate risk
ties, including credit derivatives. Maintaining to the economic value of a banking organiza-
detailed and comprehensive credit-risk mea- tion’s capital and, in particular, sound practice
sures is most necessary at institutions that in selecting appropriate interest-rate scenarios
conduct asset securitization programs, due to be applied for capital adequacy purposes.
to the potential of these activities to greatly • Operational and other risks. Many banking
change—and reduce the transparency of—the organizations see operational risk—often
risk profile of credit portfolios. SR-97-21, viewed as any risk not categorized as credit or
‘‘Risk Management and Capital Adequacy of market risk—as second in significance only to
Exposures Arising from Secondary-Market credit risk. This view has become more widely
Credit Activities,’’ states that such changes held in the wake of recent, highly visible
have the effect of distorting portfolios that breakdowns in internal controls and corporate
were previously ‘‘balanced’’ in terms of credit governance by internationally active institu-
risk. As used here, the term ‘‘balanced’’ refers tions. Although operational risk does not eas-
to the overall weighted mix of risks assumed ily lend itself to quantitative measurement, it
in a loan portfolio by the current regulatory can have substantial costs to banking organi-
risk-based capital standard. This standard, for zations through error, fraud, or other perfor-
example, effectively treats the commercial mance problems. The great dependence of
loan portfolios of all banks as having ‘‘typi- banking organizations on information tech-
cal’’ levels of risk. The current capital stan- nology systems highlights only one aspect of
dard treats most loans alike; consequently, the growing need to identify and control this
banks have an incentive to reduce their regu- operational risk.
latory capital requirements by securitizing
or otherwise selling lower-risk assets, while
increasing the average level of remaining
credit risk through devices like first-loss posi- Examiner Review of Internal Analysis
tions and contingent exposures. It is impor- of Capital Adequacy
tant, therefore, that these institutions have the
ability to assess their remaining risks and hold Supervisors and examiners should review inter-
levels of capital and allowances for credit nal processes for capital assessment at large and
losses. These institutions are at the frontier of complex banking organizations, as well as the
financial innovation, and they should also be adequacy of their capital and their compliance
at the frontier of risk measurement and inter- with regulatory standards, as part of the regular
nal capital allocation. supervisory process. In general, this review
• Market risk. The current regulatory capital should assess the degree to which an institution
standard for market risk (see ‘‘Market-Risk has in place, or is making progress toward
Measure,’’ below) is based largely on a bank’s implementing, a sound internal process to assess
own measure of value-at-risk (VAR). This capital adequacy as described above. Examiners
approach was intended to produce a more should briefly describe in the examination or
accurate measure of risk and one that is also inspection report the approach and internal pro-
compatible with the management practices of cesses used by an institution to assess its capi-
banks. The market-risk standard also empha- tal adequacy with respect to the risks it takes.
sizes the importance of stress testing as a Examiners should then document their evalua-
critical complement to a mechanical VAR- tion of the adequacy and appropriateness of
based calculation in evaluating the adequacy these processes for the size and complexity of
of capital to support the trading function. the institution, along with their assessment
• Interest-rate risk. Interest-rate risk within the of the quality and timing of the institution’s
banking book (that is, in nontrading activities) plans to develop and enhance its processes for
should also be closely monitored. The bank- evaluating capital adequacy with respect to risk.
ing agencies have emphasized that banks In all cases, the findings of this review should be
should carefully assess the risk to the eco- considered in determining the institution’s
nomic value of their capital from adverse supervisory rating for management. Over time,
changes in interest rates. The ‘‘Joint Policy this review should also become an integral
Statement on Interest-Rate Risk,’’ SR-96-13, element of assessing and assigning a supervi-
provides guidance in this matter that includes sory rating for capital adequacy as the institution
Trading and Capital-Markets Activities Manual April 2000
Page 17
2110.1 Capital Adequacy
develops appropriate processes for establishing of tier 1 limitations, adverse capital-market
capital targets and analyzing its capital ade- responses, and other such magnification effects.
quacy as described above. If an institution’s Finally, supervisors should consider the quality
internal assessments suggest that capital levels of the institution’s management information
appear to be insufficient to support its risk reporting and systems, the manner in which
positions, examiners should note this finding in business risks and activities are aggregated, and
examination and inspection reports, discuss plans management’s record in responding to emerging
for correcting this insufficiency with the institu- or changing risks.
tion’s directors and management, and, as appro- In performing this review, supervisors and
priate, initiate follow-up supervisory actions. examiners should be careful to distinguish
Supervisors and examiners should assess the between (1) a comprehensive process that seeks
degree to which internal targets and processes to identify an institution’s capital requirements
incorporate the full range of material risks faced on the basis of measured economic risk, and
by a banking organization. Examiners should (2) one that focuses only narrowly on the
also assess the adequacy of risk measures used calculation and use of allocated capital (also
in assessing internal capital adequacy for this known as ‘‘economic value added’’ or EVA) for
purpose, and the extent to which these risk individual products or business lines for internal
measures are also used operationally in setting profitability analysis. The latter approach, which
limits, evaluating business-line performance, and measures the amount by which operations or
evaluating and controlling risk more generally. projects return more or less than their cost of
Measurement systems that are in place but are capital, can be important to an organization in
not integral to an institution’s risk management targeting activities for future growth or cut-
should be viewed with some skepticism. Super- backs. However, it requires that the organization
visors and examiners should review whether an first determine by some method the amount of
institution treats similar risks across products capital necessary for each activity or business
and/or business lines consistently, and whether line. Moreover, an EVA approach often is unable
changes in the institution’s risk profile are fully to meaningfully aggregate the allocated capital
reflected in a timely manner. Finally, supervisors across business lines and risk types as a tool for
and examiners should consider the results of evaluating the institution’s overall capital ade-
sensitivity analyses and stress tests conducted quacy. Supervisors and examiners should there-
by the institution, and how these results relate to fore focus on the first process above and should
capital plans. not be confused with related efforts of manage-
In addition to being in compliance with reg- ment to measure relative returns of the firm or of
ulatory capital ratios, banking organizations individual business lines, given an amount of
should be able to demonstrate through internal capital already invested or allocated.
analysis that their capital levels and composition
are adequate to support the risks they face, and
that these levels are properly monitored and
reviewed by directors. Supervisors and examin- MARKET-RISK MEASURE
ers should review this analysis, including the
target levels of capital chosen, to determine In August 1996, the Federal Reserve amended
whether it is sufficiently comprehensive and its risk-based capital framework to incorporate a
relevant to the current operating environment. measure for market risk. (See 12 CFR 208,
Supervisors and examiners should also consider appendix E, for state member banks and 12 CFR
the extent to which an institution has provided 225, appendix E, for bank holding companies.)
for unexpected events in setting its capital lev- As described more fully below, certain institu-
els. In this connection, the analysis should cover tions with significant exposure to market risk
a sufficiently wide range of external conditions must measure that risk using their internal
and scenarios, and the sophistication of tech- value-at-risk (VAR) measurement model and,
niques and stress tests used should be commen- subject to parameters contained in the market-
surate with the institution’s activities. Consider- risk rules, hold sufficient levels of capital to
ation of such conditions and scenarios should cover the exposure. The market-risk amendment
take appropriate account of the possibility that is a supplement to the credit risk-based capital
adverse events may have disproportionate effects rules: An institution applying the market-risk
on overall capital levels, such as the effect rules remains subject to the requirements of the
April 2000 Trading and Capital-Markets Activities Manual
Page 18
Capital Adequacy 2110.1
credit-risk rules, but must adjust its risk-based Covered Positions
capital ratio to reflect market risk.21
For supervisory purposes, a covered banking
organization must hold capital to support its
Covered Banking Organizations exposure to general market risk arising from
fluctuations in interest rates, equity prices,
The market-risk rules apply to any insured state foreign-exchange rates, and commodity prices,
member bank or bank holding company whose including risk associated with all derivative
trading activity (on a worldwide consolidated positions. In addition, capital must support its
basis) equals (1) 10 percent or more of its total exposure to specific risk arising from changes in
assets or (2) $1 billion or more. For purposes of the market value of debt and equity positions in
these criteria, a banking organization’s trading the trading account due to factors other than
activity is defined as the sum of its trading assets broad market movements, including the credit
and trading liabilities as reported in its most risk of an instrument’s issuer. An institution’s
recent Consolidated Report of Condition and covered positions include all of its trading-
Income (call report) for a bank or in its most account positions as well as all foreign-exchange
recent Y-9C report for a bank holding company. and commodity positions, whether or not they
Total assets means quarter-end total assets as are in the trading account.
most recently reported by the institution. When For market-risk capital purposes, an institu-
addressing this capital requirement, bank hold- tion’s trading account is defined in the instruc-
ing companies should include any section 20 tions to the banking agencies’ call report. In
subsidiary as well as any other subsidiaries general, the trading account includes on- and
consolidated in their FR Y-9 reports. off-balance-sheet positions in financial instru-
In addition, on a case-by-case basis, the ments acquired with the intent to resell in order
Federal Reserve may require an institution that to profit from short-term price or rate move-
does not meet the applicability criteria to com- ments (or other price or rate variations). All
ply with the market-risk rules if it deems it positions in the trading account must be marked
necessary for safety-and-soundness reasons, or to market and reflected in an institution’s earn-
may exclude an institution that meets the appli- ings statement. Debt positions in the trading
cability criteria if its recent or current exposure account include instruments such as fixed or
is not reflected by the level of its ongoing floating-rate debt securities, nonconvertible pre-
trading activity. Institutions most likely to be ferred stock, certain convertible bonds, or
exempted from this capital requirement are small derivative contracts of debt instruments. Equity
banks whose reported trading activities exceed positions in the trading account include instru-
the 10 percent criterion but whose management ments such as common stock, certain convert-
of trading risks does not raise supervisory con- ible bonds, commitments to buy or sell equities,
cerns. Such banks may be those whose trading or derivative contracts of equity instruments. An
activities focus on maintaining a market in local institution may include in its measure for gen-
municipal securities, but who are not otherwise eral market risk certain nontrading account
actively engaged in trading or position-taking instruments that it deliberately uses to hedge
activities. However, before making any excep- trading activities. Those instruments are not
tions to the criteria, Reserve Banks should subject to a specific-risk capital charge, but
consult with Board staff. An institution that does instead continue to be included in risk-weighted
not meet the applicability criteria may, subject assets under the credit-risk framework.
to supervisory approval, comply voluntarily with The market-risk capital charge applies to all
the market-risk rules. An institution applying of an institution’s foreign-exchange and com-
the market-risk rules must have its internal- modities positions. An institution’s foreign-
model and risk-management procedures evalu- exchange positions include, for each currency,
ated by the Federal Reserve to ensure compli- items such as its net spot position (including
ance with the rules. ordinary assets and liabilities denominated in a
foreign currency), forward positions, guarantees
that are certain to be called and likely to be
21. An institution adjusts its risk-based capital ratio by
removing certain assets from its credit-risk weight categories
unrecoverable, and any other items that react
and, instead, including those assets (and others) in the primarily to changes in exchange rates. An
measure for market risk. institution may, subject to examiner approval,
Trading and Capital-Markets Activities Manual April 2000
Page 19
2110.1 Capital Adequacy
exclude from the market-risk measure any struc- VAR calculated under the regulatory criteria, but
tural positions in foreign currencies. For this without the multiplication factor. An institu-
purpose, structural positions include transac- tion’s multiplication factor is three unless its
tions designed to hedge an institution’s capital backtesting 22 results or supervisory judgment
ratios against the effect of adverse exchange-rate indicate that a higher factor or other action is
movements on (1) subordinated debt, equity, or appropriate.
minority interests in consolidated subsidiaries An institution’s risk-based capital ratio
and capital assigned to foreign branches that are numerator consists of a combination of core
denominated in foreign currencies, and (2) any (tier 1) capital; supplemental (tier 2) capital; and
positions related to unconsolidated subsidiaries a third tier of capital (tier 3), which may only
and other items that are deducted from an be used to meet market-risk capital require-
institution’s capital when calculating its capital ments. To qualify as capital, instruments must
base. An institution’s commodity positions be unsecured and may not contain or be covered
include all positions, including derivatives, that by any covenants, terms, or restrictions that are
react primarily to changes in commodity prices. inconsistent with safe and sound banking prac-
tices. Tier 3 capital is subordinated debt with an
original maturity of at least two years. It must be
fully paid up and subject to a lock-in clause that
Adjustment to the Risk-Based Capital prevents the issuer from repaying the debt even
Calculation at maturity if the issuer’s capital ratio is, or with
repayment would become, less than the mini-
An institution applying the market-risk rules mum 8.0 percent risk-based capital ratio.
must measure its market risk and, on a daily An institution must satisfy the overall condi-
basis, hold capital to maintain an overall mini- tions that at least 50 percent of its total qualify-
mum 8.0 percent ratio of total qualifying capital ing capital must be tier 1 capital and term
to risk-weighted assets adjusted for market risk. subordinated debt (excluding mandatory convert-
An institution’s risk-based capital ratio ible debt), and intermediate term preferred stock
denominator is its adjusted credit-risk-weighted (and related surplus) may not exceed 50 percent
assets plus its market-risk-equivalent assets. of tier 1 capital. In addition, an institution’s
Adjusted risk-weighted assets are risk-weighted tier 3 capital must not exceed 250 percent of its
assets, as determined under the credit-risk-based tier 1 capital allocated for market risk (that is,
capital standards, less the risk-weighted amounts tier 3 capital is limited to 71.4 percent of the
of all covered positions other than foreign- institution’s measure for market risk).23
exchange positions outside the trading account
and over-the-counter (OTC) derivatives. (In other
words, an institution should not risk weight (or Internal Models
could risk weight at zero percent) any nonderiva-
tive debt, equity, or foreign-exchange positions An institution applying the market-risk rules
in its trading account and any nonderivative must use its internal model to measure its daily
commodity positions whether in or out of the VAR in accordance with the rule’s requirements.
trading account. These positions are no longer However, institutions can and will use different
subject to a credit-risk capital charge.) An insti- assumptions and modeling techniques when
tution’s market-risk-equivalent assets is its mea- determining their VAR measures for internal
sure for market risk (determined as discussed in
the following sections) multiplied by 12.5 (the
reciprocal of the minimum 8.0 percent capital 22. Beginning one year after an institution begins to apply
ratio). the market-risk rules, it must begin ‘‘backtesting’’ its VAR
An institution’s measure for market risk is a measures generated for internal risk-management purposes
against actual trading results to assist in evaluating the
VAR-based capital charge plus an add-on capital accuracy of its internal model.
charge for specific risk. The VAR-based capital 23. The market-risk rules (12 CFR 208 appendix E, section
charge is the larger of either (1) the average 3(b)(2)) discuss ‘‘allocating’’ capital to cover credit risk and
VAR measure for the last 60 business days, market risk. The allocation terminology is only relevant for
the limit on tier 3 capital. Otherwise, as long as the 50 percent
calculated under the regulatory criteria and tier 1 and tier 2/tier 3 condition is satisfied, there is no
increased by a multiplication factor ranging requirement that an institution must allocate or identify its
from three to four, or (2) the previous day’s capital for credit or market risk.
April 2000 Trading and Capital-Markets Activities Manual
Page 20
Capital Adequacy 2110.1
risk-management purposes. These differences and risk-management committees and minutes.
often reflect distinct business strategies and The review of committee minutes provides
approaches to risk management. For example, insights into the level of discussion of market-
an institution may calculate VAR using an risk issues by senior management and, in some
internal model based on variance-covariance cases, by outside directors of the institution.
matrices, historical simulations, Monte Carlo An institution must have an internal model
simulations, or other statistical approaches. In that is fully integrated into its daily manage-
all cases, however, the model must cover the ment, must have policies and procedures for
institution’s material risks.24 Where shortcom- conducting appropriate stress tests and backtests
ings exist, the use of the model for the calcula- and for responding to the results of those tests,
tion of general market risk may be allowed, and must conduct independent reviews of its
subject to certain conditions designed to cor- risk-management and -measurement systems at
rect deficiencies in the model within a given least annually. An institution should develop
timeframe. and use those stress tests appropriate to its
The market-risk rules do not specify model- particular situation. Thus, the market-risk rules
ing parameters for an institution’s internal risk- do not include specific stress-test methodologies.
management purposes. However, the rules do An institution’s stress tests should be rigorous
include minimum qualitative requirements for and comprehensive enough to cover a range of
internal risk-management processes, as well as factors that could create extraordinary losses in
certain quantitative requirements for the param- a trading portfolio, or that could make the
eters and assumptions for internal models used control of risk in a portfolio difficult. The review
to measure market-risk exposure for regulatory of stress testing is important, given that VAR-
capital purposes. Examiners should verify that based models are designed to measure market
an institution’s risk-measurement model and risk in relatively stable markets (for example, at
risk-management system conform to the mini- a 99 percent confidence interval, as prescribed in
mum qualitative and quantitative requirements the market-risk amendment to the capital rules).
discussed below. However, sound risk-management practices
require analyses of wider market conditions.
Examiners should review the institution’s poli-
Qualitative Requirements cies and procedures for conducting stress tests
and assess the timeliness and frequency of stress
The qualitative requirements reiterate several tests, the comprehensive capture of traded posi-
basic components of sound risk management tions and parameters (for example, changes in
discussed in earlier sections of this manual. For risk factors), and the dissemination and use of
example, an institution must have a risk-control testing results. Examiners should pay particular
unit that reports directly to senior management attention to whether stress tests result in an
and is independent from business-trading func- effective management tool for controlling expo-
tions. The risk-control unit is expected to con- sure and their ‘‘plausibility’’ in relation to the
duct regular backtests to evaluate the model’s institution’s risk profile. Stress testing continues
accuracy and conduct stress tests to identify the to be more of an art than a science, and the role
impact of adverse market events on the institu- of the examiner is to ensure that institutions
tion’s portfolio. An in-depth understanding of have the appropriate capabilities, processes, and
the risk-control unit’s role and responsibilities is management oversight to conduct meaningful
completed through discussions with the institu- stress testing.
tion’s market-risk and senior management teams Stress tests should be both qualitative and
and through the review of documented policies quantitative, incorporate both market risk and
and procedures. In addition, examiners should liquidity aspects of market disturbances, and
review the institution’s organizational structure reflect the impact of an event on positions with
either linear or nonlinear price characteristics.
24. For institutions using an externally developed or out- Examiners should assess whether banks are in a
sourced risk-measurement model, the model may be used for position to conduct three types of broad stress
risk-based capital purposes provided it complies with the tests—those incorporating (1) historical events,
requirements of the market-risk rules, management fully
understands the model, the model is integrated into the
using market data from the respective time
institution’s daily risk management, and the institution’s periods; (2) hypothetical events, using ‘‘market
overall risk-management process is sound. data’’ constructed by the institution to model
Trading and Capital-Markets Activities Manual April 2000
Page 21
2110.1 Capital Adequacy
extreme market events that would pose a sig- example, its treatment of nonlinear risks or its
nificant financial risk to the institution; and approach to stress testing) and its ongoing com-
(3) institution-specific analysis, based on the pliance with the market-risk capital rule. These
institution’s portfolios, that identifies key vul- discussions are particularly important during
nerabilities. When stress tests reveal a particular turbulent markets where exposures and capital
vulnerability, the institution should take effec- may be affected by dramatic swings in market
tive steps to appropriately manage those risks. volatility.
An institution’s independent review of its In order to monitor compliance with the
risk-management process should include the market-risk amendment and to further their
activities of business-trading units and the risk- understanding of market-risk exposures, super-
control unit. Examiners should verify that an visors should make quarterly requests to insti-
institution’s review includes assessing whether tutions subject to the market-risk amendment for
its risk-management system is fully integrated the following information:
into the daily management process and whether
the system is adequately documented. Examiner • total trading gain or loss for the quarter (net
assessments of the integration of risk models interest income from trading activities plus
into the daily market-risk-management process realized and unrealized trading gain or loss)
is a fundamental component of the review for • average risk-based capital charge for market
compliance with the market-risk capital rule. As risk during the quarter
a starting point, examiners should review the • market-risk capital charge for specific risk
risk reports that are generated by the institu- during the quarter
tion’s internal model to assess the ‘‘stratifica- • market-risk capital charge for general risk
tion,’’ or level of detail of information provided during the quarter
to different levels of management, from head
• average one-day VAR for the quarter
traders to senior managers and directors. The
review should evaluate the organizational struc- • maximum one-day VAR for the quarter
ture of the risk-control unit and analyze the • largest one-day loss during the quarter and the
approval process for risk-pricing models and VAR for the preceding day
valuation systems. The institution’s review • the number of times the loss exceeded the
should consider the scope of market risks cap- one-day VAR during the quarter, and for each
tured by the risk-measurement model; accuracy occurrence, the amount of the loss and the
and completeness of position data; verification prior day’s VAR
of the consistency, timeliness, and reliability of • the cause of backtesting exceptions, either by
data sources used to run the internal model; portfolio or major risk factor (for example,
accuracy and appropriateness of volatility and volatility in the S&P 500)
correlation assumptions; and validity of valua- • the market-risk multiplier currently in use
tion and risk-transformation calculations. Exam-
iners should assess the degree to which the If significant deficiencies are uncovered, exam-
institution’s methodology serves as the basis for iners may require the institution’s audit group to
trading limits allocated to the various trading- enhance the scope and independence of its
business units. Examiners should review this market-risk review processes. If the audit or
limit structure to assess its coverage of risk independent review function lacks expertise in
sensitivities within the trading portfolio. In addi- this area, examiners may require that the insti-
tion, examiners should assess the limit- tution outsource this review to a qualified inde-
development and -monitoring mechanisms to pendent consultant. Follow-up discussions are
ensure that positions versus limits and exces- held with the institution once appropriate review
sions are appropriately documented and scopes are developed and upon the completion
approved. of such reviews.
In addition to formal reviews, examiners and
specialist teams may hold regular discussions
with institutions regarding their market-risk
exposures and the methodologies they employ Quantitative Requirements
to measure and control these risks. These dis-
cussions enable supervisors to remain abreast of To ensure that an institution with significant
the institution’s changes in methodology (for market risk holds prudential levels of capital and
April 2000 Trading and Capital-Markets Activities Manual
Page 22
Capital Adequacy 2110.1
that regulatory capital charges for market risk • VAR measures may incorporate empirical cor-
are consistent across institutions with similar relations (calculated from historical data on
exposures, an institution’s VAR measures must rates and prices) both within and across broad
meet the following quantitative requirements: risk categories, subject to examiner confirma-
tion that the model’s system for measuring
• The VAR methodology must be commensu- such correlation is sound. If an institution’s
rate with the nature and size of the insti- model does not incorporate empirical correla-
tution’s trading activities and risk profile. tions across risk categories, then the institu-
Because the capital rules do not prescribe a tion must calculate the VAR measures by
particular VAR methodology, the institution summing the separate VAR measures for the
can use generally accepted techniques, such as broad risk categories (that is, interest rates,
variance-covariance, historical simulation, and equity prices, foreign-exchange rates, and com-
Monte Carlo simulations. modity prices).
• VAR measures must be computed each busi-
ness day based on a 99 percent (one-tailed) During the examination process, examiners
confidence level of estimated maximum loss. should review an institution’s risk-management
• VAR measures must be based on a price shock process and internal model to ensure that it
equivalent to a 10-day movement in rates and processes all relevant data and that modeling
prices. The Federal Reserve believes that and risk-management practices conform to the
shorter periods do not adequately reflect the parameters and requirements of the market-
price movements that are likely during periods risk rule. When reviewing an internal model
of market volatility and that they would sig- for risk-based capital purposes, examiners may
nificantly understate the risks embedded in consider reports and opinions about the accu-
options positions, which display nonlinear racy of an institution’s model that have been
price characteristics. The Board recognizes, generated by external auditors or qualified
however, that it may be overly burdensome consultants.
for institutions to apply precise 10-day price If a banking institution does not fully comply
or rate movements to options positions at this with a particular standard, examiners should
time and, accordingly, will permit institutions review the banking institution’s plan for meet-
to estimate one-day price movements using ing the requirement of the market-risk amend-
the ‘‘square root of time’’ approach.25 As ment. These reviews should be tailored to the
banks enhance their modeling techniques, institution’s risk profile (for example, its level of
examiners should consider whether they are options activity) and methodologies.
making substantive progress in developing In reviewing the model’s ability to capture
adequate and more robust methods for identi- optionality, examiners’ reviews should identify
fying nonlinear price risks. Such progress is the subportfolios in which optionality risk is
particularly important at institutions with siz- present and review the flow of deal data to the
able options positions. risk model and the capture of higher-order risks
• VAR measures must be based on a minimum (for example, gamma and vega) within VAR.
historical observation period of one year Where options risks are not fully captured, the
for estimating future price and rate changes. institutions should identify and quantify these
If historical market movements are not risks and identify corrective-action plans to
weighted evenly over the observation period, incorporate the risks. Examiners should review
the weighted average for the observation the calculation of volatilities (implied or histori-
period must be at least six months, which is cal), sources of this data (liquid or illiquid
equivalent to the average for the minimum markets), and measurement of implied price
one-year observation period. volatility along varying strike prices. The under-
• An institution must update its model data at standing of the institution’s determination of
least once every three months and more fre- volatility smiles and skewness is a basic tenet
quently if market conditions warrant. in assessing a VAR model’s reasonableness if
optionality risk is material. Volatility smiles
reflect the phenomenon that out-of-the-market
25. For example, under certain statistical assumptions, an
institution can estimate the 10-day price volatility of an
and in-the-market options both have higher
instrument by multiplying the volatility calculated on one-day volatilities than at-the-market options. Volatility
changes by the square root of 10 (approximately 3.16). skew refers to the differential patterns of implied
Trading and Capital-Markets Activities Manual April 2000
Page 23
2110.1 Capital Adequacy
volatilities between out-of-the-market calls and may use the market-risk factors it has deter-
out-of-the-market puts. mined affect the value of its positions and the
The examiners should review the institution’s risks to which it is exposed. However, examin-
methodology for aggregating VAR estimates ers should confirm that an institution is using
across the entire portfolio. The institution should sufficient risk factors to cover the risks inherent
have well-documented policies and procedures in its portfolio. For example, examiners should
governing its aggregation process, including the verify that interest-rate-risk factors correspond
use of correlation assumptions. The inspection to interest rates in each currency in which the
of correlation assumptions is accomplished institution has interest-rate-sensitive positions.
through a review of the institution’s documented The risk-measurement system should model the
testing of correlation assumptions and select- yield curve using one of a number of generally
transaction testing when individual portfolios accepted approaches, such as by estimating
are analyzed to gauge the effects of correlation forward rates or zero-coupon yields, and should
assumptions. Although the summation of port- incorporate risk factors to capture spread risk.
folio VARs is permitted under the capital rules, The yield curve should be divided into various
the aggregation of VAR measures generally maturity segments to capture variation in the
overstates risk and may represent an ineffective volatility of rates along the yield curve. For
risk-management tool. Examiners should encour- material exposure to interest-rate movements in
age institutions to develop more rigorous and the major currencies and markets, modeling
appropriate correlation estimates to arrive at a techniques should capture at least six segments
more meaningful portfolio VAR. of the yield curve.
The aggregation processes utilized by bank- The internal model should incorporate risk
ing institutions may also be subject to certain factors corresponding to individual foreign cur-
‘‘missing risks,’’ resulting in an understatement rencies in which the institution’s positions are
of risk in the daily VAR. Examiners should denominated, each of the equity markets in
understand the aggregation process through dis- which the institution has significant positions (at
cussions with risk-management personnel and a minimum, a risk factor should capture market-
reviews of models-related documents. Examin- wide movements in equity prices), and each of
ers should identify key control points, such as the commodity markets in which the institution
timely updating and determination of correlation has significant positions. Risk factors should
statistics, that may result in the misstatement of measure the volatilities of rates and prices under-
portfolio VAR. lying options positions. An institution with a
Examiners should evaluate the institution’s large or complex options portfolio should mea-
systems infrastructure and its ability to support sure the volatilities of options positions by
the effective aggregation of risk across trading different maturities. The sophistication and
portfolios. They should also review the systems nature of the modeling techniques should corre-
architecture to identify products that are cap- spond to the level of the institution’s exposure.
tured through automated processes and those
that are captured in spreadsheets or maintained
in disparate systems. This review is important in
order to understand the aggregation processes, Backtesting
including the application of correlations, and its
impact on the timeliness and accuracy of risk- One year after beginning to apply the market-
management reports. risk rules, an institution will be required to
backtest VAR measures that have been calcu-
lated for its internal risk-management purposes.
The results of the backtests will be used to
Market-Risk Factors evaluate the accuracy of the institution’s internal
model, and may result in an adjustment to the
For risk-based capital purposes, an institution’s institution’s VAR multiplication factor used for
internal model must use risk factors that address calculating regulatory capital requirements. Spe-
market risk associated with interest rates, equity cifically, the backtests must compare the insti-
prices, exchange rates, and commodity prices, tution’s daily VAR measures calculated for
including the market risk associated with options internal purposes, calibrated to a one-day move-
in each of these risk categories. An institution ment in rates and prices and a 99 percent
April 2000 Trading and Capital-Markets Activities Manual
Page 24
Capital Adequacy 2110.1
(one-tailed) confidence level, against the insti- size and cause of the exception and any correc-
tution’s actual daily net trading profit or loss for tive action taken to improve the assumptions or
the past year (that is, the preceding 250 business risk factor inputs underlying the VAR model.
days). In addition to recording daily gains and
losses arising from changes in market valuations
of the trading portfolio, net trading profits (or
losses) may include items such as fees and Specific Risk
commissions and earnings from bid/ask spreads.
These backtests must be performed each quarter. An institution may use its internal model to
Examiners should review the institution’s back- calculate specific risk if it can demonstrate that
testing results at both the portfolio and subport- the model sufficiently captures the changes in
folio (for example, business-line) levels. Although market values for covered debt and equity
not required under the capital rules, subportfolio instruments and related derivatives (for exam-
backtesting provides management and exam- ple, credit derivatives) due to factors other than
iners with deeper insight into the causes of broad market movements. These factors include
exceptions. It also gives examiners a framework idiosyncratic price variation and event/default
within which to discuss with risk managers the risk. The capital rules also stipulate that the
adequacy of the institution’s modeling assump- model should explain the historical price varia-
tions as well as issues of position valuation and tion in the portfolio and capture potential con-
profit attribution at the business-line level. centrations, including magnitude and changes
Examiners should review the profit-and-loss in composition. Finally, the model should be
basis of the backtesting process, including sufficiently robust to capture greater volatility
actual trading profits and losses (that is, realized due to adverse market conditions. If the bank’s
and unrealized profits or losses on end-of-day internal model cannot meet these requirements,
portfolio positions) and fee income and commis- the bank must use the standardized approach to
sions associated with trading activities. measuring specific risk under the capital rules.
If the backtest reveals that an institution’s The capital charge for specific risk may be
daily net trading loss exceeded the correspond- determined either by applying standardized mea-
ing VAR measure five or more times, the insti- surement techniques (the standardized approach)
tution’s multiplication factor should begin to or using an institution’s internal model.
increase—from three to as high as four if 10 or
more exceptions are found. However, the deci-
sion regarding the specific size of any increase Standardized Approach
to the institution’s multiplier may be tempered
by examiner judgment and the circumstances Under the standardized approach, trading-
surrounding the exceptions. In particular, special account debt instruments are categorized as
consideration may be granted for exceptions that ‘‘government,’’ ‘‘qualifying,’’ or ‘‘other,’’ based
produce abnormal changes in interest rates or on the type of obligor and, in the case of
exchange rates as a result of major political instruments such as corporate debt, on the credit
events or other highly unusual market events. rating and remaining maturity of the instrument.
Examiners may also consider factors such as the Each category has a specific-risk weighting
magnitude of an exception (that is, the differ- factor. The specific-risk capital charge for debt
ence between the VAR measure and the actual positions is calculated by multiplying the cur-
trading loss), and the institution’s response to rent market value of each net long or short
the exception. Examiners may determine that an position in a category by the appropriate risk-
institution does not need to increase its multi- weight factor. An institution must risk weight
plication factor if it has taken adequate steps to derivatives (for example, swaps, futures, for-
address any modeling deficiencies or other wards, or options on certain debt instruments)
actions that are sufficient to improve its risk- according to the relevant underlying instrument.
management process. The Federal Reserve will For example, in a forward contract, an institu-
monitor industry progress in developing back- tion must risk weight the market value of the
testing methodologies and may adjust the back- effective notional amount of the underlying
testing requirements in the future. Where the instrument (or index portfolio). Swaps must be
backtest reveals exceptions, examiners should included as the notional position in the under-
review the institution’s documentation of the lying debt instrument or index portfolio, with a
Trading and Capital-Markets Activities Manual April 2000
Page 25
2110.1 Capital Adequacy
receiving side treated as a long position and a Table 3—Specific-Risk Weighting
paying side treated as a short position. Options, Factors
whether long or short, are included by risk
weighting the market value of the effective
notional amount of the underlying instrument or Risk-Weight
index multiplied by the option’s delta. An insti- Remaining Maturity Factor
tution may net long and short positions in
6 months or less 0.25%
identical debt instruments with the same issuer,
over 6 months to 24 months 1.00%
coupon, currency, and maturity. An institution
over 24 months 1.60%
may also net a matched position in a derivative
instrument and the derivative’s corresponding
underlying instrument. The specific-risk charge for equity positions
The government category includes general is based on an institution’s gross equity position
obligation debt instruments of central govern- for each national market. Gross equity position
ments of OECD countries, as well as local is defined as the sum of all long and short equity
currency obligations of non-OECD central gov- positions, including positions arising from
ernments to the extent the institution has liabili- derivatives such as equity swaps, forwards,
ties booked in that currency. The risk-weight futures, and options. The current market value
factor for the government category is zero of each gross equity position is weighted by a
percent. The qualifying category includes debt designated factor, with the relevant underlying
instruments of U.S. government–sponsored agen- instrument used to determine risk weights of
cies, general obligation debt instruments issued equity derivatives. For example, swaps are
by states and other political subdivisions of included as the notional position in the under-
OECD countries, multilateral development banks, lying equity instrument or index portfolio, with
and debt instruments issued by U.S. depository a receiving side treated as a long position and a
institutions or OECD banks that do not qualify paying side treated as a short position. Options,
as capital of the issuing institution. Qualifying whether long or short, are included by risk
instruments also may be corporate debt and weighting the market value of the effective
revenue instruments issued by states and politi- notional amount of the underlying equity instru-
cal subdivisions of OECD countries that are ment or index multiplied by the option’s delta.
(1) rated as investment grade by at least two Long and short positions in identical equity
nationally recognized credit-rating firms; issues or indexes may be netted. An institution
(2) rated as investment grade by one nationally may also net a matched position in a derivative
recognized credit-rating firm and not less than instrument and its corresponding underlying
investment grade by any other credit-rating instrument.
agency; or (3) if unrated and the issuer has The specific-risk charge is 8.0 percent of the
securities listed on a recognized stock exchange, gross equity position, unless the institution’s
deemed to be of comparable investment quality portfolio is both liquid and well diversified, in
by the reporting institution, subject to review by which case the capital charge is 4.0 percent. A
the Federal Reserve. The risk-weighting factors portfolio is liquid and well diversified if (1) it is
for qualifying instruments vary according to the characterized by a limited sensitivity to price
remaining maturity of the instrument as set in changes of any single equity or closely related
table 3. Other debt instruments not included in group of equity issues; (2) the volatility of the
the government or qualifying categories receive portfolio’s value is not dominated by the vola-
a risk weight of 8.0 percent. tility of equity issues from any single industry or
economic sector; (3) it contains a large number
of equity positions, with no single position
representing a substantial portion of the port-
folio’s total market value;26 and (4) it consists
mainly of issues traded on organized exchanges
or in well-established over-the-counter markets.
26. For practical purposes, examiners may interpret ‘‘sub-
stantial’’ as meaning more than 5 percent.
April 2000 Trading and Capital-Markets Activities Manual
Page 26
Capital Adequacy 2110.1
For positions in an index comprising a broad- • demonstrably capture concentration (magni-
based, diversified portfolio of equities, the tude and changes in composition);28
specific-risk charge is 2.0 percent of the net long • be robust to an adverse environment;29 and
or short position in the index. In addition, a • be validated through backtesting aimed at
2.0 percent specific-risk charge applies to only assessing whether specific risk is being accu-
one side (long or short) in the case of certain rately captured.
futures-related arbitrage strategies (for instance,
long and short positions in the same index at In addition, the institution must be able to
different dates or in different market centers, and demonstrate that it has methodologies in place
long and short positions at the same date in which allow it to adequately capture event and
different, but similar indexes). Finally, under default risk for its trading positions. In assessing
certain conditions, futures positions on a broad- the model’s robustness, examiners review the
based index that are matched against positions banking institution’s testing of the model, includ-
in the equities composing the index are subject ing regression analysis testing (that is, ‘‘goodness-
to a specific-risk charge of 2.0 percent against of-fit’’), stress-test simulations of ‘‘shocked’’
each side of the transaction. market conditions, and changing credit-cycle
conditions. Examiners evaluate the scope of
testing (for example, what factors are shocked
Internal-Models Approach and to what degree, and what the resultant
changes in risk exposures are), the number of
Institutions using models will be permitted to tests completed, and the results of these tests. If
base their specific-risk capital charge on mod- testing is deemed insufficient or the results are
eled estimates if they meet all of the qualitative unclear, the banking institution is expected to
and quantitative requirements for general risk address these concerns before supervisory rec-
models as well as the additional criteria set out ognition of the model.
below. Institutions which are unable to meet As previously noted, the review of these
these additional criteria will be required to base models is conducted after supervisory recogni-
their specific-risk capital charge on the full tion of the banking institution’s general market-
amount of the standardized specific-risk charge. risk methodology. The examiner reviews are
Conditional permission for the use of specific- generally conducted on a subportfolio basis (for
risk models is discouraged. Institutions should example, investment-grade corporate debt, credit
use the standardized approach for a particular derivatives, etc.), with a focus on the modeling
portfolio until they have fully developed a methodology, validation, and backtesting pro-
model to accurately measure the specific risk cess. The portfolio-level approach addresses the
inherent in that portfolio. case in which a banking institution’s model
The criteria for applying modeled estimates adequately captures specific risk within its
of specific risk require that an institution’s investment-grade corporate-debt portfolio but
model— not within its high-yield corporate-debt port-
folio. In this case, the banking institution would
• explain the historical price variation in the generally be granted internal-models treatment
portfolio;27 for the investment-grade debt portfolio while
continuing to apply the standardized approach
for its high-yield debt portfolio.
27. The key ex ante measures of model quality are
‘‘goodness-of-fit’’ measures which address the question of
how much of the historical variation in price value is
explained by the model. One measure of this type which can 28. The institution would be expected to demonstrate that
often be used is an R-squared measure from regression the model is sensitive to changes in portfolio construction and
methodology. If this measure is to be used, the institution’s that higher capital charges are attracted for portfolios that have
model would be expected to be able to explain a high increasing concentrations.
percentage, such as 90 percent, of the historical price variation 29. The institution should be able to demonstrate that the
or to explicitly include estimates of the residual variability not model will signal rising risk in an adverse environment. This
captured in the factors included in this regression. For some could be achieved by incorporating in the historical estimation
types of models, it may not be feasible to calculate a period of the model at least one full credit cycle and ensuring
goodness-of-fit measure. In such an instance, a bank is that the model would not have been inaccurate in the
expected to work with its national supervisor to define an downward portion of the cycle. Another approach for dem-
acceptable alternative measure which would meet this regu- onstrating this is through simulation of historical or plausible
latory objective. worst-case environments.
Trading and Capital-Markets Activities Manual April 2000
Page 27
2110.1 Capital Adequacy
Examiner assessments of the adequacy of a to supervisory guidelines 30 or
banking institution’s specific-risk modeling • the value-at-risk measures of subportfolios of
address the following major points: debt and equity positions that contain specific
risk.31
• the type, size, and composition of the modeled
portfolio and other relevant information (for Institutions using the second option are required
example, market data) to identify their subportfolio structure ahead of
time and should not change it without supervi-
• the VAR-based methodology and relevant sory consent.
assumptions applicable to the modeled port- Institutions which apply modeled estimates of
folio and a description of how it captures the specific risk are required to conduct backtesting
key specific-risk areas—idiosyncratic varia- aimed at assessing whether specific risk is being
tion and event and default risk accurately captured. The methodology an insti-
• the backtesting analysis performed by the tution should use for validating its specific-risk
banking institution that demonstrates the mod- estimates is to perform separate backtests on
el’s ability to capture specific risk within the subportfolios using daily data on subportfolios
identified portfolio (This backtesting is spe- subject to specific risk. The key subportfolios
cific to the modeled portfolio, not the entire for this purpose are traded-debt and equity
trading portfolio.) positions. However, if an institution itself
decomposes its trading portfolio into finer cate-
• additional testing (for example, stress testing) gories (for example, emerging markets or traded
performed by the banking institution to dem- corporate debt), it is appropriate to keep these
onstrate the model’s performance under market- distinctions for subportfolio backtesting pur-
stress events
30. Techniques for separating general market risk and
Institutions which meet the criteria set out specific risk would include the following:
above for models but that do not have method-
ologies in place to adequately capture event and Equities
default risk will be required to calculate their
specific-risk capital charge based on the internal- • The market should be identified with a single factor that is
representative of the market as a whole, for example, a
model measurements plus an additional pruden- widely accepted, broadly based stock index for the country
tial surcharge as defined in the following para- concerned.
graph. The surcharge is designed to treat the • Institutions that use factor models may assign one factor of
modeling of specific risk on the same basis as a their model, or a single linear combination of factors, as
their general-market-risk factor.
general market-risk model that has proven defi-
cient during backtesting. That is, the equivalent Bonds
of a scaling factor of four would apply to the
• The market should be identified with a reference curve for
estimate of specific risk until such time as an the currency concerned. For example, the curve might be a
institution can demonstrate that the methodolo- government bond yield curve or a swap curve; in any case,
gies it uses adequately capture event and default the curve should be based on a well-established and liquid
risk. Once an institution is able to demonstrate underlying market and should be accepted by the market as
a reference curve for the currency concerned.
this, the minimum multiplication factor of three
can be applied. However, a higher multiplication Institutions may select their own technique for identifying the
factor of four on the modeling of specific risk specific-risk component of the value-at-risk measure for
would remain possible if future backtesting purposes of applying the multiplier of four. Techniques would
include—
results were to indicate a serious deficiency with
the model. • using the incremental increase in value-at-risk arising from
For institutions applying the surcharge, the the modeling of specific-risk factors;
• using the difference between the value-at-risk measure and
total of the market-risk capital requirement will a measure calculated by substituting each individual equity
equal a minimum of three times the internal position by a representative index; or
model’s general- and specific-risk measure plus • using an analytic separation between general market risk
a surcharge in the amount of either— and specific risk implied by a particular model.
31. This would apply to subportfolios containing positions
• the specific-risk portion of the value-at-risk that would be subject to specific risk under the standardized-
measure which should be isolated according based approach.
April 2000 Trading and Capital-Markets Activities Manual
Page 28
Capital Adequacy 2110.1
poses. Institutions are required to commit to a to take immediate action to correct the problem
subportfolio structure and stick to it unless it can in the model and ensure that there is a sufficient
be demonstrated to the supervisor that it would capital buffer to absorb the risk that the backtest
make sense to change the structure. showed had not been adequately captured.
Institutions are required to have in place a Examiners must confirm with the institution
process to analyze exceptions identified through that its model incorporates specific risk for both
the backtesting of specific risk. This process is debt and equity positions. For instance, if the
intended to serve as the fundamental way in model addressed the specific risk of debt posi-
which institutions correct their models of spe- tions but not equity positions, then the institu-
cific risk if they become inaccurate. Models that tion could use the model-based specific-risk
incorporate specific risk are presumed unaccept- charge (subject to the limitation described ear-
able if the results at the subportfolio level lier) for debt positions, but must use the full
produce 10 or more exceptions. Institutions with standard specific-risk charge for equity positions.
unacceptable specific-risk models are expected
Trading and Capital-Markets Activities Manual April 2000
Page 29
Accounting
Section 2120.1
The securities and financial contracts that make work for trading activities
up an institution’s trading portfolio are generally • general framework for derivative instruments,
marked to market, and gains or losses on the including hedges
positions are recognized in the current period’s • specific accounting principles for derivative
income. A single class of financial instrument instruments, including domestic futures;
that can meet trading, investment, or hedging foreign-currency instruments; forward con-
objectives may have a different accounting treat- tracts (domestic), including forward rate agree-
ment applied to it depending on management’s ments; interest-rate swaps; and options
purpose for holding it. Therefore, an examiner
reviewing trading activities should be familiar
with the different accounting methods to ensure ACCOUNTING STANDARDS
that the particular accounting treatment being
used is appropriate for the purpose of holding a The Federal Reserve has long viewed account-
financial instrument and the economic substance ing standards as a necessary step to efficient
of the related transaction. market discipline and bank supervision. Account-
The accounting principles that apply to secu- ing standards provide the foundation for cred-
rities portfolios, including trading accounts and ible and comparable financial statements and
derivative instruments are complex; their other financial reports. Accurate information,
authoritative standards and related banking prac- reported in a timely manner, provides a basis for
tices have evolved over time. This section sum- the decisions of market participants. The effec-
marizes the major aspects of the accounting tiveness of market discipline, to a very consid-
principles for trading and derivative activities erable degree, rests on the quality and timeliness
for both financial and regulatory reporting pur- of reported financial information.
poses. Accordingly, this section does not set Financial statements and regulatory financial
forth new accounting policies or list or explain reports perform a critical role for depository
the detailed line items of financial reports that institution supervisors. Supervisory agencies
must be reported for securities portfolios or have monitoring systems in place which enable
derivative instruments. Examiners should con- them to follow, off-site, the financial develop-
sult the sources of generally accepted account- ments at depository institutions. When reported
ing principles (GAAP) and regulatory reporting financial information indicates that an institu-
requirements that are referred to in this section tion’s financial condition has deteriorated, these
for more detailed guidance. systems can signal the need for on-site exami-
Examiners should be aware that accounting nations and any other appropriate actions. In
practices in foreign countries may differ from short, the better the quality of reported financial
those followed in the United States. Neverthe- information from institutions, the greater the
less, foreign institutions are required to submit ability of agencies to monitor and supervise
regulatory reports prepared in accordance with effectively.
regulatory reporting instructions for U.S. bank-
ing agencies, which are generally consistent
with GAAP. This section will focus on reporting Accounting Principles for Financial
requirements of the United States. Reporting
The major topics covered in this section are
listed below. The discussion of specific types of Financial statements provide information needed
balance-sheet instruments (such as securities) to evaluate an institution’s financial condition
and derivative instruments (for example, swaps, and performance. GAAP must be followed for
futures, forwards, and options) is interwoven financial-reporting purposes—that is, for annual
with these discussions. and quarterly published financial statements.
The standards in GAAP for trading activities
• sources of GAAP accounting standards and and derivative instruments are based on pro-
regulatory reporting requirements nouncements issued by the Financial Account-
• the broad framework for accounting for secu- ing Standards Board (FASB); the American
rities portfolios, including the general frame- Institute of Certified Public Accountants
Trading and Capital-Markets Activities Manual April 2002
Page 1
2120.1 Accounting
(AICPA); and, for publicly traded companies, other reports that are filed with the Board
the Securities and Exchange Commission (SEC). by state member banks that are subject to the
GAAP pronouncements usually take the forms reporting requirements of the SEC.1 The other
described in table 1. requirement involves the regulatory financial
statements for state member banks, other feder-
ally insured commercial banks, and federally
Table 1—GAAP Pronouncements and insured savings banks—the Reports of Condi-
Abbreviations tion and Income, commonly referred to as call
reports. The call reports, the form and content of
Source Major Pronouncements which are developed by the Federal Financial
Institutions Examination Council (FFIEC), are
FASB Statements of Financial currently required to be filed in a manner gen-
Accounting Standards erally consistent with GAAP.2 For purposes of
(FAS) preparing the call reports, the guidance in the
FASB Interpretations (FIN) instructions (including related glossary items) to
Technical Bulletins (TB) the Reports of Condition and Income should be
followed. U.S. banking agencies require foreign
AICPA Audit and Accounting Guides banking organizations operating in the United
Industry Audit Guides States to file regulatory financial reports pre-
Statements of Position (SOP) pared in accordance with relevant regulatory
Accounting Interpretations reporting instructions.
Issues Papers* Various Y-series reports submitted to the
Federal Reserve by bank holding companies
SEC Financial Reporting Releases have long been prepared in accordance with
(FRR) GAAP. Section 112 of the Federal Deposit
Regulation S-X Insurance Corporation Improvement Act of 1991
Guide 3 to Regulation S-X, (FDICIA) mandates that state member banks
Article 9 with total consolidated assets of $500 million or
Staff Accounting Bulletins more have to submit to the Federal Reserve
(SAB) annual reports containing audited financial state-
ments prepared in accordance with GAAP.
Emerging Consensus positions by a group Alternatively, the financial-statement requirement
Issues Task of leading accountants from can be satisfied by filing consolidated financial
Force (EITF) industry and the accounting statements of the bank holding company. Thus,
profession the summary of GAAP that follows will be
relevant for purposes of (1) financial statements
* These are generally nonauthoritative. of state member banks and bank holding com-
panies, (2) call reports of banks, (3) Y-series
The SEC requires publicly traded banking reports of bank holding companies, and (4) the
organizations and other public companies to
follow GAAP in preparing their form 10-Ks,
annual reports, and other SEC financial reports.
1. Generally, pursuant to section 12(b) or 12(g) of the
These public companies must also follow spe- Securities Exchange Act of 1934, state member banks whose
cial reporting requirements mandated by the securities are subject to registration are required to file with
SEC, such as the guidance listed above, when the Federal Reserve Board annual reports, quarterly financial
preparing their financial reports. statements, and other financial reports that conform with SEC
reporting requirements.
2. The importance of accounting standards for regulatory
Accounting Principles for Regulatory reports is recognized by section 121 of the Federal Deposit
Insurance Corporation Act of 1991. Section 121 requires
Reporting that accounting principles applicable to regulatory financial
reports filed by federally insured banks and thrifts with their
Currently, state member banks are subject to federal banking agency must be consistent with GAAP.
However, under section 121, a federal banking agency may
two main regulatory requirements to file finan- require institutions to use accounting principles ‘‘no less
cial statements with the Federal Reserve. One stringent than GAAP’’ when the agency determines that
requirement involves financial statements and GAAP does not meet supervisory objectives.
April 2002 Trading and Capital-Markets Activities Manual
Page 2
Accounting 2120.1
section 112 annual reports of state member recover substantially all of its recorded invest-
banks and bank holding companies. ment must be recorded as either available-for-
sale or trading. Reclassifications of held-to-
maturity securities as a result of the initial
ACCOUNTING FOR SECURITIES application of FAS 140 would not call into
question an entity’s intent to hold other secu-
PORTFOLIOS rities to maturity in the future.
• Trading account. Debt and equity securities
Treatment Under FASB Statement that are bought and held principally for the
No. 115 purpose of selling them in the near term are
classified as trading securities and reported at
Statement of Financial Accounting Standards fair value, with unrealized gains and losses
No. 115 (FAS 115), ‘‘Accounting for Certain included in earnings. Trading generally reflects
Investments in Debt and Equity Securities,’’ as active and frequent buying and selling, and
amended by Statement of Financial Accounting trading securities are generally used with the
Standards No. 140 (FAS 140), ‘‘Accounting for objective of generating profits on short-term
Transfers and Servicing of Financial Assets and differences in price.
Extinguishments of Liabilities,’’ is the authori- • Available-for-sale account. Debt and equity
tative guidance for accounting for equity secu- securities not classified as either held-to-
rities that have readily determinable fair values maturity securities or trading securities are
and for all debt securities.3 (FAS 140 replaces classified as available-for-sale securities and
FAS 125, which had the same title.) Investments reported at fair value, with unrealized gains
subject to FAS 115 are to be classified in three and losses excluded from earnings and reported
categories and accounted for as follows: as a net amount in a separate component of
shareholders’ equity.
• Held-to-maturity account. Debt securities that
the institution has the positive intent and Under FAS 115, mortgage-backed securities
ability to hold to maturity are classified as that are held for sale in conjunction with mort-
held-to-maturity securities and reported at gage banking activities should be reported at fair
amortized cost. FAS 140 amended FAS 115 to value in the trading account. FAS 115 does not
require that securities that can contractually be apply to loans, including mortgage loans, that
prepaid or otherwise settled in such a way that have not been securitized.
the holder of the security would not Upon the acquisition of a debt or equity
security, an institution must place the security
3. FAS 115 does not apply to investments in equity into one of the above three categories. At each
securities accounted for under the equity method nor to reporting date, the institution must reassess
investments in consolidated subsidiaries. This statement does
not apply to institutions whose specialized accounting prac-
whether the balance-sheet classification 4 contin-
tices include accounting for substantially all investments in ues to be appropriate.
debt and equity securities at market value or fair value, with Proper classification of securities is a key
changes in value recognized in earnings (income) or in the examination issue. As stated above, instruments
change in net assets. Examples of those institutions are
brokers and dealers in securities, defined benefit pension
that are intended to be held principally for the
plans, and investment companies. purpose of selling them in the near term should
FAS 115 states that the fair value of an equity security is be classified as trading assets. Reporting secu-
readily determinable if sales prices or bid-and-asked quota- rities held for trading purposes as available-for-
tions are currently available on a securities exchange regis-
tered with the SEC or in the over-the-counter market, pro-
sale or held-to-maturity would result in the
vided that those prices or quotations for the over-the-counter improper deferral of unrealized gains and losses
market are publicly reported by the National Association of from earnings and regulatory capital. Accord-
Securities Dealers’ automated quotation systems or by the ingly, examiners should scrutinize institutions
National Quotation Bureau. Restricted stock does not meet
that definition.
that exhibit a pattern or practice of selling
The fair value of an equity security traded only in a foreign securities from the available-for-sale or held-to-
market is readily determinable if that foreign market is of a maturity accounts after a short-term holding
breadth and scope comparable to one of the U.S. markets
referred to above. The fair value of an investment in a mutual
fund is readily determinable if the fair value per share (unit)
is determined and published and is the basis for current 4. In this context, ‘‘classification’’ refers to the security’s
transactions. balance-sheet category, not the credit quality of the asset.
Trading and Capital-Markets Activities Manual September 2001
Page 3
2120.1 Accounting
period, particularly if significant amounts of accounted for as sales.) However, all sales and
losses on securities in these accounts have not transfers of held-to-maturity securities must
been recognized. be disclosed in the footnotes to the financial
FAS 115 recognizes that certain changes in statements.
circumstances may cause the institution to An institution must not classify a debt secu-
change its intent to hold a certain security to rity as held-to-maturity if the institution intends
maturity without calling into question its intent to hold the security for only an indefinite period.5
to hold other debt securities to maturity in the Consequently, a debt security should not, for
future. Thus, the sale or transfer of a held-to- example, be classified as held-to-maturity if the
maturity security due to one of the following banking organization or other company antici-
changes in circumstances will not be viewed pates that the security would be available to be
as inconsistent with its original balance-sheet sold in response to—
classification:
• changes in market interest rates and related
• evidence of a significant deterioration in the changes in the security’s prepayment risk,
issuer’s creditworthiness
• needs for liquidity (for example, due to the
• a change in tax law that eliminates or reduces
withdrawal of deposits, increased demand for
the tax-exempt status of interest on the debt
loans, surrender of insurance policies, or pay-
security (but not a change in tax law that
ment of insurance claims),
revises the marginal tax rates applicable to
interest income) • changes in the availability of and the yield on
• a major business combination or major dispo- alternative investments,
sition (such as the sale of a segment) that • changes in funding sources and terms, and
necessitates the sale or transfer of held-to- • changes in foreign-currency risk.
maturity securities to maintain the institu-
tion’s existing interest-rate risk position or According to FAS 115, an institution’s asset-
credit-risk policy liability management may consider the maturity
• a change in statutory or regulatory require- and repricing characteristics of all investments
ments significantly modifying either what con- in debt securities, including those held to matu-
stitutes a permissible investment or the maxi- rity or available for sale, without tainting or
mum level of investments in certain kinds of casting doubt on the standard’s criterion that
securities, thereby causing an institution to there be a ‘‘positive intent to hold until matu-
dispose of a held-to-maturity security rity.’’ However, to demonstrate its ongoing
• a significant increase by the regulator in the intent and ability to hold the securities to matu-
industry’s capital requirements that causes the rity, management should designate the held-to-
institution to downsize by selling held-to- maturity securities as not available for sale for
maturity securities purposes of the ongoing adjustments that are a
• a significant increase in the risk weights of necessary part of its asset-liability management.
debt securities used for regulatory risk-based Further, liquidity can be derived from the held-
capital purposes. to-maturity category by the use of repurchase
agreements that are classified as financings, but
Furthermore, FAS 115 recognizes other events not sales.
that are isolated, nonrecurring, and unusual for
the reporting institution and that could not have
been reasonably anticipated may cause the in- 5. In summary, under FAS 115, sales of debt securities that
stitution to sell or transfer a held-to-maturity meet either of the following two conditions may be considered
security without necessarily calling into ques- as ‘‘maturities’’ for purposes of the balance-sheet classifica-
tion its intent to hold other debt securities to tion of securities: (1) The sale of a security occurs near enough
to its maturity date (or call date if exercise of the call is
maturity. EITF 96-10, as amended by FAS 140, probable)—for example, within three months—that interest-
provides that transactions that are not accounted rate risk has been substantially eliminated as a pricing factor.
for as sales under FAS 140 would not contradict (2) The sale of a security occurs after the institution has
the entity’s intent to hold that security, or any already collected at least 85 percent of the principal outstand-
ing at acquisition from either prepayments or scheduled
other securities, to maturity. (See paragraph nine payments on a debt security payable in equal installments over
of FAS 140 for additional guidance on criteria its term (variable-rate securities do not need to have equal
which would require such transactions to be payments).
September 2001 Trading and Capital-Markets Activities Manual
Page 4
Accounting 2120.1
Transfers of a security between investment Other Sources of Regulatory
categories should be accounted for at fair value. Reporting Guidance
FAS 115 requires that, at the date of transfer, the
security’s unrealized holding gain or loss must As mentioned above, FAS 115 has been adopted
be accounted for as follows: for regulatory reporting purposes. Call report
instructions are another source of guidance,
• For a security transferred from the trading particularly, the glossary entries on—
category, the unrealized holding gain or loss at
the date of transfer will already have been • coupon stripping, Treasury receipts, and
recognized in earnings and should not be STRIPS;
reversed. • fails;
• For a security transferred into the trading • foreign debt exchange transactions;
category, the unrealized holding gain or loss at • market value of securities;
the date of transfer should be recognized in • nonaccrual status;
earnings immediately. • premiums and discounts;
• For a debt security transferred into the • short positions;
available-for-sale category from the held-to- • transfers of financial assets;
maturity category, the unrealized holding gain • trading accounts;
or loss at the date of transfer should be • trade-date and settlement-date accounting;6
recognized in a separate component of share- and
holders’ equity. • when-issued securities transactions.
• For a debt security transferred into the held-
to-maturity category from the available-for-
sale category, the unrealized holding gain or
loss at the date of transfer should continue to Traditional Model Under GAAP
be reported in a separate component of share-
The traditional model was used to account for
holders’ equity, but should be amortized over
investment and equity securities before FAS
the remaining life of the security as an adjust-
115. However, the traditional model still applies
ment of its yield in a manner consistent with
to assets that are not within the scope of FAS
the amortization of any premium or discount.
115 (for example, equity securities that do not
have readily determinable fair values).
Transfers from the held-to-maturity category
Under the traditional accounting model for
should be rare, except for transfers due to the
securities portfolios and certain other assets,
changes in circumstances that were discussed
debt securities are placed into the following
above. According to the standard, transfers into
three categories based on the institution’s intent
or from the trading category should also be rare.
and ability to hold them:
FAS 115 requires that institutions determine
whether a decline in fair value below the amor-
• Investment account. Investment assets are car-
tized cost for individual securities in the
ried at amortized cost. A bank must have the
available-for-sale or held-to-maturity accounts
intent and ability to hold these securities for
is ‘‘other than temporary’’ (that is, whether this
long-term investment purposes. The market
decline results from permanent impairment).
value of the investment account is fully
For example, if it is probable that the investor
disclosed in the footnotes to the financial
will be unable to collect all amounts due accord-
statements.
ing to the contractual terms of a debt security
• Trading account. Trading assets are marked
that was not impaired at acquisition, an other-
to market. Unrealized gains and losses are
than-temporary impairment should be consid-
recognized in income. Trading is character-
ered to have occurred. If the decline in fair value
ized by a high volume of purchase and sale
is judged to be other than temporary, the cost
activity.
basis of the individual security should be written
down to its fair value, and the write-down
should be accounted in earnings as a realized
loss. This new cost basis should not be written 6. As described in this glossary entry, for call report
up if there are any subsequent recoveries in fair purposes, the preferred method for reporting securities trans-
value. actions is recognition on the trade date.
Trading and Capital-Markets Activities Manual September 2001
Page 5
2120.1 Accounting
• Held-for-sale account. Assets so classified are transaction. FAS 140 requires that entities rec-
carried at the lower of cost or market value ognize newly created (acquired) assets and
(LOCOM). Unrealized losses on these securi- liabilities, including derivatives, at fair value. It
ties are recognized in income. This account also requires all assets sold and the portion of
is characterized by intermittent sales of any assets retained to be valued by allocating the
securities. previous carrying value of the assets based on
their relative fair value.
Under GAAP, the traditional model has been Financial assets that can be prepaid contrac-
generally followed for other assets as well. tually or that can otherwise be settled in such a
Thus, loans that are held for trading purposes way that the holder would not recover substan-
would be marked to market, and loans that are tially all of its recorded investments should be
held for sale would be carried at LOCOM. measured in the same way as investments in
debt securities as either available-for-sale or
trading under FAS 115. Examples include some
SECURITIZATIONS interest-only strips, retained interests in securi-
tizations, loans, other receivables, or other finan-
FAS 140 covers the accounting treatment for the cial assets. However, financial instruments cov-
securitization of receivables. The statement ad- ered under the scope of Statement of Financial
dresses (1) when a transaction qualifies as a sale Accounting Standards No. 133 (FAS 133),
for accounting purposes and (2) the treatment of ‘‘Accounting for Derivative Instruments and
the various financial components (identifiable Hedging Activities,’’ should follow that guidance.
assets and liabilities) that are created in the
securitization process.
To identify whether a transfer of assets quali-
fies as a sale for accounting purposes, FAS 140 ACCOUNTING FOR REPURCHASE
focuses on control of the assets while taking a AGREEMENTS
‘‘financial components approach.’’ The standard
requires that an entity surrender control to In addition to securitizations, FAS 140 deter-
‘‘derecognize’’ the assets, or take the assets off mines the accounting for repurchase agree-
its balance sheet. Under FAS 140, control is ments. A repurchase agreement is either
considered to be surrendered and, therefore, a accounted for as a secured borrowing or as a
transfer is considered a sale if all of the follow- sale and subsequent repurchase. The treatment
ing conditions are met: depends on whether the seller has surrendered
control of the securities as described in the
• The transferred assets have been put beyond ‘‘Securitizations’’ subsection. If control is main-
the reach of the transferor, even in bankruptcy. tained, the transaction should be accounted for
• Either (1) the transferee has the right to pledge as a secured borrowing. If control is surren-
or exchange the transferred assets or (2) the dered, the transaction should be accounted for as
transferee is a qualifying special-purpose a sale and subsequent repurchase. Control is
entity, and the holder of beneficial interests in generally considered to be maintained if the
that entity has the right to pledge or exchange security being repurchased is identical to the
the transferred assets. security being sold.
• The transferor does not maintain control over In a dollar-roll transaction, an institution
the transferred assets through (1) an agree- agrees to sell a security and repurchase a similar,
ment that entitles and obligates the transferor but not identical, security. If the security being
to repurchase or redeem them before their repurchased is considered to be ‘‘substantially
maturity or (2) an agreement that entitles the the same’’ as the security sold, the transaction
transferor to repurchase or redeem transferred should be reported as a borrowing. Otherwise,
assets that are not readily obtainable. the transaction should be reported as a sale and
subsequent repurchase. The AICPA Audit and
The financial components approach recognizes Accounting Guide for Banks and Savings Insti-
that complex transactions, such as securitiza- tutions establishes criteria that must be met for a
tions, often involve the use of valuation tech- security to be considered ‘‘substantially the
niques and estimates to determine the value of same,’’ including having the same obligor,
each component and any gain or loss on the maturity, form, and interest rate.
September 2001 Trading and Capital-Markets Activities Manual
Page 6
Accounting 2120.1
Generally, a bank surrenders control if the side of net income.
repurchase agreement does not require the repur- • If the derivative represents a hedge of the
chase of the same or substantially the same foreign-currency exposure of a net investment
security. In such cases, the bank accounts for the in foreign operation, an unrecognized firm
transaction as a sale (with gain or loss) and a commitment, an available-for-sale security, or
forward contract to repurchase the securities. a foreign currency–denominated forecasted
When a repurchase agreement is not a sale (for transaction (foreign-currency hedge), the gains
example, requires the repurchase of the same or or losses based on changes in fair value are
substantially the same security), the transaction included in comprehensive income, outside of
is accounted for as a borrowing. However, net income, as part of the cumulative transla-
repurchase agreements that extend to the secu- tion adjustment.
rity’s maturity date, and repurchase agreements
in which the seller has not obtained sufficient This general framework is set forth in FAS 133.
collateral to cover the replacement cost of the This statement, issued in June 1998 and amended
security, should be accounted for as sales. by FAS 137 and FAS 138, became effective for
fiscal years beginning after June 15, 2000. Thus,
banks operating on a calendar year adopted the
guidance on January 1, 2001.
ACCOUNTING FOR DERIVATIVE FAS 133 comprehensively changes account-
INSTRUMENTS ing and disclosure standards for derivatives.
FAS 133 amends Statement of Financial Account-
As discussed in the previous subsection, the ing Standards No. 52 (FAS 52), ‘‘Foreign Cur-
general accounting framework for securities port- rency Translation,’’ to permit special accounting
folios divides them into three categories: held- for foreign-currency hedges and makes the fol-
to-maturity (accounted for at amortized cost), lowing standards obsolete:
available-for-sale (accounted for at fair value,
with unrealized changes in fair value recorded in • FAS 80 Accounting for Futures Contracts
equity), and trading securities (accounted for at • FAS 105 Disclosure of Information About
fair value, with changes in fair value recorded in Financial Instruments with Off Bal-
earnings). ance Sheet Risk and Financial In-
In contrast, derivative instruments can be struments with Concentrations of
classified in one of the following categories: Credit Risk
(1) no hedge designation, (2) fair-value hedge, • FAS 107 Disclosures About Fair Value of
(3) cash-flow hedge, and (4) foreign-currency Financial Instruments
hedge. The general accounting framework for • FAS 119 Disclosure About Derivative
derivative instruments under GAAP is set forth Financial Instruments and Fair
below: Value of Financial Instruments
• If the derivative does not have a hedge desig- FAS 133 requires entities to recognize all
nation, the gains or losses based on changes in derivatives on the balance sheet as either assets
fair value of the derivative instrument are or liabilities and to report them at their fair
included in current income. value. The accounting recognition of changes in
• If the derivative is determined to be a hedge of the fair value of a derivative (gains or losses)
exposure to changes in the fair value of a depends on the intended use of the derivative
recognized asset or liability or an unrecog- and the resulting designation. For qualifying
nized firm commitment (fair-value hedge), the hedges, an entity is required to establish at the
gains or losses based on changes in fair value inception of the hedge the method it will use for
are included in current net income with the assessing the effectiveness of the hedging
offsetting gain or loss on the hedged item derivative and the measurement approach for
attributable to the risk being hedged. determining the ineffective aspect of the hedge.
• If the derivative is determined to be a hedge of The methods applied should be consistent with
exposure to variable cash flows of a forecasted the entity’s approach to managing risk. FAS 133
transaction (cash-flow hedge), the gains or also precludes designating a nonderivative finan-
losses based on changes in fair value are cial instrument as a hedge of an asset, a liability,
included in other comprehensive income out- an unrecognized firm commitment, or a fore-
Trading and Capital-Markets Activities Manual April 2002
Page 7
2120.1 Accounting
casted transaction, except if any of these are covering of a short sale of futures through the
denominated in a foreign currency. purchase of an equal number of contracts of the
Proper classification of derivative instruments same delivery month on the same underlying
is a key examination issue. Inappropriately clas- instrument on the same exchange.
sifying a derivative instrument as a hedge would
result in the improper treatment of gains and
losses in earnings and regulatory capital. Insti- Special Types of Derivatives
tutions should retain adequate documentation to
support their hedge activity. Examiners should Credit derivatives are financial instruments that
scrutinize any institutions that do not comply permit one party (the beneficiary) to transfer the
with these new GAAP requirements. credit risk of a reference asset, which it typically
owns, to another party (the guarantor) without
Definitions
A derivative instrument is a financial instrument
or other contract with all three of the following
characteristics;
• It has one or more underlyings, and one or
more notional amounts or payment provisions
or both.
• It requires no initial net investment or an
initial net investment that is smaller than what
would be required for other types of contracts
expected to have a similar response to changes
in market factors.
• Its terms require or permit net settlement, it
can be readily settled net by means outside the
contract, or it provides for delivery of an asset
that puts the recipient in a position not sub-
stantially different from net settlement.
An underlying is a specified interest rate, secu-
rity price, commodity price, foreign-exchange
rate, index of prices or rates, or other variable.
An underlying may be a price or rate of an asset
or liability but is not the asset or liability itself.
A notional amount is a number of currency
units, shares, bushels, pounds, or other units
specified in the contract.
A payment provision specifies a fixed or deter-
minable settlement to be made if the underlying
behaves in a specified manner.
A hedge is an identifiable asset, liability, firm
commitment, or anticipated transaction.
Offset is the liquidating of a purchase of futures
through the sale of an equal number of contracts
of the same delivery month on the same under-
lying instrument on the same exchange, or the
April 2002 Trading and Capital-Markets Activities Manual
Page 8
Accounting 2120.1
actually selling the assets. Credit derivatives An asset or liability is eligible for designation as
that provide for payments to be made only to a hedged item in a fair-value hedge if all of the
reimburse the guaranteed party for a loss incurred following criteria are met:
because the debtor fails to pay when payment is
due (financial guarantees), which is an identifi- • The hedged item is specifically identified as
able event, are not considered derivatives under an asset, a liability, or a firm commitment. The
FAS 133 for accounting purposes. Those credit hedged item can be a single asset, liability, or
derivatives not accounted for under FAS 133 firm commitment or a portfolio of similar
would not be recorded in the financial state- assets, liabilities, or firm commitments.
ments as assets or liabilities at fair value, but, if • The hedged item is not one of the following:
material, would typically be disclosed in the — an asset or liability that is already reported
financial statements. Credit derivatives not con- at fair value;
sidered financial guarantees, as defined above, — an investment accounted for by the equity
are reported as derivatives as determined by method;
FAS 133. — a minority interest in one or more consoli-
Equity derivatives are derivatives that are dated subsidiaries;
linked to various indexes and individual securi- — an equity investment in a consolidated
ties in the equity markets. FAS 133 covers the subsidiary;
accounting treatment for equity derivatives that — a firm commitment either to enter into a
are not indexed to an institution’s own stock. business combination or to acquire or
Equity derivatives indexed to the institution’s dispose of a subsidiary, a minority interest,
own stock are determined in accordance with or an equity-method investee; or
APB No. 18, ‘‘The Equity Method of Account-
— an equity instrument issued by the institu-
ing for Investments in Common Stock,’’ and
tion and classified as stockholders’ equity
Statement of Financial Accounting Standards
in the statement of financial position.
No. 123 (FAS 123), ‘‘Accounting for Stock-
• If the hedged item is all or a portion of a debt
Based Compensation.’’
security classified as held-to-maturity, the des-
ignated risk being hedged is the risk of changes
in its fair value attributable to changes in the
Hedging Activities obligor’s creditworthiness. If the hedged item
is an option component of a held-to-maturity
Accounting for Fair-Value Hedges
security that permits its repayment, the desig-
A fair-value hedge is a derivative instrument nated risk being hedged is the risk of changes
that hedges exposure to changes in the fair value in the entire fair value of that option
of an asset or a liability, or an identified portion component.
thereof, that is attributable to a particular risk. • If the hedged item is a nonfinancial asset or
To qualify for fair-value-hedge accounting, the liability or is not a recognized loan-servicing
hedge must meet all of the following criteria: right or a nonfinancial firm commitment with
financial components, the designated risk being
• Formal documentation must be made at the hedged is the risk of changes in the fair value
inception of the hedging relationship of the of the entire hedged asset or liability.
institution’s risk-management objective and • If the hedged item is a financial asset or
strategy for undertaking the hedge. This liability, a recognized loan-servicing right, or
includes documenting the hedged instrument, a nonfinancial firm commitment with financial
the hedged item, the nature of the risk, and components, the designated risk being hedged
how the hedge’s effectiveness in offsetting the is—
exposure to changes in the fair value will be — the risk of changes in the overall fair value
assessed. of the entire hedged item,
• Assessment is required whenever financial — the risk of changes in its fair value attrib-
statements or earnings are reported, and at utable to changes in market interest rates,
least every three months, to ensure the hedge — the risk of changes in its fair value attrib-
relationship is highly effective in achieving utable to changes in the related foreign-
offsetting changes in fair value to the hedged currency exchange rates, or
risk. — the risk of changes in its fair value attrib-
Trading and Capital-Markets Activities Manual September 2001
Page 9
2120.1 Accounting
utable to changes in the obligor’s credit- • The forecasted transaction is with a party that
worthiness. is external to the reporting institution.
• The forecasted transaction is not the acquisi-
An institution is subject to applicable GAAP tion of an asset or incurrence of a liability that
requirements for assessment of impairment for will subsequently be remeasured with changes
assets, or recognition of an increased obligation in fair value attributed to the hedged risk
for liabilities. An institution shall also discon- currently reported in earnings.
tinue the accounting treatment for a financial • If the variable cash flows of the forecasted
instrument as a fair-value hedge if any of the transaction relate to a debt security that is
following conditions occurs: classified as held-to-maturity, the risk being
hedged is the risk of changes in the cash flows
• Any criterion of the fair-value hedge or hedged attributable to default or the risk of changes in
item is no longer met. the obligor’s creditworthiness.
• The derivative expires or is sold, terminated, • The forecasted transaction does not involve
or exercised. a business combination subject to the provi-
• The institution removes the designation of the sions of Statement of Financial Accounting
fair-value hedge. Standards No. 141 (FAS 141), ‘‘Business
Combinations,’’ and is not a transaction
involving—
Accounting for Cash-Flow Hedges — a parent company’s interest in consoli-
dated subsidiaries,
A cash-flow hedge is a derivative hedging the — a minority interest in a consolidated
exposure to variability in expected cash flows subsidiary,
attributed to a particular risk. That exposure may — an equity-method investment, or
be associated with an existing asset or liability — an institution’s own equity instruments.
(that is, variable-rate debt) or a forecasted trans- • If the hedged transaction is the forecasted
action (that is, a forecasted purchase or sale). purchase or sale of a financial asset or liability
Designated hedging instruments and hedged or the variable cash inflow or outflow of an
items or transactions qualify for cash-flow- existing financial asset or liability, the desig-
hedge accounting if all of the following criteria nated risk being hedged is—
are met: — the risk of changes in the cash flows of the
entire asset or liability,
• Formal documentation is required at inception — the risk of changes in its cash flows
of the hedging relationship, and the institu- attributable to changes in market interest
tion’s risk-management objective and strategy rates,
for undertaking the hedge must be done as — the risk of changes in the cash flows of the
noted in ‘‘Accounting for Fair-Value Hedges.’’ equivalent functional currency attributable
• The hedge effectiveness must be assessed as to changes in the related foreign-currency
described in ‘‘Accounting for Fair-Value exchange rates, or
Hedges.’’ — the risk of changes in cash flows attribut-
• If an instrument is used to hedge the variable able to default or the risk of change in the
interest rates associated with a financial asset obligor’s creditworthiness.
or liability, the hedging instrument must be
clearly linked to the financial asset or liability As required for fair-value-hedge accounting, an
and highly effective in achieving offset. institution shall discontinue the accounting for
cash-flow hedges if—
A forecasted transaction is eligible for designa- — any criterion for a cash-flow hedge or the
tion as a hedged item in a cash-flow hedge if all hedged forecasted transaction is no longer
of the following additional criteria are met: met;
— the derivative expires or is sold, termi-
• The forecasted transaction is specifically iden- nated, or exercised; or
tified as a single transaction or a group of — the institution removes the designation of
individual transactions. the cash-flow hedge.
• The occurrence of the forecasted transaction is
probable. If cash-flow-hedge accounting is discontin-
September 2001 Trading and Capital-Markets Activities Manual
Page 10
Accounting 2120.1
ued, the accumulated amount in other compre- Foreign-Currency Translations
hensive income remains and is reclassified into
earnings when the hedged forecasted transaction Translation is the conversion of the financial
affects earnings. Existing GAAP for impairment statements of a foreign operation (a branch,
of an asset or recognition of an increased liabil- division, or subsidiary) denominated in the
ity applies. operation’s functional currency to U.S. dollars,
generally for inclusion in consolidated financial
Accounting for Foreign-Currency Hedges statements. The balance sheets of foreign opera-
tions are translated at the exchange rate in effect
Consistent with the functional-currency concept on the statement date, while income-statement
of FAS 52 (discussed below), FAS 133 indicates amounts are generally translated at an appropri-
that an institution may designate the following ate weighted amount. Meeting this criterion will
types of hedges as hedges of foreign-currency be particularly difficult when an anticipated
exposure: transaction is not expected to take place in the
near future.
• a fair value of an unrecognized firm commit- Detailed guidance for determining the func-
ment or an available-for-sale security tional currency is set forth in appendix 1 of FAS
• a cash-flow hedge of a forecasted foreign- 52: ‘‘An entity’s functional currency is the
currency-denominated transaction or a fore- currency of the primary economic environment
casted intercompany foreign-currency- in which the entity operates; normally, that is the
denominated transaction currency of the environment in which an entity
• a hedge of a net investment in a foreign primarily generates and expends cash. The func-
operation tional currency of an entity is, in principle, a
matter of fact. In some cases, the facts will
Foreign-currency fair-value hedges and cash- clearly identify the functional currency; in other
flow hedges are generally subject to the fair- cases, they will not.’’
value-hedge and cash-flow-hedge accounting FAS 52 indicates the salient economic indi-
requirements discussed in those respective cators and other possible factors that should be
subsections. considered both individually and collectively
when determining the functional currency: cash
flow, price and market sales indicators, expense
indicators, financing indicators, intercompany
ACCOUNTING FOR transactions and arrangements, and other factors.
FOREIGN-CURRENCY
INSTRUMENTS
The primary source of authoritative guidance for Foreign-Currency Transactions
accounting for foreign-currency translations and
foreign-currency transactions is FAS 52. The Gains or losses on foreign-currency transac-
standard encompasses futures contracts, forward tions, in contrast to translation, are recognized in
agreements, and currency swaps as they relate to income as they occur, unless they arise from a
foreign-currency hedging. FAS 52 draws a dis- qualifying hedge. FAS 52 provides guidance
tinction between foreign-exchange ‘‘transla- about the types of foreign-currency transactions
tion’’ and ‘‘transactions.’’ Translation, generally, for which gain or loss is not currently recog-
focuses on the combining of foreign and domes- nized in earnings. Gains and losses on the
tic entities so they can be presented and reported following foreign-currency transactions should
in the consolidated financial statements in one not be included in determining net income but
currency. Foreign-currency transactions, in con- should be reported in the same manner as
trast, are transactions (such as purchases or translation adjustments:
sales) by an operation in currencies other than • foreign-currency transactions that are desig-
its ‘‘functional currency.’’ For U.S. depository nated and effective as economic hedges of a
institutions, the functional currency will gener- net investment in a foreign entity, commenc-
ally be the dollar for its U.S. operations and the ing as of the designation date
local currency of wherever its foreign operations • intercompany foreign-currency transactions
transact business. that are long-term investments (that is, settle-
Trading and Capital-Markets Activities Manual September 2001
Page 11
2120.1 Accounting
ment is not planned or anticipated in the Under FIN 39, offsetting, or the netting of
foreseeable future), when the entities to the assets and liabilities, is not permitted unless all
transaction are consolidated, combined, or of the following four criteria are met:
accounted for by the equity method in the
reporting institution’s financial statements. • Two parties must owe each other determin-
able amounts.
• The reporting entity must have a right to set
NETTING OR OFFSETTING off its obligation with the amount due to it.
• The reporting entity must actually intend to
ASSETS AND LIABILITIES set off these amounts.
FASB Interpretation 39 (FIN 39), ‘‘Offsetting of • The right of setoff must be enforceable at law.
Amounts Related to Certain Contracts,’’ pro-
vides guidance on the netting of assets and When all four criteria are met, a bank or other
liabilities arising from (1) traditional activities, company may offset the related asset and liabil-
such as loans and deposits, and (2) derivative ity and report the net amount in its GAAP
instruments. The assets and liabilities from financial statements. On the other hand, if any
derivatives are primarily the fair values, or one of these criteria is not met, the fair value of
estimated market values, for swaps and other contracts in a loss position with a given coun-
contracts, and the receivables and payables on terparty will not be offset against the fair value
these instruments. FIN 39 clarifies the definition of contracts in a gain position with that coun-
of a ‘‘right of setoff’’ that GAAP has long terparty, and organizations will be required to
indicated must exist before netting of assets and record gross unrealized gains on such contracts
liabilities can occur in the balance sheet. One of as assets and to report gross unrealized losses as
the main purposes of FIN 39 was to clarify that liabilities. However, FIN 39 relaxes the third
FASB’s earlier guidance on the netting of assets criterion (the parties’ intent requirement) to
and liabilities (Technical Bulletin 88-2) applies permit the netting of fair values of OBS deriva-
to amounts recognized for OBS derivative tive contracts executed with the same counter-
instruments as well. party under a legally enforceable master netting
Balance-sheet items arise from off-balance- agreement.8 A master netting arrangement exists
sheet interest-rate and foreign-currency instru- if the reporting institution has multiple con-
ments in primarily two ways. First, those bank- tracts, whether for the same type of conditional
ing organizations and other companies that or exchange contract or for different types of
engage in various trading activities involving contracts, with a single counterparty that are
OBS derivative instruments (for example, subject to a contractual agreement that provides
interest-rate and currency swaps, forwards, and for the net settlement of all contracts through a
options) are required by GAAP to mark to single payment in a single currency in the event
market these positions by recording their fair of default or termination of any one contract.
values (estimated market values) on the balance FIN 39 defines ‘‘right of setoff’’ and specifies
sheet and recording any changes in these fair conditions that must be met to permit offsetting
values (unrealized gains and losses) in earnings. for accounting purposes. FASB’s Interpretation
Second, interest-rate and currency swaps have
receivables and payables that accrue over time, netting agreement, the accrual components in fair value are
also netted.
reflecting expected cash inflows and outflows 8. The risk-based capital guidelines provide generally that
that must periodically be exchanged under these a credit-equivalent amount is calculated for each individual
contracts, and these receivables and payables interest-rate and exchange-rate contract. The credit-equivalent
must be recorded on the balance sheet as assets amount is determined by summing the positive mark-to-
market values of each contract with an estimate of the
and liabilities, respectively.7 potential future credit exposure. The credit-equivalent amount
is then assigned to the appropriate risk-weight category.
Netting of swaps and similar contracts is recognized for
7. In contrast, the notional amounts of off-balance-sheet risk-based capital purposes only when accomplished through
derivative instruments, or the principal amounts of the under- ‘‘netting by novation.’’ This is defined as a written bilateral
lying asset or assets to which the values of the contracts are contract between two counterparties under which any obliga-
indexed, are not recorded on the balance sheet. Note, however, tion to each other is automatically amalgamated with all other
that if the OBS instrument is carried at market value, that obligations for the same currency and value date, legally
value will include any receivable or payable components. substituting one single net amount for the previous gross
Thus, for those OBS instruments that are subject to a master obligations.
September 2001 Trading and Capital-Markets Activities Manual
Page 12
Accounting 2120.1
41 (FIN 41), ‘‘Offsetting of Amounts Relating to receivables that represent repurchase agree-
Certain Repurchase and Reverse Repurchase ments and reverse repurchase agreements under
Agreements,’’ was issued in December 1994. certain circumstances in which net settlement is
This interpretation modifies FIN 39 to permit not feasible. (See FIN 41 for further information.)
offsetting in the balance sheet of payables and
Trading and Capital-Markets Activities Manual April 2001
Page 13
Accounting
Examination Objectives Section 2120.2
1. To determine whether the organization’s writ- ments are netted for only those counterpar-
ten accounting policies relating to trading ties whose contracts conform with specific
and hedging with derivatives instruments criteria permitting such setoff.
have been approved by senior management 6. To determine whether management’s asser-
for conformance with generally accepted tions that financial instruments are hedges
accounting practices, and that such policies meet the necessary criteria for exclusion
conform with regulatory reporting principles. from classification as trading instruments.
2. To determine whether capital-markets and 7. To ascertain whether the organization has
trading activities appear in regulatory reports, adequate support that a purported hedge
as reported by accounting personnel, to con- reduces risk in conformance with FAS 133.
form with written accounting policies. 8. To determine whether the amount and recog-
3. To determine whether securities held in nition of deferred losses arising from hedg-
available-for-sale or held-to-maturity accounts ing activities are properly recorded and being
meet the criteria of FAS 115 and are, there- amortized appropriately.
fore, properly excluded from the trading 9. To recommend corrective action when poli-
account. cies, procedures, practices, internal controls,
4. To determine whether market values of traded or management information systems are
assets are accurately reflected in regulatory found to be deficient, or when violations of
reports. law, rulings, or regulations have been noted.
5. To determine whether, for financial and regu-
latory reporting purposes, financial instru-
Trading and Capital-Markets Activities Manual April 2002
Page 1
Accounting
Examination Procedures Section 2120.3
These procedures list a number of processes and 3. Obtain a sample of financial instruments held
activities to be reviewed during a full-scope in the trading account and compare the
examination. The examiner-in-charge will estab- reported market value against outside quota-
lish the general scope of examination and work tions or compare valuation assumptions
with the examination staff to tailor specific areas against market data.
for review as circumstances warrant. As part of 4. Review the organization’s controls over
this process, the examiner reviewing a function reporting certain financial instruments on a
or product will analyze and evaluate internal- net basis. Using a sample of transactions,
audit comments and previous examination work- review the contractual terms to determine
papers to assist in designing the scope of exami- that the transactions qualify for netting for
nation. In addition, after a general review of a financial reporting and regulatory reporting
particular area to be examined, the examiner purposes, according to the criteria specified
should use these procedures, to the extent they by FIN 39, FIN 41, or regulatory reporting
are applicable, for further guidance. Ultimately, requirements.
it is the seasoned judgment of the examiner and 5. Review the organization’s methods for iden-
the examiner-in-charge as to which procedures tifying and quantifying risk for purposes
are warranted in examining any particular of hedging. Review the adequacy of docu-
activity. mented risk reduction (FAS 52 and FAS 133)
and the enterprise or business-unit risk reduc-
1. Obtain a copy of the organization’s account- tion (FAS 80) that are necessary conditions
ing policies and review them for conform- to applying hedge accounting treatment.
ance with the relevant sections (that is, those 6. Obtain schedules of the gains or losses result-
sections regarding trading and hedging trans- ing from hedging activities and review
actions) of authoritative pronouncements by whether the determination was appropriate
FASB and AICPA (for Y-series reports) and and reasonable.
with the call report instructions. 7. Determine if accounting reversals are well
2. Using a sample of securities purchase and documented.
sales transactions, check the following: 8. Determine if accounting profits and losses
a. Securities subledgers accurately state the prepared by control staff are reviewed by the
cost, and the market values of the securi- appropriate level of management and that the
ties agree to outside quotations. senior staff in the front office (head trader,
b. Securities are properly classified among treasurer) has agreed with accounting num-
trading, available-for-sale, and held-to- bers. Determine if the frequency of review by
maturity classifications. senior managers is adequate for the institu-
c. Transactions that transfer securities from tion’s volume and level of earnings.
the trading account to either held-to- 9. Recommend corrective action when policies,
maturity or available-for-sale are autho- procedures, practices, internal controls, or
rized and conform with authoritative management information systems are found
accounting guidance (such transfers should to be deficient, or when violations of law,
be rare, according to FAS 115). rulings, or regulations have been noted.
Trading and Capital-Markets Activities Manual April 2002
Page 1
Accounting
Internal Control Questionnaire Section 2120.4
1. Does the organization have a well-staffed 4. Do the revaluation rates used for a sample of
accounting unit that is responsible for follow- financial instruments held in the trading
ing procedures and instructions for recording account appear within range when compared
transactions; marking to market when appro- with supporting documentation of market
priate; filing regulatory and stockholder rates?
reports; and dealing with regulatory, tax, and 5. Do the contractual terms of a sample of
accounting issues? transactions qualify for netting for financial
2. Do the organization’s accounting policies reporting and regulatory reporting purposes,
conform to the relevant sections (that is, according to the criteria specified by FIN 39,
those sections regarding trading and hedging FIN 41, or regulatory reporting requirements?
transactions) of authoritative pronounce- 6. Does the financial institution have proce-
ments by FASB and AICPA, and do they dures to document risk reduction (FAS 52
conform to the call report instructions? If the and FAS 133), and does it have enterprise or
organization is a foreign institution, does business-unit risk-reduction (FAS 133) con-
the organization have appropriate policies ditions to apply hedge accounting treatment?
and procedures to convert foreign accounting Do the procedures apply to the full range of
principles to U.S. reporting guidance? Is applicable products used for investment? Is
there an adequate audit trail to reconcile the record retention adequate for this process?
financial statements to regulatory reports? 7. Are the methods for assessing gains or losses
3. For revaluation— resulting from hedging activities appropriate
a. do securities subledgers accurately state and reasonable?
the cost, and do market values of the 8. Are accounting reversals justified by super-
securities agree to outside quotations, and visory personnel and are they well
b. are securities properly classified among documented?
trading, available-for-sale, and held-to- 9. Are profits and losses prepared by control
maturity classifications? staff reviewed by the appropriate level of
Evaluate the transfer of securities from the management and senior staff (head trader,
trading account to either held-to-maturity or treasurer) for agreement? Is the frequency of
available-for-sale for authorization in con- review by senior managers adequate for the
formance with authoritative accounting guid- institution’s volume and level of earnings?
ance. Are such transfers rare? (According to
FAS 115, such transfers should be rare.)
Trading and Capital-Markets Activities Manual April 2002
Page 1
Accounting
Appendix—Related Financial Statement Disclosures Section 2120.5
SECURITIES PORTFOLIO computing realized gain or loss (that is,
DISCLOSURES UNDER FAS 115 specific identification, average cost, or other
method used),
For securities classified as available-for-sale and • the gross gains and gross losses included in
separately for securities classified as held-to- earnings from transfers of securities from the
maturity, all reporting institutions should dis- available-for-sale category into the trading
close the aggregate fair value, gross unrealized category,
holding gains, gross unrealized holding losses, • the change in net unrealized holding gain or
and amortized cost basis by major security type loss on available-for-sale securities that has
as of each date for which a statement of financial been included in the separate component of
position is presented. Financial institutions shareholders’ equity during the period, and
should include the following major security • the change in net unrealized holding gain or
types in their disclosure, though additional types loss on trading securities that has been included
may be included as appropriate: in earnings during the period.
• equity securities For any sales of or transfers from securities
• debt securities issued by the U.S. Treasury and classified as held-to-maturity, the amortized cost
other U.S. government corporations and amount of the sold or transferred security, the
agencies related realized or unrealized gain or loss, and
• debt securities issued by states of the United the circumstances leading to the decision to sell
States and political subdivisions of the states or transfer the security should be disclosed in
• debt securities issued by foreign governments the notes to the financial statements for each
• corporate debt securities period for which the results of operations are
presented. Such sales or transfers should be rare,
• mortgage-backed securities
except for sales and transfers due to the changes
• other debt securities in circumstances as previously discussed.
For investments in debt securities classified as
available-for-sale and separately for securities
classified as held-to-maturity, all reporting insti- ACCOUNTING DISCLOSURES
tutions should disclose information about the FOR DERIVATIVES AND
contractual maturities of those securities as of
the date of the most recent statement of financial
HEDGING ACTIVITIES
position presented. Maturity information may be Under FAS 133, institutions that hold or issue
combined in appropriate groupings. In comply- derivative instruments, or nonderivative instru-
ing with this requirement, financial institutions ments qualifying as hedge instruments, should
should disclose the fair value and the amortized disclose their objectives for holding or issuing
cost of debt securities based on at least four the instruments and their strategies for achieving
maturity groupings: (1) within one year, (2) after the objectives. Institutions should distinguish
one year through five years, (3) after five years whether the derivative instrument is to be used
through 10 years, and (4) after 10 years. Secu- as a fair-value, cash-flow, or foreign-currency
rities not due at a single maturity date, such as hedge. The description should include the risk-
mortgage-backed securities, may be disclosed management policy for each of the types of
separately rather than allocated over several hedges. Institutions not using derivative instru-
maturity groupings; if allocated, the basis for ments as hedging instruments should indicate
allocation also should be disclosed. For each the purpose of the derivative activity.
period for which the results of operations are
presented, an institution should disclose—
• the proceeds from sales of available-for-sale Fair-Value Hedges
securities and the gross realized gains and
gross realized losses on those sales, For foreign-currency-transaction gains or losses
• the basis on which cost was determined in that qualify as fair-value hedges, report—
Trading and Capital-Markets Activities Manual April 2002
Page 1
2120.5 Accounting: Appendix—Related Financial Statement Disclosures
• the net gain or loss recognized in earnings hedges, the net amount of gains or losses
during the reporting period, which represents included in the cumulative translation adjust-
the amount of hedge ineffectiveness and the ment during the reporting period should be
component of gain or loss, if any, excluded disclosed.
from the assessment of hedge effectiveness,
and a description of where the net gain or loss
is reported in the income statement; and Reporting Changes in Other
• the amount of net gain or loss recognized in
earnings when a hedged firm commitment no
Comprehensive Income
longer qualifies as a fair-value hedge.
Institutions should show as a separate classifi-
cation within OCI the net gain or loss on
derivative instruments designated and qualify-
Cash-Flow Hedges ing as cash-flow hedges. Additionally, pursuant
to FAS 130, ‘‘Reporting Comprehensive
For cash-flow gains or losses that qualify as Income,’’ institutions should disclose the begin-
cash-flow hedges, report— ning and ending accumulated derivative gain or
loss, the related net change associated with
• the net gain or loss recognized in earnings current-period hedging transactions, and the net
during the reporting period, which represents amount of any reclassification into earnings.
the amount of ineffectiveness and the compo-
nent of the derivative’s gain or loss, if any,
excluded from the assessment of hedge effec- SEC Disclosure Requirements for
tiveness, and a description of where the net
gain or loss is reported in the income
Derivatives
statement;
In the first quarter of 1997, the SEC issued rules
• a description of the transactions or other
requiring the following expanded disclosures for
events that will result in the reclassification
derivative and other financial instruments for
into earnings of gains and losses that are
public companies:
reported in accumulated other comprehensive
income (OCI), and the estimated net amount
• in the footnotes of the financial statements,
of the existing gains or losses at the reporting
improved descriptions of accounting policies
date that is expected to be reclassified into
for derivatives
earnings within the next 12 months;
• outside of the footnotes to the financial state-
• the maximum length of time over which the
ments, disclosure of quantitative and qualita-
entity is hedging its exposure to the variability
tive information about derivatives and other
in further cash flows for forecasted transac-
financial instruments
tions, excluding those forecasted transactions
— For the quantitative disclosures about
related to the payment of variable interest on
market-risk-sensitive instruments, regis-
existing financial instruments; and
trants must follow one of three methodolo-
• the amount of gains and losses reclassified
gies and distinguish between instruments
into earnings as a result of the discontinuance
used for trading purposes and instruments
of cash-flow hedges because it is probable that
used for purposes other than trading. The
the original forecasted transactions will not
three disclosure methodology alternatives
occur by the end of the originally specified
are (1) tabular presentation of fair values
time period or within an additional time period
and contract terms, (2) sensitivity analysis,
as outlined in FAS 133.
or (3) value-at-risk disclosures. Registrants
must disclose separate quantitative infor-
mation for each type of market risk to
Foreign-Currency Hedges which the entity is exposed (for example,
interest-rate or foreign-exchange rate).
For derivatives, as well as nonderivatives, that — The qualitative disclosures about market
may give rise to foreign-currency-transaction risk must include the registrant’s primary
gains or losses under FAS 52, and that have been market-risk exposures at the end of the
designated as and qualify for foreign-currency reporting period, how those exposures are
April 2002 Trading and Capital-Markets Activities Manual
Page 2
Accounting: Appendix—Related Financial Statement Disclosures 2120.5
managed, and changes in primary risk ments with any financial instruments, firm
exposures or how those risks are managed commitments, commodity positions, and
as compared with the previous reporting anticipated transactions that are being hedged
period. by such items (these are included to avoid
• disclosures about derivative financial instru- misleading disclosures).
Trading and Capital-Markets Activities Manual April 2002
Page 3
Regulatory Reporting
Section 2130.1
The internal-control function is critical in the is filed with the appropriate self-regulatory
assessment of an institution’s regulatory report- organization (SRO), and the SEC furnishes
ing. The examiner must gain a thorough under- microdata to the Board for bank-affiliated secu-
standing of (1) the information flows from the rities dealers. The Y-20, another FRB report,
execution of a transaction to its inclusion in the summarizes the FOCUS data and segregates
appropriate regulatory report, (2) the design and revenues from eligible and ineligible securities.
performance of critical internal-control pro- The Y-20 report is only filed by securities
cedures, and (3) the adherence to regulatory subsidiaries that are still operating pursuant to
reporting standards. section 4(c)(8) of the Bank Holding Company
Examiners, report processors, and economists Act, and are therefore subject to the Board’s
who analyze regulatory reports or otherwise use revenue test designed to prevent violation of the
the data contained in them depend on the data’s former Glass-Steagall Act. Other bank holding
accuracy. False reporting is punishable by civil company subsidiaries that trade eligible securi-
monetary penalties as prescribed in the Finan- ties also file the FOCUS report with the SEC
cial Institutions Recovery, Reform, and and the appropriate SRO. The appendix to this
Enhancement Act of 1989 (FIRREA). section describes frequently used regulatory
reports.
OVERVIEW OF REPORTS
SOUND PRACTICES
Several types of regulatory reports contain trad-
ing data: the Report of Condition (FFIEC 031– • Every organization should have procedures to
034), the Report of Assets and Liabilities of U.S. prepare regulatory reports. When conversion
Branches and Agencies of Foreign Banks (FFIEC from foreign accounting principles to gener-
002), and financial statements of the securities ally accepted accounting principles (GAAP) is
subsidiaries. required, a mapping should document an audit
The Federal Reserve Board (FRB) and Fed- trail. This documentation is particularly
eral Financial Institutions Examination Council important as the degree to which reconcilia-
(FFIEC) require financial institutions to summa- tion is automated declines.
rize their gross positions outstanding in traded • Every institution should maintain clear and
products on the Report of Condition and Income concise records with special emphasis on
as well as on the Report of Assets and Liabilities documenting adjustments.
(collectively, the call reports). These regulatory • Every organization should have a procedure to
reports vary according to the size and type of ensure that current reporting instructions are
institution. For example, the reports required by maintained and understood by control staff.
the FFIEC include the 002 for U.S. branches and • To ensure correct classification of new prod-
agencies of foreign banks and a series of reports ucts, every organization should have a proce-
for domestic banks, while the FRB requires the dure whereby staff who are preparing regula-
Y-series to cover bank holding companies. tory reports are consulted if new products are
Section 20 subsidiaries show their securities introduced.
revenue and capitalization in detail on the Finan- • Every organization should have a procedure,
cial and Operational Combined Uniform Single such as contacting the appropriate statistics
(FOCUS) report as required by the Securities units within the Federal Reserve System, to
and Exchange Commission (SEC). This report resolve questions when they arise.
Trading and Capital-Markets Activities Manual April 2001
Page 1
Regulatory Reporting
Examination Objectives Section 2130.2
The examiner’s principal objective when review- 3. To assess the effectiveness of the system of
ing the regulatory reporting function is to verify internal controls over the regulatory report-
the accuracy and consistency of reporting ing function. To identify, document, and test
requirements. The examiner’s review of regula- internal-control procedures that are critical to
tory reporting, as it applies to trading activities the accurate, reliable, and complete reporting
of the institution, should be coordinated with of trading transactions in regulatory reports.
overall trading-examination objectives. To assess 4. To determine the effectiveness of the internal
the accuracy of regulatory reports, examiners controls over financial reporting, which can
should review appropriate supporting docu- have an impact on the extent of examination
ments, such as workpapers, general ledgers, procedures that need to be applied to verify
subsidiary ledgers, and other information used the accuracy of regulatory reports. (For exam-
to prepare the regulatory reports. ple, if an examiner has determined that an
organization has very effective internal con-
The reports must meet the following objectives: trols over financial reporting, then the extent
of detailed testing procedures applied to
1. To confirm that the trading data are as of the verifying the accuracy of regulatory reports
report date and that they match the records of will be less extensive than the procedures
the traders and include all material post- applied to an institution that has ineffective
closing adjustments to the general ledger. controls or a system of controls with poten-
2. To check that the data conform to the require- tial weaknesses.)
ments of the report instructions. (‘‘Account- 5. To review the Financial and Operational
ing requirements’’ refers to how a transaction Combined Uniform Single (FOCUS) report
should be valued. It also prescribes when to evaluate capital adequacy. (For section 20
transactions should be reported (for example, subsidiaries, the examiner reviews the FR
the rules regarding trade-date accounting). Y-20 report to ensure that revenue from
The reports required by the Board are gener- ineligible securities does not exceed 10 per-
ally consistent with generally accepted cent of total revenue.)
accounting principles (GAAP).
Trading and Capital-Markets Activities Manual April 2001
Page 1
Regulatory Reporting
Examination Procedures Section 2130.3
These procedures list processes and activities latory reports in order to check the descrip-
that may be reviewed during a full-scope exami- tions of each transaction included in the line
nation. The examiner-in-charge will establish items. These details must match the instruc-
the general scope of examination and work with tions for the corresponding lines.
the examination staff to tailor specific areas for 4. The examiner should reconcile the regulatory
review as circumstances warrant. As part of this reports to the institution’s official records,
process, the examiner reviewing a function or especially the general ledger, and to reports
product will analyze and evaluate internal-audit of the area in charge of trading. The recon-
comments and previous examination workpa- ciliation process begins with a review of the
pers to assist in designing the scope of exami- regulatory report through a spot check of the
nation. In addition, after a general review of a regulatory report against the preparer’s
particular area to be examined, the examiner sources. The examiner may be able to avoid
should use these procedures, to the extent they line-by-line reconciliation if accuracy runs
are applicable, for further guidance. Ultimately, high in the spot check or if the examiner
it is the seasoned judgment of the examiner and verifies that the institution has an approved,
the examiner-in-charge as to which procedures independently verified reconciliation process.
are warranted in examining any particular 5. The examiner should ensure that post-closing
activity. adjustments and all accounting and timing
differences, if any, between the regulatory
1. Early in the examination, the examiner should reporting requirements and generally accepted
review trading data for arithmetic mistakes, accounting principles (GAAP) have been
general accounting errors, and any misunder- effected.
standing of the regulatory reporting instruc-
tions. Common conceptual errors include Call report data are the basis for the balance
incorrect recognition of income on traded sheet, off-balance-sheet items or activities,
products, incorrect valuation of trading- income statement, and risk-based capital sched-
account securities, omission of securities not ules of the Report of Examination. Corrections
yet settled, and reporting of currency swaps to the data made during the reconcilement of the
as interest-rate swaps. regulatory reports must be reflected in Report of
2. The examiner should ensure that previously Examination schedules. In the rare instance
noted exceptions (either in the prior Report when the dates of the regulatory reports and the
of Examination or by auditors) have been examination do not coincide, data as of the
properly addressed. examination date must be compiled in accor-
3. The examiner should review the workpapers dance with call report instructions.
of the person responsible for preparing regu-
Trading and Capital-Markets Activities Manual April 2001
Page 1
Regulatory Reporting
Internal Control Questionnaire Section 2130.4
1. Before reports are submitted to the regula- that are handled outside of normal pro-
tory authorities, are all regulatory reports cesses or automated systems may be omitted
reviewed for accuracy by a person who is if procedures and adequate communication
independent of the preparation process? exist between the reporting and trading
2. Does internal audit at the institution review functions.
the process of regulatory reporting, includ- 7. Do reporting personnel have an adequate
ing the accuracy of the trading data on understanding of trading instruments, trad-
regulatory reports? ing transactions, and reporting requirements
3. Are internal controls in place that provide to ensure accurate and reliable regulatory
reasonable assurances of the accuracy, relia- reporting?
bility, and completeness of reported trading
8. Does the preparer or reviewer maintain the
information?
most current instructions for the reports he
4. Are the internal controls documented and
or she is responsible for?
tested by internal audit? If not, examination
personnel should document and test critical 9. Does the accounting department have pro-
internal controls in this area to the extent cedures to ensure that the preparer or
appropriate to satisfy examination objectives. reviewer investigates questions from the
5. Does supporting documentation include FRB report analysts? (Report analysts ask
sources of information and reconciliation to the accounting department over the tele-
the general or subsidiary ledgers, and are phone to explain arithmetic discrepancies
reconciling items handled appropriately? and large variances from prior periods.)
6. Are procedures in place to capture exotic 10. What knowledge does the signatory have
instruments or other transactions that require regarding the report he or she is signing and
special handling? Off-balance-sheet items the controls in place to ensure accuracy?
Trading and Capital-Markets Activities Manual April 2001
Page 1
Regulatory Reporting
Appendix—Reports for Trading Instruments Section 2130.5
REPORTS LISTED BY TYPE OF detail by product type, while others only have
INSTITUTION data aggregated for selected products. Before
undertaking a review of any trading instruments,
Listed below, according to the type of respon- examiners should become familiar with the data
dent, are the regulatory reports that include data available to them in the reports filed by the
on traded products. Some of the reports show entity under examination.
Bank Holding Company Reports
1. FR Y-9C Consolidated financial statements for top-tier bank holding companies with total
consolidated assets of $150 million or more and lower-tier bank holding
companies that have total consolidated assets of $1 billion or more. In addition,
FR Y-9C reports are filed by all multibank bank holding companies with debt
outstanding to the general public or that are engaged in certain nonbank
activities, regardless of size.
Frequency: quarterly
Each of the instruments listed below is captured on this report. See the report
instructions/glossary for the treatment of each instrument. See schedule HC-R
for risk-based capital components.
Schedule HC-B
Securities
U.S. Treasuries
Municipal
Mortgage-backed
Asset-backed
Foreign governments
Corporations
LDC debt
Equities
Schedule HC-L
Futures and forwards
Forward rate agreements
Interest-rate swaps
Foreign exchange
Currency swaps
Options (interest-rate, currency)
Commodities
Index-linked activities
Hybrids
Trading and Capital-Markets Activities Manual April 2001
Page 1
2130.5 Regulatory Reporting: Appendix—Reports for Trading Instruments
2. FR Y-9SP Parent-company-only financial statements for one-bank holding companies with
total consolidated assets of less than $150 million.
Frequency: semiannually
Typically, examiners will encounter only securities (for example, U.S. Treasur-
ies, obligations of states and municipalities, and mortgage-backed securities)
when reviewing this report. No off-balance-sheet items are captured on this
report.
3. FR Y-9LP Parent-company-only financial statements for each bank holding company that
files the FR Y-9C. In addition, for tiered bank holding companies, parent-
company-only financial statements for each lower-tier bank holding company if
the top-tier bank holding company files the FR Y-9C.
Frequency: quarterly
Typically, examiners will encounter only securities transactions (for example,
U.S. Treasuries, municipal, and mortgage-backed) when reviewing this report.
No off-balance-sheet items are captured on this report.
4. FR Y-8 Bank Holding Company Report of Insured Depository Institutions’ Section 23A
Transactions with Affiliates.
Frequency: quarterly
This report collects information on transactions between an insured depository
institution and its affiliates that are subject to section 23A of the Federal Reserve
Act (FRA). The information is used to enhance the Federal Reserve’s ability to
monitor bank exposures to affiliates and to ensure compliance with section 23A
of the FRA. Section 23A is one of the most important statutes on limiting
exposures to individual institutions and protecting the federal safety net.
Reporters include all top-tier bank holding companies (BHCs), including
financial holding companies (FHCs). In addition, all foreign banking organiza-
tions that directly own a U.S. subsidiary bank must file this report. Participation
is mandatory.
5. FR Y-20 Financial statements for a bank holding company subsidiary engaged in
ineligible securities underwriting and dealing.
Frequency: quarterly only by firms that continue to function as ‘‘section 20
subsidiaries’’
Schedules SUD and SUD-A capture securities transactions (for example, U.S.
Treasuries, municipal, foreign, and asset-backed securities) as well as transac-
tions involving equities, futures and forwards, and options.
April 2001 Trading and Capital-Markets Activities Manual
Page 2
Regulatory Reporting: Appendix—Reports for Trading Instruments 2130.5
6. FR Y-11Q Financial statements for each individual nonbank subsidiary of a bank holding
company with total consolidated assets of $150 million or more in which the
nonbank subsidiary has total assets of 5 percent or more of the top-tier bank
holding company’s consolidated tier 1 capital, or in which the nonbank
subsidiary’s total operating revenue equals 5 percent or more of the top-tier
bank holding company’s consolidated total operating revenue.
Frequency: quarterly
Each of the instruments listed below is captured on this report.
Balance-Sheet Items
Securities
Off-Balance-Sheet Items
Futures and forwards
Forward rate contracts
Interest-rate swaps
Foreign exchange
Currency swaps
Option contracts
7. FR Y-11I Financial statements for each individual nonbank subsidiary that is owned or
controlled by a bank holding company with total consolidated assets of less than
$150 million or with total consolidated assets of $150 million or more if (1) the
total assets of the nonbank subsidiary are less than 5 percent of the top-tier bank
holding company’s consolidated tier 1 capital and (2) the total operating revenue
is less than 5 percent of the top-tier bank holding company’s consolidated total
operating revenue.
Frequency: annually
Each of the instruments listed below is captured on this report.
Balance-Sheet Items
Securities
Off-Balance-Sheet Items
Futures and forwards
Forward rate contracts
Interest-rate swaps
Foreign exchange
Currency swaps
Option contracts
Trading and Capital-Markets Activities Manual April 2001
Page 3
2130.5 Regulatory Reporting: Appendix—Reports for Trading Instruments
8. FFIEC 009 Country Exposure Report filed by U.S. commercial banks and/or bank holding
companies that meet the reporting criteria specified in the instructions to this
report.
Frequency: quarterly
8a. FFIEC 009a Country Exposure Information Report supplements the FFIEC 009 and is
intended to detail significant exposures as defined in the instructions to this
report.
Frequency: quarterly
These reports show country distribution of foreign claims held by U.S. banks
and bank holding companies. They also include foreign securities in the
aggregate assets of the countries shown.
These reports may also be filed by U.S.-chartered insured commercial banks,
Edge Act and agreement corporations, and other banking organizations.
9. X-17A-5 FOCUS Report.
Frequency: quarterly
This report collects data on securities and spot commodities owned by
broker-dealers. In addition, it reflects the haircuts the broker-dealers are required
to take, when applicable, pursuant to SEC rule 15c3-1(f).
Bank Reports
1. FFIEC 031 Consolidated reports of condition and income for a bank with domestic and
foreign offices.
Frequency: quarterly
Each of the instruments listed below is captured on this report. See the report
instructions for the treatment of each instrument. See schedule RC-R for
risk-based capital computation.
Schedules RC-B and RC-D
Securities
U.S. Treasury
Municipal
Mortgage-backed
Asset-backed
Foreign government
Equity
All others
April 2001 Trading and Capital-Markets Activities Manual
Page 4
Regulatory Reporting: Appendix—Reports for Trading Instruments 2130.5
Schedule RC-L
Futures and forwards
Forward rate agreements
Interest-rate swaps
Foreign exchange
Currency swaps
Options (interest-rate, currency)
Commodities
Index-linked activities
Hybrids
Credit derivatives
The FFIEC 032, 033, and 034 reports of condition and income capture
information on the same instruments as the FFIEC 031.
2. FFIEC 030 Report of condition for foreign branch of U.S. bank.
Frequency: annually for all overseas branch offices of insured U.S. commercial
banks
quarterly for significant branches with either total assets of at least
$2 billion or commitments to purchase foreign currencies and U.S.
dollar exchange of at least $5 billion
This is a two-page report that captures information on balance-sheet data as well
as selected off-balance-sheet data (options, foreign exchange, interest-rate
swaps, and futures and forward contracts).
Reports for U.S. Branches and Agencies of Foreign Banks
1. FFIEC 002 Report of assets and liabilities of U.S. branches and agencies of foreign banks.
Frequency: quarterly
This report captures information pertaining to balance-sheet and off-balance-
sheet transactions reported by all branches and agencies.
Schedule RAL
Securities
U.S. Treasuries
Government agencies
All others
Schedules L and M—part 5
Futures and forwards
Forward rate agreements
Interest-rate swaps
Foreign exchange
Currency swaps
Options (interest-rate, currency)
Trading and Capital-Markets Activities Manual April 2001
Page 5
2130.5 Regulatory Reporting: Appendix—Reports for Trading Instruments
2. FR 2069 Weekly report of assets and liabilities for large U.S. branches and agencies of
foreign banks.
Frequency: as of the close of business every Wednesday
Securities are included in this abbreviated report of assets and liabilities, which
resembles schedule RAL on FFIEC 002.
3. FFIEC 019 Country exposure for U.S. branches and agencies of foreign banks.
Frequency: quarterly
This report shows country distribution of foreign claims held by branches and
agencies. It includes foreign securities in the aggregate assets of the countries
shown.
The FFIEC 009 (filed by banks, bank holding companies, and Edge Act and
agreement corporations) is similar to this form.
Other Reports
1. FR 2314a Report of condition for foreign subsidiaries of U.S. banking organizations (to be
filed by companies with total assets exceeding U.S. $100 million as of the report
date).
Frequency: annually
quarterly for significant subsidiaries with either total assets greater
than $2 billion or $5 billion in commitments to purchase and sell
foreign currencies
1a. FR 2314b Report of condition for foreign subsidiaries of U.S. banking organizations (to be
filed by companies with total assets between U.S. $50–100 million as of the
report date).
Frequency: annually
1b. FR 2314c Report of Condition for Foreign Subsidiaries of U.S. Banking Organizations (to
be filed by companies with total assets less than U.S. $50 million as of the report
date).
Frequency: annually
These three schedules are intended to capture financial information on the
overseas subsidiaries of U.S. banking organizations (that is, bank holding
companies, banks, and Edge Act corporations). The level of detail reported will
depend on the asset size of the reporting entity. The FR 2314a and FR 2314b
capture information on balance-sheet and off-balance-sheet transactions. The FR
2314c report cannot be used to track individual categories as the other two
reports can.
April 2001 Trading and Capital-Markets Activities Manual
Page 6
Regulatory Reporting: Appendix—Reports for Trading Instruments 2130.5
2. FR 2886b Report of condition for Edge Act and agreement corporations.
Frequency: quarterly
This report reflects the consolidation of all Edge and agreement operations,
except for those majority-owned Edge or agreement subsidiaries. The latter are
accounted for within a single line item, claims on affiliates. Asset instruments
(securities and LDC debt) are reflected in the securities and loan lines,
respectively, of this report. Off-balance-sheet items are grouped except for
foreign-exchange and options contracts.
Trading and Capital-Markets Activities Manual April 2001
Page 7
Regulatory Compliance
Section 2140.1
The trading activities and related instruments ments, and interest-rate swaps) are exempt from
discussed in this manual are covered by various general CFTC regulation, either by statute in the
securities, commodities, or banking laws and case of foreign exchange or under CFTC regu-
regulations. Trading and other activities relating latory exemptions in the case of other types of
to securities are regulated under a variety of swaps and related transactions. While these
statutes, including the Securities Act of 1933, instruments are not themselves subject to regu-
Securities Exchange Act of 1934, and Govern- lation, the activities of regulated entities in these
ment Securities Act of 1986. In addition to instruments are subject to oversight by the
regulation by the Securities and Exchange Com- banking or other regulators.
mission (SEC) and U.S. Treasury Department, In addition to laws and regulations issued by
various self-regulatory organizations (SROs) are the regulatory authorities, industry trade groups
responsible for oversight of securities broker- such as the International Swaps Dealers Asso-
dealers. The SROs include the Municipal Secu- ciation or the Public Securities Association
rities Rulemaking Board (MSRB), the National (PSA) have developed industry guidelines or
Association of Securities Dealers (NASD), and standards in some areas. Additionally, organiza-
exchanges such as the New York Stock Exchange tions such as the Financial Accounting Stan-
(NYSE). dards Board (FASB) and the American Institute
Bank activities in the trading of securities are of Certified Public Accountants (AICPA) issue
subject to further regulation from the various opinions and standards that relate to a financial
banking regulators. One of the more important institution’s trading activities and financial
statutory provisions governing securities activi- disclosure.1
ties of banks was the Banking Act of 1933 (the Increasingly, securities trading activities of
Glass-Steagall Act), which provided that mem- banking organizations are being conducted in
ber banks could purchase only certain limited separately incorporated, nonbank entities owned,
types of securities (referred to as ‘‘eligible directly or indirectly, by bank holding compa-
securities’’) and prohibited member banks from nies. The Board has permitted some banking
affiliating with entities that were engaged prin- organizations to engage in securities underwrit-
cipally in the business of underwriting or issuing ing and dealing—most importantly, in corporate
ineligible securities. Under the provisions of the debt and equity—that previously was restricted
Gramm-Leach-Bliley Act (GLB Act) enacted in largely to securities firms. The subsidiaries in
1999, financial holding companies are permitted which these securities activities are conducted
to establish broker-dealer subsidiaries engaged are commonly referred to as ‘‘section 20’’ sub-
in underwriting, dealing, and market making in sidiaries, after section 20 of the Glass-Steagall
securities, without the restrictions applicable to Act. Before the Board’s approval of limited
section 20 subsidiaries. The GLB Act provisions underwriting activities relating to corporate debt
also permit financial subsidiaries of banks to and equity securities, banking organizations were
engage in comparable activities, subject to cer- restricted to underwriting and dealing in bank-
tain bank capital limitations and deductions. eligible securities, such as government securi-
Permissible equity trading activities of foreign ties, general municipal obligations, and money
and Edge corporation subsidiaries of U.S. banks market instruments.
are governed under the Board’s Regulation K. Section 20 companies also are registered
Activities involving instruments other than broker-dealers, as are many other bank holding
securities also may be subject to a variety of company or bank subsidiaries. As such, they fall
regulatory provisions. Commodities futures and under the regulatory authority of securities regu-
options are regulated primarily by the Commod- lators. The GLB Act requires banking regulators
ity Futures Trading Commission (CFTC), with to rely to the greatest extent possible on the
the activities of futures commission merchants functional regulator of securities firms. Only
(FCMs) subject to regulation by the CFTC as under certain specified circumstances may a
well as the rules of the National Futures Asso-
ciation (an SRO) and various exchanges on
1. For example, FASB’s Statement No. 80 outlines account-
which trading is conducted. Most over-the- ing requirements relating to futures contracts, while Practice
counter derivative instruments (for example, Bulletin 4 of the AICPA addresses accounting issues concern-
foreign-exchange contracts, forward rate agree- ing debt-for-equity swaps involving LDC obligations.
Trading and Capital-Markets Activities Manual April 2001
Page 1
2140.1 Regulatory Compliance
banking regulator conduct an examination of a appropriate bank regulatory authority that it is
broker-dealer. Thus, bank examiners need to acting in that capacity.
become familiar with the regulatory environ-
ment in which securities broker-dealers have
traditionally operated. This section will focus on CAPITAL REQUIREMENTS
that goal, deferring to existing material in the
following manuals: Commercial Bank Examina- Registered securities broker-dealers are subject
tion Manual, Merchant and Investment Bank to minimum net capital requirements pursuant to
Examination Manual, and Bank Holding Com- SEC Rule 15c3-1 or the U.S. Treasury’s rules
pany Supervision Manual. for government securities dealers (17 CFR 402).
Requirements in excess of the minimum are also
established by NYSE, NASD, and other SROs.
If any of these minimums are breached, the firm
PRINCIPLES OF SUPERVISION is subject to harsh restrictions on its operations.
Net capital is generally defined as the broker-
The main principles of securities regulation dealer’s net worth plus subordinated borrow-
employed by the SEC are the protection of ings, minus nonliquid (nonallowable) assets,
investors (especially the small and unsophisti- certain operational deductions, and required
cated) and maintenance of the integrity and deductions (‘‘haircuts’’) from the market value
liquidity of the capital markets. These are not of securities inventory and commitments. The
unlike the goals of banking regulators, who seek level of the haircut depends on the type and
to protect small depositors and promote a stable duration of the security; the greater the duration
banking system. However, securities and bank- and risk (or volatility), the greater the haircut.
ing regulators differ in how they apply these
goals to an institution encountering problems.
Securities capital-adequacy rules are liquidity- CREDIT RESTRICTIONS
based and designed to ensure that a troubled
broker-dealer can promptly pay off all custom- Various credit and concentration restrictions are
ers in the event of liquidation. Banking regula- imposed on a securities broker-dealer if the
tors face a different set of constraints when dealer is unduly concentrated in a given issue.
dealing with troubled banks and are less inclined Additionally, the Federal Reserve’s Regula-
to rely as quickly on the liquidation process. tion T imposes limits on the amount of credit
which may be extended by broker-dealers to
customers purchasing securities. This restriction
varies with the type of security.
REGISTRATION
Securities broker-dealers generally must register REGULATORY REQUIREMENTS
with the SEC before conducting business. While
broker-dealer activities undertaken by a bank Regulatory Examinations
itself generally are exempt from registration
requirements, bank subsidiaries and bank hold- All securities broker-dealers are required to
ing companies or subsidiaries that are broker- publish annual financial statements audited
dealers must register with the SEC. Registered by independent accountants. The SEC has the
securities broker-dealers also are registered with authority to conduct examinations, including
the NASD or another SRO, such as an exchange, examinations for compliance with sales-practice
and are required to have their sales and super- and customer securities custody-protection rules,
visory personnel pass written examinations. recordkeeping and internal controls, and regula-
Broker-dealers that engage in transactions tory reporting. In most cases, the SEC delegates
involving municipal or government securities this examination responsibility to the NYSE or
generally are registered with the SEC, but are the appropriate SRO. The NASD also conducts
subject to somewhat different requirements than all examinations of firms, except banks, that
the general registration requirements. When the engage strictly in municipal or government
bank itself acts as a government securities securities trading. In the case of banks, bank
broker-dealer, the bank is required to notify its regulators are responsible for the examination.
April 2001 Trading and Capital-Markets Activities Manual
Page 2
Regulatory Compliance 2140.1
Regulatory Reporting often make them available to large customers
for credit reasons.
Securities broker-dealers are required to file a U.S. commercial banks and branches and
monthly Financial and Operational Combined agencies of foreign banks are required to file call
Uniform Single (FOCUS) report with their reports with the appropriate federal bank regu-
examining authority. This report contains finan- latory agency. The call report includes schedules
cial statements and computations for the net that detail various off-balance-sheet instruments
capital rule, segregated funds held on behalf and information on the institutions’ trading-
of commodity futures customers, and a reserve account securities.
account designed to protect customer balances.2
Government securities dealers file a somewhat
similar report, the G-405 or ‘‘FOG’’ report, FOREIGN SECURITIES
unless they are banks. Bank dealers file their ACTIVITIES
normal call reports. If the broker-dealer is a
bank-affiliated section 20 company, it will also Foreign-owned securities firms in the United
file a monthly Y-20 report. This report consists States are subject to the same rules as domesti-
of a balance sheet and income statement and cally owned firms. In general, offshore activities
is used to ensure compliance with the Federal conducted by U.S. broker-dealers that are located
Reserve’s restrictions on the amount of ‘‘ineli- entirely outside of U.S. jurisdiction and do not
gible’’ revenue a section 20 company may have. involve U.S. persons are not subject to U.S.
Although FOCUS and FOG reports are gener- securities regulation. Moreover, for FOCUS and
ally confidential, securities broker-dealers will FOG reporting purposes, the securities broker-
dealer is not required to consolidate foreign
2. SEC Rule 15c3-3 restricts the use of customers’ funds (or domestic) subsidiaries unless the assets and
and fully paid securities for proprietary transactions. liabilities have been guaranteed by the parent.
Trading and Capital-Markets Activities Manual April 2001
Page 3
Regulatory Compliance
Examination Objectives Section 2140.2
The overall objective is to determine if the tory compliance aspect of its various trading
institution’s trading activities are in compliance activities.
with applicable laws, regulations, and super- 2. To determine if the bank has in place risk-
visory guidelines. Specified senior management, management procedures and controls that
as well as the regulatory reporting area of the provide management with accurate and timely
bank, must be thoroughly familiar with regula- information on all trading positions and their
tory requirements. Whenever possible, the bank potential impact on the institution’s financial
examiner uses the examination results of the and regulatory position.
securities regulators and FOCUS/FOG reports 3. To ascertain whether the institution’s person-
to help assess the firm’s overall compliance nel involved in trading activities are aware of
record. and knowledgeable about laws, regulations,
and supervisory and other standards applica-
1. To determine if the institution’s internal con- ble to these activities.
trols and audit program address the regula-
Trading and Capital-Markets Activities Manual February 1998
Page 1
Ethics
Section 2150.1
Senior management of financial institutions trading for the employee’s personal account and
should establish ethical standards and codes of on the acceptance of gratuities and entertain-
conduct governing the activities of their employ- ment. When developing compensation pro-
ees to protect the institution’s integrity and grams, institutions should recognize and guard
standing in the market. The orderly operation of against any potential conflicts that may arise
financial markets depends greatly on an overall between compensation structures and the insti-
level of trust among all market participants. tution’s code of ethics and standards of conduct.
Traders and marketing and support staff must Fee-based activities, securitization, underwrit-
conduct themselves at all times with unquestion- ing, and secondary-market trading activities in a
able integrity to protect the institution’s reputa- number of traditional bank assets may create the
tion with customers and market participants. potential for conflicts of interests if there is no
clear segregation of duties and responsibilities.
Conflicts of interest may arise when access to
CODES OF CONDUCT AND inside information gives an institution an unfair
advantage over other market participants.
ETHICAL STANDARDS Accordingly, policies should ensure that employ-
To ensure that employees understand all ethical ees conduct themselves consistent with legal
and legal implications of trading activities, and regulatory restrictions on the use of inside
institutions should have comprehensive rules of information.
conduct and ethical standards for capital-markets
and trading activities—especially in areas where
the complexity, speed, competitive environ- Confidentiality and Insider
ment, and volume of activity could create the Information
potential for abuse and misunderstandings. At a
minimum, policies and standards should address The maintenance of confidentiality and cus-
potential conflicts of interest, confidentiality and tomer anonymity is critical for the operation of
the use of insider information, and customer an efficient trading environment. No client
sales practices. Ethical standards and codes of information should be divulged outside the
conduct in these areas should conform with institution without the client’s authorization
applicable laws, industry conventions, and other unless required by law or by regulatory authori-
bank policies. They should also provide proper ties acting in their official capacities. Managers
oversight mechanisms for monitoring staff com- are responsible for ensuring that their staffs are
pliance and dealing with violations and cus- aware of what constitutes confidential informa-
tomer complaints. Internal controls, including tion, and that they know how to deal appro-
the role of internal and external audits, should priately with situations that require customer
be appropriate to ensure adherence to corporate anonymity.
ethical standards of conduct. Policies and pro- Many institutions have established appropri-
cedures should provide ongoing training for ate policies (so-called ‘‘Chinese walls’’) that
staff, as well as periodic review, revision, and separate those areas of the institution that rou-
approval of ethical standards and codes of tinely have access to confidential or insider
conduct to ensure that they incorporate new information from those areas that are legally
products, business initiatives, and market restricted from having access to the information.
developments. To prevent the misuse of confidential informa-
tion, employees in sensitive areas should be
physically segregated from employees in public
Conflicts of Interest areas.
Institutions should ensure that capital-markets
personnel do not allow self-interest to influence Sales Practices
or give the appearance of influencing any activ-
ity conducted on behalf of the institution. Safe- It is a sound business practice for managers to
guards should include specific restrictions on establish policies and procedures governing stan-
Trading and Capital-Markets Activities Manual February 1998
Page 1
2150.1 Ethics
dards for dealing with counterparties. These take steps to ensure that its counterparties
guidelines and policies preserve the institution’s understand the nature and risks inherent in
reputation in the marketplace by avoiding situ- agreed-upon transactions. When a counterparty
ations that create unjustified expectations on the is unsophisticated, either generally or with
part of a counterparty or client. When determin- respect to a particular type of transaction, the
ing the responsibilities of sales and marketing financial institution should take additional steps
staff, management should take into account to adequately disclose the attendant risks of
the sophistication of the counterparty, the nature specific types of transactions. Furthermore, a
of the relationship, and the type of transaction financial institution that recommends specific
being contemplated or executed. In addition, transactions to an unsophisticated counterparty
certain regulated entities and markets may have should ensure that it has adequate information
specific legal or regulatory requirements govern- on which to base its recommendation—and that
ing sales and marketing practices, which mar- the recommendation is consistent with the needs
keters and sales personnel must be aware of. of the counterparty as known to the financial
Financial institutions should take steps to institution. The institution also should ensure
ascertain the character and financial sophistica- that its recommendations are consistent with any
tion of their counterparties. An appropriate level restrictions imposed by a counterparty’s man-
of due diligence should be performed on all agement or board of directors on the types or
counterparties with which the institution deals. amounts of transactions it may enter into.
Financial institutions should also determine that Institutions should establish policies govern-
their counterparties have the legal authority to ing the content of sales materials provided to
enter into, and will be legally bound by the their customers. Typically, these policies call for
terms of, the transaction. sales materials that accurately describe the terms
When an advisory relationship does not exist of the proposed transaction and provide a fair
between a financial institution and its counter- representation of the risks involved. Policies
party, the transaction is assumed to be con- may also identify the types of analysis to be
ducted at ‘‘arms-length’’ and the counterparty is provided to the customer and often specify that
generally considered to be wholly responsible analyses include stress tests of the proposed
for the transactions it chooses to enter. At times, instrument or transaction over a sufficiently
clients may not wish to make independent invest- broad range of possible outcomes to adequately
ment or hedging decisions and instead may wish assess the risk. Some institutions use standard-
to rely on a financial institution’s recommenda- ized disclosure statements and analyses to inform
tions and investment advice. Similarly, clients customers of the risks involved and suggest that
may give a financial institution the discretionary the customer independently obtain advice about
authority to trade on their behalf. Financial the tax, accounting, legal, and other aspects of a
institutions providing investment advice to cli- proposed transaction.
ents, or using discretionary authority to trade on Institutions should also ensure that proce-
a client’s behalf, should formalize and set forth dures and mechanisms to document analyses of
the boundaries of these relationships with their transactions and disclosures to clients are ade-
clients. Formal advisory relationships may quate and that internal controls ensure ongoing
entail significantly different legal and business adherence to disclosure and customer-
obligations between an institution and its cus- appropriateness policies and procedures. Man-
tomers than less formal agency relationships. agement should clearly communicate to capital-
The authority, rights, and responsibilities of markets and all other relevant personnel any
both parties should be documented in a written specific standards that the institution has estab-
agreement. lished for sales materials.
Marketing personnel should receive proper Many customers request periodic valuations
guidance and training on how to delineate and of their positions. Institutions that provide peri-
maintain appropriate client relationships. This odic valuations of customers’ holdings should
includes guidance to sales and trading personnel have internal policies and procedures governing
regarding the avoidance of the implication of an the manner in which such quotations are derived
advisory relationship when none is intended. and transmitted to the customer, including the
While procedures may vary depending on the nature and form of disclosure and any disclaim-
type and sophistication of a counterparty, for its ers. Price quotes can be either indicative, meant
own protection, a financial institution should to give a general level of market prices for a
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Ethics 2150.1
transaction, or firm, which represent prices at complaints concerning trading, capital-markets,
which the institution is willing to execute a and sales personnel that originate from outside
transaction. When providing a quote to a coun- the institution, such as from customers, other
terparty, institutions should be careful that the trading institutions, or intermediaries. Patterns
counterparty does not confuse indicative quotes of broker usage should be monitored to alert
for firm prices. Firms receiving dealer quotes management to unusual concentrations. Broker
should be aware that these values may not be the entertainment of traders should be fully docu-
same as those used by the dealer for its internal mented, reviewed, and approved by manage-
purposes and may not represent other ‘‘market’’ ment. In addition, excessive entertainment of
or model-based valuations. brokers by traders should be prohibited.
When securities trading activities are con- Management should also be well acquainted
ducted in a registered broker-dealer that is a with the institution’s trading activities and cor-
member of the National Association of Securi- responding reports so that, upon regular review,
ties Dealers (NASD), the broker-dealer will they can determine unusual patterns or concen-
have obligations to its customers under the trations of trading activity or transactions with a
NASD’s ‘‘business conduct rule’’ and ‘‘suitabil- customer that are not consistent with the cus-
ity rule.’’ The banking agencies have adopted tomer’s usual activities. Management should
identical rules governing the sales of govern- clearly and regularly communicate all prohib-
ment securities in financial institutions. The ited practices to capital-markets and all other
business-conduct rule requires an NASD mem- relevant personnel.
ber to ‘‘observe high standards of commercial
honor, and just and equitable principles of trade’’
in the conduct of its business. The suitability
rule requires that, in recommending a transac- COMPLIANCE MEASURES
tion to a customer, an NASD member must have
‘‘reasonable grounds for believing that the rec- Personnel affirmations and disclosures are valu-
ommendation is suitable for the customer upon able tools for ensuring compliance with an
the basis of facts, if any, disclosed by the institution’s code of conduct and ethical stan-
customers as to the customer’s other securities dards. Procedures for obtaining appropriate
holdings and as to the customer’s financial affirmations and disclosures where and when
situation and needs.’’ required, as well as the development of forms on
The suitability rule further provides that, for which these statements are made, are particu-
customers who are not institutional customers, larly important. At a minimum, employees
an NASD member must make reasonable efforts should be asked to acknowledge annually that
to obtain information concerning the customer’s they have read and understood the institution’s
financial and tax status and investment objec- ethics and code of conduct standards. Some
tives before executing a transaction recom- companies also require that this annual affirma-
mended to the customer. For institutional cus- tion contain a covenant that employees will
tomers, an NASD interpretation of its suitability report any noted violations. Several major finan-
rule requires that a member determine (1) the cial institutions have adopted additional disclo-
institutional customer’s capability for evaluating sure procedures to enforce the personal financial
investment risk generally and the risk of the responsibilities set out in their codes. They
particular instruments offered and (2) whether require officers to file with the compliance
the customer is exercising independent judg- manager an annual statement dealing with fam-
ment in making investment decisions. The NASD ily financial matters or, in some cases, a state-
interpretation cites factors relevant to determin- ment of indebtedness. Finally, many institutions
ing these two requirements. require traders to conduct their personal trading
through a designated account at the institution.
Adequate internal controls including review by
MANAGEMENT OVERSIGHT internal audit and, when appropriate, external
audit are critical for ensuring compliance with
Management should monitor any pattern of an institution’s ethical standards.
Trading and Capital-Markets Activities Manual February 1998
Page 3
Ethics
Examination Objectives Section 2150.2
1. To determine if the institution has adequate 3. To determine that management has adequate
codes of conduct and ethical standards spe- policing mechanisms and internal controls to
cific to its capital-markets and trading activi- monitor compliance with the code of ethics
ties, that their scope is comprehensive, and and that procedures for reporting and dealing
that they are periodically updated. with violations are adequate. To determine if
2. To review and ensure the adequacy of the the supervision of staff is adequate for the
institution’s policies, procedures, and internal- level of business conducted.
control mechanisms used to avoid potential 4. To recommend corrective actions when poli-
conflicts of interest, prevent breeches in cus- cies, procedures, practices, or internal con-
tomer confidentiality, and ensure ethical sales trols are found to be deficient or when
practices across the institution’s trading violations of laws, rulings, or regulations
activities. To determine if the institution has have been noted.
established appropriate and effective firewall
policies where needed.
Trading and Capital-Markets Activities Manual February 1998
Page 1
Ethics
Examination Procedures Section 2150.3
These procedures represent a list of processes dards address an appropriate range of
and activities that may be reviewed during a transactions, customers, and customer
full-scope examination. The examiner-in-charge relationships?
will establish the general scope of the examina- 5. Review the institutions’s firewall policies
tion and work with the examination staff to segregating its trading and advisory activi-
tailor specific areas for review as circumstances ties from those areas which have access
warrant. As part of this process, the examiner to material nonpublic or ‘‘insider informa-
reviewing a function or product will analyze and tion.’’ Are the areas physically separated?
evaluate internal-audit comments and previous Are employees aware of the requirements of
examination workpapers to assist in designing the law restricting the use of such infor-
the scope of the examination. In addition, after a mation, specifically section 10(b) of the
general review of a particular area to be exam- Securities Exchange Act of 1934 and SEC
ined, the examiner should use these procedures, Rule 10(b)5?
to the extent they are applicable, for further 6. Identify the officer within the institution
guidance. Ultimately, it is the seasoned judg- who is designated as compliance manager.
ment of the examiner and the examiner-in- Are trading personnel required to confirm in
charge as to which procedures are warranted in writing their acknowledgment of the vari-
examining any particular activity. ous codes and to report violations? Are they
required to file annual statements of indebt-
1. Obtain copies of the institution’s written edness and outside affiliations? Check to
code of conduct and ethics and any related see that adherence to these reporting require-
policies and guidance. Determine if there ments is being monitored by the compliance
are codes specific to all relevant trading and manager.
marketing activities.
7. Determine how compliance with sales-
2. Obtain any procedures used to guide staff in
practice policies is monitored by the insti-
developing new accounts or preparing sales
tution. Are personnel outside the trading
presentations and documents.
area reviewing sales documents and disclo-
3. Evaluate the various codes and policies as
sures for compliance with policies? Review
to their adequacy and scope. Are prohibited
and evaluate the findings of internal and
practices clearly identified? These may
external audits conducted in this area.
include but are not limited to the following:
a. altering clients’ orders without their 8. Conduct limited transaction testing of sales
permission documentation to review compliance with
b. using the names of others when submit- financial-institution policies and sound
ting bids practices.
c. compensating clients for losses on trades 9. Determine if there is a general policy con-
d. submitting false price information to pub- cerning violations of the code. Is there a
lic information services specific procedure for reporting violations
e. churning managed client accounts to senior management and the general
f. altering official books and records with- auditor? Does it detail grounds for disciplin-
out legitimate business purposes ary action?
g. trading in instruments prohibited by regu- 10. Recommend corrective action when poli-
latory authorities cies, procedures, practices, or internal con-
4. Are standards for the content of sales pre- trols are found to be deficient or when
sentations and the offering transaction docu- violations of laws, rulings, or regulations
ments clearly identified? Do these stan- have been noted.
Trading and Capital-Markets Activities Manual February 1998
Page 1
Ethics
Internal Control Questionnaire Section 2150.4
1. Does the institution have a written code of cial conduct and avoid excessive
conduct or ethics? Are there specific codes debts or risks?
for capital-markets staff? — monitor employee business interac-
a. Is there a statement as to the code’s tion with other staff members, fam-
intention to conform with U.S. laws or ily, or organizations in which an
laws of other countries where the institu- employee has a financial interest?
tion has operations? — prohibit employee use of confiden-
b. Does this code cover the whole institu- tial information for personal gain?
tion, including subsidiaries? If not, are provide for adequate control over
there codes that apply to those particular trading for personal accounts?
areas? — require periodic disclosure and
c. Does the code address specific activities approval of outside directorships and
which are unique to this particular insti- business associations?
tution? Do other areas of the institution • Regarding personal and corporate politi-
with a higher potential for conflicts of cal activities, is the illegality of cor-
interest have more explicit policies? porate political activities (for example,
d. Do the codes address the following issues: contributions of goods, services, or other
• Employee relationships with present or support) addressed?
prospective customers and suppliers? • The necessity to avoid what might only
Has the institution conducted appropri- appear to be a possible conflict of
ate inquiry for customer integrity? Does interest?
the institution’s code properly address 2. Does management have the necessary mecha-
the following employee-customer or nism in place to monitor compliance with the
supplier relationship issues? code of ethics?
— safeguarding confidential informa- a. Are officers and staff members required to
tion sign an acknowledgment form that veri-
— borrowings fies they have indeed seen and read the
— favors code of conduct and ethics?
— acceptance of gifts • Is there a periodic program to make staff
— outside activities aware of and acknowledge the impor-
— kickbacks, bribes, and other tance of adhering to the code?
remunerations • Are officers required to disclose their
— integrity of accounting records borrowing arrangements with other
— candor in dealings with auditors, financial institutions to identify a poten-
examiners, and legal counsel tial conflict of interest?
— appropriate background check and b. What departments and which officers are
assessment of the credit quality and responsible for monitoring compliance
financial sophistication of new with the code of conduct and ethics and
customers related policies? What mechanisms do
— appropriate sales practices they employ and are they adequate?
• Internal employee relationships between c. How is information in the code relayed to
specific areas of the bank? staff?
— Do policies exist covering the rela- • Have there been any breaches of the
tionship on sharing information code? If so, what was the situation and
between trading and other areas of how was it resolved?
the bank? • Do bank personnel avail themselves of
— Is the confidentiality of account the resources outlined in the code when
relationships addressed? there is a question regarding a potential
• Personal employee activities outside the conflict of interest? If not, why?
corporation? Does the institution— • Are all employees aware of the exist-
— periodically check whether employ- ence of the code? If not, why?
ees maintain sound personal finan- • Does the bank’s management generally
Trading and Capital-Markets Activities Manual February 1998
Page 1
2150.4 Ethics: Internal Control Questionnaire
believe that all potential conflicts of ties even when the issues are not their
interest have been anticipated and are particular responsibility? Are the proper
adequately covered in the code? channels of action outlined for these types
• Are internal auditors involved in moni- of cases?
toring the code of ethics? b. Does the code outline the penalties or
• Does the organization’s culture encour- repercussions such as the following for
age officers and employees to follow the breach of the code of conduct and ethics?
standards established by the code? • potential to lose one’s job?
3. Are there resources for an employee to obtain
an opinion on the legitimacy of a particular • potential for civil or legal action?
circumstance outlined in the code of conduct • eventual damage to the corporation’s
and ethics? reputation?
a. Does the code emphasize the need for 4. Is the code of ethics updated frequently to
employees to report questionable activi- encompass new activities?
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Investment Securities and End-User Activities
Section 3000.1
A depository institution’s investment and end- banks—often with direct reference. In turn, the
user activities involve the use of securities (both security investments of national banks are gov-
available-for-sale and held-to-maturity) and erned by the seventh paragraph of 12 USC 24
derivative contracts to achieve earnings and (section 5136 of the Revised Statutes) and
risk-management objectives that involve longer by the investment-securities regulation of the
time horizons than those typically associated Office of the Comptroller of the Currency (OCC).
with trading activities.1 These ‘‘nontrading’’ Under 12 USC 24, an ‘‘investment security’’
activities involve the full array of cash securi- is defined as a debt obligation that is not pre-
ties, money market instruments, and derivative dominantly speculative. A security is not pre-
contracts. Cash securities include fixed- and dominantly speculative if it is rated investment-
floating-rate notes and bonds, structured notes, grade. An ‘‘investment-grade security’’ has been
mortgage pass-through and other asset-backed rated in one of the four highest rating categories
securities, and mortgage-derivative products. by two or more nationally recognized statistical
OBS derivative contracts include swaps, futures, rating organizations (one rating may suffice if
and options. the security has only been rated by one organi-
When institutions acquire and manage secu- zation). In the case of split ratings—different
rities and derivative instruments, they must ratings from different rating organizations—the
ensure that these activities are permissible and lower rating applies.
appropriate within the established limitations The OCC’s investment-securities regulation,
and restrictions on banks’ holdings. Institutions which was revised in 2001, identifies five basic
must also employ sound risk-management prac- types of investment securities (types I, II, III, IV,
tices consistently across these varying product and V) and establishes limitations on a bank’s
categories, regardless of their legal characteris- investment in these types of securities based on
tics or nomenclature. This section provides the percentage of capital and surplus that such
examiners with guidance on— holdings represent. For calculating concentra-
tion limits, the term ‘‘capital and surplus’’
• the permissibility and appropriateness of includes the balance of a bank’s allowance for
securities holdings by state member banks; loan and lease losses not included in tier 2
• sound risk-management practices and internal capital. Table 1 summarizes bank-eligible secu-
controls used by banking institutions in their rities and their investment limitations.
investment and end-user activities;
Type I securities are those debt instruments
• interaffiliate derivatives transactions;
that national and state member banks can deal
• securities and derivatives acquired by the
in, underwrite, purchase, and sell for their own
bank’s international division and overseas
accounts without limitation. Type I securities
branches for its own account, as well as on the
are obligations of the U.S. government or
bank’s foreign equity investments that are
its agencies, general obligations of states and
held either directly or through Edge Act
political subdivisions, and mortgage-related
corporations; and
securities. As a result of the Gramm-Leach-
• unsuitable investment practices.
Bliley Act (GLB Act), municipal revenue bonds
that are not general obligation bonds are the
equivalent of type I investment securities for
LIMITATIONS AND well-capitalized state member banks. A bank
RESTRICTIONS ON SECURITIES may purchase type I securities for its own
HOLDINGS account subject to no limitations, other than the
exercise of prudent banking judgment (see 12
Many states extend the same investment authori- USC 24 (seventh) and 15 USC 78c(a)(41)).
ties available to national banks to their chartered Type II securities are those debt instruments
that national and state member banks may deal
in, underwrite, purchase, and sell for their own
1. In general terms, derivatives are financial contracts
whose value derives from the value of one or more underlying
accounts subject to a 10 percent limitation of a
assets, interest rates, exchange rates, commodities, or financial bank’s capital and surplus for any one obligor.
or commodity indexes. Type II investments include obligations issued
Trading and Capital-Markets Activities Manual April 2002
Page 1
3000.1 Investment Securities and End-User Activities
by the International Bank for Reconstruction which are fully secured by type I securities.
and Development; the Inter-American Develop- Type V securities consist of all ABS that are
ment Bank; the Asian Development Bank; the not type IV securities. Specifically, they are
Tennessee Valley Authority; the U.S. Postal defined as marketable, investment-grade-rated
Service; obligations issued by any state or securities that are not type IV and are ‘‘fully
political subdivision for housing, university, or secured by interests in a pool of loans to
dormitory purposes; and other issuers specifi- numerous obligors and in which a national bank
cally identified in 12 USC 24 (seventh). could invest directly.’’ They include securities
Type III is a residual securities category backed by auto loans, credit card loans, home
consisting of all types of investment securities equity loans, and other assets. Also included are
not specifically designated to another security residential and commercial mortgage securities
‘‘type’’ category. Banks cannot deal in or under- as described in section 3(a)(41) of the Securities
write type III securities, and their holdings of Exchange Act of 1934 (15 USC 78c(a)(41)).
these instruments are limited to 10 percent of the These securities are not rated in one of the two
banks’ capital and surplus for any one obligor. highest investment-grade-rating categories, but
Type IV securities include the following asset- they are still investment-grade. A bank may
backed securities (ABS) that are fully secured purchase or sell type V securities for its own
by interests in pools of loans made to numerous account provided the aggregate par value of type
obligors: V securities issued by any one issuer held by the
bank does not exceed 25 percent of the bank’s
• investment-grade residential mortgage–related capital and surplus.
securities offered or sold pursuant to section As mentioned above, type III securities rep-
4(5) of the Securities Act of 1933 (15 USC resent a residual category. The OCC requires a
77d(5)) national bank to determine (1) that the type III
instrument it plans to purchase is marketable
• residential mortgage–related securities as
and of sufficiently high investment quality and
described in section 3(a)(41) of the Securities
(2) that the obligor will be able to meet all
Exchange Act of 1934 (15 USC 78c(a)(41))
payments and fulfill all the obligations it has
that are rated in one of the two highest
undertaken in connection with the security. For
investment-grade rating categories
example, junk bonds, which are often issued to
• investment-grade commercial mortgage secu- finance corporate takeovers, are usually not
rities offered or sold pursuant to section 4(5) considered to be of investment quality because
of the Securities Act of 1933 (15 USC 77d(5)) they are predominately speculative and have
• commercial mortgage securities as described limited marketability.
in section 3(a)(41) of the Securities Exchange The purchase of type II and III securities is
Act of 1934 (15 USC 78c(a)(41)) that are limited to 10 percent of equity capital and
rated in one of the two highest investment- reserves for each obligor when the purchase is
grade rating categories based on adequate evidence of the maker’s
• investment-grade, small-business-loan securi- ability to perform. That limitation is reduced to
ties as described in section 3(a)(53)(A) of the 5 percent of equity capital and reserves for all
Securities Exchange Act of 1934 (15 USC obligors in the aggregate when the judgment of
78c(a)(53)(A)) the obligor’s ability to perform is based predom-
inantly on ‘‘reliable estimates.’’ The term ‘‘reli-
For all type IV commercial and residential able estimates’’ refers to projections of income
mortgage securities and for type IV small- and debt-service requirements or conditional
business-loan securities rated in the top two ratings when factual credit information is not
categories, there is no limitation on the amount available and when the obligor does not have a
a bank can purchase or sell for its own account. record of performance. Securities purchased
Type IV investment-grade, small-business-loan subject to the 5 percent limitation may, in fact,
securities that are not rated in the top two rating become eligible for the 10 percent limitation
categories are subject to a limit of 25 percent of once a satisfactory financial record has been
a bank’s capital and surplus for any one issuer. established. Additional limitations on specific
In addition to being able to purchase and sell securities that have been ruled eligible for invest-
type IV securities, subject to the above limita- ment are detailed in 12 CFR 1.3. The par value,
tion, a bank may deal in those type IV securities not the book value or purchase price, of the
April 2002 Trading and Capital-Markets Activities Manual
Page 2
Investment Securities and End-User Activities 3000.1
security is the basis for computing the limita- securities acquired through debts previously
tions. However, the limitations do not apply to contracted.
Table 1—Summary of New Investment-Type Categories
Type Category Characteristics Limitations
Type I • U.S. government securities No limitations on banks’ investment,
securities • general obligations of a state or dealing, or underwriting abilities.
political subdivision
• obligations backed by the full faith
and credit of the U.S. government
• FHLB, FNMA, and FHLMC debt
• for well-capitalized banks, muni-
cipal revenue bonds that are not
general obligation bonds
Type II • state obligations for housing, Banks may deal in, underwrite, or invest
securities university, or dormitory purposes subject to the limitation that the aggre-
that would not qualify as a gate par value of the obligation of any
type I municipal security one obligor may not exceed 10 percent
• obligations of development banks of a bank’s capital and surplus.
• debt of Tennessee Valley
Authority
• debt of U.S. Postal Service
Type III • obligations that a national bank The aggregate par value of a bank’s
securities is authorized to deal in, under- purchases and sales of the securities
write, purchase, or sell under 12 of any one obligor may not exceed
USC 24 (seventh), other than 10 percent of a bank’s capital and
type I securities surplus. Banks may not deal in or
• an investment security that does underwrite these securities.
not qualify as type I, II, IV, or V
• municipal revenue bonds, except
those that qualify as a type I
municipal security
• corporate bonds
Type IV • small business–related securities For securities rated AA or Aa or higher,
securities that are rated investment-grade no investment limitations. For securities
or the equivalent and that are rated A or Baa, the aggregate par value
fully secured by a loan pool of a bank’s purchases and sales of the
• residential and commercial securities of any one obligor may not
mortgage–related securities rated exceed 25 percent of a bank’s capital
AA, Aa, or higher and surplus.
For mortgage-related securities, no
investment limitations.
A bank may deal in type IV securities
that are fully secured by type I
securities, with limitations.
Trading and Capital-Markets Activities Manual April 2002
Page 3
3000.1 Investment Securities and End-User Activities
Type Category Characteristics Limitations
Type V • asset-backed securities (credit The aggregate par value of a bank’s
securities card, auto, home equity, student purchases and sales of the securities
loan, manufactured housing) that of any one obligor may not exceed
are investment-grade and 25 percent of a bank’s capital and
marketable surplus.
• residential and commercial
mortgage–related securities
rated AA or Aa, but still
investment-grade
Sub-investment-quality securities are those in highest grades and unrated securities of equiva-
which the investment characteristics are dis- lent quality will be valued at market price. The
tinctly or predominantly speculative. This group market value will be classified substandard, and
includes securities in grades below the four the depreciation will be classified doubtful.
highest grades and unrated securities of equiva- Depreciation in defaulted securities and sub-
lent quality, defaulted securities, and sub- investment-quality stocks will generally be
investment-quality stocks. As noted in the fol- classified loss; market value will be classified
lowing table, securities in grades below the four substandard.
Table 2—Security Classifications
Classification
Type of Security Substandard Doubtful Loss
Investment-quality XXX XXX XXX
Sub-investment-quality, except— Market value Market depreciation XXX
Sub-investment-quality, municipal Book value XXX XXX
general obligations
Defaulted securities and Market value XXX Market depreciation
sub-investment-quality stocks,
except—
Defaulted municipal general
obligations:
Interim XXX Book value XXX
Final, i.e., when market is Market value XXX Market depreciation
reestablished
An exception to the above is to be made for to stabilize or for the issuer to put in place
municipal general obligations, which are backed budgetary, tax, or other actions that may elimi-
by the credit and taxing power of the issuer. The nate the default or otherwise improve the post-
entire book value of sub-investment-quality default value of the securities. The market for
municipal general obligations that are not in the defaulted securities will be periodically
default should be classified substandard. In the reviewed by the regulatory authorities. Upon a
event of a default of a municipal general obli- determination that a functioning market has
gation, a period of time is usually necessary to been reestablished, depreciation on defaulted
permit the market for these defaulted securities municipal general obligations will be classified
April 2002 Trading and Capital-Markets Activities Manual
Page 4
Investment Securities and End-User Activities 3000.1
as loss. During this interim, the book value of all the transfer was with the parent holding com-
defaulted municipal general obligation securi- pany or a nonbank affiliate, the records of the
ties will be classified doubtful. affiliate should be reviewed as well.
Banks are required to maintain adequate credit
information in their files to demonstrate that
they are exercising prudent judgment in their
securities and derivative transactions. Unrated MORTGAGE-DERIVATIVE
securities must be evaluated by the bank to PRODUCTS
determine if the instrument is a bank-eligible
investment. Examiners must ensure that the In April 1998, the FFIEC rescinded its Supervi-
bank’s methodology for evaluating unrated sory Policy Statement on Securities Activities,
securities is sound. All credit-related informa- published in February 1992, including the high-
tion and analyses should be retained for as long risk test for mortgage-derivative products.
as the security remains in the bank’s portfolio.
Low-quality securities are sometimes trans-
ferred from one depository institution to another
to avoid detection and classification during regu- EVALUATING RISK
latory examinations. This type of transfer may MANAGEMENT AND INTERNAL
be accomplished through participations, pur- CONTROLS
chases or sales, and asset swaps with other
affiliated or nonaffiliated financial institutions. Examiners are expected to conduct an adequate
Broadly defined, low-quality securities include evaluation of the risk-management process an
depreciated or sub-investment-grade securities institution uses to acquire and manage the secu-
of questionable quality. Situations in which an rities and derivative contracts used in nontrading
institution appears to be concealing low-quality activities. In conducting this analysis, examiners
securities to avoid examination scrutiny and should evaluate the following four key elements
possible classification represent an unsafe and of a sound risk-management process:
unsound practice. Further, this type of transfer
between affiliated banks is a violation of section • active board and senior management oversight
23A of the Federal Reserve Act. • adequate risk-management policies and limits
Any situations involving the transfer of low-
• appropriate risk-measurement and -reporting
quality or questionable securities should be
systems
brought to the attention of Reserve Bank super-
visory personnel who, in turn, should notify the • comprehensive internal controls
local office of the primary federal regulator of
the other depository institution involved in the This section identifies basic factors that exam-
transaction. For example, if an examiner deter- iners should consider in evaluating these ele-
mines that a state member bank or holding ments for investment and end-user activities. It
company has transferred or intends to transfer reiterates and supplements existing guidance
low-quality securities to another depository and directives on the use of these instruments
institution, the Reserve Bank should notify the for nontrading purposes as provided in various
recipient institution’s primary federal regulator supervisory letters and examination manuals.2
of the transfer. The same notification require-
ment holds true if an examiner determines that a
2. Existing policies and examiner guidance on various
state member bank or holding company has supervisory topics applicable to securities and off-balance-
acquired or intends to acquire low-quality secu- sheet instruments can be found in this manual, the Commer-
rities from another depository institution. This cial Bank Examination Manual, the Bank Holding Company
procedure applies to transfers involving savings Supervision Manual, and the Trust Activities Examination
Manual, as well as in various supervision and regulation (SR)
and loan associations and savings banks, as well letters, including SR-90-16, ‘‘Implementation of Examination
as commercial banking organizations. Guidelines for the Review of Asset Securitization Activities’’;
Situations may arise when transfers of secu- SR-91-4, ‘‘Inspections of Investment-Adviser Subsidiaries of
rities are undertaken for legitimate reasons. In Bank Holding Companies’’; SR-92-1, ‘‘Supervisory Policy
Statement on Securities Activities’’; SR-93-69, ‘‘Risk Man-
these cases, the securities should be properly agement and Internal Controls for Trading Activities’’; SR-
recorded on the books of the acquiring institu- 95-17, ‘‘Evaluating the Risk Management and Internal Con-
tion at their fair value on the date of transfer. If trols of Securities and Derivative Contracts Used in Nontrading
Trading and Capital-Markets Activities Manual April 2002
Page 5
3000.1 Investment Securities and End-User Activities
In evaluating an institution’s risk-management with nontrading activities involving securities
process, examiners should consider the nature and derivative instruments.
and size of its holdings. Examiner judgment
plays a key role in assessing the adequacy of an
institution’s risk-management process for secu- Board of Directors
rities and derivative contracts. Examiners should
focus on evaluating an institution’s understand- The board of directors has the ultimate respon-
ing of the risks involved in the instruments it sibility for the level of risk taken by the institu-
holds. Regardless of any responsibility, legal or tion. Accordingly, the board should approve
otherwise, assumed by a dealer or counterparty overall business strategies and significant poli-
for a particular transaction, the acquiring insti- cies that govern risk-taking, including those
tution is ultimately responsible for understand- involving securities and derivative contracts. In
ing and managing the risks of the transactions particular, the board should approve policies
into which it enters. Failure of an institution to identifying managerial oversight and articulat-
adequately understand, monitor, and evaluate ing risk tolerances and exposure limits for secu-
the risks involved in its securities or derivative rities and derivative activities. The board should
positions, either through lack of internal exper- also actively monitor the performance and risk
tise or inadequate outside advice, constitutes an profile of the institution and its various securi-
unsafe and unsound banking practice. ties and derivative portfolios. Directors should
As with all risk-bearing activities, institutions periodically review information that is suffi-
should fully support the risk exposures of non- ciently detailed and timely to allow them to
trading activities with adequate capital. Banking understand and assess the credit, market, and
organizations should ensure that their capital liquidity risks facing the institution as a whole
positions are sufficiently strong to support all the and its securities and derivative positions in
risks associated with these activities on a fully particular. These reviews should be conducted at
consolidated basis and should maintain adequate least quarterly and more frequently when the
capital in all affiliated entities engaged in these institution holds significant positions in complex
activities. In evaluating the adequacy of an instruments. In addition, the board should peri-
institution’s capital, examiners should consider odically reevaluate the institution’s business
any unrecognized net depreciation or apprecia- strategies and significant risk-management poli-
tion in an institution’s securities and derivative cies and procedures, placing special emphasis
holdings. Further consideration should also be on the institution’s financial objectives and risk
given to the institution’s ability to hold these tolerances. The minutes of board meetings and
securities and thereby avoid recognizing losses. accompanying reports and presentation materi-
als should clearly demonstrate the board’s
fulfillment of these basic responsibilities. The
section of this guidance on managing specific
Board of Directors and Senior risks provides guidance on the types of objec-
Management Oversight tives, risk tolerances, limits, and reports that
directors should consider.
Active oversight by the institution’s board of The board of directors should also conduct
directors and relevant senior management is and encourage discussions between its members
critical to a sound risk-management process. and senior management, as well as between
Examiners should ensure that these individuals senior management and others in the institution,
are aware of their responsibilities and that they regarding the institution’s risk-management pro-
adequately perform their appropriate roles in cess and risk exposures. Although it is not
overseeing and managing the risks associated essential for board members to have detailed
technical knowledge of these activities, if they
do not, it is their responsibility to ensure that
Activities’’; and SR-98-12, ‘‘FFIEC Policy Statement on they have adequate access to independent legal
Investment Securities and End-User Derivatives Activities.’’ and professional advice on the institution’s
Examiners of U.S. branches and agencies of foreign banks securities and derivative holdings and strategies.
should take the principles included in these guidelines into
consideration in accordance with the procedures set forth in
The familiarity, technical knowledge, and aware-
the Examination Manual for Branches and Agencies of ness of directors and senior management should
Foreign Banking Organizations. be commensurate with the level and nature of an
April 2002 Trading and Capital-Markets Activities Manual
Page 6
Investment Securities and End-User Activities 3000.1
institution’s securities and derivative positions. within an institution should be managed as
Accordingly, the board should be knowledge- independently as possible from those individu-
able enough or have access to independent als who have the authority to initiate transac-
advice to evaluate recommendations presented tions. Otherwise, conflicts of interest could
by management or investment advisers. develop. The nature and extent of this indepen-
dence should be commensurate with the size and
complexity of an institution’s securities and
Senior Management derivative activities. Institutions with large and
complex balance sheets or with significant hold-
Senior management is responsible for ensuring ings of complex instruments would be expected
that there are adequate policies and procedures to have risk managers or risk-management func-
for conducting investment and end-user activi- tions fully independent of the individuals who
ties on both a long-range and day-to-day basis. have the authority to conduct transactions.
Management should maintain clear lines of Institutions with less complex holdings should
authority and responsibility for acquiring instru- ensure they have some mechanism for indepen-
ments and managing risk, setting appropriate dently reviewing both the level of risk exposures
limits on risk-taking, establishing adequate sys- created by securities and derivative holdings and
tems for measuring risk, setting acceptable the adequacy of the process used in managing
standards for valuing positions and measuring those exposures. Depending on the size and
performance, establishing effective internal nature of the institution, this review function
controls, and enacting a comprehensive risk- may be carried out by either management or a
reporting and risk-management review process. board committee. Regardless of size and sophis-
To provide adequate oversight, management tication, institutions should ensure that back-
should fully understand the institution’s risk office, settlement, and transaction-reconciliation
profile, including that of its securities and responsibilities are conducted and managed by
derivative activities. Examiners should review personnel who are independent of those initiat-
the reports to senior management and evaluate ing risk-taking positions.
whether they provide both good summary infor-
mation and sufficient detail to enable manage-
ment to assess the sensitivity of securities and
derivative holdings to changes in credit quality, Policies, Procedures, and Limits
market prices and rates, liquidity conditions, and
other important risk factors. As part of its Institutions should maintain written policies and
oversight responsibilities, senior management procedures that clearly outline their approach
should periodically review the organization’s for managing securities and derivative instru-
risk-management procedures to ensure that they ments. These policies should be consistent with
remain appropriate and sound. Senior manage- the organization’s broader business strategies,
ment should also encourage and participate in capital adequacy, technical expertise, and general
active discussions with members of the board willingness to take risks. They should identify
and with risk-management staff regarding risk- relevant objectives, constraints, and guidelines
measurement, reporting, and management for both acquiring instruments and managing
procedures. portfolios. In doing so, policies should establish
Management should ensure that investment a logical framework for limiting the various
and end-user activities are conducted by com- risks involved in an institution’s securities and
petent staff whose technical knowledge and derivative holdings. Policies should clearly
experience is consistent with the nature and delineate lines of responsibility and authority
scope of the institution’s activities. There should over securities and derivative activities. They
be sufficient depth in staff resources to manage should also provide for the systematic review of
these activities if key personnel are not avail- products new to the firm, specify accounting
able. Management should also ensure that guidelines, and ensure the independence of the
back-office and financial-control resources are risk-management process. Written policies and
sufficient to manage and control risks effectively. procedures governing municipal securities under-
writing, dealing, and investment should be main-
Independence in managing risks. The process tained by banks engaged in these activities. The
of measuring, monitoring, and controlling risks types of policies and procedures that are appro-
Trading and Capital-Markets Activities Manual April 2002
Page 7
3000.1 Investment Securities and End-User Activities
priate are described in SR-01-13 (May 14, all credit-, market-, and liquidity-risk limits and
2001). Examiners should evaluate the adequacy constraints and should help delineate a clear set
of an institution’s risk-management policies and of institutional limits for use in acquiring spe-
procedures in relation to its size, its sophistica- cific instruments and managing portfolios. Lim-
tion, and the scope of its activities. its can be specified either as guidelines within
the overall policies or as management operating
procedures. Further guidance on managing spe-
Specifying Objectives cific risks and on the types of constraints and
limits an institution might use in managing the
Institutions can use securities and derivative credit, market, and liquidity risk of securities
instruments for several primary and complemen- and derivative contracts is provided later in this
tary purposes.3 Banking organizations should section.
articulate these objectives clearly and identify Limits should be set to guide acquisition and
the types of securities and derivative contracts to ongoing management decisions, control expo-
be used for achieving them. Objectives also sures, and initiate discussion within the organi-
should be identified at the appropriate portfolio zation about apparent opportunities and risks.
and institutional levels. These objectives should Although procedures for establishing limits and
guide the acquisition of individual instruments operating within them may vary among institu-
and provide benchmarks for periodically evalu- tions, examiners should determine whether the
ating the performance and effectiveness of an organization enforces its policies and proce-
institution’s holdings, strategies, and programs. dures through a clearly identified system of risk
Whenever multiple objectives are involved, man- limits. The organization’s policies should also
agement should identify the hierarchy of poten- include specific guidance on the resolution of
tially conflicting objectives. limit excesses. Positions that exceed established
limits should receive the prompt attention of
appropriate management and should be resolved
Identifying Constraints, Guidelines, and according to approved policies.
Limits Limits should implement the overall risk
tolerances and constraints articulated in general
An institution’s policies should clearly articulate policy statements. Depending on the nature of
the organization’s risk tolerance by identifying an institution’s holdings and its general sophis-
its willingness to take the credit, market, and tication, limits can be identified for individual
liquidity risks involved in holding securities and business units, portfolios, instrument types, or
derivative contracts. A statement of authorized specific instruments. The level of detail in risk
instruments and activities is an important vehi- limits should reflect the characteristics of the
cle for communicating these risk tolerances. institution’s holdings, including the types of risk
This statement should clearly identify permis- to which the institution is exposed. Regardless
sible instruments or instrument types and the of their specific form or level of aggregation,
purposes or objectives for which the institution limits should be consistent with the institution’s
may use them. The statement also should iden- overall approach to managing various types of
tify permissible credit-quality, market-risk- risks. Limits should also be integrated to the
sensitivity, and liquidity characteristics of the fullest extent possible with institution-wide limits
instruments and portfolios used in nontrading on the same risks as they arise in other activities
activities. For example, in the case of market of the firm. Later in this section, specific exam-
risk, policies should address the permissible iner considerations for evaluating the policies
degree of price sensitivity or effective maturity and limits used in managing each of the various
volatility, taking into account an instrument’s or types of risks involved in nontrading securities
portfolio’s option and leverage characteristics. and derivative activities are addressed.
Specifications of permissible risk characteristics
should be consistent with the institution’s over-
New-Product Review
3. Such purposes include, but are not limited to, generating
earnings, creating funding opportunities, providing liquidity,
hedging risk exposures, taking risk positions, modifying and
An institution’s policies should also provide for
managing risk profiles, managing tax liabilities, and meeting effective review of any products being consid-
pledging requirements. ered that would be new to the firm. An insti-
April 2002 Trading and Capital-Markets Activities Manual
Page 8
Investment Securities and End-User Activities 3000.1
tution should not acquire a meaningful position management process. Examiners should ensure
in a new instrument until senior management that an institution sufficiently integrates these
and all relevant personnel (including those in functions into its ongoing management process
internal-control, legal, accounting, and auditing and that relevant personnel recognize their role
functions) understand the product and can inte- and understand the instruments held.
grate it into the institution’s risk-measurement
and control systems. An institution’s policies
should define the terms ‘‘new product’’ and
‘‘meaningful position’’ consistent with its size,
complexity, and sophistication. Institutions should
not be hesitant to define an instrument as a new
product. Small changes in the payment formulas
or other terms of relatively simple and standard
products can greatly alter their risk profiles and
justify designation as a new product. New-
product reviews should analyze all of the rel-
evant risks involved in an instrument and assess
how well the product or activity achieves speci-
fied objectives. New-product reviews also should
include a description of the relevant accounting
guidelines and identify the procedures for mea-
suring, monitoring, and controlling the risks
involved.
Accounting Guidelines
The accounting systems and procedures used for
general-purpose financial statements and regu-
latory reporting purposes are critically important
to enhancing the transparency of an institution’s
risk profile. Accordingly, an institution’s poli-
cies should provide clear guidelines on account-
ing for all securities and derivative holdings.
Accounting treatment should be consistent with
specified objectives and with the institution’s
regulatory requirements. Furthermore, institu-
tions should ensure that they designate each
cash or derivative contract for accounting pur-
poses consistent with appropriate accounting
policies and requirements. Accounting for non-
trading securities and derivative contracts should
reflect the economic substance of the transac-
tions. When instruments are used for hedging
purposes, the hedging rationale and perfor-
mance criteria should be well documented. Man-
agement should reassess these designations peri-
odically to ensure that they remain appropriate.
Risk-Measurement and
Risk-Reporting Systems
Clear procedures for measuring and monitoring
risks are the foundation of a sound risk-
Trading and Capital-Markets Activities Manual April 2002
Page 8.1
Investment Securities and End-User Activities 3000.1
Risk Measurement standard industry calculators and market con-
ventions. Such analyses must comprehensively
An institution’s system for measuring the credit, depict the potential risks involved in the acqui-
market, liquidity, and other risks involved in sition, and they should be accompanied by
cash and derivative contracts should be as com- documentation that sufficiently demonstrates that
prehensive and accurate as practicable. The the acquirer understands fully both the analyses
degree of comprehensiveness should be com- and the nature of the institution’s relationship
mensurate with the nature of the institution’s with the provider of the analyses. Notwithstand-
holdings and risk exposures. Exposures to each ing information and analyses obtained from
type of risk (that is, credit, market, liquidity) outside sources, management is ultimately
should be aggregated across securities and responsible for understanding the nature and
derivative contracts and integrated with similar risk profiles of the institution’s securities and
exposures arising from lending and other busi- derivative holdings.
ness activities to obtain the institution’s overall It is a prudent practice for institutions to
risk profile. obtain and compare price quotes and risk analy-
Examiners should evaluate whether the risk ses from more than one dealer before acquisi-
measures and the risk-measurement process are tion. Institutions should ensure that they clearly
sufficient to accurately reflect the different types understand the responsibilities of any outside
of risks facing the institution. Institutions should parties that provide analyses and price quotes. If
establish clear risk-measurement standards for analyses and price quotes provided by dealers
both the acquisition and ongoing management are used, institutions should assume that each
of securities and derivative positions. Risk- party deals at arm’s length for its own account
measurement standards should provide a com- unless a written agreement states otherwise.
mon framework for limiting and monitoring Institutions should exercise caution when deal-
risks and should be understood by relevant ers limit the institution’s ability to show securi-
personnel at all levels of the institution—from ties or derivative contract proposals to other
individual managers to the board of directors. dealers to receive comparative price quotes or
risk analyses. As a general sound practice,
Acquisition standards. Institutions conducting unless the dealer or counterparty is also acting
securities and derivative activities should have under a specific investment advisory relation-
the capacity to evaluate the risks of instruments ship, an investor or end-user should not acquire
before acquiring them. Before executing any an instrument or enter into a transaction if its
transaction, an institution should evaluate the fair value or the analyses required to assess its
instrument to ensure that it meets the various risk cannot be determined through a means
objectives, risk tolerances, and guidelines iden- that is independent of the originating dealer or
tified by the institution’s policies. Evaluations of counterparty.
the credit-, market-, and liquidity-risk exposures
should be clearly and adequately documented Portfolio-management standards. Institutions
for each acquisition. Documentation should be should periodically review the performance and
appropriate for the nature and type of instru- effectiveness of instruments, portfolios, and
ment; relatively simple instruments would prob- institutional programs and strategies. This review
ably require less documentation than instru- should be conducted at least quarterly and should
ments with significant leverage or option evaluate the extent to which the institution’s
characteristics. securities and derivative holdings meet the vari-
Institutions with significant securities and ous objectives, risk tolerances, and guidelines
derivative activities are expected either to established by its policies.4 Institutions with
conduct in-house preacquisition analyses or use large or highly complex holdings should con-
specific third-party analyses that are indepen- duct reviews more frequently.
dent of the seller or counterparty. Analyses
provided by the originating dealer or counter-
party should be used only when a clearly defined
investment advisory relationship exists. Less 4. For example, the performance of instruments and port-
folios used to meet objectives for tax-advantaged earnings
active institutions with relatively uncomplicated should be evaluated to ensure that they meet the necessary
holdings may use risk analyses provided by the credit-rating, market-sensitivity, and liquidity characteristics
dealer only if the analyses are derived using established for this objective.
Trading and Capital-Markets Activities Manual February 1998
Page 9
3000.1 Investment Securities and End-User Activities
For internal measurements of risk, effective should consider the circumstances at each insti-
measurement of the credit, market, and liquidity tution when evaluating the adequacy or need for
risks of many securities and derivative contracts stress-testing procedures.
requires mark-to-market valuations. Accord-
ingly, the periodic revaluation of securities and
derivative holdings is an integral part of an Risk Reporting
effective risk-measurement system. Periodic
revaluations should be fully documented. When An accurate, informative, and timely manage-
available, actual market prices should be used. ment information system is essential. Examiners
For less liquid or complex instruments, institu- should evaluate the adequacy of an institution’s
tions with only limited holdings may use prop- monitoring and reporting of the risks, returns,
erly documented periodic prices and analyses and overall performance of security and deriva-
provided by dealers or counterparties. More tive activities to senior management and the
active institutions should conduct periodic board of directors. Management reports should
revaluations and portfolio analyses using either be frequent enough to provide the responsible
in-house capabilities or outside-party analytical individuals with adequate information to judge
systems that are independent of sellers or coun- the changing nature of the institution’s risk
terparties. Institutions should recognize that profile and to evaluate compliance with stated
indicative price quotes and model revaluations policy objectives and constraints.
may differ from the values at which transactions Management reports should translate mea-
can be executed. sured risks from technical and quantitative
formats to formats that can be easily read and
Stress testing. Analyzing the credit, market, and understood by senior managers and directors,
liquidity risk of individual instruments, port- who may not have specialized and technical
folios, and the entire institution under a variety knowledge of all financial instruments used by
of unusual and stressful conditions is an impor- the institution. Institutions should ensure that
tant aspect of the risk-measurement process. they use a common conceptual framework for
Management should seek to identify the types of measuring and limiting risks in reports to senior
situations or the combinations of credit and managers and directors. These reports should
market events that could produce substantial include the periodic assessment of the perfor-
losses or liquidity problems. Typically, securi- mance of appropriate instruments or portfolios
ties and derivative contracts are managed on the in meeting their stated objective, subject to the
basis of an institution’s consolidated exposures, relevant constraints and risk tolerances.
and stress testing should be conducted on the
same basis. Stress tests should evaluate changes Management evaluation and review. Manage-
in market conditions, including alternatives in ment should regularly review the institution’s
the underlying assumptions used to value instru- approach and process for managing risks. This
ments. All major assumptions used in stress includes regularly assessing the methodologies,
tests should be identified. models, and assumptions used to measure risks
Stress tests should not be limited to quantita- and limit exposures. Proper documentation of
tive exercises that compute potential losses or the elements used in measuring risks is essential
gains, but should include qualitative analyses of for conducting meaningful reviews. Limits
the tools available to management to deal with should be compared to actual exposures. Reviews
various scenarios. Contingency plans outlining should also consider whether existing measures
operating procedures and lines of communica- of exposure and limits are appropriate in view of
tion, both formal and informal, are important the institution’s holdings, past performance, and
products of such qualitative analyses. current capital position.
The appropriate extent and sophistication of The frequency of the reviews should reflect
an institution’s stress testing depend heavily on the nature of an institution’s holdings and the
the scope and nature of its securities and deriva- pace of market innovations in measuring and
tive holdings and on its ability to limit the effect managing risks. At a minimum, institutions
of adverse events. Institutions holding securities with significant activities in complex cash or
or derivative contracts with complex credit, derivative contracts should review the under-
market, or liquidity risk profiles should have an lying methodologies of the models they use at
established regime of stress testing. Examiners least annually—and more often as market con-
February 1998 Trading and Capital-Markets Activities Manual
Page 10
Investment Securities and End-User Activities 3000.1
ditions dictate—to ensure that they are appro- Examiners should also review the internal
priate and consistent. Reviews by external audi- controls of all key activities involving securities
tors or other qualified outside parties, such as and derivative contracts. For example, examin-
consultants with expertise in highly technical ers should evaluate and assess adherence to the
models and risk-management techniques, may written policies and procedures for transaction
often supplement these internal evaluations. recording and processing. They should analyze
Institutions depending on outside parties to the transaction-processing cycle to ensure the
provide various risk-measurement capabilities integrity and accuracy of the institution’s records
should ensure that the outside institution has and management reports. Examiners should
personnel with the necessary expertise to iden- review all significant internal controls associ-
tify and evaluate the important assumptions ated with management of the credit, market,
incorporated in the risk-measurement method- liquidity, operational, and legal risks involved in
ologies it uses. securities and derivative holdings.
The examiner should review the frequency,
scope, and findings of any independent internal
and external auditors relative to the institution’s
Comprehensive Internal Controls and securities and derivative activities. When appli-
Audit Procedures cable, internal auditors should audit and test the
risk-management process and internal controls
Institutions should have adequate internal con- periodically. Internal auditors are expected to
trols to ensure the integrity of the management have a strong understanding of the specific
process used in investment and end-user activities. products and risks faced by the organization. In
Internal controls consist of procedures, approval addition, they should have sufficient expertise to
processes, reconciliations, reviews, and other evaluate the risks and controls of the institution.
mechanisms designed to provide a reasonable The depth and frequency of internal audits
assurance that the institution’s risk-management should increase if weaknesses and significant
objectives for these activities are achieved. issues exist or if portfolio structures, modeling
Appropriate internal controls should address all methodologies, or the overall risk profile of the
of the various elements of the risk-management institution has changed.
process, including adherence to policies and In reviewing risk management of nontrading
procedures and the adequacy of risk identifica- securities and derivative activities, internal
tion, risk measurement, and reporting. auditors should thoroughly evaluate the effec-
An important element of a bank’s internal tiveness of the internal controls used for mea-
controls for investment and end-user activities suring, reporting, and limiting risks. Internal
is comprehensive evaluation and review by auditors should also evaluate compliance with
management. Management should ensure that risk limits and the reliability and timeliness of
the various components of the bank’s risk- information reported to the institution’s senior
management process are regularly reviewed and management and board of directors, as well as
evaluated by individuals who are independent of the independence and overall effectiveness of
the function they are assigned to review. the institution’s risk-management process. The
Although procedures for establishing limits and level of confidence that examiners place in an
for operating within them may vary among institution’s audit programs, the nature of the
banks, periodic management reviews should be internal and external audit findings, and man-
conducted to determine whether the organiza- agement’s response to those findings will influ-
tion complies with its investment and end-user ence the scope of the current examination of
risk-management policies and procedures. Any securities and derivative activities.
positions that exceed established limits should Examiners should pay special attention to
receive the prompt attention of appropriate man- significant changes in the nature of instruments
agement and should be resolved according to the acquired, risk-measurement methodologies,
process described in approved policies. Periodic limits, and internal controls that have occurred
reviews of the risk-management process should since the last examination. Significant changes
also address any significant changes in the in earnings from securities and derivative con-
nature of instruments acquired, limits, and inter- tracts, in the size of positions, or in the value-
nal controls that have occurred since the last at-risk associated with these activities should
review. also receive attention during the examination.
Trading and Capital-Markets Activities Manual February 1998
Page 11
3000.1 Investment Securities and End-User Activities
EVALUATING MANAGEMENT OF managing these risks effectively. An institu-
SPECIFIC RISKS tion’s policies should identify criteria for select-
ing these organizations and list all approved
Specific considerations in evaluating the key firms. The management of a depository institu-
elements of sound risk-management systems as tion must have sufficient knowledge about the
they relate to the credit, market, liquidity, oper- securities firms and personnel with whom they
ating, and legal risks involved in securities and are doing business. A depository institution
derivative contracts for nontrading activities are should not engage in securities transactions with
described below. any securities firm that is unwilling to provide
complete and timely disclosure of its financial
condition. Management should review the secu-
rities firm’s financial statements and evaluate
Credit Risk the firm’s ability to honor its commitments both
before entering into transactions with the firm
Broadly defined, credit risk is the risk that an and periodically thereafter. An inquiry into the
issuer or counterparty will fail to perform on an general reputation of the dealer also is neces-
obligation to the institution. The policies of an sary. The board of directors or an appropriate
institution should recognize credit risk as a committee of the board should periodically
significant risk posed by the institution’s secu- review and approve a list of securities firms with
rities and derivative activities. Accordingly, poli- whom management is authorized to do business.
cies should identify credit-risk constraints, risk The board or an appropriate committee thereof
tolerances, and limits at the appropriate instru- should also periodically review and approve
ment, portfolio, and institutional levels. In doing limits on the amounts and types of transactions
so, institutions should ensure that credit-risk to be executed with each authorized securities
constraints are clearly associated with specified firm. Limits to be considered should include
objectives. For example, credit-risk constraints dollar amounts of unsettled trades, safekeeping
and guidelines should be defined for instruments arrangements, repurchase transactions, securi-
used to meet pledging requirements, generate ties lending and borrowing, other transactions
tax-advantaged income, hedge positions, gener- with credit risk, and total credit risk with an
ate temporary income, or meet any other spe- individual dealer.
cifically defined objective. At a minimum, depository institutions should
As a matter of general policy, an institution consider the following when selecting and
should not acquire securities or derivative con- retaining a securities firm:
tracts until it has assessed the creditworthiness
of the issuer or counterparty and determined that • the ability of the securities dealer and its
the risk exposure conforms with its policies. The subsidiaries or affiliates to fulfill commit-
credit risk arising from these positions should be ments as evidenced by their capital strength,
incorporated into the overall credit-risk profile liquidity, and operating results (this evidence
of the institution to the fullest extent possible. should be gathered from current financial
Given the interconnectedness of the various data, annual reports, credit reports, and other
risks facing the institution, organizations should sources of financial information)
also evaluate the effect of changes in issuer or • the dealer’s general reputation or financial
counterparty credit standing on an instrument’s stability and its fair and honest dealings with
market and liquidity risk. The board of directors customers (other depository institutions that
and responsible senior management should be have been or are currently customers of the
informed of the institution’s total credit-risk dealer should be contacted)
exposures at least quarterly. • information available from state or federal
securities regulators and securities industry
self-regulatory organizations, such as the
Selection of Securities Dealers National Association of Securities Dealers,
concerning any formal enforcement actions
In managing their credit risk, institutions also against the dealer, its affiliates, or associated
should consider settlement and presettlement personnel
credit risk. The selection of dealers, investment • when the institution relies on the advice of a
bankers, and brokers is particularly important in dealer’s sales representative, the experience
February 1998 Trading and Capital-Markets Activities Manual
Page 12
Investment Securities and End-User Activities 3000.1
and expertise of the sales representative with concentration limits, which may define concen-
whom business will be conducted trations to a single or related issuer or counter-
party, in a geographical area, or in obligations
In addition, the board of directors (or an appro- with similar characteristics. Policies should also
priate committee of the board) must ensure that include procedures such as increased monitoring
the depository institution’s management has and stop-loss limits, for addressing deterioration
established appropriate procedures to obtain and in credit quality.
maintain possession or control of securities Sound credit-risk management requires that
purchased. In this regard, purchased securities credit limits be developed by personnel who are
and repurchase-agreement collateral should only independent of the acquisition function. In
be left in safekeeping with selling dealers when authorizing issuer and counterparty credit lines,
(1) the board of directors or an appropriate these personnel should use standards that are
committee thereof is completely satisfied as to consistent with those used for other activities
the creditworthiness of the securities dealer and conducted within the institution and with the
(2) the aggregate market value of securities held organization’s overall policies and consolidated
in safekeeping is within credit limitations that exposures. To assess the creditworthiness of
have been approved by the board of directors (or other organizations, institutions should not rely
an appropriate committee of the board) for solely on outside sources, such as standardized
unsecured transactions (see the October 1985 ratings provided by independent rating agencies,
FFIEC policy statement ‘‘Repurchase Agree- but should perform their own analysis of a
ments of Depository Institutions with Securities counterparty’s or issuer’s financial strength. In
Dealers and Others’’). addition, examiners should review the credit-
State lending limits generally do not extend to approval process to ensure that the credit risks
the safekeeping arrangements described above. of specific products are adequately identified
Notwithstanding this general principle, a bank’s and that credit-approval procedures are followed
board of directors should establish prudent lim- for all transactions.
its for safekeeping arrangements. These pruden- For most cash instruments, credit exposure is
tial limits generally involve a fiduciary relation- measured as the current carrying value. In the
ship, which presents operational rather than case of many derivative contracts, especially
credit risks. those traded in OTC markets, credit exposure
To avoid concentrations of assets or other is measured as the replacement cost of the
types of risk, banking organizations should, to position, plus an estimate of the institution’s
the extent possible, try to diversify the firms potential future exposure to changes in the
they use for safekeeping arrangements. Further, replacement value of that position in response to
while certain transactions with securities market price changes. Replacement costs of
dealers and safekeeping custodians may entail derivative contracts should be determined using
only operational risks, other transactions with current market prices or generally accepted
these parties may involve credit risk that could approaches for estimating the present value of
be subject to statutory lending limits, depend- future payments required under each contract, at
ing on applicable state laws. If certain trans- current market rates.
actions are deemed subject to a state’s legal The measurement of potential future credit-
lending limit statute because of a particular risk exposure for derivative contracts is more
safekeeping arrangement, the provisions of the subjective than the measurement of current
state’s statutes would, of course, control the exposure and is primarily a function of the time
extent to which the safekeeping arrangement remaining to maturity; the number of exchanges
complies with an individual state’s legal lending of principal; and the expected volatility of the
limit. price, rate, or index underlying the contract.
Potential future exposure can be measured using
an institution’s own simulations or, more sim-
Limits ply, by using add-ons such as those included in
the Federal Reserve’s risk-based capital guide-
An institution’s credit policies should also lines. Regardless of the method an institution
include guidelines on the quality and quantity of uses, examiners should evaluate the reasonable-
each type of security that may be held. Policies ness of the assumptions underlying the institu-
should provide credit-risk diversification and tion’s risk measure.
Trading and Capital-Markets Activities Manual February 1998
Page 13
3000.1 Investment Securities and End-User Activities
For derivative contracts and certain types of When evaluating capital adequacy, examiners
cash transactions, master agreements (including should consider the effect of changes in market
netting agreements) and various credit enhance- rates and prices on the economic value of the
ments (such as collateral or third-party guaran- institution by evaluating any unrealized losses in
tees) can reduce settlement, issuer, and counter- an institution’s securities or derivative positions.
party credit risk. In such cases, an institution’s This evaluation should assess the ability of the
credit exposures should reflect these risk- institution to hold its positions and function as a
reducing features only to the extent that the going concern if recognition of unrealized losses
agreements and recourse provisions are legally would significantly affect the institution’s capi-
enforceable in all relevant jurisdictions. This tal ratios. Examiners also should consider the
legal enforceability should extend to any insol- impact that liquidating positions with unrealized
vency proceedings of the counterparty. Institu- losses may have on the institution’s prompt-
tions should be prepared to demonstrate suffi- corrective-action capital category.
cient due diligence in evaluating the enforceability Market-risk limits should be established for
of these contracts. both the acquisition and ongoing management
In reviewing credit exposures, examiners of an institution’s securities and derivative hold-
should consider the extent to which positions ings and, as appropriate, should address expo-
exceed credit limits and whether exceptions are sures for individual instruments, instrument
resolved according to the institution’s adopted types, and portfolios. These limits should be
policies and procedures. Examiners should also integrated fully with limits established for the
evaluate whether the institution’s reports ade- entire institution. At the institutional level, the
quately provide all personnel involved in the board of directors should approve market-risk
acquisition and management of financial instru- exposure limits. Such limits may be expressed
ments with relevant, accurate, and timely infor- as specific percentage changes in the economic
mation about the credit exposures and approved value of capital and, when applicable, in the
credit lines. projected earnings of the institution under vari-
ous market scenarios. Similar and complemen-
tary limits on the volatility of prices or fair value
should be established at the appropriate instru-
Market Risk ment, product-type, and portfolio levels, based
on the institution’s willingness to accept market
Market risk is the exposure of an institution’s risk. Limits on the variability of effective matu-
financial condition to adverse movements in the rities may also be desirable for certain types of
market rates or prices of its holdings before such instruments or portfolios.
holdings can be liquidated or expeditiously off- The scenarios an institution specifies for
set. It is measured by assessing the effect of assessing the market risk of its securities and
changing rates or prices on the earnings or derivative products should be sufficiently rigor-
economic value of an individual instrument, a ous to capture all meaningful effects of any
portfolio, or the entire institution. Although options. For example, in assessing interest-rate
many banking institutions focus on carrying risk, scenarios such as 100-, 200-, and 300-basis-
values and reported earnings when assessing point parallel shifts in yield curves should be
market risk at the institutional level, other mea- considered as well as appropriate nonparallel
sures focusing on total returns and changes in shifts in structure to evaluate potential basis,
economic or fair values better reflect the poten- volatility, and yield curve risks.
tial market-risk exposure of institutions, port- Accurately measuring an institution’s market
folios, and individual instruments. Changes in risk requires timely information about the cur-
fair values and total returns directly measure the rent carrying and market values of its securities
effect of market movements on the economic and derivative holdings. Accordingly, institu-
value of an institution’s capital and provide tions should have market-risk measurement sys-
significant insights into their ultimate effects on tems commensurate with the size and nature of
the institution’s long-term earnings. Institutions their holdings. Institutions with significant hold-
should manage and control their market risks ings of highly complex instruments should
using both an earnings and an economic-value ensure that they have independent means to
approach, and at least on an economic or fair- value their positions. Institutions using internal
value basis. models to measure risk should have adequate
February 1998 Trading and Capital-Markets Activities Manual
Page 14
Investment Securities and End-User Activities 3000.1
procedures to validate the models and periodi- to the general funding of their activities. The
cally review all elements of the modeling former, market-liquidity risk, is the risk that an
process, including its assumptions and risk- institution cannot easily unwind, or offset, a
measurement techniques. Institutions relying on particular position at or near the previous market
third parties for market-risk-measurement sys- price because of inadequate market depth or
tems and analyses should fully understand the disruptions in the marketplace. The second,
assumptions and techniques used by the third funding-liquidity risk, is the risk that the bank
party. will be unable to meet its payment obligations
Institutions should evaluate the market-risk on settlement dates. Since neither type of liquid-
exposures of their securities and derivative posi- ity risk is unique to securities and derivative
tions and report this information to their boards activities, management should evaluate these
of directors regularly, not less frequently than risks in the broader context of the institution’s
each quarter. These evaluations should assess overall liquidity.
trends in aggregate market-risk exposure and the When specifying permissible securities and
performance of portfolios relative to their estab- derivative instruments to accomplish established
lished objectives and risk constraints. They also objectives, institutions should take into account
should identify compliance with board-approved the size, depth, and liquidity of the markets for
limits and identify any exceptions to established specific instruments, and the effect these char-
standards. Examiners should ensure that institu- acteristics may have on achieving an objective.
tions have mechanisms to detect and adequately The market liquidity of certain types of instru-
address exceptions to limits and guidelines. ments may make them entirely inappropriate for
Examiners should also determine that manage- achieving certain objectives. Moreover, institu-
ment reporting on market risk appropriately tions should consider the effects that market risk
addresses potential exposures to basis risk, yield can have on the liquidity of different types of
curve changes, and other factors pertinent to the instruments. For example, some government
institution’s holdings. In this connection, exam- agency securities may have embedded options
iners should assess an institution’s compliance that make them highly illiquid during periods of
with broader guidance for managing interest- market volatility and stress, despite their high
rate risk in a consolidated organization. credit rating. Accordingly, institutions should
Complex and illiquid instruments often involve clearly articulate the market-liquidity character-
greater market risk than broadly traded, more istics of instruments to be used in accomplishing
liquid securities. Frequently, the higher potential institutional objectives.
market risk arising from this illiquidity is not
The funding risk of an institution becomes a
captured by standardized financial-modeling
more important consideration when its unreal-
techniques. This type of risk is particularly acute
ized losses are material; therefore, this risk
for instruments that are highly leveraged or that
should be a factor in evaluating capital ade-
are designed to benefit from specific, narrowly
quacy. Institutions with weak liquidity positions
defined market shifts. If market prices or rates
are more likely to be forced to recognize these
do not move as expected, the demand for these
losses and suffer declines in their accounting
instruments can evaporate. When examiners
and regulatory capital. In extreme cases, these
encounter such instruments, they should review
effects could force supervisors to take prompt
how adequately the institution has assessed its
corrective actions.
potential market risks. If the risks from these
instruments are material, the institution should Examiners should assess whether the institu-
have a well-documented process for stress test- tion adequately considers the potential liquidity
ing their value and liquidity assumptions under a risks associated with the liquidation of securities
variety of market scenarios. or the early termination of derivative contracts.
Many forms of standardized contracts for
derivative transactions allow counterparties to
request collateral or terminate their contracts
Liquidity Risk early if the institution experiences an adverse
credit event or a deterioration in its financial
Banks face two types of liquidity risk in their condition. In addition, under situations of mar-
securities and derivative activities: risks related ket stress, customers may ask for the early
to specific products or markets and risks related termination of some contracts within the context
Trading and Capital-Markets Activities Manual April 2002
Page 15
3000.1 Investment Securities and End-User Activities
of the dealer’s market-making activities. In transactions consummated orally are confirmed
these circumstances, an institution that owes as soon as possible. As noted earlier in this
money on derivative transactions may be required section, banking organizations should, to the
to deliver collateral or settle a contract early; extent possible, seek to diversify the firms they
possibly at a time when the institution may use for their safekeeping arrangements to avoid
face other funding and liquidity pressures. Early concentrations of assets or other types of risk.
terminations may also open additional, unin- Legal risk is the risk that the contracts an
tended market positions. Management and institution enters into are not legally enforceable
directors should be aware of these potential or documented correctly. This risk should be
liquidity risks and address them in the institu- limited and managed through policies developed
tion’s liquidity plan and in the broader context by the institution’s legal counsel. At a mini-
of the institution’s liquidity-management process. mum, guidelines and processes should be in
In their reviews, examiners should consider the place to ensure the enforceability of counter-
extent to which such potential obligations could party agreements. Examiners should determine
present liquidity risks to the institution. whether an institution is adequately evaluating
the enforceability of its agreements before indi-
vidual transactions are consummated. Institu-
tions should also ensure that a counterparty has
Operating and Legal Risks sufficient authority to enter into the proposed
transaction and that the terms of the agreement
Operating risk is the risk that deficiencies in are legally sound. Institutions should further
information systems or internal controls will ascertain that their netting agreements are
result in unexpected loss. Some specific sources adequately documented, have been executed
of operating risk include inadequate procedures, properly, and are enforceable in all relevant
human error, system failure, or fraud. Inaccu- jurisdictions. Institutions should know about
rately assessing or controlling operating risks is relevant tax laws and interpretations governing
one of the more likely sources of problems the use of netting instruments.
facing institutions involved in securities and An institution’s policies should also provide
derivative activities. conflict-of-interest guidelines for employees who
Adequate internal controls are the first line are directly involved in purchasing securities
of defense in controlling the operating risks from and selling securities to securities dealers
involved in an institution’s securities and deriva- on behalf of their institution. These guidelines
tive activities. Of particular importance are should ensure that all directors, officers, and
internal controls to ensure that persons execut- employees act in the best interest of the institu-
ing transactions are separated from those indi- tion. The board of directors may wish to adopt
viduals responsible for processing contracts, policies prohibiting these employees from
confirming transactions, controlling various engaging in personal securities transactions with
clearing accounts, approving the accounting these same securities firms without the specific
methodology or entries, and performing prior approval of the board. The board of
revaluations. directors may also wish to adopt a policy appli-
Institutions should have approved policies, cable to directors, officers, and employees that
consistent with legal requirements and internal restricts or prohibits them from receiving gifts,
policies, that specify documentation require- gratuities, or travel expenses from approved
ments for transactions and formal procedures for securities dealer firms and their personnel.
saving and safeguarding important documents.
Relevant personnel should fully understand these
requirements. Examiners should also consider
the extent to which institutions evaluate and FEDERAL RESERVE ACT
control operating risks through internal audits, SECTIONS 23A AND 23B
stress testing, contingency planning, and other
managerial and analytical techniques. In May 2001, the Board published the following
An institution’s operating policies should rules interpreting sections 23A and 23B of the
establish appropriate procedures to obtain and Federal Reserve Act (FRA):
maintain possession or control of instruments
purchased. Institutions should ensure that • a final rule, effective June 11, 2001, that
April 2002 Trading and Capital-Markets Activities Manual
Page 16
Investment Securities and End-User Activities 3000.1
adopts an interpretation and exemptions from have purchased the security from another affili-
the quantitative limits and collateral require- ate of the insured depository institution.
ments of section 23A for certain loans to third Finally, the rule provides an exemption for
parties that are used to purchase securities or extensions of credit by an insured depository
other assets through an affiliate of the deposi- institution to customers that use the proceeds to
tory institution purchase securities from a broker-dealer affiliate
• a final rule, effective June 11, 2001, that of the institution when the extension of credit is
adopts an interpretation that expands the types made pursuant to a preexisting line of credit not
of asset purchases that are eligible for the entered into in contemplation of the purchase of
exemption for purchases from a broker-dealer securities from the affiliate. The extension of
affiliate of assets with a readily identifiable credit should be consistent with any restrictions
and publicly available market quotation imposed by the line of credit. In determining
• an interim rule, effective January 1, 2002, whether this exemption is being used in good
addressing the treatment under section 23B of faith, examiners should consider the timing of
derivative transactions between an insured the line of credit, the conditions imposed on the
depository institution and its affiliates (interaf- line, and whether the line of credit has been used
filiate derivative transactions) and intraday for purposes other than the purchase of securi-
extensions of credit by an insured depository ties from an affiliate. The fact that a line of credit
institution to its affiliates has been preapproved does not necessarily lead
to a conclusion that the line is preexisting.
Rather, the line should be actively used by the
customer.
Loans to Third Parties to Purchase
Securities or Assets from an Affiliate
Purchases of Assets with a Readily
The final rule provides three exemptions from
section 23A. First, an exemption from is pro-
Identifiable and Publicly Available
vided for extensions of credit by an insured Market Quotation
depository institution to customers that use the
loan proceeds to purchase a security or other The rule exempts from section 23A the purchase
asset through an affiliate of the depository insti- of a security by an insured depository institution
tution, provided that the affiliate is acting exclu- from an affiliated SEC-registered broker-dealer
sively as a broker in the transaction and retains if the following conditions are met:
no portion of the loan proceeds in excess of a
market-rate brokerage commission or agency • the security has a ready market, as defined by
fee. To take advantage of this exemption, the the SEC5
security or other asset cannot be issued, under- • the security is eligible for purchase directly by
written by, or sold from the inventory of an a state member bank, and the transaction is
affiliate of the depository institution. recorded as a purchase of securities on the
institution’s call report
Second, the rule adopts an exemption from
• the security is not a low-quality asset
section 23A for extensions of credit by an
• if an affiliate is the underwriter of the security,
insured depository institution to customers that
the security is not purchased during or within
use the proceeds to purchase a security issued by
30 days of an underwriting; however, this
a third party through an SEC-registered broker-
restriction does not apply to the purchase of
dealer affiliate of the institution that is acting as
obligations of, or fully guaranteed as to prin-
riskless principal in the securities transaction,
provided that the markup for executing the trade
is on or below market terms. The security cannot
5. The SEC defines a ‘‘ready market’’ as including a
be issued, underwritten by, or sold from the recognized established securities market (1) in which there
inventory of an affiliate. This limitation does not exists independent bona fide offers to buy and sell so that a
preclude a broker-dealer affiliate from selling to price reasonably related to the last sales price or current bona
the customer a security it purchased immedi- fide competitive bid and offer quotations can be determined
for a particular security almost instantaneously, and (2) in
ately before the sale to effect the riskless- which payment will be received in settlement of a sale at such
principal transaction initiated by the customer. price within a relatively short time conforming to trade
However, the broker-dealer affiliate should not custom.
Trading and Capital-Markets Activities Manual April 2002
Page 17
3000.1 Investment Securities and End-User Activities
cipal and interest by, the United States or its affiliates at least as rigorously as it monitors
agencies unaffiliated exposures to comparable compa-
• the security’s price is quoted routinely on an nies. Finally, the pricing and collateral require-
unaffiliated electronic service that provides ments imposed on IDTs and intraday extensions
real-time financial data, provided that— of credit to affiliates should be at least as
— the price paid by the depository institution favorable to the institution as those imposed on
is at or below the current market quotation comparable unaffiliated companies.
for the security, and
— the size of the transaction does not cast
doubt on the appropriateness of relying on
the current market quotation INTERNATIONAL DIVISION
• the security is not issued by an affiliate INVESTMENTS
Any such purchases remain subject to the The same types of instruments exist in interna-
provisions of section 23B that require the trans- tional banking as in domestic banking. Securi-
action to be on market terms and consistent with ties and derivative contracts may be acquired
safe and sound banking practices. Records re- by a bank’s international division and overseas
lating to such purchases must be maintained by branches, and foreign equity investments may
the depository institution for a period of two be held by the bank directly or through Edge Act
years after the purchase. corporations. The investments held by most
international divisions are predominately secu-
rities issued by various governmental entities of
the countries in which the bank’s foreign
Derivative Transactions with Affiliates branches are located. These investments are held
and Intraday Extensions of Credit to for a variety of purposes:
Affiliates
• They are required by various local laws.
The interim rule confirms that interaffiliate • They are used to meet foreign reserve
derivative transactions (IDTs) and intraday requirements.
extensions of credit by an insured depository • They result in reduced tax liabilities.
institution to an affiliate are subject to the • They enable the bank to use new or increased
market-terms requirement of section 23B.6 An rediscount facilities or benefit from greater
insured depository institution must establish and deposit or lending authorities.
maintain policies and procedures that, at a
• They are used by the bank as an expression of
minimum, provide for the monitoring and con-
‘‘goodwill’’ toward a country.
trol of the bank’s credit exposure from these
transactions, with each affiliate and with all
The examiner should be familiar with the
affiliates in the aggregate. Policies should also
applicable sections of Regulation K (12 CFR
ensure that the transactions comply with section
211) governing a member bank’s international
23B. To comply with section 23B, the transac-
investment holdings, as well as with other regu-
tions should be on terms and conditions at least
lations discussed in this section. Because of the
as favorable to the insured depository institution
mandatory investment requirements of some
as those transactions conducted with unaffiliated
countries, securities held cannot always be as
counterparties that are engaged in similar busi-
‘‘liquid’’ and ‘‘readily marketable’’ as required
ness and substantially equivalent in size and
in domestic banking. However, the amount of a
credit quality. Specifically, credit limits imposed
bank’s ‘‘mandatory’’ international holdings will
on IDTs and intraday extensions of credit to
normally be a relatively small amount of its total
affiliates should be at least as strict as those
investments or capital funds.
imposed on comparable unaffiliated companies.
A bank’s international division may also
The institution should monitor exposures to
hold securities strictly for investment purposes;
these are expected to provide a reasonable rate
6. IDTs are defined under the interim rule as any derivative of return commensurate with safety consider-
contract subject to the Board’s risk-based capital guidelines
(that is, most interest-rate, currency, equity, or commodities
ations. As with domestic investment securities,
derivatives and other similar contracts, including credit the bank’s safety must take precedence, fol-
derivatives.) lowed by liquidity and marketability require-
April 2002 Trading and Capital-Markets Activities Manual
Page 18
Investment Securities and End-User Activities 3000.1
ments. Securities held by international divisions UNSUITABLE INVESTMENT
are considered to be liquid if they are readily PRACTICES
convertible into cash at their approximate carry-
ing value. They are marketable if they can be Institutions should categorize each of their
sold in a very short time at a price commen- security activities as trading, available-for-sale,
surate with yield and quality. Speculation in or held-to-maturity consistent with GAAP (that
marginal foreign securities to generate more is, Statement of Financial Accounting Standards
favorable yields is an unsound banking practice No. 115, ‘‘Accounting for Certain Investments
and should be discouraged. in Debt and Equity Securities,’’ as amended) and
Banks are generally prohibited from investing regulatory reporting standards. Management
in stocks. However, a number of exceptions should reassess the categorizations of its secu-
(detailed earlier in this section) are often appli- rities periodically to ensure that they remain
cable to the international division. For example, appropriate.
the bank may, under section 24A of the Federal Securities that are intended to be held princi-
Reserve Act (12 USC 371d), hold stock in pally for the purpose of selling in the near term
overseas corporations that hold title to foreign should be classified as trading assets. Trading
bank premises. A foreign branch of a member activity includes the active and frequent buying
bank may invest in the securities of the central and selling of securities for the purpose of
bank, clearinghouses, governmental entities, and generating profits on short-term fluctuations in
government-sponsored development banks of price. Securities held for trading purposes must
the country where the branch is located and may be reported at fair value, with unrealized gains
make other investments necessary to the busi- and losses recognized in current earnings and
ness of the branch. Other sections of Regulation regulatory capital. The proper categorization of
K permit the bank to make equity investments in securities is important to ensure that trading
Edge Act and agreement corporations and in gains and losses are promptly recognized—
foreign banks, subject to certain limitations. which will not occur when securities intended to
Standard & Poor’s, Moody’s, and other pub- be held for trading purposes are categorized as
lications from U.S. rating services rate Canadian held-to-maturity or available-for-sale.
and other selected foreign securities that are It is an unsafe and unsound practice to report
authorized for U.S. commercial bank investment securities held for trading purposes as available-
purposes under 12 USC 24 (seventh). However, for-sale or held-to-maturity securities. A close
in many other countries, securities-rating ser- examination of an institution’s actual securities
vices are limited or nonexistent. When they do activities will determine whether securities it
exist, the ratings are only indicative and should reported as available-for-sale or held-to-maturity
be supplemented with additional information on are, in reality, held for trading. When the fol-
legality, credit soundness, marketability, and lowing securities activities are conducted in
foreign-exchange and country-risk factors. The available-for-sale or held-to-maturity accounts,
opinions of local attorneys are often the best they should raise supervisory concerns. The first
source of determining whether a particular for- five practices below are considered trading
eign security has the full faith and credit backing activities and should not occur in available-for-
of a country’s government. sale or held-to-maturity securities portfolios,
Sufficient analytical data must be provided to and the sixth practice is wholly unacceptable
the bank’s board of directors and senior man- under all circumstances.
agement so they can make informed judgments
about the effectiveness of the international divi-
sion’s investment policy and procedures. The Gains Trading
institution’s international securities and deriva-
tive contracts should be included on all board Gains trading is the purchase of a security and
and management reports detailing domestic the subsequent sale of that security at a profit
securities and derivative contracts. These reports after a short holding period. However, at the
should be timely and sufficiently detailed to same time, securities acquired for gains trading
allow the board of directors and senior manage- that cannot be sold at a profit are retained in the
ment to understand and assess the credit, mar- available-for-sale or held-to-maturity portfolio;
ket, and liquidity risks facing the institution and unrealized losses on debt securities in these two
its securities and derivative positions. categories do not directly affect regulatory capi-
Trading and Capital-Markets Activities Manual April 2002
Page 19
3000.1 Investment Securities and End-User Activities
tal and are not reported in income until the backed securities and derivative contracts) is
security is sold. Examiners should note institu- one business day after the trade date. Regular-
tions that exhibit a pattern or practice of report- way settlement for corporate and municipal
ing significant amounts of realized gains on securities is three business days after the trade
sales of nontrading securities (typically, available- date, and settlement for mortgage-backed secu-
for-sale securities) after short holding periods, rities can be up to 60 days or more after the trade
while continuing to hold other nontrading secu- date. Using a settlement period that exceeds the
rities with significant amounts of unrealized regular-way settlement periods to facilitate
losses. In these situations, examiners may speculation is considered a trading activity.
designate some or all of the securities reported
outside of the trading category as trading assets.
Short Sales
When-Issued Securities Trading
A short sale is the sale of a security that is not
When-issued securities trading is the buying and owned. Generally, the purpose of a short sale is
selling of securities in the period between the to speculate on a fall in the price of the security.
announcement of an offering and the issuance Short sales should be conducted in the trading
and payment date of the securities. A purchaser portfolio. A short sale that involves the delivery
of a when-issued security acquires all of the of the security sold short by borrowing it from
risks and rewards of owning a security and may the depository institution’s available-for-sale
sell this security at a profit before having to take or held-to-maturity portfolio should not be
delivery and pay for it. These transactions should reported as a short sale. Instead, it should be
be regarded as trading activities. reported as a sale of the underlying security with
gain or loss recognized. Short sales are not
permitted for federal credit unions.
Pair-Offs
Pair-offs are security purchases that are closed
out or sold at or before settlement date. In a Adjusted Trading
pair-off, an institution commits to purchase a
security. Then before the predetermined settle- Adjusted trading involves the sale of a security
ment date, the institution will pair off the pur- to a broker or dealer at a price above the
chase with a sale of the same security. Pair-offs prevailing market value and the simultaneous
are settled net when one party to the transaction purchase and booking of a different security,
remits the difference between the purchase and frequently a lower-grade issue or one with a
sale price to the counterparty. Other pair-off longer maturity, at a price above its market
transactions may involve the same sequence of value. Thus, the dealer is reimbursed for its
events using swaps, options on swaps, forward losses on the initial purchase from the institution
commitments, options on forward commit- and ensured a profit. Adjusted-trading trans-
ments, or other derivative contracts. actions inappropriately defer the recognition of
losses on the security sold and establish an
excessive reported value for the newly acquired
Extended Settlements security. Consequently, these transactions are
prohibited and may be in violation of 18 USC
Regular-way settlement for U.S. government 1001 (False Statements or Entries) and 1005
and federal-agency securities (except mortgage- (False Entries).
April 2002 Trading and Capital-Markets Activities Manual
Page 20
Investment Securities and End-User Activities
Examination Objectives Section 3000.2
1. To determine if policies, practices, proce- 5. To determine compliance with laws and
dures, and internal controls for investments regulations.
are adequate. 6. To initiate corrective action when policies,
2. To determine if bank officers are operating in practices, procedures, or internal controls are
conformance with the established guidelines. deficient or when violations of laws or regu-
3. To determine the scope and adequacy of the lations have been noted.
audit function.
4. To determine the overall quality of the invest-
ment portfolio and how that quality relates to
the soundness of the bank.
Trading and Capital-Markets Activities Manual February 1998
Page 1
Investment Securities and End-User Activities
Examination Procedures Section 3000.3
These procedures represent a list of processes memo should state conclusions on the
and activities that may be reviewed during a effectiveness of directors’ supervision of
full-scope examination. The examiner-in-charge the domestic and international-division
will establish the general scope of examination investment policy. All conclusions should
and work with the examination staff to tailor be documented.
specific areas for review as circumstances war- 3. Obtain the following:
rant. As part of this process, the examiner a. trial balances of investment-account hold-
reviewing a function or product will analyze and ings, money market instruments, and
evaluate internal audit comments and previous end-user derivative positions including
examination workpapers to assist in designing commercial paper, banker’s acceptances,
the scope of examination. In addition, after a negotiable certificates of deposit, securi-
general review of a particular area to be exam- ties purchased under agreements to resell,
ined, the examiner should use these procedures, and federal funds sold (Identify any
to the extent they are applicable, for further depository instruments placed through
guidance. Ultimately, it is the seasoned judg- money brokers.)
ment of the examiner and the examiner-in- b. a list of any assets carried in loans and
charge as to which procedures are warranted in any discounts on which interest is exempt
examining any particular activity. from federal income taxes and which are
carried in the investment account on call
1. Based on the evaluation of internal controls reports
and the work performed by internal and
c. a list of open purchase-and-sale
external auditors, determine the scope of the
commitments
examination.
d. a schedule of all securities, forward place-
2. Test for compliance with policies, practices,
ment contracts, and derivative contracts
procedures, and internal controls in con-
including contracts on exchange-traded
junction with performing the examination
puts and calls, option contracts on futures
procedures. Also, obtain a listing of any
puts and calls, and standby contracts
deficiencies noted in the latest review con-
purchased or sold since the last
ducted by internal and external auditors and
examination
determine if corrections have been accom-
plished. Determine the extent and effective- e. a maturity schedule of securities sold
ness of investment-policy supervision by— under repurchase agreements
a. reviewing the abstracted minutes of board f. a list of pledged assets and secured
of directors meetings and minutes of liabilities
appropriate committee meetings; g. a list of the names and addresses of all
b. determining that proper authorizations securities dealers doing business with the
have been made for investment officers bank
or committees; h. a list of the bank’s personnel authorized
c. determining any limitations or restric- to trade with dealers
tions on delegated authorities; i. a list of all U.S. government–guaranteed
d. evaluating the sufficiency of analytical loans which are recorded and carried as
data used by the board or investment an investment-account security
committee; j. for international division and overseas
e. reviewing the reporting methods used branches, a list of investments—
by department supervisors and internal • held to comply with various foreign
auditors to ensure compliance with governmental regulations requiring such
established policy; and investments,
f. preparing a memo for the examiner who • used to meet foreign reserve
is assigned to review the duties and requirements,
responsibilities of directors and for the • required as stock exchange guarantees
examiner responsible for the interna- or used to enable the bank to provide
tional examination, if applicable. This securities services,
Trading and Capital-Markets Activities Manual February 1998
Page 1
3000.3 Investment Securities and End-User Activities: Examination Procedures
• representing investment of surplus from the trial balances the international
funds, investments, municipal investments, and
• used to obtain telephone and telex money market and derivative holdings for
services, examination. If transaction volume permits,
• representing club and school include in the population of items to be
memberships, reviewed all securities purchased since the
• acquired through debts previously last general examination.
contracted, 7. Perform the following procedures for each
• representing minority interests in non- investment and money market holding
affiliated companies, selected in step 6.
• representing trading-account securities, a. Check appropriate legal opinions or pub-
• representing equity interests in Edge lished data outlining legal status.
Act and agreement corporations and in b. If market prices are provided to the bank
foreign banks, and by an independent party (excluding
• held for other purposes. affiliates and securities dealers selling
4. Using updated data available from reports investments to the bank), or if they are
of condition, UBPR printouts, and invest- independently tested as a documented
ment advisor and correspondent bank port- part of the bank’s audit program, those
folio analysis reports, obtain or prepare an prices should be accepted. If the inde-
analysis of investment, money market, and pendence of the prices cannot be estab-
end-user derivative holdings that includes— lished, test market values by referring to
a. a month-by-month schedule of par, book, one of the following sources:
and market values of issues maturing in • published quotations, if available
one year; • appraisals by outside pricing services,
b. schedules of par, book, and market val- if performed
ues of holdings in the investment port- c. For investments and money market obli-
folio (these schedules should be indexed gations in the sample that are rated,
by maturity date, and the schedule should compare the ratings provided to the most
be detailed by maturity dates over the recent published ratings.
following time periods: over 1 through 5
years, over 5 through 10 years, and over Before continuing, refer to steps 15 through
10 years); 17. They should be performed in conjunction
c. book value totals of holdings by obligor with steps 8 through 14. International-division
or industry, related obligors or industries, holdings should be reviewed with domestic
geographic distribution, yield, and spe- holdings to ensure compliance, when combined,
cial characteristics, such as moral obli- with applicable legal requirements.
gations, conversion, or warrant features;
d. par value schedules of type I, II, and III 8. To the extent practicable under the circum-
investment holdings, by those legally stances, test that the institution has analyzed
defined types; and the following:
e. for the international division, a list of a. the obligors on securities purchased under
international investment holdings agreements to resell, when the readily
(foreign-currency amounts and U.S. dol- marketable value of the securities is not
lar equivalents) to include— sufficient to satisfy the obligation
• descriptions of securities held (par, b. all international investments, nonrated
book, and market values), securities, derivatives, and money mar-
• names of issuers, ket instruments selected in step 6 or
• issuers’ countries of domicile, acquired since the last examination
• interest rates, and c. all previously detailed or currently known
• pledged securities. speculative issues
5. Review the reconcilement of the trial bal- d. all defaulted issues
ances investment and money market accounts e. any issues in the current Interagency
to general-ledger control accounts. Country Exposure Review Committee
6. Using either an appropriate sampling tech- credit schedule (obtained from the inter-
nique or the asset-coverage method, select national loan portfolio manager):
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Investment Securities and End-User Activities: Examination Procedures 3000.3
• compare the schedule to the foreign • how and when each issue was acquired
securities trial balance obtained in step • default date, if appropriate
3 to ascertain which foreign securities • date interest was paid to the issue
are to be included in Interagency Coun- • rating at time of acquisition
try Exposure Review Committee credits • comments supporting the classification
• for each security so identified, tran- 11. Review the bank’s maturity program.
scribe the following appropriate infor- a. Review the maturity schedules by—
mation to a separate examiner’s line • comparing book and market values
sheet or a related examiner’s credit and, after considering the gain or loss
line sheet: on year-to-date sales, determine if the
— amount (and U.S. dollar equivalent costs of selling intermediate and long-
if a foreign currency) to include term issues appear prohibitive, and
par, book, and market values • determine if recent acquisitions show a
— how and when acquired trend toward lengthened or shortened
— maturity dates maturities. Discuss such trends with
— default date, if appropriate management, particularly with regard
— any pertinent comments to investment objectives approved by
• return the schedule and appropriate the investment committee.
examiner’s line sheets to the examiner b. Review the pledged-asset and secured-
who is assigned to international—loan liability schedules and isolate pledged
portfolio management. securities by maturity segment, then
9. Review the most recent reports of examina- determine the market value of securities
tion of the bank’s Edge Act and agreement pledged in excess of net secured liabilities.
corporation affiliates and foreign subsidi- c. Review the schedule of securities sold
aries to determine their overall conditions. under repurchase agreement and
Also, compile data on Edge Act and agree- determine—
ment corporations and foreign subsidiaries • if financing for securities purchases is
that are necessary for the commercial report provided via repurchase agreement by
of examination (such as asset criticisms, the securities dealer who originally
transfer risk, and other material examina- sold the security to the bank,
tion findings). • if funds acquired through the sale of
10. Classify speculative and defaulted issues securities under agreement to repur-
according to the following standards (except chase are invested in money market
those securities in the Interagency Country assets or if short-term repurchase agree-
Exposure Review and other securities ments are being used to fund longer-
on which special instructions have been term, fixed-rate assets,
issued): • the extent of matched-asset repo and
a. The entire book value of speculative- liability repo maturities and the overall
grade municipal general obligation effect on liquidity resulting from
securities which are not in default will unmatched positions,
be classified substandard. Market depre- • if the interest rate paid on securities
ciation on other speculative issues should sold under agreement to repurchase is
be classified doubtful. The remaining appropriate relative to current money
book value usually is classified market rates, and
substandard. • if the repurchase agreement is at the
b. The entire book value of all defaulted option of the buying or selling bank.
municipal general obligation securities d. Review the list of open purchase-and-
will be classified doubtful. Market depre- sale commitments and determine the
ciation on other defaulted bonds should effect of their completion on maturity
be classified loss. The remaining book scheduling.
value usually is classified substandard. e. Submit investment portfolio information
c. Market depreciation on nonexempt stock regarding the credit quality and practical
should be classified loss. liquidity of the investment portfolio to
d. Report comments should include: the examiner who is assigned to asset/
• description of issue liability management.
Trading and Capital-Markets Activities Manual February 1998
Page 3
3000.3 Investment Securities and End-User Activities: Examination Procedures
12. Consult with the examiner responsible for • Review acquisitions since the prior
the asset/liability management analysis to examination and ascertain reasons for
determine what information is needed to trends that may suggest a shift in the
assess the bank’s sensitivity to interest-rate rated quality of investment holdings.
fluctuations and its ability to meet short- d. Review coupon rates or yields (when
term funding requirements. If requested, available) and compare those recently
compile the information using bank records acquired investments and money market
or other appropriate sources. (See the holdings with coupon rates or yields that
Instructions for the Report of Examination appear high or low to similarly acquired
section of this manual for factors to be taken instruments of analogous types, ratings,
into account when compiling this informa- and maturity characteristics. Discuss
tion.) Information which may be required to significant rate or yield variances with
be furnished includes— management.
a. the market value of unpledged govern- e. Review the schedule of securities, futures,
ment and federal-agency securities forward, and standby contracts purchased
maturing within one year; and sold since the last examination and
b. the market value of other unpledged determine whether the volume of trading
government and federal-agency securi- is consistent with policy objectives.
ties which would be sold without loss; If the bank does not have a separate
c. the market value of unpledged municipal trading account, determine whether such
securities maturing within one year; an account should be established, includ-
d. the book value of money market instru- ing appropriate recordkeeping and
ments, such as banker’s acceptances, controls.
commercial paper, and certificates of
deposit (provide amounts for each cate- f. If the majority of sales resulted in gains,
gory); and determine if profit-taking is consistent
e. commitments to purchase and sell secu- with stated policy objectives or is
rities, including futures, forward, and motivated by anxiety for short-term
standby contracts. (Provide a description income.
of the security contract, the purchase or g. Determine whether the bank has dis-
sales price, and the settlement or expira- counted or has plans to discount future
tion date.) investment income by selling interest
13. Determine whether the bank’s investment coupons in advance of interest-payment
policies and practices are balancing earn- dates.
ings and risk satisfactorily. h. Review the list of commitments to pur-
a. Use UBPR or average call report data to chase or sell investments or money mar-
calculate investments as a percentage of ket investments. Determine the effect of
total assets and average yields on U.S. completion of these contracts on future
government and nontaxable investments. earnings.
• Compare results to peer-group statistics. 14. Review the bank’s federal income tax
• Determine the reasons for significant position.
variances from the norm.
• Determine if trends are apparent and a. Determine, by discussion with appropri-
the reasons for such trends. ate officers, if the bank is taking advan-
b. Calculate current market depreciation as tage of procedures to minimize tax
a percentage of gross capital funds. liability in view of other investment
c. Review the analysis of municipal and objectives.
corporate issues by rating classification. b. Review or compute the bank’s actual and
• Determine the total in each rating class budgeted tax-exempt holdings as a per-
and the total of nonrated issues. centage of total assets and its applicable
• Determine the total of nonrated invest- income taxes as a percentage of net
ment securities issued by obligors operating income before taxes.
located outside of the bank’s service c. Discuss with management the tax impli-
area (exclude U.S. government– cations of losses resulting from securities
guaranteed issues). sales.
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Investment Securities and End-User Activities: Examination Procedures 3000.3
15. Determine that proper risk diversification revalued on the basis of market or
exists within the portfolio. the lower of cost or market at each
a. Review totals of holdings by single month-end;
obligor or industry, related obligors or — securities acquired as the result of
industries, geographic distribution, yields, completed contracts valued at
and securities that have special charac- the lower of cost or market upon
teristics (include individual due from settlement;
bank accounts from the list received — fee income received by the bank on
from the bank or from the examiner who standby contracts accounted for
is assigned to due from banks and all properly;
money market instruments). — financial reports disclosing futures,
• Detail, as concentrations, all holdings forwards, options, and standby
equaling 25 percent or more of capital activity;
funds. — a bank-instituted system for moni-
• List all holdings equaling at least toring credit-risk exposure in for-
10 percent but less than 25 percent of ward and standby contract activity;
capital funds and submit that informa- and
tion to the examiner who is assigned to — the bank’s internal controls, man-
loan portfolio management. These hold- agement reports, and audit proce-
ings will be combined with any addi- dures to ensure adherence to policy.
tional advances in the lending areas. 17. If the bank is engaged in financial futures,
b. Perform a credit analysis of all nonrated forward placement, options, or standby con-
holdings determined to be a concentra- tracts, determine if the contracts have a
tion (if not performed in step 8). reasonable correlation to the bank’s busi-
16. If the bank is engaged in financial futures, ness needs (including gap position) and if
exchange-traded puts and calls, forward the bank fulfills its obligations under the
placements, or standby contracts, determine contracts.
the following. a. Compare the contract commitment and
a. The policy is specific enough to outline maturity dates to anticipated offset.
permissible contract strategies and their b. Report significant gaps to the examiner
relationships to other banking activities. who is assigned to asset/liability manage-
b. Recordkeeping systems are sufficiently ment (see step 12).
detailed to permit a determination of c. Compare the amounts of outstanding
whether operating personnel have acted contracts to the amounts of the antici-
in accordance with authorized objectives. pated offset.
c. The board of directors or its designee d. Ascertain the extent of the correlation
has established specific contract-position between expected interest-rate move-
limits and reviews contract positions at ments on the contracts and the antici-
least monthly to ascertain conformance pated offset.
with those limits. e. Determine the effect of the loss recog-
d. Gross and net positions are within autho- nition on future earnings, and, if signifi-
rized positions and limits, and trades cant, report it to the examiner who is
were executed by persons authorized to assigned to analytical review and income
trade futures. and expense.
e. The bank maintains general-ledger memo- 18. On the basis of the pricings, ratings, and
randum accounts or commitment regis- credit analyses performed above, and using
ters which, at a minimum, include— the investments selected in step 6 or from
• the type and amount of each contract, lists previously obtained, test for compli-
• the maturity date of each contract, ance with applicable laws and regulations.
• the current market price and cost of a. Determine if the bank holds type II or III
each contract, and investments that are predominantly specu-
• the amount held in margin accounts, lative or if it holds securities that are not
including— marketable (12 CFR 1.3(b)).
— all futures contracts and forward, b. Review the recap of investment securi-
standby, and options contracts ties by legal types, as defined by 12 CFR
Trading and Capital-Markets Activities Manual February 1998
Page 5
3000.3 Investment Securities and End-User Activities: Examination Procedures
1, on the basis of the legal restrictions determine whether the transaction is
of 12 USC 24 and competent legal within applicable legal lending limits in
opinions. the state.
c. For those investment securities that are g. Review securities sold under agreement
convertible into stock or which have to repurchase and determine whether
stock purchase warrants attached— they are, in fact, deposits (Regulation D,
• determine if the book value has been 12 CFR 204.2(a)(1)).
written down to an amount that repre- h. Determine that securities and money mar-
sents the investment value of the secu- ket investments held by foreign branches
rity, independent of the conversion or comply with section 211.3 of Regulation
warrant provision (12 CFR 1.10) and K—Foreign Branches of Member Banks
• determine if the par values of other (12 CFR 211.3) as to—
securities that have been ruled eligible • acquiring and holding securities (sec-
for purchase are within specified capi- tion 211.3(b)(3)) and
tal limitations. • underwriting, distributing, buying, and
d. Review pledge agreements and secured selling obligations of the national gov-
liabilities and determine that— ernment of the country in which the
• proper custodial procedures have been branch is located (section 211.3(b)(4)).
followed,
• eligible securities are pledged, (Further considerations relating to the above are
• securities pledged are sufficient to in other sections of Regulation K. Also review
secure the liability that requires any applicable sections of Regulation T—Credit
securing, by Brokers and Dealers (12 CFR 220), Regula-
• Treasury tax and loan remittance options tion X—Borrowers of Securities Credit (12 CFR
and note options are properly secured, 224), and Board interpretations 6150 (regarding
and securities issued or guaranteed by the Interna-
• private deposits are not being secured. tional Bank for Reconstruction and Develop-
ment) and 6200 (regarding borrowing by a
(Information needed to perform the above steps domestic broker from a foreign broker). Edge
will be in the pledge agreement; Treasury cir- Act and agreement corporations are discussed in
culars 92 and 176, as amended.) the bank-related organizations section.
e. Review accounting procedures to deter- i. Determine that the bank’s equity invest-
mine that— ments in foreign banks comply with the
• investment premiums are being extin- provisions of section 25 of the Federal
guished by maturity or call dates Reserve Act and section 211.5 of Regu-
(12 CFR 1.11); lation K as to—
• premium amortization is charged to • investment limitations (section 211.5(b))
operating income (12 CFR 1.11); and
• accretion of discount is included in • investment procedures (section
current income for banks required to 211.5(c)).
use accrual accounting for reporting 19. Test for compliance with other laws and
purposes; regulations as follows.
• accretion of bond discount requires a a. Review lists of affiliate relationships and
concurrent accrual of deferred income lists of directors and principal officers
tax payable; and and their interests.
• securities gains or losses are reported • Determine if the bank is an affiliate of
net of applicable taxes, and net gains a firm that is primarily engaged in
or losses are reflected in the period in underwriting or selling securities (12
which they are realized. USC 377).
f. Determine if securities purchased under • Determine if directors or officers are
agreement to resell are in fact securities engaged in or employed by firms that
(not loans), are eligible for investment are engaged in similar activities (12
by the bank, and are within prescribed USC 78, 377, and 378). (It is an
limits (12 USC 24 and 12 CFR 1). If not, acceptable practice for bank officers to
February 1998 Trading and Capital-Markets Activities Manual
Page 6
Investment Securities and End-User Activities: Examination Procedures 3000.3
act as directors of securities companies c. Determine if the volume of trading
not doing business in the United States, activity in the investment portfolio appears
the stock of which is owned by the unwarranted. If so—
bank as authorized by the Board of • review investment-account daily led-
Governors of the Federal Reserve gers and transaction invoices to deter-
System.) mine if sales were matched by a like
• Review the list of federal funds sold, amount of purchases,
securities purchased under agreements • determine whether the bank is financ-
to resell, interest-bearing time depos- ing a dealer’s inventory,
its, and commercial paper, and deter- • compare purchase and sale prices with
mine if the bank is investing in money independently established market prices
market instruments of affiliated banks as of trade dates, if appropriate (the
or firms (section 23A, Federal Reserve carrying value should be determined
Act and 12 USC 371(c)). by the market value of the securities as
• Determine if transactions involving of the trade date), and
affiliates, insiders, or their interests • cross reference descriptive details on
have terms that are less favorable to investment ledgers and purchase con-
the bank than transactions involving firmations to the actual bonds or safe-
unrelated parties (sections 23A and 22 keeping receipts to determine if the
of the Federal Reserve Act (12 USC bonds delivered are those purchased.
371c, 375, 375a, and 375b)). 21. Discuss with appropriate officers and pre-
b. Determine if Federal Reserve stock pare report comments on—
equals 3 percent of the subject bank’s a. defaulted issues;
booked capital and surplus accounts b. speculative issues;
(Regulation I and 12 CFR 209). c. incomplete credit information;
c. Review the nature and duration of fed- d. the absence of legal opinions;
eral funds sales to determine if term e. significant changes in maturity
federal funds are being sold in an amount scheduling;
exceeding the limit imposed by state f. shifts in the rated quality of holdings;
legal lending limits. g. concentrations;
20. With regard to potential unsafe and unsound h. unbalanced earnings and risk
investment practices and possible violations considerations;
of the Securities Exchange Act of 1934, i. unsafe and unsound investment practices;
review the list of securities purchased and/or j. apparent violations of laws, rulings, and
sold since the last examination. regulations and the potential personal
a. Determine if the bank engages one secu- liability of the directorate;
rities dealer or salesperson for virtually k. significant variances from peer-group
all transactions. If so— statistics;
• evaluate the reasonableness of the l. market-value depreciation, if significant;
relationship on the basis of the dealer’s m. weaknesses in supervision;
location and reputation and n. policy deficiencies; and
• compare purchase and sale prices to o. material problems being encountered by
independently established market prices the bank’s Edge Act and agreement cor-
as of trade dates, if appropriate. poration affiliates and other related inter-
b. Determine if investment-account securi- national concerns that could affect the
ties have been purchased from the bank’s condition of the bank.
own trading department. If so— 22. The following guidelines are to be imple-
• independently establish the market mented while reviewing securities partici-
price as of trade date, pations, purchases and sales, swaps, or other
• review trading-account purchase and transfers. The guidelines are designed to
sale confirmations and determine if the ensure that securities transfers involving
security was transferred to the invest- state member banks, bank holding compa-
ment portfolio at market price, and nies, and nonbank affiliates are carefully
• review controls designed to prevent evaluated to determine if they were carried
dumping. out to avoid classification and to determine
Trading and Capital-Markets Activities Manual February 1998
Page 7
3000.3 Investment Securities and End-User Activities: Examination Procedures
the effect of the transfer on the condition of f. Determine that transactions involving
the institution. In addition, the guidelines transfers of low-quality securities to the
are designed to ensure that the primary parent holding company or a nonbank
regulator of the other financial institution affiliate are properly reflected at fair
involved in the transfer is notified. market value on the books of both the
a. Investigate any situations in which secu- bank and the holding company affiliate.
rities were transferred before the date of g. If poor-quality securities were trans-
examination to determine if any were ferred to or from another financial insti-
transferred to avoid possible criticism tution for which the Federal Reserve is
during the examination. not the primary regulator, prepare a
b. Determine whether any of the securities memorandum to be submitted to Reserve
transferred were nonperforming at the Bank supervisory personnel. The Reserve
time of transfer, classified at the pre- Bank will then inform the local office of
vious examination, depreciated or sub- the primary federal regulator of the other
investment-grade, or for any other reason institution involved in the transfer. The
considered to be of questionable quality. memorandum should include the follow-
c. Review the bank’s policies and proce- ing information, as applicable:
dures to determine whether securities • names of originating and receiving
purchased by the bank are given an institutions
independent, complete, and adequate • the type of securities involved and
credit evaluation. If the bank is a holding type of transfer (such as participation,
company subsidiary or a member of a purchase or sale, or swap)
chain banking organization, review secu- • dates of transfer
rities purchases or participations from
• the total number and dollar amount of
affiliates or other known members of the
securities transferred
chain to determine if the securities pur-
chases are given an arm’s-length and • the status of the securities when trans-
independent credit evaluation by the pur- ferred (for example, rating, deprecia-
chasing bank. tion, nonperforming, or classified)
d. Determine whether bank purchases of • any other information that would be
securities from an affiliate are in con- helpful to the other regulator
formance with section 23A, which gen- 23. Evaluate the quality of department manage-
erally prohibits purchases of low-quality ment. Communicate your conclusion to the
assets from an affiliate. examiner who is assigned to management
e. Determine that any securities purchased assessment and the examiner responsible
by the bank are properly reflected on its for the international examination, if
books at fair market value (fair market applicable.
value should at a minimum reflect both 24. Update workpapers with any information
the rate of return being earned on such that will facilitate future examinations. If
assets and an appropriate risk premium). the bank has overseas branches, indicate
Determine that appropriate write-offs are those securities that will require review
taken on any securities sold by the bank during the next overseas examination and
at less than book value. the reasons for the review.
February 1998 Trading and Capital-Markets Activities Manual
Page 8
Investment Securities and End-User Activities
Internal Control Questionnaire Section 3000.4
Review the bank’s internal controls, policies, b. Are purchases or sales reported to the
practices, and procedures regarding purchases, board of directors or its investment
sales, and servicing of the investment portfolio. committee?
The bank’s system should be documented com- c. Are maximums established for the
pletely and concisely, and should include, where amount of each type of asset?
appropriate, narrative descriptions, flow charts, d. Are maximums established for the
copies of forms used, and other pertinent infor- amount of each type of asset that may
mation. Items in the questionnaire marked with be purchased from or sold to any one
an asterisk require substantiation by observa- bank?
tion or testing. e. Do money market investment policies
outline acceptable maturities?
f. Have credit standards and review pro-
POLICIES cedures been established?
8. Are the bank’s policies in compliance with
1. Has the board of directors, consistent with sections 23A and 23B of the Federal
its duties and responsibilities, adopted writ- Reserve Act and the Board’s rules there-
ten investment-securities policies, includ- under?
ing policies for when-issued securities,
futures, and forward placement contracts?
Do policies outline the following:
a. objectives CUSTODY OF SECURITIES
b. permissible types of investments
c. diversification guidelines to prevent *9. Do procedures preclude the custodian of
undue concentration the bank’s securities from—
d. maturity schedules a. having sole physical access to securities;
e. limitations on quality ratings b. preparing release documents without
f. policies for exceptions to standard the approval of authorized persons;
policy c. preparing release documents not subse-
g. valuation procedures and their frequency quently examined or tested by a second
2. Are investment policies reviewed at least custodian; and
annually by the board to determine if they d. performing more than one of the fol-
are compatible with changing market lowing transactions: (1) execution of
conditions? trades, (2) receipt or delivery of secu-
3. At the time of purchase, are securities rities, (3) receipt and disbursement of
designated as to whether they are invest- proceeds?
ments for the portfolio or trading account? *10. Are securities physically safeguarded to
4. Have policies been established governing prevent loss or their unauthorized removal
the transfer of securities from the trading or use?
account to the investment-securities 11. Are securities, other than bearer securities,
account? held only in the name or nominee of the
5. Have limitations been imposed on the bank?
investment authority of officers? 12. When a negotiable certificate of deposit is
*6. Do security transactions require dual acquired, is the certificate safeguarded in
authorization? the same manner as any other negotiable
7. Does the bank have any of the following: investment instrument?
due from commercial banks or from other
depository institutions, time accounts, fed-
eral funds sold, commercial paper, securi- RECORDS
ties purchased under agreements to resell,
or any other money market type of invest- 13. Do subsidiary records of investment
ment? If so, determine the following: securities show all pertinent data describ-
a. Is purchase or sale authority clearly ing the security; its location; pledged or
defined? unpledged status; premium amortization;
Trading and Capital-Markets Activities Manual April 2002
Page 1
3000.4 Investment Securities and End-User Activities: Internal Control Questionnaire
discount accretion; and interest earned, b. notified in writing of revocation of
collected, and accrued? trading authority?
*14. Is the preparation and posting of subsidi- 23. Has the bank established end-user limits—
ary records performed or reviewed by a. for individual traders and total outstand-
persons who do not also have sole custody ing contracts?
of securities? b. that are endorsed by the board or an
*15. Are subsidiary records reconciled, at least appropriate board committee?
monthly, to the appropriate general-ledger c. whose basis is fully explained?
accounts, and are reconciling items inves- 24. Does the bank obtain prior written approval
tigated by persons who do not also have detailing the amount of, duration, and
sole custody of securities? reason—
16. For international division investments, are a. for deviations from individual limits
entries for U.S. dollar carrying values of and
securities denominated in foreign currencies b. for deviations from gross trading limits?
rechecked at inception by a second person? 25. Are these exceptions subsequently submit-
ted to the board or an appropriate board
committee for ratification?
PURCHASES, SALES, AND 26. Does the trader prepare a prenumbered
REDEMPTIONS trade ticket?
27. Does the trade ticket contain all of the
*17. Is the preparation and posting of the pur- following information:
chase, sale, and redemption records of a. trade date
securities and open contractual commit- b. purchase or sale
ments performed or reviewed by persons c. contract description
who do not also have sole custody of d. quantity
securities or authorization to execute trades? e. price
*18. Are supporting documents, such as bro- f. reason for trade
ker’s confirmations and account state- g. reference to the position being matched
ments for recorded purchases and sales, (immediate or future case settlement)
checked or reviewed subsequently by per- h. signature of trader
sons who do not also have sole custody 28. Are the accounting records maintained and
of securities or authorization to execute controlled by persons who cannot initiate
trades? trades?
*19. Are purchase confirmations compared with 29. Are accounting procedures documented in
delivered securities or safekeeping receipts a procedures manual?
to determine if the securities delivered are 30. Are all incoming trade confirmations—
the securities purchased? a. received by someone independent of
the trading and recordkeeping functions
and
DERIVATIVE-CONTRACTS b. verified to the trade tickets by this
CONTROLS independent party?
31. Does the bank maintain general-ledger
20. Do end-user policies— control accounts disclosing, at a
a. outline specific strategies and minimum—
b. relate permissible strategies to other a. futures or forward contracts memo-
banking activities? randa accounts,
21. Are the formalized procedures used by the b. deferred gains or losses, and
trader— c. margin deposits?
a. documented in a manual and 32. Are futures and forward contracts
b. approved by the board or an appropriate activities—
board committee? a. supported by detailed subsidiary records
22. Are the bank’s futures commission mer- and
chants and forward brokers— b. agreed daily to general-ledger controls
a. notified in writing to trade with only by someone who is not authorized to
those persons authorized as traders and prepare general-ledger entries?
April 2002 Trading and Capital-Markets Activities Manual
Page 2
Investment Securities and End-User Activities: Internal Control Questionnaire 3000.4
33. Do periodic statements received from OTHER
futures commission merchants reflect—
a. trading activity for the period, 40. Does the board of directors receive regular
b. open positions at the end of the period, reports on domestic and international divi-
c. the market value of open positions, sion investment securities, and do reports
d. unrealized gains and losses, and include—
e. cash balances in accounts? a. valuations,
34. Are all of these periodic statements— b. maturity distributions,
a. received by someone independent of
c. the average yield, and
both the trading and recordkeeping func-
tions and d. reasons for holding and benefits received
b. reconciled to all of the bank’s account- (international division and overseas
ing records? holdings only)?
35. Are the market prices reflected on the 41. Are purchases, exchanges, and sales of
statements— securities and open contractual commit-
a. verified with listed prices from a pub- ments ratified by action of the board of
lished source and directors or its investment committee and
b. used to recompute gains and losses? thereby made a matter of record in the
36. Are daily reports of unusual increases in minutes?
trading activity reviewed by senior man-
agement?
37. Are weekly reports prepared for an appro-
priate board committee and do reports CONCLUSION
reflect—
a. all trading activity for the week, 42. Is the foregoing information an adequate
b. open positions at the end of the week, basis for evaluating internal control? Are
c. the market value of open positions, there significant deficiencies in areas not
d. unrealized gains and losses, covered in this questionnaire that impair
e. total trading limits outstanding for the any controls? Explain any deficiencies
bank, and briefly and indicate any additional exami-
f. total trading limits for each authorized nation procedures deemed necessary.
trader? 43. Based on a composite evaluation, as evi-
38. Is the futures and forward contracts port- denced by answers to the foregoing ques-
folio revalued monthly to market value or tions, is internal control adequate or
the lower of cost or market? inadequate?
39. Are revaluation prices provided by per-
sons or sources who are totally indepen-
dent of the trading function?
Trading and Capital-Markets Activities Manual April 2002
Page 3
Interest-Rate Risk Management
Section 3010.1
Interest-rate risk (IRR) is the exposure of an SOURCES OF IRR
institution’s financial condition to adverse move-
ments in interest rates. Accepting this risk is a As financial intermediaries, banks encounter
normal part of banking and can be an important IRR in several ways. The primary and most
source of profitability and shareholder value. discussed source of IRR is differences in the
However, excessive levels of IRR can pose a timing of the repricing of bank assets, liabilities,
significant threat to an institution’s earnings and and off-balance-sheet (OBS) instruments.
capital base. Accordingly, effective risk manage- Repricing mismatches are fundamental to the
ment that maintains IRR at prudent levels is business of banking and generally occur from
essential to the safety and soundness of banking either borrowing short-term to fund longer-term
institutions. assets or borrowing long-term to fund shorter-
Evaluating an institution’s exposure to changes term assets. Such mismatches can expose an
in interest rates is an important element of any institution to adverse changes in both the overall
full-scope examination and, for some institu- level of interest rates (parallel shifts in the yield
tions, may be the sole topic for specialized or curve) and the relative level of rates across the
targeted examinations. Such an evaluation yield curve (nonparallel shifts in the yield curve).
includes assessing both the adequacy of the Another important source of IRR, commonly
management process used to control IRR and referred to as basis risk, occurs when the adjust-
the quantitative level of exposure. When assess- ment of the rates earned and paid on different
ing the IRR management process, examiners instruments is imperfectly correlated with other-
should ensure that appropriate policies, proce- wise similar repricing characteristics (for exam-
dures, management information systems, and ple, a three-month Treasury bill versus a three-
internal controls are in place to maintain IRR at month LIBOR). When interest rates change,
prudent levels with consistency and continuity. these differences can change the cash flows and
Evaluating the quantitative level of IRR expo- earnings spread between assets, liabilities, and
sure requires examiners to assess the existing OBS instruments of similar maturities or repric-
and potential future effects of changes in interest ing frequencies.
rates on an institution’s financial condition, An additional and increasingly important
including its capital adequacy, earnings, liquid- source of IRR is the options in many bank asset,
ity, and, where appropriate, asset quality. To liability, and OBS portfolios. An option pro-
ensure that these assessments are both effective vides the holder with the right, but not the
and efficient, examiner resources must be appro- obligation, to buy, sell, or in some manner alter
priately targeted at those elements of IRR that the cash flow of an instrument or financial
pose the greatest threat to the financial condition contract. Options may be distinct instruments,
of an institution. This targeting requires an such as exchange-traded and over-the-counter
examination process built on a well-focused contracts, or they may be embedded within the
assessment of IRR exposure before the on-site contractual terms of other instruments. Examples
engagement, a clearly defined examination of instruments with embedded options include
scope, and a comprehensive program for follow- bonds and notes with call or put provisions
ing up on examination findings and ongoing (such as callable U.S. agency notes), loans that
monitoring.
Both the adequacy of an institution’s IRR and guidance provided in SR-96-13, ‘‘Interagency Guidance
management process and the quantitative level on Sound Practices for Managing Interest Rate Risk.’’ It also
of its IRR exposure should be assessed. Key incorporates, where appropriate, fundamental risk-management
elements of the examination process used to principles and supervisory policies and approaches identified
in SR-93-69, ‘‘Examining Risk Management and Internal
assess IRR include the role and importance of a Controls for Trading Activities of Banking Organizations’’;
preexamination risk assessment, proper scoping SR-95-17, ‘‘Evaluating the Risk Management of Securities
of the examination, and the testing and verifica- and Derivative Contracts Used in Nontrading Activities’’;
tion of both the management process and inter- SR-95-22, ‘‘Enhanced Framework for Supervising the U.S.
Operations of Foreign Banking Organizations’’; SR-95-51,
nal measures of the level of IRR exposure.1 ‘‘Rating the Adequacy of Risk Management Processes and
Internal Controls at State Member Banks and Bank Holding
Companies’’; and SR-96-14, ‘‘Risk-Focused Safety and Sound-
1. This section incorporates and builds on the principles ness Examinations and Inspections.’’
Trading and Capital-Markets Activities Manual February 1998
Page 1
3010.1 Interest-Rate Risk Management
give borrowers the right to prepay balances to reflect market rates. By extension, an institu-
without penalty (such as residential mortgage tion’s economic value of equity (EVE) can be
loans), and various types of nonmaturity deposit viewed as the present value of the expected cash
instruments that give depositors the right to flows on assets minus the present value of the
withdraw funds at any time without penalty expected cash flows on liabilities plus the net
(such as core deposits). If not adequately man- present value of the expected cash flows on OBS
aged, the asymmetrical payoff characteristics of instruments. Economic values, which may differ
options can pose significant risk to the banking from reported book values due to GAAP
institutions that sell them. Generally, the options, accounting conventions, can provide a number
both explicit and embedded, held by bank cus- of useful insights into the current and potential
tomers are exercised to the advantage of the future financial condition of an institution. Eco-
holder, not the bank. Moreover, an increasing nomic values reflect one view of the ongoing
array of options can involve highly complex worth of the institution and can often provide a
contract terms that may substantially magnify basis for assessing past management decisions
the effect of changing reference values on the in light of current circumstances. Moreover,
value of the option and, thus, magnify the economic values can offer comprehensive insights
asymmetry of option payoffs. into the potential future direction of earnings
performance since changes in the economic
value of an institution’s equity reflect changes in
the present value of the bank’s future earnings
EFFECTS OF IRR arising from its current holdings.
Generally, commercial banking institutions
Repricing mismatches, basis risk, options, and have adequately managed their IRR exposures,
other aspects of a bank’s holdings and activities and few banks have failed solely as a result of
can expose an institution’s earnings and value to adverse interest-rate movements. Nevertheless,
adverse changes in market interest rates. The changes in interest rates can have negative
effect of interest rates on accrual or reported effects on bank profitability and must be care-
earnings is the most common focal point. In fully managed, especially given the rapid pace
assessing the effects of changing rates on earn- of financial innovation and the heightened level
ings, most banks focus primarily on their net of competition among all types of financial
interest income—the difference between total institutions.
interest income and total interest expense. How-
ever, as banks have expanded into new activities
to generate new types of fee-based and other
noninterest income, a focus on overall net income
SOUND IRR MANAGEMENT
is becoming more appropriate. The noninterest PRACTICES
income arising from many activities, such as
As is the case in managing other types of risk,
loan servicing and various asset-securitization
sound IRR management involves effective board
programs, can be highly sensitive to changes in
and senior management oversight and a compre-
market interest rates. As noninterest income
hensive risk-management process that includes
becomes an increasingly important source of
the following elements:
bank earnings, both bank management and
supervisors need to take a broader view of the • effective policies and procedures designed to
potential effects of changes in market interest control the nature and amount of IRR, includ-
rates on bank earnings. ing clearly defined IRR limits and lines of
Market interest rates also affect the value of a responsibility and authority
bank’s assets, liabilities, and OBS instruments • appropriate risk-measurement, monitoring, and
and, thus, directly affect the value of an institu- reporting systems
tion’s equity capital. The effect of rates on the • systematic internal controls that include the
economic value of an institution’s holdings and internal or external review and audit of key
equity capital is a particularly important consid- elements of the risk-management process
eration for shareholders, management, and
supervisors alike. The economic value of an The formality and sophistication used in man-
instrument is an assessment of the present value aging IRR depends on the size and sophistica-
of its expected net future cash flows, discounted tion of the institution, the nature and complexity
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Interest-Rate Risk Management 3010.1
of its holdings and activities, and the overall Board of Directors
level of its IRR. Adequate IRR management
practices can vary considerably. For example, a Ultimately, the board of directors is responsible
small institution with noncomplex activities and for the level of IRR taken by an institution. The
holdings, a relatively short-term balance-sheet board should approve business strategies and
structure presenting a low IRR profile, and significant policies that govern or influence the
senior managers and directors who are actively institution’s interest-rate risk. It should articu-
involved in the details of day-to-day operations late overall IRR objectives and provide clear
may be able to rely on relatively simple and guidance on the level of acceptable IRR. The
informal IRR management systems. board should also approve policies and proce-
More complex institutions and those with dures that identify lines of authority and respon-
higher interest-rate-risk exposures or holdings sibility for managing IRR exposures.
of complex instruments may require more elabo- Directors should understand the nature of the
rate and formal IRR management systems to risks to their institution and ensure that manage-
address their broader and typically more com- ment is identifying, measuring, monitoring, and
plex range of financial activities, as well as controlling them. Accordingly, the board should
provide senior managers and directors with the monitor the performance and IRR profile of the
information they need to monitor and direct institution. Information that is timely and suffi-
day-to-day activities. More complex processes ciently detailed should be provided to directors
for interest-rate-risk management may require to help them understand and assess the IRR
more formal internal controls, such as internal facing the institution’s key portfolios and the
and external audits, to ensure the integrity of the institution as a whole. The frequency of these
information senior officials use to oversee com- reviews depends on the sophistication of the
pliance with policies and limits. institution, the complexity of its holdings, and
Individuals involved in the risk-management the materiality of changes in its holdings between
process should be sufficiently independent of reviews. Institutions holding significant posi-
business lines to ensure adequate separation of tions in complex instruments or with significant
duties and avoid potential conflicts of interest. changes in their composition of holdings would
The degree of autonomy these individuals have be expected to have more frequent reviews. In
may be a function of the size and complexity of addition, the board should periodically review
the institution. In smaller and less complex significant IRR management policies and proce-
institutions with limited resources, it may not be dures, as well as overall business strategies that
possible to completely remove individuals with affect the institution’s IRR exposure.
business-line responsibilities from the risk- The board of directors should encourage dis-
management process. In these cases, the focus cussions between its members and senior man-
should be on ensuring that risk-management agement, as well as between senior management
functions are conducted effectively and objec- and others in the institution, regarding the insti-
tively. Larger, more complex institutions may tution’s IRR exposures and management pro-
have separate and independent risk-management cess. Board members need not have detailed
units. technical knowledge of complex financial instru-
ments, legal issues, or sophisticated risk-
management techniques. However, they are
responsible for ensuring that the institution has
Board and Senior Management personnel available who have the necessary
Oversight technical skills and that senior management
fully understands and is sufficiently controlling
Effective oversight by a bank’s board of direc- the risks incurred by the institution.
tors and senior management is critical to a sound A bank’s board of directors may meet its
IRR management process. The board and senior responsibilities in a variety of ways. Some board
management should be aware of their responsi- members may be identified to become directly
bilities related to IRR management, understand involved in risk-management activities by par-
the nature and level of interest-rate risk taken by ticipating on board committees or gaining a
the bank, and ensure that the formality and sufficient understanding and awareness of the
sophistication of the risk-management process is institution’s risk profile through periodic brief-
appropriate for the overall level of risk. ings and management reports. Information pro-
Trading and Capital-Markets Activities Manual February 1998
Page 3
3010.1 Interest-Rate Risk Management
vided to board members should be presented in the nature and scope of the institution’s activi-
a format that members can readily understand ties. There should be enough knowledgeable
and that will assist them in making informed people on staff to allow some individuals to
policy decisions about acceptable levels of risk, back up key personnel, as necessary.
the nature of risks in current and proposed new
activities, and the adequacy of the institution’s
risk-management process. In short, regardless of Policies, Procedures, and Limits
the structure of the organization and the com-
position of its board of directors or delegated Institutions should have clear policies and pro-
board committees, board members must ensure cedures for limiting and controlling IRR. These
that the institution has the necessary technical policies and procedures should (1) delineate
skills and management expertise to conduct its lines of responsibility and accountability over
activities prudently and consistently within the IRR management decisions, (2) clearly define
policies and intent of the board. authorized instruments and permissible hedging
and position-taking strategies, (3) identify the
frequency and method for measuring and moni-
Senior Management toring IRR, and (4) specify quantitative limits
that define the acceptable level of risk for the
Senior management is responsible for ensuring institution. In addition, management should
that the institution has adequate policies and define the specific procedures and approvals
procedures for managing IRR on both a long- necessary for exceptions to policies, limits, and
range and day-to-day basis and that clear lines authorizations. All IRR policies should be
of authority and responsibility are maintained reviewed periodically and revised as needed.
for managing and controlling this risk. Manage-
ment should develop and implement policies
and procedures that translate the board’s goals, Clear Lines of Authority
objectives, and risk limits into operating stan-
dards that are well understood by bank person- Through formal written policies or clear operat-
nel and that are consistent with the board’s ing procedures, management should define the
intent. Management is also responsible for main- structure of managerial responsibilities and over-
taining (1) adequate systems and standards for sight, including lines of authority and responsi-
measuring risk, (2) standards for valuing posi- bility in the following areas:
tions and measuring performance, (3) a compre-
hensive IRR reporting and monitoring process, • developing and implementing strategies and
and (4) effective internal controls and review tactics used in managing IRR
processes. • establishing and maintaining an IRR measure-
IRR reports to senior management should ment and monitoring system
provide aggregate information as well as suffi- • identifying potential IRR and related issues
cient supporting detail so that management can arising from the potential use of new products
assess the sensitivity of the institution to changes • developing IRR management policies, proce-
in market conditions and other important risk dures, and limits, and authorizing exceptions
factors. Senior management should periodically to policies and limits
review the organization’s IRR management poli-
cies and procedures to ensure that they remain Individuals and committees responsible for mak-
appropriate and sound. Senior management ing decisions about interest-rate risk manage-
should also encourage and participate in discus- ment should be clearly identified. Many medium-
sions with members of the board and—when sized and large banks, and banks with
appropriate to the size and complexity of the concentrations in complex instruments, delegate
institution—with risk-management staff regard- responsibility for IRR management to a com-
ing risk-measurement, reporting, and manage- mittee of senior managers, sometimes called an
ment procedures. asset/liability committee (ALCO). In these
Management should ensure that analysis and institutions, policies should clearly identify the
risk-management activities related to IRR are members of an ALCO, the committee’s duties
conducted by competent staff whose technical and responsibilities, the extent of its decision-
knowledge and experience are consistent with making authority, and the form and frequency of
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Interest-Rate Risk Management 3010.1
its periodic reports to senior management and Limits
the board of directors. An ALCO should have
sufficiently broad participation across major The goal of IRR management is to maintain an
banking functions (for example, in the lending, institution’s interest-rate risk exposure within
investment, deposit, funding areas) to ensure self-imposed parameters over a range of pos-
that its decisions can be executed effectively sible changes in interest rates. A system of IRR
throughout the institution. In many large insti- limits and risk-taking guidelines provides the
tutions, the ALCO delegates day-to-day respon- means for achieving that goal. This system
sibilities for IRR management to an independent should set boundaries for the institution’s level
risk-management department or function. of IRR and, where appropriate, allocate these
Regardless of the level of organization and limits to individual portfolios or activities. Limit
formality used to manage IRR, individuals systems should also ensure that limit violations
involved in the risk-management process (includ- receive prompt management attention.
ing separate risk-management units, if present) Aggregate IRR limits should clearly articulate
should be sufficiently independent of the busi- the amount of IRR acceptable to the firm, be
ness lines to ensure adequate separation of approved by the board of directors, and be
duties and avoid potential conflicts of interest. reevaluated periodically. Limits should be
Also, personnel charged with measuring and appropriate to the size, complexity, and financial
monitoring IRR should have a well-founded condition of the organization. Depending on the
understanding of all aspects of the institution’s nature of an institution’s holdings and its gen-
IRR profile. Compensation policies for these eral sophistication, limits can also be identified
individuals should be adequate enough to attract for individual business units, portfolios, instru-
and retain personnel who are well qualified to ment types, or specific instruments. The level of
assess the risks of the institution’s activities. detail of risk limits should reflect the character-
istics of the institution’s holdings, including the
Authorized Activities various sources of IRR to which the institution
is exposed. Limits applied to portfolio catego-
Institutions should clearly identify the types ries and individual instruments should be con-
of financial instruments that are permissible sistent with and complementary to consolidated
for managing IRR, either specifically or by limits.
their characteristics. As appropriate to its size IRR limits should be consistent with the
and complexity, the institution should delineate institution’s overall approach to measuring and
procedures for acquiring specific instruments, managing IRR and address the potential impact
managing individual portfolios, and controlling of changes in market interest rates on both
the institution’s aggregate IRR exposure. Major reported earnings and the institution’s EVE.
hedging or risk-management initiatives should From an earnings perspective, institutions should
be approved by the board or its appropriate explore limits on net income as well as net
delegated committee before being implemented. interest income to fully assess the contribution
Before introducing new products, hedging, or of noninterest income to the IRR exposure of the
position-taking initiatives, management should institution. Limits addressing the effect of chang-
ensure that adequate operational procedures and ing interest rates on economic value may range
risk-control systems are in place. Proposals to from those focusing on the potential volatility of
undertake these new instruments or activities the value of the institution’s major holdings to a
should— comprehensive estimate of the exposure of the
institution’s EVE.
• describe the relevant product or activity An institution’s limits for addressing the effect
• identify the resources needed to establish of rates on its profitability and EVE should be
sound and effective IRR management of the appropriate for the size and complexity of its
product or activity underlying positions. Relatively simple limits
• analyze the risk of loss from the proposed that identify maximum maturity or repricing
activities in relation to the institution’s overall gaps, acceptable maturity profiles, or the extent
financial condition and capital levels of volatile holdings may be adequate for insti-
• outline the procedures to measure, monitor, tutions engaged in traditional banking activities—
and control the risks of the proposed product and those with few holdings of long-term instru-
or activity ments, options, instruments with embedded
Trading and Capital-Markets Activities Manual February 1998
Page 5
3010.1 Interest-Rate Risk Management
options, or other instruments whose value may institution’s business lines and its IRR
be substantially affected by changes in market characteristics.
rates. For more complex institutions, quantita-
tive limits on acceptable changes in estimated
earnings and EVE under specified scenarios IRR Measurement
may be more appropriate. Banks that have
significant intermediate- and long-term mis- Well-managed banks have IRR measurement
matches or complex option positions should, at systems that measure the effect of rate changes
a minimum, have economic value–oriented lim- on both earnings and economic value. The latter
its that quantify and constrain the potential is particularly important for institutions with
changes in economic value or bank capital that significant holdings of intermediate and long-
could arise from those positions. term instruments or instruments with embedded
Limits on the IRR exposure of earnings options because the market values of all these
should be broadly consistent with those used to instruments can be particularly sensitive to
control the exposure of a bank’s economic changes in market interest rates. Institutions
value. IRR limits on earnings variability prima- with significant noninterest income that is sen-
rily address the near-term recognition of the sitive to changes in interest rates should focus
effects of changing interest rates on the institu- special attention on net income as well as net
tion’s financial condition. IRR limits on eco- interest income. Since the value of instruments
nomic value reflect efforts to control the effect with intermediate and long maturities and
of changes in market rates on the present value embedded options is especially sensitive to
of the entire future earnings stream arising from interest-rate changes, banks with significant hold-
the institution’s current holdings. ings of these instruments should be able to
IRR limits and risk tolerances may be keyed assess the potential longer-term impact of
to specific scenarios of market-interest-rate changes in interest rates on the value of these
movements, such as an increase or decrease of positions—the overall potential performance of
a particular magnitude. The rate movements the bank.
used in developing these limits should represent IRR measurement systems should (1) assess
meaningful stress situations, taking into account all material IRR associated with an institution’s
historical rate volatility and the time required assets, liabilities, and OBS positions; (2) use
for management to address exposures. More- generally accepted financial concepts and risk-
over, stress scenarios should take account of measurement techniques; and (3) have well-
the range of the institution’s IRR characteristics, documented assumptions and parameters. Mate-
including mismatch, basis, and option risks. rial sources of IRR include the mismatch, basis,
Simple scenarios using parallel shifts in interest and option risk exposures of the institution. In
rates may be insufficient to identify these risks. many cases, the interest-rate characteristics of a
Large, complex institutions are increasingly bank’s largest holdings will dominate its aggre-
using advanced statistical techniques to measure gate risk profile. While all of a bank’s holdings
IRR across a probability distribution of potential should receive appropriate treatment, measure-
interest-rate movements and express limits in ment systems should rigorously evaluate the
terms of statistical confidence intervals. If major holdings and instruments whose values
properly used, these techniques can be particu- are especially sensitive to rate changes. Instru-
larly useful in measuring and managing options ments with significant embedded or explicit
positions. option characteristics should receive special
attention.
IRR measurement systems should use gener-
ally accepted financial measurement techniques
Risk-Measurement and and conventions to estimate the bank’s expo-
Risk-Monitoring Systems sure. Examiners should evaluate these systems
in the context of the level of sophistication and
An effective process of measuring, monitoring, complexity of the institution’s holdings and
and reporting exposures is essential for ade- activities. A number of accepted techniques are
quately managing IRR. The sophistication and available for measuring the IRR exposure of
complexity of this process should be appropriate both earnings and economic value. Their com-
to the size, complexity, nature, and mix of an plexity ranges from simple calculations and
February 1998 Trading and Capital-Markets Activities Manual
Page 6
Interest-Rate Risk Management 3010.1
static simulations using current holdings to Further refinements to simple risk-weighting
highly sophisticated dynamic modeling tech- techniques incorporate the risk of options, the
niques that reflect potential future business and potential for basis risk, and nonparallel shifts
business decisions. Basic IRR measurement tech- in the yield curve by using customized risk
niques begin with a maturity/repricing schedule, weights applied to the specific instruments or
which distributes assets, liabilities, and OBS instrument types arrayed in the maturity/repricing
holdings into time bands according to their final schedule.
maturity (if fixed-rate) or time remaining to their Larger institutions and those with complex
next repricing (if floating). The choice of time risk profiles that entail meaningful basis or
bands may vary from bank to bank. When assets option risks may find it difficult to monitor IRR
and liabilities do not have contractual repricing adequately using simple maturity/repricing analy-
intervals or maturities, they are assigned to ses. Generally, they will need to employ more
repricing time bands according to the judgment sophisticated simulation techniques. For assess-
and analysis of the institution’s IRR manage- ing the exposure of earnings, simulations that
ment staff (or those individuals responsible for estimate cash flows and resulting earnings
controlling IRR). streams over a specific period are conducted
Simple maturity/repricing schedules can be based on existing holdings and assumed interest-
used to generate rough indicators of the IRR rate scenarios. When these cash flows are simu-
sensitivity of both earnings and economic values lated over the entire expected lives of the
to changing interest rates. To evaluate earnings institution’s holdings and discounted back to
exposures, liabilities arrayed in each time band their present values, an estimate of the change in
can be subtracted from the assets arrayed in the EVE can be calculated.
same time band to yield a dollar amount of Static cash-flow simulations of current hold-
maturity/repricing mismatch or gap in each time ings can be made more dynamic by incorporat-
band. The sign and magnitude of the gaps in ing more detailed assumptions about the future
various time bands can be used to assess poten- course of interest rates and the expected changes
tial earnings volatility arising from changes in in a bank’s business activity over a specified
market interest rates. time horizon. Combining assumptions on future
A maturity/repricing schedule can also be activities and reinvestment strategies with infor-
used to evaluate the effects of changing rates mation about current holdings, these simulations
on an institution’s economic value. At the most can project expected cash flows and estimate
basic level, mismatches or gaps in long-dated dynamic earnings and EVE outcomes. These
time bands can provide insights into the poten- more sophisticated techniques, such as option-
tial vulnerability of the economic value of rela- adjusted pricing analysis and Monte Carlo simu-
tively noncomplex institutions. Long-term gap lation, allow for dynamic interaction of payment
calculations along with simple maturity distri- streams and interest rates to better capture the
butions of holdings may be sufficient for rela- effect of embedded or explicit options.
tively noncomplex institutions. On a slightly The IRR measurement techniques and asso-
more advanced yet still simplistic level, esti- ciated models should be sufficiently robust to
mates of the change in an institution’s economic adequately measure the risk profile of the insti-
value can be calculated by applying economic- tution’s holdings. Depending on the size and
value sensitivity weights to the asset and liabil- sophistication of the institution and its activities,
ity positions slotted in the time bands of a as well as the nature of its holdings, the IRR
maturity/repricing schedule. The weights can measurement system should be able to adequately
be constructed to represent estimates of the reflect (1) uncertain principal amortization and
change in value of the instruments maturing or prepayments; (2) caps and floors on loans and
repricing in that time band given a specified securities, where material; (3) the characteristics
interest-rate scenario. When these weights are of both basic and complex OBS instruments
applied to the institution’s assets, liabilities, and held by the institution; and (4) changing spread
OBS positions and subsequently netted, the relationships necessary to capture basis risk.
result can provide a rough approximation of the Moreover, IRR models should provide clear
change in the institution’s EVE under the reports that identify major assumptions and
assumed scenario. These measurement tech- allow management to evaluate the reasonable-
niques can prove especially useful for institu- ness of and internal consistency among key
tions with small holdings of complex instruments. assumptions.
Trading and Capital-Markets Activities Manual February 1998
Page 7
3010.1 Interest-Rate Risk Management
Data Integrity and Assumptions accounts. Nonmaturity deposits represent a large
portion of the industry’s funding base, and a
The usefulness of IRR measures depends on the variety of techniques are used to analyze their
integrity of the data on current holdings, validity IRR characteristics. The use of these techniques
of the underlying assumptions, and IRR sce- should be appropriate to the size, sophistication,
narios used to model IRR exposures. Tech- and complexity of the institution.
niques involving sophisticated simulations should In general, treatment of nonmaturity deposits
be used carefully so that they do not become should consider the historical behavior of the
‘‘black boxes,’’ producing numbers that appear institution’s deposits; general conditions in the
to be precise, but that may be less accurate when institution’s markets, including the degree of
their specific assumptions and parameters are competition it faces; and anticipated pricing
revealed. behavior under the scenario investigated.
The integrity of data on current positions is an Assumptions should be supported to the fullest
important component of the risk-measurement extent practicable. Treatment of nonmaturity
process. Institutions should ensure that current deposits within the measurement system may, of
positions are delineated at an appropriate level course, change from time to time based on
of aggregation (for example, by instrument type, market and economic conditions. Such changes
coupon rate, or repricing characteristic) to ensure should be well founded and documented. Treat-
that risk measures capture all meaningful types ments used to construct earnings-simulation
and sources of IRR, including those arising from assessments should be conceptually and empiri-
explicit or embedded options. Management cally consistent with those used to develop EVE
should also ensure that all material positions are assessments of IRR.
represented in IRR measures, that the data used
are accurate and meaningful, and that the data
adequately reflect all relevant repricing and IRR Scenarios
maturity characteristics. When applicable, data
should include information on the contractual IRR exposure estimates, whether linked to earn-
coupon rates and cash flows of associated in- ings or economic value, use some form of
struments and contracts. Manual adjustments to forecasts or scenarios of possible changes in
underlying data should be well documented. market interest rates. Bank management should
Senior management and risk managers should ensure that IRR is measured over a probable
recognize the key assumptions used in IRR range of potential interest-rate changes, includ-
measurement, as well as reevaluate and approve ing meaningful stress situations. The scenarios
them periodically. Assumptions should also be used should be large enough to expose all of the
documented clearly and, ideally, the effect of meaningful sources of IRR associated with an
alternative assumptions should be presented so institution’s holdings. In developing appropriate
that their significance can be fully understood. scenarios, bank management should consider
Assumptions used in assessing the interest-rate the current level and term structure of rates and
sensitivity of complex instruments, such as those possible changes to that environment, given
with embedded options, and instruments with the historical and expected future volatility of
uncertain maturities, such as core deposits, market rates. At a minimum, scenarios should
should be subject to rigorous documentation and include an instantaneous plus or minus 200-
review, as appropriate to the size and sophisti- basis-point parallel shift in market rates. Insti-
cation of the institution. Assumptions about tutions should also consider using multiple sce-
customer behavior and new business should take narios, including the potential effects of changes
proper account of historical patterns and be in the relationships among interest rates (option
consistent with the interest-rate scenarios used. risk and basis risk) as well as changes in the
general level of interest rates and changes in the
shape of the yield curve.
Nonmaturity Deposits The risk-measurement system should support
a meaningful evaluation of the effect of stressful
An institution’s IRR measurement system should market conditions on the institution. Stress test-
consider the sensitivity of nonmaturity deposits, ing should be designed to provide information
including demand deposits, NOW accounts, sav- on the kinds of conditions under which the
ings deposits, and money market deposit institution’s strategies or positions would be
February 1998 Trading and Capital-Markets Activities Manual
Page 8
Interest-Rate Risk Management 3010.1
most vulnerable; thus, testing may be tailored to that have been taken or are being actively
the risk characteristics of the institution. Pos- considered;
sible stress scenarios include abrupt changes in • understand the implications of various stress
the term structure of interest rates, relationships scenarios, including those involving break-
among key market rates (basis risk), liquidity of downs of key assumptions and parameters;
key financial markets, or volatility of market • review IRR policies, procedures, and the
rates. In addition, stress scenarios should include adequacy of the IRR measurement systems;
the conditions under which key business assump- and
tions and parameters break down. The stress • determine whether the bank holds sufficient
testing of assumptions used for illiquid instru- capital for the level of risk being taken.
ments and instruments with uncertain contrac-
tual maturities, such as core deposits, is particu-
larly critical to achieving an understanding of
the institution’s risk profile. Therefore, stress Comprehensive Internal Controls
scenarios may not only include extremes of
observed market conditions but also plausible An institution’s IRR management process
worst-case scenarios. Management and the board should be an extension of its overall structure of
of directors should periodically review the results internal controls. Banks should have adequate
of stress tests and the appropriateness of key internal controls to ensure the integrity of their
underlying assumptions. Stress testing should be interest-rate risk management process. Internal
supported by appropriate contingency plans. controls consist of procedures, approval pro-
cesses, reconciliations, reviews, and other
mechanisms designed to provide a reasonable
IRR Monitoring and Reporting assurance that the institution’s objectives for
interest-rate risk management are achieved.
An accurate, informative, and timely manage- Appropriate internal controls should address all
ment information system is essential for manag- of the various elements of the risk-management
ing IRR exposure, both to inform management process, including adherence to polices and
and support compliance with board policy. The procedures, and the adequacy of risk identifica-
reporting of risk measures should be regular and tion, risk measurement, and risk reporting.
clearly compare current exposures with policy An important element of a bank’s internal
limits. In addition, past forecasts or risk esti- controls for interest-rate risk is management’s
mates should be compared with actual results as comprehensive evaluation and review. Manage-
one tool to identify any potential shortcomings ment should ensure that the various components
in modeling techniques. of the bank’s interest-rate risk management
A bank’s senior management and its board or process are regularly reviewed and evaluated by
a board committee should receive reports on the individuals who are independent of the function
bank’s IRR profile at least quarterly. More they are assigned to review. Although proce-
frequent reporting may be appropriate depend- dures for establishing limits and for operating
ing on the bank’s level of risk and its potential within them may vary among banks, periodic
for significant change. While the types of reports reviews should be conducted to determine
prepared for the board and various levels of whether the organization complies with its
management will vary based on the institution’s interest-rate risk policies and procedures. Posi-
IRR profile, reports should, at a minimum, allow tions that exceed established limits should
senior management and the board or committee receive the prompt attention of appropriate
to— management and should be resolved according
to approved policies. Periodic reviews of the
• evaluate the level of and trends in the bank’s interest-rate risk management process should
aggregate IRR exposure; also address any significant changes in the types
• demonstrate and verify compliance with all or characteristics of instruments acquired, lim-
policies and limits; its, and internal controls since the last review.
• evaluate the sensitivity and reasonableness of Reviews of the interest-rate risk measurement
key assumptions; system should include assessments of the
• assess the results and future implications of assumptions, parameters, and methodologies
major hedging or position-taking initiatives used. These reviews should seek to understand,
Trading and Capital-Markets Activities Manual February 1998
Page 9
3010.1 Interest-Rate Risk Management
test, and document the current measurement The results of reviews, along with any recom-
process, evaluate the system’s accuracy, and mendations for improvement, should be reported
recommend solutions to any identified weak- to the board and acted upon in a timely manner.
nesses. The results of this review, along with Institutions with complex risk exposures are
any recommendations for improvement, should encouraged to have their measurement systems
be reported to the board, which should take reviewed by external auditors or other knowl-
appropriate, timely action. Since measurement edgeable outside parties to ensure the adequacy
systems may incorporate one or more subsidiary and integrity of the systems. Since measurement
systems or processes, banks should ensure that systems may incorporate one or more subsidiary
multiple component systems are well integrated systems or processes, institutions should ensure
and consistent with each other. that multiple component systems are well inte-
Banks, particularly those with complex risk grated and consistent.
exposures, are encouraged to have their mea- The frequency and extent to which an insti-
surement systems reviewed by an independent tution should reevaluate its risk-measurement
party, whether an internal or external auditor or methodologies and models depends, in part, on
both. Reports written by external auditors or the specific IRR exposures created by their
other outside parties should be available to holdings and activities, the pace and nature of
relevant supervisory authorities. Any indepen- changes in market interest rates, and the extent
dent reviewer should be sure that the bank’s to which there are new developments in mea-
risk-measurement system is sufficient to capture suring and managing IRR. At a minimum,
all material elements of interest-rate risk. A institutions should review their underlying IRR
reviewer should consider the following factors measurement methodologies and IRR manage-
when making the risk assessment: ment process annually, and more frequently as
market conditions dictate. In many cases, inter-
• the quantity of interest-rate risk nal evaluations may be supplemented by reviews
— the volume and price sensitivity of various of external auditors or other qualified outside
products parties, such as consultants with expertise in
— the vulnerability of earnings and capital IRR management.
under differing rate changes, including yield
curve twists
— the exposure of earnings and economic
value to various other forms of interest- RATING THE ADEQUACY OF IRR
rate risk, including basis and optionality MANAGEMENT
risk
• the quality of interest-rate risk management Examiners should incorporate their assessment
— whether the bank’s internal measurement of the adequacy of IRR management into their
system is appropriate to the nature, scope, overall rating of risk management, which is
and complexities of the bank and its subsequently factored into the management com-
activities ponent of an institution’s CAMELS rating. Rat-
— whether the bank has an independent risk- ings of IRR management can follow the general
control unit responsible for the design of framework used to rate overall risk management:
the risk-management system
— whether the board of directors and senior • A rating of 1 or strong would indicate that
management are actively involved in the management effectively identifies and con-
risk-control process trols the IRR posed by the institution’s activi-
— whether internal policies, controls, and ties, including risks from new products.
procedures concerning interest-rate risk • A rating of 2 or satisfactory would indicate
are well documented and complied with that the institution’s management of IRR is
— whether the assumptions of the risk- largely effective, but lacking in some modest
management system are well documented, degree. It reflects a responsiveness and ability
data are accurately processed, and data to cope successfully with existing and fore-
aggregation is proper and reliable seeable exposures that may arise in carrying
— whether the organization has adequate staff- out the institution’s business plan. While the
ing to conduct a sound risk-management institution may have some minor risk-
process management weaknesses, these problems have
February 1998 Trading and Capital-Markets Activities Manual
Page 10
Interest-Rate Risk Management 3010.1
been recognized and are being addressed. changes in interest rates might affect their per-
Generally, risks are being controlled in a formance. The rigor of the quantitative IRR
manner that does not require additional or evaluation process should reflect the size,
more than normal supervisory attention. sophistication, and nature of the institution’s
• A rating of 3 or fair signifies IRR management holdings.
practices that are lacking in some important
ways and, therefore, are a cause for more than
normal supervisory attention. One or more of
the four elements of sound IRR management Assessment of the Composition of
are considered fair and have precluded the Holdings
institution from fully addressing a significant
risk to its operations. Certain risk-management An overall evaluation of an institution’s hold-
practices need improvement to ensure that ings and its business mix is an important first
management and the board are able to iden- step to determine its quantitative level of IRR
tify, monitor, and control adequately all sig- exposure. The evaluation should focus on iden-
nificant risks to the institution. tifying (1) major on- and off-balance-sheet posi-
• A rating of 4 or marginal represents marginal tions, (2) concentrations in interest-sensitive
IRR management practices that generally fail instruments, (3) the existence of highly volatile
to identify, monitor, and control significant instruments, and (4) significant sources of non-
risk exposures in many material respects. interest income that may be sensitive to changes
Generally, such a situation reflects a lack of in interest rates. Identifying major holdings of
adequate guidance and supervision by man- particular types or classes of assets, liabilities, or
agement and the board. One or more of the off-balance-sheet instruments is particularly per-
four elements of sound risk management are tinent since the interest-rate-sensitivity charac-
considered marginal and require immediate teristics of an institution’s largest positions or
and concerted corrective action by the board activities will tend to dominate its IRR profile.
and management. The composition of assets should be assessed to
• A rating of 5 or unsatisfactory indicates a determine the types of instruments held and the
critical absence of effective risk-management relative proportion of holdings they represent,
practices to identify, monitor, or control sig- both with respect to total assets and within
nificant risk exposures. One or more of the appropriate instrument portfolios. Examiners
four elements of sound risk management is should note any specialization or concentration
considered wholly deficient, and management in particular types of investment securities or
and the board have not demonstrated the lending activities and identify the interest-rate
capability to address deficiencies. Deficien- characteristics of the instruments or activities.
cies in the institution’s risk-management pro- The assessment should also incorporate an evalu-
cedures and internal controls require immedi- ation of funding strategies and the composition
ate and close supervisory attention. of deposits, including core deposits. Trends and
changes in the composition of assets, liabilities,
and off-balance-sheet holdings should be fully
QUANTITATIVE LEVEL OF IRR assessed—especially when the institution is
EXPOSURE experiencing significant growth.
Examiners should identify the interest sensi-
Evaluating the quantitative level of IRR involves tivity of an institution’s major holdings. For
assessing the effects of both past and potential many instruments, the stated final maturity,
future changes in interest rates on an institu- coupon interest payment, and repricing fre-
tion’s financial condition, including the effects quency are the primary determinants of interest-
on its earnings, capital adequacy, liquidity, rate sensitivity. In general, the shorter the repric-
and—in some cases—asset quality. This assess- ing frequency (or maturity for fixed-rate
ment involves a broad analysis of an institu- instruments), the greater the impact of a change
tion’s business mix, balance-sheet composition, in interest rates on the earnings of the asset,
OBS holdings, and holdings of interest rate– liability, or OBS instrument employed will be
sensitive instruments. Characteristics of the because the cash flows derived, either through
institution’s material holdings should also be repricing or reinvestment, will more quickly
investigated to determine (and quantify) how reflect market rates. From a value perspective,
Trading and Capital-Markets Activities Manual February 1998
Page 11
3010.1 Interest-Rate Risk Management
the longer the repricing frequency (or maturity increase IRR when asset structures are fixed-rate
for fixed-rate instruments), the more sensitive or long-term. Long-term liabilities used to
the value of the instrument will be to changes in finance shorter-term assets can also increase
market interest rates. Accordingly, basic maturity/ IRR. The role of nonmaturity or core deposits in
repricing distributions and gap schedules are an institution’s funding base is particularly per-
important first screens to identify the interest tinent to any assessment of IRR. Depending on
sensitivity of major holdings from both an their composition and the underlying client base,
earnings and value standpoint. core deposits can provide significant opportuni-
Efforts should be made to identify instru- ties for institutions to administer and manage the
ments whose value is highly sensitive to rate interest rates paid on this funding source. Thus,
changes. Even if these instruments may not high levels of stable core deposit funding may
make up a major portion of an institution’s provide an institution with significant control
holdings, their rate sensitivity may be large over its IRR profile. Examiners should assess
enough to materially affect the institution’s the characteristics of an institution’s nonmatu-
aggregate exposure. Highly interest rate– rity deposit base, including the types of accounts
sensitive instruments generally have fixed-rate offered, the underlying customer base, and
coupons with long maturities, significant embed- important trends that may influence the rate
ded options, or some elements of both. Identi- sensitivity of this funding source.
fying explicit options and instruments with In general, examiners should evaluate trends
embedded options is particularly important; these and attempt to identify any structural changes in
holdings may exhibit significantly volatile price the interest-rate risk profile of an institution’s
and earnings behavior (because of their asym- holdings, such as shifts of asset holdings into
metrical cash flows) when interest rates change. longer-term instruments or instruments that may
The interest-rate sensitivity of exchange-traded have embedded options, changes in funding
options is usually easy to identify because strategies and core deposit balances, and the use
exchange contracts are standardized. On the of off-balance-sheet instruments. Significant
other hand, the interest-rate sensitivity of over- changes in the composition of an institution’s
the-counter derivative instruments and the option holdings may reduce the usefulness of its his-
provisions embedded in other financial instru- torical performance as an indicator of future
ments, such as the right to prepay a loan without performance.
penalty, may be less readily identifiable. Instru- Examiners should also identify and assess
ments tied to residential mortgages, such as material sources of interest-sensitive fee income.
mortgage pass-through securities, collateralized Loan-servicing income, especially when related
mortgage obligations (CMOs), real estate mort- to residential mortgages, can be an important
gage investment conduits (REMICs), and vari- and highly volatile element in an institution’s
ous mortgage-derivative products, generally earnings profile. Servicing income is linked
entail some form of embedded optionality. Cer- to the size of the servicing portfolio and, thus,
tain types of CMOs and REMICs constitute can be greatly affected by the prepayment rate
high-risk mortgage-derivative products and for mortgages in the servicing portfolio. Rev-
should be clearly identified. U.S. agency and enues arising from securitization of other types
municipal securities, as well as traditional forms of loans, including credit card receivables, can
of lending and borrowing arrangements, can also be very sensitive to changes in interest
often incorporate options into their structures. rates.
U.S. agency structured notes and municipal An analysis of both on- and off-balance-sheet
securities with long-dated call provisions are holdings should also consider potential basis
just two examples. Many commercial loans also risk, that is, whether instruments with adjustable-
use caps or floors. Over-the-counter OBS instru- rate characteristics that reprice in a similar time
ments, such as swaps, caps, floors, and collars, period will reprice differently than assumed.
can involve highly complex structures and, thus, Basis risk is a particular concern for offsetting
can be quite volatile in the face of changing positions that reprice in the same time period.
interest rates. Typical examples include assets that reprice
An evaluation of an institution’s funding with three-month Treasury bills paired against
sources relative to its assets profile is fundamen- liabilities repricing with three-month LIBOR or
tal to the IRR assessment. Reliance on volatile prime-based assets paired against other short-
or complex funding structures can significantly term funding sources. Analyzing the repricing
February 1998 Trading and Capital-Markets Activities Manual
Page 12
Interest-Rate Risk Management 3010.1
characteristics of major adjustable-rate positions performance during prior periods of volatile
should help to identify these situations. rates.
Important tools used to gauge the potential
volatility in future earnings include basic matu-
rity and repricing gap calculations and income
EXPOSURE OF EARNINGS TO IRR simulations. Short-term repricing gaps between
assets and liabilities in intervals of one year
When evaluating the potential effects of chang- or less can provide useful insights on the expo-
ing interest rates on an institution’s earnings, sure of earnings. These can be used to develop
examiners should assess the key determinants of rough approximations of the effect of changes in
the net interest margin, the effect that fluctua- market rates on an institution’s profitability.
tions in net interest margins can have on overall Examiners can develop rough gap estimates
net income, and the rate sensitivity of noninter- using available call report information, as well
est income and expense. Analyzing the histori- as the bank’s own internally generated gap or
cal behavior of the net interest margin, including other earnings exposure calculations if risk-
the yields on major assets, liabilities, and off- management and measurement systems are
balance-sheet positions that make up that mar- deemed adequate. When available, a bank’s own
gin, can provide useful insights into the relative earnings-simulation model provides a particu-
stability of an institution’s earnings. For exam- larly valuable source of information: a formal
ple, a review of the historical composition of estimate of future earnings (a baseline) and an
assets and the yields earned on those assets evaluation of how earnings would change under
clearly identifies an institution’s business mix different rate scenarios. Together with historical
and revenue-generating strategies, as well as earnings patterns, an institution’s estimate of the
potential vulnerabilities of these revenues to IRR sensitivity of its earnings derived from
changes in rates. Similarly, an assessment of the simulation models is an important indication of
rates paid on various types of deposits over time the exposure of its near-term earnings stability.
can help identify the institution’s funding strat- As detailed in the preceding subsection, sound
egies, how the institution competes for deposits, risk-management practices require IRR to be
and the potential vulnerability of its funding measured over a probable range of potential
base to rate changes. interest-rate changes. At a minimum, an instan-
Understanding the effect of potential fluctua- taneous shift in the yield curve of plus or minus
tions in net interest income on overall operating 200 basis points should be used to assess the
performance is also important. At some banks, potential impact of rate changes on an institu-
high overhead costs may require high net inter- tion’s earnings.
est margins to generate even moderate levels of Examiners should evaluate the exposure of
income. Accordingly, relatively high net interest earnings to changes in interest rates relative to
margins may not necessarily imply a higher the institution’s overall level of earnings and the
tolerance to changes in interest rates. Examiners potential length of time such exposure might
should fully consider the potential effects of persist. For example, simulation estimates of a
fluctuating net interest margins when they ana- small, temporary decline in earnings, while
lyze the exposure of net income to changes in likely an issue for shareholders and directors,
interest rates. may be less of a supervisory concern if the
Additionally, examiners should assess the institution has a sound earnings and capital base.
contribution of noninterest income to net income, On the other hand, exposures that could offset
including its interest-rate sensitivity and how it earnings for a significant period (as some thrifts
affects the IRR of the institution. Significant experienced during the 1980s) and even deplete
sources of rate-insensitive noninterest income capital would be a great concern to both man-
provide stability to net income and can mitigate agement and supervisors. Exposures measured
the effect of fluctuations in net interest margins. by gap or simulation analysis under the mini-
A historical review of changes in an institu- mum 200 basis point scenario that would result
tion’s earnings—both net income and net inter- in a significant decline in net interest margins or
est income—in relation to changes in market net income should prompt further investigation
rates is an important step in assessing the rate of the adequacy and stability of earnings and the
sensitivity of its earnings. When appropriate, adequacy of the institution’s risk-management
this review should assess the institution’s process. Specifically, in institutions exhibiting
Trading and Capital-Markets Activities Manual February 1998
Page 13
3010.1 Interest-Rate Risk Management
significant earnings exposures, examiners Banking organizations with (1) low propor-
should focus on the results of the institution’s tions of assets maturing or repricing beyond five
stress tests to determine the extent to which years, (2) relatively few assets with volatile
more significant and stressful rate moves might market values (such as high-risk CMOs and
magnify the erosion in earnings identified in structured notes or certain off-balance-sheet
the more modest rate scenario. In addition, derivatives), and (3) large and stable sources of
examiners should emphasize the need for man- nonmaturity deposits are unlikely to face signifi-
agement to understand the magnitude and nature cant economic-value exposure. Consequently,
of the institution’s IRR and the adequacy of its an evaluation of their economic-value exposure
limits. may be limited to reviewing available internal
While an erosion in net interest margins or reports showing the asset/liability composition
net income of more than 25 percent under a of the institution or the results of internal-gap,
200 basis point scenario should warrant consid- earnings-simulation, or economic-value simula-
erable examiner attention, examiners should tion models to confirm that conclusion.
take into account the absolute level of an insti- Institutions with (1) fairly significant holdings
tution’s earnings both before and after the esti- of assets with longer maturities or repricing
mated IRR shock. For example, a 33 percent frequencies, (2) concentrations in value-sensitive
decline in earnings for a bank with a strong on- and off-balance-sheet instruments, or (3) a
return on assets (ROA) of 1.50 percent would weak base of nonmaturity deposits warrant more
still leave the bank with an ROA of 1.00 percent. formal and quantitative evaluations of economic-
In contrast, the same percentage decline in value exposures. This includes reviewing the
earnings for a bank with a fair ROA of 0.75 results of the bank’s own internal reports for
percent results in a marginal ROA of 0.50 measuring changes in economic value, which
percent. should address the adequacy of the institution’s
Examiners should ensure that their evaluation risk-management process, reliability of risk-
of the IRR exposure of earnings is incorporated measurement assumptions, integrity of the data,
into the rating of earnings under the CAMELS and comprehensiveness of any modeling
rating system. Institutions receiving an earnings procedures.
rating of 1 or 2 would typically have minimal For institutions that appear to have a poten-
exposure to changing interest rates. However, tially significant level of IRR and that lack a
significant exposure of earnings to changes in reliable internal economic-value model, exam-
interest rates may, in itself, provide sufficient iners should consider alternative means for
basis for a lower rating. quantifying economic-value exposure, such as
internal-gap measures, off-site monitoring, or
surveillance screens that rely on call report data
to estimate economic-value exposure. For
Exposure of Capital and Economic example, the institution’s gap schedules might
Value be used to derive a duration gap by applying
duration-based risk weights to the bank’s aggre-
As set forth in the capital adequacy guidelines gate positions. When alternative means are used
for state member banks, the risk-based capital to estimate changes in economic value, the
ratio focuses principally on broad categories of relative crudeness of these techniques and lack
credit risk and does not incorporate other fac- of detailed data (such as the absence of coupon
tors, including overall interest-rate exposure and or off-balance-sheet data) should be taken into
management’s ability to monitor and control account—especially when drawing conclusions
financial and operating risks. Therefore, the about the institution’s exposure and capital
guidelines point out that in addition to evaluat- adequacy.
ing capital ratios, an overall assessment of An evaluation of an institution’s capital
capital adequacy must take account of ‘‘a bank’s adequacy should also consider the extent to
exposure to declines in the economic value of its which past interest-rate moves may have reduced
capital due to changes in interest rates. For this the economic value of capital through the accu-
reason, the final supervisory judgment on a mulation of net unrealized losses on financial
bank’s capital adequacy may differ significantly instruments. To the extent that past rate moves
from conclusions that might be drawn solely have reduced the economic or market value of a
from the level of its risk-based capital ratio.’’ bank’s claims more than they have reduced the
February 1998 Trading and Capital-Markets Activities Manual
Page 14
Interest-Rate Risk Management 3010.1
value of its obligations, the institution’s eco- surveillance screens that use call report data or
nomic value of capital is less than its stated book from the bank’s internal reports.
value. Examiners should also consider the potential
To evaluate the embedded net loss or gain effect of declines and fluctuations in earnings on
in an institution’s financial structure, fair value an institution’s capital adequacy. Using the
data on the securities portfolio can be used as results of internal model simulations or gap
the starting point; this information should be reports, examiners should determine whether
readily available from the call report or bank capital-impairing losses might result from
internal reports. Other major asset categories changes in market interest rates. In cases where
that might contain material embedded gains or potential rate changes are estimated to cause
losses include any assets maturing or repricing declines in margins that actually result in losses,
in more than five years, such as residential, examiners should assess the effect on capital
multifamily, or commercial mortgage loans. By over a two- or three-year earnings horizon.
comparing a portfolio’s weighted average cou- When capital adequacy is rated in the context
pon with current market yields, examiners may of IRR exposure, examiners should consider the
get an indication of the magnitude of any effect of changes in market interest rates on the
potential unrealized gains or losses. For compa- economic value of equity, level of embedded
nies with hedging strategies that use derivatives, losses in the bank’s financial structure, and
the current positive or negative market value of impact of potential rate changes on the institu-
these positions should be obtained, if available. tion’s earnings. The IRR of institutions that
For banks with material holdings of originated show material declines in earnings or economic
or purchased mortgage-servicing rights, capital- value of capital from a 200 basis point shift
ized amounts should be evaluated to ascertain should be evaluated fully, especially if that
that they are recorded at the lower of cost or fair decline would lower an institution’s pro forma
value and that management has appropriately prompt-corrective-action category. For example,
written down any values that are impaired pur- a well-capitalized institution with a 5.5 percent
suant to generally accepted accounting rules. leverage ratio and an estimated change in eco-
The presence of significant depreciation in nomic value arising from an appropriate stress
securities, loans, or other assets does not neces- scenario amounting to 2.0 percent of assets
sarily indicate significant embedded net losses; would have an adjusted leverage ratio of 3.5 per-
depreciation may be offset by a decline in the cent, causing a pro forma two-tier decline in its
market value of a bank’s liabilities. For exam- prompt-corrective-action category to the under-
ple, stable, low-cost nonmaturity deposits typi- capitalized category. After considering the level
cally become more profitable to banks as rates of embedded losses in the balance sheet, the
rise, and they can add significantly to the bank’s stability of the institution’s funding base, its
financial strength. Similarly, below-market-rate exposure to near-term losses, and the quality of
deposits, other borrowings, and subordinated its risk-management process, the examiner may
debt may also offset unrealized asset losses need to give the institution’s capital adequacy a
caused by past rate hikes. relatively low rating. In general, sufficiently
For banks with (1) substantial depreciation in adverse effects of market interest-rate shocks or
their securities portfolios, (2) low levels of weak management and control procedures can
nonmaturity deposits and retail time deposits, or provide a basis for lowering a bank’s rating of
(3) high levels of IRR exposure, unrealized capital adequacy. Moreover, even less severe
losses can have important implications for the exposures could contribute to a lower rating if
supervisory assessment of capital adequacy. If combined with exposures from asset concentra-
stressful conditions require the liquidation or tions, weak operating controls, or other areas of
restructuring of the securities portfolio, eco- concern.
nomic losses could be realized and, thereby,
reduce the institution’s regulatory capitalization.
Therefore, for higher-risk institutions, an evalu-
ation of capital adequacy should consider the EXAMINATION PROCESS FOR
potential after-tax effect of the liquidation of IRR
available-for-sale and held-to-maturity accounts.
Estimates of the effect of securities losses on the As the primary market risk most banks face,
regulatory capital ratio may be obtained from IRR should usually receive consideration in
Trading and Capital-Markets Activities Manual February 1998
Page 15
3010.1 Interest-Rate Risk Management
full-scope exams. It may also be the topic of • board of directors reports on IRR exposures
targeted examinations. To meet examination • audit reports (both internal and external)
objectives efficiently and effectively while • position reports, including those for invest-
remaining sensitive to potential burdens imposed ment securities and off-balance-sheet
on institutions, the examination of IRR should instruments
follow a structured, risk-focused approach. Key • other available internal reports on the bank’s
elements of a risk-focused approach to the risks, including those detailing key assumptions
examination process for IRR include (1) off-site • reports outlining the key characteristics of
monitoring and risk assessment of an institu- concentrations and any material holdings of
tion’s IRR profile and (2) appropriate planning interest-sensitive instruments
and scoping of the on-site examination to ensure • documentation for the inputs, assumptions,
that it is as efficient and productive as possible. and methodologies used in measuring risk
A fundamental tenet of this approach is that • Federal Reserve surveillance reports and
supervisory resources are targeted at functions, supervisory screens
activities, and holdings that pose the most risk to
the safety and soundness of an institution. The analysis for determining an institution’s
Accordingly, institutions with low levels of IRR quantitative IRR exposure can be assessed off-
would be expected to receive relatively less site as much as possible, including assessments
supervisory attention than those with more severe of the bank’s overall balance-sheet composition
IRR exposures. and holdings of interest-sensitive instruments.
Many banks have become especially skilled An assessment of the exposure of earnings can
in managing and limiting the exposure of their be accomplished using supervisory screens,
earnings to changes in interest rates. Accord- examiner-constructed measures, and internal
ingly, for most banks and especially for smaller bank measures obtained from management
institutions with less complex holdings, the IRR reports received before the on-site engagement.
element of the examination may be relatively Similar assessments can be made on the expo-
simple and straightforward. On the other hand, sure of capital or economic value.
some banks consider IRR an intended conse- An off-site review of the quality of the risk-
quence of their business strategies and choose to management process can significantly improve
take and manage that risk explicitly—often with the efficiency of the on-site engagement. The
complex financial instruments. These banks, key to assessing the quality of management is an
along with banks that have a wide array of organized discovery process aimed at determin-
activities or complex holdings, generally should ing whether appropriate policies, procedures,
receive greater supervisory attention. limits, reporting systems, and internal controls
are in place. This discovery process should, in
particular, ascertain whether all the elements of
Off-Site Risk Assessment a sound IRR management policy are applied
consistently to material concentrations of interest-
sensitive instruments. The results and reports of
Off-site monitoring and analysis involves devel-
prior examinations provide important informa-
oping a preliminary view or ‘‘risk assessment’’
tion about the adequacy of risk management.
before initiating an on-site examination. Both
the level of IRR exposure and quality of IRR
management should be assessed to the fullest
extent possible during the off-site phase of the Scope of On-Site Examination
examination process. The following information
can be helpful in this assessment: The off-site risk assessment is an informed
hypothesis of both the adequacy of IRR man-
• organizational charts and policies identifying agement and the magnitude of the institution’s
authorities and responsibilities for managing exposure. The scope of the on-site examination
IRR of IRR should be designed to confirm or reject
• IRR policies, procedures, and limits that hypothesis and should target specific areas
• asset/liability committee (ALCO) minutes and of interest or concern. In this way, on-site
reports (going back six to twelve months examination procedures are tailored to the
before the examination) activities and risk profile of the institution, using
February 1998 Trading and Capital-Markets Activities Manual
Page 16
Interest-Rate Risk Management 3010.1
flexible and targeted work-documentation pro- extensive work-documentation program. The
grams. Confirmation of hypotheses on the institution’s internal measures should be relied
adequacy of the IRR management process is on cautiously, if at all.
especially important. In general, if off-site analy- Regardless of the size or complexity of an
sis identifies IRR management as adequate, institution, care must be taken during the on-site
examiners can rely more heavily on the bank’s phase of the examination to ensure confirmation
internal IRR measures for assessing quantitative of the risk assessment and identification of
exposures. issues that may have escaped off-site analysis.
The examination scope for assessing IRR Accordingly, the examination scope should be
should be commensurate with the complexity of adjusted as on-site findings dictate.
the institution and consistent with the off-site
risk assessment. For example, only baseline
examination procedures would be used for
institutions whose off-site risk assessment indi- CAMELS Ratings
cates that they have adequate IRR management
processes and low levels of quantitative exposure. As with other areas of the examination, the
For those and other institutions identified as evaluation of IRR exposure should be incorpo-
potentially low risk, the scope of the on-site rated into an institution’s CAMELS rating. Find-
examination would consist of only those exami- ings on the adequacy of an institution’s IRR
nation procedures necessary to confirm the risk- management process should be reflected in the
assessment hypothesis. The adequacy of IRR examiner’s rating of risk management—a key
management could be confirmed through a basic component of an institution’s management rat-
review of the appropriateness of policies, inter- ing. Findings on the quantitative level of IRR
nal reports, and controls and the institution’s exposure should be incorporated into the earn-
adherence to them. The integrity and reliability ings and capital components of the CAMELS
of the information used to assess the quantitative ratings.
level of risk could be confirmed through limited An overall assessment of an institution’s IRR
sampling and testing. In general, if the risk exposure can be developed by combining assess-
assessment is confirmed by basic examination ments of the adequacy of IRR management
procedures, the examiner may conclude the IRR practices with the evaluation of the quantitative
examination process. IRR exposure of the institution’s earnings and
Institutions assessed to have high levels of capital base. The assessment of the adequacy of
IRR exposure and strong IRR management may IRR management should provide the primary
require more extensive examination scopes to basis for reaching an overall assessment since it
confirm the off-site risk assessment. These pro- is a leading indicator of potential IRR exposure.
cedures may entail more analysis of the institu- Accordingly, overall ratings for IRR sensitivity
tion’s IRR measurement system and the IRR should be no greater than the rating given to IRR
characteristics of major holdings. When high management. Unsafe exposures and manage-
quantitative levels of exposure are found, exam- ment weaknesses should be fully reflected in
iners should focus special attention on the these ratings. Unsafe exposures and unsound
sources of this risk and on significant concen- management practices that are not resolved
trations of interest-sensitive instruments. Insti- during the on-site examination should be
tutions assessed to have high exposure and weak addressed through subsequent follow-up actions
risk-management systems would require an by the examiner and other supervisory personnel.
Trading and Capital-Markets Activities Manual March 1999
Page 17
Interest-Rate Risk Management
Examination Objectives Section 3010.2
1. To evaluate the policies for interest-rate risk 4. To determine if internal management-
established by the board of directors and reporting systems provide the information
senior management, including the limits necessary for informed interest-rate manage-
established for the bank’s interest-rate risk ment decisions and to monitor the results of
profile. those decisions.
2. To determine if the bank’s interest-rate risk 5. To initiate corrective action when interest-
profile is within those limits. rate management policies, practices, and pro-
3. To evaluate the management of the bank’s cedures are deficient in controlling and moni-
interest-rate risk, including the adequacy of toring interest-rate risk.
the methods and assumptions used to mea-
sure interest-rate risk.
Trading and Capital-Markets Activities Manual February 1998
Page 1
Interest-Rate Risk Management
Examination Procedures Section 3010.3
These procedures represent a list of processes g. copies of reports from external auditors or
and activities that may be reviewed during a consultants who have reviewed the valid-
full-scope examination. The examiner-in-charge ity of various interest-rate risk, options-
will establish the general scope of examination pricing, and other models used by the
and work with the examination staff to tailor institution in managing market-rate risks,
specific areas for review as circumstances war- if available
rant. As part of this process, the examiner h. other management reports and first-day
reviewing a function or product will analyze and letter items
evaluate internal audit comments and previous
examination workpapers to assist in designing
the scope of examination. In addition, after a REVIEW POLICIES AND
general review of a particular area to be exam- PROCEDURES
ined, the examiner should use these procedures,
to the extent they are applicable, for further 1. Review the bank’s policies and procedures
guidance. Ultimately, it is the seasoned judg- (written or unwritten) for adequacy. (See
ment of the examiner and the examiner-in- item 1 of the internal control questionnaire.)
charge as to which procedures are warranted in
examining any particular activity.
ASSESS MANAGEMENT
PRACTICES
REVIEW PRIOR EXCEPTIONS
1. Determine if the function is managed on a
AND DETERMINE SCOPE OF bank-only or a consolidated basis.
EXAMINATION 2. Determine who is responsible for interest-
rate risk review (an individual, ALCO, or
1. Obtain descriptions of exceptions noted and other group) and whether this composition is
assess the adequacy of management’s response appropriate for the function’s decision-
to the most recent Federal Reserve and state making structure.
examination reports and the most recent
3. Determine who is responsible for implement-
internal and external audit reports.
ing strategic decisions (for example, with a
flow chart). Ensure that the scope of that
function’s authority is reasonable.
OBTAIN INFORMATION 4. Review the background of individuals respon-
sible for IRR management to determine their
1. Obtain the following information: level of experience and sophistication (obtain
a. interest-rate risk policy (may be incorpo- resumes if necessary).
rated in the funds management or invest- 5. Review appropriate committee minutes and
ment policy) and any other policies related board packages since the previous examina-
to asset/liability management (such as tion and detail significant discussions in work-
derivatives) papers. Note the frequency of board and
b. board and management committee meet- committee meetings to discuss interest-rate
ing minutes since the previous examina- risk.
tion, including packages presented to the 6. Determine if and how the asset liability
board management function is included in the in-
c. most recent internal interest-rate risk man- stitution’s overall strategic planning process.
agement reports (these may include gap
reports and internal-model results, includ-
ing any stress testing) ASSESS BOARD OF DIRECTORS
d. organization chart OVERSIGHT
e. current corporate strategic plan
f. detailed listings of off-balance-sheet 1. Determine how frequently the IRR policy is
derivatives used to manage interest-rate reviewed and approved by the board (at least
risk annually).
Trading and Capital-Markets Activities Manual February 1998
Page 1
3010.3 Interest-Rate Risk Management: Examination Procedures
2. Determine whether the results of the mea- trend and adequacy of the net interest margin
surement system provide clear and reliable and economic value.
information and whether the results are com- 7. Based on the above items, determine the
municated to the board at least quarterly. institution’s risk profile. (What are the most
Board reports should identify the institu- likely sources of interest-rate risk?) Deter-
tion’s current position and its relationship to mine if the profile is consistent with stated
policy limits. interest-rate risk objectives and strategies.
3. Determine the extent to which exceptions to 8. Determine whether changes in the net inter-
policies and resulting corrective measures est margin are consistent with the interest-
are reported to the board, including the rate risk profile developed above.
promptness of reporting.
4. Determine the extent to which the board or a
board committee is briefed on underlying EVALUATE THE INSTITUTION’S
assumptions (major assumptions should be RISK-MEASUREMENT SYSTEMS
approved when established or changed, and AND INTEREST-RATE RISK
at least annually thereafter) and any signifi- EXPOSURE
cant limitations of the measurement system.
5. Assess the extent that major new products are The institution’s risk-measurement system and
reviewed and approved by the board or a corresponding limits should be consistent with
board committee. the size and complexity of the institution’s on-
and off-balance-sheet activities.
1. Review previous examinations and audits
INTEREST-RATE RISK PROFILE of the IRR management system and model.
OF THE INSTITUTION a. Review previous examination work-
papers and reports concerning the model
1. Identify significant holdings of on- and off- to determine which areas may require
balance-sheet instruments and assess the especially close analysis.
interest-rate risk characteristics of these items. b. Review reports and workpapers (if avail-
able) from internal and external audits of
2. Note relevant trends of on- and off-balance-
the model, and, if necessary, discuss the
sheet instruments identified as significant
audit process and findings with the insti-
holdings. Preparing a sources and uses sched-
tution’s audit staff. Depending on the
ule may help determine changes in the levels
sophistication of the institution’s on- and
of interest-sensitive instruments.
off-balance-sheet activities, a satisfac-
3. Determine whether the institution offers or tory audit may not necessarily address
holds products with embedded interest-rate each of the items listed below. The scope
floors and caps (investments, loans, depos- of the procedures may be adjusted if they
its). Evaluate their potential effect on the have been addressed satisfactorily by an
institution’s interest-rate exposure. audit or in previous exams. Determine
4. For those institutions using high-risk mort- whether the audits accomplished the
gage derivative securities to manage interest- following:
rate risk— • Identified the individual or committee
a. determine whether a significant holding of that is responsible for making primary
these securities exists and model assumptions, and whether this
b. assess management’s awareness of the person or committee regularly reviews
risk characteristics of these instruments. and updates these assumptions.
5. Evaluate the purchases and sales of securities • Reviewed data integrity. Auditors
since the previous examination to determine should verify that critical data were
whether the transactions and any overall accurately downloaded from computer
changes in the portfolio mix are consistent subsystems or the general ledger.
with management’s stated interest-rate risk • Reviewed the primary model assump-
objectives and strategies. tions and evaluated whether these
6. Review the UBPR, interim financial state- assumptions were reasonable given
ments, and internal management reports for past activity and current conditions.
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Interest-Rate Risk Management: Examination Procedures 3010.3
• Reviewed whether the assumptions a. Determine how the data on existing
were incorporated into the model as financial positions and contracts are
management indicated. entered into the model. Data may be
• Reviewed assumptions concerning how downloaded from computer subsystems
account balances will be replaced as or the general ledger or they may be
items mature for models that calculate manually entered (or a combination of
earnings or market values. Assump- both).
tions should be reasonable given past b. Determine who has responsibility for
patterns of account balances and cur- inputting or downloading data into the
rent conditions. model. Assess whether appropriate inter-
• Reviewed methodology for determin- nal controls are in place to ensure data
ing cash flows from or market values integrity. For example, the institution
of off-balance-sheet items, such as may have procedures for reconciling data
futures, forwards, swaps, options, caps, with the general ledger, comparing data
and floors. with data from previous months, or error
checking by an officer or other analyst.
• Reviewed current yields or discount
c. Check data integrity by comparing data
rates for critical account categories.
for broad account categories with—
(Determine whether the audit reviewed
• the general ledger, and
the interest-rate scenarios used to mea-
• appropriate call report schedules.
sure interest-rate risk.)
d. Ensure that data from all relevant non-
• Verified the underlying calculations bank subsidiaries have been included.
for the model’s output. e. Assess the quality of the institution’s
• Verified that summary reports pre- financial data. For example, data should
sented to the board of directors and allow the model to distinguish maturity
senior management accurately reflect and repricing, identify embedded options,
the results of the model. include coupon and amortization rates,
c. Determine whether adverse comments identify current asset yields or liability
in the audit reports have been addressed costs.
by the institution’s management and 4. Review selected rate-sensitive items.
whether corrective actions have been a. Review how the model incorporates resi-
implemented. dential mortgages and mortgage-related
d. Discuss weaknesses in the audit process products, including adjustable-rate mort-
with senior management. gages, mortgage pass-throughs, CMOs,
2. Review management and board of directors and purchased and excess mortgage-
oversight of model operation. servicing rights.
• Determine whether the level of data
a. Identify which individual or committee
aggregation for mortgage-related prod-
is responsible for making the principal
ucts is appropriate. Data for pass-
assumptions and parameters used in the
throughs, CMOs, and servicing rights
model.
should identify the type of security,
b. Determine whether this individual or coupon range, and maturity to capture
committee reviews the principal assump- prepayment risk.
tions and parameters regularly (at least • Identify the sources of data or assump-
annually) and updates them as needed. If tions on expected cash flows, includ-
reviews have taken place, state where ing prepayment rates and cash flows
this information is documented. on CMOs. Data may be provided by
c. Determine the extent to which the appro- brokerage firms, independent industry
priate board or management committee information services, or internal
is briefed on underlying assumptions estimates.
(major assumptions should be approved • If internal prepayment and cash-flow
when established or changed, and at least estimates are used for mortgages and
annually thereafter) and any significant mortgage-related products, note how
limitations of the measurement system. the estimates are derived and review
3. Review the integrity of data inputs. them for reasonableness.
Trading and Capital-Markets Activities Manual February 1998
Page 3
3010.3 Interest-Rate Risk Management: Examination Procedures
• If internal prepayment estimates are and forward contracts reflect the
used, determine who has responsibility duration of the underlying instru-
for reviewing these assumptions. Deter- ment (durations should be negative
mine whether this person or committee for net sold positions) and
reviews prepayment rates regularly (at — review the methodology for deter-
least quarterly) and updates the prepay- mining market values of swaps
ment assumptions as needed. under different interest-rate sce-
• For each interest-rate scenario, deter- narios. Compare results with prices
mine if the model adjusts key assump- obtained or calculated from stan-
tions and parameters to account for dard industry information services.
possible changes in— f. Review how the model incorporates
— prepayment rates, options, caps, floors, and collars.
— amortization rates, • For simulation models, review the
— cash flows and yields, and methodology for determining cash
— prices and discount rates. flows of options, caps, floors, and col-
• Determine if the model appropriately lars under various rate scenarios.
incorporates the effects of annual and • For market-value models, review the
lifetime caps and floors on adjustable- methodology used to obtain prices for
rate mortgages. In market-value mod- options, caps, and floors under differ-
els, determine whether these option ent interest-rate scenarios. Compare
values are appropriately reflected. results with prices obtained or calcu-
b. Determine whether the institution has lated from standard industry informa-
structured notes or other instruments with tion services.
similar characteristics. g. Identify any other instruments or posi-
• Identify the risk characteristics of these tions that tend to exhibit significant sen-
instruments, with special attention to sitivity, including those with significant
embedded call/put provisions, caps and embedded options (such as loans with
floors, or repricing opportunities. caps or rights of prepayment) and review
• Determine if the interest-rate risk model treatment of these items for accu-
model is capable of accounting for racy and rigor.
these risks and, if a simplified repre-
5. Review other modeling assumptions.
sentation of the risk is used, whether
that treatment adequately reflects the a. For simulation models that calculate earn-
risk of the instruments. ings, review the assumptions concerning
c. Review how the model incorporates non- how account balances change over time,
maturity deposits. Review the repricing including assumptions about replace-
or sensitivity assumptions. Review and ment rates for existing business and
evaluate the documentation provided. growth rates for new business. (These
d. If the institution has significant levels of items should be reviewed for models that
noninterest income and expense items estimate market values in future periods.)
that are sensitive to changes in interest • Determine whether the assumptions
rates, determine whether these items are are reasonable given current business
incorporated appropriately in the model. conditions and the institution’s strate-
This would include items such as amor- gic plan.
tization of core deposit intangibles and • Determine whether assumptions about
purchased or excess servicing rights for future business are sensitive to changes
credit card receivables. in interest rates.
e. Review how the model incorporates • If the institution uses historical perfor-
futures, forwards, and swaps. mance or other studies to determine
• For simulation models, review the changes in account balances caused by
methodology for determining cash interest-rate movements, review this
flows of futures, forwards, and swaps documentation for reasonableness.
under various rate scenarios. b. For market-value models, review the
• For market-value models— treatment of balances not sensitive to
— determine if the durations of futures interest-rate changes (building and prem-
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Interest-Rate Risk Management: Examination Procedures 3010.3
ises, other long-term fixed assets). Iden- If the institution uses a gap report, continue with
tify whether these balances are included question 8. Otherwise skip to question 9.
in the model and whether the effect is 8. Review the most recent rate-sensitivity
material to the institution’s exposure. report (gap), evaluating whether the report
6. Review the interest-rate scenarios. reasonably characterizes the interest-rate risk
a. Determine the interest-rate scenarios used profile of the institution. Assumptions under-
in the internal model to check the interest- lying the reporting system should also be
rate sensitivity of those scenarios. If evaluated for reasonableness. This evalua-
there is flexibility concerning the sce- tion is particularly critical for categories,
narios to be used, determine who is on- or off-balance-sheet, in which the insti-
responsible for selecting the scenario. tution has significant holdings.
b. Determine whether the institution uses a. Review the reasonableness of the assump-
scenarios that encompass a significant tions used to slot nonmaturity deposits in
rate movement, both increasing and time bands.
decreasing. b. Determine whether residential mort-
c. Review yields/costs for significant gages, pass-through securities, or CMOs
account categories for future periods are slotted by weighted average life or
(base case or scenario) for reasonable- maturity. (Generally, weighted average
ness. The rates should be consistent with life is preferred.)
the model’s assumptions and with the c. If applicable, review the assumptions for
institution’s historical experience and the slotting of securities available for
strategic plan. sale.
d. For market-value models, indicate how d. If the institution has significant holdings
the discount rates in the base case and of other highly rate-sensitive instruments
alternative scenarios are determined. (such as structured notes), review how
e. For Monte Carlo simulations or other these items are incorporated into the
models that develop a probability distri- measurement system.
bution for future interest rates, determine e. If applicable, review the slotting of the
whether the volatility factors used to trading account for reasonableness.
generate interest-rate paths and other f. If applicable, evaluate how the report
parameters are reasonable. incorporates futures, forwards, and swaps.
7. Provide an overall evaluation of the internal The data should be entered in the correct
model. time bands using offsetting entries,
a. Review ‘‘variance reports,’’ reports that ensuring that each cash flow has the
compare predicted and actual results. appropriate sign (positive or negative).
Comment on whether the model has g. Ensure all assumptions are well docu-
made reasonably accurate predictions in mented, including a discussion of how
earlier periods. the assumptions were derived.
b. Evaluate whether the model’s structure h. Confirm that management, at least annu-
and capabilities are adequate to ally, tests, reviews, and updates, as
• accurately assess the risk exposure of needed, the assumptions for
the institution and reasonableness.
• support the institution’s risk- i. Determine if the measurement system
management process and serve as a used is able to adequately model new
basis for internal limits and products that the institution may be using
authorizations. since the previous examination.
c. Evaluate whether the model is operated j. Determine whether the report accurately
with sufficient discipline to— measures the interest-rate exposure of
• accurately assess the risk exposure of the institution.
the institution and k. Assess management’s review and under-
• support the institution’s risk- standing of the assumptions used in the
management process and serve as a institution’s rate-sensitivity report (gap),
basis for internal limits and as well as the system’s strengths and
authorizations. weaknesses.
Trading and Capital-Markets Activities Manual February 1998
Page 5
3010.3 Interest-Rate Risk Management: Examination Procedures
Highly sensitive instruments, including struc- EVALUATE INSTRUMENTS USED
tured notes, have interest-rate risk characteris- IN RISK MANAGEMENT
tics that may not be easily measured in a static
gap framework. If the institution has a signifi- 1. Review the institution’s use of various instru-
cant holding of these instruments, gap may not ments for risk-management purposes (such
be an appropriate way to measure interest-rate as derivatives). Assess the extent that poli-
risk. cies require the institution to—
9. Review the current interest-sensitivity posi- a. document specific objectives for instru-
tion for compliance with internal policy ments used in risk management;
limits. b. prepare an analysis showing the intended
10. Evaluate the institution’s overall interest- results of each risk-management program
rate risk exposure. If the institution uses a before the inception of the program; and
gap schedule, analyze the institution’s gap c. assess at least quarterly the effectiveness
position. If the institution uses an internal of each risk-management program in
model to measure interest-rate risk— achieving its stated objectives.
a. indicate whether the model shows sig- 2. Review the institution’s use of derivative
nificant risks in the following areas: products. Determine if the institution has
• changing level of rates entered into transactions as an end-user to
• basis or shape risk manage interest-rate risk, or is acting in an
• velocity of rate changes intermediary or dealer capacity.
3. When the institution has entered into a trans-
• customer reactions;
action to reduce its own risk, evaluate the
b. for simulation models, determine whether effectiveness of the hedge.
the model indicates a significant level of 4. Determine whether transactions involving
income at risk as a percentage of current derivatives are accounted for properly and in
income or capital; and accordance with the institution’s stated policy.
c. for market-value models, determine 5. Complete the internal control questionnaire
whether the model indicates significant on derivative products used in the manage-
market value at risk relative to assets or ment of interest-rate risk.
capital.
11. Determine the adequacy of the institution’s
method of measuring and monitoring
interest-rate exposure, given the institu- ASSESS STRESS TESTING AND
tion’s size and complexity. CONTINGENCY PLANNING
12. Review management reports.
a. Evaluate whether the reports on interest- 1. Determine if the institution conducts stress
rate risk provide an appropriate level of testing and what kinds of market stress con-
detail given the institution’s size and the ditions management has identified that would
complexity of its on- and off-balance- seriously affect the financial condition of the
sheet activities. Review reports to— institution. These conditions may include
• senior management and (1) abrupt and significant shifts in the term
structure of interest rates or (2) movements in
• the board of directors or board
the relationships among other key rates.
committees.
2. Assess management’s ability to adjust the
b. Indicate whether the reports discuss
institution’s interest-rate risk position under—
exposure to changes in the following:
a. normal market conditions and
• level of interest rates
b. under conditions of significant market
• shape of yield curve and basis risk stress.
• customer reactions 3. Determine the extent to which management
• velocity of rate changes or the board has considered these risks (nor-
13. Review management’s future plans for new mal and significant market stress) and evalu-
systems, improvements to the existing ate contingency plans for adjusting the
measurement system, and use of vendor interest-rate risk position should positions
products. approach or exceed established limits.
February 1998 Trading and Capital-Markets Activities Manual
Page 6
Interest-Rate Risk Management: Examination Procedures 3010.3
VERIFY FINDINGS WITH a. scope of the review
DEPARTMENT OFFICIALS b. adequacy of written policies and proce-
dures, including—
1. Verify examination findings with department • the consistency of limits and parameters
officials to ensure the accuracy and complete- with the stated objectives of the board
ness of conclusions, particularly negative of directors;
conclusions. • the reasonableness of these limits and
parameters given the institution’s capi-
tal, sophistication and management
expertise, and the complexity of its
SUMMARIZE FINDINGS balance sheet;
c. instances of noncompliance with written
1. Summarize the institution’s overall interest-
policies and procedures;
rate risk exposure.
d. apparent violations of laws and regula-
2. Ensure that the method of measuring interest-
tions, indicating those noted at previous
rate risk reflects the complexity of the insti-
examinations;
tution’s interest-rate risk profile.
e. internal control deficiencies and excep-
3. Assess the extent management and the board
tions, indicating those noted during previ-
of directors understand the level of risk and
ous examinations or audits;
sources of exposure.
f. other matters of significance; and
4. Evaluate the appropriateness of policy limits
g. corrective actions planned by management.
relative to (1) earnings and capital-at-risk,
(2) the adequacy of internal controls, and
(3) the risk-measurement systems.
5. If the institution has an unacceptable interest- ASSEMBLE AND REVIEW
rate risk exposure or an inadequate interest- WORKPAPERS
rate risk management process, discuss find-
ings with the examiner-in-charge. 1. Ensure that the workpapers adequately docu-
6. Prepare comments for the workpapers and ment the work performed and conclusions of
examination report, as appropriate, concern- this assignment.
ing the findings of the examination of this 2. Forward the assembled workpapers to the
section including the following: examiner-in-charge for review and approval.
Trading and Capital-Markets Activities Manual February 1998
Page 7
Interest-Rate Risk Management
Internal Control Questionnaire Section 3010.4
MANAGEMENT, POLICIES, AND 6. Does one individual exert undue influence
PROCEDURES over interest-rate risk management activities?
1. Has the board of directors, consistent with its
duties and responsibilities, adopted written
policies and procedures related to interest- INTERNAL MODELS
rate risk that establish
a. the risk-management philosophy and 1. Has the internal model been audited (by
objectives regarding interest-rate risk, internal or external auditors)?
b. clear lines of responsibility, 2. Does one individual control the modeling
c. definition and setting of limits on interest- process or otherwise exert undue influence
rate risk exposure, over the risk-measurement process?
d. specific procedures for reporting and the 3. Is the model reconciled to source data to
approvals necessary for exceptions to poli- ensure data integrity?
cies and limits, 4. Are principal assumptions and parameters
e. plans or procedures the board and man- used in the model reviewed periodically by
agement will implement if interest-rate the board and senior management?
risk falls outside established limits, 5. Are the workings of and the assumptions
f. specific interest-rate risk measurement used in the internal model adequately docu-
systems, mented and available for examiner review?
g. acceptable activities used to manage or 6. Is the model run on the same scenarios on
adjust the institution’s interest-rate risk which the institution’s limits are established?
exposure, 7. Does management compare the historical
h. the individuals or committees who are results of the model with actual backtesting
responsible for interest-rate risk manage- results?
ment decisions, and
i. a process for evaluating major new
products and their interest-rate risk
characteristics? CONCLUSIONS
2. Is the bank in compliance with its policies,
and is it adhering to its written procedures? If 1. Is the foregoing information an adequate
not, are exceptions and deviations— basis for evaluating the systems of internal
a. approved by appropriate authorities, controls? Are there significant deficiencies in
b. made infrequently, and areas not covered in this questionnaire that
c. nonetheless consistent with safe and sound impair any controls? If so, explain answers
banking practices? briefly, indicate additional internal control
3. Does the board review and approve the questions or elements deemed necessary, and
policy at least annually? forward recommendations to the supervisory
4. Did the board and management review IRR examiner or designee.
positions and the relationship of these posi- 2. Based on a composite evaluation, as evi-
tions to established limits at least quarterly? denced by answers to the foregoing ques-
5. Were exceptions to policies promptly reported tions, are the systems of internal control
to the board? considered adequate?
Trading and Capital-Markets Activities Manual February 1998
Page 1
Securitization and Secondary-Market Credit Activities
Section 3020.1
In recent years, the secondary-market credit ments and the reserves held against the deposits
activities of many institutions have increased used to fund the sold assets. Second, securitiza-
substantially. As the name implies, secondary- tion provides originators with an additional
market credit activities involve the transforma- source of funding or liquidity since the process
tion of traditionally illiquid loans, leases, and of securitization converts an illiquid asset into a
other assets into instruments that can be bought security with greater marketability. Securitized
and sold in secondary capital markets. It also issues often require a credit enhancement, which
involves the isolation of credit risk in various results in a higher credit rating than what would
types of derivative instruments. Secondary- normally be obtainable by the institution itself.
market credit activities include asset securitiza- Consequently, securitized issues may provide
tions, loan syndications, loan sales and partici- the institution with a cheaper form of funding.
pations, and credit derivatives, as well as the Third, securitization may be used to reduce
provision of credit enhancements and liquidity interest-rate risk by improving the institution’s
facilities to these transactions. Secondary-market asset/liability mix. This is especially true if the
credit activities can enhance both credit avail- institution has a large investment in fixed-rate,
ability and bank profitability, but managing the low-yield assets. Finally, the ability to sell these
risks of these activities poses increasing chal- securities worldwide diversifies the institution’s
lenges: The risks involved, while not new to funding base, which reduces the bank’s depen-
banking, may be less obvious and more complex dence on local economies.
than the risks of traditional lending activities. While securitization activities can enhance
Some secondary-market credit activities involve both credit availability and bank profitability,
credit, liquidity, operational, legal, and reputa- the risks of these activities must be known
tional risks in concentrations and forms that may and managed. Asset securitization may involve
not be fully recognized by bank management or credit, liquidity, operational, legal, and reputa-
adequately incorporated in an institution’s risk- tional risks in concentrations and forms that may
management systems. In reviewing these activi- not be fully recognized by bank management or
ties, supervisors and examiners should assess adequately incorporated in an institution’s risk-
whether banking organizations fully understand management systems. Accordingly, banking
and adequately manage the full range of the institutions should ensure that their overall risk-
risks involved in secondary-market credit management process explicitly incorporates the
activities. full range of the risks involved in their securiti-
zation activities.
In reviewing asset securitization activities,
examiners should assess whether banking orga-
ASSET SECURITIZATION nizations fully understand and adequately man-
age the full range of the risks involved in their
Banking organizations have long been involved activities. Specifically, supervisors and examin-
in asset-backed securities (ABS), both as inves- ers should determine whether institutions are
tors and as major participants in the securitiza- recognizing the risks of securitization activities
tion process. In recent years, banks have both by (1) adequately identifying, quantifying, and
increased their participation in the long- monitoring these risks; (2) clearly communicat-
established residential mortgage-backed securi- ing the extent and depth of risks in reports to
ties market and expanded their activities in senior management and the board of directors
securitizing other types of assets, such as credit and in regulatory reports; (3) conducting ongo-
card receivables, automobile loans, boat loans, ing stress testing to identify potential losses and
commercial real estate loans, student loans, liquidity needs under adverse circumstances;
nonperforming loans, and lease receivables. and (4) setting adequate minimum internal stan-
While the objectives of securitization may dards for allowances or liabilities for losses,
vary from institution to institution, several bene- capital, and contingency funding. Incorporating
fits can be derived from securitized transactions. asset securitization activities into banking orga-
First, the sale of assets may reduce regulatory nizations’ risk-management systems and inter-
costs by reducing both risk-based capital require- nal capital-adequacy allocations is particularly
Trading and Capital-Markets Activities Manual March 1999
Page 1
3020.1 Securitization and Secondary-Market Credit Activities
important; current regulatory capital rules may lying pool of assets and for transmitting these
not fully capture the economic substance of the funds to investors (or a trustee representing
risk exposures arising from many of these them). A trustee is responsible for monitoring
activities. the activities of the servicer to ensure that it
An institution’s failure to adequately under- properly fulfills its role. A guarantor may also be
stand the risks inherent in its secondary-market involved to ensure that principal and interest
credit activities and to incorporate risks into payments on the securities will be received by
its risk-management systems and internal capi- investors on a timely basis, even if the servicer
tal allocations may constitute an unsafe and does not collect these payments from the obli-
unsound banking practice. Accordingly, for those gors of the underlying assets. Many issues of
institutions involved in asset securitization or mortgage-backed securities are either guaran-
providing credit enhancements in connection teed directly by the Government National Mort-
with loan sales and securitization, examiners gage Association (GNMA or GinnieMae), which
should assess whether the institutions’ systems is backed by the full faith and credit of the U.S.
and processes adequately identify, measure, government, or by the Federal National Mort-
monitor, and control all of the risks involved in gage Association (FNMA or FannieMae), or the
the secondary-market credit activities.1 Federal Home Loan Mortgage Corporation
(FHLMC or FreddieMac), which are government-
sponsored agencies that are perceived by the
Securitization Process credit markets to have the implicit support of the
federal government. Privately issued, mortgage-
In its simplest form, asset securitization is the backed securities and other types of ABS gen-
transformation of generally illiquid assets into erally depend on some form of credit enhance-
securities that can be traded in the capital ment provided by the originator or third party
markets. The asset securitization process begins to insulate the investor from a portion of or all
with the segregation of loans or leases into pools credit losses. Usually, the amount of the credit
that are relatively homogeneous with respect enhancement is based on several multiples of
to their cash-flow characteristics and risk pro- the historical losses experienced on the particu-
files, including both credit and market risks. lar asset backing the security.
These pools of assets are then transferred to a The structure of an asset-backed security and
bankruptcy-remote entity such as a grantor trust the terms of the investors’ interest in the collat-
or special-purpose corporation that issues secu- eral can vary widely depending on the type of
rities or ownership interests in the cash flows of collateral, the desires of investors, and the use of
the underlying collateral. These ABS may take credit enhancements. Often ABS are structured
the form of debt, certificates of beneficial own- to re-allocate the risks entailed in the underlying
ership, or other instruments. The issuer is typi- collateral (particularly credit risk) into security
cally protected from bankruptcy by various tranches that match the desires of investors. For
structural and legal arrangements. Normally, the example, senior-subordinated security structures
sponsor that establishes the issuer is the origi- give holders of senior tranches greater credit-
nator or provider of the underlying assets. risk protection (albeit at lower yields) than
Each issue of ABS has a servicer that is holders of subordinated tranches. Under this
responsible for collecting interest and principal structure, at least two classes of asset-backed
payments on the loans or leases in the under- securities, a senior class and a junior or subor-
dinated class, are issued in connection with the
same pool of collateral. The senior class is
structured so that it has a priority claim on the
cash flows from the underlying pool of assets.
The subordinated class must absorb credit losses
on the collateral before losses can be charged to
1. The Federal Reserve System has developed a three- the senior portion. Because the senior class has
volume set that contains educational material concerning the this priority claim, cash flows from the under-
process of asset securitization and examination guidelines (see lying pool of assets must first satisfy the require-
SR-90-16). The volumes are (1) An Introduction to Asset
Securitization, (2) Accounting Issues Relating to Asset
ments of the senior class. Only after these
Securitization, and (3) Examination Guidelines for Asset requirements have been met will the cash flows
Securitization. be directed to service the subordinated class.
March 1999 Trading and Capital-Markets Activities Manual
Page 2
Securitization and Secondary-Market Credit Activities 3020.1
Credit Enhancements Types of Asset-Backed Securities
ABS can use various forms of credit enhance- The many different varieties of asset-backed
ments to transform the risk-return profile of securities are often customized to the terms and
underlying collateral. These include third-party characteristics of the underlying collateral.
credit enhancements, recourse provisions, over- Most common are securities collateralized by
collateralization, and various covenants and (1) revolving credit lines such as card receiv-
indentures. Third-party credit enhancements ables, (2) closed-end installment loans such as
include standby letters of credit, collateral or automobile and student loans, and (3) lease
pool insurance, or surety bonds from third receivables. The instrument profiles on asset-
parties. Recourse provisions are guarantees that backed securities and mortgage-backed securi-
require the originator to cover any losses up to ties in this manual (sections 4105.1 and 4110.1,
a contractually agreed-on amount. One type of respectively) present specific information on the
recourse provision, usually seen in securities nature and structure of various types of securi-
backed by credit card receivables, is the ‘‘spread tized assets.
account.’’ This account is actually an escrow In addition to specific ABS, other types of
account, the funds of which are derived from a financial instruments may arise as a result of
portion of the spread between the interest earned asset securitization, such as loan-servicing rights,
on the assets in the underlying pool of collateral excess-servicing-fee receivables, and ABS
and the lower interest paid on securities issued residuals. Loan-servicing rights are created in
by the trust. The amounts that accumulate in this one of two ways.2 Servicing rights can be pur-
escrow account are used to cover credit losses chased outright from other institutions or can be
in the underlying asset pool, up to several created when organizations (1) purchase or origi-
multiples of historical losses on the particular nate loans or (2) sell or securitize these loans
asset collateralizing the securities. and retain the right to act as servicers for the
Overcollateralization is another form of credit pools of loans. The capitalized servicing asset
enhancement that covers a predetermined amount is treated as an identified intangible asset for
of potential credit losses. When the value of the purposes of regulatory capital. Excess-servicing-
underlying assets exceeds the face value of the fee receivables generally arise when the present
securities, the securities are said to be over- value of any additional cash flows from the
collateralized. A similar form of credit enhance- underlying assets that a servicer expects to
ment is the cash-collateral account, which is receive exceeds standard servicing fees. ABS
established when a third party deposits cash into residuals (sometimes referred to as ‘‘residuals’’
a pledged account. The use of cash-collateral or ‘‘residual interests’’) represent claims on any
accounts, which are considered to be loans, cash flows that remain after all obligations to
grew as the number of highly rated banks and investors and any related expenses have been
other credit enhancers declined in the early met. The excess cash flows may arise as a result
1990s. Cash-collateral accounts eliminate ‘‘event of overcollateralization or from reinvestment
risk,’’ or the risk that the credit enhancer will income. Residuals can be retained by spon-
have its credit rating downgraded or that it will sors or purchased by investors in the form of
not be able to fulfill its financial obligation to securities.
absorb losses. Thus, credit protection is pro-
vided to the investors of a securitization.
Generally, an investment banking firm or
Securitization of Commercial Paper
other organization serves as an ABS under- Bank involvement in the securitization of com-
writer. In addition, for asset-backed issues that mercial paper has increased significantly over
are publicly offered, a credit rating agency will time. However, asset-backed commercial paper
analyze the policies and operations of the origi-
nator and servicer, as well as the structure, 2. In May 1995, the Financial Accounting Standards Board
underlying pool of assets, expected cash flows, issued its Statement of Financial Accounting Standards No. 122
and other attributes of the securities. Before (FAS 122), ‘‘Accounting for Mortgage Servicing Rights.’’
assigning a rating to the issue, the rating agency FAS 122 eliminated the accounting distinctions between
originated servicing rights, which were not allowed to be
will also assess the extent of loss protection recognized on the balance sheet, and purchased servicing
provided to investors by the credit enhance- rights, which were capitalized as a balance-sheet asset. See
ments associated with the issue. section 2120.1, ‘‘Accounting.’’
Trading and Capital-Markets Activities Manual September 2001
Page 3
3020.1 Securitization and Secondary-Market Credit Activities
programs differ from other methods of securiti- appropriate back- and front-office staffing; inter-
zation. One difference is that more than one type nal and external accounting and legal support;
of asset may be included in the receivables pool. audit or independent-review coverage; informa-
Moreover, in certain cases, the cash flow from tion systems capacity; and oversight mecha-
the receivables pool may not necessarily match nisms to execute, record, and administer these
the payments to investors because the maturity transactions.
of the underlying asset pool does not always
parallel the maturity of the structure of the
commercial paper. Consequently, when the paper Risks to Investors
matures, it is usually rolled over or funded by
another issue. In certain circumstances, a matur- Investors in ABS will be exposed to varying
ing issue of commercial paper cannot be rolled degrees of credit risk, just as they are in direct
over. To address this problem, many banks have investments in the underlying assets. Credit risk
established back-up liquidity facilities. Certain is the risk that obligors will default on principal
banks have classified these back-up facilities as and interest payments. ABS investors are also
pure liquidity facilities, despite the credit- subject to the risk that the various parties in the
enhancement element present in them. As a securitization structure, for example, the ser-
result, the risks associated with these facilities vicer or trustee, will be unable to fulfill its
are incorrectly assessed. In these cases, the contractual obligations. Moreover, investors may
back-up liquidity facilities are more similar to be susceptible to concentrations of risks across
direct credit substitutes than to loan commitments. various asset-backed security issues through
overexposure to an organization performing vari-
ous roles in the securitization process or as a
RISKS OF ASSET result of geographic concentrations within the
SECURITIZATION pool of assets providing the cash flows for an
individual issue. Since the secondary markets
While banking organizations that engage in for certain ABS are limited, investors may
securitization activities and invest in ABS accrue encounter greater than anticipated difficulties
clear benefits, these activities can potentially when seeking to sell their securities (liquidity
increase the overall risk profile of the banking risk). Furthermore, certain derivative instru-
organization. For the most part, the types of ments, such as stripped asset-backed securities
risks that financial institutions encounter in the and residuals, may be extremely sensitive to
securitization process are identical to those faced interest rates and exhibit a high degree of price
in traditional lending transactions, including volatility. Therefore, derivative instruments may
credit risk, concentration risk, interest-rate risk dramatically affect the risk exposure of investors
(including prepayment risk), operational risk, unless these instruments are used in a properly
liquidity risk, moral-recourse risk, and funding structured hedging strategy. Examiner guidance
risk. However, since the securitization process in section 3000.1, ‘‘Investment Securities and
separates the traditional lending function into End-User Activities,’’ is directly applicable to
several limited roles, such as originator, ser- ABS held as investments.
vicer, credit enhancer, trustee, and investor, the
types of risks that a bank will encounter will
differ depending on the role it assumes. Risks to Issuers and Institutions
Senior management and the board of directors Providing Credit Enhancements
should have the requisite knowledge of the
effects of securitization on the banking organi- Banking organizations that issue ABS may be
zation’s risk profile and should be fully aware of subject to pressures to sell only their best assets,
the accounting, legal, and risk-based capital thus reducing the quality of their loan portfolios.
implications of this activity. Banking organiza- On the other hand, some banking organizations
tions need to fully and accurately distinguish may feel pressured to relax their credit standards
and measure the risks that are transferred versus because they can sell assets with higher risk than
those retained, and they must adequately man- they would normally want to retain for their own
age the retained portion. Banking organizations portfolios. To protect their names in the market,
engaging in securitization activities must have issuers may also face pressures to provide ‘‘moral
September 2001 Trading and Capital-Markets Activities Manual
Page 4
Securitization and Secondary-Market Credit Activities 3020.1
recourse’’ by repurchasing securities backed by
loans or leases they have originated that have
deteriorated and become nonperforming. Fund-
ing risk may also be a problem for issuers when
market aberrations do not permit asset-backed
securities that are in the securitization pipeline
to be issued.
Credit Risks
The partial, first-loss recourse obligations an
institution retains when selling assets, and the
extension of partial credit enhancements (for
example, 10 percent letters of credit) in connec-
tion with asset securitization, can be sources of
concentrated credit risk. Institutions are exposed
Trading and Capital-Markets Activities Manual April 2001
Page 4.1
Securitization and Secondary-Market Credit Activities 3020.1
to the full amount of expected losses on the program to retire maturing commercial paper
protected assets. For instance, the credit risk when a mismatch occurs in the maturities of the
associated with whole loans or pools of assets underlying receivables and the commercial paper,
that are sold to secondary-market investors can or when a disruption occurs in the commercial
often be concentrated within the partial, first- paper market. However, depending on the pro-
loss recourse obligations retained by the bank- visions of the facility—such as whether the
ing organizations selling and securitizing the facility covers dilution of the underlying receiv-
assets. In these situations, even though institu- able pool—credit risk can be shifted from the
tions may have reduced their exposure to cata- program’s explicit credit enhancements to the
strophic loss on the assets sold, they generally liquidity facility.3 Such provisions may enable
retain the same credit-risk exposure as if they certain programs to fund riskier assets and
continued to hold the assets on their balance maintain the credit rating on the program’s
sheets. commercial paper without increasing the pro-
In addition to recourse obligations, institu- gram’s credit-enhancement levels.
tions assume concentrated credit risk through The structure of various securitization trans-
the extension of partial direct credit substitutes, actions can also result in an institution’s retain-
such as through the purchase (or retention) of ing the underlying credit risk in a sold pool of
subordinated interests in their own asset securi- assets. Examples of this contingent credit-risk
tizations or through the extension of letters of retention include credit card securitization, in
credit. For example, banking organizations that which the securitizing organization explicitly
sponsor certain asset-backed commercial paper sells the credit card receivables to a master trust,
programs, or so-called ‘‘remote origination’’ but, in substance, retains the majority of the
conduits, can be exposed to high degrees of economic risk of loss associated with the assets
credit risk even though their notional exposure because of the credit protection provided to
may seem minimal. This type of remote origi- investors by the excess yield, spread accounts,
nation conduit lends directly to corporate cus- and structural provisions of the securitization.
tomers that are referred to it by the sponsoring Excess yield provides the first level of credit
banking organization that used to lend directly protection that can be drawn on to cover cash
to these same borrowers. The conduit funds this shortfalls between (1) the principal and coupon
lending activity by issuing commercial paper owed to investors and (2) the investors’ pro rata
that, in turn, the sponsoring banking organiza- share of the master trust’s net cash flows. The
tion guarantees. The net result is that the spon- excess yield is equal to the difference between
soring institution’s credit-risk exposure through the overall yield on the underlying credit card
this guarantee is about the same as it would have portfolio and the master trust’s operating
been if it had made the loans directly and held expenses.4 The second level of credit protection
them on its books. However, this is an off- is provided by the spread account, which is
balance-sheet transaction, and its associated risks essentially a reserve initially funded from the
may not be fully reflected in the institution’s excess yield.
risk-management system. In addition, the structural provisions of credit
Furthermore, banking organizations that extend card securitization generally provide credit pro-
liquidity facilities to securitized transactions, tection to investors through the triggering of
particularly to asset-backed commercial paper early amortization events. Such an event usually
programs, may be exposed to high degrees of is triggered when the underlying pool of credit
credit risk subtly embedded within a facility’s card receivables deteriorates beyond a certain
provisions. Liquidity facilities are commitments
to extend short-term credit to cover temporary 3. Dilution essentially occurs when the receivables in the
shortfalls in cash flow. While all commitments underlying asset pool—before collection—are no longer viable
embody some degree of credit risk, certain financial obligations of the customer. For example, dilution
can arise from returns of consumer goods or unsold merchan-
commitments extended to asset-backed commer- dise by retailers to manufacturers or distributors.
cial paper programs to provide liquidity may 4. The monthly excess yield is the difference between the
subject the extending institution to the credit overall yield on the underlying credit card portfolio and the
risk of the underlying asset pool (often trade master trust’s operating expenses. It is calculated by subtract-
ing from the gross portfolio yield the (1) coupon paid to
receivables) or a specific company using the investors, (2) charge-offs for that month, and (3) servicing fee,
program for funding. Often the stated purpose usually 200 basis points paid to the banking organization
of liquidity facilities is to provide funds to the sponsoring the securitization.
Trading and Capital-Markets Activities Manual February 1998
Page 5
3020.1 Securitization and Secondary-Market Credit Activities
point and requires that the outstanding credit action and throughout the life of the securities to
card securities begin amortizing early to pay off better ascertain its future funding needs.
investors before the prior credit enhancements An institution’s contingency plans should con-
are exhausted. The early amortization acceler- sider the need to obtain replacement funding and
ates the redemption of principal (paydown) on specify possible alternative funding sources, in
the security, and the credit card accounts that the event of the amortization of outstanding
were assigned to the master credit-card trust asset-backed securities. Replacement funding is
return to the securitizing institution more quickly particularly important for securitization with
than had originally been anticipated. Thus, the revolving receivables, such as credit cards, in
institution is exposed to liquidity pressures and which an early amortization of the asset-backed
any further credit losses on the returned accounts. securities could unexpectedly return the out-
standing balances of the securitized accounts to
the issuing institution’s balance sheet. An early
Reputational Risks amortization of a banking organization’s asset-
backed securities could impede its ability to
The securitization activities of many institutions fund itself—either through re-issuance or other
may expose them to significant reputational borrowings—since the institution’s reputation
risks. Often, banking organizations that sponsor with investors and lenders may be adversely
the issuance of asset-backed securities act as a affected.
servicer, administrator, or liquidity provider in
the securitization transaction. These institutions
must be aware of the potential losses and risk
exposure associated with reputational risk from
Servicer-Specific Risks
securitization activities. The securitization of
Banking organizations that service securiti-
assets whose performance has deteriorated may
zation issues must ensure that their policies,
result in a negative market reaction that could
operations, and systems will not permit break-
increase the spreads on an institution’s subse-
downs that may lead to defaults. Substantial fee
quent issuances. To avoid a possible increase in
income can be realized by acting as a servicer.
their funding costs, institutions have supported
An institution already has a fixed investment in
their securitization transactions by improving
its servicing systems; achieving economies of
the performance of the securitized asset pool.
scale relating to that investment is in its best
This has been accomplished, for example, by
interest. The danger, though, lies in overloading
selling discounted receivables or adding higher
the system’s capacity, thereby creating enor-
quality assets to the securitized asset pool. Thus,
mous out-of-balance positions and cost over-
an institution’s voluntary support of its securi-
runs. Servicing problems may precipitate a tech-
tization to protect its reputation can adversely
nical default, which in turn could lead to the
affect the sponsoring or issuing organization’s
premature redemption of the security. In addi-
earnings and capital.
tion, expected collection costs could exceed fee
income. (For further guidance, see section
2040.3, ‘‘Loan Portfolio Management,’’ exami-
Liquidity Risks nation procedure 14b, of the Commercial Bank
Examination Manual.)
The existence of recourse provisions in asset
sales, the extension of liquidity facilities to
securitization programs, and the early amortiza-
tion triggers of certain asset securitization trans- ACCOUNTING ISSUES
actions can involve significant liquidity risk to
institutions engaged in these secondary-market Asset securitization transactions are frequently
credit activities. Institutions should ensure that structured to obtain certain accounting treat-
their liquidity contingency plans fully incorpo- ments, which in turn affect reported measures of
rate the potential risk posed by their secondary- profitability and capital adequacy. In transfer-
market credit activities. When new asset-backed ring assets into a pool to serve as collateral for
securities are issued, the issuing banking orga- ABS, a key question is whether the transfer
nization should determine their potential effect should be treated as a sale of the assets or as a
on its liquidity at the inception of each trans- collateralized borrowing, that is, a financing
February 1998 Trading and Capital-Markets Activities Manual
Page 6
Securitization and Secondary-Market Credit Activities 3020.1
transaction secured by assets. Treating these the institution should maintain against the con-
transactions as a sale of assets results in their centrated credit risk in the guarantee. Supervi-
being removed from the banking organization’s sors and examiners should ensure that banking
balance sheet, thus reducing total assets relative organizations have implemented reasonable
to earnings and capital, and thereby producing methods for allocating capital against the eco-
higher performance and capital ratios. Treating nomic substance of credit exposures arising
these transactions as financings, however, means from early-amortization events and liquidity
that the assets in the pool remain on the balance facilities associated with securitized transac-
sheet and are subject to capital requirements and tions. These facilities are usually structured
the related liabilities-to-reserve requirements. as short-term commitments to avoid a risk-
based capital requirement, even though the
inherent credit risk may be approaching that of a
CAPITAL ADEQUACY guarantee.5
If, in the supervisor’s judgment, an institu-
As with all risk-bearing activities, institutions tion’s capital level is not sufficient to provide
should fully support the risk exposures of their protection against potential losses from such
securitization activities with adequate capital. credit exposures, this deficiency should be
Banking organizations should ensure that their reflected in the banking organization’s CAMELS
capital positions are sufficiently strong to sup- or BOPEC ratings. Furthermore, supervisors
port all of the risks associated with these activi- and examiners should discuss the capital defi-
ties on a fully consolidated basis and should ciency with the institution’s management and, if
maintain adequate capital in all affiliated enti- necessary, its board of directors. The institution
ties engaged in these activities. The Federal will be expected to develop and implement a
Reserve’s risk-based capital guidelines establish plan for strengthening the organization’s overall
minimum capital ratios, and those banking orga- capital adequacy to levels deemed appropriate
nizations exposed to high or above-average given all the risks to which it is exposed.
degrees of risk are, therefore, expected to oper-
ate significantly above the minimum capital
standards. RISK-BASED CAPITAL
The current regulatory capital rules may not
fully incorporate the economic substance of the
PROVISIONS AFFECTING ASSET
risk exposures involved in many securitization SECURITIZATION
activities. Therefore, when evaluating capital
adequacy, examiners should ensure that bank-
Recourse Obligations, Residual
ing organizations that sell assets with recourse, Interests, and Direct-Credit Substitutes
that assume or mitigate credit risk through the
The risk-based capital framework for recourse
use of credit derivatives, and that provide direct-
obligations, residual interests, and direct-credit
credit substitutes and liquidity facilities to secu-
substitutes resulting from asset securitization
ritization programs are accurately identifying
was revised effective January 1, 2002.6 A one-
and measuring these exposures—and maintain-
year transition period applies to existing trans-
ing capital at aggregate levels sufficient to sup-
actions, but banks may elect early adoption of
port the associated credit, market, liquidity,
the new rules. All transactions settled on or after
reputational, operational, and legal risks.
January 1, 2002, are subject to the revised rule
Examiners should also review the substance
(the rule).
of securitization transactions when assessing
The rule seeks to treat recourse obligations
underlying risk exposures. For example, partial,
and direct-credit substitutes more consistently
first-loss direct-credit substitutes that provide
and in a way that is more closely aligned to the
credit protection to a securitization transaction
can, in substance, involve the same credit risk as 5. For further guidance on distinguishing, for risk-based
the risk involved in holding the entire asset pool capital purposes, whether a facility is a short-term commit-
on the institution’s balance sheet. However, ment or a direct-credit substitute, see SR-92-11, ‘‘Asset-
under current rules, regulatory capital is explic- Backed Commercial Paper Programs.’’ Essentially, facilities
that provide liquidity, but which also provide credit protection
itly required only against the amount of the to secondary-market investors, are to be treated as direct-
direct-credit substitute, which can be signifi- credit substitutes for purposes of risk-based capital.
cantly different from the amount of capital that 6. 66 Fed. Reg. 59614 (November 29, 2001).
Trading and Capital-Markets Activities Manual April 2002
Page 7
3020.1 Securitization and Secondary-Market Credit Activities
credit-risk profile of these instruments. The rule the banking organization to credit risk that
emphasizes the economic substance of a trans- exceeds its pro rata claim on the underlying
action over its form, and allows regulators to assets. This type of residual interest is created
recharacterize transactions or change the capital when assets are transferred in a securitization
treatment to reflect the exposure’s actual risk transaction that qualifies for sale treatment under
profile and to prevent regulatory arbitrage or GAAP, and it typically results in the recognition
evasion of the capital requirements. of a gain-on-sale on the seller’s income state-
ment. Generally, credit-enhancing I/O strips are
held on the balance sheet at the present value of
Coverage of the Rule expected future net cash flows, adjusted for
expected prepayments and losses and dis-
The rule applies to banks, their holding compa- counted at an appropriate market interest rate.
nies, and thrift institutions. It covers recourse Regulators will look to the economic substance
obligations, residual interests, direct-credit sub- of these residual assets and reserve the right to
stitutes, and asset-backed and mortgage-backed identify other cash flows or similar spread-
securities held in both the banking and trading related assets as credit-enhancing I/O strips on a
books (to the extent that the institution is not case-by-case basis. Credit-enhancing I/O strips
subject to the market-risk rule). include both purchased and retained interest-
The rule defines ‘‘recourse’’ as an arrange- only strips that serve in a credit-enhancing
ment in which a banking organization retains, in capacity.
form or substance, the credit risk in connection Direct-credit substitutes are arrangements in
with an asset sale in accordance with GAAP, if which a banking organization assumes, in form
the credit risk exceeds the pro rata share of the or in substance, credit risk associated with an
banking organization’s claim on the assets. If on- or off-balance-sheet asset or exposure that it
the banking organization has no claim on a did not previously own (third-party asset), and
transferred asset, then the retention of any credit the risk assumed by the banking organization
risk is also recourse. The purchase of credit exceeds the pro rata share of its interest in the
enhancements for a securitization, in which the third-party asset. This definition includes guar-
banking organization is completely removed antees, letters of credit, purchased subordinated
from any credit risk, will not, in most instances, interests, agreements to cover credit losses that
constitute recourse. arise from purchased loan-servicing rights, credit
Residual interests are on-balance-sheet assets derivatives, and lines of credit that provide
that represent an interest (including a beneficial credit enhancement. For direct-credit substitutes
interest) created by a transfer that qualifies as a that take the form of syndications in which each
sale of financial assets under GAAP. This trans- bank is obligated only for its pro rata share of
fer exposes the banking organization to any the risk and there is no recourse to the originat-
credit risk that exceeds a pro rata share of the ing bank, each bank includes only its pro rata
organization’s claim on the asset. Examples of share of the assets supported by the direct-credit
residual interests include credit-enhancing substitute in its risk-based capital calculation.
interest-only (I/O) strips, spread accounts, Representations and warranties that function
cash-collateral accounts, retained subordinated as credit enhancements to protect asset purchas-
interests, and other assets that function as credit ers or investors from credit risk are treated as
enhancements. Interests retained in a transaction recourse or direct-credit substitutes. However,
accounted for as a financing under GAAP early-default clauses that permit the return of
are not included within the definition of residual 50 percent of risk-weighted one- to four-family
interests. In addition, the rule excludes seller’s residential mortgage loans for a maximum period
interest (common to revolving transactions) of 120 days are excluded from the definition of
from the definition of residual interest if the recourse or direct-credit substitutes. Also
seller’s interest does not act as a credit enhance- excluded from coverage are premium-refund
ment and is exposed to only a pro-rated share of clauses on loans guaranteed by U.S. government
loss. agencies or U.S. government–sponsored enter-
Credit-enhancing I/O strips are on-balance- prises (for example, one- to four-family residen-
sheet assets that, in form or substance, represent tial mortgages) that provide for a maximum
the contractual right to receive some or all of the 120-day put period. Warranties that cover losses
interest due on transferred assets, and that expose due to fraud or incomplete documentation are
April 2002 Trading and Capital-Markets Activities Manual
Page 8
Securitization and Secondary-Market Credit Activities 3020.1
also excluded from the definition of recourse or enhancing I/O strips) based on their relative
direct-credit substitutes. exposure to credit risk. The approach generally
The rule provides a limited exemption from uses credit ratings from the ratings agencies.7
the definition of recourse or direct-credit substi- The capital requirement is computed by multi-
tute for clean-up calls when the remaining plying the face amount of the position by the
balance of the loans is equal to or less than appropriate risk weight as determined from
10 percent of the original pool balance. This table 1.
allows for the timely maturity of the related Different rules apply to traded and untraded
securities to accommodate transaction efficiency positions under the ratings-based approach.8
or administrative cost savings. Traded positions need to be rated by only one
The definitions of recourse and direct-credit rating agency. A position is "traded" if, at the
substitute include loan-servicing arrangements time of rating by the external credit agency,
if the banking organization, as servicer, is there is a reasonable expectation that in the near
responsible for credit losses on the serviced future either (1) the position may be sold to
loans. However, the definitions do not apply to unaffiliated investors relying on the rating or
cash advances servicers make to ensure an (2) an unaffiliated third party relying on the
uninterrupted flow of payments to investors or rating may enter into a transaction involving the
the timely collection of residential mortgage position. If multiple ratings have been received
loans, provided that the servicer is entitled to on a position, the lowest rating must be used.
reimbursement of these amounts and the right to Rated, but untraded, positions are eligible for
reimbursement is not subordinated to other the ratings-based approach if the ratings are
claims. The banking organization is required to (1) provided by more than one rating agency;
make an independent credit assessment of the (2) as provided by each rating agency from
likelihood of repayment, and the maximum which a rating is received, one category below
possible amount of any nonreimbursed advances
must be ‘‘insignificant.’’
7. Ratings agencies are those organizations recognized by
the Division of Market Regulation of the SEC as nationally
Ratings-Based Approach recognized statistical rating organizations for various pur-
poses, including the SEC’s uniform net capital requirements
The rule imposes a multilevel, ratings-based for brokers and dealers.
approach to assessing capital requirements on 8. Traded positions are those that are retained, assumed, or
issued in connection with an asset securitization and that are
asset-backed securities, mortgage-backed secu- externally rated. There must be a reasonable expectation that,
rities, recourse obligations, direct-credit substi- in the near future, unaffiliated third parties will rely on the
tutes, and residual interests (other than credit- rating.
Table 1—Rating Categories
Examples Risk weight
Long-term rating category
Highest or second-highest investment grade AAA or AA 20%
Third-highest investment grade A 50%
Lowest investment grade BBB 100%
One category below investment grade BB 200%
More than one category below
investment grade or unrated B or unrated Not eligible for ratings-
based approach
Short-term rating category
Highest investment grade A-1, P-1 20%
Second-highest investment grade A-2, P-2 50%
Lowest investment grade A-3, P-3 100%
Below investment grade Not prime Not eligible for ratings-
based approach
Trading and Capital-Markets Activities Manual April 2002
Page 9
3020.1 Securitization and Secondary-Market Credit Activities
investment grade or better, for long-term posi- by the risk weight and 8 percent, but is never
tions, or investment grade or better, for short- greater than the full capital charge that would
term positions; (3) publicly available; and apply if the assets were held on the balance
(4) based on the same criteria used to rate traded sheet.
positions. Again, the lowest rating will deter- Residual interests that are not eligible for the
mine the applicable risk weight. ratings-based approach require dollar-for-dollar
An unrated position that is senior or preferred treatment; that is, for every dollar of residual
in all respects (including collateralization and interest, one dollar of capital must be held. A
maturity) to a rated and traded subordinated banking organization is permitted to net from
position may be treated as if it has the same the capital requirement any deferred tax liability
rating assigned to the subordinated position. held on its balance sheet that is directly associ-
Before using this approach, the banking organi- ated with the residual interests.
zation must demonstrate to its supervisor’s sat- A special concentration limit of 25 percent of
isfaction that such treatment is appropriate. tier 1 capital applies to retained and purchased
A banking organization may use a program or credit-enhancing I/O strips. The gross dollar
computer rating obtained from a rating agency amount (before netting any deferred tax liabil-
for unrated direct-credit substitutes or recourse ity) of credit-enhancing I/O strips that exceeds
obligations (but not residual interests) in certain 25 percent of tier 1 capital must be deducted
structured-finance programs.9 Before using this from tier 1 capital. The deduction may be made
approach, a banking organization must demon- net of any related deferred tax liabilities. This
strate to its primary regulator that the rating concentration limit affects both leverage and
generally meets the standards used by the rating risk-based capital ratios.
agency for rating similarly traded positions.
In addition, the banking organization must dem- Permissible uses of banking organizations’
onstrate that it is reasonable and consistent internal risk ratings. The rule provides limited
with the rule to rely on the ratings assigned opportunities for banking organizations to use
under the structured-finance program. Risk their internal risk-rating systems to assign risk-
weights derived in this manner may not be lower based capital charges to a narrow range of
than 100 percent. exposures. A banking organization with a quali-
fying internal risk-rating system may use its
Interests ineligible for the ratings-based internal rating system to apply the ratings-based
approach. Banking organizations that hold approach to its unrated direct-credit substitutes
recourse obligations and direct-credit substitutes extended to asset-backed commercial paper pro-
(other than residual interests) that do not qualify grams. The risk weight assigned under this
for the ratings-based approach must hold capital approach may not be less than 100 percent.
against the amount of the position plus all more A qualifying internal risk-rating system is one
senior positions, subject to the low-level-recourse that is approved by the organization’s primary
rule.10 This is referred to as ‘‘gross-up treat- regulator (that is, the applicable Reserve Bank
ment.’’ The grossed-up amount is placed in a and the Board, for Federal Reserve–supervised
risk-weight category by reference to the obligor, entities) before use. In general, a qualifying
or, if applicable, the guarantor or nature of the system is an integral part of an effective risk-
collateral. The grossed-up amount is multiplied management system that explicitly incorporates
the full range of risks from securitization activi-
9. Structured-finance programs are programs in which ties. The system must (1) be capable of linking
receivable interests and asset-backed securities issued by
multiple participants are purchased by a special-purpose entity
ratings to measurable outcomes; (2) separately
that repackages these exposures into securities that can be sold consider the risk associated with the underlying
to investors. loans and borrowers and the risks associated
10. The low-level-recourse rule provides that if the maxi- with specific positions in the securitization trans-
mum contractual exposure to loss in connection with a
recourse obligation or direct-credit substitute is less than the
action; (3) identify gradations of risk among
risk-based capital requirement for the assets, the risk-based ‘‘pass’’ assets; and (4) classify assets into risk
capital requirement is limited to the maximum contractual grades using clear, explicit factors. The banking
exposure, less any recourse liability account established in organization must have an independent review
accordance with GAAP. The low-level-recourse rule does not
apply when a banking organization provides credit enhance-
function to assign or review credit-risk ratings,
ment beyond any contractual obligation to support the assets periodically verify ratings, track ratings perfor-
it has sold. mance over time, and make adjustments when
April 2002 Trading and Capital-Markets Activities Manual
Page 10
Securitization and Secondary-Market Credit Activities 3020.1
warranted. Ratings assumptions must be consis- incorporates the risks involved in its securitiza-
went with, or more conservative than, those tion activities into its overall risk-management
applied by the rating agencies. process. The process should entail (1) inclusion
of risk exposures in reports to the institution’s
senior management and board to ensure proper
Small-Business Obligations management oversight; (2) adoption of appro-
priate policies, procedures, and guidelines to
Another divergence from the general risk-based manage the risks involved; (3) appropriate mea-
capital treatment for assets sold with recourse surement and monitoring of risks; and (4) assur-
concerns small-business obligations. Qualifying ance of appropriate internal controls to verify
institutions that transfer small-business obliga- the integrity of the management process with
tions with recourse are required, for risk-based respect to these activities. The formality and
capital purposes, to maintain capital only against sophistication of an institution’s risk-management
the amount of recourse retained, provided two system should be commensurate with the nature
conditions are met. First, the transactions must and volume of its securitization activities. Insti-
be treated as a sale under GAAP, and second, the tutions with significant activities in this area are
transferring institutions must establish, pursuant expected to have more elaborate and formal
to GAAP, a noncapital reserve sufficient to meet approaches to manage the risk of their secondary-
the reasonably estimated liability under their market credit activities.
recourse arrangements.
Banking organizations will be considered
qualifying if, pursuant to the Board’s prompt- Board and Senior Management
corrective-action regulation (12 CFR 208.30),
they are well capitalized or, by order of the
Oversight
Board, adequately capitalized. To qualify, an
institution must be determined to be well capi- Both the board of directors and senior manage-
talized or adequately capitalized without taking ment are responsible for ensuring that they fully
into account the preferential capital treatment understand the degree to which the organization
for any previous transfers of small-business is exposed to the credit, market, liquidity, oper-
obligations with recourse. The total outstanding ational, legal, and reputational risks involved in
amount of recourse retained by a qualifying the institution’s securitization activities. They
banking organization on transfers of small- are also responsible for ensuring that the formal-
business obligations receiving the preferential ity and sophistication of the techniques used to
capital treatment cannot exceed 15 percent of manage these risks are commensurate with the
the institution’s total risk-based capital. level of the organization’s activities. The board
should approve all significant policies relating to
risk management of securitization activities and
Standby Letters of Credit should ensure that risk exposures are fully
incorporated in board reports and risk-
Banking organizations that issue standby letters management reviews.
of credit as credit enhancements for ABS issues
must hold capital against these contingent liabili-
ties under the risk-based capital guidelines. Policies and Procedures
According to the guidelines, financial standby
letters of credit are direct-credit substitutes, Senior management is responsible for ensuring
which are converted in their entirety to credit- that the risks arising from securitization activi-
equivalent amounts. The credit-equivalent ties are adequately managed on both a short-
amounts are then risk-weighted according to the term and long-run basis. Management should
type of counterparty or, if relevant, to any ensure that there are adequate policies and
guarantee or collateral. procedures in place for incorporating the risk of
these activities into the overall risk-management
process of the institution. Policies should ensure
SOUND RISK-MANAGEMENT that the economic substance of the risk expo-
PRACTICES sures generated by these activities is fully rec-
ognized and appropriately managed. In addition,
Examiners should verify that an institution banking organizations involved in securitization
Trading and Capital-Markets Activities Manual April 2002
Page 10.1
3020.1 Securitization and Secondary-Market Credit Activities
activities should have appropriate policies, behavior that could have unfavorable effects on
procedures, and controls for underwriting asset- the institution and then assessing the organiza-
backed securities; funding the possible return of tion’s ability to withstand them. Stress testing
revolving receivables (for example, credit card should consider not only the probability of
receivables and home equity lines); and estab- adverse events, but also likely worst-case sce-
lishing limits on exposures to individual insti- narios. Analysis should be on a consolidated
tutions, types of collateral, and geographic and basis and consider, for instance, the effect of
industrial concentrations. Policies should specify higher than expected levels of delinquencies and
a consistently applied accounting methodology defaults, as well as the consequences of early-
and valuation methods, including FAS 140 amortization events for credit card securities,
residual-value assumptions and the procedures that could raise concerns about the institution’s
to change those assumptions. capital adequacy and its liquidity and funding
capabilities. Stress-test analyses should also
include contingency plans for possible manage-
Risk Measurement and Monitoring ment actions in certain situations.
An institution’s management information and
risk-measurement systems should fully incor- Valuation of Retained Interests
porate the risks involved in its securitization
activities. Banking organizations must be able to Retained interests from securitization activities,
identify credit exposures from all securitization including interest-only strips receivable, arise
activities and to measure, quantify, and control when a banking organization keeps an interest in
those exposures on a fully consolidated basis. the assets sold to a securitization vehicle that, in
The economic substance of the credit exposures turn, issues bonds to investors. The methods and
of securitization activities should be fully incor- models that banking organizations use to value
porated into the institution’s efforts to quantify retained interests, as well as the difficulties in
its credit risk, including efforts to establish more managing exposure to these volatile assets, can
formal grading of credits to allow for statisti- raise supervisory concerns. SR-99-37 and its
cal estimation of loss-probability distributions. reference interagency guidance (included in the
Securitization activities should also be included ‘‘Selected Federal Reserve SR-Letters’’ at the
in any aggregations of credit risk by borrower, end of this section) address the risk management
industry, or economic sector. and valuation of retained interests arising from
An institution’s information systems should asset-securitization activities.
identify and segregate those credit exposures Appropriate valuation and modeling method-
arising from the institution’s loan-sale and ologies should be used in valuing retained inter-
securitization activities. These exposures include ests. The carrying value of a retained interest
the sold portions of participations and syndica- should be fully documented, based on reason-
tions; exposures arising from the extension of able assumptions, and regularly analyzed for
credit-enhancement and liquidity facilities; the any impairment in value. When quoted market
effects of an early-amortization event; and the prices are not available, accounting rules allow
investment in asset-backed securities. Manage- fair value to be estimated. An estimate must be
ment reports should provide the board and based on the ‘‘best information available in the
senior management with timely and sufficient circumstances’’ and supported by reasonable
information to monitor the institution’s expo- and current assumptions. If a best estimate of
sure limits and overall risk profile. fair value is not practicable, the asset is to be
recorded at zero in financial and regulatory
reports.
Stress Testing
The use of stress testing, including combina- Internal Controls
tions of market events that could affect a bank-
ing organization’s credit exposures and securi- One of management’s most important responsi-
tization activities, is another important element bilities is establishing and maintaining an effec-
of risk management. Stress testing involves tive system of internal controls. Among other
identifying possible events or changes in market things, internal controls should enforce the offi-
April 2002 Trading and Capital-Markets Activities Manual
Page 10.2
Securitization and Secondary-Market Credit Activities 3020.1
cial lines of authority and the appropriate sepa- these reports to compare historical perfor-
ration of duties in managing the institution’s mance trends with underwriting standards,
risks. These internal controls must be suitable including the use of a validated credit-scoring
for the type and level of risks at the institution, model, to ensure loan pricing is consistent
given the nature and scope of its activities. with risk levels. Vintage analysis also helps in
Moreover, internal controls should ensure that the comparison of deal performance at peri-
financial reporting is reliable (in published finan- odic intervals and validates retained-interest
cial reports and regulatory reports), including valuation assumptions.
the reporting of adequate allowances or liabili- • Static-pool cash-collection analysis. A static-
ties for expected losses. pool cash-collection analysis involves review-
The internal-control and risk-management ing monthly cash receipts relative to the
function should also ensure that appropriate principal balance of the pool to determine the
management information systems (MIS) exist to cash yield on the portfolio, comparing the
monitor securitization activities. Reporting and cash yield with the accrual yield, and tracking
documentation methods must support the initial monthly changes. Management should com-
valuation of retained interests and ongoing im- pare monthly the timing and amount of cash
pairment analyses of these assets. Pool- flows received from the trust with those pro-
performance information will help well-managed jected as part of the FAS 140 retained-interest
banking organizations ensure, on a qualitative valuation analysis. Some master-trust struc-
basis, that a sufficient amount of economic tures allow excess cash flow to be shared
capital is being held to cover the various risks between series or pools. For revolving-asset
inherent in securitization transactions. The trusts with this master-trust structure, manage-
absence of quality MIS will hinder manage- ment should perform a cash-collection analy-
ment’s ability to monitor specific pool perfor- sis for each master-trust structure. These analy-
mance and securitization activities. ses are essential in assessing the actual
At a minimum, MIS reports should address performance of the portfolio in terms of default
the following: and prepayment rates. If cash receipts are less
than those assumed in the original valuation of
• Securitization summaries for each transac- the retained interest, this analysis will provide
tion. The summary should include relevant management and the board with an early
transaction terms such as collateral type, warning of possible problems with collections
facility amount, maturity, credit-enhancement or extension practices and impairment of the
and subordination features, financial cov- retained interest.
enants (termination events and spread-account • Sensitivity analysis. A sensitivity analysis mea-
capture ‘‘triggers’’), right of repurchase, and sures the effect of changes in default rates,
counterparty exposures. Management should prepayment or payment rates, and discount
ensure that the summaries for each transaction rates to assist management in establishing and
are distributed to all personnel associated with validating the carrying value of the retained
securitization activities. interest. Stress tests should be performed at
• Performance reports by portfolio and specific least quarterly. Analyses should consider
product type. Performance factors include potential adverse trends and determine ‘‘best,’’
gross portfolio yield, default rates and loss ‘‘probable,’’ and ‘‘worst-case’’ scenarios for
severity, delinquencies, prepayments or pay- each event. Other factors that need to be
ments, and excess spread amounts. The reports considered are the impact of increased defaults
should reflect the performance of assets, both on collections staffing, the timing of cash
on an individual-pool basis and for total flows, spread-account capture triggers, over-
managed assets. These reports should segre- collateralization triggers, and early-
gate specific products and different marketing amortization triggers. An increase in defaults
campaigns. can result in higher than expected costs and a
• Vintage analysis for each pool using monthly delay in cash flows, thus decreasing the value
data. Vintage analysis will help management of the retained interests. Management should
understand historical performance trends and periodically quantify and document the poten-
their implications for future default rates, tial impact to both earnings and capital, and
prepayments, and delinquencies, and therefore report the results to the board of directors.
retained interest values. Management can use Management should incorporate this analysis
Trading and Capital-Markets Activities Manual April 2002
Page 10.3
3020.1 Securitization and Secondary-Market Credit Activities
into their overall interest-rate risk measure-
ment system.11
• Statement of covenant compliance. Ongoing
compliance with deal-performance triggers as
defined by the pooling and servicing agree-
ments should be affirmed at least monthly.
Performance triggers include early amortiza-
tion, spread capture, changes to overcollater-
alization requirements, and events that would
result in servicer removal.
EXAMINATION GUIDELINES
A banking organization may be involved in
asset securitization in many ways: originating
the assets to be pooled, packaging the assets for
securitization, servicing the pooled assets, act-
ing as trustee for the pool, providing credit
enhancements, underwriting or placing the ABS,
or investing in the securities. Individual securi-
tization arrangements often possess unique fea-
tures, and the risks addressed in this abbreviated
version of the examiner guidelines do not apply
to all securitization arrangements.12 Arrange-
ments may also entail risks not summarized
11. The Joint Agency Policy Statement on Interest-Rate
Risk (see SR-96-13) advises institutions with a high level of
exposure to interest-rate risk relative to capital that they will
be directed to take corrective action.
12. A complete version of the Examination Guidelines for
Asset Securitization is attached to SR-90-16.
April 2002 Trading and Capital-Markets Activities Manual
Page 10.4
Securitization and Secondary-Market Credit Activities 3020.1
here. Examiners should judge a banking organi- Analysis of the underlying assets should be
zation’s exposure to securitization with refer- conducted independently by each participant
ence to the specific structures in which the in the process, giving consideration to yield,
organization is involved, and the degree to maturity, credit risk, prepayment risk, and the
which the organization has identified exposures accessibility of collateral in cases of default. An
and implemented policies and controls to man- originator should further consider the impact of
age them. Examiners may tailor the scope of securitization on the remaining asset portfolio
their examinations if the banking organization’s and on the adequacy of loan-loss reserves and
involvement in securitization is immaterial rela- overall capital.
tive to its size and financial strength. The financial position and operational capac-
Examiners should determine if a banking ity should be adequate to meet obligations to
organization involved in the issuance of ABS as other parties in a securitization arrangement,
originator, packager, servicer, credit enhancer, even under adverse scenarios. Accordingly, a
underwriter, or trustee has adequately analyzed banking organization should ensure that the
the assets underlying the asset-backed security pricing of services is adequate to cover costs
and the structure of its transactions, including— over the term of the obligation, as well as to
compensate for associated risks. Furthermore,
• the characteristics and expected performance the organization should have contingency plans
of the underlying assets, to transfer responsibilities to another institution
• the banking organization’s ability to meet its in the event that those responsibilities can no
obligations under the securitization arrange- longer be fulfilled.
ment, and
• the ability of the other participants in the
arrangement to meet their obligations.
Trading and Capital-Markets Activities Manual February 1998
Page 11
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D.C. 20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 97-21 (SUP)
July 11, 1997
TO THE OFFICER IN CHARGE OF SUPERVISION
AT EACH FEDERAL RESERVE BANK
SUBJECT: Risk Management and Capital Adequacy of Exposures Arising from
Secondary Market Credit Activities
Introduction and Overview
In recent years, some banking organizations have substantially increased
their secondary market credit activities such as loan syndications, loan sales and
participations, credit derivatives, and asset securitizations, as well as the provision of
credit enhancements and liquidity facilities to such transactions. These activities can
enhance both credit availability and bank profitability, but managing the risks of these
activities poses increasing challenges. This is because the risks involved, while not
new to banking, may be less obvious and more complex than the risks of traditional
lending activities. Some secondary market credit activities involve credit, liquidity,
operational, legal, and reputational risks in concentrations and forms that may not be
fully recognized by bank management or adequately incorporated in an institution’s risk
management systems. In reviewing these activities, supervisors and examiners should
assess whether banking organizations fully understand and adequately manage the full
range of the risks involved in secondary market credit activities.
The heightened need for management attention to these risks is
underscored by reports from examiners, senior lending officer surveys, and discussions
with trade and advisory groups that have indicated that competitive conditions over the
past few years have encouraged an easing of credit terms and conditions in both
commercial and consumer lending. In addition, indications are that some potential
participants in loan syndications have felt it necessary to make complex credit decisions
within a much shorter timeframe than has been customary. Although the recent easing
may not be imprudent, the incentives and pressures to lower credit standards have
increased as competition has intensified and borrowers have experienced generally
favorable business and economic conditions. Supervisors and bank management alike
should remain alert to the possibility that loan performance could deteriorate if certain
February 1998 Trading and Capital-Markets Activities Manual
Page 12
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
sectors of the economy experience problems. The recent rise in consumer
bankruptcies, credit card delinquencies, and credit charge-offs illustrates this concern.
These types of developments could have significant implications for the risks
associated with secondary market credit activities.
This letter identifies some of the important risks involved in several of the
more common types of secondary market credit activities. It also provides guidance on
sound practices and discusses special considerations supervisors should take into
account in assessing the risk management systems for these activities. A copy of this
letter should be sent to each state member bank, bank holding company, Edge
corporation, and U.S. branch or agency of a foreign bank. A suggest transmittal letter
is attached.
A fundamental principle advanced by this guidance is that banking
institutions should explicitly incorporate the full range of risks of their secondary market
credit activities into their overall risk management systems. In particular, supervisors
and examiners should determine whether institutions are recognizing the risks of
secondary market credit activities by: 1) adequately identifying, quantifying, and
monitoring these risks; 2) clearly communicating the extent and depth of these risks in
reports to senior management and the board of directors and in regulatory reports; 3)
conducting ongoing stress testing to identify potential losses and liquidity needs under
adverse circumstances; and 4) setting adequate minimum internal standards for
allowances or liabilities for losses, capital, and contingency funding. Incorporating
secondary market credit activities into banking organizations’ risk management systems
and internal capital adequacy allocations is particularly important since the current
regulatory capital rules do not fully capture the economic substance of the risk
exposures arising from many of these activities.
Failure to understand adequately the risks inherent in secondary market
credit activities and to incorporate them into risk management systems and internal
capital allocations may constitute an unsafe and unsound banking practice.
Scope
This guidance applies to the secondary market credit activities conducted
by state member banks, bank holding companies, Edge corporations and U.S.
branches and agencies of foreign banks.1 For purposes of this guidance, secondary
market credit activities include, but are not limited to, loan syndications, loan
participations, loan sales and purchases, credit derivatives, asset securitization, and
1 This guidance applies to U.S. branches and agencies of foreign banks with recognition that
appropriate adaptations may be necessary to reflect that: 1) those offices are an integral part of a foreign
bank, which should be managing its risks on a consolidated basis and recognizing possible obstacles to
cash movements among branches, and 2) the foreign bank is subject to overall supervision by its home
country authorities.
-2-
Trading and Capital-Markets Activities Manual April 2002
Page 13
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
both implied and direct credit enhancements that may support these or the related
activities of the institution, its affiliates, or third parties. Asset securitization activities
refer to issuance, underwriting, and servicing of asset-backed securities; provision of
credit or liquidity enhancements to securitized transactions; and investment in asset-
backed securities. This guidance builds on, supports, and is fully consistent with
existing guidance on risk management issued by the Federal Reserve.2
Background
Improvements in technology, greater standardization of lending products,
and the use of credit enhancements have helped to increase dramatically the volume of
loan syndications, loan sales, loan participations, asset securitizations, and credit
guarantees undertaken by commercial banks, affiliates of bank holding companies, and
some U.S. branches and agencies of foreign banks. In addition, the advent of credit
derivatives permits banking organizations to trade credit risk, manage it in isolation from
other types of risk, and maintain credit relationships while transferring the associated
credit risk. These developments have improved the availability of credit to businesses
and consumers, allowed management to better tailor the mix of credit risk within loan
and securities portfolios, and helped to improve overall bank profitability.
At the same time, however, certain credit and liquidity enhancements that
banking organizations provide to facilitate various secondary market credit activities
may make the evaluation of the risks of these activities less straightforward than the
risks involved in traditional banking activities in which assets are held in their entirety on
the balance sheet of the originating institution. These enhancements, or guarantees,
generally manifest themselves as recourse provisions, securitization structures that
entail credit-linked early amortization and collateral replacement events, and direct
credit substitutes such as letters of credit and subordinated interests that, in effect,
provide credit support to secondary market instruments and transactions.3
2 For a more detailed discussion of risk management, refer to SR letter 95-51, "Rating the Adequacy of
Risk Management Processes and Internal Controls at State Member Banks and Bank Holding
Companies;" SR letter 95-17, "Evaluating the Risk Management and Internal Controls of Securities and
Derivative Contracts Used in Nontrading Activities;" SR letter 93-69, "Risk Management and Internal
Controls for Trading Activities of Banking Organizations;" and SR letter 90-16, "Implementation of
Examination Guidelines for the Review of Asset Securitization Activities."
3 Examiners should also review SR letter 96-30, "Risk-Based Capital Treatment for Spread Accounts
that Provide Credit Enhancement for Securitized Receivables." In addition, banking organizations have
retained the risk of loss, i.e., recourse, on sales and securitizations of assets when, in accordance with
generally accepted accounting principles, they record on their balance sheets interest-only strip
receivables or other assets that serve as credit enhancements. For more information, see Statement of
Financial Accounting Standard No. 125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities"* and the instructions to the Reports of Income and Condition.
-3-
* FAS 140 has superseded FAS 125.
April 2002 Trading and Capital-Markets Activities Manual
Page 14
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
The transactions that such enhancements are associated with tend to be
complex and may expose institutions extending the enhancements to hidden
obligations that may not become evident until the transactions deteriorate. In
substance, such activities move the credit risk off the balance sheet by shifting risks
associated with traditional on-balance-sheet assets into off-balance-sheet contingent
liabilities. Given the potential complexity and, in some cases, the indirect nature of
these enhancements, the actual credit risk exposure can be difficult to assess,
especially in the context of traditional credit risk limit, measurement, and reporting
systems.
Moreover, many secondary market credit activities involve new and
compounded dimensions of reputational, liquidity, operational and legal risks that are
not readily identifiable and may be difficult to control. For example, recourse provisions
and certain asset-backed security structures can give rise to significant reputational and
liquidity risk exposures and ongoing management of underlying collateral in
securitization transactions can expose an institution to unique operating and legal risks.
Accordingly, for those institutions involved in providing credit
enhancements in connection with loan sales and securitizations, and those involved in
credit derivatives and loan syndications, supervisors and examiners should assess
whether the institutions’ systems and processes adequately identify, measure, monitor,
and control all of the risks involved in the secondary market credit activities. In
particular, the risk management systems employed should include the identification,
measurement, and monitoring of these risks as well as an appropriate methodology for
the internal allocation of capital and reserves. The stress testing conducted within the
risk measurement element of the management system should fully incorporate the risk
exposures of these activities under various scenarios to identify their potential effect on
an institution’s liquidity, earnings, and capital adequacy. Moreover, management
reports should adequately communicate to senior management and the board of
directors the risks associated with these activities and the contingency plans that are in
place to deal with adverse conditions.
Credit Risks in Secondary Market Credit Activities
Institutions should be aware that the credit risk involved in many
secondary market credit activities may not always be obvious. For certain types of loan
sales and securitization transactions, a banking organization may actually be exposed
to essentially the same credit risk as in traditional lending activities, even though a
particular transaction may, superficially, appear to have isolated the institution from any
risk exposure. In such cases, removal of an asset from the balance sheet may not
result in a commensurate reduction in credit risk. Transactions that can give rise to
-4-
Trading and Capital-Markets Activities Manual February 1998
Page 15
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
such instances include loan sales with recourse, credit derivatives, direct credit
substitutes, such as letters of credit, and liquidity facilities extended to securitization
programs, as well as certain asset securitization structures, such as the structure
typically used to securitize credit card receivables.
Loan Syndications - Recently, the underwriting standards of some
syndications have been relaxed through the easing or elimination of certain covenants
or the use of interest-only arrangements. Bank management should continually review
syndication underwriting standards and pricing practices to ensure that they remain
consistent over time with the degree of risk associated with the activity and the potential
for unexpected economic developments to affect adversely borrower creditworthiness.
In some cases, potential participants in loan syndications have felt it
necessary to make decisions to commit to the syndication within a shorter period of
time than is customary. Supervisors and examiners should determine whether
syndicate participants are performing their own independent credit analysis of the
syndicated credit and make sure they are not placing undue reliance on the analysis of
the lead underwriter or commercial loan credit ratings. Banking organizations should
not feel pressured to make an irrevocable commitment to participate in a syndication
until such an analysis is complete.
Credit Derivatives - Credit derivatives are off-balance sheet financial
instruments that are used by banking organizations to assume or mitigate the credit risk
of loans and other assets.4 Banking organizations are increasingly employing these
instruments either as end-users, purchasing credit protection from--or providing credit
protection to--third parties, or as dealers intermediating such protection. In reviewing
credit derivatives, supervisors should consider the credit risk associated with the
reference asset, as well as general market risk and the risk of the counterparty to the
contract.
With respect to credit derivative transactions where banking organizations
are mitigating their assets’ credit risk, supervisors and examiners should carefully
review those situations where the reference assets are not identical to the assets
actually owned by the institutions. Supervisors should consider whether the reference
asset is an appropriate proxy for the loan or other asset whose credit exposure the
banking organizations intend to offset.
4 See SR letter 96-17, "Supervisory Guidance for Credit Derivatives," for a discussion of supervisory
issues regarding credit derivatives, including the risk-based capital treatment of credit derivatives held in
the banking book. SR letter 97-18, "Application of Market Risk Capital Requirements to Credit
Derivatives," provides guidance on the risk-based capital treatment of credit derivatives held in the trading
book.
-5-
February 1998 Trading and Capital-Markets Activities Manual
Page 16
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
Recourse Obligations and Direct Credit Substitutes - Partial, first loss
recourse obligations retained when selling assets, and the extension of partial credit
enhancements (e.g., 10 percent letters of credit) can be a source of concentrated credit
risk by exposing institutions to the full amount of expected losses on the protected
assets. For instance, the credit risk associated with whole loans or pools of assets that
are sold to secondary market investors can often be concentrated within the partial, first
loss recourse obligations retained by banking organizations selling and securitizing the
assets. In these situations, even though institutions may have reduced their exposure
to catastrophic loss on the assets sold, they generally retain the same credit risk
exposure as if they continued to hold the assets on their balance sheets.
In addition to recourse obligations, institutions assume concentrated credit
risk through the extension of partial direct credit substitutes such as through the
purchase of subordinated interests and extension of letters of credit. For example,
banking organizations that sponsor certain asset-backed commercial paper programs,
or so-called "remote origination" conduits, can be exposed to high degrees of credit risk
even though it may seem that their notional exposure is minimal. Such a remote
origination conduit lends directly to corporate customers referred to it by the sponsoring
banking organization that used to lend directly to these same borrowers. The conduit
funds this lending activity by issuing commercial paper that, in turn, is guaranteed by
the sponsoring banking organization. The net result is that the sponsoring institution
has much the same credit risk exposure through this guarantee as if it had made the
loans directly and held them on its books. However, such credit extension is an off-
balance-sheet transaction and the associated risks may not be fully reflected in the
institution’s risk management system.
Furthermore, banking organizations that extend liquidity facilities to
securitized transactions, particularly asset-backed commercial paper programs, may be
exposed to high degrees of credit risk which may be subtly embedded within the
facilities’ provisions. Liquidity facilities are commitments to extend short-term credit to
cover temporary shortfalls in cash flow. While all commitments embody some degree
of credit risk, certain commitments extended to asset-backed commercial paper
programs in order to provide liquidity may subject the extending institution to the credit
risk of the underlying asset pool, often trade receivables, or of a specific company using
the program for funding. Often the stated purpose of such liquidity facilities is to
provide funds to the program to retire maturing commercial paper when a mismatch
occurs in the maturities of the underlying receivables and the commercial paper, or
when a disruption occurs in the commercial paper market. However, depending upon
the provisions of the facility--such as whether the facility covers dilution of the
underlying receivable pool--credit risk can be shifted from the program’s explicit credit
-6-
Trading and Capital-Markets Activities Manual February 1998
Page 17
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
enhancements to the liquidity facility.5 Such provisions may enable certain programs to
fund riskier assets and yet maintain the credit rating on the program’s commercial paper
without increasing the program’s credit enhancement levels.
Asset Securitization Structures - The structure of various securitization
transactions can also result in an institution retaining the underlying credit risk in a sold
pool of assets. Examples of this contingent credit risk retention include credit card
securitizations where the securitizing organization explicitly sells the credit card
receivables to a master trust, but, in substance, retains the majority of the economic risk
of loss associated with the assets because of the credit protection provided to investors
by the excess yield, spread accounts, and structural provisions of the securitization.
Excess yield provides the first level of credit protection that can be drawn upon to cover
cash shortfalls between the principal and coupon owed to investors and the investors’
pro rata share of the master trust’s net cash flows. The excess yield is equal to the
difference between the overall yield on the underlying credit card portfolio and the
master trust’s operating expenses.6 The second level of credit protection is provided by
the spread account, which is essentially a reserve funded initially from the excess yield.
In addition, the structural provisions of credit card securitizations generally
provide credit protection to investors through the triggering of early amortization events.
Such an event usually is triggered when the underlying pool of credit card receivables
deteriorates beyond a certain point and requires that the outstanding credit card
securities begin amortizing early in order to pay off investors before the prior credit
enhancements are exhausted. As the early amortization accelerates the redemption of
principal (paydown) on the security, the credit card accounts that were assigned to the
master credit card trust return to the securitizing institution more quickly than had
originally been anticipated, thus, exposing the institution to liquidity pressures and any
further credit losses on the returned accounts.
Reputational Risks
The secondary market credit activities of many institutions may also
expose them to significant reputational risks. Loan syndication underwriting may
present significant reputational risk exposure to lead underwriters because syndicate
participants may seek to hold the lead underwriter responsible for actual or perceived
5 Dilution essentially occurs when the receivables in the underlying asset pool--prior to collection--are
no longer viable financial obligations of the customer. For example, dilution can arise from returns of
consumer goods or unsold merchandise by retailers to manufacturers or distributors.
6 The monthly excess yield is the difference between the overall yield on the underlying credit card
portfolio and the master trust’s operating expenses. It is calculated by subtracting from the gross portfolio
yield the (1) coupon paid to investors, (2) charge-offs for that month, and (3) servicing fee, usually 200
basis points paid to the banking organization sponsoring the securitization.
-7-
February 1998 Trading and Capital-Markets Activities Manual
Page 18
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
inadequacies in the loan’s underwriting even though participants are responsible for
conducting an independent due diligence evaluation of the credit. Such risk may be
compounded by the rapid growth of new investors in this market, usually nonbanks that
may not have previously endured a downturn in the loan market.
There is the potential that pressure may be brought to bear on the lead
participant to repurchase portions of the syndication if the credit deteriorates in order to
protect its reputation in the market even though the syndication was sold without
recourse. In addition, the deterioration of the syndicated credit also exposes the lead
organization to possible litigation, as well as increased operational and credit risk. One
way to mitigate reputational risk with respect to syndications is for banking
organizations to know their customers and to determine whether syndication customers
are in a position to conduct their own evaluation of the credit risks involved in the
transaction.
Asset securitization programs also can be a source of increasing
reputational risk. Often, banking organizations sponsoring the issuance of asset-
backed securities act as servicer, administrator, or liquidity provider in the securitization
transaction. It is imperative that these institutions are aware of the potential losses and
risk exposure associated with reputational risk. The securitization of assets whose
performance has deteriorated may result in a negative market reaction that could
increase the spreads on an institution’s subsequent issuances. In order to avoid a
possible increase in their funding costs, institutions have supported their securitization
transactions by improving the performance of the securitized asset pool. This has been
accomplished, for example, by selling discounted receivables or adding higher quality
assets to the securitized asset pool. Thus, an institution’s voluntary support of its
securitization in order to protect its reputation can adversely affect the
sponsoring/issuing organization’s earnings and capital.
These and other methods of improving the credit quality of securitized
asset pools have been used recently by banking organizations providing voluntary
support to their securitizations, especially for credit card master trusts. Such actions
generally are taken to avoid either a rating downgrade or an early amortization of the
outstanding asset-backed securities.
Liquidity Risks
The existence of recourse provisions in asset sales, the extension of
liquidity facilities to securitization programs, and the early amortization triggers of
certain asset securitization transactions can involve significant liquidity risk to
institutions engaged in these secondary market credit activities. Institutions should
ensure that their liquidity contingency plans fully incorporate the potential risk posed by
their secondary market credit activities. With the issuance of new asset-backed
-8-
Trading and Capital-Markets Activities Manual February 1998
Page 19
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
securities, the issuing banking organization should determine the potential effect on its
liquidity at the inception of each transaction and throughout the life of the securities in
order to better ascertain its future funding needs.
An institution’s contingency plans should take into consideration the need
to obtain replacement funding, and specify the possible alternative funding sources, in
the event of the amortization of outstanding asset-backed securities. This is particularly
important for securitizations with revolving receivables, such as credit cards, where an
early amortization of the asset-backed securities could unexpectedly return the
outstanding balances of the securitized accounts to the issuing institution’s balance
sheet. It should be recognized that an early amortization of a banking organization’s
asset-backed securities could impede its ability to fund itself--either through re-issuance
or other borrowings--since the institution’s reputation with investors and lenders may be
adversely affected.
Incorporating the Risks of Secondary Market Credit Activities
Into Risk Management
Supervisors should verify that an institution incorporates in its overall risk
management system the risks involved in its secondary market credit activities. The
system should entail: 1) inclusion of risk exposures in reports to the institution’s senior
management and board to ensure proper management oversight; 2) adoption of
appropriate policies, procedures, and guidelines to manage the risks involved;
3) appropriate measurement and monitoring of risks; and 4) assurance of appropriate
internal controls to verify the integrity of the management process with respect to these
activities. The formality and sophistication with which the risks of these activities are
incorporated into an institution’s risk management system should be commensurate
with the nature and volume of its secondary market credit activities. Institutions with
significant activities in this area are expected to have more elaborate and formal
approaches to manage the risk of their secondary market credit activities.
Both the board of directors and senior management are responsible for
ensuring that they fully understand the degree to which the organization is exposed to
the credit, market, liquidity, operational, legal, and reputational risks involved in the
institution’s secondary market credit activities. They are also responsible for ensuring
that the formality and sophistication of the techniques used to manage these risks are
commensurate with the level of the organization’s activities. The board should approve
all significant polices relating to the management of risk arising from secondary market
credit activities and should ensure that the risk exposures are fully incorporated in
board reports and risk management reviews.
Senior management is responsible for ensuring that the risks arising from
secondary market credit activities are adequately managed on both a short-term and
-9-
February 1998 Trading and Capital-Markets Activities Manual
Page 20
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
long-run basis. Management should ensure that there are adequate policies and
procedures in place for incorporating the risk of these activities into the overall risk
management process of the institution. Such policies should ensure that the economic
substance of the risk exposures generated by these activities is fully recognized and
appropriately managed. In addition, banking organizations involved in securitization
activities should have appropriate policies, procedures, and controls with respect to
underwriting asset-backed securities; funding the possible return of revolving
receivables (e.g., credit card receivables and home equity lines); and establishing limits
on exposures to individual institutions, types of collateral, and geographic and industrial
concentrations. Lead banking organizations in loan syndications should have policies
and procedures in place that address whether or in what situations portions of
syndications may be repurchased. Furthermore, banking organizations participating in
a loan syndication should not place undue reliance on the credit analysis performed by
the lead organization. Rather, the participant should have clearly defined policies and
procedures to ensure that it performs its own due diligence in analyzing the risks
inherent in the transaction.
An institution’s management information and risk measurement systems
should fully incorporate the risks involved in its secondary market credit activities.
Banking organizations must be able to identify credit exposures from all secondary
market credit activities, and be able to measure, quantify, and control those exposures
on a fully consolidated basis. The economic substance of the credit exposures of
secondary market credit activities should be fully incorporated into the institution’s
efforts to quantify its credit risk, including efforts to establish more formal grading of
credits to allow for statistical estimation of loss probability distributions. Secondary
market credit activities should also be included in any aggregations of credit risk by
borrower, industry, or economic sector.
It is particularly important that an institution’s information systems can
identify and segregate those credit exposures arising from the institution’s loan sale and
securitization activities. Such exposures include the sold portions of participations and
syndications; exposures arising from the extension of credit enhancement and liquidity
facilities; the effects of an early amortization event; and the investment in asset-backed
securities. The management reports should provide the board and senior management
with timely and sufficient information to monitor the institution’s exposure limits and
overall risk profile.
Stress Testing
The use of stress testing, including combinations of market events that
could affect a banking organization’s credit exposures and securization activities, is
another important element of risk management. Such testing involves identifying
possible events or changes in market behavior that could have unfavorable effects on
- 10 -
Trading and Capital-Markets Activities Manual February 1998
Page 21
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
the institution and assessing the organization’s ability to withstand them. Stress testing
should not only consider the probability of adverse events, but also likely "worst case"
scenarios. Such an analysis should be done on a consolidated basis and consider, for
instance, the effect of higher than expected levels of delinquencies and defaults as well
as the consequences of early amortization events with respect to credit card securities
that could raise concerns regarding the institution’s capital adequacy and its liquidity
and funding capabilities. Stress test analyses should also include contingency plans
regarding the actions management might take given certain situations.
One of management’s most important responsibilities is establishing and
maintaining an effective system of internal controls that, among other things, enforces
the official lines of authority and the appropriate separation of duties in managing the
risks of the institution. These internal controls must be suitable for the type and level of
risks given the nature and scope of the institution’s activities. Moreover, these internal
controls should provide reasonable assurance of reliable financial reporting (in
published financial reports and regulatory reports), including adequate allowances or
liabilities for expected losses.
Capital Adequacy
As with all risk-bearing activities, institutions should fully support the risk
exposures of their secondary market credit activities with adequate capital. Banking
organizations should ensure that their capital positions are sufficiently strong to support
all of the risks associated with these activities on a fully consolidated basis and should
maintain adequate capital in all affiliated entities engaged in these activities. The
Federal Reserve’s risk-based capital guidelines establish minimum capital ratios, and
those banking organizations exposed to a high or above average degrees of risk are,
therefore, expected to operate significantly above the minimum capital standards.
The current regulatory capital rules do not fully incorporate the economic
substance of the risk exposures involved in many secondary market credit activities.
Therefore, when evaluating capital adequacy, supervisors should ensure that banking
organizations that sell assets with recourse, assume or mitigate credit risk through the
use of credit derivatives, and provide direct credit substitutes and liquidity facilities to
securitization programs, are accurately identifying and measuring these exposures and
maintaining capital at aggregate levels sufficient to support the associated credit,
market, liquidity, reputational, operational, and legal risks.
Supervisors and examiners should review the substance of secondary
market transactions when assessing underlying risk exposures. For example, partial,
first loss direct credit substitutes providing credit protection to a securitization
transaction can, in substance, involve much the same credit risk as that involved in
holding the entire asset pool on the institution’s balance sheet. However, under current
- 11 -
February 1998 Trading and Capital-Markets Activities Manual
Page 22
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
rules, regulatory capital is explicitly required only against the amount of the direct credit
substitute, which can be significantly different from the amount of capital that the
institution should maintain against the concentrated credit risk in the guarantee.
Supervisors and examiners should ensure that banking organizations have
implemented reasonable methods for allocating capital against the economic substance
of credit exposures arising from early amortization events and liquidity facilities
associated with securitized transactions since such facilities are usually structured as
short-term commitments in order to avoid a risk-based capital requirement, even though
the inherent credit risk may be approaching that of a guarantee.7
If, in the supervisor’s judgment, an institution’s capital level is not sufficient
to provide protection against potential losses from such credit exposures, this deficiency
should be reflected in the banking organization’s CAMELS or BOPEC ratings.
Furthermore, supervisors and examiners should discuss the capital deficiency with the
institution’s management and, if necessary, its board of directors. Such an institution
will be expected to develop and implement a plan for strengthening the organization’s
overall capital adequacy to levels deemed appropriate given all the risks to which it is
exposed.
Please forward this letter to each state member bank, bank holding
company, Edge corporation and U.S. branch or agency of a foreign bank located in
your District--a suggested transmittal letter is attached. If you have any questions,
please contact Roger Cole, Deputy Associate Director (202/452-2618), Tom Boemio,
Supervisory Financial Analyst, (202/452-2982) or Jim Embersit, Manager,
(202/452-5249).
Richard Spillenkothen
Director
7 For further guidance on distinguishing, for risk-based capital purposes, whether a facility is a short-
term commitment or a direct credit substitute, refer to SR letter 92-11, "Asset-Backed Commercial Paper
Programs." Essentially, facilities that provide liquidity, but which also provide credit protection to
secondary market investors, are to be treated as direct credit substitutes for purposes of risk-based
capital.
- 12 -
Trading and Capital-Markets Activities Manual February 1998
Page 23
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D.C. 20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 97-18 (GEN)
June 13, 1997
TO THE OFFICER IN CHARGE OF SUPERVISION
AT EACH FEDERAL RESERVE BANK
SUBJECT: Application of Market Risk Capital Requirements to Credit Derivatives
In December 1995, the Basle Supervisors Committee approved an amendment to
the Basle Accord that sets forth capital requirements for exposure to general market risk for all
positions held in an institution’s trading account and for foreign exchange and commodity
positions wherever located, as well as for specific risk of debt and equity positions held in the
trading account.1 In addition, this amendment requires capital to cover counterparty credit
exposure associated with over-the-counter (OTC) derivative positions in accordance with the
credit risk capital requirements set forth in the Basle Accord and implemented in the Federal
Reserve’s risk-based capital guidelines (12 CFR Parts 208 and 225, Appendix A). The
requirements of the U.S. rules implementing the market risk amendment, contained in 12 CFR
Parts 208 and 225, Appendix E,2 were effective on an optional basis beginning January 1, 1997,
with mandatory compliance for certain banking organizations with significant market risk
exposure required as of January 1, 1998.3
1 General market risk refers to changes in the market value of on-balance sheet assets and
liabilities, and off-balance sheet items resulting from broad market movements, such as changes in the
general level of interest rates, equity prices, foreign exchange rates, and commodity prices. Specific risk
refers to changes in the market value of individual positions due to factors other than broad market
movements and includes such risks as the credit risk of an instrument’s issuer.
2 See "Risk-Based Capital Standards: Market Risk," 61 Federal Register 47,358 (1996).
3The market risk amendment applies to banking organizations whose trading activity (on a
worldwide, consolidated basis) equals 1) 10 percent or more of total assets or 2) $1 billion or more.
Trading activity means the gross sum of trading assets and liabilities as reported in the bank’s most recent
quarterly Consolidated Report of Condition and Income (Call Report). Banking supervisors may require an
institution to comply with the market risk capital requirements if deemed necessary for safety and
soundness purposes. An institution that does not meet the applicability criteria may, subject to
supervisory approval, comply voluntarily with the amendment.
February 1998 Trading and Capital-Markets Activities Manual
Page 24
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
This SR letter provides guidance on how credit derivatives held in the trading
account should be treated under the market risk capital requirements by state member banks and
bank holding companies. Specifically, the SR letter defines the risks to which credit derivative
transactions are exposed and sets forth the risk-based capital requirements for each type of risk.
In addition, the SR letter supplements SR letter 96-17 (GEN), dated August 12, 1996, which
provides a detailed discussion of the more prevalent credit derivative structures,4 and provides
guidance on a number of supervisory issues pertaining to the use of credit derivatives, including
the appropriate risk-based capital treatment for credit derivatives held in the banking book. The
risk-based capital guidance set forth in SR letter 96-17 will continue to apply to credit derivatives
held in the trading book of banks that have not implemented the market risk capital rule.
Credit derivatives are financial instruments used to assume or mitigate the credit
risk of loans and other assets through off-balance sheet transactions. Banking organizations may
employ these off-balance sheet instruments either as end-users, purchasing credit protection or
acquiring credit exposure from third parties, or as dealers intermediating such activity. End-user
banking organizations may use credit derivatives to reduce credit concentrations, improve
portfolio diversification, or manage overall credit risk exposure. Although the market for these
instruments is relatively small, banking organizations are entering into credit derivative
transactions with increasing frequency.
U.S. banking supervisors, together with banking supervisors abroad, have been
assessing the use and development of credit derivatives, as well as risk management practices
and risk modeling at major banks for some time. U.S. and international supervisors intend to
continue studying credit derivatives in the marketplace, which may result in additional or revised
guidance on regulatory issues, including the appropriate banking book and trading book capital
treatment.
Definitions
Credit derivative transactions held in the trading account are exposed to
counterparty credit risk and general market risk. In addition, they are exposed to the specific risk
of the underlying reference asset. This specific risk is the same as that associated with a cash
position in a loan or bond. Table 1 defines each of the three risks as they relate to derivatives.
This SR letter describes the three risk elements of credit derivatives against which
banking organizations should hold risk-based capital, based upon three defined types of
positions. These three position types are 1) open positions, 2) matched positions, and
3) offsetting positions. Matched positions encompass long and short positions in
4 These include total rate of return swaps, credit default swaps and credit-linked notes.
-2-
Trading and Capital-Markets Activities Manual February 1998
Page 25
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
Definitions
• Counterparty Credit Risk - The risk arising from
the possibility that the counterparty may default on
amounts owed on a derivative transactions.
• General Market Risk - The risk arising from
changes in the reference asset’s value due to broad
market movements such as changes in the general
level of interest rates.
• Specific Risk - The risk arising from changes in
the reference asset’s value due to factors other
than broad market movements, including changes
in the reference asset’s credit risk.
Table 1
identical credit derivative structures over identical maturities referencing identical assets.5
Offsetting positions encompass long and short credit derivative positions in reference assets
of the same obligor with the same level of seniority in bankruptcy. Offsetting positions include
positions that would otherwise be matched except that the long and short credit derivative
positions have different maturities or one leg is a total return product and the other is purely
a default product (i.e., credit default swap). Positions that do not qualify as matched or
offsetting are open positions. Table 2 identifies which of the three risk elements is
present for each of the three defined position types.
5 Position structures are matched only if both legs are either total rate of return products or credit
default products. Matching treatment also requires that default definitions include the same credit events,
and that materiality thresholds and other relevant contract terms in the matched positions are not
substantially different. For purposes of this letter, cash instruments are considered total return products.
Hence, a long position in a bond and a short total return swap of identical maturity referencing that bond is
a matched position. If the maturities do not match, or if the swap is a credit default swap, the position is
offsetting (as long as the reference asset has the same obligor and level of seniority as the bond).
-3-
February 1998 Trading and Capital-Markets Activities Manual
Page 26
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
Table 2
Credit Derivatives
Market Risk Capial Framework
Counterparty General Specific
Credit Risk Market Risk Risk
Open Position Y Y Y
Matched Position Y N N
Offsetting Position Y Y (Some) Y (Some)
Y - Risk is present; capital charge is indicated.
N - Risk is not present; no capital charge is indicated.
In summarizing Table 2, it is clear that all credit derivative positions create
exposures to counterparties and, thus, have counterparty risk.6 In the case of matched positions,
counterparty risk is the only risk present. The matched nature of the position eliminates the
general market and specific risk of the reference asset. Both open and offsetting positions have
all three risk elements, but general market and specific risk are present to a significantly lesser
degree in offsetting positions than in open positions.
Market Risk Capital Approach for Credit Derivatives in the Trading Account
General Market Risk
Beginning January 1, 1998, a banking organization subject to the market risk
amendment must use internal models to measure its daily value-at-risk (VAR) for covered
positions located in its trading account and for foreign exchange and commodity positions
6 An exception involves written options where the seller receives the premium at origination. In such
instances, risk-based capital is not required since there is no counterparty risk to the banking organization
writing the option.
-4-
Trading and Capital-Markets Activities Manual February 1998
Page 27
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
wherever located.7 General market risk capital charges for credit derivatives are to be calculated
using internal models in the same manner as for cash market debt instruments.
Specific Risk
As set out in the market risk capital rule, if a banking organization can
demonstrate to the Federal Reserve that its internal model measures the specific risk of its debt
and equity positions in the trading account, and this measure is included in its VAR-based capital
charge, then the bank may reduce or eliminate its specific risk capital charges, subject to the
minimum specific risk charges prescribed in the amendment.8 This SR letter applies the same
treatment to credit derivatives. The Federal Reserve intends to continue discussions with the
banking industry on the measurement and management of specific risk.
Alternatively, standard specific risk charges for credit derivatives may be
calculated using the specific risk weighting factors that apply to the referenced asset. As set forth
in the market risk amendment, matched positions do not incur specific risk charges. For
offsetting positions, standard specific risk charges are to be applied only against the largest leg of
the offsetting credit derivative and cash positions.9 That is, standard specific risk charges are not
to be applied to each leg separately. Open positions attract the same standard specific risk
charges that a cash position in the reference asset would incur.
Counterparty Risk
Counterparty risk is calculated by summing the mark-to-market value of the credit
derivative and an "add-on" factor representing potential future credit exposure. Under the Basle
Accord and the Federal Reserve’s risk-based capital guidelines, the add-on factor is a specified
percentage of notional amount, depending on the type and maturity of the derivative transaction.
In order to calculate a capital charge for counterparty risk for credit derivatives, an appropriate
add-on factor is needed. However, the current matrix of add-on factors in the Basle Accord and
the Federal Reserve’s guidelines does not include a specific factor for credit or other derivatives
for which the underlying transaction is a debt instrument.
7 An institution’s VAR is the estimate of the maximum amount that the value of covered positions could
decline during a fixed holding period within a stated confidence level. Covered positions encompass all
positions in a banking organization’s trading account, as well as all foreign exchange and commodity
positions, whether or not in the trading account. Positions include on-balance-sheet assets and liabilities
and off-balance sheet items. See 12 CFR Parts 208 and 225, Appendix E.
8 The amount of capital held to cover specific risk must be equal to at least 50 percent of the specific
risk charge that would result from the standardized calculation.
9 Exposure is measured by notional amount for credit derivatives or by market value for cash
instruments.
-5-
February 1998 Trading and Capital-Markets Activities Manual
Page 28
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
Based on an analysis of typical debt instruments underlying credit derivative
transactions, the Federal Reserve has determined that the following add-on factors will apply to
credit derivative transactions. The equity add-on factors are to be used when the reference asset
is an investment grade instrument (or its bank-internal equivalent), or where the reference asset is
unrated but well-secured by high-quality collateral. The commodity add-on factor is to be used
when the reference asset is either below investment grade (or its bank-internal equivalent) or is
unrated and unsecured.
If you have questions on the supervisory or capital issues related to credit
derivatives, please contact Roger Cole, Deputy Associate Director (202/452-2618), Norah
Barger, Manager (202/452-2402), or Tom Boemio, Supervisory Financial Analyst (202/452-
2982).
Richard Spillenkothen
Director
-6-
Trading and Capital-Markets Activities Manual February 1998
Page 29
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D.C. 20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 96-30 (SUP)
November 7, 1996
TO THE OFFICER IN CHARGE OF SUPERVISION
AT EACH FEDERAL RESERVE BANK
SUBJECT: Risk-Based Capital Treatment for Spread Accounts that Provide
Credit Enhancement for Securitized Receivables
Overview
This letter provides guidance on the risk-based capital treatment for
transactions in which a bank holding company sells assets and recognizes on its
balance sheet a spread account that furnishes credit enhancement to the assets
old. Such transactions are most commonly found in connection with the
securitization of credit card receivables and are deemed to be asset sales with
recourse. The treatment set forth in this letter is a clarification and reiteration of
existing policy and is consistent with the effective risk-based capital treatment of
spread accounts for commercial banks.
In accordance with the Federal Reserve’s capital adequacy guidelines,
a bank holding company that has recorded on its balance sheet a spread account
associated with assets it has sold must hold 8 percent capital against the full
amount of assets transferred, and not just against the amount of the spread
account. However, in most cases, the total capital charge may be limited to the
dollar amount of the spread account in accordance with the low level recourse
capital treatment.
Role of Spread Accounts in Absorbing Losses
A spread account is an escrow account that a banking organization
typically establishes to absorb losses on receivables it has sold in a securitization,
thereby providing credit enhancement to investors in the securities backed by the
receivables. The account is funded up to a pre-determined specified amount by the
excess spread created when the expenses of the trust -- including the yield passed
on to investors, the servicing fee (typically 200 basis points for credit card
-1-
February 1998 Trading and Capital-Markets Activities Manual
Page 30
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
receivables), and the expected credit losses -- are less than the yield earned on the
assets in the pool. The funds in the escrow or spread account are used to absorb
losses on the underlying receivables and must be exhausted before investors in the
securities backed by those receivables are exposed to losses.
Regulatory Reporting and Capital Treatment
Despite the fact that holding companies file their regulatory reports
(e.g., the FR Y-9C) in accordance with generally accepted accounting principles
(GAAP), which allows transferred assets to be removed from the balance sheet
even if the related spread amount is booked, these assets are still subject to a
capital charge under the Federal Reserve’s risk-based capital guidelines for bank
holding companies.
Under the bank holding company risk-based capital guidelines (12 CFR
225, appendix A), a sale of assets is not deemed to be a true sale unless it meets
the same criteria that apply to banks. These criteria are set forth in the instructions
to the commercial bank Reports of Income and Condition (Call Reports). The Call
Report instructions state that a transfer of assets is not a true sale for capital
adequacy purposes unless the transferring institution (1) retains no risk of loss from
the assets transferred from any cause and (2) has no obligation to any party for the
payment of principal or interest on the assets transferred.1
Since a bank holding company is at risk of loss in a transaction in
which it has transferred assets and recorded on its balance sheet a spread account
serving as a credit enhancement, the company must treat the transaction as an
asset sale with recourse for risk-based capital purposes. Under the guidelines,
capital must be held against the entire risk-weighted amount of any assets sold
with recourse. Since assets that bank holding companies have sold with recourse
usually have been removed from the balance sheet, the risk-weighted amount of
such assets is typically calculated by converting the assets to an on-balance sheet
credit equivalent amount and assigning that amount to the appropriate risk
category.
For asset transfers that involve recognition of a spread account on the
balance sheet, a bank holding company may use the low level recourse capital
1 A bank that transfers loans "without recourse" and maintains a residual interest in an escrow
account established to absorb losses on the transferred loans (e.g., a spread account) has not
retained the risk of loss or an obligation for payment for purposes of the Call Report as long as
the spread account is not recognized on the balance sheet. (See Federal Financial Institution
Examination Council (FFIEC) press release dated November 26, 1986.)
-2-
Trading and Capital-Markets Activities Manual February 1998
Page 31
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
treatment that applies to asset sales with recourse in general.2 Under the low level
recourse rule, a banking organization that contractually limits its maximum recourse
obligation to less than the full effective risk-based capital requirement for the
transferred assets would be required to hold risk-based capital equal only to the
contractual maximum amount of its recourse obligation. For example, under this
dollar-for-dollar capital requirement, the capital charge for a 100 percent risk-
weighted asset transferred with 1 percent recourse would be 1 percent of the value
of the transferred assets, rather than the 8 percent requirement that would be
applied to the assets if they were retained on the transferring institution’s balance
sheet.
The size of spread accounts (relative to the assets that they protect) is
often smaller than the effective risk-based capital requirement, e.g., 8 percent, on
the securitized assets. Thus, the low level recourse capital rule typically would
apply. In addition, an institution may reduce the dollar-for-dollar capital charge held
against the recourse exposure on assets transferred with low level recourse for a
transaction recognized as a sale under GAAP and for regulatory reporting purposes
by the balance of any associated non-capital GAAP recourse liability account.3
In March 1997, commercial banks will begin filing their Call Reports in
accordance with GAAP. However, this reporting change will not change the
effective treatment of recourse transactions under the banking agencies’ risk-based
capital guidelines.4 To compensate for the change in reporting treatment beginning
with the March 1997 Call Report, the Federal Reserve and the other banking
agencies intend to apply to commercial banks the risk-based capital off-balance
sheet treatment for recourse transactions that is currently applied to bank holding
companies. Included in the application of this treatment are transactions where the
transferring institution has recognized on its balance sheet a spread account that
provides credit protection to the transferred assets.
2 See parts 208 and 225, appendix A, section III.B for the specific capital requirements that
apply to small business obligations that are transferred with recourse by qualifying banking
organizations.
3 Under GAAP, the transferor must establish a separate non-capital recourse liability account
that is equal to the estimated probable losses under the recourse provision.
4 Under the current regulatory reporting requirements for commercial banks set forth in the
instructions to the Call Reports, banks selling assets with recourse generally are required to treat
the transaction as a financing. Thus, until the March Call Report date, assets a bank has sold
with recourse typically are incorporated directly into the on-balance sheet portion of the bank’s
calculation of its risk-weighted assets.
-3-
February 1998 Trading and Capital-Markets Activities Manual
Page 32
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
In order to facilitate the dissemination of this guidance to bank holding
companies engaged in securitization activities, a suggested transmittal letter is
attached. If you have any questions, please contact Tom Boemio, Supervisory
Financial Analyst, at 202/452-2982 or David Elkes, Supervisory Financial Analyst,
at 202/452-5218.
Richard Spillenkothen
Director
-4-
Trading and Capital-Markets Activities Manual February 1998
Page 33
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D.C. 20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 96-17 (GEN)
August 12, 1996
TO THE OFFICER IN CHARGE OF SUPERVISION
AT EACH FEDERAL RESERVE BANK
SUBJECT: Supervisory Guidance for Credit Derivatives
Overview
In recent months, examiners have encountered credit derivative
transactions at several dealer and end-user banking organizations. Credit
derivatives are financial instruments used to assume or lay off credit risk on loans
and other assets, sometimes to only a limited extent. Banking organizations are
increasingly employing these off-balance sheet instruments either as end-users,
purchasing credit protection from -- or providing credit protection to -- third parties,
or as dealers intermediating such protection. Banking organizations use credit
derivatives to reduce credit concentrations and manage overall credit risk exposure.
Although the market for these instruments is still quite small, banking organizations
are entering into credit derivative transactions with increasing frequency.
Questions have been raised about how credit derivatives should be treated in light
of existing supervisory capital and reporting rules and prudential guidance.
This SR letter provides guidance on supervisory issues pertaining to
the use of credit derivatives for such purposes as risk management, yield
enhancement, reduction of credit concentrations, or diversification of overall risk.
It is essential that banks, bank holding companies, and U.S. branches and agencies of
foreign banks that use credit derivatives establish sound risk management policies
and procedures and effective internal controls. Federal Reserve staff will continue
to review credit derivatives as their use and structure evolve in the marketplace.
The analytical techniques used to manage credit derivatives may
provide new insights into credit risk and its management. For this reason, U.S.
banking supervisors, as well as banking supervisors abroad, intend to continue
assessing the use and development of credit derivatives in the marketplace.
Discussions with the other U.S. and international banking supervisors may result in
-1-
February 1998 Trading and Capital-Markets Activities Manual
Page 34
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
revised or additional guidance on the appropriate supervisory treatment of credit
derivatives. This is particularly true with respect to the treatment of dealer
banking organizations’ positions in credit derivatives and how such transactions,
if held in banks’ trading books, would be treated as market-risk instruments for
capital purposes once the proposed market risk capital rules become effective.1
Background
Credit derivatives are off-balance sheet arrangements that allow one
party (the "beneficiary") to transfer the credit risk of a "reference asset," which it
often actually owns, to another party (the "guarantor").2 This arrangement allows
the guarantor to assume the credit risk associated with the reference asset without
directly purchasing it. Unlike traditional guarantee arrangements, credit derivatives
transactions often are documented using master agreements developed by the
International Swaps and Derivatives Association (ISDA) similar to those governing
swaps or options.
Under some credit derivative arrangements, the beneficiary may pay
the total return on a reference asset, including any appreciation in the asset’s price,
to a guarantor in exchange for a spread over funding costs plus any depreciation in
the value of the reference asset (a "total rate-of-return swap"). Alternatively, a
beneficiary may pay a fee to the guarantor in exchange for a guarantee against any
loss that may occur if the reference asset defaults (a "credit default swap"). These
1 Once the proposed market risk capital rules are effective, credit derivatives that are held in a
bank’s trading book would be subject to those rules. These rules are scheduled to be effective by
January 1, 1998, although supervisors will have the discretion to permit institutions to adopt the
rules early. Under the market risk rules for derivatives, the risk of the reference asset generally is
included in the calculation of general market risk and specific risk. In addition, capital is
required to cover the counterparty credit exposure on the transaction. The assumptions that were
used in the development of the specific risk factors included in the proposed market risk capital
rules and the potential future exposure conversion factors under the credit risk capital rules,
however, did not take into account credit derivatives and may need to be reviewed if the market
risk capital treatment is applied to these instruments.
2 For purposes of this supervisory letter, where the beneficiary owns the reference asset it will
be referred to as the "underlying" asset. However, in some cases, the reference asset and the
underlying asset are not the same. For example, the credit derivative contract may reference the
performance of an ABC Company bond, while the beneficiary bank may actually own an ABC
Company loan.
-2-
Trading and Capital-Markets Activities Manual February 1998
Page 35
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
two structures are the most prevalent types of credit derivatives and are described
in greater detail in the Appendix.3
The credit derivative market has been evolving rapidly, and credit
derivative structures are likely to take on new forms. For example, very recently a
market has developed for put options on specific corporate bonds or loans. While
the payoffs of these puts are expressed in terms of a strike price, rather than a
default event, if the strike price is sufficiently high, credit risk effectively could be
transferred from the buyer of the put to the writer of the put.
Overview of Guidance
In reviewing credit derivatives, examiners should consider the credit
risk associated with the reference asset as the primary risk, as they do for loan
participations or guarantees. A banking organization providing credit protection
through a credit derivative can become as exposed to the credit risk of the
reference asset as it would if the asset were on its own balance sheet. Thus, for
supervisory purposes, the exposure generally should be treated as if it were a letter
of credit or other off-balance sheet guarantee.4 This treatment would apply, for
example, in determining an institution’s overall credit exposure to a borrower for
purposes of evaluating concentrations of credit. The institution’s overall exposure
should include exposure it assumes by acting as a guarantor in a credit derivative
transaction where the borrower is the obligor of the reference asset.5
In addition, banking organizations providing credit protection through a
credit derivative should hold capital and reserves against their exposure to the
reference asset. This broad principle holds for all credit derivatives, except for
credit derivative contracts that incorporate periodic payments for depreciation or
appreciation, including most total rate of return swaps. For these transactions, the
guarantor can deduct the amount of depreciation paid to the beneficiary from the
3 The Appendix provides a detailed discussion on the mechanics and cash flows of the two
most prevalent types of credit derivatives; guidance on how credit derivatives are to be treated
for purposes of regulatory capital and other supervisory purposes, such as credit exposure, asset
classification, allowance for loan and lease losses, and transactions involving affiliates; and
guidance on the appropriate accounting and regulatory reporting treatment for credit derivatives.
4 Credit derivatives that are based on a broad based index, such as the Lehman Brothers Bond
Index or the S&P 500 stock index, could be treated for capital and other supervisory purposes as
a derivative contract. This determination should be made on a case-by-case basis.
5 Legal lending limits are established by the individual states for state-chartered banks and by
the Office of the Comptroller of the Currency (OCC) for national banks. The determination of
whether credit derivatives are guarantees to be included in the legal lending limits are the
purview of the state banking regulators and the OCC.
-3-
February 1998 Trading and Capital-Markets Activities Manual
Page 36
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
notional amount of the contract in determining the amount of reference exposure
subject to a capital charge.
In some cases, such as total rate of return swaps, the guarantor also
is exposed to the credit risk of the counterparty, which for derivative contracts
generally is measured as the replacement cost of the credit derivative transaction
plus an add-on for the potential future exposure of the derivative to market price
changes. For banks acting as dealers that have matching offsetting positions, the
counterparty risk stemming from credit derivative transactions could be the
principal risk to which the dealer banks are exposed.
In reviewing a credit derivative entered into by a beneficiary banking
organization the examiner should review the organization’s credit exposure to the
guarantor, as well as to the reference asset -- if the asset is actually owned by the
beneficiary. The degree to which a credit derivative, unlike most other credit
guarantee arrangements, transfers the credit risk of an underlying asset from the
beneficiary to the guarantor may be uncertain or limited. The degree of risk
transference depends upon the terms of the transaction. For example, some credit
derivatives are structured so that a payout only occurs when a pre-defined event of
default or a downgrade below a pre-specified credit rating occurs. Others may
require a payment only when a defined default event occurs and a pre-determined
materiality (or loss) threshold is exceeded. Default payments themselves may be
based upon an average of dealer prices for the reference asset during some period
of time after default using a pre-specified sampling procedure or may be specified in
advance as a set percentage of the notional amount of the reference asset. Finally,
the term of many credit derivative transactions is shorter than the maturity of the
underlying asset and, thus, provides only temporary credit protection to the
beneficiary.
Examiners must ascertain whether the amount of credit protection a
beneficiary receives by entering into a credit derivative is sufficient to warrant
treatment of the derivative as a guarantee for regulatory capital and other
supervisory purposes. Those arrangements that provide virtually complete credit
protection to the underlying asset will be considered effective guarantees for
purposes of asset classification and risk-based capital calculations. On the other
hand, if the amount of credit risk transferred by the beneficiary is severely limited
or uncertain, then the limited credit protection provided by the derivative should not
be taken into account for these purposes.
In this regard, examiners should carefully review credit derivative
transactions in which the reference asset is not identical to the asset actually
owned by the beneficiary banking organization. In order to determine that the
derivative contract provides effective credit protection, the examiner must be
satisfied that the reference asset is an appropriate proxy for the loan or other asset
-4-
Trading and Capital-Markets Activities Manual February 1998
Page 37
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
whose credit exposure the banking organization intends to offset. In making this
determination, examiners should consider, among other factors, whether the
reference asset and owned asset have the same obligor and seniority in bankruptcy
and whether both contain mutual cross-default provisions.
The supervisory and regulatory treatment that is currently outlined will
continue to be reviewed to ensure the appropriate treatment for credit derivatives
transactions. Such a review will take into consideration the potential offsetting of
credit exposures within the portfolio and how the proposed market risk capital rules
would be applied to credit derivative transactions once they become effective.
An institution should not enter into credit derivative transactions
unless its management has the ability to understand and manage the credit and
other risks associated with these instruments in a safe and sound manner.
Accordingly, examiners should determine the appropriateness of these instruments
on an institution-by-institution basis. Such a determination should take into
account management’s expertise in evaluating such instruments; the adequacy of
relevant policies, including position limits; and the quality of the institution’s
relevant information systems and internal controls.6
If you have any questions on the supervisory or capital issues related
to credit derivatives, please contact Norah Barger, Manager (202/452-2402), or
Tom Boemio, Supervisory Financial Analyst (202/452-2982). Questions concerning
the accounting treatment for these products may be addressed to Charles Holm,
Project Manager (202/452-3502), or Greg Eller, Supervisory Financial Analyst
(202/452-5277).
Richard Spillenkothen
Director
6 Further guidance on examining the risk management practices of banking organizations,
including guidance on derivatives, which examiners may find helpful in reviewing an
organization’s management of its credit derivative activity, is contained in the Commercial Bank
Examination Manual; Bank Holding Company Supervision Manual; Trading Activities Manual;
SR Letter 93-69 (12/20/93), "Examining Risk Management and Internal Controls for Trading
Activities of Banking Organizations;" SR Letter 94-45 (8/5/94), "Supervisory Policies Relating
to Structured Notes;" SR Letter 95-17 (3/28/95), "Evaluating the Risk Management and Internal
Controls of Securities and Derivatives Contracts Used in Nontrading Activities;" and SR Letter
95-51 (11/14/95), "Rating the Adequacy of Risk Management Processes and Internal Controls at
State Member Banks and Bank Holding Companies."
-5-
February 1998 Trading and Capital-Markets Activities Manual
Page 38
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
Appendix
Supervisory and Accounting Guidance
Relating to Credit Derivatives
I. Description of Credit Derivatives
The most widely used types of credit derivatives to date are credit default swaps
and total rate-of-return (TROR) swaps.1 While the timing and structure of the cash flows
associated with credit default and TROR swaps differ, the economic substance of both
arrangements is that they seek to transfer the credit risk on the asset(s) referenced in the
transaction.
The use of credit derivatives may allow a banking organization to mitigate its
concentration to a particular borrower or industry without severing the customer
relationship. In addition, organizations that are approaching established in-house
limits on counterparty credit exposure could continue to originate loans to a particular
industry and use credit derivatives to transfer the credit risk to a third party. Furthermore,
institutions may use credit derivatives to diversify their portfolios by assuming credit
exposures to different borrowers or industries without actually purchasing the underlying
assets. Nonbank institutions may serve as counterparties to credit derivative transactions
with banks in order to gain access to the commercial bank loan market. These institutions
either do not lend or do not have the ability to administer a loan portfolio.
Credit Default Swaps
The purpose of a credit default swap, as its name suggests, is to provide
protection against credit losses associated with a default on a specified reference asset.
The swap purchaser, i.e., the beneficiary, "swaps" the credit risk with the provider of
the swap, i.e., the guarantor. While the transaction is called a "swap," it is very similar
to a guarantee or financial standby letter of credit.
1 Another less common form of credit derivative is the credit linked note which is an
obligation that is based on a reference asset. Credit linked notes are similar to structured notes
with embedded credit derivatives. The payment of interest and principal are influenced by credit
indicators rather than market price factors. If there is a credit event, the repayment of the bond’s
principal is based on the price of the reference asset. When reviewing these transactions,
examiners should consider the purchasing bank’s exposure to the underlying reference asset as
well as the exposure to the issuing entity.
-1-
Trading and Capital-Markets Activities Manual February 1998
Page 39
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
In a credit default swap, illustrated in Figure 1, the beneficiary (Bank A) agrees
to pay to the guarantor (Bank B) a fee typically amounting to a certain number of basis
points on the par value of the reference asset either quarterly or annually. In return, the
guarantor agrees to pay the beneficiary an agreed upon, market-based, post-default
amount or a predetermined fixed percentage of the value of the reference asset if there
is a default. The guarantor makes no payment until there is a default. A default is
strictly defined in the contract to include, for example, bankruptcy, insolvency, or
payment default, and the event of default itself must be publicly verifiable. In some
instances, the guarantor is not obliged to make any payments to the beneficiary
until a pre-established amount of loss has been exceeded in conjunction with a default
event; this is often referred to as a materiality threshold.
The swap is terminated if the reference asset defaults prior to the maturity of the
swap. The amount owed by the guarantor is the difference between the reference asset’s
Credit Default Swap
Bank A Fixed payments per quarter Bank B
Payment upon default
Five-year note
If default occurs, then B pays A
for the depreciated amount of the
C & I Loan loan or an amount agreed upon at
the outset.
Principal and interest
Figure 1 Credit Default Swap Cash Flow Diagram.
-2-
February 1998 Trading and Capital-Markets Activities Manual
Page 40
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
initial principal (or notional) amount and the actual market value of the defaulted,
reference asset. The methodology for establishing the post-default market value of the
reference asset should be set out in the contract. Often, the market value of the defaulted
reference asset may be determined by sampling dealer quotes. The guarantor may have
the option to purchase the defaulted, underlying asset and pursue a workout with the
borrower directly, an action it may take if it believes that the "true" value of the reference
asset is higher than that determined by the swap pricing mechanism. Alternatively, the
swap may call for a fixed payment in the event of default, for example, 15 percent of the
notional value of the reference asset.
Total Rate-of-Return Swap
In a total rate-of-return (TROR) swap, illustrated in Figure 2, the beneficiary
(Bank A) agrees to pay the guarantor (Bank B) the "total return" on the reference
Total Rate of Return Swap
Principal & Interest
plus appreciation
Bank A (Total Return) Bank B
(beneficiary) (guarantor)
LIBOR plus spread
Five-year note plus depreciation
C & I Loan The swap has a maturity of one
year, with the C & I loan as the
‘‘reference asset.’’ At each
payment date, or on default
of the loan, Bank B pays Bank A
Principal and interest for any depreciation of the loan.
Figure 2 Total Return Swap Cash Flow Diagram
-3-
Trading and Capital-Markets Activities Manual February 1998
Page 41
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
asset, which consists of all contractual payments, as well as any appreciation in
the market value of the reference asset. To complete the swap arrangement, the
guarantor agrees to pay LIBOR plus a spread and any depreciation to the beneficiary.2
The guarantor in a TROR swap could be viewed as having synthetic ownership of the
reference asset since it bears the risks and rewards of ownership over the term of the
swap.
At each payment exchange date (including when the swap matures) -- or upon
default, at which point the swap may terminate -- any depreciation or appreciation in the
amortized value of the reference asset is calculated as the difference between the notional
principal balance of the reference asset and the "dealer price." 3 The dealer price is
generally determined either by referring to a market quotation source or by polling a
group of dealers and reflects changes in the credit profile of the reference obligor and
reference asset.
If the dealer price is less than the notional amount (i.e., the hypothetical original
price of the reference asset) of the contract, then the guarantor must pay the difference
to the beneficiary, absorbing any loss caused by a decline in the credit quality of the
reference asset.4 Thus, a TROR swap differs from a standard direct credit substitute in
that the guarantor is guaranteeing not only against default of the reference obligor, but
also against a deterioration in that obligor’s credit quality, which can occur even if
there is no default.
II. Supervisory Issues Relating to Credit Derivatives Risk-Based Capital Treatment
For purposes of risk-based capital, credit derivatives generally are to be treated
as off-balance sheet direct credit substitutes. The notional amount of the contract
should be converted at 100 percent to determine the credit equivalent amount to be
included in risk weighted assets of the guarantor.5 A banking organization providing a
2 The reference asset is often a floating rate instrument, e.g., a prime-based loan. Thus, if both
sides of a TROR swap are based on floating rates, interest rate risk is effectively eliminated with
the exception of some basis risk.
3 Depending upon contract terms, a TROR swap may not terminate upon default of the
reference asset. Instead, payments would continue to be made on subsequent payment dates
based on the reference asset’s post-default prices until the swap’s contractual maturity.
4 As in a credit default swap, the guarantor may have the option of purchasing the underlying
asset from the beneficiary at the dealer price and trying to collect from the borrower directly.
5 Guarantor banks which have made cash payments representing depreciation on reference
assets may deduct such payments from the notional amount when computing credit equivalent
amounts for capital purposes. For example, if a guarantor bank makes a depreciation payment of
$10 on a $100 notional total rate-of-return swap, the credit equivalent amount would be $90.
-4-
February 1998 Trading and Capital-Markets Activities Manual
Page 42
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
guarantee through a credit derivative transaction should assign its credit exposure to
the risk category appropriate to the obligor of the reference asset or any collateral. On the
other hand, a banking organization that owns the underlying asset upon which effective
credit protection has been acquired through a credit derivative may under certain
circumstances assign the unamortized portion of the underlying asset to the risk category
appropriate to the guarantor, e.g., the 20 percent risk category if the guarantor is a bank.
Whether the credit derivative is considered an eligible guarantee for purposes of
risk-based capital depends upon the degree of credit protection actually provided. As
explained earlier, the amount of credit protection actually provided by a credit derivative
may be limited depending upon the terms of the arrangement. In this regard, for
example, a relatively restrictive definition of a default event or a materiality threshold
that requires a comparably high percentage of loss to occur before the guarantor is obliged
to pay could effectively limit the amount of credit risk actually transferred in the transaction.
If the terms of the credit derivative arrangement significantly limit the degree of risk
transference, then the beneficiary bank cannot reduce the risk weight of the "protected"
asset to that of the guarantor bank. On the other hand, even if the transfer of credit risk
is limited, a banking organization providing limited credit protection through a credit
derivative should hold appropriate capital against the underlying exposure while it is
exposed to the credit risk of the reference asset.
Banking organizations providing a guarantee through a credit derivative may
mitigate the credit risk associated with the transaction by entering into an offsetting credit
derivative with another counterparty, a so-called "back-to-back" position. Organizations
that have entered into such a position may treat the first credit derivative as guaranteed
by the offsetting transaction for risk-based capital purposes. Accordingly, the notional
amount of the first credit derivative may be assigned to the risk category appropriate
to the counterparty providing credit protection through the offsetting credit derivative
arrangement, e.g., the 20 percent risk category if the counterparty is an OECD bank.
In some instances, the reference asset in the credit derivative transaction may
not be identical to the underlying asset for which the beneficiary has acquired credit
protection. For example, a credit derivative used to offset the credit exposure of a loan
to a corporate customer may use a publicly-traded corporate bond of the customer as the
reference asset, whose credit quality serves as a proxy for the on-balance sheet loan. In
such a case, the underlying asset will still generally be considered guaranteed for capital
purposes as long as both the underlying asset and the reference asset are obligations of
the same legal entity and have the same level of seniority in bankruptcy. In addition,
banking organizations offsetting credit exposure in this manner would be obligated to
demonstrate to examiners that there is a high degree of correlation between the two
instruments; the reference instrument is a reasonable and sufficiently liquid proxy for the
underlying asset so that the instruments can be reasonably expected to behave in a similar
manner in the event of default; and, at a minimum, the reference asset and underlying
asset are subject to mutual cross-default provisions. A banking organization that uses
-5-
Trading and Capital-Markets Activities Manual February 1998
Page 43
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
a credit derivative, which is based on a reference asset that differs from the protected
underlying asset, must document the credit derivative being used to offset credit risk and
must link it directly to the asset or assets whose credit risk the transaction is designed to
offset. The documentation and the effectiveness of the credit derivative transaction are
subject to examiner review. Banking organizations providing credit protection through
such arrangements must hold capital against the risk exposures that are assumed.
Some credit derivative transactions provide credit protection for a group or
basket of reference assets and call for the guarantor to absorb losses on only the first
asset in the group that defaults. Once the first asset in the group defaults, the credit
protection for the remaining assets covered by the credit derivative ceases. If examiners
determine that the credit risk for the basket of assets has effectively been transferred to the
guarantor and the beneficiary banking organization owns all of the reference assets included
in the basket, then the beneficiary may assign the asset with the smallest dollar amount in
the group -- if less than or equal to the notional amount of the credit derivative -- to the
risk category appropriate to the guarantor. Conversely, a banking organization extending
credit protection through a credit derivative on a basket of assets must assign the
contract’s notional amount of credit exposure to the highest risk category appropriate to
the assets in the basket.
Other Supervisory Issues
The decision to treat credit derivatives as guarantees could have significant
supervisory implications for the way examiners treat concentration risk, classified
assets, the adequacy of the allowance for loan and lease losses (ALLL), and transactions
involving affiliates. Examples of how credit derivatives that effectively transfer credit
risk could affect supervisory procedures are discussed below.
Credit Exposure
For internal credit risk management purposes, banks are encouraged to develop
policies to determine how credit derivative activity will be used to manage credit
exposures. For example, a bank’s internal credit policies may set forth situations in
which it is appropriate to reduce credit exposure to an underlying obligor through credit
derivative transactions. Such policies need to address when credit exposure is effectively
reduced and how all credit exposures will be monitored, including those resulting
from credit derivative activities.
For supervisory purposes, a concentration of credit generally exists when a bank’s
loans and other exposures -- e.g., fed funds sold, securities, and letters of credit -- to a
single obligor, geographic area, or industry exceed 25 percent of the bank’s Tier 1 capital
and ALLL.6 Examiners will not consider a bank’s asset concentration to a particular
6 See Section 2050.1 of the Commercial Bank Examination Manual.
-6-
February 1998 Trading and Capital-Markets Activities Manual
Page 44
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
borrower reduced because of the existence of a non-government guarantee on one of the
borrower’s loans because the underlying concentration to the borrower still exists.
However, examiners should consider how the bank manages the concentration, which
could include the use of non-governmental guarantees. Asset concentrations are to be
listed in the examination report to highlight that the ultimate risk to the bank stems
from these concentrations, although the associated credit risk may be mitigated by the
existence of non-governmental guarantees.
Any non-government guarantee will be included with other exposures to the
guarantor to determine if there is an asset concentration with respect to the guarantor.
Thus, the use of credit derivatives will increase the beneficiary’s concentration exposure
to the guarantor without reducing concentration risk of the underlying borrower.
Similarly, a guarantor bank’s exposure to all reference assets will be included in its
overall credit exposure to the reference obligor.
Classification
The criteria used to classify assets are primarily based upon the degree of risk
and the likelihood of repayment as well as on the assets’ potential effect on the bank’s
safety and soundness.7 When evaluating the quality of a loan, examiners should review
the overall financial condition of the borrower; the borrower’s credit history; any
secondary sources of repayment, such as guarantees; and other factors. The primary
focus in the review of a loan’s quality is the original source of payment. The assessment
of the credit quality of a troubled loan, however, should take into account support
provided by a "financially responsible guarantor." 8
The protection provided on an underlying asset by a credit derivative from a
financially responsible guarantor may be sufficient to preclude classification of the
underlying asset, or reduce the severity of classification. Sufficiency depends upon
the extent of credit protection that is provided. In order for a credit derivative to be
considered a guarantee for purposes of determining the classification of assets, the credit
risk must be transferred from the beneficiary to the financially responsible guarantor; the
financially responsible guarantor must have both the financial capacity and willingness
to provide support for the credit; the guarantee (i.e., the credit derivative contract) must
be legally enforceable; and the guarantee must provide support for repayment of the
indebtedness, in whole or in part, during the remaining term of the underlying asset.
7 Loans that exhibit potential weaknesses are categorized as "special mention," while those
with well-defined weaknesses and a distinct possibility of loss are assigned to the general
category of "classified." The classified category is divided into the more specific subcategories
of "substandard," "doubtful," and "loss." The amount of classified loans as a percent of capital is
the standard measure of the overall quality of a bank’s loan portfolio.
8 See Section 2060.1 of the Commercial Bank Examination Manual.
-7-
Trading and Capital-Markets Activities Manual February 1998
Page 45
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
However, credit derivatives tend to have a shorter maturity than the underlying
asset being protected. Furthermore, there is uncertainty as to whether the credit derivative
will be renewed once it matures. Thus, examiners need to consider the term of the credit
derivative relative to the maturity of the protected underlying asset, the probability that
the protected underlying asset will default while the guarantee is in force, as well as
whether the credit risk has actually been transferred, when determining whether to
classify an underlying asset protected by a credit derivative. In general, the beneficiary
banking organization continues to be exposed to the credit risk of the classified
underlying asset when the maturity of the credit derivative is shorter than the underlying
asset. Thus, in situations of a maturity mismatch, the presumption may be against a
diminution of the severity of the classification of the underlying asset.
For guarantor banking organizations, examiners should review the credit
quality of individual reference assets in derivative contracts in the same manner as
other credit instruments, such as standby letters of credit. Thus, examiners should
evaluate a credit derivative, in which a banking organization provides credit protection,
based upon the overall financial condition and resources of the reference obligor; the
obligor’s credit history; and any secondary sources of repayment, such as collateral.
As a rule, exposure from providing credit protection through a credit derivative should
be classified if the reference asset is classified.9
Allowance for Loan and Lease Losses
In accordance with the Interagency Policy Statement on the Allowance for Loan
and Lease Losses (ALLL), institutions must maintain an ALLL at a level that is adequate
to absorb estimated credit losses associated with the loan and lease portfolio. Federal
Reserve staff continues to review accounting issues related to credit derivatives and
reserving practices and may issue additional guidance upon completion of this review or
when more definitive guidance is provided by accounting authorities. Likewise,
consideration will be given to improving disclosures in regulatory reports to improve
the transparency of credit derivatives and their effects on the credit quality of the loan
portfolio, particularly if the market for credit derivatives grows significantly.
Transactions Involving Affiliates
Although examiners have not seen credit derivative transactions involving two
or more legal entities within the same banking organization, the possibility of such
transactions exists. Transactions between or involving affiliates raise important
9 A guarantor banking organization providing credit protection through the use of a credit
derivative on a classified asset of a beneficiary bank may preclude classification of its derivative
contract by laying off the risk exposure to another financially responsible guarantor. This could
be accomplished through the use of a second offsetting credit derivative transaction.
-8-
February 1998 Trading and Capital-Markets Activities Manual
Page 46
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
supervisory issues, especially whether such arrangements are effective guarantees
of affiliate obligations, or transfers of assets and their related credit exposure between
affiliates. Thus, banking organizations should carefully consider existing supervisory
guidance on interaffiliate transactions before entering into credit derivative arrangements
involving affiliates, particularly when substantially the same objectives could be
met using traditional guarantee instruments.
III. Accounting and Regulatory Reporting
Treatment for Credit Derivatives
The instructions to the bank and bank holding company regulatory reports do
not contain explicit accounting guidance on credit derivatives at this time. Furthermore,
there is no authoritative accounting guidance under GAAP that directly applies to credit
derivatives. Accordingly, as a matter of sound practice, banking organizations entering
into credit derivative transactions should have a written accounting policy that has been
approved by senior management for credit derivatives and any asset (e.g., a loan or
security) for which protection has been purchased. Banking organizations are strongly
encouraged to consult with their outside accountants to ensure appropriate accounting
practices in this area.
Pending any authoritative guidance from the accounting profession, banking
organizations should report credit derivatives in the commercial bank Reports of
Condition and Income ("Call Reports") in accordance with the following instructions.10
Beneficiary banking organizations that purchase credit protection on an asset
through a credit derivative should continue to report the amount and nature of the
underlying asset for regulatory reporting purposes, without regard to the
credit derivative transaction. That is, all underlying assets should be reported in
the category appropriate for that transaction and obligor. Furthermore, the underlying
asset should be reported as past due or nonaccrual, as appropriate, in Schedule RC-N
in the Call Report, regardless of the existence of an associated credit derivative
transaction.
The notional amount of all credit derivatives entered into by beneficiary
banking organizations should be reported in Schedule RC-L, item 13, "All other
10 The accounting principles for the Call Reports are generally based on GAAP, and effective
March 1997 will be consistent with GAAP. When supervisory concerns arise with respect to the
lack of authoritative guidance under GAAP, the banking agencies may issue reporting guidance that is
more specific than, but within the range of, GAAP. As indicated in the Call Report instructions,
institutions should promptly seek a specific ruling from their primary federal bank supervisory agency
when reporting events and transactions are not covered by the instructions.
-9-
Trading and Capital-Markets Activities Manual February 1998
Page 47
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
off-balance-sheet assets," of the Call Report.11 Furthermore, institutions may report the
amount of credit derivatives that provide effective protection for their past due and
nonaccrual assets in "Optional Narrative Statement Concerning the Amounts Reported
in the Reports of Condition and Income" or in item 9 of Schedule RI-E, "Other
explanations" of the Call Reports.12
In Schedule RC-R, the carrying value of all specifically identified underlying
assets that are effectively guaranteed through credit derivative transactions may be
assigned to the risk category of the guarantor or obligor, whichever is lower.
Both at inception and each reporting period thereafter, banking organizations
that extend credit protection through credit derivatives (guarantors) should report in the
Call Report the notional amount of the credit derivatives in Schedule RC-L, item 12,
"All other off-balance sheet liabilities," and Schedule RC-R, "credit equivalent
amounts of off-balance sheet items," in the appropriate risk category. In addition, all
liabilities for expected losses arising from these contracts should be reflected in financial
statements promptly. For regulatory reporting purposes, the notional value of credit
derivative transactions should not be reported as interest rate, foreign exchange,
commodity, or equity derivative transactions. Institutions that have been reporting credit
derivatives as such derivative transactions in the Call Report do not have to restate
past reports.
In Schedule RC-R, the guarantor bank must report the carrying value of
reference assets whose credit risk has been assumed in the risk category of the
reference asset obligor or any guarantor, whichever is lower. For example, a bank that
assumes the credit risk of a corporate bond would assign the exposure to the
100 percent risk category. However, if the bank laid off the corporate bond’s credit
risk by purchasing a credit derivative from another bank, the exposure would instead be
assigned to the 20 percent risk category.
11 For credit derivatives where the apparent notional amount differs from the effective notional
amount, banking organizations must use the effective notional amount. For example, the
effective notional amount of a credit derivative that is based on a $100 million bond, the value of
which changes $2 for every $1 change in the value of the bond, is $200 million.
12 Consideration may be given to capturing new information related to credit derivatives and
other guarantee arrangements in specific line items in regulatory reports. The amount of past due and
nonaccrual assets that are wholly or partially guaranteed by the U.S. Government is currently collected
in regulatory reports.
- 10 -
February 1998 Trading and Capital-Markets Activities Manual
Page 48
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D.C. 20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 92-11
April 2, 1992
TO THE OFFICER IN CHARGE OF SUPERVISION
AT EACH FEDERAL RESERVE BANK
SUBJECT: Asset-Backed Commercial Paper Programs
A number of commercial banks have become involved in asset-backed
commercial paper programs. These securitization programs enable banks to help arrange
short-term financing support for their customers without having to extend credit directly.
This provides borrowers with an alternative source of funding and allows banks to earn
fee income for managing the programs. Banks also earn fees for providing credit and
liquidity enhancements to these programs.
It is important to emphasize that involvement in such programs can have
potentially significant implications for the organizations’ credit and liquidity risk exposure.
Therefore, examiners should be fully informed on the fundamentals of these programs,
on the risks associated with these programs, and on the procedures for examining
banks and inspecting bank holding companies engaged in this activity.1
Asset-backed commercial paper programs have been in existence since the early
1980s and have grown substantially over the last few years. These programs use a special
purpose entity (SPE) to acquire receivables generally originated either by corporations
or sometimes by the advising bank itself.2 The SPEs, which are owned by third
1 SR letter 89-12 (July 6, 1989) originally provided guidance to examiners with respect to asset
securitization. Examination guidelines for the review of asset securitization and supplemental
background information on securitization was distributed as an attachment to SR letter 90-16
(May 25, 1990).
2 To date, the type of receivables that have been included in such programs are trade
receivables, installment sales contracts, financing leases, and non-cancelable portions of
operating leases and credit card receivables.
-1-
Trading and Capital-Markets Activities Manual February 1998
Page 49
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
parties,3 fund their acquisitions of receivables by issuing commercial paper that is to be
repaid from the cash flow of the receivables.
Bank involvement in an asset-backed commercial paper program can range from
advising the program to advising and providing all of the required credit and liquidity
enhancements in support of the SPE’s commercial paper. Typically, the advising bank, or an
affiliate, performs a review to determine if the receivables of potential program participants
(i.e., corporate sellers) are eligible for purchase by the SPE. The scope of the review is similar
to that used in structuring credit card or automobile-loan-backed transactions.
Once the bank (or its affiliate) determines that a receivables portfolio has an
acceptable credit risk profile, it approves the purchase of the portfolio at a discounted price by
the SPE. The bank or its affiliate may also act as the operating agent for the SPE. This entails
structuring the sale of receivable pools to the SPE and then overseeing the performance of the
pools on an ongoing basis.
The SPE pays for the receivables by issuing commercial paper in an amount equal
to the discounted price paid for the receivables. The difference between the face value of the
receivables and the discounted price paid provides, as discussed below, the first level of credit
protection for the commercial paper. The individual companies selling their receivables
traditionally act as the servicer for receivables sold to an SPE; that is, they are responsible
for collecting principal and interest payments from the obligors and passing these funds on
to the SPE on a periodic basis. The SPE then distributes the proceeds to the holders of the
commercial paper.
Asset-backed commercial paper programs typically have several levels of credit
enhancement cushioning the commercial paper purchaser from potential loss. As noted above,
the first level of loss protection is provided by the difference between the face value of the
receivables purchased and the discounted price paid for them, known as a "holdback" or
"overcollateralization." In some cases, the terms of the sale also give the SPE recourse
back to the seller if there are defaults on the receivables. The amount of overcollateralization
and recourse varies from pool to pool and depends, in part, upon the quality of the receivables
in the pool and the desired credit rating for the paper to be issued. Usually, the level of credit
protection provided by overcollateralization is specified in terms of some multiple of historical
loss experience for similar assets.
In addition to overcollateralization and recourse, secondary credit enhancements
are also customarily provided. Secondary credit enhancements include letters of credit,
surety bonds, or other backup facilities that obligate a third party to purchase pools of
receivables from the SPE at a specified price. In addition to credit enhancements, the
3 Employees of an investment banking firm or some other third party generally own the equity
of the SPE. The advising bank specifically avoids owning the stock as it does not want to raise
the issue of whether it must consolidate the SPE for accounting purposes.
-2-
February 1998 Trading and Capital-Markets Activities Manual
Page 50
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
programs also generally have liquidity enhancements to ensure that the SPE can meet
maturing paper obligations.
The rating agencies typically require an SPE’s commercial paper to have
secondary enhancements aggregating 100 percent of the amount outstanding in order to
receive the highest credit rating. These enhancements are generally structured in one of
two ways. In the first, a commercial bank enters into a single agreement under
which it is unconditionally obligated to provide funding for all or any portion of maturing
commercial paper that an SPE cannot pay from other sources. The obligation to fund may
be triggered by credit losses, a liquidity shortfall, or both. In the second, two separate a
greements that jointly cover 100 percent of an SPE’s outstanding commercial paper are
established. The first, typically an irrevocable letter of credit, is primarily intended to
absorb credit losses that exceed the first tier of credit enhancement for the commercial
paper. The second arrangement is a "liquidity" facility that may or may not provide credit
support. This second structure will often have a letter of credit equalling 10 to 15 percent
of outstandings, with the liquidity facility covering the remaining 85 to 90 percent.
Risk-Based Capital Treatment
Generally, a single funding agreement that has no escape clause, such as a
material adverse change clause, which requires a bank to unconditionally provide funding to
repay maturing commercial paper when the need arises because of either credit or liquidity
problems should be treated as a direct credit substitute, or guarantee. The risk-based capital
guidelines specify that the full amount of such obligations are to be converted to an
on-balance sheet credit equivalent amount using a 100 percent conversion factor. No part
of these arrangements should be considered commitments (either short-term or
long-term) for risk-based capital purposes and assigned the conversion factor of a
commitment. In the case of enhancements provided by separate facilities, a 100 percent
conversion factor should be assigned to a letter of credit or any other form of credit guarantee
provided by the bank. The accompanying liquidity facility, on the other hand, should be
treated as a commitment and assigned a 50 percent conversion factor if over one year in
maturity and a zero percent conversion factor if one year or less in maturity. One of the
characteristics of liquidity facilities is that such arrangements generally have some
reasonable asset quality test that must be met before extending funds to the SPE to ensure
that the bank is not providing credit protection.
Policies
A banking organization (i.e., a bank or bank holding company) participating in an
asset-backed commercial paper program should ensure that such participation is clearly and
logically integrated into its overall strategic objectives. Furthermore, the management should
assure that the risks associated with the various roles that the institution may play in such
programs are fully understood and that safeguards are in place to properly manage these risks.
-3-
Trading and Capital-Markets Activities Manual February 1998
Page 51
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
Appropriate policies, procedures, and controls should be established by a banking
organization prior to participating in asset-backed commercial paper programs. Significant
policies and procedures should be approved and reviewed periodically by the organization’s
board of directors. These policies and procedures should ensure that the organization follows
prudent standards of credit assessment and approval regardless of the role an institution plays
in an asset-backed commercial paper program. Such policies and procedures would be
applicable to all pools of receivables to be purchased by the SPE as well as the extension of
any credit enhancements and liquidity facilities. Procedures should include an initial, thorough
credit assessment of each pool for which it had assumed credit risk, followed by periodic
credit reviews to monitor performance throughout the life of the exposure. Furthermore,
the policies and procedures should outline the credit approval process and establish
"in-house" exposure limits, on a consolidated basis, with respect to particular industries
or organizations, i.e., companies from which the SPE purchased the receivables
as well as the receivable obligors themselves. Controls should include well-developed
management information systems and monitoring procedures.
Institutions should analyze the receivables pools underlying the commercial paper
as well as the structure of the arrangement. This analysis should include a review of:
(i) the characteristics, credit quality, and expected performance of the underlying
receivables;
(ii) the banking organization’s ability to meet its obligations under the securitization
arrangement; and
(iii) the ability of the other participants in the arrangement to meet their obligations.
Banking organizations providing credit enhancements and liquidity facilities
should conduct a careful analysis of their funding capabilities to ensure that they will be
able to meet their obligations under all foreseeable circumstances. The analysis should
include a determination of the impact that fulfillment of these obligations would have on
their interest rate risk exposure, asset quality, liquidity position, and capital adequacy.
Reserve Banks are requested to review carefully the asset-backed commercial
paper facilities provided by banks in their Districts to ensure that banks are applying, for risk-
based capital purposes, the proper conversion factors to their obligations supporting asset-
backed. commercial paper programs. In addition, examiners should review that the policies
discussed above are operative and that institutions are adequately managing their risk
exposure. A discussion of the size, effectiveness and risks associated with these programs
should be included in the confidential section of the examination report if not appropriate
for the open section.
-4-
February 1998 Trading and Capital-Markets Activities Manual
Page 52
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
Should you have any questions, contact Roger T. Cole (202-452-2618), Rhoger H.
Pugh (202-728-5883) or Thomas R. Boemio (202-452-2982).
Stephen C. Schemering
Deputy Director
-5-
Trading and Capital-Markets Activities Manual April 2001
Page 53
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D.C. 20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 99-37 (SUP)
December 13, 1999
TO THE OFFICER IN CHARGE OF SUPERVISION AND APPROPRIATE
SUPERVISORY AND EXAMINATION STAFF
AT EACH FEDERAL RESERVE BANK AND TO CERTAIN BANKING
ORGANIZATIONS SUPERVISED BY THE FEDERAL RESERVE
SUBJECT: Risk Management and Valuation of Retained Interest Arising
from Securitization Activities
Significant weaknesses in the asset securitization practices of some
banking organizations have raised concerns about the general level of understanding
and controls in institutions that engage in such activities. Securitization activities
present unique and sometimes complex risks that require the attention of senior
management and the board of directors. The purpose of this SR letter is to
underscore the importance of sound risk management practices in all aspects of
asset securitization. This letter and the attached guidance, developed jointly by the
federal banking agencies, should be distributed to state member banks, bank holding
companies, and foreign banking organizations supervised by the Federal Reserve
that engage in securitization activities.
Retained interests, including interest-only strips receivable, arise when
a selling institution keeps an interest in assets sold to a securitization vehicle that, in
turn, issues bonds to investors. Supervisors are concerned about the methods and
models banking organizations use to value these interests and the difficulties in
managing exposure to these volatile assets. Under generally accepted accounting
principles (GAAP), a banking organization recognizes an immediate gain (or loss)
on the sale of assets by recording its retained interest at fair value. The valuation of
the retained interest is based upon the present value of future cash flows in excess
of amounts needed to service the bonds and cover credit losses and other fees of the
securitization vehicle.1 Determination of fair value should be based on reasonable,
conservative assumptions about such factors as discount rates, projected credit
losses, and prepayment rates. Bank supervisors expect retained interests to be
supported by verifiable documentation of fair value in accordance with GAAP. In
Notes:
1 See Financial Accounting Standard No. 125, ‘‘Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities.’’
April 2001 Trading and Capital-Markets Activities Manual
Page 54
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
the absence of such support, the retained interests should not be carried as assets on
an institution’s books, but instead should be charged off. Other supervisory
concerns include failure to recognize and hold sufficient capital against recourse
obligations generated by securitizations, and the absence of an adequate
independent audit function.
The concepts underlying the attached guidance are not new. They
reflect the long-standing supervisory principles that i) a banking organization should
have in place risk management systems and controls that are adequate in relation to
the nature and volume of its risks, and ii) asset values that cannot be supported
should be written off. The guidance incorporates fundamental concepts of
risk-focused supervision: active oversight by an institution’s senior management and
board of directors, effective policies and limits, accurate and independent
procedures to measure and assess risk, and strong internal controls.2 Bank
supervisors are particularly concerned about institutions that are relatively new
users of securitization techniques and institutions whose senior management and
directors are not fully aware of the risks, as well as the accounting, legal, and
risk-based capital nuances, of this activity. The interagency guidance discusses
sound risk management, modeling, valuation, and disclosure practices for asset
securitization, and complements previous supervisory guidance on this subject.3
The federal banking agencies will continue to study supervisory issues
relating to securitization, including the valuation of retained interests, and may in
the future make adjustments to their regulatory capital requirements to reflect the
riskiness, volatility, and uncertainty in the value of retained interests. Questions
pertaining to this letter should be directed to Tom Boemio, Senior Supervisory
Financial Analyst, (202) 452-2982, or Anna Lee Hewko, Financial Analyst,
(202) 530-6260.
Richard Spillenkothen
Director
Attachment (36K PDF3)
Notes:
2 See SR letters 96-14, ‘‘Risk-focused Safety and Soundness Examinations and
Inspections,’’ and 95-51, ‘‘Rating the Adequacy of Risk Management Processes
and Internal Controls at State Member Banks and Bank Holding Companies.’’
3 See SR letters 97-21, ‘‘Risk Management and Capital Adequacy of Exposures
Arising from Secondary Market Credit Activities,’’ 96-40, ‘‘Interim Guidance for
Purposes of Applying FAS 125 for Regulatory Reporting in 1997 and for the
Treatment of Servicing Assets for Regulatory Capital;’’ and 96-30, ‘‘Risk-Based
Capital Treatment for Spread Accounts that Provide Credit Enhancement for
Securitized Receivables.’’
-2-
Trading and Capital-Markets Activities Manual April 2001
Page 55
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
Office of the Comptroller of the Currency
Federal Deposit Insurance Corporation
Board of Governors of the Federal Reserve System
Office of Thrift Supervision
INTERAGENCY GUIDANCE ON ASSET SECURITIZATION ACTIVITIES
BACKGROUND AND PURPOSE
Recent examinations have disclosed significant weaknesses in the asset securitization practices
of some insured depository institutions. These weaknesses raise concerns about the general
level of understanding and controls among institutions that engage in such activities. The most
frequently encountered problems stem from: (1) the failure to recognize and hold sufficient
capital against explicit and implicit recourse obligations that frequently accompany securitiza-
tions, (2) the excessive or inadequately supported valuation of ‘‘retained interests,’’ 1 (3) the
liquidity risk associated with over reliance on asset securitization as a funding source, and
(4) the absence of adequate independent risk management and audit functions.
The Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the
Board of Governors of the Federal Reserve System, and the Office of Thrift Supervision,
hereafter referred to as ‘‘the Agencies,’’ are jointly issuing this statement to remind financial
institution managers and examiners of the importance of fundamental risk management prac-
tices governing asset securitization activities. This guidance supplements existing policy state-
ments and examination procedures issued by the Agencies and emphasizes the specific expec-
tation that any securitization- related retained interest claimed by a financial institution will be
supported by documentation of the interest’s fair value, utilizing reasonable, conservative
valuation assumptions that can be objectively verified. Retained interests that lack such objec-
tively verifiable support or that fail to meet the supervisory standards set forth in this docu-
ment will be classified as loss and disallowed as assets of the institution for regulatory capital
purposes.
The Agencies are reviewing institutions’ valuation of retained interests and the concentration
of these assets relative to capital. Consistent with existing supervisory authority, the Agencies
may, on a case-by-case basis, require institutions that have high concentrations of these assets
relative to their capital, or are otherwise at risk from impairment of these assets, to hold addi-
tional capital commensurate with their risk exposures. Furthermore, given the risks presented
1 In securitizations, a seller typically retains one or more interests in the assets sold. Retained interests rep-
resent the right to cash flows and other assets not used to extinguish bondholder obligations and pay credit
losses, servicing fees and other trust related fees. For the purpose of this statement, retained interests
include over-collateralization, spread accounts, cash collateral accounts, and interest only strips (IO strips).
Although servicing assets and liabilities also represent a retained interest of the seller, they are currently
determined based on different criteria and have different accounting and risk-based capital requirements. See
applicable comments in Statement of Financial Accounting Standard No. 125, ‘‘Accounting for Transfers
and Servicing of Financial Assets and Extinguishments of Liabilities’’ (FAS 125), for additional information
about these interests and associated accounting requirements.
April 2001 Trading and Capital-Markets Activities Manual
Page 56
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
by these activities, the Agencies are actively considering the establishment of
regulatory restrictions that would limit or eliminate the amount of certain
retained interests that may be recognized in determining the adequacy of
regulatory capital. An excessive dependence on securitizations for day-to-day
core funding can also present significant liquidity problems—either during
times of market turbulence or if there are difficulties specific to the institution
itself. As applicable, the Agencies will provide further guidance on the
liquidity risk associated with over reliance on asset securitizations as a fund-
ing source and implicit recourse obligations.
CONTENTS* Page
Description of Activity ............................................................... 2
Independent Risk Management Function ......................................... 4
Valuation and Modeling Process ................................................... 7
Use of Outside Parties ............................................................... 8
Internal Controls ...................................................................... 8
Audit Function or Internal Review ................................................ 8
Regulatory Reporting ................................................................. 9
Market Discipline and Disclosures ................................................. 10
Risk-Based Capital for Recourse and Low Level Recourse Transactions ... 10
Institution Imposed Concentration Limits on Retained Interests .............. 11
Summary ............................................................................... 12
DESCRIPTION OF ACTIVITY
Asset securitization typically involves the transfer of on-balance sheet assets
to a third party or trust. In turn the third party or trust issues certificates or
notes to investors. The cash flow from the transferred assets supports repay-
ment of the certificates or notes. For several years, large financial institutions,
and a growing number of regional and community institutions, have been
using asset securitization to access alternative funding sources, manage con-
centrations, improve financial performance ratios, and more efficiently meet
customer needs. In many cases, the discipline imposed by investors who buy
assets at their fair value has sharpened selling institutions’ credit risk selec-
tion, underwriting, and pricing practices. Assets typically securitized by insti-
tutions include credit card receivables, automobile receivable paper, commer-
cial and residential first mortgages, commercial loans, home equity loans, and
student loans.
-2-
* Page numbers have been updated for this format.
Trading and Capital-Markets Activities Manual April 2001
Page 57
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
While the Agencies continue to view the use of securitization as an efficient
means of financial intermediation, we are concerned about events and trends
uncovered at recent examinations. Of particular concern are institutions that
are relatively new users of securitization techniques and institutions whose
senior management and directors do not have the requisite knowledge of the
effect of securitization on the risk profile of the institution or are not fully
aware of the accounting, legal and risk-based capital nuances of this activity.
Similarly, the Agencies are concerned that some institutions have not fully
and accurately distinguished and measured the risks that have been trans-
ferred versus those retained, and accordingly are not adequately managing
the retained portion. It is essential that institutions engaging in securitization
activities have appropriate front and back office staffing, internal and external
accounting and legal support, audit or independent review coverage, informa-
tion systems capacity, and oversight mechanisms to execute, record, and
administer these transactions correctly.
Additionally, we are concerned about the use of inappropriate valuation and
modeling methodologies to determine the initial and ongoing value of
retained interests. Accounting rules provide a method to recognize an imme-
diate gain (or loss) on the sale through booking a ‘‘retained interest;’’ how-
ever, the carrying value of that interest must be fully documented, based on
reasonable assumptions, and regularly analyzed for any subsequent value
impairment. The best evidence of fair value is a quoted market price in an
active market. In circumstances where quoted market prices are not available,
accounting rules allow fair value to be estimated. This estimate must be
based on the ‘‘best information available in the circumstances.’’2 An estimate
of fair value must be supported by reasonable and current assumptions. If a
best estimate of fair value is not practicable, the asset is to be recorded at
zero in financial and regulatory reports.
History shows that unforeseen market events that affect the discount rate or
performance of receivables supporting a retained interest can swiftly and dra-
matically alter its value. Without appropriate internal controls and indepen-
dent oversight, an institution that securitizes assets may inappropriately gen-
erate ‘‘paper profits’’ or mask actual losses through flawed loss assumptions,
inaccurate prepayment rates, and inappropriate discount rates. Liberal and
unsubstantiated assumptions can result in material inaccuracies in financial
statements, substantial write-downs of retained interests, and, if interests
2 FAS 125, at par.43
-3-
April 2001 Trading and Capital-Markets Activities Manual
Page 58
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
represent an excessive concentration of the institution’s capital, the demise of the spon-
soring institution.
Recent examinations point to the need for institution managers and directors to ensure
that:
• Independent risk management processes are in place to monitor securitization pool
performance on an aggregate and individual transaction level. An effective risk man-
agement function includes appropriate information systems to monitor securitization
activities.
• Conservative valuation assumptions and modeling methodologies are used to estab-
lish, evaluate and adjust the carrying value of retained interests on a regular and
timely basis.
• Audit or internal review staffs periodically review data integrity, model algorithms,
key underlying assumptions, and the appropriateness of the valuation and modeling
process for the securitized assets retained by the institution. The findings of such
reviews should be reported directly to the board or an appropriate board committee.
• Accurate and timely risk-based capital calculations are maintained, including recog-
nition and reporting of any recourse obligation resulting from securitization activity.
• Internal limits are in place to govern the maximum amount of retained interests as a
percentage of total equity capital.
• The institution has a realistic liquidity plan in place in case of market disruptions.
The following sections provide additional guidance relating to these and other critical
areas of concern. Institutions that lack effective risk management programs or that
maintain exposures in retained interests that warrant supervisory concern may be sub-
ject to more frequent supervisory review, more stringent capital requirements, or other
supervisory action.
INDEPENDENT RISK MANAGEMENT FUNCTION
Institutions engaged in securitizations should have an independent risk management
function commensurate with the complexity and volume of their securitizations and
their overall risk exposures. The risk management function should ensure that securiti-
zation policies and operating procedures, including clearly articulated risk limits, are in
place and appropriate for the institution’s circumstances. A sound asset securitization
policy should include or address, at a minimum:
• A written and consistently applied accounting methodology;
• Regulatory reporting requirements;
-4-
Trading and Capital-Markets Activities Manual April 2001
Page 59
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
• Valuation methods, including FAS 125 residual value assumptions, and procedures to
formally approve changes to those assumptions;
• Management reporting process; and
• Exposure limits and requirements for both aggregate and individual transaction
monitoring.
It is essential that the risk management function monitor origination, collection, and
default management practices. This includes regular evaluations of the quality of
underwriting, soundness of the appraisal process, effectiveness of collections activities,
ability of the default management staff to resolve severely delinquent loans in a timely
and efficient manner, and the appropriateness of loss recognition practices. Because the
securitization of assets can result in the current recognition of anticipated income, the
risk management function should pay particular attention to the types, volumes, and
risks of assets being originated, transferred and serviced. Both senior management and
the risk management staff must be alert to any pressures on line managers to originate
abnormally large volumes or higher risk assets in order to sustain ongoing income
needs. Such pressures can lead to a compromise of credit underwriting standards. This
may accelerate credit losses in future periods, impair the value of retained interests and
potentially lead to funding problems.
The risk management function should also ensure that appropriate management infor-
mation systems (MIS) exist to monitor securitization activities. Reporting and docu-
mentation methods must support the initial valuation of retained interests and ongoing
impairment analyses of these assets. Pool performance information has helped well-
managed institutions to ensure, on a qualitative basis, that a sufficient amount of eco-
nomic capital is being held to cover the various risks inherent in securitization transac-
tions. The absence of quality MIS hinders management’s ability to monitor specific
pool performance and securitization activities more broadly. At a minimum, MIS
reports should address the following:
Securitization summaries for each transaction - The summary should include relevant
transaction terms such as collateral type, facility amount, maturity, credit enhancement
and subordination features, financial covenants (termination events and spread account
capture ‘‘triggers’’), right of repurchase, and counterparty exposures. Management
should ensure that the summaries are distributed to all personnel associated with secu-
ritization activities.
Performance reports by portfolio and specific product type - Performance
factors include gross portfolio yield, default rates and loss severity, delinquencies, pre-
payments or payments, and excess spread amounts. The reports should reflect perfor-
mance of assets, both on an individual pool basis and total managed assets. These
reports should segregate specific products and different marketing campaigns.
-5-
April 2001 Trading and Capital-Markets Activities Manual
Page 60
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
Vintage analysis for each pool using monthly data - Vintage analysis helps manage-
ment understand historical performance trends and their implications for future default
rates, prepayments, and delinquencies, and therefore retained interest values. Manage-
ment can use these reports to compare historical performance trends to underwriting
standards, including the use of a validated credit scoring model, to ensure loan pricing
is consistent with risk levels. Vintage analysis also helps in the comparison of deal
performance at periodic intervals and validates retained interest valuation assumptions.
Static pool cash collection analysis - This analysis entails reviewing monthly cash
receipts relative to the principal balance of the pool to determine the cash yield on the
portfolio, comparing the cash yield to the accrual yield, and tracking monthly changes.
Management should compare the timing and amount of cash flows received from the
trust with those projected as part of the FAS 125 retained interest valuation analysis on
a monthly basis. Some master trust structures allow excess cash flow to be shared
between series or pools. For revolving asset trusts with this master trust structure, man-
agement should perform a cash collection analysis for each master trust structure.
These analyses are essential in assessing the actual performance of the portfolio in
terms of default and prepayment rates. If cash receipts are less than those assumed in
the original valuation of the retained interest, this analysis will provide management
and the board with an early warning of possible problems with collections or extension
practices, and impairment of the retained interest.
Sensitivity analysis - Measuring the effect of changes in default rates, prepayment or
payment rates, and discount rates will assist management in establishing and validating
the carrying value of the retained interest. Stress tests should be performed at least
quarterly. Analyses should consider potential adverse trends and determine ‘‘best,’’
‘‘probable,’’ and ‘‘worst case’’ scenarios for each event. Other factors to consider are
the impact of increased defaults on collections staffing, the timing of cash flows,
‘‘spread account’’ capture triggers, over-collateralization triggers, and early amortiza-
tion triggers. An increase in defaults can result in higher than expected costs and a
delay in cash flows, decreasing the value of the retained interests. Management should
periodically quantify and document the potential impact to both earnings and capital,
and report the results to the board of directors. Management should incorporate this
analysis into their overall interest rate risk measurement system.3 Examiners will
review the analysis conducted by the institution and the volatility associated with
retained interests when assessing the Sensitivity to Market Risk component rating.
Statement of covenant compliance - Ongoing compliance with deal performance trig-
gers as defined by the pooling and servicing agreements should be affirmed at least
monthly. Performance triggers include early amortization, spread capture, changes to
overcollateralization requirements, and events that would result in servicer removal.
3 Under the Joint Agency Policy Statement on the Interest Rate Risk, institutions with a high level
of exposure to interest rate risk relative to capital will be directed to take corrective action. Savings
associations can find OTS guidance on interest rate risk in Thrift Bulletin 13a - Management of
Interest Rate Risk, Investment Securities, and Derivative Activities.
-6-
Trading and Capital-Markets Activities Manual April 2001
Page 61
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
VALUATION AND MODELING PROCESSES
The method and key assumptions used to value the retained interests and servicing
assets or liabilities must be reasonable and fully documented. The key assumptions in
all valuation analyses include prepayment or payment rates, default rates, loss severity
factors, and discount rates. The Agencies expect institutions to take a logical and con-
servative approach when developing securitization assumptions and capitalizing future
income flows. It is important that management quantifies the assumptions on a pool-
by-pool basis and maintains supporting documentation for all changes to the assump-
tions as part of the valuation process, which should be done no less than quarterly.
Policies should define the acceptable reasons for changing assumptions and require
appropriate management approval.
An exception to this pool-by-pool valuation analysis may be applied to revolving asset
trusts if the master trust structure allows excess cash flows to be shared between series.
In a master trust, each certificate of each series represents an undivided interest in all
of the receivables in the trust. Therefore, valuations are appropriate at the master trust
level.
In order to determine the value of the retained interest at inception, and make appro-
priate adjustments going forward, the institution must implement a reasonable model-
ing process to comply with FAS 125. The Agencies expect management to employ
reasonable and conservative valuation assumptions and projections, and to maintain
verifiable objective documentation of the fair value of the retained interest. Senior
management is responsible for ensuring the valuation model accurately reflects the
cash flows according to the terms of the securitization’s structure. For example, the
model should account for any cash collateral or overcollateralization triggers, trust
fees, and insurance payments if appropriate. The board and management are account-
able for the "model builders" possessing the necessary expertise and technical profi-
ciency to perform the modeling process. Senior management should ensure that inter-
nal controls are in place to provide for the ongoing integrity of MIS associated with
securitization activities.
As part of the modeling process, the risk management function should ensure that peri-
odic validations are performed in order to reduce vulnerability to model risk. Valida-
tion of the model includes testing the internal logic, ensuring empirical support for the
model assumptions, and back-testing the models with actual cash flows on a pool-by-
pool basis. The validation process should be documented to support conclusions.
Senior management should ensure the validation process is independent from line man-
agement as well as the modeling process. The audit scope should include procedures to
ensure that the modeling process and validation mechanisms are both appropriate for
the institution’s circumstances and executed consistent with the institution’s asset secu-
ritization policy.
-7-
April 2001 Trading and Capital-Markets Activities Manual
Page 62
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
USE OF OUTSIDE PARTIES
Third parties are often engaged to provide professional guidance and support regarding
an institution’s securitization activities, transactions, and valuing of retained interests.
The use of outside resources does not relieve directors of their oversight responsibility,
or senior management of its responsibilities to provide supervision, monitoring, and
oversight of securitization activities, and the management of the risks associated with
retained interests in particular. Management is expected to have the experience, knowl-
edge, and abilities to discharge its duties and understand the nature and extent of the
risks presented by retained interests and the policies and procedures necessary to
implement an effective risk management system to control such risks. Management
must have a full understanding of the valuation techniques employed, including the
basis and reasonableness of underlying assumptions and projections.
INTERNAL CONTROLS
Effective internal controls are essential to an institution’s management of the risks
associated with securitization. When properly designed and consistently enforced, a
sound system of internal controls will help management safeguard the institution’s
resources, ensure that financial information and reports are reliable, and comply with
contractual obligations, including securitization covenants. It will also reduce the possi-
bility of significant errors and irregularities, as well as assist in their timely detection
when they do occur. Internal controls typically: (1) limit authorities, (2) safeguard
access to and use of records, (3) separate and rotate duties, and (4) ensure both regular
and unscheduled reviews, including testing.
The Agencies have established operational and managerial standards for internal con-
trol and information systems.4 An institution should maintain a system of internal con-
trols appropriate to its size and the nature, scope, and risk of its activities. Institutions
that are subject to the requirements of FDIC regulation 12 CFR Part 363 should
include an assessment of the effectiveness of internal controls over their asset securiti-
zation activities as part of management’s report on the overall effectiveness of the sys-
tem of internal controls over financial reporting. This assessment implicitly includes
the internal controls over financial information that is included in regulatory reports.
AUDIT FUNCTION OR INTERNAL REVIEW
It is the responsibility of an institution’s board of directors to ensure that its audit staff
or independent review function is competent regarding securitization activities. The
audit function should perform periodic reviews of securitization activities, including
transaction testing and verification, and report all findings to the board or appropriate
board committee. The audit function also may be useful to senior management in iden-
tifying and measuring risk related to securitization activities. Principal audit targets
4 Safety and Soundness Standards 12 CFR Part 30 (OCC), 12 CFR Part 570 (OTS).
-8-
Trading and Capital-Markets Activities Manual April 2001
Page 63
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
should include compliance with securitization policies, operating and accounting proce-
dures (FAS 125), and deal covenants, and accuracy of MIS and regulatory reports. The
audit function should also confirm that the institution’s regulatory reporting process is
designed and managed in such a way to facilitate timely and accurate report filing.
Furthermore, when a third party services loans, the auditors should perform an inde-
pendent verification of the existence of the loans to ensure balances reconcile to inter-
nal records.
REGULATORY REPORTING
The securitization and subsequent removal of assets from an institution’s balance sheet
requires additional reporting as part of the regulatory reporting process. Common regu-
latory reporting errors stemming from securitization activities include:
• Failure to include off-balance sheet assets subject to recourse treatment when calcu-
lating risk-based capital ratios;
• Failure to recognize retained interests and retained subordinate security interests as a
form of credit enhancement;
• Failure to report loans sold with recourse in the appropriate section of the regulatory
report; and
• Over-valuing retained interests.
An institution’s directors and senior management are responsible for the accuracy of its
regulatory reports. Because of the complexities associated with securitization account-
ing and risk-based capital treatment, attention should be directed to ensuring that per-
sonnel who prepare these reports maintain current knowledge of reporting rules and
associated interpretations. This often will require ongoing support by qualified account-
ing and legal personnel.
Institutions that file the Report of Condition and Income (Call Report) should pay par-
ticular attention to the following schedules on the Call Report when institutions are
involved in securitization activities: Schedule RC-F: Other Assets; Schedule RC-L: Off
Balance Sheet Items; and Schedule RC-R: Regulatory Capital. Institutions that file the
Thrift Financial Report (TFR) should pay particular attention to the following TFR
schedules: Schedule CC: Consolidated Commitments and Contingencies, Schedule
CCR: Consolidated Capital Requirement, and Schedule CMR: Consolidated Maturity
and Rate.
Under current regulatory report instructions, when an institution’s supervisory agency’s
interpretation of how generally accepted accounting principles (GAAP) should be
applied to a specified event or transaction differs from the institution’s interpretation,
the supervisory agency may require the institution to reflect the event or transaction in
its regulatory reports in accordance with the agency’s interpretation and amend previ-
ously submitted reports.
-9-
April 2001 Trading and Capital-Markets Activities Manual
Page 64
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
MARKET DISCIPLINE AND DISCLOSURES
Transparency through public disclosure is crucial to effective market discipline and can
reinforce supervisory efforts to promote high standards in risk management. Timely
and adequate information on the institution’s asset securitization activities should be
disclosed. The information contained in the disclosures should be comprehensive; how-
ever, the amount of disclosure that is appropriate will depend on the volume of securi-
tizations and complexity of the institution. Well-informed investors, depositors, credi-
tors and other bank counterparties can provide a bank with strong incentives to
maintain sound risk management systems and internal controls. Adequate disclosure
allows market participants to better understand the financial condition of the institution
and apply market discipline, creating incentives to reduce inappropriate risk taking or
inadequate risk management practices. Examples of sound disclosures include:
• Accounting policies for measuring retained interests, including a discussion of the
impact of key assumptions on the recorded value;
• Process and methodology used to adjust the value of retained interests for changes in
key assumptions;
• Risk characteristics, both quantitative and qualitative, of the underlying securitized
assets;
• Role of retained interests as credit enhancements to special purpose entities and other
securitization vehicles, including a discussion of techniques used for measuring
credit risk; and
• Sensitivity analyses or stress testing conducted by the institution showing the effect
of changes in key assumptions on the fair value of retained interests.
RISK-BASED CAPITAL FOR RECOURSE AND LOW LEVEL RECOURSE
TRANSACTIONS
For regulatory purposes, recourse is generally defined as an arrangement in which an
institution retains the risk of credit loss in connection with an asset transfer, if the risk
of credit loss exceeds a pro rata share of the institution’s claim on the assets.5 In addi-
tion to broad contractual language that may require the selling institution to support a
securitization, recourse can also arise from retained interests, retained subordinated
security interests, the funding of cash collateral accounts, or other forms of credit
enhancements that place an institution’s earnings and capital at risk.
These enhancements should generally be aggregated to determine the extent of an
institution’s support of securitized assets. Although an asset securitization qualifies for
5 The risk-based capital treatment for sales with recourse can be found at 12 CFR Part 3 Appendix
A, Section (3)(b)(1)(iii) {OCC}, 12 CFR Part 567.6(a)(2)(i)(c) {OTS}. For a further explanation of
recourse see the glossary entry ‘‘Sales of Assets for Risk-Based Capital Purposes’’ in the instruc-
tions for the Call Report.
- 10 -
Trading and Capital-Markets Activities Manual April 2001
Page 65
3020.1 Securitization and Secondary-Market Credit Activities
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
sales treatment under GAAP, the underlying assets may still be subject to regulatory
risk-based capital requirements. Assets sold with recourse should generally be risk-
weighted as if they had not been sold.
Securitization transactions involving recourse may be eligible for ‘‘low level recourse’’
treatment.6 The Agencies’ risk-based capital standards provide that the dollar amount
of riskbased capital required for assets transferred with recourse should not exceed the
maximum dollar amount for which an institution is contractually liable. The ‘‘low level
recourse’’ treatment applies to transactions accounted for as sales under GAAP in
which an institution contractually limits its recourse exposure to less than the full risk-
based capital requirements for the assets transferred. Under the low level recourse prin-
ciple, the institution holds capital on approximately a dollar-for-dollar basis up to the
amount of the aggregate credit enhancements.
Low level recourse transactions should be reported in Schedule RC-R of the Call
Report or Schedule CCR of the TFR using either the "direct reduction method" or the
‘‘gross-up method’’ in accordance with the regulatory report instructions.
If an institution does not contractually limit the maximum amount of its recourse obli-
gation, or if the amount of credit enhancement is greater than the risk-based capital
requirement that would exist if the assets were not sold, the low level recourse treat-
ment does not apply. Instead, the institution must hold risk-based capital against the
securitized assets as if those assets had not been sold.
Finally, as noted earlier, retained interests that lack objectively verifiable support or
that fail to meet the supervisory standards set forth in this document will be classified
as loss and disallowed as assets of the institution for regulatory capital purposes.
INSTITUTION IMPOSED CONCENTRATION LIMITS ON RETAINED INTERESTS
The creation of a retained interest (the debit) typically also results in an offsetting
‘‘gain on sale’’ (the credit) and thus generation of an asset. Institutions that securitize
high yielding assets with long durations may create a retained interest asset value that
exceeds the risk-based capital charge that would be in place if the institution had not
sold the assets (under the existing riskbased capital guidelines, capital is not required
for the amount over eight percent of the securitized assets). Serious problems can arise
for institutions that distribute contrived earnings only later to be faced with a down-
ward valuation and charge-off of part or all of the retained interests.
As a basic example, an institution could sell $100 in subprime home equity loans and
book a retained interest of $20 using liberal "gain on sale" assumptions. Under the cur-
6 The banking agencies’ low level recourse treatment is described in the Federal Register in the
following locations: 60 Fed. Reg. 17986 (April 10, 1995) (OCC); 60 Fed. Reg. 8177 (February 13,
1995)(FRB); 60 Fed. Reg. 15858 (March 28, 1995)(FDIC). OTS has had a low level recourse rule
in 12 CFR Part 567.6(a)(2)(i)(c) since 1989. A brief explanation is also contained in the instruc-
tions for regulatory reporting in section RC-R for the Call Report or schedule CCR for the TFR.
- 11 -
April 2001 Trading and Capital-Markets Activities Manual
Page 66
Securitization and Secondary-Market Credit Activities 3020.1
SELECTED FEDERAL RESERVE SR-LETTERS—Continued
rent capital rules, the institution is required to hold approximately $8 in capital. This
$8 is the current capital requirement if the loans were never removed from the balance
sheet (eight percent of $100 = $8). However, the institution is still exposed to substan-
tially all of the credit risk, plus the additional risk to earnings and capital from the
volatility of the retained interest. If the value of the retained interest decreases to $10
due to inaccurate assumptions or changes in market conditions, the $8 in capital is
insufficient to cover the entire loss.
Normally, the sponsoring institution will eventually receive any excess cash flow
remaining from securitizations after investor interests have been met. However, recent
experience has shown that retained interests are vulnerable to sudden and sizeable
write-downs that can hinder an institution’s access to the capital markets, damage its
reputation in the market place, and in some cases, threaten its solvency. Accordingly,
the Agencies expect an institution’s board of directors and management to develop and
implement policies that limit the amount of retained interests that may be carried as a
percentage of total equity capital, based on the results of their valuation and modeling
processes. Well constructed internal limits also serve to lessen the incentive of institu-
tion personnel to engage in activities designed to generate near term ‘‘paper profits’’
that may be at the expense of the institution’s long term financial position and
reputation.
SUMMARY
Asset securitization has proven to be an effective means for institutions to access new
and diverse funding sources, manage concentrations, improve financial performance
ratios, and effectively serve borrowing customers. However, securitization activities
also present unique and sometimes complex risks that require board and senior man-
agement attention. Specifically, the initial and ongoing valuation of retained interests
associated with securitization, and the limitation of exposure to the volatility repre-
sented by these assets, warrant immediate attention by management.
Moreover, as mentioned earlier in this statement, the Agencies are studying various
issues relating to securitization practices, including whether restrictions should be
imposed that would limit or eliminate the amount of retained interests that qualify as
regulatory capital. In the interim, the Agencies will review affected institutions on a
case-by-case basis and may require, in appropriate circumstances, that institutions hold
additional capital commensurate with their risk exposure. In addition, the Agencies will
study, and issue further guidance on, institutions’ exposure to implicit recourse obliga-
tions and the liquidity risk associated with over reliance on asset securitization as a
funding source.
- 12 -
Trading and Capital-Markets Activities Manual April 2001
Page 67
Futures Brokerage Activities and Futures Commission
Merchants Section 3030.1
Bank holding company subsidiaries, banks (gen- management, and advisory activities. Significant
erally through operating subsidiaries), Edge Act emphasis should be placed on evaluating the
corporations, and foreign banking organizations adequacy of management and the management
(FBOs) operating in the United States may processes used to control the credit, market,
operate futures brokerage and clearing services liquidity, legal, reputational, and operations risks
involving a myriad of financial and nonfinancial entailed in these operations. Both the adequacy
futures contracts and options on futures. These of risk management and the quantitative level of
activities can involve futures exchanges and risk exposures should be assessed as appropriate
clearinghouses throughout the world. In general, to the scope of the FCM’s activities. The objec-
most institutions conduct these activities as tives of a particular inspection or examination
futures commission merchants (FCMs). FCM is should dictate the FCM activities to be reviewed
the term used in the Commodity Exchange Act and set the scope of the inspection.
to refer to registered firms that are in the Examiners are also instructed to take a
business of soliciting or accepting orders, as functional-regulatory approach to minimize
broker, for the purchase or sale of any exchange- duplicative inspection and supervisory burdens.
traded futures contract and options on futures Reviews and reports of functional regulators
contracts. In connection with these activities, should be used to their fullest extent. However,
institutions may hold customer funds, assets, or absent recent oversight inspection, or if an
property and may be members of futures examiner believes particular facts and circum-
exchanges and their associated clearinghouses. stances at the banking organization or in the
They may also offer related advisory services as marketplace deem it necessary, a review of
registered commodity trading advisors (CTAs). operations that would normally be assessed by
The Federal Reserve has a supervisory inter- the appropriate commodities regulator may be
est in ensuring that the banking organizations appropriate (such as review of front- or back-
subject to its oversight conduct their futures office operations).
brokerage activities safely and soundly consis- When futures brokerage occurs in more than
tent with Regulations Y and K (including any one domestic or foreign affiliate, examiners
terms and conditions contained in Board orders should assess the adequacy of the management
for a particular organization). Accordingly, a of the futures brokerage activities of the consoli-
review of futures brokerage activities is an dated financial organization to ensure that the
important element for inspections of bank hold- parent organization recognizes and effectively
ing companies (BHCs), examinations of state manages the risks posed by its various futures
member banks, and reviews of FBO operations. subsidiaries. Accordingly, in reviewing futures
The following guidance on evaluating the futures brokerage operations, examiners should identify
brokerage activities of bank holding company all bank holding company, bank operating, or
subsidiaries, branches and agencies of foreign FBO subsidiaries that engage in FCM activities
banks operating in the United States, or any and the scope of those activities. Not all subsid-
operating subsidiaries of state member banks iaries may need to be reviewed to assess the risk
provides a list of procedures that may be used to management of the consolidated organization.
tailor the scope of an examination or inspection Selection of the particular FCM subsidiaries to
of these activities at individual institutions. For be reviewed should be based on an assessment
the purposes of this discussion, the term FCM of the risks posed by their activities to the
activities is used in a broad context and refers to consolidated organization.
all of an institution’s futures brokerage activities
and operations. This guidance primarily addresses the assess-
ment of activities associated with futures bro-
kerage operations. Any proprietary trading that
occurs at an FCM should be assessed in connec-
SCOPE OF GUIDANCE tion with the review of proprietary trading
activities of the consolidated financial organiza-
Examiners are instructed to take a risk-based tion, using the appropriate guidance from other
examination approach to evaluating FCM sections of this manual. Similarly, when a review
activities—including brokerage, clearing, funds of futures advisory activities is planned, exam-
Trading and Capital-Markets Activities Manual February 1998
Page 1
3030.1 Futures Brokerage Activities and Futures Commission Merchants
iners should refer to investment advisory inspec- For their part, senior management is respon-
tion guidance in the Bank Holding Company sible for ensuring that policies and procedures
Supervision Manual and the Trust Examination for conducting FCM activities on both a long-
Manual as appropriate. range and day-to-day basis are adequate. These
policies should be approved and reviewed annu-
ally by senior management or a designated
subcommittee of the board; the consistency of
these policies with parent-company limits or
EVALUATION OF FCM RISK other directions pertaining to the FCM’s activi-
MANAGEMENT ties should be confirmed. Management must
also maintain (1) clear lines of authority and
Consistent with existing Federal Reserve poli- responsibility for managing operations and the
cies, examiners should evaluate the risk- risks involved, (2) appropriate limits on risk-
management practices of FCM operations and taking, (3) adequate systems and standards
ensure that this evaluation is incorporated for measuring and tracking risk exposures and
appropriately in the rating of risk management measuring finanical performance, (4) effective
under the bank (CAMELS), BHC (BOPEC), internal controls, and (5) a comprehensive risk-
and FBO (ROCA) rating systems. Accordingly, reporting and risk-management review process.
examiners should place primary consideration To provide adequate oversight, management
on findings related to the adequacy of (1) board should fully understand the risk profile of their
and senior management oversight; (2) policies, FCM activities. Examiners should review reports
procedures, and limits used to control risks; to senior management and evaluate whether the
(3) risk measurement, monitoring, and reporting reports provide both good summary information
systems; and (4) internal controls and audit and sufficient detail to enable management to
programs. General considerations in each of assess and manage the FCM’s risk. As part of
these areas are discussed below. their oversight responsibilities, senior manage-
ment should periodically review the organiza-
tion’s risk-management procedures to ensure
that they remain appropriate and sound.
Board and Senior Management
Management should also ensure that activities
Oversight are conducted by competent staff whose tech-
nical knowledge and experience are consistent
The board of directors has the ultimate respon- with the nature and scope of the institution’s
sibility for the level of risks taken by the activities. There should be sufficient depth in
institution. Accordingly, the board, a designated staff resources to manage these activities if key
subcommittee of the board, or a high level of personnel are not available. Management should
senior management should approve overall also ensure that back-office and financial-control
business strategies and significant policies that resources are sufficient to effectively manage
govern risk-taking in the institution’s FCM and control risks. Risk-measurement, monitor-
activities. In particular, the board or a committee ing, and control functions should have clearly
thereof should approve policies that identify defined duties. Separation of duties in key ele-
authorized activities and managerial oversight, ments of the risk-management process should be
and articulate risk tolerances and exposure lim- adequate to avoid potential conflicts of interest.
its of FCM activities. The board should also The nature and scope of these safeguards should
actively monitor the performance and risk pro- be in accordance with the scope of the FCM’s
file of its FCM activities. Directors and senior activities.
management should periodically review infor-
mation that is sufficiently detailed and timely to
allow them to understand and assess the various
risks involved in these activities. In addition, the Policies, Procedures, and Limits
board or a delegated committee should periodi-
cally reevaluate the institution’s business strat- FCMs should maintain written policies and
egies and major risk-management policies and procedures that clearly outline their approach
procedures, emphasizing the institution’s finan- for managing futures brokerage and related
cial objectives and risk tolerances. activities. Such policies should be consistent
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Futures Brokerage Activities and Futures Commission Merchants 3030.1
with the organization’s broader business strate- factor in the overall evaluation of the risk-
gies, capital adequacy, technical expertise, and management process. Appropriate mechanisms
general willingness to take risk. Policies, proce- should exist for reporting risk exposures and the
dures, and limits should address the relevant financial performance of the FCM to its board
credit, market, liquidity, reputation, and opera- and parent company, as well as for internal
tions risks in light of the scope and complexity management purposes. FCMs must establish
of the FCM’s activities. Policies and procedures management reporting policies to apprise their
should establish a logical framework for limit- boards of directors and senior management of
ing the various risks involved in an FCM’s material developments, the adequacy of risk
activities and clearly delineate lines of respon- management, operating and financial perfor-
sibility and authority over these activities. They mance, and material deficiencies identified dur-
should also address the approval of new product ing reviews by regulators and by internal or
lines, strategies, and other activities; conflicts of external audits. The FCM should also provide
interest including transactions by employees; reports to the parent company (or in the case of
and compliance with all applicable legal require- foreign-owned FCMs, to its U.S. parent organi-
ments. Procedures should incorporate and imple- zation, if any) of financial performance; adher-
ment the parent company’s relevant policies, ence to risk parameters and other limits and
and should be consistent with Federal Reserve controls established by the parent for the FCM;
Board regulations and any applicable Board and any material developments, including find-
orders. ings of material deficiencies by regulators.
A sound system of integrated limits and Examiners should determine the adequacy of an
risk-taking guidelines is an essential component FCM’s monitoring and reporting of its risk
of the risk-management process. This system exposure and financial performance to appropri-
should set boundaries for organizational risk- ate levels of senior management and to the
taking and ensure that positions that exceed board of directors.
certain predetermined levels receive prompt
management attention, so they can be either
reduced or prudently addressed.
Internal Controls
An FCM’s internal-control structure is critical to
Risk Measurement, Monitoring, and its safe and sound functioning in general and to
Reporting its risk-management system, in particular. Estab-
lishing and maintaining an effective system of
An FCM’s system for measuring the credit, controls, including the enforcement of official
market, liquidity, and other risks involved in its lines of authority and appropriate separation of
activities should be as comprehensive and accu- duties—such as trading, custodial, and back-
rate as practicable and should be commensurate office—is one of management’s more important
with the nature of its activities. Risk exposures responsibilities. Appropriately segregating duties
should be aggregated across customers, prod- is a fundamental and essential element of a
ucts, and activities to the fullest extent possible. sound risk-management and internal-control sys-
Examiners should evaluate whether the risk tem. Failure to implement and maintain an
measures and the risk-measurement process are adequate separation of duties can constitute an
sufficiently robust to reflect accurately the dif- unsafe and unsound practice, possibly leading to
ferent types of risks facing the institution. Insti- serious losses or otherwise compromising the
tutions should establish clear standards for mea- financial integrity of the FCM.
suring risk exposures and financial performance. When properly structured, a system of inter-
Standards should provide a common framework nal controls promotes effective operations and
for limiting and monitoring risks and should be reliable financial and regulatory reporting, safe-
understood by all relevant personnel. guards assets, and helps to ensure compliance
An accurate, informative, and timely manage- with relevant laws, regulations, and institutional
ment information system is essential to the policies. Ideally, internal controls are tested by
prudent operation of an FCM. Accordingly, the an independent internal auditor who reports
examiner’s assessment of the quality of the directly to either the institution’s board of direc-
management information system is an important tors or its designated committee. Personnel who
Trading and Capital-Markets Activities Manual February 1998
Page 3
3030.1 Futures Brokerage Activities and Futures Commission Merchants
perform these reviews should generally be inde- sides of the transaction with the clearinghouse,
pendent of the function they are assigned to usually by closing out the position before deliv-
review. Given the importance of appropriate ery of the futures contract or the expiration of
internal controls to banking organizations of all the option on the futures contract.
sizes and risk profiles, the results of audits or An exchange member that wishes to clear or
reviews, whether conducted by an internal settle transactions for itself, customers, other
auditor or by other personnel, should be ade- FCMs, or commodity professionals (locals or
quately documented, as should management’s market makers) may become a member of the
responses to them. In addition, communication affiliated clearinghouse (clearing member) if it
channels should allow negative or sensitive is able to meet the clearinghouse’s financial-
findings to be reported directly to the board of eligibility requirements. In general, these require-
directors or the relevant board committee. ments are more stringent than those required for
exchange membership. For example, a clearing
member usually is required to maintain a speci-
FUTURES EXCHANGES, fied amount of net capital in excess of the
regulatory required minimum and to make a
CLEARINGHOUSES, AND FCMs guaranty deposit as part of the financial safe-
Futures exchanges provide auction markets for guards of the clearinghouse. The size of the
standardized futures and options on futures deposit is related to the scale of the clearing
contracts. In the United States and most other member’s activity. If it is not a member of the
countries, futures exchanges and FCMs are clearinghouse for the exchange on which a
regulated by a governmental agency. Futures contract is executed, an FCM must arrange for
exchanges are membership organizations and another FCM that is a clearing member to clear
impose financial and other regulatory require- and settle its transactions.2
ments on members, particularly those that do Margin requirements are an important risk-
business for customers as brokers. In the United management tool for maintaining the financial
States and most other countries, futures exchanges integrity of clearinghouses and their affiliated
also have quasi-governmental (self-regulatory) exchanges. Clearinghouses require that their
responsibilities to monitor trading and prevent members post initial margin (performance bond)
fraud, with the authority to discipline or sanc- on a new position to cover potential credit
tion members that violate exchange rules. FCMs exposures borne by the clearinghouse. The clear-
may be members of the exchange on which they ing firm, in turn, requires its customers to post
effect customers’ trades. When they are not margin. At the end of each day, and on some
members, FCMs must use other firms who are exchanges on an intraday basis, all positions are
exchange members to execute customer trades.1 marked to the market. Clearing members with
Each futures exchange has an affiliated clear- positions that have declined in value pay that
inghouse responsible for clearing and settling amount in cash to the clearinghouse, which then
trades on the exchange and managing associated pays the clearing members holding positions
risks. When a clearinghouse accepts transaction that have increased in value on that day. This
information from its clearing members, it process of transferring gains and losses among
generally guarantees the performance of the clearing-member firms, known as collecting
transaction to each member and becomes the variation margin, is intended to periodically
counterparty to the trade (that is, the buyer to
every seller and the seller to every buyer). Daily
cash settlements are paid or collected by clear-
ing members through the clearinghouse. The 2. The nonmember FCM opens an account, usually on an
omnibus basis, with the clearing-member FCM. Separate
cash transfers represent the difference between omnibus accounts have to be maintained for customer and
the original trade price and the daily official noncustomer or proprietary trading activity. If the FCM does
closing settlement price for each commodity not carry customer accounts by holding customer funds and
futures contract. The two members settle their maintaining account records, the clearing member will carry
the customer’s account on a fully disclosed basis and issue
confirmations, account statements, and margin calls directly to
the customer on behalf of the introducing FCM. In such cases,
1. A firm or trading company that maintains only a the introducing FCM operates as an introducing broker (IB)
proprietary business may become a member of an exchange and could have registered with Commodity Futures Trading
without registering as an FCM. Commission as such.
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Futures Brokerage Activities and Futures Commission Merchants 3030.1
eliminate credit-risk exposure from the clearing- sionals that buy or sell exchange-traded futures
house.3 In volatile markets, a clearinghouse contracts.
may call for additional variation margin during The futures exchanges, in addition to provid-
the trading day, sometimes with only one hour’s ing a marketplace for futures contracts, are
notice, and failure to meet a variation (or initial) deemed to be self-regulatory organizations
margin call is treated as a default to the (SROs) under the CEA. For example, a number
clearinghouse. of SROs have adopted detailed uniform practice
Some clearinghouses also require that their rules for FCMs, including ‘‘know your cus-
members be prepared to pay loss-sharing assess- tomer’’ recordkeeping rules and other formal
ments to cover losses sustained by the clearing- customer-disclosure requirements. The National
house in meeting the settlement obligations of a Futures Association (NFA) also is an SRO,
clearing member that has defaulted on its (or its although it does not sponsor a futures exchange
customers’) obligations. Such assessments arise or other marketplace. The NFA has adopted
when losses exceed the resources of defaulting sales-practice rules applicable to members who
members, the guaranty fund, and other surplus do business with customers. All FCMs that wish
funds of the clearinghouse. Each clearinghouse to accept orders and hold customer funds and
has its own unique loss-sharing rules.4 At least assets must be members of the NFA.
one U.S. and one foreign exchange have unlim- The CEA and rules of the CFTC require the
ited loss-sharing requirements. Most U.S. clear- SROs to establish and maintain enforcement and
inghouses relate loss-sharing requirements to surveillance programs for their markets and to
the size of a member’s business at the clearing- oversee the financial responsibility of their mem-
house. Given the potential drain on an institu- bers.6 The CFTC has approved an arrangement
tion’s financial resources, the exposure to loss- under which a designated SRO (DSRO) is
sharing agreements should be a significant responsible for performing on-site audits and
consideration in an institution’s decision to reviewing periodic reports of a member FCM
become a clearing member. that is a member of more than one futures
exchange. The NFA is the DSRO for FCMs that
are not members of any futures exchange.
Oversight of FCMs is accomplished through
COMMODITY EXCHANGE ACT, annual audits by the DSRO and the filing of
COMMODITY FUTURES periodic financial statements and early warning
TRADING COMMISSION, AND reports by FCMs, in compliance with CFTC and
SELF-REGULATORY SRO rules. In summary, this oversight encom-
ORGANIZATIONS passes the following three elements.
In the United States, the primary regulator of 1. Full-scope audits at least once every other
exchange-traded futures activities is the Com- year of each FCM that carries customer
modity Futures Trading Commission (CFTC), accounts. Audit procedures conform to a
which was created by and derives its authority Uniform Audit Guide developed jointly by
from the Commodity Exchange Act (CEA). The the SROs. The full-scope audit focuses on
CFTC has adopted registration,5 financial respon- the firm’s net capital computations, segrega-
sibility, antifraud, disclosure, and other rules for tion of customer funds and property, financial
FCMs and CTAs, and has general enforcement reporting, recordkeeping, and operations.7
authority over commodities firms and profes-
6. CFTC Rule 1.51, contract market program for enforce-
ment, requires that SROs monitor market activity and trading
3. Some foreign exchanges do not allow the withdrawal of practices in their respective markets, perform on-site exami-
unrealized profits as mark-to-market variation. nations (audits) of members’ books and records, review
4. Clearinghouses usually retain the right to use assets periodic financial reports filed by members, and bring disci-
owned by clearing members, but under the control of the plinary and corrective actions against members for violations
clearinghouse (for example, proprietary margin); require addi- of the CEA, and of CFTC and SRO rules.
tional contributions of funds or assets or require the member 7. If an FCM is also a broker-dealer, the DSRO is not
to purchase additional shares of the clearinghouse; or perfect required to examine the FCM for compliance with net capital
a claim against the member for its share of the loss. requirements if the DSRO confers with the broker-dealer’s
5. Many FCMs also are SEC-registered as broker-dealers examining authority at least annually to determine that the
and are subject to SEC and CFTC financial responsibility FCM is in compliance with the broker-dealer’s net capital
rules. requirements and receives the DSRO copies of all examinations.
Trading and Capital-Markets Activities Manual February 1998
Page 5
3030.1 Futures Brokerage Activities and Futures Commission Merchants
The audit also reviews sales practices (includ- FEDERAL RESERVE
ing customer records, disclosures, advertise- REGULATION OF FCMs AND
ments, and customer complaints) and the CTAs
adequacy of employee supervision. The
audit’s scope should reflect the FCM’s prior Bank holding companies are permitted, under
compliance history as well as the examiner’s Regulation Y, to engage in FCM and CTA
on-site evaluation of the firm’s internal con- activities on both domestic and foreign futures
trols. During the off-year, the DSROs per- exchanges through separately incorporated
form limited scope audits of member FCMs. nonbank subsidiaries. As a general matter, the
This audit is limited to financial matters such nonbank subsidiaries of bank holding compa-
as a review of the FCM’s net capital compu- nies (and some foreign banks) provide services
tations, segregation of customer funds, and to unaffiliated customers in the United States
its books and records. under section 4(c)(8) of the Bank Holding Com-
2. FCM quarterly financial reporting require- pany Act (BHC Act) and to unaffiliated custom-
ments. FCMs are required to file quarterly ers outside the United States under Regulation
financial statements (form 1-FR-FCM) with K.9 Banks and the operating subsidiaries of
their DSROs. The fourth-quarter statement banks usually provide futures-related services to
must be filed as of the close of the FCM’s unaffiliated parties in the United States under the
fiscal year and must be certified by an inde- general powers of the bank and to unaffiliated
pendent public accountant. The filings gen- parties outside the United States under Regula-
erally include statements regarding changes tion K. These various subsidiaries may provide
in ownership equity, current financial condi- services to affiliates under section 4(c)(1)(C) of
tion, changes in liabilities subordinated to the BHC Act.
claims of general creditors, computation of Regulation Y permits a bank holding com-
minimum net capital, segregation require- pany subsidiary that acts as an FCM to engage
ments and funds segregated for customers, in other activities in the subsidiary, including
secured amounts and funds held in separate futures advisory services and trading, as well as
accounts, and any other material information other permissible securities and derivative
relevant to the firm’s financial condition. The activities as defined in sections 225.28(b)(6)
certified year-end financial report also must (financial and investment advisory activities)
contain statements of income and cash flows. and 225.28(b)(7) (agency transactional services
3. Early warning reports. FCMs are required to for customer investments). Section 225.28(b)(7)
notify the CFTC and the SROs when certain specifically authorizes FCMs to provide agency
financial weaknesses are experienced.8 For services for unaffiliated persons in execution,
example, if an FCM’s net capital falls to a clearance, or execution and clearance of any
specified warning level, it must file a written futures contract and option on a futures contract
notice within five business days and file traded on an exchange in the United States and
monthly financial reports (form 1-FR-FCM) abroad. It also includes the authority to engage
until its net capital meets or exceeds the in other agency-type transactions, (for example,
warning level for a full three months. If an riskless principal), involving a forward contract,
FCM’s net capital falls below the minimum option, future, option on a future, and similar
required, it must cease doing business and instruments. Furthermore, this section codifies
give telegraphic notice to the CFTC and any the longstanding prohibition against a parent
commodities or securities SRO of which it is bank holding company’s issuing any guarantees
a member. Similar notices must be given by or otherwise becoming liable to an exchange or
a clearing organization or carrying FCM clearinghouse for transactions effected through
when it determines that a position of an FCM
must be liquidated for failure to meet a
9. Those nonbank subsidiaries that operate in the United
margin call or other required deposit. States may open offices outside the United States if (1) the
bank holding company’s authority under Regulation Y is not
limited geographically, (2) the foreign office is not a sepa-
rately incorporated entity, and (3) the activities conducted by
8. CFTC Rule 1.12 requires the maintenance of minimum the foreign office are within the scope of the bank holding
financial requirements by FCMs and introducing brokers. company’s authority under Regulation Y. In addition, a bank
These requirements are similar to those applicable to broker- holding company may operate a limited foreign-based busi-
dealers under SEC rules. ness in the United States under Regulation K.
February 1998 Trading and Capital-Markets Activities Manual
Page 6
Futures Brokerage Activities and Futures Commission Merchants 3030.1
an FCM, except for the proprietary trades of the performs due diligence on relevant legal and
FCM and those of affiliates. regulatory issues, as well as on local business
A well-capitalized and well-managed bank practices. Foreign-exchange risks should be
holding company, as defined in sections 225.2(r) understood and authorized by the FCM’s parent
and (s) of Regulation Y, respectively, may com- company, and any limits set by the parent
mence activities as an FCM or a CTA by filing company or FCM management should be care-
a notice prescribed under section 225.23(a) of fully monitored. The FCM and its parent com-
Regulation Y. Bank holding companies that are pany also should assess the regulatory and
not eligible to file notices or wish to act in a financial risks associated with exchange and
capacity other than as an FCM or CTA, such as clearinghouse membership in a foreign market,
a commodities pool operator, must follow the including an understanding of the extent to
specific application process for these activities. which the foreign clearinghouse monitors and
Examiners should ensure that all of these activi- controls day-to-day credit risk and its loss-
ties are conducted in accordance with the Board’s sharing requirements.
approval order.
A bank holding company, bank, or FBO
parent company of an FCM is expected to SPECIFIC RISKS AND THEIR
establish specific risk parameters and other lim-
its and controls on the brokerage operation.
RISK-MANAGEMENT
These limits and controls should be designed to CONSIDERATIONS
manage financial risk to the consolidated orga-
In general, FCMs face five basic categories of
nization and should be consistent with its busi-
risk—credit risk, market risk, liquidity risk,
ness objectives and overall willingness to assume
reputation risk, and operations risk. The follow-
risk.
ing discussions highlight specific considerations
in evaluating the key elements of sound risk
management as they relate to these risks. The
PARTICIPATION IN FOREIGN compliance and internal-controls functions pro-
MARKETS vide the foundation for managing the risks of an
FCM.
Institutions frequently transact business on for-
eign exchanges as either exchange or clearing-
house members or through third-party brokers Credit Risk
that are members of the foreign exchange. The
risks of doing business in foreign markets gen- FCMs encounter a number of different types of
erally parallel those in U.S. markets; however, credit risks. The following discussions identify
some unique issues of doing business on foreign some of these risks and discuss sound risk-
futures exchanges must be addressed by the management practices applicable to each.
FCM and its parent company to ensure that the
activity does not pose undue risks to the con-
solidated financial organization. Customer-Credit Risk
Before doing business on a foreign exchange,
an FCM should understand the legal and opera- Customer-credit risk is the potential that a cus-
tional differences between the foreign exchange tomer will fail to meet its variation margin calls
and U.S. exchanges. For example, the FCM or its payment or delivery obligations. An FCM
should know about local business practices and should establish a credit-review process for new
legal precedents that pertain to business in the customers that is independent of the marketing
foreign market. In addition, the FCM should and sales function. It is not unusual for the
know how the foreign exchange is regulated and FCM’s parent company (or banking affiliate) to
how it manages risk, and should develop poli- perform the credit evaluation and provide the
cies and the appropriate operational infrastruc- necessary internal approvals for the FCM to
ture of controls, procedures, and personnel to execute and clear futures contracts for particular
manage these risks. Accordingly, examiners customers. In some situations, however, the
should confirm that, in considering whether and FCM may have the authority to perform the
how to participate in a foreign market, an FCM credit review internally. Examiners should
Trading and Capital-Markets Activities Manual February 1998
Page 7
3030.1 Futures Brokerage Activities and Futures Commission Merchants
determine how customers are approved and addition, the FCM should review financial
confirm that documentation in the customer’s information on its customers periodically and
credit files is adequate even when the approval adjust lending limits when appropriate.
is performed by the parent. Customer-credit files
should indicate the scope of the credit review
and contain approval of the customer’s account Clearing-Only Risk
and credit limits. For example, customer-credit
files may contain recent financial statements, FCMs often enter into agreements to clear, but
sources of liquidity, trading objectives, and any not execute, trades for customers. Under a
other pertinent information used to support the ‘‘clearing-only’’ arrangement, the customer gives
credit limits established for the customer. In its order directly to an executing FCM. The
addition, customer-credit files should be updated executing FCM then gives the executed transac-
periodically. tion to the clearing FCM, which is responsible
FCM procedures should describe how for accepting and settling the transaction. Cus-
customer-credit exposures will be identified and tomers often prefer this arrangement because it
controlled. For example, an FCM could monitor provides the benefits of centralized clearing
a customer’s transactions, margin settlements, (recordkeeping and margin payments) with the
or open positions as a means of managing the flexibility of using a number of specialized
customer’s credit risk. Moreover, procedures brokers to execute transactions.
should be in place to handle situations in which FCMs entering into clearing-only arrange-
the customer has exceeded credit limits. These ments execute written give-up agreements, which
procedures should give senior managers who are are triparty contracts that set forth the responsi-
independent of the sales and marketing function bilities of the clearing FCM, the executing
the authority to approve limit exceptions and FCM, and the customer. Most FCMs use the
require that such exceptions be documented. uniform give-up agreement prepared by the
Futures Industry Association, although some
FCMs still use their own give-up contracts. The
Customer-Financing Risk uniform give-up agreement permits a clearing
FCM, upon giving prior notice to the customer
Several exchanges, particularly in New York and the executing FCM, to place limits or
and overseas, allow FCMs to finance customer conditions on the transactions it will accept to
positions. These exchanges allow an FCM to clear or terminate the arrangement. If an executed
lend initial and variation margin to customers transaction exceeds specified limits, the FCM
subject to taking the capital charges under the may decline to clear the transaction unless it is
CFTC’s (or SEC’s) capital rules if the charges acting as the qualifying or primary clearing
are not repaid within three business days. In FCM for the customer and has not given prior
addition, some exchanges allow FCMs to finance notice of termination, as discussed further below.
customer deliveries, again subject to a capital Clearing-only arrangements can present sig-
charge. nificant credit risks for an FCM. An FCM’s
An FCM providing customer-financing ser- risk-management policies and procedures for
vices should adopt financing policies and proce- clearing-only activities should address the quali-
dures that identify customer-credit standards. fications required of clearing-only customers
The financing policies should be approved by and their volume of trading, the extent to which
the parent company and should be consistent customer-trading activities can be monitored
with the FCM’s risk tolerance. In addition, an by the clearing-FCM at particular exchanges,
FCM should establish overall lending limits for and how aggregate risk will be measured and
each customer based on a credit review that is managed.
analogous to that performed by a bank with The FCM should establish trading limits for
similar lending services. The process should be each of its clearing-only customers and have
independent of the FCM’s marketing, sales, and procedures in place to monitor their intraday
financing functions but may be performed by the trading exposures. The FCM should take appro-
FCM’s banking affiliate. Examiners should deter- priate action to limit its liability if a clearing-
mine how customer-financing decisions are made only customer has exceeded acceptable trading
and confirm that documentation is adequate, limits either by reviewing and approving a limit
even when an affiliate approves the financing. In exception or by rejecting the trade. Examiners
February 1998 Trading and Capital-Markets Activities Manual
Page 8
Futures Brokerage Activities and Futures Commission Merchants 3030.1
should confirm that the FCM formally advises example, the FCM could maintain a significant
(usually in the give-up agreement) its customers physical presence on the trading floor to monitor
and their executing FCMs of the trading param- customer trading activities and promote more
eters established for the customer. Examiners frequent collection (and tallying) of trade infor-
should also confirm that the FCM personnel mation from clearing-only customers. The
responsible for accepting or rejecting an executed resources necessary for such monitoring obvi-
trade for clearance have sufficient current infor- ously will depend on the physical layout of the
mation to determine whether the trade is consis- exchange—the size of the trading floor and the
tent with the customer’s trading limits. Give-up number of trading pits, the floor population and
agreements (or other relevant documents such as daily trading volumes, and the level of familiar-
the customer account agreement) should permit ity the FCM has with the trading practices and
the FCM to adjust the customer’s transaction objectives of its primary clearing customers.
limits when appropriate in light of market con- The FCM should be able to increase its floor
ditions or changes in the customer’s financial presence in times of market stress.
condition.
Some FCMs act as the primary clearing firm
(also referred to as the sponsoring or qualifying Carrying-Broker Risk
firm) for customers.10 A primary clearing firm
guarantees to the clearinghouse that it will An FCM may enter into an agreement with
accept and clear all trades submitted by the another FCM to execute and clear transactions
customer or executing FCM, even if the trade is on behalf of the first FCM (typically, when the
outside the agreed-on limits. Because an FCM is first FCM is not an exchange or clearing mem-
obligated to accept and clear all trades submitted ber of an exchange). In such cases, the FCM
by its primary clearing customers, the FCM seeking another or carrying FCM to execute its
must be able to monitor its customers’ trading transactions should have procedures for review-
activities on an intraday basis for compliance ing the creditworthiness of the carrying FCM. If
with agreed-on trading limits. Monitoring is the FCM reasonably expects that the carrying
especially important during times of market FCM will use yet another FCM to clear its
stress. The FCM should be ready and able to transactions (for example, if the carrying FCM
take immediate steps to address any unaccept- enters into its own carrying-broker relationship
able risks that arise, for example, by contacting with another firm for purposes of executing or
the customer to obtain additional margin or clearing transactions on another exchange), the
other assurances, approving a limit exception, first FCM should try to obtain an indemnifica-
taking steps to liquidate open customer posi- tion from the carrying FCM for any losses
tions, or giving appropriate notice of termina- incurred on these transactions.11 When carrying
tion of the clearing arrangement to enable the transactions occur on a foreign exchange, an
FCM to reject future transactions. FCM should know about the legal ramifications
Intraday monitoring techniques will vary of the carrying relationship under the rules of
depending on the technology available at the the exchange and laws of the host country.
particular exchange. A number of the larger, Moreover, it may be appropriate for an FCM
more automated U.S. exchanges have developed to reach an agreement with its customers that
technologies that permit multiple intraday col- addresses liabilities relative to transactions
lection, matching, and reporting of trades— effected on a non-U.S. exchange by a carrying
although the frequency of such reconciliations broker.
varies. On exchanges that are less automated,
the primary clearing FCM must develop proce-
dures for monitoring clearing-only risks. For Executing-FCM Risk
When an FCM uses an unaffiliated FCM to
execute customer transactions under a give-up
10. Primary clearing customers include institutions and
individuals, as well as other nonclearing futures professionals 11. The CFTC takes the position that an FCM is respon-
(locals or floor traders), who execute their own trades on the sible to its customers for losses arising from the failure of the
exchange and other nonclearing FCMs that execute trades for performance of a carrying broker. The industry disagrees with
unaffiliated customers. this position, and the issue has not been resolved by the courts.
Trading and Capital-Markets Activities Manual February 1998
Page 9
3030.1 Futures Brokerage Activities and Futures Commission Merchants
arrangement, the clearing firm that sponsors the some foreign clearinghouses have unlimited loss-
executing FCM guarantees its performance. sharing requirements, and some have ‘‘limited’’
Therefore, the first FCM should review the requirements that are set at very high percent-
subcontracting risk of its executing FCMs and ages. However, the loss-sharing provisions of
their sponsoring clearing firms. However, unlike some of the foreign clearinghouses have not yet
the clearing risk inherent in a carrying-broker been applied, which means that there are no
relationship, the subcontracting risk for an FCM legal and regulatory precedents for applying the
using an executing FCM is limited to transaction stated requirements. In addition, the board should
risk (execution errors). An FCM’s management be apprised of any differences in how foreign
should approve each executing broker it uses, accounts are viewed, for example, whether cus-
considering the broker’s reputation for obtaining tomer funds are considered separate from those
timely executions and the financial condition of of the FCM, whether the relationship between
its sponsoring clearing firm. an FCM and its customer is viewed as an agency
rather than a principal relationship, and whether
there are material differences in the way futures
activities are regulated.
Pit-Broker Risk
The board also should be apprised of any
Usually, FCMs will subcontract the execution of material changes in the financial condition of
their orders to unaffiliated pit brokers who every clearinghouse of which the FCM is a
accept and execute transactions for numerous member. Senior management should monitor
FCMs during the trading day. The risk associ- the financial condition of its clearinghouses as
ated with using a pit broker is similar to that of part of its risk-management function.
using an executing broker: the risk is limited to
the broker’s performance in completing the
transaction. If the pit broker fails, then the Guarantees
primary clearing firm is responsible for complet-
ing the transaction. Therefore, an FCM should FCM parent companies often are asked to pro-
approve each pit broker it uses, considering the vide assurances to customers and clearinghouses
pit broker’s reputation for obtaining timely that warrant the FCM’s performance. These
executions and the resources of its sponsoring arrangements may take the form of formal
clearing firm. guarantees or less formal letters of comfort.
Under Regulation Y, a bank holding company
may not provide a guarantee to a clearinghouse
for the performance of the FCM’s customer
Clearinghouse Risk obligations. A bank holding company may pro-
vide a letter of comfort or other agreement to the
Clearinghouse risk is the potential that a clear- FCM’s customers that states the parent (or
inghouse will require a member to meet loss- affiliate) will reimburse the customers’ funds on
sharing assessments caused by another clearing deposit with the FCM if they are lost as a result
member’s failure. Before authorizing member- of the FCM’s failure or default. Customers may
ship in an exchange or clearinghouse, an FCM’s seek this assurance to avoid losses that could
board of directors and its parent company must arise from credit exposure created by another
fully understand the initial and ongoing regula- customer of the FCM, since the clearinghouse
tory and financial requirements for members. may use some or all of the FCM’s customer-
The FCM’s board of directors should approve segregated funds in the event of a default by the
membership in a clearinghouse only after a FCM stemming from a failing customer’s obli-
thorough consideration of the financial condi- gations.12 Examiners should note any permis-
tion, settlement and default procedures, and sible guarantees for purposes of the consolidated
loss-sharing requirements of the clearinghouse. report of the parent bank holding company, as
Particularly when it is considering member-
ship in a foreign exchange or clearinghouse, an
FCM’s board should examine any regulatory 12. The letter of comfort would protect customers whose
funds were used to cover other customer losses by the
and legal precedents related to how the exchange, clearinghouse. U.S. clearinghouses also have guarantee funds
clearinghouse, or host country views loss- that can be used to reimburse customers at the clearinghouse’s
sharing arrangements. As in the United States, discretion.
February 1998 Trading and Capital-Markets Activities Manual
Page 10
Futures Brokerage Activities and Futures Commission Merchants 3030.1
they are relevant to calculating the consolidated could create an illiquid market, thereby creating
risk-based capital of the bank holding company. a risk that the FCM could not liquidate its
positions. Most U.S. clearinghouses monitor
concentrations and will contact an FCM that
holds more than a certain percentage of the open
Market Risk interest in a product. In some situations, the
exchange could sanction or discipline the FCM
When an FCM acts as a broker on behalf of
if it finds that the FCM, by holding the undue
customers, it generally is only subject to market
concentration, was attempting to manipulate the
risk if it executes customers’ transactions in
market. These prudential safeguards may not be
error. In this regard, operational problems can
in place on foreign exchanges; consequently, an
expose the FCM to market fluctuations in con-
FCM will have to establish procedures to moni-
tract values. However, when an FCM engages in
tor its liquidity risk on those exchanges.
proprietary trading, such as market making and
other position-taking, it will be directly exposed
to market risk. Potential market-risk exposure
should be addressed appropriately in an FCM’s Reputation Risk
policies and procedures.
An FCM that engages in proprietary trading
FCMs should have reporting procedures in place
should establish market-risk and trading param-
to ensure that any material events that harm its
eters approved by its parent company. The
reputation, and the reputations of its bank affili-
FCM’s senior management should establish an
ates, are brought to the attention of senior
independent risk-management function to con-
management; the FCM’s board of directors;
trol and monitor proprietary trading activities.
and, when appropriate, its parent company.
Finally, the FCM should institute procedures to
Reports of potentially damaging events should
control potential conflicts of interest between its
be sent to senior management at the parent bank
brokerage and proprietary trading activities.
holding company who will evaluate their effect
on the FCM to determine what, if any, steps
should be taken to mitigate the impact of the
Liquidity Risk event on the whole organization.
Liquidity risk is the risk that the FCM will not
be able to meet its financial commitments (end- Commodity Trading Advisor
of-day and intraday margin calls) to its clearing
FCM or clearinghouse. Clearing FCMs are Acting as a commodity trading advisor (includ-
required to establish an account at one of the ing providing discretionary investment advice
settlement banks used by the clearinghouse for to retail and institutional customers or commod-
its accounts and the accounts of its clearing ity pools) may pose reputational and litigation
members. In some foreign jurisdictions, the risks to a CTA or FCM, particularly when retail
central bank fulfills this settlement function. An customers are involved. Accordingly, the FCM’s
FCM should establish and monitor daily settle- board should adopt policies and procedures
ment limits for its customers and should ensure addressing compliance with CFTC and NFA
that there are back-up liquidity facilities to meet sales-practice rules (including compliance with
any unexpected shortfalls in same-day funds. To the know-your-customer recordkeeping rules).
ensure the safety of its funds and assets, an FCM
should also monitor the financial condition of
the settlement bank it has chosen and should be
prepared to transfer its funds and assets to Operations Risk
another settlement bank, if necessary.
To control other types of liquidity risks, an Operations risk is the potential that deficiencies
FCM should adopt contingency plans for liquid- in information systems or internal controls will
ity demands that may arise from dramatic mar- result in unexpected loss. Some specific sources
ket changes. An FCM, to the extent posible, of operating risk at FCMs include inadequate
should monitor the markets it trades in to procedures, human error, system failure, or fraud.
identify undue concentrations by others that For FCMs, failure to assess or control operating
Trading and Capital-Markets Activities Manual February 1998
Page 11
3030.1 Futures Brokerage Activities and Futures Commission Merchants
risks accurately can be a likely source of and sound manner. In addition, the internal-audit
problems. function should review any significant issues
Adequate internal controls are the first line of raised by compliance personnel to ensure that
defense in controlling the operations risks they are resolved. Other staff within the FCM
involved in FCM activities. Internal controls should be able to reach internal audit staff to
that ensure the separation of duties involving discuss any serious concerns they might have.
account acceptance, order receipt, execution, Internal audit reports should be forwarded to
confirmation, margin processing, and account- the FCM’s senior management and material
ing are particularly important. findings should be reported to the FCM’s board
An FCM’s approved policies should specify of directors and the parent company. Frequently,
documentation requirements for transactions and the internal audit function is located at the
formal procedures for saving and safeguarding parent company, and audit reports are routinely
important documents, consistent with legal sent to senior management at the parent
requirements and internal policies. Relevant per- company.
sonnel should fully understand documentation
requirements. Examiners should also consider
the extent to which institutions evaluate and EXAMINATION AND INSPECTION
control operations risks through internal audits, PROCEDURES
contingency planning, and other managerial and
analytical techniques. The review of an FCM’s functions should take
Back-office or transaction-processing opera- a functional regulatory approach, using the
tions are an important source of operations-risk findings of the FCM’s primary regulators as
exposures. In conducting reviews of back-office much as possible. Examiners should especially
operations, examiners should consult the appro- focus on the risks that the FCM poses to the
priate chapters of this manual for further parent company and affiliated banks. These
guidance. risks should be assessed by reviewing the ade-
Operations risk also includes potential losses quacy of the FCM’s policies and procedures,
from computer and communication systems that internal controls, and risk-management func-
are unable to handle the volume of FCM trans- tions. Compliance with policies and procedures,
actions, particularly in periods of market stress. and with any conditions on the FCM’s activities
FCMs should have procedures that address the imposed by regulatory authorities (including
operations risks of these systems, including the Federal Reserve Board), should be fully
contingency plans to handle systems failures reviewed.
and back-up facilities for critical parts of risk Bank holding companies, banks, and FBOs
management, communications, and accounting may have more than one subsidiary that acts as
systems. an FCM in the United States or that engages in
When FCMs execute or clear transactions in futures transactions for customers in foreign
nonfinancial commodities, they may have to markets. To ensure that the FCM/CTA activities
take delivery of a commodity because a cus- of a banking organization are evaluated on a
tomer is unable or unwilling to make or take consolidated basis, a cross-section of affiliated
delivery on its contract. To address this situa- futures brokerage and advisory firms should be
tion, the FCM should have in place the proce- reviewed periodically—particularly those that
dures it will follow to terminate its position and present the greatest risk to the consolidated
avoid dealing in physical commodities. Internal financial organization. Relevant factors to con-
controls should also be established to record, sider when identifying firms for review include
track, and resolve errors and discrepancies with (1) the volume of business; (2) whether the
customers and other parties. FCM has unaffiliated customers; (3) the number
of customers; (4) whether the firm provides
customer financing; (5) the number of brokers
effecting transactions; (6) whether exchange
INTERNAL AUDITS or clearinghouse memberships are involved;
(7) whether the FCM provides clearing-only
An FCM should be subject to regular internal services; and (8) the date and scope of the last
audits to confirm that it complies with its poli- review conducted by the Federal Reserve, SRO,
cies and procedures and is managed in a safe or other regulator.
February 1998 Trading and Capital-Markets Activities Manual
Page 12
Futures Brokerage Activities and Futures Commission Merchants 3030.1
The scope of any review to be conducted to reporting requirements if capital falls below
depends on the size of the FCM and the scope of warning levels. Examiners should perform a
its activities. The draft first-day letter should front- and back-office review of the FCM’s
provide an overview of an FCM’s authorized operations outside of the United States.14
activities and conditions, as well as a description Examiners may rely on well-documented
of the actual scope of its business. Examiners internal-audit reports and workpapers to verify
should review the most recent summary of the adequacy of risk management at the FCM. If
management points or other inspection results an examiner finds that an internal audit ade-
issued by the FCM’s SRO or other regulator, as quately documents the FCM’s compliance with
well as any correspondence between the FCM a policy or procedure pertaining to the manage-
and any federal agency or SRO. If examiners ment of the various risk assessments required by
should have any questions about the findings of the current inspection, he or she should docu-
an SRO’s or a regulator’s results, they should ment the audit finding in the workpapers and
contact the organization to determine whether complete inspection procedures in any area not
the matter is material and relevant to the current adequately addressed by the internal audit report.
inspection. The status of any matters left open Examiners should periodically spot check areas
after the SRO’s or regulator’s review should covered by internal audits to ensure the ongoing
also be inquired about. integrity of the audit process. Examiners should
An important factor in determining the scope also review internal-audit reports and work-
of the inspection is whether the FCM has papers for their scope and thoroughness in
unaffiliated customers or conducts transactions complying with FCM policies and procedures.
solely for affiliates. Other factors include whether Finally, examiners should ensure that internal
the FCM is a clearing member of an exchange, auditors have adequate training to evaluate the
particularly of a non-U.S. exchange; it acts as a FCM’s compliance with its policies and proce-
carrying broker on behalf of other FCMs; it has dures and with applicable laws and regulations
omnibus accounts with other brokers in markets (both inside and, if applicable, outside the United
in which it is not a member (U.S. or foreign); it States).
provides advisory or portfolio management ser- If an examiner has determined that it is not
vices, including discretionary accounts, or has necessary to perform a routine back-office
been authorized to act as a commodity pool review, he or she should confirm that the FCM
operator (CPO); it provides clearing services to has addressed operations risks in its policies and
locals or market-makers; and it provides financ- procedures. Examiners also should review the
ing services to customers.13 internal controls of an FCM to ensure that the
Examiners are not expected to routinely per- firm is operated safely and soundly according to
form a front- or back-office inspection unless industry standards and that it complies with any
(1) the FCM’s primary regulator found material Board regulations or conditions placed on the
deficiencies in either office during its most FCM’s activities. Examiners should be alert to
recent examination or (2) if front- or back-office any ‘‘red flags’’ that might indicate inadequate
operations have not been examined by the pri- internal controls. An FCM must be organized so
mary regulator within the last two years. How- that its sales, operations, and compliance func-
ever, examiners may still choose to review a tions are separate and managed independently.
small sample of accounts and transactions to If an FCM engages in proprietary trading,
confirm that appropriate controls are in place. In examiners should confirm that the firm has
addition, net capital computations of U.S. FCMs procedures that protect against conflicts of inter-
do not need to be reviewed; they are reviewed est in the handling of customer orders (examples
by the FCM’s DSRO, and the FCM is subject of these conflicts of interest include front-
running or ex-pit transactions). To make an
overall assessment of the FCM’s future busi-
13. If the FCM engages in proprietary trading for its own ness, the results of any review should be con-
account, particularly for purposes other than hedging (market
making or position-taking), or if the FCM acts as an interme-
solidated with the results of reviews by other
diary in any over-the-counter futures or other derivative FCMs inspected during this cycle.
activities, the examiner should advise the examiner in charge
of the inspection so that the firm’s proprietary trading can be 14. The inspection procedures for reviewing front- and
evaluated in connection with similar activities of the consoli- back-office operations may be found in sections 2050.3 and
dated financial organization. 2060.3, respectively.
Trading and Capital-Markets Activities Manual February 1998
Page 13
Futures Brokerage Activities and
Futures Commission Merchants
Examination Objectives Section 3030.2
1. To identify the potential for and extent of 4. To assess the adequacy of and compliance
various risks associated with the FCM’s with the FCM’s policies and procedures and
activities, particularly credit, market, liquid- the adequacy of the internal-control function.
ity, operations, and reputation risks. 5. To evaluate and determine the FCM’s level
2. To evaluate the adequacy of the audit func- of compliance with relevant Board regula-
tion and review significant findings, the tions, orders, and policies.
method of follow-up, and management’s 6. To assess the adequacy of risk management
response to correct any deficiencies. of affiliated FCMs on a consolidated basis.
3. To assess the adequacy of the risk-
management function at the FCM.
Trading and Capital-Markets Activities Manual February 1998
Page 1
Futures Brokerage Activities and
Futures Commission Merchants
Examination Procedures Section 3030.3
1. Identify all bank holding company subsidi- cial commitments and guarantees by the
aries that engage in FCM- or CTA-type FCM or its parent to the exchange or
activities in the United States or abroad or clearinghouse with respect to proprietary,
identify U.S. FCM or CTA subsidiaries of affiliate, or customer transactions.
FBOs. Determine which firms should be 5. Note any new lines of business or activities
inspected to provide a global view of occurring at the FCM or any changes to
the adequacy of management of these exchange and clearinghouse memberships
activities on a consolidated basis, based on since the last inspection.
the scope of activities and degree of super- 6. Note what percentage of business is con-
vision by other regulators. Complete appli- ducted for—
cable procedures below for firms selected a. affiliate banks,
for inspection. b. nonbank affiliates,
2. Review first-day letter documents; notices
c. customers (note the breakdown between
filed under Regulation Y; Board orders and
institutional and retail, and any guaran-
letters authorizing activities; previous
tee or letter of comfort to customers in
inspection reports and workpapers; and pre-
which the parent company provides that
vious audits by futures regulators (CFTC,
it will reimburse customers for loss as a
designated self-regulatory organization
result of the FCM’s failure or other
(DSRO), National Futures Association, for-
default),
eign futures regulator); and reports by inter-
nal or external auditors or consultants. d. proprietary accounts (hedging, position-
taking), and
3. Note the scope of the FCM’s activities,
including— e. professional floor traders (locals, market
a. execution and clearing; makers).
b. execution only for affiliates and third 7. Determine the quality of the internal audit
parties; program. Assess the scope, frequency, and
c. clearing only for affiliates, third parties, quality of the audit program for the FCM
professional floor traders (locals); and related activities.
d. pit brokerage; a. Review the most recent audit report,
e. advisory; noting any exceptions and their resolution.
f. discretionary portfolio management; b. Verify that audit findings have been com-
g. commodities pool operator (in an FCM municated to senior management and
or affiliate); that material findings have been reported
h. margin financing; to the FCM’s board of directors and
i. proprietary trading; parent company.
j. exchange market maker or specialist; c. Identify any areas covered by these pro-
k. types of instruments (financial, agricul- cedures that are not adequately addressed
tural, precious metals, petroleum); by the internal audit report.
l. contract markets where business is d. Identify areas of the internal audit report
directed; that should be verified as part of the
m. other derivative products (interest rate current inspection.
swaps and related derivative contracts, 8. Determine the scope of review that is
foreign-exchange derivative contracts, appropriate to the activities and allocate
foreign government securities, and resources, considering the adequacy of
others); internal audit workpapers. Complete appro-
n. other futures-related activities, including priate front- or back-office inspection pro-
off-exchange transactions; cedures if—
o. riskless-principal transactions; and a. front- and back-office operations have
p. registered broker-dealers. not been examined by the designated
4. Review exchange and clearinghouse mem- self-regulatory organization (DSRO)
berships here and abroad, noting any finan- within the last two years,
Trading and Capital-Markets Activities Manual February 1998
Page 1
3030.3 Futures Brokerage Activities and Futures Commission Merchants: Examination Procedures
b. material deficiencies in front- or back- regulatory and supervisory standards and
office operations were found by the address all of the FCM’s activities.
DSRO during the most recent audit, or 14. Review management information reporting
c. the primary regulator for the FCM is not systems and determine whether the board of
a U.S. entity. directors of the parent company (or a des-
9. Advise the examiner who is in charge of ignated committee of the parent’s board) is
inspection of the parent company if the apprised of—
FCM engages in proprietary trading or over- a. material developments at the FCM;
the-counter futures or derivative business as b. the financial position of the firm, includ-
principal or agent. ing significant credit exposures;
c. the adequacy of risk management;
d. material findings of the audit or compli-
ance functions; or
BOARD AND SENIOR e. material deficiencies identified during
MANAGEMENT OVERSIGHT the course of regulatory reviews or
inspections.
10. Review the background and experience of 15. Review the FCM’s strategic plan.
the FCM’s board of directors and senior a. Assess whether there are material incon-
management, noting prior banking and sistencies between the stated plans and
futures brokerage experience. the FCM’s stated risk tolerances.
11. Determine if the board of directors of the b. Verify that the strategic plan is reviewed
FCM has approved written policies summa- and updated periodically.
rizing the firm’s activities and addressing
oversight by the board or a board desig-
nated committee of— CREDIT RISK
a. the risk appropriate for the FCM, includ-
ing credit, market, liquidity, operations, 16. Review credit-risk policies and procedures.
reputation, and legal risk (see SR-95- a. Verify the independence of credit-review
51); approval from the limit-exceptions
b. the monitoring of compliance with risk approval.
parameters; b. Verify that the procedures designate a
c. exchange and clearinghouse member- senior officer who has responsibility to
ships; and monitor and approve limit-exception
d. the internal audit function. approvals.
12. Determine if senior management of the 17. Determine whether the FCM has authority
FCM has adopted procedures implementing to open customer accounts without parent-
the board’s policies for— company approval.
a. approval of new-product lines and other 18. Review the customer base (affiliates, third
activities; parties) for credit quality in terms of affili-
b. transactions with affiliates; ation and business activity (affiliates, cor-
c. transactions by employees; porate, retail, managed funds, floor traders).
d. compliance with applicable regulations, 19. Evaluate the process for customer-credit
policies, and procedures; review and approval. Determine whether
e. management information reports; customer-credit review identifies credit risks
f. the separation of sales, operations, back- associated with the volume of transactions
office, and compliance functions; and executed or cleared for the customer.
g. reports to FCM boards of directors that 20. Evaluate the adequacy of credit-risk-
describe material findings of the com- management policies. Determine that they—
plaint or audit functions and material a. establish credit limits for each customer
deficiencies identified during the course that reflect the respective financial
of regulatory audits or inspections. strengths, liquidity, trading objectives,
13. Determine if policies and procedures are and potential market risk associated with
periodically reviewed by the board of direc- the products traded,
tors or senior management, as appropriate, b. require periodic updates of such credit
to ensure that they comply with existing limits in light of changes in the financial
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Futures Brokerage Activities and Futures Commission Merchants: Examination Procedures 3030.3
condition of each customer and market creditworthiness and trading objectives;
conditions, and and
c. do not permit the FCM to waive impor- c. permits transaction limits to be adjusted
tant broker safeguards, such as the right to accommodate market conditions or
to liquidate customer positions upon changes in the customer’s financial
default or late payment of margin. condition.
21. Verify this information by sampling cus- 28. When the FCM has entered into a clearing-
tomer credit files. only agreement with a customer, verify that
22. Verify that up-to-date customer credit files it has reviewed the creditworthiness of each
are maintained on site or are available for executing broker or its qualifying clearing
review during the inspection. If the cus- firm identified in the agreement.
tomer credit approval was performed by the 29. If the FCM acts as the primary clearing firm
parent company or an affiliate bank, verify for locals or other customers, confirm that
that the FCM’s files contain information the firm has adopted procedures for moni-
indicating the scope of the credit review, the toring and controlling exposure. Note
approval, and credit limits. whether the firm monitors customer posi-
23. Review notifications and approval of limit tions throughout the trading day and how
exceptions for compliance with FCM this monitoring is accomplished.
procedures.
24. Determine whether the FCM has adopted
procedures identifying when the FCM CARRYING BROKERS,
should take steps to limit its customer credit EXECUTING BROKERS, AND PIT
exposure (for example, when to refuse a BROKERS
trade, grant a limit exception, transfer posi-
tions to another FCM, or liquidate customer 30. If the FCM uses other brokers to execute or
positions). clear transactions, either on an omnibus or a
25. Evaluate the adequacy of risk management fully disclosed basis, determine that it has
of customer-financing activities. adequately reviewed the creditworthiness
a. Determine that the credit-review process and approved the use of the other brokers. If
is independent from the marketing and the FCM uses nonaffiliated executing bro-
sales and financing functions. kers, confirm that it also has considered the
b. Verify that the FCM has policies that reputation of the broker’s primary clearing
identify customer-credit standards and firm. If the other broker is likely to use
establish overall lending limits for each another broker, determine whether the bro-
customer. ker has given the FCM an indemnification
c. Assess the adequacy of the credit-review against any loss that results from the per-
process and its documentation, even when formance or failure of the other broker.
credit review is performed by an affiliate. 31. If the FCM uses other brokers to execute or
26. Review the instances when the FCM has clear transactions in non-U.S. markets, deter-
lent margin to customers on an unsecured mine whether senior management under-
basis. If the FCM does not engage in margin stands the legal risks pertinent to doing
financing as a business line, verify that business in those markets and has adopted
extensions are short term and within the policies for managing those risks.
operational threshold set for the customer. 32. When the FCM utilizes third-party ‘‘pit
brokers’’ to execute transactions, verify that
the FCM has reviewed and approved each
CLEARING-ONLY RISK broker after considering the reputation of
the pit broker’s primary clearing firm.
27. Determine whether each clearing arrange-
ment is in writing and that it—
a. identifies the customer and executing EXCHANGE AND
brokers, and defines the respective rights CLEARINGHOUSE MEMBERSHIP
and obligations of each party;
b. establishes overall limits for the cus- 33. Verify that the FCM completes a due dili-
tomer that are based on the customer’s gence study of each exchange and clearing-
Trading and Capital-Markets Activities Manual February 1998
Page 3
3030.3 Futures Brokerage Activities and Futures Commission Merchants: Examination Procedures
house before applying for membership in are in place to control potential conflicts of
the organization. interest between its brokerage business and
a. Determine whether board minutes trading activities.
approving membership demonstrate a
thorough understanding of the loss-
assessment provisions and other obliga-
tions of membership for each exchange LIQUIDITY RISK
and clearinghouse, as well as a general
understanding of the regulatory scheme. 38. Verify that the FCM has established and
b. Determine whether, in approving mem- monitors daily settlement limits for each
bership in a non-U.S. exchange or clear- customer to ensure that its liquidity is suf-
inghouse, the minutes indicate a discus- ficient to meet clearinghouse obligations.
sion of the regulatory environment and 39. Determine whether the FCM has estab-
any relevant credit, liquidity, and legal lished back-up liquidity facilities to meet
risks associated with doing business in unexpected shortfalls.
the particular jurisdiction. Minutes also 40. Verify that the FCM monitors by product
should reflect discussion of any material the amount of open interest (concentrations)
differences from U.S. precedent in how that it, holds at each exchange either directly
foreign accounts are viewed. For exam- or indirectly through other brokers. If posi-
ple, are customer funds held in an tions are held on foreign exchanges in
omnibus account considered separate which concentrations are not monitored,
(segregated) from those of the FCM, or verify that the FCM is able to monitor its
is the relationship between the FCM positions and manage its potential liquidity
and its customers viewed as an agency risks arising from that market.
or principal relationship in the host 41. Review liquidity contingency plans for deal-
country? ing with dramatic market changes.
34. Verify that the FCM has apprised its parent
company of the results of its study of the
exchange or clearinghouse and that it has
written authorization from the senior man- REPUTATION RISK
agement of its parent company to apply for
membership. 42. Review management information reporting
35. Verify that the FCM monitors the financial systems to determine whether the FCM is
condition of each exchange and clearing able to assess the extent of any material
organization for which it is a member. exposure to legal or reputation risk arising
36. Review all guarantees, letters of comfort, or from its activities.
other forms of potential contingent liability. 43. Review management information reporting
Verify that the parent company has not systems to determine whether the parent
provided a guarantee to the clearinghouse company receives sufficient information
for the performance of the FCM’s customer from the FCM to assess the extent of any
obligations. Note any guarantees against material exposure to litigation or reputation
losses the parent bank holding company risk arising from the FCM’s activities.
incurred from the failure of the FCM and 44. If the FCM provides investment advice to
advise the examiner who is in charge of the customers or commodities pools, determine
parent company’s examination, who can whether it has procedures designed to mini-
confirm that guarantees are included in the mize the risks associated with advisory
bank holding company’s calculation of con- activities. Procedures might address the
solidated risk-based capital. delivery of risk disclosures to customers,
the types of transactions and trading strate-
gies that could be recommended or effected
for retail customers, compliance with the
MARKET RISK know-your-customer recordkeeping and
other sales practice rules of the SROs, and
37. If an FCM engages in proprietary trading, conformance to any trading objectives
determine whether policies and procedures established by the customer or fund.
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Futures Brokerage Activities and Futures Commission Merchants: Examination Procedures 3030.3
45. If the FCM acts as a commodities pool ‘‘exchange for physical transactions’’ for
operator, verify that it has obtained prior customers.
Board approval and is in compliance with 51. When the FCM takes physical delivery of
any conditions contained in the Board order. commodities due to the failure or unwilling-
ness of a customer to make or take delivery
of its contracts, determine whether the FCM
has and follows procedures to close out its
OPERATIONS, INTERNAL position. Note if the FCM frequently takes
CONTROLS, AND COMPLIANCE delivery of physical commodities.
52. Assess the adequacy of customer-complaint
46. Review the most recent summary of man- review by reviewing the complaint file and
agement points or similar document issued how complaints are resolved. Note if the
by the FCM’s DSRO or other primary FCM receives repeat or multiple complaints
futures regulator. Discuss any criticism with involving one or more of its activities or
FCM management and confirm that correc- employees.
tive action has been taken. 53. Determine whether the FCM has developed
47. Review the organizational structure and contingency plans that describe actions to
reporting lines within the FCM, and verify be taken in times of market disruptions and
separation of sales, trading, operations, com- whether plans address management respon-
pliance, and audit functions. sibilities including communications with its
48. Determine that FCM policies and proce- parent bank holding company, liquidity, the
dures address the booking of transactions effect on customer credit quality, and com-
by affiliates and employees and other poten- munications with customers.
tial conflicts of interest.
49. If the FCM is authorized to act as a com-
modity pool operator, review the most recent CONCLUSIONS
NFA or other primary futures regulator’s
audit, including any informal findings by 54. Prepare inspection findings and draw con-
examiners. Discuss any criticism with FCM clusions on the adequacy of the FCM’s
management and confirm that corrective risk-management, compliance, operations,
action has been taken. internal controls, and audit functions.
50. If the FCM executes and clears nonfinancial 55. Present findings to FCM management and
futures, verify that it has procedures to submit inspection findings to the examiner
avoid taking physical possession of the who is in charge of the parent company’s
nonfinancial product when effecting inspection.
Trading and Capital-Markets Activities Manual February 1998
Page 5
Equity Investment and Merchant Banking Activities
Section 3040.1
INTRODUCTION supervisors and functional regulators of holding
company affiliates in reviewing the potential
Equity investment activities have had a signifi- risks of equity investment activities. The super-
cant impact on earnings and business relation- visory assessment should include a review of the
ships at a number of banking organizations. The banking organization’s compliance with the laws,
Gramm-Leach-Bliley Act (GLB Act), enacted regulations, and supervisory guidance applica-
in November 1999, enhanced the potential ble to this business line. (See ‘‘Compliance with
growth of equity investment activities, as well Laws and Regulations’’ below.)
as the potential for institutions new to the
equity-investing business to undertake these
activities. The merchant banking provisions of
the GLB Act authorized financial holding com-
TYPES OF EQUITY
panies (FHCs) to make investments, in any INVESTMENTS
amount, in the shares, assets, or ownership
Banking organizations may make a variety of
interests of any type of nonfinancial company.
equity investments with different characteristics
While equity-investing activities can contribute
and risk profiles, under different regulatory
substantially to earnings when market condi-
authorities. Equity investments may provide
tions are favorable, they can entail significant
seed or early-stage investment funds to start-up
market, liquidity, and other risks and give rise to
companies, or they may finance changes in
increased volatility of earnings and capital.
ownership, middle-market business expansions,
Accordingly, sound investment- and risk-
and mergers and acquisitions. Alternatively,
management practices are critical to success-
banking organizations may hold interests in
fully conducting equity investment activities in
mature companies for long-term investment.
banking organizations.
Equity investments may be in publicly traded
This section provides a supervisory frame-
securities or privately held equity interests. The
work and examination procedures for reviewing
investment may be made as a direct investment
the soundness of the investment-management
in a specific portfolio company or may be made
and risk-management techniques used to con-
indirectly through a pooled investment vehicle,
duct equity investment activities. Guidance on
such as a private equity fund. In general, private
evaluating the impact of these activities on the
equity funds are investment companies, typi-
risk profile and financial condition of the bank-
cally organized as limited partnerships, that pool
ing organization is included. The section incor-
capital from third-party investors to invest in
porates and expands on guidance on sound
shares, assets, and ownership interests in com-
practices for managing the risk of equity invest-
panies for resale or other disposition.
ments that was provided in SR-00-9, issued on
June 22, 2000. Direct investment holdings can be in the form
of common stock, preferred stock, convertible
securities, and options or warrants to purchase
Goals of Supervision the stock of a particular portfolio company.
Direct equity investors often play an active role
As in the examination or review of any financial in the strategic direction (but not the day-to-day
activity that a banking organization conducts, management) of the portfolio company, typi-
the supervisory assessment of equity investment cally through board representation or board
activities should be risk-focused and structured visitation rights.
to identify material risks to the safety and A banking organization may make indirect
soundness of the depository institution that is equity investments by acquiring equity interests
conducting the activity, or to identify risks that in either a single company or a portfolio of
are attributable to affiliates of FHCs and bank different companies as a partner in a limited
holding companies (BHCs) engaged in these partnership. Indirect investments are typically
business lines. Consistent with the Federal made in the form of commitments to limited
Reserve’s role as umbrella supervisor of FHCs partnership funds; these commitments are funded
and BHCs, examiners should, where appropriate when capital calls are made by the fund’s
and available, use the findings of primary bank general partner (or partners). The liquidity of
Trading and Capital-Markets Activities Manual September 2002
Page 1
3040.1 Equity Investment and Merchant Banking Activities
indirect fund investments may be more con- investments can be varied and complex. The
stricted since fund managers may limit inves- supervisory review of accounting and valuation
tors’ ability to sell investments. However, these methodologies is critical, as the methodology
fund investments often provide the advantages used can have a significant impact on the earn-
of increased diversification. ings and earnings volatility of the banking
Indirect ownership interests can also be made organization. For some equity investments, valu-
through limited partnerships that in turn hold ation can be more of an art than a science. Many
only ownership interests in other limited part- equity investments are made in privately held
nerships of equity investments. Such tiered part- companies, for which independent price quota-
nership entities are often termed ‘‘funds of tions are either unavailable or not available in
funds.’’ Fund-of-funds investments are profes- sufficient volume to provide meaningful liquid-
sionally managed limited partnerships that pool ity or a market valuation. Valuations of some
the capital of investors for investment in other equity investments may involve a high degree of
equity investment limited partnerships. While judgment on the part of management or may
fund-of-funds investments may generally involve involve the skillful use of peer comparisons.
high administrative costs, they also have the Similar circumstances may exist for publicly
benefit of providing generally high levels of traded securities that are thinly traded or subject
diversification. to resale and holding-period restrictions or when
A banking organization can act as the general the institution holds a significant block of a
partner or manager of a limited partnership fund. company’s shares.
As the general partner of a fund, the banking Accordingly, clearly articulated policies and
organization earns management fees and a per- procedures on the accounting and valuation
centage of the earnings of the fund, often termed methodologies used for equity investments are
‘‘carried interest.’’ Management fees can range of paramount importance. Formal valuation poli-
between 1.5 percent and 2.5 percent of fund net cies that specify appropriate and sound portfolio-
asset value (NAV) or committed capital, and valuation methodologies should be established
these fees may decline in later years of the for investments in public companies; direct
partnership as investments mature. Carried inter- private investments; indirect fund investments;
est, generally ranging from 20 percent to 25 per- and, where appropriate and to the extent pos-
cent of earnings, is the general partner’s share of sible, other types of investments with special
the fund profits. characteristics. Portfolio-valuation methodolo-
Banking organizations may offer fund invest- gies should conform to generally accepted
ments as an asset-management product to high accounting principles (GAAP) and be based on
net worth private-banking and institutional cli- sound, empirically based approaches that are
ents. Fund investments provide private-banking clearly articulated, well documented, and applied
and institutional investors with access to invest- consistently across similar investments over time.
ments that they may not otherwise have access
to because of minimum investment size and
marketing restrictions. However, securities laws
and regulations may apply to these sales, and Accounting Methods
banks engaged in sales of fund investments to
customers should establish a comprehensive Several methods are used in accounting for
securities law compliance program. (See ‘‘Other equity investments. The key methods are
Laws and Regulations’’ at ‘‘Compliance with (1) mark-to-market accounting, (2) available-for-
Laws and Regulations’’ below.) In addition, sale (AFS) accounting, (3) cost-basis account-
when a banking organization acts as a general ing, and (4) equity-method accounting.
partner of a limited partnership fund, it must
have adequate operational and system support
capabilities in place. System support capabilities Mark-to-Market Accounting
may be established internally or outsourced.
Under GAAP, equity investments held by invest-
ment companies or broker-dealers, as well as
ACCOUNTING AND VALUATION securities held in the trading account, are
reported at fair value, with any unrealized appre-
The accounting for and valuation of equity ciation or depreciation included in earnings and
September 2002 Trading and Capital-Markets Activities Manual
Page 2
Equity Investment and Merchant Banking Activities 3040.1
flowing to tier 1 capital. Securities for which suggested by the model are reviewed for overall
market quotations are readily available are val- reasonableness and to evaluate additional fac-
ued at prevailing closing prices derived from tors not considered by the model, such as
market-pricing sources or at an average market proprietary information, historical discount rates,
price. Banking organizations that employ aver- hedging or exit opportunities, and other empiri-
age price ranges typically do so for varying cal data.
periods after the initial public offering (IPO) for A banking organization using a model-driven
issues in more volatile sectors, such as technol- approach should have policies and procedures
ogy, media, and telecommunications. Most that clearly specify the instruments for which
institutions revert to closing prices after an issue the model is appropriate and should provide
is seasoned. guidance for appropriate use of the model.
When the resale or transfer of securities is not Banking organizations that use models should
restricted, current market value is the quoted maintain comprehensive written documentation
market price. Some publicly traded securities of the assumptions, methodologies, and quanti-
may not be freely liquidated because of securi- tative and qualitative factors contained in the
ties law restrictions, underwriting lock-up pro- model. Independent reviews of models should
visions, or significant concentrations of hold- be conducted periodically to verify model inputs
ings. The market value of restricted securities and results. (See ‘‘Valuation Reviews’’ below.)
must be determined in good faith by the board of
directors, taking into account factors such as
(1) the fundamental analytical data relating to Available-for-Sale Accounting
the investment, (2) the nature and duration of
restrictions on disposition of the securities, and Equity investments (1) not held with the intent
(3) an evaluation of the forces that influence the to hold to maturity or (2) held in the trading
market in which the securities are purchased and account that have a readily determinable fair
sold.1 value (quoted market value) are generally
Liquidity discounts generally are applied to reported as available-for-sale (AFS). They are
restricted holdings, based on the severity of the marked to market with unrealized appreciation
restrictions and the estimated period of time the or depreciation recognized in a separate compo-
investment must be held before it can be liqui- nent of equity (other comprehensive income),
dated. Regardless of the method used, discounts but not earnings. Appreciation or depreciation
should be consistently applied. Changes in dis- flows to equity, but for regulatory capital pur-
count rates should generally be based on objec- poses only, depreciation is included in tier 1
tive and verifiable transactions or events. capital. Under regulatory capital rules, tier 2
While most banking organizations employ an capital may include up to 45 percent of the
objective approach for identifying appropriate unrealized appreciation of AFS equity invest-
discounts when specific discounts are applied to ments with readily determinable fair values.
a given set of parameters, a limited number have Under Statement of Financial Accounting
adopted a model-driven approach. The model- Standards No. 115 (FAS 115), a firm must
driven approach considers the marketability dis- determine whether any decline in fair value
count as the value of a put option based on below the cost basis of an equity investment
assumptions about volatility, trading volumes, held AFS is ‘‘other than temporary.’’ If the
market absorption, and interest rates. decline in fair value is judged to be other than
The marketability discount increases as the temporary, the cost basis of the individual secu-
length of the restriction period and the volatility rity must be written down to fair value to
of the share price increase. Discount ranges establish a new cost basis. The amount of the
write-down must be charged against earnings.
1. More specific factors may include the type of security, The new cost basis remains unchanged for
the financial condition of the company, the cost of the
securities at the date of purchase, the size of the holding, the
subsequent fair-value recoveries.
discount from market value of unrestricted securities of the Increases in the fair value of AFS securities
same class at the time of purchase, special reports prepared by after the purchase date are included in other
analysts, information about any transactions or offers on the comprehensive income. Subsequent decreases
security, the existence of merger proposals or tender offers
affecting the security, the price and extent of public trading in
in fair value, if not an other-than-temporary
similar securities of the issuer or comparable companies, and impairment, are also included in other compre-
other relevant matters. hensive income. SEC Staff Accounting Bulletin
Trading and Capital-Markets Activities Manual September 2002
Page 3
3040.1 Equity Investment and Merchant Banking Activities
(SAB) 59 specifies that declines in the valuation • a recent IPO of the company
of marketable investment securities of SEC- • a binding offer to purchase the company
registered companies caused by general market • a transaction involving the sale of a compa-
conditions or by specific information pertaining rable company
to an industry or individual company should • comparable information on publicly traded
cause management to consider all evidence to companies that is based on meaningful indus-
evaluate the realizable value of the investment. try statistics, such as multiples or earnings-
Under SAB 59, SEC-registered companies are performance ratios, and that takes into account
expected to employ a systematic methodology appropriate liquidity or restricted-security
that documents all of the factors, in addition to discounts
impairment, considered in valuing the security. • if comparable information for the public mar-
These factors include the length of time and ket is not available or relevant, private trans-
extent to which the market value has been less actions involving comparable companies or
than cost, the financial condition and near-term indices of small-cap companies could provide
prospects of the issuer, and the intent and ability benchmarks for valuation purposes
of the holder to retain the investment for a • net asset or liquidation values
period of time sufficient to allow for any antici- • company-specific developments indicating an
pated market-value recovery. other-than-temporary impairment in the value
It is a sound practice for banking organiza- of the investment
tions to clearly articulate events, criteria, or • market developments
conditions that trigger an other-than-temporary
impairment of value. Examples of criteria that Valuations of equity investments are highly
may indicate other-than-temporary impairment affected by assumed and actual exit strategies.
of value include— The principal means of exiting an equity invest-
ment in a privately held company include initial
• a business model that is no longer viable; public stock offerings, sales to other investors,
• a material internal risk-rating decline; and share repurchases. An institution’s assump-
• sustained cash flow or financial-performance tions regarding exit strategies can significantly
problems (for more than one year); affect the valuation of the investment. The
• a dilutive subsequent private equity round of importance of reasonable and comprehensive
financing; primary and contingent exit, or take-out, strate-
• major loan-provision defaults; gies for equity investments should be empha-
• management, customer, and competitive sized. Secondary-market sales typically are made
changes; at a discount. A secondary sale of a limited
• a debt restructuring; and partnership interest generally needs to be
• a material, adverse industry change. approved by the general partner or a percentage
of the limited partners. Management should
periodically review investment-exit strategies,
Cost-Basis Accounting with particular focus on larger or less-liquid
investments. Policies and procedures should be
For equity investments without readily determin- established to govern the sale, exchange, trans-
able fair values, including many privately held fer, or other disposition of the institution’s
companies, fair value generally is the cost of the investments. These policies and procedures
investment, adjusted for write-downs reflecting should state clearly the level of management or
subsequent impairments to the value of the board approval required for the disposition of
assets. Periodic evaluations of the valuation are investments. In the case of investments held
performed to confirm or reestablish fair value under the merchant banking provisions of the
based on one or a combination of the following GLB Act, policies and procedures should take
events or factors: into account the time limits for holding mer-
chant banking investments, as specified in the
• a subsequent, significant round of financing in rules and regulations of the Board and the
which a majority of the new funding is pro- Department of the Treasury.
vided by unrelated, sophisticated investors, In addition, a discounted cash-flow approach
and the new securities issued are similar to the may be used to value private portfolio compa-
types and classes of existing shares held nies with operating revenue. This approach to
September 2002 Trading and Capital-Markets Activities Manual
Page 4
Equity Investment and Merchant Banking Activities 3040.1
valuation estimates the value of the stream of A loss in the value of an investment that is an
future cash flows expected to be realized from other-than-temporary decline is recognized. In
the investment. The application of appropriate applying the equity method, a banking organi-
multiples and discounts should be well docu- zation’s share of losses may equal or exceed the
mented and reasonably similar to industry data carrying value of the investment plus advances
for comparable companies. Any differences from made by the institution. The banking organiza-
industry data should be explicitly rationalized. tion ordinarily should discontinue applying the
The valuation of private investment fund equity method when the investments (and net
companies and private investment companies is advances) have been reduced to zero and should
based on fair value as determined by the general not provide for additional losses, unless the
partner, or the valuation is developed internally banking organization has guaranteed obligations
through financial information produced by the of the company or is otherwise committed to
general partner. Each portfolio company pre- provide further financial support. A banking
pares financial statements, which are used to organization should, however, provide for addi-
value the investments within the fund. Most tional losses when the company appears to be
financial statements are audited annually by positioned for an imminent return to profitabil-
independent auditors who express an opinion on ity. For example, a company may incur a mate-
the fair-value methodology of the limited part- rial, nonrecurring loss that may reduce the
nership, in accordance with GAAP. Auditors’ banking organization’s investment below zero
opinions are typically qualified. Private invest- even though the underlying profitable pattern of
ment companies maintain capital accounts that the company is unimpaired. If the company
reflect their proportional ownership in each fund subsequently reports net income, the banking
and that are reconciled periodically (not less organization should resume applying the equity
than annually) to fund financial statements. method only after its share of the net income
Write-downs are appropriate when this recon- equals the share of the net losses not recognized
ciliation process indicates unrealized losses in during the period when the use of the equity
the fund. method was suspended.
Many banking organizations adjust the value
reported by the general partner to account for
management fees and carried interest, as well as
liquidity discounts. Other banking organizations Valuation Reviews
carry their investments in limited partnership
funds at cost and write down investments to Large complex banking institutions with mate-
recognize other-than-temporary impairments in rial equity investment activities should have
value below the cost basis. periodic independent reviews of their invest-
ment process and valuation methodologies by
internal auditors or independent outside parties.
Equity-Method Accounting In smaller, less complex institutions with imma-
terial equity holdings and in which limited
For investments in which the banking organiza- resources may preclude independent review,
tion holds an ownership interest of between 20 alternative checks and balances may be estab-
and 50 percent, or for investments that are lished. In general, a banking organization should
managed or significantly influenced by the bank- conduct valuation reviews semiannually. How-
ing organization, the equity method of account- ever, an immediate review should be initiated if
ing is appropriate. A banking organization using deterioration in the value of an investment is
the equity method initially records an invest- identified. Valuation reviews should be docu-
ment at cost. Subsequently, the carrying amount mented in writing and readily available for
of the investment is increased to reflect the examiner or auditor review. Examiners should
banking organization’s share of the company’s review the frequency, scope, and findings of
income and is reduced to reflect the organiza- audits or reviews to determine whether they are
tion’s share of the company’s losses or for commensurate with the size and complexity of
dividends received from the company. The bank- the banking organization’s equity-investing
ing organization also records its share of the activities.
other comprehensive income of the company The two major components used to measure
and adjusts its investment by an equal amount. earnings, net income to assets (ROA) and net
Trading and Capital-Markets Activities Manual September 2002
Page 5
3040.1 Equity Investment and Merchant Banking Activities
income to equity (ROE), generally are not used corporate-wide compliance function. Compli-
as a performance measurement for equity invest- ance reports should be furnished to the board
ments. ROA and ROE indicate the extent to and senior management on a periodic basis and
which invested capital increased in value, but do in a timely manner. The frequency and content
not reflect how long it took the increase to occur. of these reports necessarily depends on the
In addition, the volatility of earnings from complexity and risk of the institution’s activities.
equity investments makes net income-based mea-
sures a less reliable indicator.
The standard method of measuring the per- Investment Authorities
formance of private equity investments is the
internal rate of return (IRR). The use of IRR has BHCs, FHCs, and depository institutions are
one major advantage over traditional profitabil- permitted to make direct and indirect equity
ity measurement tools: it incorporates assump- investments under various statutory and regula-
tions about both reinvestment and the time value tory authorities. The form and nature of equity
of money, thereby providing a more accurate investments are subject to the provisions of law
measure of performance. IRR measures both the and regulations that govern specific types of
degree to which invested capital increases in investments.
value and the time it takes for the increase to
occur. While increases in invested capital con-
tribute to a higher IRR, the effect of the time is Bank Holding Companies and
inversely related to IRR. Thus, the shorter the Regulation Y
time for an increase to occur, the higher the IRR.
Under section 4(c) of the Bank Holding Com-
IRR is determined by a process of trial and
pany Act (BHC Act), Congress exempted a
error. When net present values of the cash
limited number of investments from the general
outflows (the cost of the investment) and cash
prohibition against bank holding companies’
inflows (returns on the investment) equal zero,
owning or controlling shares of nonbanking
the discount rate used is the IRR. When IRR is
companies. Section 4(c)(6) of the BHC Act
greater than the required return, or the ‘‘hurdle
authorizes ownership or control of 5 percent or
rate,’’ the investment is considered acceptable.
less of the outstanding voting shares of any one
In other words, an IRR can be thought of as a
company. The Board has interpreted section
yield to maturity. The longer an investment
4(c)(6) to authorize only noncontrolling invest-
exists in an illiquid portfolio, the greater its
ments. In this regard, the Board has indicated
appreciation must be to maintain a high IRR.
that a BHC cannot own or control 25 percent or
more of the total equity of a company under
section 4(c)(6). In addition, section 4(c)(7) of
COMPLIANCE WITH LAWS AND the BHC Act authorizes ownership or control of
all of the shares of an investment company that
REGULATIONS restricts its investments to those permissible
In conducting equity investment and merchant under section 4(c)(6).
banking activities, banking organizations should
ensure compliance with the laws and regulations Small Business Investment Companies
under which investments are made. Investments
made under different laws and regulations may The Small Business Investment Act and section
be subject to very different guidelines and 4(c)(5) of the BHC Act permit bank holding
limitations. companies and banks to make equity invest-
The board of directors and senior manage- ments through small business investment com-
ment of the banking organization should estab- panies (SBICs), which may be subsidiaries of
lish a compliance function that is commensurate banks or bank holding companies. Congress
with the complexity and risks of the equity authorized the creation of SBICs to provide debt
investment activities the institution conducts. If and equity financing to small businesses in the
the compliance function for the equity invest- United States. SBICs are licensed and regulated
ment business line is decentralized, appropriate by the Small Business Administration (SBA).
mechanisms should be in place to coordinate the SBIC activities are subject to the following
equity investment compliance function with the guidelines:
September 2002 Trading and Capital-Markets Activities Manual
Page 6
Equity Investment and Merchant Banking Activities 3040.1
• An SBIC generally is permitted to own up to business can be located outside of the United
49.9 percent of the outstanding voting shares States.
of a portfolio company.
• An SBIC generally is not permitted to exer-
cise control over the portfolio company. How- Edge Corporations and Regulation K
ever, a presumption of control may be rebut-
ted when the portfolio company’s management Regulation K implements sections 25 and 25A
owns at least 25 percent of the voting securi- of the Federal Reserve Act, which authorize
ties and can elect at least 40 percent of the banking organizations to invest in Edge corpo-
directors and when the SBIC investor group rations. One power of an Edge corporation is the
cannot elect more than 40 percent of the ability to make investments in foreign portfolio
directors. Moreover, temporary control may companies, subject to the following limitations:
be permitted in certain circumstances, such as
a material breach of the financing agreement • Ownership may not exceed 19.9 percent of the
by the portfolio company or a substantial portfolio company’s voting equity or 40 per-
change in the operations or products of the cent of the portfolio company’s total equity.
portfolio company. • The aggregate level of portfolio investments
• Portfolio companies must meet specific SBA may not exceed 25 percent of the BHC’s tier
criteria, which define a small business. 1 capital. For state member banks, the relevant
limitation is 20 percent of tier 1 capital.
• Aggregate investment in the stock of SBICs is • Investments may be made under the Board’s
limited to 5 percent of the bank’s capital and general-consent provisions (which do not
surplus or, in the case of a bank holding require prior notice or approval) if the total
company, 5 percent of the bank holding com- amount invested does not exceed the greater
pany’s proportionate interest in the capital and of $25 million or 1 percent of the tier 1 capital
surplus of its subsidiary banks. of the investor.
If the SBIC takes temporary control of a small As a general rule, Edge corporations are prohib-
business, a control certification (a divestiture ited from investing in foreign companies that
plan) must be filed with the SBA within 30 days. engage in the general business of buying or
The certification must state the date on which selling goods, wares, merchandise, or commodi-
the control was taken and the basis for taking ties in the United States. In addition, an Edge
control. corporation is limited to a 5 percent interest in
Portfolio companies must meet the SBA defi- the shares of a foreign company that engages
nition of a small business, which requires that directly or indirectly in business in the United
(1) the business be independently owned and States that is impermissible for an Edge
operated, (2) the business not be dominant in its corporation.
field of operation, and (3) the business meets With Board approval, Edge corporations can
either of the two SBA methods of determining hold investments in foreign companies that do
compliance with its size and income limitations. business in the United States if (1) the foreign
Under the first method, a business, together with company is engaged predominantly in business
its affiliates, must have a consolidated net worth outside the United States or in internationally
of less than $18 million and after-tax income of related activities in the United States, (2) the
less than $6 million. The second method applies direct or indirect activities of the foreign com-
number-of-employee and revenue limits to the pany in the United States are either banking or
business based on standards set by the SBA for closely related to banking, and (3) the U.S.
the particular industry. banking organization does not own 25 percent
There are also restrictions on the type of or more of the voting stock or otherwise control
businesses in which an SBIC can invest: Invest- the foreign company.
ments cannot be made in offshore companies.
SBICs may not provide financing to a small
business that engages in re-lending or re-investing Section 24 of the Federal Deposit
activities. At the time of the investment or Insurance Act
within one year thereafter, no more than 49 per-
cent of the employees or tangible assets of the Section 24 of the Federal Deposit Insurance Act
Trading and Capital-Markets Activities Manual September 2002
Page 7
3040.1 Equity Investment and Merchant Banking Activities
(FDI Act) governs the equity investments made purposes of the rule and, therefore, may not
by insured state nonmember banks and gener- acquire or hold merchant banking investments.
ally prohibits such investments unless the equity FHCs may make merchant banking invest-
investment is permissible for a national bank. ments only as part of a bona fide underwriting,
Section 24(f) of the FDI Act permits state banks merchant banking, or investment banking
to retain equity investments in nonfinancial activity—that is, for resale or other disposition.
companies if the investments are made pursuant Investments may not be made for purposes of
to state law under certain circumstances. Other engaging in the nonfinancial activities con-
provisions of section 24 of the FDI Act permit a ducted by the entity in which the investment is
state bank to hold equity investments in nonfi- made.
nancial companies if the FDIC determines that Rules adopted by the Board and the Depart-
the investment does not pose a significant risk to ment of the Treasury, effective February 15,
the deposit insurance fund. 2001, impose the following limitations and
requirements on the conduct of merchant bank-
ing activities.
Merchant Banking and the
Gramm-Leach-Bliley Act Limitations on routine management. The GLB
Act prohibits an FHC and its subsidiaries from
The GLB Act authorizes BHCs and foreign being involved in the day-to-day ‘‘routine man-
banks subject to the BHC Act to engage in agement’’ of a portfolio company. Certain
merchant banking activities if the banking orga- activities, however, are deemed not to constitute
nization files with the Board a declaration that it routine management. These activities include
elects to be an FHC and a certification that all of (1) having one or more representatives on the
its depository institution subsidiaries are well board of directors of the portfolio company;
capitalized and well managed. To continue con- (2) entering into covenants concerning actions
ducting merchant banking activities, each of the outside of the ordinary course of business of the
depository institution subsidiaries of the BHC or portfolio company; and (3) providing advisory
foreign bank must continue to meet the well- and underwriting services to, and consulting
capitalized and well-managed criteria. In addi- with, a portfolio company. A December 21,
tion, at the time it commences any new mer- 2001, staff opinion describes examples of cov-
chant banking activity or acquires control of any enants that Board staff believe would generally
company engaged in merchant banking activi- be permissible under the GLB Act and the
ties, a domestic bank subsidiary must have at implementing regulations. (See www.federal
least a satisfactory rating under the Community reserve.gov/boarddocs/legalint.) These include
Reinvestment Act (CRA). covenants that restrict the ability of the portfolio
A BHC or foreign bank must provide notice company to—
to the Board within 30 days after commencing
merchant banking activities or acquiring any • alter its capital structure through the issuance,
company that makes merchant banking invest- redemption, authorization, or sale of any equity
ments. SR-00-1 (February 8, 2000) details the or debt securities of the portfolio company;2
information required to be provided by BHCs • establish the general purpose for funds sought
and foreign banks electing FHC status and the to be raised through the issuance or sale of any
procedures for processing FHC elections. equity or debt securities of the portfolio com-
Merchant banking investments may be con- pany (for example, retirement of existing debt,
ducted by a securities affiliate of the FHC or by acquisition of another company, or general
an insurance company affiliate that provides corporate use);
investment advice to the insurance company and • amend the terms of any equity or debt secu-
is registered under the Investment Advisers Act rities issued by the company;
of 1940, or by an affiliate of such an adviser. • declare a dividend on any class of securities of
Merchant banking investments may also be the portfolio company or change the dividend-
made by other nonbank affiliates of FHCs, but
may not be acquired or held by a depository
2. For these purposes, the phrase ‘‘equity and debt securi-
institution affiliate or subsidiary of a depository ties’’ includes options, warrants, obligations, or other instru-
institution. A U.S. branch or agency of a foreign ments that give the holder the right to acquire securities of the
bank is considered a depository institution for portfolio company.
September 2002 Trading and Capital-Markets Activities Manual
Page 8
Equity Investment and Merchant Banking Activities 3040.1
payment rate on any class of securities of the executive officers of the portfolio company;3
portfolio company; • establish, accept, or modify the terms of an
• engage in a public offering of securities of the employment agreement with an executive offi-
portfolio company; cer of the portfolio company, including the
• register a class of securities of the portfolio terms setting forth the executive officer’s
company under federal or state securities salary, compensation, and severance;
laws; • adopt or significantly modify the portfolio
• list (or de-list) any securities of the portfolio company’s policies or budget concerning the
company on a securities exchange; salary, compensation, or employment of the
• create, incur, assume, guarantee, refinance, or officers or employees of the portfolio com-
prepay any indebtedness outside the ordinary pany generally;
course of business of the portfolio company; • adopt or significantly modify any benefit plan
• voluntarily file for bankruptcy, or consent to covering officers or employees of the portfolio
the appointment of a receiver, liquidator, company, including defined benefit and defined
assignee, custodian, or trustee of the portfolio contribution retirement plans, stock option
company for purposes of winding up its affairs; plans, profit sharing, employee stock owner-
• significantly alter the regulatory, tax, or liabil- ship plans, or stock appreciation rights plans;
ity status of the portfolio company (examples • alter significantly the business strategy or
of actions that would significantly alter the operations of the portfolio company, for exam-
regulatory, tax, or liability status of the port- ple, by entering or discontinuing a significant
folio company include the registration of the line of business or by altering significantly the
portfolio company as an investment company tax, cash-management, dividend, or hedging
under the Investment Company Act of 1940, policies of the portfolio company; or
or the conversion of the portfolio company • establish, dissolve, or materially alter the
from a corporation to a partnership or limited- duties of a committee of the board of directors
liability company); of the portfolio company.
• make, or commit to make, any capital expen-
diture that is outside the ordinary course of Moreover, an FHC may routinely manage a
business of the portfolio company, such as, the portfolio company when it is necessary or
purchase or lease of a significant manufactur- required to obtain a reasonable return on the
ing facility, an office building, an asset, or investment upon resale or disposition. The FHC
another company; may only operate the portfolio company for the
• engage in, or commit to engage in, any period of time necessary to address the specific
purchase, sale, lease, transfer, or other trans- cause prompting the FHC’s involvement, to
action outside the ordinary course of business obtain suitable alternative management arrange-
of the portfolio company, which may include ments, to dispose of the investment, or to
for example— otherwise obtain a reasonable return upon resale
— entering into a contractual arrangement or disposition of the investment. Written notice
(including a property lease or consulting to the Board is required for extended involve-
agreement) that imposes significant finan- ment, which is defined as over nine months. The
cial obligations on the portfolio company; FHC must maintain and make available to the
— the sale of a significant asset of the port- Board upon request a written record describing
folio company (for example, a significant its involvement in routinely managing the port-
patent, manufacturing facility, or parcel of folio company.
real estate);
— the establishment of a significant new Permissible holding periods. An FHC may,
subsidiary by the portfolio company; without any prior approval, own or control a
— the transfer by the portfolio company of direct merchant banking investment for up to 10
significant assets to a subsidiary or to a years, and own or control an investment held
person affiliated with the portfolio com- through a private equity fund for up to 15 years.
pany; or If an FHC wants to hold an investment longer
— the establishment by the portfolio com-
pany of a significant new joint venture
with a third party; 3. The term ‘‘executive officer’’ is defined in section
• hire, remove, or replace any or all of the 225.177(d) of Regulation Y.
Trading and Capital-Markets Activities Manual September 2002
Page 9
3040.1 Equity Investment and Merchant Banking Activities
than the regulatory holding periods, a request for • types and amounts of merchant banking
approval must be submitted to the Board at least investments
90 days before the expiration of the applicable • parameters governing portfolio diversification
time period. When reviewing requests to hold • guidelines for holding periods and exit
investments in excess of the statutory time strategies
limits, the Board will consider all of the facts • hedging activities
related to the particular investment, including
• investment valuation and accounting
(1) the cost of disposing of the investment
within the applicable holding period, (2) the • investment-rating process
total exposure of the FHC to the portfolio • compensation and co-investment arrangements
company and the risks that disposing of the • periodic audits of compliance with established
investment may pose to the FHC, (3) market limits and policies and applicable laws
conditions, (4) the nature of the portfolio com-
pany’s business, (5) the extent and history of In addition to limiting and monitoring exposure
FHC involvement in the management and to portfolio companies that arises from tradi-
operations of the portfolio company, and (6) the tional banking transactions, banking organiza-
average holding period of the FHC’s merchant tions should adopt policies and practices that
banking investments. The FHC must deduct limit the legal liability of the banking organiza-
from tier 1 capital an amount equal to 25 per- tion and its affiliates to the financial obligations
cent of the carrying value of the investment held and liabilities of portfolio companies. These
beyond the regulatory holding period and abide policies and practices may include the use of
by any additional restrictions that the Board limited-liability corporations or special-purpose
may impose in connection with granting vehicles to hold certain types of investments, the
approval to hold the interest in excess of the insertion of corporations that insulate liability
time limit. between a bank holding company and a partner-
An FHC must provide a written notice to the ship controlled by the holding company, and
Board within 30 days after acquiring more than contractual limits on liability.
5 percent of the voting shares, assets, or own-
ership interests of any company under this
subpart, including interest in a private equity Sections 23A and 23B. Sections 23A and 23B of
fund, at a total cost to the FHC that exceeds the the Federal Reserve Act impose specific quan-
lesser of 5 percent of the tier 1 capital of the titative, qualitative, and collateral requirements
FHC or $200 million. No post-acquisition notice on certain types of transactions between an
under section 4(k)(6) of the BHC Act is required insured depository institution and companies
by an FHC in connection with a merchant that are under common control with the insured
banking investment if the FHC has previously depository institution. The GLB Act includes a
filed a notice under section 225.87 of Regulation presumption that an FHC controls a company
Y indicating that it had commenced merchant for purposes of sections 23A and 23B if it owns
banking investment activities, except for the or controls 15 percent or more of the equity
notice of large individual investment capital of the company. This ownership thresh-
requirements. old is lower than the ordinary definition of an
affiliate, which is typically 25 percent. The final
Equity investment policies and procedures. FHCs rule identifies three ways that the GLB Act
engaging in merchant banking activities must presumption-of-control provision will be consid-
have appropriate policies, procedures, and man- ered rebutted:
agement information systems. SR-00-9 identi-
fies the structure of such policies and procedures • No officer, director, or employee of the FHC
not only for merchant banking activities but for serves as a director, trustee, or general partner
all equity investments. The formality of these (or as an individual exercising similar func-
policies and procedures should be commensu- tions) of the portfolio company.
rate with the scope, complexity, and nature of • An independent third party owns or controls
the institution’s equity investment activities and more than 50 percent of the voting shares of
risk profile. The required policies, discussed in the portfolio company, and the officers and
depth in subsequent sections, should address the employees of the FHC do not constitute a
following: majority of the directors, trustees, or general
September 2002 Trading and Capital-Markets Activities Manual
Page 10
Equity Investment and Merchant Banking Activities 3040.1
partners (or individuals exercising similar 1843(k)(4)(H)) and subpart J of the Board’s
functions) of the portfolio company. Regulation Y;
• An independent third party owns or controls a • the authority to acquire up to 5 percent of the
greater percentage of the equity capital of the voting shares of any company under section
portfolio company than the FHC, and no more 4(c)(6) or 4(c)(7) of the BHC Act (12 USC
than one officer or employee of the holding 1843(c)(6) and (c)(7));
company serves as a director, trustee, or • the authority to invest in SBICs under section
general partner (or as an individual exercising 302(b) of the Small Business Investment Act
similar functions) of the portfolio company. of 1958 (15 USC 682(b));
• the portfolio investment provisions of Regu-
If the FHC investment meets any of these lation K (12 CFR 211.8(c)(3)), including the
conditions and there are no other circumstances authority to make portfolio investments through
that indicate that the FHC controls the portfolio Edge and agreement corporations; and
company, the presumption of control will be • the authority to make investments under sec-
deemed rebutted. However, if the FHC’s invest- tion 24 of the FDI Act (other than under
ment does not meet one of these criteria, the section 24(f)) (12 USC 1831a).
holding company may still request a determina-
tion from the Board that it does not control the An equity investment includes the purchase,
company. acquisition, or retention of any equity instru-
ment (including common stock, preferred stock,
Cross-marketing limitations. A depository insti- partnership interests, interests in limited-liability
tution controlled by an FHC may not cross- companies, trust certificates, and warrants and
market the products or services of a portfolio call options that give the holder the right to
company if more than 5 percent of the compa- purchase an equity instrument), any equity fea-
ny’s voting shares, assets, or ownership interests ture of a debt instrument (such as a warrant or
are owned or controlled by the FHC under the call option), and any debt instrument that is
merchant banking authority. A portfolio com- convertible into equity. The rule generally does
pany that meets the foregoing ownership crite- not apply to investments in nonconvertible senior
rion may not cross-market the products or ser- or subordinated debt. The agencies, however,
vices of the depository institution subsidiaries of may impose the rule’s higher charges on any
the FHC. Management should ensure that these instrument if an agency, based on a case-by-case
limits are observed through internal controls to review of the instrument in the supervisory
monitor transactions with portfolio companies process, determines that the instrument serves as
that are deemed affiliates. the functional equivalent of equity or exposes
the banking organization to essentially the same
risks as an equity investment.
Regulatory Capital Requirements The capital charge applies to investments held
directly or indirectly in ‘‘nonfinancial compa-
In January 2002, the Board, Office of the Comp- nies’’ under one of the authorities listed above.
troller of the Currency, and Federal Deposit A nonfinancial company is defined as an entity
Insurance Corporation (the agencies) jointly pub- that engages in any activity that has not been
lished a rule establishing special minimum regu- determined to be financial in nature or incidental
latory capital requirements for equity invest- to financial activities under section 4(k) of the
ments in nonfinancial companies. The new BHC Act. For investments held directly or
capital requirements, which apply symmetri- indirectly by a bank, the term ‘‘nonfinancial
cally to banks and bank holding companies, company’’ does not include a company that
impose a series of marginal capital charges on engages only in activities that are permissible
covered equity investments that increase with for the parent bank to conduct directly.
the level of a banking organization’s overall The rule does not impose an additional regu-
exposure to equity investments relative to tier 1 latory capital charge on SBIC investments held
capital. The capital rules apply to equity invest- directly or indirectly by a bank to the extent that
ments made under— the aggregate adjusted carrying value of all such
investments does not exceed 15 percent of the
• the merchant banking authority of section tier 1 capital of the bank. For BHCs, no addi-
4(k)(4)(H) of the BHC Act (12 USC tional regulatory capital charge is imposed on
Trading and Capital-Markets Activities Manual September 2002
Page 11
3040.1 Equity Investment and Merchant Banking Activities
SBIC investments held directly or indirectly by 1 capital, and thus the marginal capital charge
the holding company to the extent the aggregate that applies to the organization’s covered equity
adjusted carrying value of all such investments investments.
does not exceed 15 percent of the aggregate of The marginal capital charges are applied by
the holding company’s pro rata interests in the making a deduction from the banking organiza-
tier 1 capital of its subsidiary banks. However, tion’s tier 1 capital. For investments with an
the adjusted carrying value of such investments aggregate adjusted carrying value equal to less
must be included in determining the total amount than 15 percent of the banking organization’s
of nonfinancial equity investments held by the tier 1 capital, 8 percent of the aggregate adjusted
banking organization in relation to its tier 1 carrying value is deducted from tier 1 capital.
capital, and thus the marginal capital charge that For investments with an aggregate adjusted
applies to the organization’s covered equity carrying value equal to 15 to 24.99 percent of
investments. Investments made by a state bank the banking organization’s tier 1 capital, 12 per-
under the authority in section 24(f) of the FDI cent of the aggregate adjusted carrying value is
Act are also exempt from additional regulatory deducted from tier 1 capital. For investments
capital charges. The rule does not apply the with an aggregate adjusted carrying value in
higher capital charges to equity securities excess of 25 percent of the banking organiza-
acquired and held by a bank or BHC as a bona tion’s tier 1 capital, 25 percent of the aggregate
fide hedge of an equity derivatives transaction adjusted carrying value is deducted from tier 1
lawfully entered into by the institution. capital.
The rule does not apply to investments made The adjusted carrying value of an investment
in community development corporations under is the value at which the investment is recorded
12 USC 24 (eleventh), or to equity securities on the balance sheet of the banking organiza-
that are acquired in satisfaction of a debt previ- tion, reduced by (1) net unrealized gains that are
ously contracted (DPC) and that are held and included in carrying value but have not been
divested in accordance with applicable law. The included in tier 1 capital and (2) associated
rule also does not apply to equity investments deferred tax liabilities. The total adjusted carry-
made under section 4(k)(4)(I) of the BHCA by ing value of a banking organization’s nonfinan-
an insurance underwriting affiliate of an FHC. cial equity investments that is subject to a
A grandfather provision exempts from the deduction from tier 1 capital will be excluded
higher capital charges any individual investment from the organization’s average total consoli-
made by a bank or BHC before March 13, 2000, dated assets for purposes of computing the
or made after such date pursuant to a binding denominator of the organization’s tier 1 lever-
written commitment entered into before March age ratio.
13, 2000. An investment qualifies for grand-
The capital requirements established by the
father rights only if the banking organization has
rule are minimum levels of capital required to
continuously held the investment since March
adequately support a banking organization’s
13, 2000. For example, if the banking organiza-
equity investment activities. The rule requires
tion sold 40 shares of a grandfathered invest-
banking organizations to maintain, at all times,
ment in Company X on March 15, 2000, and
capital that is commensurate with the level and
purchased another 40 shares of Company X on
nature of the risks to which they are exposed,
December 31, 2000, the 40 shares would be
including the risks of private equity and mer-
ineligible for grandfathered status. Shares or
chant banking investments. The Board may
other interests received by a banking organiza-
impose a higher capital charge on the nonfinan-
tion through a stock split or stock dividend on a
cial equity investments of a banking organiza-
grandfathered investment are not considered
tion if the facts and circumstances indicate that
new investments if the banking organization
a higher capital level is appropriate in light of
does not provide any consideration for the
the risks associated with the organization’s
shares or interests and the transaction does not
investment activities.
materially increase the organization’s propor-
tional interest in the portfolio company. The
adjusted carrying value of grandfathered invest- Internal Capital
ments must be included in determining the total
amount of nonfinancial equity investments held Consistent with the guidelines identified in SR-
by the banking organization in relation to its tier 99-18 (July 1, 1999), institutions conducting
September 2002 Trading and Capital-Markets Activities Manual
Page 12
Equity Investment and Merchant Banking Activities 3040.1
material equity investment activities are expected lated to a Russell index rather than the S&P
to have internal methods for allocating capital 500). A common approach to estimating industry-
based on the inherent risk and control environ- specific declines reflects the application of indus-
ment of these activities. These methodologies try beta adjustments to each portfolio company.
should identify material risks and their potential Techniques can also be employed to measure
impact on the safety and soundness of the the estimated exposure of the portfolio to unfa-
consolidated entity. Internal capital-allocation vorable price moves over an extended holding
methodologies for equity-investing activities period. The analysis is based on the historical
consider both the risks posed by the broader volatility of each investment at a selected con-
market and those risks specific to the underlying fidence interval. The process is based on the
portfolio companies. Other relevant risks may longest period for which historical volatility
include country, business, and operational risk. data are available.
More sophisticated banking organizations also Internal capital-allocation methodologies for
identify the risks inherent in and allocate capital private equity investments should consider both
to equity-investing activities based on the invest- the market and credit risks inherent in this asset
ment stage (early-stage seed investments to class. However, most methodologies employed
later-stage buyouts) and type of investment to determine capital allocation for the market
(public versus private). risk inherent in private equity investments are
The level of capital dedicated to equity- typically volatility-based approaches. Stress-test
investing activities should be appropriate to the scenarios reflect conditions that prevailed during
size, complexity, and financial condition of the historically volatile equity markets with the
banking organization. Accordingly, it is gener- results adjusted by industry betas. A number of
ally appropriate for banking organizations to banking organizations employ industry-adjusted,
maintain capital in excess of minimum regula- historical volatility–based measures to estimate
tory requirements to ensure that equity invest- the risk to private equity valuations from declines
ment activities do not compromise the integrity in earnings multiples. Some banking organiza-
of the institution’s capital. Examiners should not tions base their stress scenarios on historical-
only assess the institution’s compliance with volatility data provided by private equity ven-
regulatory capital requirements and the quality dors. While exposure to broader market risk is
of regulatory capital, but also review an institu- considered nondiversifiable, measurement of
tion’s methodologies for internally allocating credit-specific risk should attempt to identify
capital to this business line. As set forth in risk at the portfolio company–specific level, as
SR-99-18, the fundamental elements of a sound well as identify other idiosyncratic factors that
internal analysis of capital adequacy include could result in impairments of value.
(1) identifying and measuring all material risks, The amount of capital held should not only
(2) relating capital to the level of risk, (3) stating reflect measured levels of risk, but also consider
explicit capital adequacy goals with respect to potential uncertainties in risk measurement. A
risk, and (4) assessing conformity to the institu- banking organization’s internal capital should
tion’s stated objectives. For equity-investing reflect an adequate cushion to take into account
activities in particular, changes in the risk profile the perceived level of precision in the risk
of the banking organization’s equity portfolio, measures used, the potential volatility of expo-
including the introduction of new instruments, sures, and the relative importance to the institu-
increased investment volumes, changes in port- tion of equity-investing activities.
folio composition or concentrations, changes in Banking organizations should be able to dem-
the quality of the bank’s portfolio, or changes in onstrate that their approach to relating capital to
the overall economic environment, should be risk is conceptually sound and that results are
reflected in risk measurements and internal capi- reasonable. In assessing its approach, an insti-
tal levels. tution may use sensitivity analysis of key inputs
Risk-measurement methodologies for public and compare its practices to peer practices.
securities generally reflect price declines based
on standard stress scenarios. The selected stress-
test benchmark should be appropriate to the Other Laws and Regulations
characteristics of the portfolio holdings (for
example, the sensitivity of small company– The conduct of equity investment activities is
oriented portfolios may be more closely corre- subject to different laws and regulations, depend-
Trading and Capital-Markets Activities Manual September 2002
Page 13
3040.1 Equity Investment and Merchant Banking Activities
ing on the authority under which the activities dures, records, and systems reasonably designed
are conducted. Compliance with all laws and to conduct, monitor, and manage such invest-
regulations applicable to the institution’s invest- ment activities, as well as the risks associated
ment activities should be a focus of the institu- with them, in a safe and sound manner. The
tion’s system of internal controls. Regulatory banking organization should have a sound pro-
compliance requirements should be incorpo- cess for executing all elements of investment
rated into internal controls so that managers management, including initial due diligence,
outside of the compliance or legal functions periodic reviews of holdings, investment valua-
understand the parameters of permissible invest- tion, and realization of returns. This process
ment activities. requires appropriate policies, procedures, and
In particular, examiners should determine management information systems, the formality
whether the institution has an effective program of which should be commensurate with the
for compliance with federal and state securities scope, complexity, and nature of an institution’s
laws and regulations. This is particularly impor- equity investment activities. A sound invest-
tant if the institution offers private equity fund ment process should be applied to all equity
investments to its private-banking customers. investment activities, regardless of the legal
These investments generally represent a long- entity in which investments are booked. Super-
term and illiquid investment. Significant returns visory reviews of equity investment activities
on investment may not be realized until the later should be risk-focused, taking into account the
stages of the funds’ terms. Therefore, fund institution’s stated tolerance for risk, the ability
investments generally are suitable only for of senior management to govern these activities
investors that can bear the risk of holding their effectively, the materiality of activities in light
investments for an indefinite time period and the of the institution’s risk profile, and the capital
risk of investment loss. Examiners should ensure position of the institution.
that management has established a process to Policies, procedures, records, and systems
review to whom the funds are marketed and how should be reasonably designed to—
the banking organization verifies that a custom-
er’s investment in the fund is suitable. As a • delineate the types and amounts of invest-
general matter, fund investments are deemed to ments that may be made;
be suitable investments only after it is deter- • provide guidelines on appropriate holding
mined that— periods for different types of investments;
• establish parameters for portfolio
• the client’s investment in the fund is compat-
diversification;
ible with the size, condition, and nature of the
client’s investment objective, and • monitor and assess the carrying value, market
value, and performance of each investment
• the client has the capability (either personally
and the aggregate portfolio;
or through independent professional advice)
to understand the nature, material terms, con- • identify and manage the market, credit, con-
ditions, and risks of the fund. centration, and other risks;
• identify, monitor, and assess the terms, amounts,
Examiners should encourage staff involved in and risks arising from transactions and rela-
marketing funds to private-banking clients to tionships (including contingent fees or inter-
use an investor-suitability checklist. In addition, ests) with each company in which the FHC
the Investment Company Act of 1940 and the holds an interest;
Securities Act of 1933, as well as state securities • ensure the maintenance of corporate separate-
laws, may impose restrictions on the sale of fund ness between the FHC and each company in
interests. Banking organizations involved in fund which the FHC holds an interest under mer-
sales should consult with qualified securities chant banking authority, and protect the FHC
counsel. and its depository institution subsidiaries from
legal liability for the operations conducted and
financial obligations of each such company;
RISK MANAGEMENT and
• ensure compliance with laws and regulations
A banking organization engaged in equity invest- governing transactions and relationships with
ment activities must maintain policies, proce- companies in which the FHC holds an interest.
September 2002 Trading and Capital-Markets Activities Manual
Page 14
Equity Investment and Merchant Banking Activities 3040.1
Portfolio-diversification policies should identify formal investment decision, should be docu-
factors pertinent to the risk profile of the invest- mented and clearly understood by the staff
ments being made, such as industry, sector, conducting these activities.
geographic, and market factors. Policies estab- An institution’s evaluation of potential invest-
lishing expected holding periods should specify ments in private equity funds, as well as reviews
the general criteria for liquidation of invest- of existing fund investments, should involve
ments and guidelines for the divestiture of an assessments of a fund’s structure, with due
underperforming investment. Decisions to liqui- consideration given to (1) management fees,
date underperforming investments are necessar- (2) carried interest and its computation on an
ily made on a case-by-case basis considering all aggregate portfolio basis, (3) the sufficiency of
relevant factors; however, policies and proce- general partners’ capital commitments in pro-
dures stipulating more frequent review and viding management incentives, (4) contingent
analysis are generally used to address invest- liabilities of the general partner, (5) distribution
ments that are performing poorly or have been policies and wind-down provisions, and (6) per-
in portfolio for a considerable length of time. formance-based return-calculation methodolo-
Policies should identify the aggregate exposure gies. A banking organization must make its
that the institution is willing to accept, by type policies, procedures, and records available to the
and nature of investment. Adherence to these Board or the appropriate Reserve Bank upon
exposure limits should take into consideration request. A banking organization must provide
unfunded, as well as funded, commitments. reports to the appropriate Reserve Bank in such
Many institutions have different procedures format and at such times as the Board may
for assessing, approving, and reviewing invest- prescribe.
ments based on the size, nature, and risk profile
of an investment. Often, procedures used for
direct investments are different from those used
for indirect investments made through private
equity funds. For example, different levels of Internal Controls
due diligence and senior-management approvals
may be required. Accordingly, management An adequate system of internal controls, with
should ensure that the infrastructure for conduct- appropriate checks and balances and clear audit
ing these activities contains operating proce- trails, is critical to conducting equity investment
dures and internal controls that appropriately activities effectively. Appropriate internal con-
reflect the diversity of investments. Supervisors trols should address all elements of the
should recognize this potential diversity of prac- investment-management process, focusing on
tice when conducting reviews of the equity the appropriateness of existing policies and
investment process. Their focus should be on procedures; adherence to policies and proce-
(1) the appropriateness of the process employed dures; and the integrity and adequacy of invest-
relative to the risk of the investments made, ment valuations, risk identification, regulatory
(2) the materiality of the equity investment compliance, and management reporting. Senior
business line to the overall soundness of the management should review and document
banking organization, and (3) the potential departures from policies and procedures, and
impact on affiliated depository institutions. this documentation should be available for
Well-founded analytical assessments of invest- examiner review.
ment opportunities and formal processes for As with other financial activities, assessments
approving investments are critical in conducting of compliance with both written and implied
equity investment activities. While analyses and policies and procedures should be independent
approval processes may differ by individual of line decision-making functions to the fullest
investments and across institutions, the methods extent possible. Large complex banking organi-
and types of analyses conducted should be zations with material equity investment activi-
appropriately structured to assess adequately the ties should have periodic independent reviews
specific risk profile, industry dynamics, manage- of their investment process and valuation meth-
ment, and specific terms and conditions of the odologies by internal auditors or independent
investment opportunity, as well as other relevant outside parties. In smaller, less complex institu-
factors. All elements of the analytical and tions where limited resources may preclude
approval processes, from initial review through independent review, alternative checks and bal-
Trading and Capital-Markets Activities Manual September 2002
Page 15
3040.1 Equity Investment and Merchant Banking Activities
ances should be established, such as random geographic location, or type of investment;
internal audits, senior management reviews of • regulatory compliance reports;
the function, or the use of outside third parties. • management and investment committee reports
that make commitments for or approve new
transactions or a redirection of corporate plans;
and
Management Information Systems and • a semiannual investment-portfolio review,
Reporting Mechanisms which is a full review of the equity investment
portfolio that determines the quality (valua-
The board of directors and senior management tion) of the assets by reviewing and analyzing
should ensure that the risks associated with their financial condition, management assess-
private equity investments and merchant bank- ment, future prospects, strengths and weak-
ing activities do not adversely affect the safety nesses, and exit strategies.
and soundness of the banking organization and
its affiliated insured depository institutions. An In addition to a review of the content of MIS
adequate and detailed management information reports, examiners should determine whether
system (MIS) is essential for managing equity reports are prepared and disseminated to senior
investments and allowing the board of directors management and the board (or an appropriate
to actively monitor the performance and risk committee of the board) on a timely basis.
profile of equity investment business lines in Reports provided to senior management and the
light of established objectives, strategies, and board should be readily understandable by mem-
policies. bers who are not experts in the equity invest-
MIS should be commensurate with the scope, ment business line.
complexity, and nature of an institution’s equity The sophistication of the software a banking
investment activities. The following MIS reports organization employes to conduct equity-
may be appropriate for a banking organization investing activities will depend on the complex-
engaged in equity investment activities. Examples ity of those activities. Several software options
of annual reports include the— are available to simplify portfolio management,
monitoring, and reporting.
• strategic plan, which should detail country A quality portfolio database should be easy to
and industry limits and concentrations, earn- use and logical, have general-ledger capabilities,
ings goals based on IRRs, and investment access information readily, be network-ready
plans; and compatible with the operating system, and
• budget, which should show performance use a programming language based on industry-
results versus projections and identify antici- established sound practices. In general, a com-
pated investments for the next annual period; prehensive software system should be able to
and produce the following reports:
• annual peformance review, which should
clearly identify sources of revenue (such as • risk summary data for the investment port-
unrealized gains or losses, dividend income, folio, for example, by industry, investment
or realized gains or losses). stage, and geographic region;
• comprehensive data for each investment hold-
Examples of monthly and quarterly reports are— ing (its cost, market, IRR, net cash flows, and
legal entity and authority); and
• portfolio-valuation reports that provide, for • the unfunded commitments schedule and stock
each material investment, a brief overview of distributions.
the investment, the unrealized gain or loss,
any unfunded commitments or contingencies, In addition, if the banking organization sponsors
and projected exit timetables; a fund of funds, additional features of a com-
• portfolio-wide performance and statistical data, prehensive software system could include the
including gains or losses on the portfolio for ability to provide information on—
the period and the performance of any hedg-
ing strategies; • total commitments;
• the results of any stress tests; • individual-investor contributions;
• analyses of concentrations by sector, industry, • distributions to individual investors;
September 2002 Trading and Capital-Markets Activities Manual
Page 16
Equity Investment and Merchant Banking Activities 3040.1
• IRRs and total returns by individual fund, desires to sell its directly held investment, or if
vintage year, and portfolio; and the general partner of a fund investment that
• exposures by stage, industry, geographic holds marketable securities decides to liquidate
region, and company. a hedged investment before option maturity. In
such cases, the banking company is effectively
short the underlying investment until maturity
date. To maintain their business relationships,
Hedging Activities counterparties offering the hedging products
will allow banking organizations to unwind
A limited number of banking organizations have contracts for a fee when an unanticipated sale
engaged in hedging strategies in an effort to occurs. In selected cases, the banking organiza-
reduce the impact of volatility on their holdings. tion may be required to post collateral to the
The expansion of international private equity counterparty for the hedging transaction. Most
investments in the increasingly global financial- banking organization equity-investing units do
products market has given rise to foreign- not hold U.S. Treasury obligations in portfolio;
exchange risk exposure, as well as market-risk therefore, the most common form of collateral
exposure. Hedging strategies have been devel- provided is cash. In certain cases, the parent
oped to reduce these risks at some large com- company will provide a guarantee on behalf of
plex banking organizations (LCBOs) that have the equity-investing unit if it is a stand-alone
material foreign equity investments. subsidiary engaged in these activities. Common
The most basic hedging strategy is to capture currency-hedging strategies for investments
a portion of an investment’s unrealized increase made in the international markets are currency
in fair value through the purchase of a long put forward sales or, to a lesser extent, option
option. The cost of this strategy is the premium transactions.
price of the option, which varies with the strike If a banking organization uses hedging strat-
price and maturity. The closer the underlying egies to conduct equity investment activities,
instrument’s market value is to the strike price, examiners should assess whether the organiza-
the more expensive the premium and vice versa. tion has in place—
To avoid the premium cost of the long put, the
equity investor may instead purchase a ‘‘cost- • formal and clearly articulated hedging policies
less’’ collar, in which the premium paid for the and strategies, approved by the board of
put is offset by the premium received on the sale directors or an appropriate committee, that
of the call. The collar limits both the upside identify limits on hedged exposures and per-
potential and downside risk of the investment missible hedging instruments;
through the purchase of a put and the sale of a • procedures for the review of hedging transac-
call. A collar strategy can be an effective hedg- tions for compliance with Statement of Finan-
ing strategy if the value of the investment is cial Accouting Standards No. 133 (FAS 133);
expected to remain relatively stable or decline. and
However, if the value of the investment increases, • appropriate management information systems
the holder of the call option is likely to exercise, and reporting systems for monitoring the hedge
and the banking organization (the seller) will strategies. Systems should include mark-to-
forego the appreciation in the value of the market valuation of the hedging instruments,
investment. premium amortization of purchased instru-
Another transaction used to hedge equity ments, and an all-in performance evaluation
exposure is an equity swap. A specific price is that includes the current fair value of the
established for the investment, and cash flows underlying position.
are paid to the purchaser or seller of the swap,
depending on whether the underlying security
value increases or decreases.
Most of the hedging instruments described COMPENSATION
above, particularly the option strategies, are ARRANGEMENTS
European in nature, meaning that the option or
embedded option may only be exercised on the The need to maintain a qualified staff is an
stated maturity date. This feature may pose extremely important aspect of risk management
liquidity issues for the banking organization if it in equity investing. In many instances, the
Trading and Capital-Markets Activities Manual September 2002
Page 17
3040.1 Equity Investment and Merchant Banking Activities
compensation package for professional equity performance of the equity investment portfolios.
investment staff includes a co-investment This method is less accepted within the industry.
arrangement under which the professional staff If compensation is based on investment perfor-
invests on a percentage basis in each of the mance, a thorough understanding of the formula
portfolio companies or funds in which the bank- used and the underlying accounting treatments
ing organization invests during the year. Gener- must be determined. Unrealized gains generally
ally, a new co-investment partnership is formed should not be included in determining compen-
annually so that each partnership reflects invest- sation, as they do not reflect funds taken into
ments made in a particular calendar year. The income by the banking organization and may
duration of the partnership corresponds to the not ultimately be realized.
expected holding period of the investments in
the partnership.
Each professional staff member’s percentage
of ownership within the partnership generally is NONINVESTMENT BUSINESS
based on that individual’s tenure, experience, or TRANSACTIONS
rank. Staff members generally contribute a por-
tion of the partnership’s investment in cash; the Additional risk-management issues arise when a
remaining portion of the investment may be banking institution or an affiliate lends to or has
borrowed from the parent bank holding com- other business relationships with (1) a company
pany or a nonbank subsidiary at a market rate, in which the banking institution or an affiliate
such as the applicable federal rate (AFR), which has invested (that is, a portfolio company),
is published monthly by the IRS. While the (2) the general partner or manager of a private
holding company or a nonbank subsidiary may equity fund that has also invested in a portfolio
provide loans to the investing employees, it is company, or (3) a private-equity-financed com-
recommended that the employees be required to pany in which the banking institution does not
furnish a portion of the investment with funds hold a direct or indirect ownership interest but
that have not been borrowed. that is an investment or portfolio company of a
The borrowings should be serviced according general partner or fund manager with which the
to formal written agreements, and full payment banking organization has other investments.
of amounts borrowed, with interest, should be Given their potentially higher than normal risk
made before any partnership distributions to the attributes, institutions should devote special at-
employees. A private equity subsidiary should tention to ensuring that the terms and conditions
establish clear policies and procedures govern- of such lending relationships are at arm’s-
ing compensation arrangements, including length, in accordance with section 23B of the
co-investment structures, terms and conditions Federal Reserve Act, and are consistent with the
of employee loans, and sales of participants’ lending policies and procedures of the institu-
interests, before the release of any liens. tion. Similar issues may arise in the context of
If a partnership does not participate in every derivative transactions with or guaranteed by
investment of the venture subsidiary, the exam- portfolio companies and general partners.
iner should consider this practice, known as Lending and other business transactions
‘‘cherry picking,’’ to be an exception worthy of between an insured depository institution and a
criticism, as the intent of co-investment arrange- portfolio company that meets the definition of
ment is for senior management responsible for an affiliate must comply with sections 23A and
the business line to share the investment risks 23B of the Federal Reserve Act. The holding
with the banking organization. Moreover, if the company should have systems and policies in
investments in the portfolio are hedged, the place to monitor transactions between the hold-
investments in the co-investment plan should ing company, or a nondepository institution
also be hedged, regardless of whether the hedge subsidiary of the holding company, and a port-
is in place to protect the upside profit potential folio company, as these transactions are not
or to minimize the downside risk. The important typically governed by section 23B. A holding
point is that co-investment plans consistently company should ensure that the risks of these
share in both the upside potential and downside transactions, including exposures of the holding
risks of investment activities. company on a consolidated basis to a single
Other equity investment compensation plans portfolio company, are reasonably limited and
base remuneration in whole or in part on the that all transactions are on reasonable terms,
September 2002 Trading and Capital-Markets Activities Manual
Page 18
Equity Investment and Merchant Banking Activities 3040.1
with special attention paid to transactions that ensure that they adequately disclose the infor-
are not on market terms. mation necessary for markets to assess an insti-
When a banking organization lends to a tution’s risk profiles and performance in the
private-equity-financed company in which it has equity investment business line. Indeed, it is in
no equity interest but in which the borrowing the interests of the institution itself, as well as its
company is a portfolio investment of private creditors and shareholders, to disclose publicly
equity fund managers or general partners with information about earnings and risk profiles.
which the institution may have other private Institutions are encouraged to disclose in public
equity–related relationships, care must be taken filings information on the type and nature of
to ensure that the extension of credit is granted investments, portfolio concentrations, returns,
on reasonable terms. In some cases, lenders may and their contributions to reported earnings and
wrongly assume that the general partners or capital. Supervisors should use such disclosures,
another third party implicitly guarantees or stands as well as periodic regulatory reports filed by
behind such credits. Reliance on implicit guar- publicly held banking organizations, as part of
antees or comfort letters should not substitute the information that they review routinely. The
for reliance on a sound borrower that is expected following topics are relevant for public disclo-
to service its debt with its own resources. As sure, though disclosures regarding each of these
with any type of credit extension, absent a topics may not be appropriate, relevant, or
written contractual guarantee, the credit quality sufficient in every case:
of a private equity fund manager, general part-
ner, or other third party should not be used to • the size of the portfolio
prevent the classification or special mention of a • the types and nature of investments (for exam-
loan. Any tendency to relax this restriction when ple, direct/indirect, domestic/international,
the general partners or sponsors of private- public/private, equity/debt with conversion
equity-financed companies have significant busi- rights)
ness dealings with the banking organization • the initial cost, carrying value, and fair value
should be strictly avoided. Banking organiza- of investments, and, when applicable, com-
tions that extend credit to companies in which parisons to publicly quoted share values of
the institution has made an equity investment portfolio companies
should also be aware of the potential for equi- • accounting techniques and valuation method-
table subordination of the lending arrangements. ologies, including key assumptions and prac-
tices affecting valuation and changes in those
practices
DISCLOSURE OF EQUITY • realized gains or losses arising from sales and
INVESTMENT ACTIVITIES unrealized gains or losses
• insights regarding the potential performance
Given the important role that market discipline of equity investments under alternative mar-
plays in controlling risk, institutions should ket conditions
Trading and Capital-Markets Activities Manual September 2002
Page 19
Equity Investment and Merchant Banking Activities
Examination Objectives Section 3040.2
Reviews of the equity investment and merchant merchant banking activities.
banking activities should be risk-focused and 8. Determine the adequacy of the institution’s
rely on any findings of the primary or functional regulatory and internally allocated capital
supervisors, where available and applicable. In relative to the activities conducted and the
selecting investments for review, a cross-section inherent risks.
of investments should be targeted. The selection 9. Evaluate the institution’s framework of poli-
process should extend across specific sectors in cies, procedures, systems, and internal con-
which the banking organization has material trols designed to measure, monitor, and
investments. A mix of both recent and seasoned control investment risks.
investments should be selected to determine 10. Determine whether the banking organiza-
whether changes have occurred in the underwrit- tion’s management information systems
ing, accounting, or valuation processes or in (MIS) and reporting mechanisms are com-
investment performance. When preparing to mensurate with the scope, complexity, and
review equity-investing activities, the review nature of its equity investment and mer-
team should collect any available background chant banking activities.
information from prior reviews, risk assess- 11. Determine the adequacy of internal and
ments, regulatory reports, or publicly available external risk-management and audit reviews.
information. 12. Determine the adequacy of policies and
procedures governing any hedging activi-
1. Identify the extent to which the banking ties authorized in connection with the bank-
organization is engaged in equity invest- ing organization’s equity investment and
ment and merchant banking activities, the merchant banking activities, and determine
types of investments made, and activities whether any of these activities are con-
conducted, and determine the materiality of ducted in accordance with Statement of
these activities to the institution’s earnings Financial Accounting Standards No. 133
and capital. (FAS 133).
2. Identify and, to the extent possible, quantify 13. Determine that personnel working in equity-
the material risks posed by the banking investing activities are technically compe-
organization’s equity investment and mer- tent and well trained; ethical standards are
chant banking activities. established, communicated, and respected;
3. Determine whether the board of directors and compensation arrangements are clearly
and senior management understand the risk documented and appropriate.
profile of the banking organization’s equity- 14. Assess any lending-based or noninvestment
investing activities. business relationships with portfolio com-
4. Determine whether the accounting and valu- panies, portfolio company managers, or gen-
ation policies and practices for the equity eral partners of equity investment ventures
investment business line are appropriate, and funds, and determine whether such
clearly articulated, consistently applied in transactions are being conducted in accor-
accordance with generally accepted account- dance with applicable laws and supervisory
ing principles (GAAP), and properly guidance and in a manner that does not
disclosed. compromise the safety or soundness of
5. Determine whether write-downs or adjust- insured depository institution subsidiaries.
ments to the valuation of investments are 15. Determine the adequacy of internal and
made in appropriate amounts and in a timely public disclosures of equity investment
manner. activities, and recommend improvements
6. Evaluate the quality and timeliness of when warranted.
portfolio-valuation reviews. 16. Recommend corrective action when poli-
7. Evaluate the adequacy and effectiveness of cies, procedures, practices, internal con-
the policies, procedures, and processes trols, or management information systems
designed to ensure compliance with appli- are found to be deficient or when violations
cable laws, regulations, and supervisory of laws, rulings, or regulations have been
guidance governing equity investment and noted.
Trading and Capital-Markets Activities Manual September 2002
Page 1
Equity Investment and Merchant Banking Activities
Examination Procedures Section 3040.3
TYPES OF EQUITY 4. Determine the appropriateness of the factors
INVESTMENTS the banking organization considered in deter-
mining whether to make private-security valu-
1. Assess the composition of investments among ation adjustments, and assess whether the
direct investments, indirect investments banking organization’s policies clearly articu-
through limited partnership funds, and indi- late conditions and criteria for indicating
rect investments through funds of funds. other-than-temporary impairment of private
Identify the types of equity instruments the equity investments.
banking organization holds (for example, 5. If the banking organization discounts public
common and preferred stock, convertible securities, determine whether policies estab-
debt, warrants, and partnership interests) and lish a rigid matrix of discounts or provide for
the stage of development of portfolio com- a more subjective approach. If a subjective
panies (for example, start-up, growth, buy- approach is used, determine how it is applied
out, and recapitalization). Identify any issuer and documented.
or industry-sector concentrations. 6. Determine how the banking organization val-
2. Determine if activities are managed along ues fund investments. Are fund-investment
legal-entity or functional-business-unit lines. valuation adjustments based on quarterly
Identify the number of geographic offices general-partner statements, or does the bank-
through which investment activities are con- ing organization monitor the potential impact
ducted, including any non-U.S. sites. Where on its fund valuations based on an analysis of
applicable, determine how foreign organiza- the underlying portfolio companies?
tions book and manage investments (that is, 7. Determine whether acceptable levels of docu-
whether investments are booked in offshore mentation support valuation decisions. Deter-
vehicles rather than in U.S.-domiciled entities). mine whether reviews of valuation method-
3. Determine whether and to what extent the ologies are supported by robust documentation
banking organization serves as the general (especially where valuations reflect consider-
partner of private equity funds, and review ation of subjective factors).
any partnership agreements, fund-offering 8. Assess whether valuation reviews are com-
documents, or other pertinent information. prehensive and timely, given the nature and
Determine whether private equity funds are complexity of the banking organization’s
offered to the banking organization’s private- investment activities.
banking clients, and, if so, review relevant 9. Identify the level of unfunded commitments
documentation. and the banking organization’s ability to
meet those commitments.
ACCOUNTING AND VALUATION
COMPLIANCE WITH LAWS AND
1. Evaluate the appropriateness of the banking REGULATIONS
organization’s accounting treatment of vari-
ous types of equity investments. 1. Identify and verify the various legal authori-
2. Determine whether the banking organization ties through which the banking organization
has established a valuation policy that estab- engages in equity-investing activities. If appli-
lishes appropriate methodologies for each cable, has the BHC (or foreign bank) prop-
type of equity investment held (for example, erly notified the appropriate Reserve Bank
private direct, funds, public security invest- that it has elected to become a financial
ments) or stage of investment. Determine if holding company (FHC) and that it has
the valuation policy is applied consistently initiated merchant banking investment
over time. activities?
3. Assess the banking organization’s current 2. Verify that the firm’s FR Y-12 accurately
year-to-date write-offs, write-downs, write- reflects the activities as conducted.
ups, and recoveries in light of past trends and 3. Identify and assess the regulatory-compliance
current market conditions. process for the equity investment business
Trading and Capital-Markets Activities Manual September 2002
Page 1
3040.3 Equity Investment and Merchant Banking Activities—Examination Procedures
line, and assess how the process is coordi- d. How frequently are positions and volatili-
nated with the consolidated compliance ties reviewed?
function. e. Are the methodology and assumptions
4. Verify that board and senior management periodically reviewed by an independent
oversight of investing activities is commen- source or function?
surate with the complexity of the portfolio f. Has the banking organization considered
(or portfolios). Are reports provided on a the feasibility of using other types of
timely basis, and do reports reflect the com- internal modeling methodologies (includ-
plexity and risk profile of the institution’s ing non-VaR methods), such as historical-
activities? scenario analyses or stress tests, for mea-
5. Determine if the banking organization has suring the risk of equity investments and
established written policies and procedures determining regulatory capital charges?
for monitoring compliance with the applica- 9. Discuss the impact of regulatory capital
ble laws, regulations, and supervisory guid- requirements on portfolio and risk-
ance, including but not limited to the rules in management activities with the banking
subpart J of Regulation Y (governing mer- organization’s management team. Ensure that
chant banking activities), sections 23A and management has established an appropriate
23B of the Federal Reserve Act, and SR- infrastructure to meet regulatory capital
00-9. requirements.
6. Determine the process for monitoring com-
pliance with sections 23A and 23B of the
Federal Reserve Act. Identify what system or
process has been established at the holding RISK MANAGEMENT
company to monitor transactions between
(1) any portfolio companies or fund manag- 1. Assess the adequacy of the banking organi-
ers that are considered affiliates and (2) its zation’s policies, procedures, systems, and
affiliate banks. internal controls in light of the complexity
7. Request and review documentation on the and risk profile of the institution’s equity
banking organization’s capital-allocation over- investment activities. Determine whether
sight infrastructure, and review how the pro- these policies, procedures, systems, and con-
cess incorporates all consolidated nontrading trols are reasonably designed to—
equity holdings. Determine if management a. delineate the types and amounts of invest-
has effectively related the level of capital ments that may be made;
allocated for equity-investing activities to the b. provide guidelines on appropriate hold-
level of inherent portfolio risks. Do internal ing periods for different types of
capital allocations distinguish between differ- investments;
ent types of equity-related investments, c. establish parameters for portfolio
including public, private, limited partnership diversification;
funds, and mezzanine holdings? Are unfunded d. monitor and assess the carrying value,
commitments to limited partnership funds market value, and performance of each
included? investment and the aggregate portfolio;
8. For those banking organizations employing e. identify and manage the market, credit,
value-at-risk (VaR) and volatility techniques concentration, and other risks;
to estimate portfolio risk for internal capital- f. identify, monitor, and assess the terms,
allocation purposes, assess the following: amounts, and risks arising from transac-
a. What is the simulation time horizon (quar- tions and relationships (including contin-
terly or annual)? gent fees or interests) with each com-
b. How appropriate is the historical data pany in which the banking organization
sample to be used (source and length of holds an interest;
time)? g. ensure the maintenance of corporate sepa-
c. How does the banking organization map rateness between the banking organiza-
its investments to industry-specific market tion and each company in which the
indices to determine volatilities and cross- banking organization holds an interest
industry correlations? under merchant banking authority, and
September 2002 Trading and Capital-Markets Activities Manual
Page 2
Equity Investment and Merchant Banking Activities—Examination Procedures 3040.3
protect the banking organization and its egy for launching limited partnerships or
depository institution subsidiaries from funds of funds?
legal liability for the operations con- b. How is the fund (or funds) structured?
ducted by and financial obligations of Who is the general partner?
each such company; and c. What are the investment objectives
h. ensure compliance with laws and regu- (review a sample of private-placement
lations governing transactions and rela- memoranda)? Are the reviewed samples
tionships with companies in which consistent with stated objectives?
the banking organization holds an interest. d. Does management understand the risks
2. Determine how risk exposures are aggre- of launching limited partnerships or funds
gated on a consolidated basis at the bank of funds?
holding company level. Determine how e. Does management use qualified internal
equity-ownership positions are aggregated counsel or retain outside counsel to
if nontrading equity investments are made ensure compliance with securities laws?
in other areas across the consolidated orga- f. Who is the client base for limited part-
nization. Request a copy of any aggregation nerships or funds of funds (that is, to
reports. whom are these funds marketed)? What
3. Review any internal audits, regulatory is the process for determining investor
examinations, consultant reports, or other suitability?
third-party reviews to identify significant g. Has the firm experienced any investor
supervisory issues. defaults on fund capital calls?
4. Identify the investment strategy and whether h. Is the administration of funds of funds
it is consistent with the institution’s risk performed in-house or outsourced? If
profile and overall investment strategy. outsourced, has management established
5. Review and assess the adequacy and com- procedures for and does it perform a
pleteness of the investment process by periodic review of the provider? How
reviewing investment memoranda, due- extensive is the provider’s client base?
diligence reviews, and periodic portfolio i. How robust are the fund-of-funds selec-
reviews for information, including— tion and due-diligence processes? What
a. an overall description of the investment, is the valuation methodology for the
which generally includes the nature of funds?
the business and type of securities held; j. How are management fees generated on
b. financial condition and trends; and the banking organization’s limited part-
c. the current valuation, exit strategies, the nership or fund-of-funds activities?
internal rate of return (IRR), and risk 9. Assess the robustness of the banking orga-
rating. nization’s risk-exposure measurement capa-
6. Assess the reasonableness of exit strategies bilities. Determine whether market sce-
for the investments reviewed. narios employed for risk-exposure
7. If the banking organization is engaged in simulations of equity investments are con-
fund-management activities, assess the sistent with those used in broader corporate
robustness of the following: market-risk modeling. Does the banking
a. the limited-partner due-diligence pro- organization periodically stress-test the port-
cess, including suitability analyses folio (or portfolios) to estimate the worst-
b. the review of fund documentation by case-scenario risk exposure in its portfolio?
outside legal counsel with sufficient 10. Review the banking organization’s
experience in such activities investment-approval process to ensure that
c. operational processing capabilities and it is consistent with board-approved poli-
limited-partner reporting capabilities cies, procedures, limits, and supervisory
d. the level of due diligence performed on guidance (such as in SR-00-9) and that it is
third parties responsible for operational appropriately documented.
or reporting functions 11. Obtain and review formal hedging policies.
8. If the banking organization acts as a general The policies should include descriptions of
partner for private equity funds or sponsors approved hedging instruments for specific
funds of funds, determine the following: hedging strategies, definitive performance-
a. What is the business objective and strat- related objectives, and appropriate risk
Trading and Capital-Markets Activities Manual September 2002
Page 3
3040.3 Equity Investment and Merchant Banking Activities—Examination Procedures
parameters, including both market- and reports for timeliness, accuracy, and
credit-risk exposure. completeness.
12. Determine whether hedges comply with
Statement of Financial Accouting Standards
No. 133 (FAS 133), if applicable. Correla- COMPENSATION
tion between the derivative and the invest-
ment (or investments) to be hedged should
ARRANGEMENTS
be well documented and periodically vali-
1. Assess whether clear policies and procedures
dated by independent, external audits.
are in place to govern compensation arrange-
13. Assess the adequacy of management infor-
ments, including the co-investment structure
mation systems (MIS), including systems
and the terms and conditions of employee
for mark-to-market valuation of the hedging
loans.
instruments, the premium amortization of
2. Determine if the co-investment partnership
purchased instruments, and performance
participates in every direct investment of the
evaluation.
private equity subsidiary.
14. If hedging strategies are developed and
3. Determine the appropriateness of the repay-
executed at the business unit, assess the
ment terms for any co-investment-plan bor-
background and experience level of staff
rowings. The loan should be serviced before
who conduct these activities.
any distributions are made to the co-
15. Obtain documentation summarizing the
investment partnership.
banking organization’s MIS capabilities,
4. If the investments in the private equity port-
including schematic diagrams, where avail-
folio are hedged, determine whether the
able, to identify the level of automation and
co-investment-plan investments are similarly
required manual processing. If MIS reports
hedged.
are generated manually, has the firm estab-
5. If there are other forms of compensation
lished a control process to ensure the integ-
besides a co-investment plan, determine
rity of the data in the reports?
if compensation is based on performance
16. Assess whether MIS is sufficiently robust
levels or operating results. Also determine if
for the size and complexity of the banking
results are based on realized or unrealized
organization’s investment activities. Does
gains and whether compensation incentives
the management information system appro-
encourage the conduct of equity investment
priately monitor and report on all material
operations in a manner consistent with the
risks?
institution’s risk appetite. The income state-
17. Determine whether the banking organiza-
ment should be closely reviewed to deter-
tion’s MIS capabilities allow for tracking of
mine what the firm represents are profits of
ownership and risk exposures across enti-
these investments.
ties in which equity investment activities
are booked or conducted.
18. Identify and assess the level of MIS inte-
gration with corporate systems. Does the NONINVESTMENT
equity investment system feed into the cor- TRANSACTIONS
porate general-ledger system or is manual
intervention required? 1. Determine the extent to which the institution
19. If applicable, request a demonstration of the is engaged in lending or other noninvestment
MIS capabilities, including the various transactions with portfolio companies or with
functions supporting a representative private equity fund managers or general part-
transaction. ners of portfolio companies, including deriva-
20. Determine if management has established tive transactions with or guaranteed by port-
follow-up or escalation procedures to be folio companies and general partners.
implemented if management reports Determine whether these transactions are
indicate emerging problems or abnormal conducted on terms and conditions that are
conditions. appropriate and reasonable from the stand-
21. If the banking organization has launched a point of the institution.
fund of funds, and if the reporting function 2. Determine whether lending and other busi-
for the fund is outsourced, review vendor ness transactions between an insured deposi-
September 2002 Trading and Capital-Markets Activities Manual
Page 4
Equity Investment and Merchant Banking Activities—Examination Procedures 3040.3
tory institution and a portfolio company that DISCLOSURE OF EQUITY
meets the definition of an affiliate comply INVESTMENT ACTIVITIES
with sections 23A and 23B of the Federal
Reserve Act. 1. Determine the completeness and appropriate-
3. Determine whether the bank holding com- ness of the institution’s public disclosures
pany has systems and policies in place to of its equity investment activities, in light of
monitor transactions between the holding the materiality and risk profile of these
company, or a nondepository institution sub- activities.
sidiary of the holding company, and a port- 2. Advise management of any material con-
folio company, including limits on exposures cerns regarding the sufficiency of disclosure
of the holding company on a consolidated and encourage consultation with qualified
basis to a single portfolio company. securities counsel, as appropriate.
Trading and Capital-Markets Activities Manual September 2002
Page 5
Introduction
Section 4000.1
This section contains product profiles of finan- Each product profile contains a general
cial instruments that examiners may encounter description of the product, its basic character-
during the course of their review of capital- istics and features, a depiction of the market-
markets and trading activities. Knowledge of place, market transparency, and the product’s
specific financial instruments is essential for uses. The profiles also discuss pricing conven-
examiners’ successful review of these activities. tions, hedging issues, risks, accounting, risk-
These product profiles are intended as a general based capital treatments, and legal limitations.
reference for examiners; they are not intended to Finally, each profile contains references for
be independently comprehensive but are struc- more information.
tured to give a basic overview of the instruments.
Trading and Capital-Markets Activities Manual February 1998
Page 1
Federal Funds
Section 4005.1
GENERAL DESCRIPTION commonly used to transfer funds between
depository institutions:
Federal funds (fed funds) are reserves held in a
bank’s Federal Reserve Bank account. If a bank • The selling institution authorizes its district
holds more fed funds than is required to cover Federal Reserve Bank to debit its reserve
its Regulation D reserve requirement, those account and credit the reserve account of the
excess reserves may be lent to another financial buying institution. Fedwire, the Federal
institution with an account at a Federal Reserve Reserve’s electronic funds and securities trans-
Bank. To the borrowing institution, these funds fer network, is used to complete the transfer
are fed funds purchased. To the lending institu- with immediate settlement. On the maturity
tion, they are fed funds sold. date, the buying institution uses Fedwire to
return the funds purchased plus interest.
• A respondent bank tells its correspondent that
CHARACTERISTICS AND it intends to sell funds. In response, the
correspondent bank purchases funds from the
FEATURES respondent by reclassifying the respondent’s
demand deposits as federal funds purchased.
Fed funds purchases are not government-insured
The respondent does not have access to its
and are not subject to Regulation D reserve
deposited money as long as it is classified as
requirements or insurance assessments. They
federal funds on the books of the correspon-
can be borrowed only by those depository insti-
dents. Upon maturity of the loan, the respon-
tutions that are required by the Monetary Con-
dent’s demand deposit account is credited for
trol Act of 1980 to hold reserves with Federal
the total value of the loan plus interest.
Reserve Banks: commercial banks, savings
banks, savings and loan associations, and credit
unions. These transactions generally occur with-
out a formal, written contract, which is a unique USES
feature of fed funds.
Most fed funds transactions are conducted on Banks lend fed funds to other banks which need
an overnight-only basis because of the unpre- to meet Regulation D reserve requirements or
dictability of the amount of excess funds a bank need additional funding sources. Since reserve
may have from day to day. Term fed funds accounts do not earn interest, banks prefer to
generally mature between two days to one year. sell fed funds rather than keep higher than
Continuing contracts are overnight fed funds necessary reserve account balances. Community
loans that are automatically renewed unless banks generally hold overnight fed funds sold as
terminated by either the lender or the borrower— a source of primary liquidity.
this type of arrangement is typically employed
by correspondents who purchase overnight fed
funds from respondent banks. Unless notified to DESCRIPTION OF
the contrary by the respondent, the correspon- MARKETPLACE
dent will continually roll the interbank deposit
into fed funds, creating a longer-term instrument Transactions may be done directly between
of open maturity. The interest payments on banks, often in a correspondent relationship, or
continuing contract fed funds loans are com- through brokers. They may be initiated by either
puted from a formula based on each day’s the buyer or the seller. Many regional banks
average fed funds rate. stand ready to buy all excess funds available
Fed funds transactions are usually unsecured. from their community bank correspondents or
Nevertheless, an upstream correspondent bank sell needed funds up to a predetermined limit.
that is selling funds may require collateraliza- Consequently, there is a large amount of demand
tion if the credit quality of the purchaser is not in the fed funds market, with selling banks
strong. easily able to dispose of all excess funds.
All fed funds transactions involve only Fed- Correspondent banks may also broker funds as
eral Reserve Bank accounts. Two methods are agent as long as their role is fully disclosed. Fed
Trading and Capital-Markets Activities Manual February 1998
Page 1
4005.1 Federal Funds
funds, including the term fed funds, are nonne- minimal due to the short maturity. For term fed
gotiable products and, therefore, there is no funds, interest-rate risk may be greater, depend-
secondary market. ing on the length of the term.
Market Participants
Credit Risk
Participants in the federal funds market include
commercial banks, thrift institutions, agencies Fed funds sold expose the lender to credit risk.
and branches of banks in the United States, Upstream correspondent banks may require col-
federal agencies, and government securities deal- lateral to compensate for their risks. All banks
ers. The participants on the buy side and sell should evaluate the credit quality of any bank to
side are the same. whom they sell fed funds and set a maximum
line for each potential counterparty.
Market Transparency
Liquidity Risk
Price transparency is high. Interbank brokers
disseminate quotes on market news services. The overnight market is highly liquid. As there
Prices of fed funds are active and visible. is no secondary market for term fed funds rates,
their liquidity is directly related to their maturity.
Banks may purchase fed funds up to the
PRICING maximum of the line established by selling
financial institutions. Those lines are generally
Fed fund yields are quoted on an add-on basis.
not disclosed to purchasing banks. Active users
All fed funds yields are quoted on an actual/360-
may need to test the availability of funds peri-
day basis. The fed funds rate is a key rate for the
odically to ensure that sufficient lines are avail-
money market because all other short-term rates
able when needed.
relate to it. Bid/offer spreads may vary among
institutions, although the differences are usually
slight. The fed effective rate on overnight fed
funds, the weighted average of all fed funds ACCOUNTING TREATMENT
transactions done in the broker’s market, is
published in The Wall Street Journal. Thompson Fed funds sold should be recorded at cost. Term
Bankwatch rates the general credit quality of fed funds sold should be reported as a loan on
banks, which is used by banks when determin- the call report.
ing credit risk for fed funds sold.
Rates on term fed funds are quoted in the
broker’s market or over the counter. In addition,
money market brokers publish indicative quotes RISK-BASED CAPITAL
on the Telerate screen. WEIGHTING
A 20 percent risk weight is appropriate for fed
HEDGING funds. For specific risk weights for qualified
trading accounts, see section 2110.1, ‘‘Capital
Due to the generally short-term nature of fed Adequacy.’’
funds, hedging does not usually occur, although
fed funds futures contracts may be used as
hedging vehicles.
LEGAL LIMITATIONS FOR BANK
INVESTMENT
RISKS
A bank may sell overnight fed funds to any
Interest-Rate Risk counterparty without limit. Sales of fed funds
with maturities of one day or less or under
For nonterm fed funds, interest-rate risk is continuing contract have been specifically
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Federal Funds 4005.1
excluded from lending limit restrictions by Federal Reserve Bank of Richmond. Instru-
12 CFR 32. Term fed funds are subject to the 15 ments of the Money Market. Richmond,
percent lending limit with any one counterparty Virginia. 1993.
and may be combined with all other credit Stigum, Marcia. The Money Market. 3rd ed.
extensions to that counterparty. Sales of fed Homewood, Illinois: Business One Irwin,
funds to affiliates are subject to 12 USC 371c, 1990.
‘‘Loans to Affiliates.’’ Woelfel, Charles J. Encyclopedia of Banking &
Finance. 10th ed. Chicago: Probus Publishing
Company, 1994.
REFERENCES
Federal Reserve Bank of New York. Fedpoints
#15. New York, June 1991.
Trading and Capital-Markets Activities Manual February 1998
Page 3
Commercial Paper
Section 4010.1
GENERAL DESCRIPTION days. Issuers prefer to issue CP with a maturity
of less than 90 days so that banks can use the CP
Commercial paper (CP) is a short-term, fixed- as collateral at the Federal Reserve discount
maturity, unsecured promissory note issued in window. Most issuers need ongoing financing
the open markets as an obligation of the issuing and roll the CP over at maturity, using the new
entity. CP is usually issued with maturities of proceeds to pay off the maturing CP. The mini-
less than 270 days, with the most common mum round-lot transaction is $100,000. Some
having maturities of 30 to 50 days or less. CP is issuers will sell CP in denominations of $25,000.
sold either directly by the issuer or through a CP is quoted on a 360-day discount basis. A
securities broker. For entities with a sufficient small amount of CP is issued in interest-bearing
credit rating, CP is generally backed by bank form; the rate paid on this paper is the quoted
lines of credit or letters of credit. However, discount rate converted to the equivalent simple
some entities with lesser-quality credit will issue interest rate. CP is typically issued in bearer
CP without credit enhancements. These issues form, but it may also be issued in registered
are typically through private placements and are form.
generally not rated. Foreign corporations may
also issue CP. Banks are active in the CP market
as issuers, investors, dealers, and lenders on
lines of credit used to back CP issuance. CP Credit Ratings
In 1996, outstanding CP in the United States
totaled approximately $803 billion: about 70 per- Credit ratings are crucial to the CP market
cent was issued by financial companies, 20 per- because most investors restrict their CP invest-
cent by domestic nonfinancial entities, and the ments to high-quality CP or will only buy rated
remainder by foreign corporations and govern- CP. The CP ratings are assessments of the
ments. The CP market grew 14 percent a year on issuer’s likelihood of timely payment. Table 1
average from 1970 to 1991. Between 1991 and summarizes CP ratings from the major rating
1996, the market grew by 50 percent. agencies.
Superior-rated issues are considered to have a
high likelihood of repayment, satisfactory-rated
issues are considered to have satisfactory likeli-
CHARACTERISTICS AND hood, and so on. Before they will assign a rating,
FEATURES the credit agencies require issuers to prove that
they have adequate short-term liquidity. Some
CP is issued in maturities which range anywhere issuers raise their credit ratings by obtaining
from a few days to 270 days (the Securities and credit support to guarantee payment, such as a
Exchange Commission (SEC) does not gener- letter of credit (credit-supported commercial
ally require registration of securities due in less paper), or by collateralizing the issue with
than 270 days), depending on the funding needs high-quality assets (asset-backed commercial
of the issuer. Most CP matures in less than 30 paper).
Table 1—Commercial Paper Ratings
Moody’s S&P Duff & Phelps Fitch
P-1 A-1+/A-1 Duff 1, Duff 1, F-1
Superior
Duff 1+
Satisfactory P-2, P-3 A-2 Duff 2 F-2
Adequate P-3 A-3 Duff 2 F-2
Speculative NP B, C Duff 4 F-3
Defaulted NP D Duff 5 F-5
Trading and Capital-Markets Activities Manual April 2001
Page 1
4010.1 Commercial Paper
USES DESCRIPTION OF
MARKETPLACE
Investors
Investors
CP is generally purchased as a short-term,
liquid, interest-bearing security. The short The short-term nature of commercial paper,
maturity structure, low credit risk, and large together with its low credit risk and large
number of issuers make CP an attractive short- number of issuers, makes it an attractive short-
term investment alternative for short-term port- term investment for many investors. Investment
folio managers and for the liquid portion of companies, especially money funds, are the
longer-term portfolios. CP is particularly attrac- largest investors in the CP market. Other signifi-
tive when interest rates are volatile, as many cant investors include the trust departments of
investors are unwilling to buy long-term, fixed- banks, insurance companies, corporate liquidity
rate debt in a volatile interest-rate environment. portfolios, and state and local government bod-
Investors wishing to take a position in short- ies. If CP carries a rating of A-2, P-2, or better,
term rates denominated in a foreign currency thrifts may buy CP and count it as part of their
without taking the risks of investing in an liquidity reserves.
unfamiliar counterparty or facing country risk
often invest in an instrument such as Goldman
Sachs’s Universal Commercial Paper (UCP) or Issuers
Merrill Lynch’s Multicurrency Commercial
Paper (MCCP). With UCP or MCCP, the dealer Issuers of CP include industrial companies such
creates synthetic foreign-currency-denominated as manufacturers, public utilities and retailers,
paper by having a U.S. issuer issue CP in a and financial institutions such as banks and
foreign currency. The dealer then executes a leasing companies. Financial issuers account for
currency swap with the issuer, which eliminates approximately 75 percent of CP outstanding,
foreign-exchange risk for the issuer. The inves- with industrial issuance making up the remain-
tor is therefore left with a short-term piece of der. Approximately 75 percent of the CP out-
paper denominated in a foreign currency which standing carries the highest credit rating of
is issued by a U.S. counterparty, thus eliminating A-1/P-1 or better, while only approximately
country risk. 5 percent of CP outstanding carries a credit
rating of A-3/P-3 or below. In the U.S. market
for CP, domestic issuers account for approxi-
mately 80 percent of issuance, with foreign
Banks and Bank Holding Companies issuers making up the remainder.
Several large finance companies and bank
Bank holding companies (BHCs) are active holding companies place their paper directly
issuers of CP. The money raised is often used to with the investor without using a dealer.
fund nonbank activities in areas such as leasing Approximately 40 percent of all CP outstanding
and credit cards and to fund offshore branches. is placed directly with the investor.
BHCs use commercial paper in sweep pro-
grams. On a BHC level, the sweep programs are
maintained with customers at the bank level, and
the funds are upstreamed to the parent as part of Primary Market
the BHC’s funding strategy. Sweep programs
use an agreement with the bank’s deposit cus- The primary market consists of CP sold directly
tomers (typically corporate accounts) that per- by issuers (direct paper) or sold through a dealer
mits them to reinvest amounts in their deposit acting as principal (dealer paper). Dealer paper
accounts above a designated level in overnight accounts for most of the market. As principals,
obligations of the parent bank holding company, dealers buy and immediately sell the CP (with a
another affiliate of the bank, or a third party. small markup called the dealer spread). Some-
These obligations include instruments such as times the dealers hold CP as inventory for a
commercial paper, program notes, and master- short time as a service to issuers in need of
note agreements. immediate funds. Dealers are mostly large invest-
April 2001 Trading and Capital-Markets Activities Manual
Page 2
Commercial Paper 4010.1
ment banks and commercial banks with section and local income tax exemption of T-bills. The
20 subsidiaries. rate on CP is also slightly higher than that
Although dealers do not normally inventory offered on comparable certificates of deposit
positions in CP, at times they will agree to (CDs) due to the poorer liquidity of CP relative
position any paper which the issuer posted but to CDs.
did not sell on a particular day. The amount
unsold is usually small, and the positions
assumed are usually on an overnight basis only. HEDGING
If the market moves, most issuers give dealers
the discretion to sell CP within established As mentioned above, dealers do not usually
bands set by the issuer. inventory positions in CP. When they do, these
Issuers of CP have their own dedicated sales positions tend to be small and are usually held
force marketing their paper. Direct issuers also only overnight. Due to the short-term nature of
post their rates on services such as Telerate and CP, dealers often do not hedge these open
Reuters, and often with bank money desks. positions. When these positions are hedged,
Sometimes a company sells direct paper under a dealers generally use instruments such as T-bill
master-note agreement, under which the inves- futures or Eurodollar futures to hedge their
tor can buy and sell CP daily, up to a specific residual exposure. However, use of these prod-
amount, for a specific interest rate that is set ucts may subject the dealer to basis risk to the
daily. The return on the master-note CP is extent that the underlying instrument and the
slightly higher than that on an overnight repo. hedge instrument do not move in tandem.
Secondary Market RISKS
The CP market is larger than the market for Credit Risk
other money market instruments, but secondary
trading is only moderately active. Most inves- Given that CP is an unsecured obligation of the
tors have purchased CP tailored to their short- issuer, the purchaser assumes the risk that the
term investment needs and hold it to maturity. If issuer will not be able to pay the debt at
an investor chooses to sell CP, he can usually maturity. This credit risk is generally mitigated
sell it back to the original seller (dealer or by the financial strength of most issuers and by
issuer). Although CP is not traded on an orga- some form of credit enhancement (unused bank
nized exchange, price quotes for most of the lines of credit, letters of credit, corporate guar-
significant issues can be obtained from security anty, or asset collateralization). Historically, the
brokers. Average yields on newly issued CP are default rate on CP has been extremely low.
published in the Wall Street Journal.
Liquidity Risk
PRICING
As most investors hold CP until maturity, trad-
Each issue is priced based on the strength of the ing in the secondary market is relatively thin. As
credit rating of the issuer. CP is a discount a result, only the highest-rated issues may be
instrument, which means that it is sold at a price readily marketable in the secondary market.
less than its maturity value (though occasion- Privately placed CP is subject to further legally
ally, CP is issued as interest-bearing paper). The mandated restrictions on resale, which presents
difference between the maturity value and the additional impediments to marketability.
price paid is the interest earned by the investor.
When calculating commercial paper, a year is
assumed to have 360 days. Interest-Rate Risk
The yield on CP tracks that of other money
market instruments. CP yields are higher than Like all fixed-income instruments, CP is subject
those offered on comparable T-bills—the higher to interest-rate risk. However, this risk is usually
credit risk is due to less liquidity and the state minimal given CP’s short-term nature.
Trading and Capital-Markets Activities Manual September 2001
Page 3
4010.1 Commercial Paper
Foreign-Exchange Risk depending on whether the obligation is a general
obligation or a revenue obligation). For specific
CP denominated in foreign currency may expose risk weights for qualified trading accounts, see
the purchaser to foreign-exchange risk. section 2110.1, ‘‘Capital Adequacy.’’
ACCOUNTING TREATMENT LEGAL LIMITATIONS FOR BANK
INVESTMENT
The accounting treatment for investments in
commercial paper is determined by the Finan- CP is considered a loan to the issuer and is
cial Accounting Standards Board’s Statement of therefore subject to the applicable lending limit
Financial Accounting Standards No. 140 (FAS of the purchasing institution. One exception
140), ‘‘Accounting for Transfers and Servicing would be a general obligation tax-exempt CP,
of Financial Assets and Extinguishments of which can be held without limitation. Holdings
Liabilities.’’ Accounting treatment for deriva- of CP issued by an affiliate are subject to the
tives used as investments or for hedging pur- limitations of section 23A of the Federal Reserve
poses is determined by Statement of Financial Act regarding loans to affiliates.
Accounting Standards No. 133 (FAS 133),
‘‘Accounting for Derivatives and Hedging
Activities.’’ (See section 2120.1, ‘‘Accounting,’’ REFERENCES
for further discussion.)
Fabozzi, Frank J., and T. Dessa, eds. The Hand-
book of Fixed Income Securities. 4th ed.
RISK-BASED CAPITAL Chicago: Irwin Professional Publishing, 1995.
WEIGHTING Hahn, Thomas K. ‘‘Commercial Paper.’’ Eco-
nomic Quarterly 29(1993): 45–67.
CP is generally weighted at 100 percent unless it Stigum, Marcia. After the Trade. Burr Ridge,
is backed by a bank letter of credit, in which Ill.: Dow Jones-Irwin, 1988.
case the asset weight would be 20 percent. Stigum, Marcia. The Money Market. 3rd ed.
Tax-exempt CP may carry weights of 20 percent Burr Ridge, Ill.: Irwin Professional Publish-
or 50 percent, depending on the issuer (that is, ing, 1990.
September 2001 Trading and Capital-Markets Activities Manual
Page 4
Repurchase Agreements
Section 4015.1
GENERAL DESCRIPTION agency securities as collateral. Repos of mort-
gage pass-through securities and collateralized
A repurchase agreement (repo) involves the sale mortgage obligations (CMOs) issued or guaran-
of a security to a counterparty with an agree- teed by U.S. government agencies are less com-
ment to repurchase it at a fixed price on an mon but occur frequently. Repos of other secu-
established future date. At initiation of the rities or loans are not common, in part because
transaction, the buyer pays the principal amount the Federal Reserve System generally considers
to the seller, and the security is transferred to the repos with other assets to be deposits of the
possession of the buyer. At expiration of the selling institution and subject to Regulation D
repo, the principal amount is returned to the reserve requirements.
initial buyer (or lender) and possession of the Repos can be conducted on an overnight
security reverts to the initial seller (or borrower). basis, for a longer fixed term, or on an open-
Importantly, the security serves as collateral account basis. Overnight repos, or one-day trans-
against the obligation of the borrower and does actions, represent approximately 80 percent of
not actually become the property of the lender. all repo transactions. Anything longer (called a
Given the short tenor of a typical repo and the ‘‘term repo’’) usually extends for less than
need to make proper custody arrangements for 30 days. Repo agreements ‘‘to maturity’’ are
the securities involved, operational issues are those that mature on the same day as the
important to proper management of repo activi- underlying securities. ‘‘Open’’ repo agreements
ties. At times, in addition to being a counter- have no specific maturity, so either party has the
party in some transactions, a bank may serve as right to close the transaction at any time.
third-party custodian of securities collateral in
other transactions as a service to the buyer and
the seller. USES
In a repurchase agreement, a bank borrows
funds when it ‘‘sells’’ the security and commits In general, repos are attractive to a variety of
to ‘‘repurchase’’ it in the future. In a reverse market participants as (1) a low-cost source of
repurchase agreement, the bank lends funds short-term funding for borrowers and (2) an
when it ‘‘buys’’ the security and commits to asset with high credit quality regardless of the
‘‘resell’’ it in the future. A reverse repo is counterparty for suppliers of funds. Participation
sometimes termed a resale agreement or a secu- in this market requires proper operational and
rity purchased under agreement to resell (SPAR). administrative arrangements as well as an inven-
The terms ‘‘repo’’ and ‘‘reverse repo’’ thus tory of eligible collateral.
describe the same transaction, but from the
perspective of each counterparty.
A closely related instrument is a dollar roll,
which is identical to a repurchase agreement Dealers
except that the ‘‘repurchase’’ leg of the trans-
action may involve a similar security rather than Repos can be used to finance long positions in
the specific security initially ‘‘sold.’’ In a dollar dealers’ portfolios by short-term borrowing. The
roll, the transaction contract explicitly allows repo market is a highly liquid and efficient
for substitution of the collateral. The borrower market for funding dealers’ bond inventory at a
of funds in this transaction thus runs the risk that short-term rate of interest. Dealers may also use
at the closing of the transaction he or she will repos to speculate on future levels of interest
own a security that is generally comparable but rates. The difference between the coupon rate on
inferior in some material way to the original the dealer’s bond and the repo rate paid by the
security. dealer is called ‘‘carry,’’ and it can be a source of
dealer profit. Sometimes the borrowing rate will
be below the bond’s coupon rate (positive carry),
CHARACTERISTICS AND and sometimes the borrowing rate will be above
FEATURES the bond’s coupon rate (negative carry).
Dealers may use reverse repos to cover short
Most repos are conducted with U.S. Treasury or positions or failed transactions. The advantage
Trading and Capital-Markets Activities Manual April 2001
Page 1
4015.1 Repurchase Agreements
of the reverse repo is that a dealer may borrow money-center or regional banks with a need for
a security it has sold short with either positive or funding.
negative carry. A problem arises, however, when Repos are not traded on organized exchanges.
demand exceeds supply for a specific bond issue There is no secondary market, and quoted mar-
(collateral), and it goes on ‘‘special.’’ This ket values are not available. The Public Securi-
means that those who own the security can earn ties Association has produced a standard master
a premium by lending it to those needing to repo agreement and supplements that are used
deliver on short positions. These ‘‘lenders’’ are throughout the industry. Although the trans-
compensated by paying a below-market borrow- actions themselves are not rated, the entities
ing rate on the cash side of the transaction (the undertaking repos (such as larger banks and
repo rate is lower on ‘‘specials’’ because the dealers) may be rated by Moody’s, Standard &
owner of the special security is the borrower of Poor’s, or other rating agencies.
cash funds and is seeking the lowest lending rate
possible).
PRICING
Bank Nondealer Activity
Repo rates may vary somewhat with the type of
Like dealers, a bank can use repos to fund long collateral and the term of the transaction. Over-
positions and profit from the carry. The market night repos with U.S. government collateral,
also gives a bank the means to use its securities however, generally take place at rates slightly
portfolio to obtain additional liquidity—that is, below the federal funds rate. Interest may be
funding—without liquidating its investments or paid explicitly, so that the ‘‘sale’’ price and
recognizing a gain or loss on the transaction. For ‘‘repurchase’’ price of the security are the same,
money market participants with excess funds to or it may be embedded in a difference between
invest in the short term, reverse repos provide a the sale price and repurchase price.
collateralized lending vehicle offering a better The seller of a security under a repo agree-
yield than comparable time deposit instruments. ment continues to receive all interest and prin-
cipal payments on the security while the pur-
chaser receives a fixed rate of interest on a
Commercial Depositors short-term investment. In this respect, interest
rates on overnight repo agreements usually are
Repos have proved to be popular temporary lower than the federal funds rate by as much as
investment vehicles for individuals, firms, and 25 basis points. The additional security provided
governments with unpredictable cash flows. by the loan collateral employed with repos
Repos (like other money market instruments) lessens their risk relative to federal funds.
can also be used as a destination investment for Interest is calculated on an actual/360 day-
commercial depositors with sweep accounts, count add-on basis. When executed under a
that is, transaction accounts in which excess continuing contract (known as a demand or
balances are ‘‘swept’’ into higher-yielding non- open-basis overnight repo), repo contracts usu-
bank instruments overnight. Again, as collateral ally contain a clause to adjust the interest rate on
for the corporation’s investment, the counter- a day-to-day basis.
party or bank will ‘‘sell’’ Treasury bills to the
customer (that is, collateralize the loan).
HEDGING
DESCRIPTION OF
MARKETPLACE Since repo rates move closely with those of
other short-term instruments, the hedge vehicles
On any given day, the volume of repo transac- available for these other instruments offer an
tions amounts to an estimated $1 trillion. Impor- attractive hedge for positions in repos. If the
tant lenders of funds in the market include large portfolio of repos is not maintained as a matched
corporations (for example, General Motors) and book by the institution, the dealer or bank could
mutual funds. Borrowers generally include large be subject to a level of residual market risk.
April 2001 Trading and Capital-Markets Activities Manual
Page 2
Repurchase Agreements 4015.1
RISKS ACCOUNTING TREATMENT
Market Risk The accounting treatment for repurchase agree-
ments is determined by the Financial Account-
ing Standards Board’s Statement of Financial
Repos and reverse repos, if used to fund longer Accounting Standards No. 140 (FAS 140),
or more sensitive positions, expose the institu- ‘‘Accounting for Transfers and Servicing of
tion to changes in the future levels of interest Financial Assets and Extinguishments of Liabili-
rates. ties.’’ Accounting treatment for derivatives used
as investments or for hedging purposes is deter-
mined by Statement of Financial Accounting
Standards No. 133 (FAS 133), ‘‘Accounting for
Credit Risk Derivatives and Hedging Activities.’’ (See
section 2120.1, ‘‘Accounting,’’ for further
The buyer is exposed to the risk that the seller discussion.)
will default on his or her obligation to repur-
chase the security when agreed. Of course, the
buyer has access to the security as collateral and, RISK-BASED CAPITAL
in the event of default, the security could be sold
to satisfy the debt. However, this could occur
WEIGHTING
only through legal procedures and bankruptcy. In general, assets collateralized by the current
Despite the conventional terminology, this type market value of securities issued or guaranteed
of transaction is a collateralized advance and not by the U.S. government, its agencies, or
truly considered a sale and repurchase. If the government-sponsored agencies are given a
value of the security has declined since the 20 percent risk weight. If appropriate procedures
funds were disbursed, a loss may be incurred. to perfect a lien in the collateral are not taken,
Overcollateralization and margin arrangements the asset should be assigned a 100 percent risk
are used to reduce this risk. weight. For specific risk weights for qualified
trading accounts, see section 2110.1, ‘‘Capital
Adequacy.’’
Operational Risk
LEGAL LIMITATIONS FOR BANK
If the buyer is to rely on its ability to sell a
security in the open market upon the seller’s
INVESTMENT
default, it must exercise effective control over Repos on securities that are eligible for bank
the securities collateralizing the transactions. investment under 12 USC 24(7th) and 12 CFR
The Government Securities Act was passed in 1, and that meet guidelines set forth by the
1986 to address abuses that had resulted in Federal Reserve System, may be held without
customer losses when the security was held by limit. Repos that do not meet these guidelines
the seller. Its requirements include (1) written should be treated as unsecured loans to the
repurchase agreements must be in place, (2) the counterparty subject to 12 USC 84, and com-
risks of the transactions must be disclosed to bined with other credit extensions to that
the customer, (3) specific repurchase securities counterparty. Repos with affiliates are subject to
must be allocated to and segregated for the 12 USC 371c.
customer, and (4) confirmations must be made
and provided to the customer by the end of the
day on which a transaction is initiated and on
any day on which a substitution of securities REFERENCES
occurs. Participants in repo transactions now
will often require securities to be delivered or Board of Governors of the Federal Reserve
held by a third-party custodian. (See sec- System. Commercial Bank Examination
tion 2020.1 of the Commercial Bank Examina- Manual. Section 2030.1, ‘‘Bank Dealer
tion Manual.) Activities.’’
Trading and Capital-Markets Activities Manual September 2001
Page 3
4015.1 Repurchase Agreements
Board of Governors of the Federal Reserve ‘‘How Banks Reap the Benefits of Repo.’’
System. Bank Holding Company Supervision International Securities Lending. Second quar-
Manual. Section 2150.0, ‘‘Repurchase ter 1994.
Transactions.’’ Mishkin, Frederic S. The Economics of Money,
Clarke, David. ‘‘U.S. Repo: A Model Market.’’ Banking, and Financial Markets. 4th ed. New
International Securities Lending. September York: Harper Collins College Publishers, 1995.
1993. Stigum, Marcia. The Money Market. 3rd ed.
Cook, Timothy Q., and Robert LaRoche, eds. Burr Ridge, Illinois: Irwin Professional Pub-
Instruments of the Money Market. 7th ed. lishing, 1990.
Richmond, Va.: Federal Reserve Bank of Stigum, Marcia. The Repo and Reverse Markets.
Richmond, 1993. Homewood, Illinois: Dow Jones-Irwin, 1989.
September 2001 Trading and Capital-Markets Activities Manual
Page 4
U.S. Treasury Bills, Notes, and Bonds
Section 4020.1
GENERAL DESCRIPTION and deep liquidity encourages the use of Trea-
suries as investment vehicles, and they are often
U.S. Treasury bills, notes, and bonds (collec- held in a bank’s investment portfolio as a source
tively known as ‘‘Treasuries’’) are issued by the of liquidity. Since it is the deepest and most
Treasury Department and represent direct efficient financial market available, many fixed-
obligations of the U.S. government. Treasuries income and derivative instruments are priced
have very little credit risk and are backed by the relative to Treasuries. Speculators often use
full faith and credit of the U.S. government. Treasuries to take positions on changes in the
Treasuries are issued in various maturities of up level and term structure of interest rates.
to 10 years.
CHARACTERISTICS AND DESCRIPTION OF
FEATURES MARKETPLACE
Treasury Bills Issuing Practices
Treasury bills, or T-bills, are negotiable, non- T-bills are issued at regular intervals on a yield-
interest-bearing securities with original maturi- auction basis. The three-month and six-month
ties of three months, six months, and one year. T-bills are auctioned every Monday. The one-
T-bills are offered by the Treasury in minimum year T-bills are auctioned in the third week of
denominations of $10,000, with multiples of every month. The amount of T-bills to be
$5,000 thereafter, and are offered only in book- auctioned is released on the preceding Tuesday,
entry form. T-bills are issued at a discount from with settlement occurring on the Thursday fol-
face value and are redeemed at par value. The lowing the auction. The auction of T-bills is
difference between the discounted purchase price done on a competitive-bid basis (the lowest-
and the face value of the T-bill is the interest yield bids are chosen because they will cost the
income that the purchaser receives. The yield on Treasury less money). Noncompetitive bids may
a T-bill is a function of this interest income and also be placed on purchases of up to $1 million.
the maturity of the T-bill. The returns are treated The price paid by these bids (if allocated a
as ordinary income for federal tax purposes and portion of the issue) is an average of the price
are exempt from state and local taxes. resulting from the competitive bids.
Two-year and 5-year notes are issued once a
month. The notes are generally announced near
Treasury Notes and Bonds the middle of each month and auctioned one
week later. They are usually issued on the last
Treasury notes are currently issued in maturities day of each month. Auctions for 3-year and
of 2, 3, 5, and 10 years on a regular schedule. 10-year notes are usually announced on the first
Treasury notes are not callable. Notes and bonds Wednesday of February, May, August, and
pay interest semiannually, when coupon rates November. The notes are generally auctioned
are set at the time of issuance based on market during the second week of those months and
interest rates and demand for the issue. Notes issued on the 15th day of the month.
and bonds are issued monthly or quarterly,
depending on the maturity of the issue. Notes
and bonds settle regular-way, which is one day Primary Market
after the trade date (T+1). Interest is calculated
using an actual/365-day-count convention. Treasury notes and bonds are issued through
yield auctions of new issues for cash. Bids are
separated into competitive bids and noncompeti-
USES tive bids. Competitive bids are made by primary
government dealers, while noncompetitive bids
Banks use Treasuries for investment, hedging, are made by individual investors and small
and speculative purposes. The lack of credit risk institutions. Competitive bidders bid yields to
Trading and Capital-Markets Activities Manual April 2002
Page 1
4020.1 U.S. Treasury Bills, Notes, and Bonds
three decimal places for specific quantities of Market Participants
the new issue. Two types of auctions are cur-
rently used to sell securities: Sell Side
• Multiple-price auction. Competitive bids are All U.S. government securities are traded OTC,
ranked by the yield bid, from lowest to high- with the primary government securities dealers
est. The lowest price (highest yield) needed to being the largest and most important market
place the allotted securities auction is deter- participants. A small group of interdealer bro-
mined. Treasuries are then allocated to non- kers disseminates quotes and broker trades on a
competitive bidders at the average yield for blind basis between primary dealers and users of
the accepted competitive bids. After all Trea- the Government Securities Clearing Corpora-
suries are allocated to noncompetitive bidders, tion (GSCC), the private clearinghouse created
the remaining securities are allocated to com- in 1986 to settle trades for the market.
petitive bidders, with the bidder bidding the
highest price (lowest yield) being awarded Buy Side
first. This procedure continues until the entire
allocation of securities remaining to be sold is A wide range of investors use Treasuries for
filled. Regional dealers who are not primary investing, hedging, and speculation. This includes
government dealers often get their allotment commercial and investment banks, insurance
of Treasury notes and bonds through primary companies, pension funds, and mutual fund and
dealers, who may submit bids for the accounts retail investors.
of their customers as well as for their own
accounts. This type of auction is used for
3-year and 10-year notes. Market Transparency
Price transparency is relatively high for Trea-
• Single-price auction. In this type of auction, sury securities since several information ven-
each successful competitive bidder and each dors disseminate prices to the investing public.
noncompetitive bidder is awarded securities at Govpx, an industry-sponsored corporation, dis-
the price equivalent to the highest accepted seminates price and trading information over
rate or yield. This type of auction is used for interdealer broker screens. Prices of Treasuries
2-year and 5-year notes. are active and visible.
During the one- to two-week period between
the time a new Treasury note or bond issue is PRICING
auctioned and the time the securities sold are
actually issued, securities that have been auc- Treasury Bills
tioned but not yet issued trade actively on a
when-issued basis. They also trade when-issued Treasury bills are traded on a discount basis.
during the announcement to the auction period. The yield on a discount basis is computed using
the following formula:
Secondary Market Annualized Yield =
[(Face Value / Price) / Face Value]
Secondary trading in Treasuries occurs in the × (360 / Days Remaining to Maturity)
over-the-counter (OTC) market. In the second-
ary market, the most recently auctioned Trea-
sury issue is considered ‘‘current,’’ or ‘‘on-the-
run.’’ Issues auctioned before current issues are
typically referred to as ‘‘off-the-run’’ securities.
In general, current issues are much more actively
traded and have much more liquidity than off-
the-run securities. This often results in off-the-
run securities trading at a higher yield than
similar-maturity current issues.
April 2002 Trading and Capital-Markets Activities Manual
Page 2
U.S. Treasury Bills, Notes, and Bonds 4020.1
Treasury Notes and Bonds sophisticated to handle the magnitude of risk to
which the dealer is exposed.
Treasury note and bond prices are quoted on a
percentage basis in 32nds. For instance, a price Liquidity Risk
of 98:16 means that the price of the note or bond
will be 98.5 percent of par (that is, 98 16/32). Due to lower liquidity, off-the-run securities
Notes and bonds can be refined to 64ths through generally have a higher yield than current secu-
the use of a plus tick. A 98:16+ bid means that rities. Many institutions attempt to arbitrage
the bid is 98 and 161⁄2 32nds (that is, 98 these pricing anomalies between current and
16.5/32), which is equivalent to 98.515625 per- off-the-run securities.
cent of par. When the note or bond is traded, the
buyer pays the dollar price plus accrued interest
as of the settlement date. Yields are also quoted
on an actual/365 day-count convention. ACCOUNTING TREATMENT
The accounting treatment for investments in
Treasuries is determined by the Financial
HEDGING Accounting Standards Board’s Statement of
Financial Accounting Standards No. 115 (FAS
Treasuries are typically hedged in the futures or
115), ‘‘Accounting for Certain Investments in
options markets or by taking a contra position in
Debt and Equity Securities,’’ as amended by
another Treasury security. Also, if a position in
Statement of Financial Accounting Standards
notes or bonds is hedged using an OTC option,
No. 140 (FAS 140), ‘‘Accounting for Transfers
the relative illiquidity of the option may dimin-
and Servicing of Financial Assets and Extin-
ish the effectiveness of the hedge.
guishments of Liabilities.’’ Accounting treat-
ment for derivatives used as investments or for
hedging purposes is determined by Statement of
RISKS Financial Accounting Standards No. 133 (FAS
Market Risk 133), ‘‘Accounting for Derivatives and Hedging
Activities.’’ (See section 2120.1, ‘‘Accounting,’’
The risks of trading Treasury securities arise for further discussion.)
primarily from the interest-rate risk associated
with holding positions and the type of trading
conducted by the institution. Treasury securities RISK-BASED CAPITAL
are subject to price fluctuations because of WEIGHTING
changes in interest rates. Longer-term issues
have more price volatility than shorter-term U.S. Treasury bills, notes, and bonds have a 0
instruments. A large concentration of long-term percent risk weighting. For specific risk weights
maturities may subject a bank’s investment for qualified trading accounts, see section 2110.1,
portfolio to increased interest-rate risk. For ‘‘Capital Adequacy.’’
instance, an institution which does arbitrage
trading by buying an issue that is relatively
cheap (that is, off-the-run securities) in compari-
son to historical relationships and selling one LEGAL LIMITATIONS FOR BANK
that is relatively expensive (that is, current INVESTMENT
securities) may expose itself to large losses if
the spread between the two securities does not U.S. Treasury bills, notes, and bonds are type I
follow its historical alignments. In addition, securities with no legal limitations on a bank’s
dealers may take positions based on their expec- investment.
tations of interest-rate changes, which can be
risky given the size of positions and the impact
that small changes in rates have on the value of REFERENCES
longer-duration instruments. If this type of trad-
ing is occurring, the institution’s risk- Fabozzi, Frank J., and T. Dessa Fabozzi, ed. The
management system should be sufficiently Handbook of Fixed Income Securities. 4th ed.
Trading and Capital-Markets Activities Manual September 2001
Page 3
4020.1 U.S. Treasury Bills, Notes, and Bonds
Chicago: Irwin Professional Publishing, 1995. U.S. Department of the Treasury. Buying Trea-
Stigum, Marcia L. The Money Market. 3d ed. sury Securities. Washington, D.C.: The
Homewood, Ill.: Dow Jones-Irwin, 1990. Bureau of the Public Debt, 1995.
September 2001 Trading and Capital-Markets Activities Manual
Page 4
U.S. Treasury STRIPS
Section 4025.1
GENERAL DESCRIPTION TIGRs and CATS has ceased, and STRIPS
now dominate the market. Trademark products
STRIPS are zero-coupon securities (zeros) of are, however, still traded in the secondary
the U.S. Treasury created by physically separat- market.
ing the principal and interest cash flows. This
process of separating cash flows from standard
fixed-rate Treasury securities is referred to as
‘‘coupon stripping.’’ Similar trademark securi-
ties with such acronyms as CATS and TIGRs are USES
created by investment banks.
STRIPS and other zero-coupon instruments can
be tailored to meet a wide range of portfolio
objectives because of their known cash-flow
CHARACTERISTICS AND value at specific future dates. Specifically, they
FEATURES appeal to investors who want to lock in a
terminal value without incurring the risk asso-
STRIPS is the U.S. Treasury’s acronym for ciated with reinvesting intervening cash flows.
‘‘Separate Trading of Registered Interest and They also appeal to investors with definite
Principal Securities,’’ the Treasury program opinions on interest rates, as prices of STRIPS
developed in 1985 to facilitate the stripping of are highly sensitive to changes in interest rates.
designated Treasury securities. All new Trea- Due to this high sensitivity to interest-rate
sury bonds and notes with maturities of 10 years changes, disproportionately large long-maturity
and longer are eligible to be stripped under this holdings of Treasury derivatives such as STRIPS,
program and are direct obligations of the U.S. CATS, or TIGRs in relation to the total invest-
government. Under the STRIPS program, the ment portfolio or total capital of a depository
holder of any eligible security can request that institution would be considered an imprudent
the U.S. Treasury create separate book-entry investment practice.
instruments for all of the principal and interest
cash flows. The principal and interest portions of
these instruments are assigned separate identifi-
cation (CUSIP) numbers and may be owned and
traded separately. DESCRIPTION OF
MARKETPLACE
The STRIPS program provides that all stripped
Trademark Products securities be maintained in a book-entry format.
For maintenance and transfer purposes, each
Trademark products, which predate the STRIPS marketable Treasury security has a unique iden-
market, are stripped Treasury securities created tification (CUSIP) number. Under STRIPS, each
by investment banks. In August 1982, Merrill principal and interest component is assigned a
Lynch marketed its Treasury Income Growth separate CUSIP number. All STRIPS are traded
Receipts (TIGRs) and Salomon Brothers mar- over the counter (OTC), with the primary gov-
keted its receipts as Certificates of Accrual on ernment securities dealers being the largest and
Treasury Securities (CATS). Other investment most important market participants. A small
banks followed suit by issuing their own receipts. group of interdealer brokers disseminates quotes
These products were created by purchasing and broker trades on a blind basis between
Treasury securities and depositing them in a market participants. Arbitrageurs continually
trust. The trusts then issued receipts represent- monitor the prices of STRIPS and underlying
ing ownership interests in the coupon and prin- coupon-bearing bonds, looking for profitable
cipal payments of the underlying Treasury opportunities to strip or reconstitute. Price trans-
securities. parency is relatively high for STRIPS since
Since the start of the STRIPS program in several information vendors disseminate prices
1985, creation of trademark products such as to the investment public.
Trading and Capital-Markets Activities Manual September 2001
Page 1
4025.1 U.S. Treasury STRIPS
Market Participants duration equals their maturity. Duration mea-
sures the percentage change in price for a given
A wide range of investors use zeros for invest- change in rates. The higher the duration, the
ing, hedging, and speculation. This includes higher the potential volatility.
commercial and investment banks, insurance
companies, pension funds, and mutual fund and
retail investors. Liquidity Risk
The STRIPS market is significantly less liquid
PRICING than the U.S. Treasury bond market. Investors
encounter wider bid/ask spreads and are subject
The prices of STRIPS, CATS, and TIGRs are to higher commissions. In addition, liquidity
quoted on a discount basis, as a percentage of may fluctuate significantly in times of market
par. Eligible securities can be stripped at any instability. However, since a dealer can strip or
time. For a book-entry security to be separated reconstitute bonds in a fairly flexible manner, if
into its component parts, the par value must be zero-coupon prices diverge too far from their
an amount which, based on the stated interest equilibrium levels, a new supply can be created
rate, will produce a semiannual interest payment or reduced through the stripping and reconstitu-
of $1,000 or a multiple of $1,000. Quotes for tion process.
STRIPS are quoted in yields to maturity. Trademark products may have an uncertain
marketability, as some may be eligible to be
purchased only though the sponsoring dealer.
CATS, however, are listed on the New York
HEDGING Stock Exchange, enhancing their liquidity. The
market for zero-coupon Treasuries is more retail-
Zeros are typically hedged in the futures or oriented than the rest of the market. This often
options markets, or by taking a contra position results in wider trading spreads, smaller trans-
in another Treasury security. The effectiveness action size, and less liquidity.
of any hedge depends on yield-curve and basis
risk. Also, if a position in zeros is hedged with
an OTC option, the relative illiquidity of the
derivative Treasury security and the option may Credit Risk
diminish the effectiveness of the hedge.
As an obligation of the U.S. Treasury, STRIPS
are considered to be free from default (credit)
risk. Trademark products such as CATS and
RISKS TIGRs are collateralized by the underlying U.S.
Treasury, but whether they are considered
Many factors affect the value of zeros. These ‘‘obligations’’ of the U.S. Treasury is uncertain.
include the current level of interest rates and the Proprietary products should be reviewed indi-
shape of their term structure (interest-rate risk), vidually to determine the extent of credit risk.
bond maturities (rate sensitivity or duration),
and the relative demand for zero-coupon bonds
(liquidity).
ACCOUNTING TREATMENT
The accounting treatment for investments in
Interest-Rate Risk U.S. Treasury STRIPS is determined by the
Financial Accounting Standards Board’s State-
Increases in the level of interest rates increase ment of Financial Accounting Standards No.
the advantages of stripping. This is because the 115 (FAS 115), ‘‘Accounting for Certain Invest-
constant-yield method applied to premium bonds ments in Debt and Equity Securities,’’ as
results in a lower price than linear amortization amended by Statement of Financial Accounting
does. Zeros have higher sensitivity to changes in Standards No. 140 (FAS 140), ‘‘Accounting for
interest rates than bonds with the same maturity. Transfers and Servicing of Financial Assets and
Because they are zero-coupon bonds, their Extinguishments of Liabilities.’’ Accounting
September 2001 Trading and Capital-Markets Activities Manual
Page 2
U.S. Treasury STRIPS 4025.1
treatment for derivatives used as investments or REFERENCES
for hedging purposes is determined by State-
ment of Financial Accounting Standards No. Fabozzi, Frank J., and T. Dessa Fabozzi, eds.
133 (FAS 133), ‘‘Accounting for Derivatives The Handbook of Fixed Income Securities.
and Hedging Activities.’’ (See section 2120.1, 4th ed. Chicago: Irwin Professional
‘‘Accounting,’’ for further discussion.) Publishing.
Federal Reserve Regulatory Service, vol. 1,
3–1562.
RISK-BASED CAPITAL Gregory, Deborah W., and Miles Livingston.
WEIGHTING ‘‘Development of the Market for U.S. Trea-
sury STRIPS.’’ Financial Analyst Journal.
U.S. Treasury STRIPS have a 0 percent risk March/April 1992.
weighting. Trademark products have a 20 per- Nagan, Peter S., and Kenneth A. Kaufman.
cent risk weighting. For specific risk weights for ‘‘STRIPS—An Exciting New Market for
qualified trading accounts, see section 2110.1, Zero-Coupons.’’ ABA Banking Journal.
‘‘Capital Adequacy.’’ Stigum, Marcia L. The Money Market. 3rd ed.
Burr Ridge, Ill.: Irwin Professional
Publishing.
LEGAL LIMITATIONS FOR BANK Woelfel, Charles J. Encyclopedia of Banking
INVESTMENT and Finance. 10th ed. Cambridge, England:
Probus Publishing Company.
U.S. Treasury STRIPS are a type I security with
no limitations on a bank’s investment. Trade-
mark products are proprietary products, so legal
limits vary. Appropriate supervisory personnel
should be consulted on specific issues.
Trading and Capital-Markets Activities Manual September 2001
Page 3
Treasury Inflation-Indexed Securities
Section 4030.1
GENERAL DESCRIPTION tax on income not received reduces the effective
yield on the security.
Treasury inflation-indexed securities (TIIs) are The following example illustrates how TIIs
issued by the Treasury Department and repre- work: suppose an investor purchases a $1,000
sent direct obligations of the U.S. government. note at the beginning of the year, in which the
The securities are designed to provide investors interest rate set at the time of the auction is
with a hedge against increases in inflation. The 3 percent. Also suppose that inflation for the first
initial auction of these relatively new securities year of the note is 3 percent. At the end of the
was held in January 1997, when a 10-year note first year, the $1,000 principal will be $1,030,
was issued. Various longer-term maturities are reflecting the increase in inflation, although the
planned for future auctions, which will be held investor will not receive this increase in princi-
quarterly. TIIs have very little credit risk, since pal until maturity. The investor will receive,
they are backed by the full faith and credit of the however, the 3 percent interest payment. At the
U.S. government. Banks can be designated as end of the first year, the notes will be paying
primary dealers of Treasury securities, but they 3 percent interest on the increased principal
may sell them in the secondary markets and balance of $1,030. Principal will be adjusted
invest in TIIs for their own account. each year, based on the increase or decrease in
inflation.
CHARACTERISTICS AND
FEATURES USES
TIIs were created to meet the needs of longer- At present, the primary strategy behind the
term investors wanting to insulate their invest- purchase of a TII would be to hedge against
ment principal from erosion due to inflation. erosion in value due to inflation. However,
The initial par amount of each TII issue is banks also use TIIs for investment, hedging, and
indexed to the nonseasonally adjusted Con- speculative purposes. As TIIs are tax disadvan-
sumer Price Index for All Urban Consumers taged, they are most likely to appeal to investors
(CPI-U). The index ratio is determined by who are not subject to tax.
dividing the current CPI-U level by the CPI-U An investor in TIIs is taking a view that real
level that applied at the time the security was interest rates will fall. Real interest rates are
issued or last re-indexed. If there is a period of defined as the nominal rate of interest less the
deflation, the principal value can be reduced rate of inflation. If nominal rates fall, but infla-
below par at any time between the date of tion does not (that is, a decline in real interest
issuance and maturity. However, if at maturity rates), TIIs will appreciate because their fixed
the inflation-adjusted principal amount is below coupon will now represent a more attractive rate
par, the Treasury will redeem the security at par. relative to the market. If inflation rises, but
Every six months, interest is paid based on a nominal rates rise more (that is, an increase in
fixed rate determined at the initial auction; this real interest rates), the security will decrease in
rate will remain fixed throughout the term of the value because it will only partially adjust to the
security. Semiannual interest payments are deter- new rate climate.
mined by multiplying the inflation-adjusted prin-
cipal amount by one-half the stated rate of
interest on each payment date. TIIs are eligible DESCRIPTION OF
for stripping into their principal and interest MARKETPLACE
components under the Treasury STRIPS
program. Issuing Practices
Similar to zero-coupon bonds, TIIs are tax
disadvantaged in that investors must pay tax on The auction process will use a single pricing
the accretion to the principal amount of the method identical to the one used for two-year
security, even though they do not currently and five-year fixed-principal Treasury notes. In
receive the increase in principal in cash. Paying this type of auction, each successful competitive
Trading and Capital-Markets Activities Manual September 2001
Page 1
4030.1 Treasury Inflation-Indexed Securities
bidder and each noncompetitive bidder is rates in the market. As the coupon rate on TIIs
awarded securities at the price equivalent to the is well below market for similar maturity instru-
highest accepted rate or yield. ments, the duration of TIIs will be higher,
increasing the price sensitivity of the instrument
for a given change in real interest rates. Also,
the CPI-U index used in calculating the princi-
Market Participants pal accretion on TIIs is lagged three months,
Sell Side which will hurt the investor when inflation is
rising (and help the investor when inflation is
Like all U.S. government securities, TIIs are falling).
traded over the counter, with the primary gov- Longer-term issues will have more price vola-
ernment securities dealers being the largest and tility than shorter-term instruments. A large
most important market participants. A small concentration of long-term maturities may sub-
group of interdealer brokers disseminate quotes ject a bank’s investment portfolio to unwar-
and broker trades on a blind basis between ranted interest-rate risk.
primary dealers and users of the Government
Securities Clearing Corporation (GSCC), the
private clearinghouse created in 1986 to settle Liquidity Risk
trades for the market.
The Treasury securities market is the largest and
most liquid in the world. While an active sec-
Buy Side ondary market for TIIs is expected, that market
initially may not be as active or liquid as the
A wide range of investors are expected to use secondary market for Treasury fixed-principal
TIIs for investing, hedging, and speculation, securities. In addition, as a new product, TIIs
including commercial and investment banks, may not be as widely traded or well understood
insurance companies, pension funds, mutual as Treasury fixed-principal securities. Lesser
funds, and individual investors. As noted above, liquidity and fewer market participants may
TIIs will most likely appeal to investors who are result in larger spreads between bid and asked
not subject to tax. prices for TIIs relative to the bid/ask spreads for
fixed-principal securities of the same maturity.
Larger bid/ask spreads normally result in higher
Market Transparency transaction costs and/or lower overall returns.
The liquidity of the TII market is expected to
Price transparency is relatively high for Trea- improve over time as additional amounts are
sury securities since several information ven- issued and more entities enter the market.
dors disseminate prices to the investing public.
Govpx, an industry-sponsored corporation, dis-
seminates price and trading information via
interdealer broker screens. Prices of TIIs are ACCOUNTING TREATMENT
active and visible.
The accounting treatment for investments in
Treasury inflation-indexed securities is deter-
mined by the Financial Accounting Standards
RISKS Board’s Statement of Financial Accounting Stan-
dards No. 115 (FAS 115), ‘‘Accounting for
Interest-Rate Risk Certain Investments in Debt and Equity Securi-
ties,’’ as amended by Statement of Financial
TIIs are subject to price fluctuations because of Accounting Standards No. 140 (FAS 140),
changes in real interest rates. TIIs will decline in ‘‘Accounting for Transfers and Servicing of
value if real interest rates increase. For instance, Financial Assets and Extinguishments of Liabili-
if nominal interest rates rise by more than the ties.’’ Accounting treatment for derivatives used
increase in inflation, the value of a TII will as investments or for hedging purposes is deter-
decrease because the inflation component will mined by Statement of Financial Accounting
not fully adjust to the higher level of nominal Standards No. 133 (FAS 133), ‘‘Accounting for
September 2001 Trading and Capital-Markets Activities Manual
Page 2
Treasury Inflation-Indexed Securities 4030.1
Derivatives and Hedging Activities.’’ (See sec- REFERENCES
tion 2120.1, ‘‘Accounting,’’ for further
discussion.) U.S. Department of the Treasury. Buying Trea-
sury Inflation-Indexed Securities. Washing-
ton, D.C.: The Bureau of the Public Debt,
RISK-BASED CAPITAL 1997.
WEIGHTING
TIIs have a 0 percent risk weighting. For spe-
cific risk weights for qualified trading accounts,
see section 2110.1, ‘‘Capital Adequacy.’’
LEGAL LIMITATIONS FOR BANK
INVESTMENT
TIIs are a type I security so there are no legal
limits on a bank’s investment in them.
Trading and Capital-Markets Activities Manual September 2001
Page 3
U.S. Government Agency Securities
Section 4035.1
GENERAL DESCRIPTION credit risk. The yield spread between these
securities and Treasury securities of comparable
Agency securities are debt obligations issued by maturity reflects differences in perceived credit
federal agencies or federally sponsored agen- risk and liquidity.
cies. Federal agencies are direct arms of the U.S. GSEs issue direct debt obligations and guar-
government; federally sponsored agencies are antee various types of asset-backed securities.
privately owned and publicly chartered organi- This section discusses only securities that rep-
zations which were created by acts of Congress resent direct obligations of federal and federally
to support a specific public purpose (also referred sponsored agencies. For a discussion of securi-
to as government-sponsored entities or GSEs). ties issued or guaranteed by some of these
Federal agencies are arms of the federal agencies, see ‘‘Residential-Mortgage-Backed
government and generally do not issue securities Securities,’’ section 4110.1. Also, many GSEs
directly in the marketplace. These agencies are active in issuing structured notes. The role of
include the Government National Mortgage the agency and particular risks involved in these
Association (GNMA or Ginnie Mae), Export- securities are discussed in section 4040.1,
Import Bank, Farmers Home Administration ‘‘Structured Notes.’’
(FmHA), General Services Administration
(GSA), Maritime Administration, Small Busi-
ness Administration (SBA), Tennessee Valley CHARACTERISTICS AND
Authority, Commodity Credit Corporation, FEATURES
Rural Electrification Administration, Rural Tele-
phone Bank, and Washington Metropolitan Area Federal-agency securities such as those issued
Transit Authority. All federally related institu- by the Government National Mortgage Associa-
tions are exempt from registration with the tion are backed by the full faith and credit of the
Securities and Exchange Commission (SEC). U.S. government. However, government-
Except for securities of the Private Export Fund- sponsored agency securities are not guaranteed
ing Corporation and the Tennessee Valley by the U.S. government, although market par-
Authority, the securities are backed by the full ticipants widely believe that the government
faith and credit of the U.S. government. would provide financial support to an agency if
Government-sponsored entities include agen- the need arose. This view has gained some
cies in the following areas: credence as a result of the federal government’s
operations to bolster the Farm Credit System in
• housing (such as the Federal Home Loan the mid-1980s. U.S. agency securities are also
Mortgage Corporation and Federal National exempt from SEC registration.
Mortgage Association)
• farm credit (such as the Federal Farm Credit
Bank System and Farm Credit System Finan- USES
cial Assistance Corporation)
• student loans (such as the Student Loan Mar- Agency securities are deemed suitable invest-
keting Association) ments for banks. They are frequently purchased
• small business (the Small Business by banks and held in their investment portfolios.
Administration)
• export funding (the Export-Import Bank)
DESCRIPTION OF
GSEs issue both discount and coupon notes and MARKETPLACE
bonds. Discount notes are short-term obliga-
tions, with maturities ranging from overnight to In the primary market, government agencies and
360 days. Coupon notes and bonds are sold with GSEs sell their securities to a select group of
maturities greater than two years. The securities commercial banks, section 20 subsidiaries of
are not backed by the full faith and credit of the commercial banks, and investment banks known
U.S. government. Consequently, investors pur- as ‘‘selling groups.’’ Members of a selling group
chasing GSEs are exposed to some potential advise the agencies on issuing debt, placing the
Trading and Capital-Markets Activities Manual April 2001
Page 1
4035.1 U.S. Government Agency Securities
debt with end-users, and making markets in dated obligations of the 12 regional Federal
these securities. Home Loan Banks whose mandate is to provide
Prices for the securities traded in the second- funds to savings and other home-financing mem-
ary market can be obtained from the ‘‘Money ber organizations.
and Investing’’ section of The Wall Street Jour- The Federal National Mortgage Association
nal or the financial section of local newspapers. (Fannie Mae) issues short-term discount notes
Other media, such as Internet financial sites and and long-term bonds with maturities of up to
Bloomberg, provide over-the-counter quotes as 30 years. Fannie Mae has also issued indexed
well. sinking-fund debentures which are callable and
contain features of both mortgage-backed secu-
rities and callable corporate bonds. The Federal
Federal Agencies Home Loan Mortgage Corporation (Freddie
Mac) issues discount notes and a limited number
Federal agencies do not issue securities directly of bonds. The Student Loan Marketing Associa-
in the marketplace. Since 1973, most have tion (Sallie Mae) issues unsecured debt obliga-
raised funds through the Federal Financing Bank, tions in the form of discount notes to provide
although many of these institutions have out- funds to support higher education.
standing obligations from previous debt issues.
Federal agencies include the following: the
Export-Import Bank of the United States, Com- PRICING
modity Credit Corporation, Farmers Home
Administration, General Services Administra- Agency notes and bonds are quoted in terms of
tion, Government National Mortgage Associa- 32nds (a percentage of par plus 32nds of a
tion, Maritime Administration, Private Export point). Thus, an investor will be willing to pay
Funding Corporation, Rural Electrification 101.5 percent of par for an agency security that
Administration, Rural Telephone Bank, Small is quoted at 101:16. Short-term discount notes
Business Administration, Tennessee Valley are issued on a discount basis similar to the way
Authority, and Washington Metropolitan Area that U.S. Treasury bills are priced.
Transit Authority (neither the Tennessee Valley Agency securities trade at yields offering a
Authority nor the Private Export Funding Cor- positive spread over Treasury security yields
poration is backed by the full faith and credit of because of slightly greater credit risk (due to
the U.S. government). the lack of an explicit government guarantee
for most obligations) and somewhat lower
liquidity.
Federally Sponsored Agencies
Following is a summary of the main federally HEDGING
sponsored agencies and the types of obligations
that they typically issue to the public. The The price risk of most agency securities is
Federal Farm Credit Bank System issues dis- hedged in the cash market for Treasury securi-
count notes; short-term bonds with maturities ties or by using Treasury futures or options. As
of three, six, and nine months; and long-term with all hedges, yield curve and basis risk must
bonds with maturities of between one and be monitored closely. In addition, dealers who
10 years. The Federal Farm Credit Bank also are actively conducting arbitrage trades and
issues medium-term notes which have maturi- other strategies should have the capability to
ties of between one and 30 years. The Federal monitor their positions effectively.
Farm Credit System Financial Assistance Cor-
poration issues 15-year notes, guaranteed by the
federal government, which were issued to sup-
port the Farm Credit System in the mid-1980s. RISKS
The Federal Home Loan Bank System issues
discount notes that mature in one year or less As with any security, much of the risk is a
and noncallable bonds with maturities ranging function of the type of trading strategy con-
from one to 10 years. These debts are consoli- ducted by an institution.
April 2001 Trading and Capital-Markets Activities Manual
Page 2
U.S. Government Agency Securities 4035.1
Interest-Rate Risk Financial Accounting Standards No. 133 (FAS
133), ‘‘Accounting for Derivatives and Hedging
Agency securities are subject to price fluctua- Activities.’’ (See section 2120.1, ‘‘Accounting,’’
tions due to changes in interest rates. As with for further discussion.)
other types of securities, the longer the term of
the security, the greater the fluctuation and level
of interest-rate risk. Moreover, some agency
securities are subject to greater interest-rate risk
RISK-BASED CAPITAL
than others. Agencies that issue structured notes WEIGHTING
that are direct obligations, such as step-up notes
from a Federal Home Loan Bank, may have Federal-agency securities have a 0 percent risk
greater risk than other agency securities. asset capital weight, as they are direct and
unconditionally guaranteed obligations of fed-
eral agencies. Obligations of federally spon-
sored agencies (not explicitly guaranteed) have
Credit Risk a 20 percent risk asset capital weight. For
specific risk weights for qualified trading
The credit risk of agency securities is slightly accounts, see section 2110.1, ‘‘Capital
higher than that of Treasury securities because Adequacy.’’
they are not explicitly guaranteed by the U.S.
government. However, their credit risk is still
low due to the implied government guarantee.
LEGAL LIMITATIONS FOR BANK
INVESTMENT
Liquidity Risk General obligations of U.S. government agen-
Agency securities as a whole are not as liquid as cies are type I securities, and are exempt from
U.S. Treasury securities, but liquidity varies the limitations of 12 USC 24 (section 5136 of
widely within the agency market, depending on the U.S. Revised Statutes). Banks may purchase
the issuer and the specific debt obligation. In these securities for their own accounts without
general, agency securities have large trading limitation, other than the exercise of prudent
volumes on the secondary market that help to banking judgment. (One exception is an obliga-
keep the liquidity risk low. However, various tion of the Tennessee Valley Authority (TVA),
debt provisions and structured notes of different which is a type II security. Investments in the
agency securities contribute to differing levels TVA are limited to 10 percent of a bank’s capital
of liquidity risk within the agency market. stock and unimpaired surplus.)
ACCOUNTING TREATMENT REFERENCES
The Financial Accounting Standards Board’s Board of Governors of the Federal Reserve
Statement of Financial Accounting Standards System. Commercial Bank Examination
No. 115 (FAS 115), ‘‘Accounting for Certain Manual.
Investments in Debt and Equity Securities,’’ as Fabozzi, Frank J., ed. The Handbook of Fixed
amended by Statement of Financial Accounting Income Securities. 4th ed. Burr Ridge, Ill.:
Standards No. 140 (FAS 140), ‘‘Accounting for Irwin, 1991.
Transfers and Servicing of Financial Assets and First Boston Corporation, The. Handbook of
Extinguishments of Liabilities,’’ determines the U.S. Government and Federal Agency Securi-
accounting treatment for investments in govern- ties. 34th ed. Chicago: Probus Publishing
ment agency securities. Accounting treatment Company, 1990.
for derivatives used as investments or for hedg- Stigum, Marcia L. The Money Market. 3d ed.
ing purposes is determined by Statement of Homewood, Ill.: Dow Jones-Irwin, 1990.
Trading and Capital-Markets Activities Manual September 2001
Page 3
Structured Notes
Section 4040.1
GENERAL DESCRIPTION embedded, path-dependent options for which
pricing involves complex models and systems.
Structured notes are hybrid securities, possess-
ing characteristics of straight debt instruments
and derivative instruments. Rather than paying a
straight fixed or floating coupon, the interest Inverse Floating-Rate Notes
payments of these instruments are tailored to a
myriad of possible indexes or rates. The Federal An inverse floating-rate note (FRN) has a cou-
Home Loan Bank (FHLB), one of the largest pon that fluctuates inversely with changes in the
issuers of such products in the United States, has reference rate. The coupon is structured as a
more than 175 indexes or index combinations base rate minus the reference rate, for example,
against which cash flows are calculated. In a three-year note with a semiannual coupon that
addition to the interest payments, the redemp- pays 13 percent minus six-month LIBOR, and
tion value and final maturity of the securities can an interest-rate floor of 0 percent, which ensures
also be affected by the derivatives embedded in that rates can never be negative. The return on
structured notes. Most structured notes contain an inverse FRN increases in a decreasing-rate
embedded options, generally sold by the inves- environment, and decreases in an increasing-
tor to the issuer. These options are primarily in rate environment. An investor in an inverse
the form of caps, floors, or call features. The FRN is taking a view that rates will decrease. An
identification, pricing, and analysis of these inverse FRN has the risk characteristics of a
options give structured notes their complexity. leveraged fixed-rate instrument: inverse FRNs
Structured notes are primarily issued by will outperform nonleveraged fixed-rate instru-
government-sponsored enterprises (GSEs), such ments when rates decrease and underperform
as the Federal Home Loan Bank (FHLB), Fed- when rates increase. If rates increase signifi-
eral National Mortgage Association (FNMA), cantly, the investor may receive no coupon
Student Loan Marketing Association (SLMA), payments on the note.
and Federal Home Loan Mortgage Corporation The leverage inherent in an inverse FRN
(FHLMC). Although the credit risk of these varies with each structure. The leverage amount
securities is minimal, other risks such as interest- of a particular structure will be equal to the
rate risk, market (price) risk, and liquidity risk underlying index plus one (that is, 13 percent
can be material. minus 6-month LIBOR has a leverage factor of
2; 20 percent − (2 × 6-month LIBOR) has a
leverage factor of 3). The degree of leverage
incorporated in an FRN will increase the vola-
CHARACTERISTICS AND tility and, hence, the interest-rate and price risk
FEATURES of the note.
There are many different types of structured
notes; typically, a structure is created specifi-
cally to meet one investor’s needs. Thus, an Step-Ups/Multi-Steps
exhaustive description of all the types of struc-
tures in which an institution may invest is Step-up notes or bonds are generally callable by
impossible. However, certain structures are fairly the issuer; pay an initial yield higher than a
common and are briefly described below. comparable fixed-rate, fixed-maturity security;
In many cases, very complex probability and and have coupons which rise or ‘‘step up’’ at
pricing models are required to accurately evalu- predetermined points in time if the issue is not
ate and price structured notes. As mentioned called. If the coupon has more than one adjust-
earlier, most structures have embedded options, ment period, it is referred to as a multi-step.
implicitly sold by the investor to the note’s Step-up notes have final maturities ranging from
issuer. The proper valuation of these options one year to as long as 20 years. Typical lock-out
poses unique challenges to investors considering periods (periods for which the note cannot be
structured notes. Many popular structures include called) range from three months to five years.
Trading and Capital-Markets Activities Manual March 1999
Page 1
4040.1 Structured Notes
An example of a step-up note is a five-year An embedded option feature, called a path-
note which has an initial coupon of 6 percent; dependent option, is present in this type of
the coupon increases 50 basis points every six security. The option is termed path-dependent
months. The note is callable by the issuer on any because the payoff structure of the option will
six-month interest-payment date. depend not only on the future path of the
Step-up notes contain embedded call options underlying index but on where that index has
‘‘sold’’ to the issuer by the investor. Any time an been in the past. The investor, in return for an
issue is callable, the purchaser of the security above-market initial yield, effectively sells this
has sold a call option to the issuer. In the above option to the issuer. The issuer has the option to
example, the investor has sold a series of call alter the principal amortization as the interest-
options, called a Bermuda option, to the issuer. rate environment changes. Caps and floors may
The note is callable on any interest-payment also be present if the issue has a floating-rate
date after a specified lock-out period. Unlike coupon.
callable issues which pay a flat rate until matu- A typical IAN is structured so that as the
rity or call, the step-up feature of these securities designated index (for example, LIBOR) rises
increases the value of the call options to the above a trigger level, the average life extends.
issuer and likewise increases the prospect of Conversely, if the designated index is at or
early redemption. Multi-steps can also be thought below the trigger level, the IAN’s principal will
of as one-way floaters since the coupon can quickly amortize, leading to a shorter average
adjust higher, but never lower. As such, they can life. The outstanding principal balance will vary
be viewed as securities in which the investor has according to the schedule at each redemption
bought a series of periodic floors and has sold a date. One may equate the amortization of the
series of periodic caps in return for above- note to the retirement (call) of some portion of
market initial yield. the principal. As the amortization quickens,
As the investor has sold a series of call more and more of the note is ‘‘called.’’
options to the issuer, a step-up note will outper- IANs generally appeal to investors who want
form a straight bond issue when rates are rela- an investment with a CMO-like risk-return pro-
tively stable and underperform in a volatile rate file, but with reduced uncertainty as to the
environment. In a decreasing-rate environment, average life. As the amortization schedule of an
the note is likely to be called and the investor IAN depends only on the level of the underlying
will be forced to invest the proceeds of the index, an IAN eliminates the noneconomic pre-
redemption in a low-interest-rate environment. payment factors of a CMO. However, like a
Conversely, in a rising-rate environment, an CMO, an IAN will outperform a straight bond
investor will be in a below-market instrument issue in a stable rate environment and underper-
when rates are high. Step-up notes with very form it in a volatile rate environment. In a
long maturities (beyond 10 years) may have decreasing-rate environment, the IAN is likely
greater liquidity and price risk than other secu- to be called, and the investor will be forced to
rities because of their long tenor. invest the proceeds of the redemption in a low
interest-rate environment. Conversely, in a rising-
rate environment, the maturity of the IAN will
extend, and an investor will be in a below-
Index-Amortizing Notes market instrument when rates are high.
An index-amortizing note (IAN) is a form of
structured note for which the outstanding prin-
cipal or note amortizes according to a predeter- De-Leveraged and Leveraged Floaters
mined schedule. The predetermined amortiza-
tion schedule is linked to the level of a designated De-leveraged and leveraged floating-rate notes
index (such as LIBOR, CMT, or the prepayment give investors the opportunity to receive an
rate of a specified pass-through pool). Thus, the above-market initial yield and tie subsequent
timing of future cash flows and, hence, the coupon adjustments to a specific point on the
average life and yield to maturity of the note yield curve. A leveraged note’s coupon will
become uncertain. The IAN does have a stated adjust by a multiple of a change in the relevant
maximum maturity date, however, at which time interest rate, for example, 1.25 × LIBOR + 100
all remaining principal balance is retired. basis points. Conversely, a de-leveraged securi-
March 1999 Trading and Capital-Markets Activities Manual
Page 2
Structured Notes 4040.1
ty’s coupon adjusts by a fraction of the change therefore depend on the frequency of resets, the
in rates, for example, .60 × 10-year CMT + 100 amount of coupon increase at each reset, and
basis points. the final maturity of the note. Longer maturity
De-leveraged floaters are combinations of notes, which have limited reset dates and limited
fixed- and floating-rate instruments. For exam- coupon increases, will be more volatile in
ple, a $10 million de-leveraged floater with a rising- rate environments and will therefore
coupon of 60 percent of the 10-year CMT + 100 have a greater degree of interest-rate and price
basis points is equivalent to the investor holding risk.
a $6 million note with a coupon equal to a
10-year CMT/LIBOR basis swap and a $4 mil-
lion fixed-rate instrument. If rates rise, an inves-
tor in a de-leveraged floater participates in the Dual-Index Notes
rise, but only by a fraction. The leverage factor
(for example, 60 percent) causes the coupons A dual-index note (sometimes called a yield
to lag the actual market. Thus, de-leveraged curve anticipation note (YCAN)) is a security
floaters will outperform straight bond issuances whose coupon is tied to the spread between two
in a declining or stable interest-rate environment. market indexes. An example is a three-year
Conversely, a leveraged floater such as the security which pays a semiannual coupon equal
example above should be purchased by inves- to (prime + 250 basis points − 6-month LIBOR).
tors with an expectation of rising rates in which Typical indexes used to structure payoffs to
they would receive better than one one-to-one these notes are the prime rate, LIBOR, COFI,
participation. The degree of leverage amplifies and CMT yields of different maturities. Yield-
the risks as well as the rewards of this type of curve notes allow the investor to lock in a very
security. The greater the leverage, the greater the specific view about forward rates. Such a play,
interest-rate and price risk of the security. while constructable in the cash market, is often
Other alternatives in this category include difficult and costly to an investor. A purchaser of
floaters which do not permit the coupon to this type of security is typically making an
decrease, so-called one-way de-leveraged float- assumption about the future shape of the yield
ers which can effectively lock in higher coupons curve. These notes can be structured to reward
in an environment where the index rises then the investors in either steepening or flattening
falls. yield-curve environments. However, these notes
can also be tied to indexes other than interest
rates, such as foreign-exchange rates, stock
indexes, or commodity prices.
Ratchet Notes An example of a note which would appeal to
investors with expectations of a flattening yield
Ratchet notes typically pay a floating-rate cou- curve (in a currently steep yield-curve environ-
pon that can never go down. The notes generally ment) would be one with a coupon that floats at
have periodic caps that limit the amount of the
increases (ratchets) or that set a predetermined [the 5-year CMT − the 10-year CMT
increase for each quarter. These periodic caps + a designated spread].
are akin to those found in adjustable-rate mort-
gage products. Based on this formula, the coupon will increase
An investor in a ratchet note has purchased if the yield curve flattens between the 5-year and
from the issuer a series of periodic floors and the 10-year maturities. Alternatively, a yield-
has sold a series of periodic caps. As such, a curve-steepening play would be an issue that
ratchet note will outperform a straight floating- floats at—
rate note in a stable or declining interest-rate
environment, and it will underperform in a [the 10-year CMT − the 5-year CMT
rapidly rising interest-rate environment. In a + a designated spread].
rapidly rising interest-rate environment, a ratchet
note will perform similarly to a fixed-rate instru- In this case, coupons would increase as the
ment with a low coupon which gradually steps spread between the long- and medium-term
up. The price volatility of the instrument will indexes widens.
Trading and Capital-Markets Activities Manual February 1998
Page 3
4040.1 Structured Notes
A dual-index note is equivalent to being a Principal-Linked Notes
long basis swap (in the example above, the
investor receives prime and pays LIBOR) and to An example of a principal-linked note is a
being long a fixed-rate instrument. As such, the one-year security which pays a fixed semi-
note has the risk-return elements of both a basis annual coupon of 8 percent, and the principal
swap and a comparable fixed-rate instrument. received at maturity is determined by the fol-
The note will underperform comparable fixed- lowing formula using market yields two days
rate instruments in an environment when the before maturity:
basis relationship (between prime and LIBOR in
the above example) narrows. These instruments P = 100 + 5 ( ( (2-year swap rate − 3-month
are subject to incremental price risk in a rising- LIBOR) − 1.40) )
rate environment in which the basis spread is
narrowing. The resulting principal-redemption amount under
varying rate scenarios would be as follows in
table 1.
Table 1—Examples of Possible Principal-Redemption Schemes
Rate
2-Year Swap
Rate − 3-Month Redemption
Par LIBOR Rate − 1.40 5*(Rate − 140) Percentage
100 180 .4 2.00 102
100 160 .2 1.00 101
100 140 .00 0.00 100
100 120 −0.20 −1.00 99
100 100 −0.40 −2.00 98
Under a principal-linked structured note, the the index remains within a designated range, the
maturity and the fixed coupon payments are lower rate is used during periods that the index
unchanged from the terms established at issu- falls outside the range. This lower level may be
ance. The issuer’s redemption obligation at zero. Range notes have been issued which ref-
maturity, however, is not the face value of the erence underlying indexes linked to interest
note. Redemption amounts are established by a rates, currencies, commodities, and equities.
formula whose components reflect historical or Most range notes reference the index daily such
prevailing market levels. Principal-linked notes that interest may accrue at 7 percent on one day
have been issued when the principal redemption and at 2 percent on the following day, if the
is a function of underlying currency, commod- underlying index crosses in and out of the range.
ity, equity, and interest-rate indexes. As the However, they can also reference the index
return of principal at maturity in many types of monthly, quarterly, or only once over the note’s
principal-linked notes is not ensured, these struc- life. If the note only references quarterly, then
tures are subject to a great degree of price risk. the index’s relationship to the range matters
only on the quarterly reset date. With the pur-
chase of one of these notes, the investor has sold
Range Notes a series of digital (or binary) options:1 a call
Range notes (also called accrual notes) accrue 1. A digital option has a fixed, predetermined payoff if the
underlying instrument or index is at or beyond the strike at
interest daily at a set coupon which is tied to an expiration. The value of the payoff is not affected by the
index. Most range notes have two coupon lev- magnitude of the difference between the underlying and the
els; the higher accrual rate is for the period that strike price.
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Structured Notes 4040.1
struck at the high end of the range and a put portfolios and/or to express a viewpoint about
struck at the low end of the range. This means the course of interest rates or other financial
that the accrual rate is strictly defined, and the variables. The basic appeal of structured notes
magnitude of movement outside the range is lies in their attendant customized risk param-
inconsequential. The narrower the range, the eters. Attributes that typically are not available
greater the coupon enhancement over a like (or not easily available) to an investor are
instrument. In some cases, the range varies each assembled in a prepackaged format. Addition-
year that the security is outstanding. ally, investors find the notes attractive for other
However, range notes also exist which require distinct reasons. In a sustained period of low
that the investor sell two barrier options:2 a interest rates (such as the United States experi-
down-and-out put struck at the low level of the enced for the five years leading up to February
range and an up-and-out call struck at the high 1994), receiving an ‘‘acceptable’’ return on an
level of the range. For these range notes, the investment became increasingly difficult. Struc-
index must remain within the target band for the tured notes, whose cash flows and market values
entire accrual period, and sometimes for the are linked to one or more benchmarks, offered
entire life of the instrument. If it crosses either the potential for greater returns than prevailing
barrier on even one day, the investor’s coupon market rates. The desire for higher yield led
will drop to zero for the whole period.3 This investors to make a risk-return tradeoff which
type of range note is quite rare, but investors reflected their market view.
should pay careful attention to the payment The fact that most structured notes are issued
provisions attached to movements outside the by government-sponsored enterprises (GSEs)
range. means that credit risk—the risk that the issuer
As the investor has sold leveraged call and will default—is minimal. GSEs are not, how-
put options to the issuer of these securities, a ever, backed by the full faith and credit of the
range note will outperform other floating-rate U.S. government, though most have explicit
instruments in stable environments when the lines of credit from the Treasury. As a result,
index remains within the specified range, and it investors were attracted by the potential returns
will underperform in volatile environments in of structured notes and by their high credit
which the underlying index is outside of the quality (implied government guarantee). As
specified range. Given the degree of leverage noted above, however, the credit risk of these
inherent in these types of structures, the securi- notes may be minimal, but their price risk may
ties can be very volatile and often exhibit a be significant.
significant degree of price risk.
Uses by Issuers
USES
Issuers often issue structured notes to achieve
Structured notes are used for a variety of pur- all-in funding rates, which are more advanta-
poses by investors, issuers, and underwriters or geous than what is achievable through a straight
traders. Banks are often involved in all three of debt issue. To induce issuers to issue complex
these capacities. and often very specialized debt instruments,
investors often will sacrifice some return, which
lowers the issuer’s all-in cost of funding. Gen-
Uses by Investors erally, only highly rated (single-A or better)
banks, corporations, agencies, and finance com-
Structured notes are investment vehicles that panies will be able to issue in the structured-note
allow investors to alter the risk profile of their market. A detailed discussion of issuing prac-
tices is included in the ‘‘Description of Market-
2. Path-dependent options with both their payoff pattern
place’’ subsection below.
and their survival to the nominal expiration date are dependent
not only on the final price of the underlying but on whether the
underlying sells at or through a barrier (instrike, outstrike) Uses by Underwriters or Traders
price during the life of the option.
3. McNeil, Rod. ‘‘The Revival of the Structured Note
Market.’’ International Bond Investor. Summer 1994, pp. Investment banks and the section 20 subsidiaries
34–37. of banks often act to underwrite structured-note
Trading and Capital-Markets Activities Manual February 1998
Page 5
4040.1 Structured Notes
issuances. They are often actively involved in Primary Market
making a market in secondary structured notes.
A detailed discussion of these activities is Structured notes are primarily issued by GSEs
included in the ‘‘Description of Marketplace’’ such as the FHLB, FNMA, SLMA, and FHLMC,
subsection below. which carry an implicit government guarantee
and are rated triple-A. Many large corporations,
banks, and finance companies, generally rated
single-A or better, also issue structured notes.
DESCRIPTION OF Most structured-note issuances originate with
MARKETPLACE investors on a reverse inquiry basis, through the
medium-term note (MTN) market. The process
Background originates when an investor has a demand for a
security with specific risk characteristics. Through
In its heyday, the structured-note market was a a reverse inquiry, an investor will use MTN
by-product of a unique period in financial his- agents such as the underwriting desk of an
tory. In 1992 and 1993, Wall Street firms engi- investment bank or section 20 subsidiary of a
neered debt that allowed borrowers to attain bank to communicate its desires to the issuer. If
highly attractive below-market funding and that the issuer agrees to the inquiry, the issuer will
rewarded investors (in large part) as long as issue the security which is sold through the
interest rates remained low. The incredible and MTN agent to the investor.
at times implausible array of structure types Although structured notes in the MTN market
came into being in response to the investment often originate with the investor, investment
community’s desire for higher returns during a banks and section 20 subsidiaries of banks also
sustained period of low interest rates. Issuers put together such transactions. Most investment
and investment dealer firms were more than banks and section 20 subsidiaries have derivative-
willing to address this need, introducing inves- product specialists who design structured notes
tors to more attractive (and by definition riskier) to take advantage of specific market opportuni-
securities whose cash flows were linked to, for ties. When an opportunity is identified, the
example, the performance of the yen; the yen’s investment bank or section 20 subsidiary will
relationship to the lira; and a host of other inform investors and propose that they buy the
indexes, currencies, or benchmarks.4 Investors’ structured note. If an investor tentatively agrees
quest for enhanced yield caused them to adopt, to purchase the security, the MTN agents in the
in many cases, very tenuous risk-reward mea- investment bank or section 20 subsidiary will
sures with respect to potential investment contact an issuer with the proposed transaction.
choices. If the structure meets the funding needs of the
issuer, the structured note will be issued to the
Structured notes received heightened atten-
investors.
tion from both regulators and investors in the
spring and summer of 1994. Many of these
structured securities, created to satisfy a per-
ceived need at the time, deteriorated in value as Secondary Market
a result of the rate increases of 1994. In many
cases, the leverage inherent in the security Structured notes are traded in the secondary
worked against the investor, obliterating once market through market makers such as invest-
attractive coupon payments. Market values of ment banks or section 20 subsidiaries of banks
many of these instruments fell below par as their or through brokers. Market makers will buy or
coupons became vastly inferior to comparable sell structured notes, at a predetermined bid and
maturity investments and as maturities were offer. Market makers will usually trade GSE
extended beyond investors’ original expectations. structured notes through their secondary agency
trader and trade corporate-issued structured notes
through their corporate bond trader. Some mar-
4. As more exotic structured-note issues came into being ket makers trade secondary structured notes
(and especially in light of the Orange County debacle), much
of the bad press centered on the (quasi-government) agencies
through their structured-note desk, a specialized
who issued the paper. As discussed later, the impetus for the group who will buy and trade all types of
vast majority of deals in fact emanated from Wall Street. structured notes.
February 1998 Trading and Capital-Markets Activities Manual
Page 6
Structured Notes 4040.1
Investors in secondary structured notes may (1) on an asset-swap basis or (2) on a straight-
buy the notes at a discount or premium to pricing basis.
issuance and receive the performance character-
istics of the note as shown in the prospectus.
Investors may also purchase structured notes on Asset-Swap Pricing
an asset-swap basis, which strips the optionality
out of a note and leaves the investor with a Structured notes are typically constructed by
synthetically created ‘‘plain vanilla’ return such embedding some form of optionality in the
as LIBOR. Asset-swap pricing is discussed in coupon, principal, or maturity component of a
the ‘‘Pricing’’ subsection below. debt issue. Once these embedded derivatives are
Secondary structured notes are also used to quantified, a swap or series of swaps can be
create special-purpose vehicles such as Merrill undertaken to strip out those options and effec-
Lynch’s STEERS program. In these types of tively create a synthetic instrument with either
programs, secondary structured notes are placed fixed or variable cash-flow streams. This pro-
in a special-purpose vehicle, the receipts of cess is known as asset-swap pricing.5
which are then sold to investors. A series of Asset-swap pricing initially involves decom-
swap transactions is then entered into between a posing and valuing the components of the note,
swap counterparty and the special-purpose vehi- including contingent cash flows. It conveys
cle, which strips the optionality out of the where those components can be cashed out in
structures. The investor therefore receives a trust the market, often referred to as the break-up
receipt which pays a plain vanilla return such as value of the note. After the note is decomposed,
LIBOR. an alternate cash-flow stream is created through
Structured notes often possess greater liquid- the asset-swap market.
ity risk than many other types of securities. The When structured notes are priced on an asset-
most important factor affecting the liquidity of swap basis, the issue is analyzed based on its
the note in the secondary market is the size of salvage value.6 The salvage value on most
the secondary note being traded. Generally, the agency structured issues varies based on the
larger the size of the note, the more liquid the current market and the size, type, and maturity
note will be in the secondary market. Most of the note.
investors will not buy a structured note of Liquidity in the structured-notes market exists
limited size unless they receive a significant because every note has a salvage value. If
premium to cover the administrative costs of demand for the note as a whole is weak, its cash
booking the note. Similarly, most market makers flows can be reconstructed via the asset-swap
will not inventory small pieces of paper unless market to create a synthetic security. In many
they charge a significant liquidity premium. cases, the re-engineered security has broader
Another factor which may affect the liquidity investor appeal, thereby generating needed
of a structured note in the secondary market is liquidity for the holder of the original issue.
the one-way ‘‘bullishness’’ or ‘‘bearishness’’ of
a note. For example, in a rising-rate environ-
ment, leveraged bullish instruments such as
inverse floaters may not be in demand by Straight Pricing
investors and may therefore have less liquidity
Contrasted with an asset-swapped issue, a note
in the secondary market. As many structured
trading on a straight-pricing basis is purchased
notes are sold on an asset-swap basis, the
and sold as is.7 Traders who price structured
characteristics of the structured note can be
notes on this basis compare the note with similar
‘‘engineered’’ out of the note, leaving the inves-
types of instruments trading in the market and
tor with a plain vanilla return. The asset-swap
derive a price accordingly.
market, therefore, helps to increase the liquidity
of these types of notes.
5. See the Federal Reserve product summary Asset Swaps—
Creating Synthetic Instruments by Joseph Cilia for a detailed
PRICING treatment on the topic.
6. Goodman, Laurie. ‘‘Anatomy of the Secondary Struc-
tured Note Market.’’ Derivatives Quarterly, Fall 1995.
The two primary methods by which structured 7. Peng, Scott Y., and Ravi E. Dattatreya. The Structured
notes are priced in the secondary market are Note Market. Chicago: Probus, 1995.
Trading and Capital-Markets Activities Manual February 1998
Page 7
4040.1 Structured Notes
HEDGING RISKS
Structured notes are, from a cash-flow perspec- Market Risk
tive, a combination of traditional debt instru-
ments and derivative contracts. As a result, the The embedded options and other leverage fac-
value (or performance) of a structured note can tors inherent in structured notes result in a great
be replicated by combining components consist- deal of uncertainty about future cash flows.
ing of appropriate zero-coupon debt plus appro- Thus, price volatility is generally high in these
priate futures or options positions that reflect the types of securities. An institution should have—
optionality embedded in the issue. Similar to the or should have ready access to—a model which
decomposition process employed in an asset- is able to quantify the risks. The model should
wap transaction, the fair value of this replicated be able to forecast the change in market price at
portfolio should be equivalent to the fair value various points in time (for example, one year
of the structured note. later or the first call date) for a given shift in
interest rates. For the many variants of these
Theoretically, one should be indifferent about products which are tied to the shape of the yield
investing in a structured note or in its equiva- curve, the ability to model price effects from
lently constructed portfolio as long as the price nonparallel interest-rate shifts is also crucial. In
of the note equals the present value of its most cases (except for some principal-linked
replication components.8 Price discrepancy notes), full principal will be returned at maturity.
should govern the selection process between However, between issuance and redemption,
these alternatives. changes in fundamental factors can give rise to
A hedge of a structured-note position involves significant reductions in the ‘‘market’’ price.
engaging in the opposite of the replication trades As with other types of instruments in which
noted above. To be fully protected in a hedge, an investor has sold an option, structured notes
the sum of the present values of each component will underperform similar straight debt issu-
of the hedge should be less than or equal to the ances in a volatile rate environment. For notes
market value of the note. If, for some reason, the such as callable step-ups and IANs, the investor
note was priced higher than the cost of the may be exposed to reinvestment risk (investing
worst-case replication components, the hedging the proceeds of the note in a low-interest-rate
firm stands to lock in a positive spread if that environment) when rates decrease and to exten-
worst-case scenario fails to materialize.9 sion risk (not being able to invest in a high-
A structured-note position itself can serve to interest-rate environment) when rates increase.
hedge unique risks faced by the investor. For
example, a company which is long (owns)
Japanese yen (¥) is exposed to the risk of yen Liquidity Risk
depreciation. The FHLB issued a one-year struc-
tured range note which accrued interest daily at Due to the complex nature of structured notes,
7 percent if the ¥/U.S.$ is greater than 108.50 or the number of firms that are able and willing to
at 0 percent if the ¥/U.S.$ is less than 108.50. If competitively price and bid for these securities
the yen depreciates, the note accrues interest at is quite small; however, an active secondary
an above-market rate. Meanwhile, the compa- market has developed over the past few years.
ny’s yen holdings will decline in value. This When the structure is complex, however, bid-
note could serve as a perfectly tailored hedge for ders may be few. Consequently, an institution
the company’s business-risk profile. In fact, the hoping to liquidate a structured-note holding
design of many of the most complicated struc- before maturity may find that their only option is
tured notes is driven not by the innovations of to sell at a significant loss. In certain cases, the
note issuers and underwriters, but rather by issue’s original underwriter is the only source
investors seeking to hedge their own unique risk for a bid (and even that is not always guaranteed).
profiles. Some factors influencing the liquidity of the
note include the type, size, and maturity of the
note. In general, the more complex the structure
8. Kawaller, Ira G. ‘‘Understanding Structured Notes.’’
or the more a note exhibits one-way bullishness
Derivatives Quarterly, Spring 1995. or bearishness, the less liquidity a note will
9. Ibid., p. 32. have. Although the asset-swap market allows
February 1998 Trading and Capital-Markets Activities Manual
Page 8
Structured Notes 4040.1
the derivative components to be engineered out RISK-BASED CAPITAL
of these complex structures, liquidity may be WEIGHTING
impaired because many institutions have invest-
ment guidelines which prohibit the purchase of Structured notes issued by GSEs should be
certain types of complex notes. Thus, the size of given a 20 percent risk weighting. Structured
the potential market is diminished, and liquidity notes issued by investment-grade corporations
decreases. Also, notes with a smaller size (gen- should be given a 100 percent risk weighting.
erally under $10 million) and a longer maturity For specific risk weights for qualified trading
(generally greater than five years) will tend to be accounts, see section 2110.1, ‘‘Capital
less liquid. Adequacy.’’
Volatility Risk
LEGAL LIMITATIONS FOR BANK
For each of these structures with embedded INVESTMENTS
options, assumptions about the volatility of
interest-rate moves are also inherent. For any of The limitations of 12 CFR 1 apply to structured
these options which are purchased by investors notes. Structured notes issued by GSEs are type
(for example, interest-rate floors), the risk that I securities, and there is no limitation on the
expectations for market-rate volatility will amount which a bank can purchase or sell.
decrease over time exists. If this happens, mar- Structured notes issued by investment-grade-
ket valuation of these securities will also rated corporations are type III securities. A
decrease, and the investor will have ‘‘pur- bank’s purchases and sales of type III securities
chased’’ an overvalued option for which he or are limited to 10 percent of its capital and
she will not be compensated if the instrument is surplus.
sold before maturity. For options which are sold
by investors (for example, interest-rate caps),
the risk that volatility increases after the note is
purchased exists. If this occurs, the market REFERENCES
valuation of the structured note will decrease,
and the investor will have ‘‘sold’’ an underval- Audley, David, Richard Chin, and Shrikant
ued option for which he or she will have to pay Ramamurthy. ‘‘Derivative Medium-Term
a higher price if the instrument is sold before Notes’’ and ‘‘Callable Multiple Step-Up
maturity. Bonds.’’ Prudential Securities Financial Strat-
egies Group, October 1993 and May 1994,
respectively.
‘‘BankAmerica Exec Explains What Happened
ACCOUNTING TREATMENT with Its $68M Fund Bailout.’’ American
Banker, October 17, 1994.
The Financial Accounting Standards Board’s Cilia, Joseph. Product Summary— Asset Swaps—
Statement of Financial Accounting Standards Creating Synthetic Instruments. Federal
No. 115 (FAS 115), ‘‘Accounting for Certain Reserve Bank of Chicago, August 1996.
Investments in Debt and Equity Securities,’’ as Cilia, Joseph, and Karen McCann. Product
amended by Statement of Financial Accounting Summary—Structured Notes. Federal Reserve
Standards No. 140 (FAS 140), ‘‘Accounting for Bank of Chicago, November 1994.
Transfers and Servicing of Financial Assets and Crabbe, Leland E., and Joseph D. Argilagos.
Extinguishments of Liabilities,’’ determines the ‘‘Anatomy of the Structured Note Market.’’
accounting treatment for investments in struc- Journal of Applied Corporate Finance, Fall
tured notes. Accounting treatment for deriva- 1994.
tives used as investments or for hedging pur- Goodman, Laurie, and Linda Lowell. ‘‘Struc-
poses is determined by Statement of Financial tured Note Alternatives to Fixed Rate and
Accounting Standards No. 133 (FAS 133), Floating Rate CMOs.’’ Derivatives Quarterly,
‘‘Accounting for Derivatives and Hedging Spring 1995.
Activities.’’ (See section 2120.1, ‘‘Accounting,’’ Kawaller, Ira G. ‘‘Understanding Structured
for further discussion.) Notes.’’ Derivatives Quarterly, Spring 1995.
Trading and Capital-Markets Activities Manual September 2001
Page 9
4040.1 Structured Notes
McNeil, Rod. ‘‘The Revival of the Structured Peng, Scott Y., and Ravi E. Dattatreya. The
Note Market.’’ International Bond Investor. Structured Note Market. Chicago: Probus,
Summer 1994, pp. 34–37. 1995.
September 2001 Trading and Capital-Markets Activities Manual
Page 10
Corporate Notes and Bonds
Section 4045.1
GENERAL DESCRIPTION Collateral Trust Bonds
Corporate bonds are debt obligations issued by Collateral trust bonds are secured by pledges of
corporations. Corporate bonds may be either stocks, notes, bonds, or other collateral. Gener-
secured or unsecured. Collateral used for secured ally, the market or appraised value of the collat-
debt includes but is not limited to real property, eral must be maintained at some percentage of
machinery, equipment, accounts receivable, the amount of the bonds outstanding, and a
stocks, bonds, or notes. If the debt is unsecured, provision for withdrawal of some collateral is
the bonds are known as debentures. Bondhold- often included, provided other acceptable collat-
ers, as creditors, have a prior legal claim over eral is provided. Collateral trust bonds may be
common and preferred stockholders as to both issued in series.
income and assets of the corporation for the
principal and interest due them and may have a
prior claim over other creditors if liens or Equipment Trust Certificates
mortgages are involved.
Corporate bonds contain elements of both Equipment trust certificates are usually issued
interest-rate risk and credit risk. Corporate bonds by railroads or airlines. The issuer, such as a
usually yield more than government or agency railroad company or airline, buys a piece of
bonds due to the presence of credit risk. Corpo- equipment from a manufacturer, who transfers
rate bonds are issued as registered bonds and are the title to the equipment to a trustee. The trustee
usually sold in book-entry form. Interest may be then leases the equipment to the issuer and at the
fixed, floating, or the bonds may be zero cou- same time sells equipment trust certificates
pons. Interest on corporate bonds is typically (ETCs) to investors. The manufacturer is paid
paid semiannually and is fully taxable to the off through the sale of the certificates, and
bondholder. interest and principal are paid to the bondhold-
ers through the proceeds of lease payments from
the issuer to the trustee. At the end of some
specified period of time, the certificates are paid
off, the trustee sells the equipment to the issuer
CHARACTERISTICS AND for a nominal price, and the lease is terminated.
FEATURES As the issuer does not own the equipment,
foreclosing a lien in event of default is facili-
tated. These bonds are often issued in serial
Security for Bonds form.
Various types of security may be pledged to
offer security beyond that of the general stand-
ing of the issuer. Secured bonds, such as first- Debenture Bonds
mortgage bonds, collateral trust bonds, and
equipment trust certificates, yield a lower rate of Debenture bonds are not secured by a specific
interest than comparable unsecured bonds pledge of designated property. Debenture bond-
because of the greater security they provide to holders have the claim of general creditors on all
the bondholder. assets of the issuer not pledged specifically to
secure other debt. They also have a claim on
pledged assets to the extent that these assets
have value greater than necessary to satisfy
First-Mortgage Bonds secured creditors. Debentures often contain a
variety of provisions designed to afford some
First-mortgage bonds normally grant the bond- degree of protection to bondholders, including
holder a first-mortgage lien on the property of limitation on the amount of additional debt
the issuer. Often first-mortgage bonds are issued issuance, minimum maintenance requirements
in series with bonds of each series secured on net working capital, and limits on the pay-
equally by the same first mortgage. ment of cash dividends by the issuer. If an issuer
Trading and Capital-Markets Activities Manual February 1998
Page 1
4045.1 Corporate Notes and Bonds
has no secured debt, it is customary to provide a semiannually and at maturity. Interest pay-
negative pledge clause—a provision that deben- ments once a year are the norm for bonds sold
tures will be secured equally with any secured overseas. Interest on corporate bonds is based
bonds that may be issued in the future. on a 360-day year, made up of twelve 30-day
months.
Subordinated and Convertible Debentures
Zero-Coupon Bonds
Subordinated debenture bonds stand behind
secured debt, debenture bonds, and often some
Zero-coupon bonds are bonds without coupons
general creditors in their claim on assets and
or a stated interest rate. These securities are
earnings. Because these bonds are weaker in
issued at discounts to par; the difference between
their claim on assets, they yield a higher rate of
the face amount and the offering price when
interest than comparable secured bonds. Often,
first issued is called the original-issue discount
subordinated debenture bonds offer conversion
(OID). The rate of return depends on the amount
privileges to convert bonds into shares of an
of the discount and the period over which it
issuer’s own common stock or the common
accretes. In bankruptcy, a zero-coupon bond
stock of a corporation other than an issuer—
creditor can claim the original offering price
referred to as exchangeable bonds.
plus accrued and unpaid interest to the date of
bankruptcy filing, but not the principal amount
of $1,000.
Guaranteed Bonds
Guaranteed bonds are guaranteed by a corpora-
tion other than the issuer. The safety of a Floating-Rate Notes
guaranteed bond depends on the financial capa-
bility of the guarantor, as well as the financial The coupon rates for floating-rate notes are
capability of the issuer. The terms of the guar- based on various benchmarks ranging from
antee may call for the guarantor to guarantee the short-term rates, such as prime and 30-day
payment of interest and/or repayment of princi- commercial paper, to one-year and longer
pal. A guaranteed bond may have more than one constant maturity Treasury rates (CMTs). Cou-
corporate guarantor, who may be responsible for pons are usually quoted as spread above or
not only its pro rata share but also the entire below the base rate (that is, three-month LIBOR
amount guaranteed by other guarantors. + 15 bp). The interest rate paid on floating-rate
notes adjusts based on changes in the base rate.
For example, a note linked to three-month U.S.
LIBOR would adjust every three months, based
Maturity on the then-prevailing yield on three-month U.S.
LIBOR. Floating-rate notes are often subject to
Corporate bonds are issued in a broad maturity a maximum (cap) or minimum (floor) rate of
spectrum, ranging from less than one year to interest.
perpetual issues. Issues maturing within one
year are usually viewed as the equivalent of cash
items. Debt maturing between one and five years
is generally thought of as short-term. Features
Intermediate-term debt is usually considered to
mature between 5 and 12 years, whereas long- A significant portion of corporate notes and
term debt matures in more than 12 years. bonds has various features. These include call
provisions, in which the issuer has the right to
redeem the bond before maturity; put options, in
Interest-Payment Characteristics which the holder has the right to redeem the
bond before maturity; sinking funds, used to
Fixed-Rate Bonds retire the bonds at maturity; and convertibility
features that allow the holder to exchange debt
Most fixed-rate corporate bonds pay interest for equity in the issuing company.
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Corporate Notes and Bonds 4045.1
Callable Bonds bond of comparable quality. An investor in a
convertible security receives the upside poten-
Callable bonds are bonds in which the investor tial of the common stock of the issuer, combined
has sold a call option to the issuer. This increases with the safety of principal in terms of a prior
the coupon rate paid by the issuer but exposes claim to assets over equity security holders. The
the investor to prepayment risk. If market inter- investor, however, pays for this conversion privi-
est rates fall below the coupon rate of the bond lege by accepting a significantly lower yield-to-
on the call date, the issuer will call the bond and maturity than that offered on comparable non-
the investor will be forced to invest the proceeds convertible bonds. Also, if anticipated corporate
in a low-interest-rate environment. As a rule, growth is not realized, the investor sacrifices
corporate bonds are callable at a premium above current yield and risks having the price of the
par, which declines gradually as the bond bond fall below the price paid to acquire it.
approaches maturity. Commercial banks may purchase eligible con-
vertible issues if the yield obtained is reasonably
similar to nonconvertible issues of similar qual-
Put Bonds ity and maturity, and the issues are not selling at
a significant conversion premium.
Put bonds are bonds in which the investor has
purchased a put option from the issuer. The cost
of this put option decreases the coupon rate paid
by the issuer, but decreases the risk to an
investor in a rising interest-rate environment. If USES
market rates are above the coupon rate of the
bond at the put date, the investor can ‘‘put’’ Corporate bonds can be used for hedging, invest-
the bond back to the issuer and reinvest the ment, or speculative purposes. In some instances,
proceeds of the bond in a high-interest-rate the presence of credit risk and lack of liquidity
environment. in various issues may discourage their use.
Speculators can use corporate bonds to take
positions on the level and term structure of both
Sinking-Fund Provisions interest rates and corporate spreads over govern-
ment securities.
Bonds with sinking-fund provisions require the Banks often purchase corporate bonds for
issuer to retire a specified portion on a bond their investment portfolios. In return for increased
issue each year. This type of provision reduces credit risk, corporate bonds provide an enhanced
the default risk on the bond because of the spread relative to Treasury securities. Banks
orderly retirement of the issue before maturity. may purchase investment-grade corporate secu-
The investor assumes the risk, however, that rities subject to a 10 percent limitation of its
the bonds may be called at a special sinking- capital and surplus for one obligor. Banks are
fund call price at a time when interest rates are prohibited from underwriting or dealing in these
lower than rates prevailing at the time the bond securities. A bank’s section 20 subsidiary may,
was issued. In that case, the bonds will be however, be able to underwrite and deal in
selling above par but may be retired by the corporate bonds.
issuer at the special call price that may be equal Banks often act as corporate trustees for
to par value. bond issues. A corporate trustee is responsible
for authenticating the bonds issued and ensuring
that the issuer complies with all of the covenants
Convertible Bonds specified in the indenture. Corporate trustees
are subject to the Trust Indenture Act, which
Convertible securities are fixed income securi- specifies that adequate requirements for the
ties that permit the holder the right to acquire, at performance of the trustee’s duties on behalf
the investor’s option, the common stock of the of the bondholders be developed. Furthermore,
issuing corporation under terms set forth in the the trustee’s interest as a trustee must
bond indenture. New convertible issues typi- not conflict with other interest it may have,
cally have a maturity of 25 to 30 years and carry and the trustee must provide reports to
a coupon rate below that of a nonconvertible bondholders.
Trading and Capital-Markets Activities Manual February 1998
Page 3
4045.1 Corporate Notes and Bonds
DESCRIPTION OF Bond ratings are published by several orga-
MARKETPLACE nizations that analyze bonds and express their
conclusions by a ratings system. The four major
The size of the total corporate bond market was nationally recognized statistical rating organiza-
$2.2 trillion dollars at the end of 1993. Nonfi- tions (NRSROs) in the United States are Duff &
nancial corporate business comprised approxi- Phelps Credit Rating Co. (D&P); Fitch Investor
mately 56 percent of total issuance in 1993. Service, Inc. (Fitch); Moody’s Investor Service,
Inc. (Moody’s); and Standard & Poor’s Corpo-
ration (S&P).
Market Participants
PRICING
Buy Side
The major factors influencing the value of a
The largest holder of corporate debt in the corporate bond are—
United States is the insurance industry, account-
ing for more than 33 percent of ownership at the • its coupon rate relative to prevailing market
end of 1993. Private pension funds are the interest rates (typical of all bonds, bond prices
second-largest holders with 13.7 percent of will decline when market interest rates rise
ownership. Commercial banks account for above the coupon rate, and prices will rise
approximately 4.5 percent of ownership of out- when interest rates decline below the coupon
standing corporate bonds. rate) and
• the issuer’s credit standing (a change in an
issuer’s financial condition or ability to finance
Sell Side the debt can cause a change in the risk
premium and price of the security).
Corporate bonds are underwritten in the primary
market by investment banks and section 20 Other factors that influence corporate bond
subsidiaries of banks. In the secondary market, prices are the existence of call options, put
corporate bonds are traded in the listed and features, sinking funds, convertibility features,
unlisted markets. Listed markets include the and guarantees or insurance. These factors can
New York Stock Exchange and the American significantly alter the risk/return profile of a
Stock Exchange. These markets primarily ser- bond issue. (These factors and their effect on
vice retail investors who trade in small lots. The pricing are discussed in the ‘‘Characteristics and
over-the-counter market is the primary market Features’’ subsection above.)
for professional investors. In the secondary The majority of corporate bonds are traded on
market, investment banks and section 20 sub- the over-the-counter market and are priced as a
sidiaries of banks may act as either a broker or spread over U.S. Treasuries. Most often the
dealer. Brokers execute orders for the accounts benchmark U.S. Treasury is the on-the-run (cur-
of customers; they are agents and get a commis- rent coupon) issue. However, pricing ‘‘abnor-
sion for their services. Dealers buy and sell for malities’’ can occur where the benchmark U.S.
their own accounts, thus taking the risk of Treasury is different from the on-the-run security.
reselling at a loss.
HEDGING
Sources of Information
Interest-rate risk for corporate debt can be hedged
For a primary offering, the primary source of either with cash, exchange-traded, or over-the-
information is contained in a prospectus filed by counter instruments. Typically, long corporate
the issuer with the Securities and Exchange bond or note positions are hedged by selling a
Commission. For seasoned issues, major con- U.S. Treasury issue of similar maturity or by
tractual provisions are provided in Moody’s shorting an exchange-traded futures contract.
manuals or Standard & Poor’s corporation The effectiveness of the hedge depends, in part,
records. on basis risk and the degree to which the hedge
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Corporate Notes and Bonds 4045.1
has neutralized interest-rate risk. Hedging strat- another corporation. The safety of the bond may
egies may incorporate assumptions about the depend on the financial condition of the guaran-
correlation between the credit spread and gov- tor, since the guarantor will make principal and
ernment rates. The effectiveness of these strat- interest payments if the obligor cannot. Credit
egies may be affected if these assumptions prove enhancements often are used to improve the
inaccurate. Hedges can be constructed with credit rating of a bond issue, thereby reducing
securities from the identical issuer but with the rate of interest that the issuer must pay.
varying maturities. Alternatively, hedges can be Zero-coupon bonds may pose greater credit-
constructed with issuers within an industry risk problems. When a zero-coupon bond has
group. The relative illiquidity of various corpo- been sold at a deep discount, the issuer must
rate instruments may diminish hedging have the funds to make a large payment at
effectiveness. maturity. This potentially large balloon repay-
ment may significantly increase the credit risk of
the issue.
RISKS
Interest-Rate Risk Liquidity Risk
For fixed-income bonds, prices fluctuate with Major issues are actively traded in large amounts,
changes in interest rates. The degree of interest- and liquidity concerns may be small. Trading
rate sensitivity depends on the maturity and for many issues, however, may be inactive and
coupon of the bond. Floating-rate issues lessen significant liquidity problems may affect pric-
the bank’s interest-rate risk to the extent that the ing. The trading volume of a security determines
rate adjustments are responsive to market rate the size of the bid/ask spread of a bond. This
movements. For this reason, these issues gener- provides an indication of the bond’s marketabil-
ally have lower yields to compensate for their ity and, hence its, liquidity. A narrow spread of
benefit to the holder. between one-quarter to one-half of 1 percent
may indicate a liquid market, while a spread of
2 or 3 percent may indicate poor liquidity for a
Prepayment or Reinvestment Risk bond. Even for major issues, news of credit
problems may cause temporary liquidity
Call provisions will also affect a bank’s interest- problems.
rate exposure. If the issuer has the right to
redeem the bond before maturity, the action has
the potential to adversely alter the investor’s Event Risk
exposure. The issue is most likely to be called
when market rates have moved in the issuer’s Event risk can be large for corporate bonds. This
favor, leaving the investor with funds to invest is the risk of an unpredictable event that imme-
in a lower-interest-rate environment. diately affects the ability of an issuer to service
the obligations of a bond. Examples of event
risk include leveraged buyouts, corporate restruc-
Credit Risk turings, or court rulings that affect the credit
rating of a company. To mitigate event risk,
Credit risk is a function of the financial condi- some indentures include a maintenance of net
tion of the issuer or the degree of support worth clause, which requires the issuer to main-
provided by a credit enhancement. The bond tain its net worth above a stipulated level. If the
rating may be a quick indicator of credit quality. requirement is not met, the issuer must begin to
However, changes in bond ratings may lag retire its debt at par.
behind changes in financial condition. Banks
holding corporate bonds should perform a peri-
odic financial analysis to determine the credit ACCOUNTING TREATMENT
quality of the issuer.
Some bonds will include a credit enhance- The Financial Accounting Standards Board’s
ment in the form of insurance or a guarantee by Statement of Financial Accounting Standards
Trading and Capital-Markets Activities Manual September 2001
Page 5
4045.1 Corporate Notes and Bonds
No. 115 (FAS 115), ‘‘Accounting for Certain LEGAL LIMITATIONS FOR BANK
Investments in Debt and Equity Securities,’’ as INVESTMENT
amended by Statement of Financial Accounting
Standards No. 140 (FAS 140), ‘‘Accounting for Corporate notes and bonds are type III securi-
Transfers and Servicing of Financial Assets and ties. A bank may purchase or sell for its own
Extinguishments of Liabilities,’’ determines the account corporate debt subject to the limitation
accounting treatment for investments in corpo- that the corporate debt of a single obligor may
rate notes and bonds. Accounting treatment for not exceed 10 percent of the bank’s capital and
derivatives used as investments or for hedging surplus. To be eligible for purchase, a corporate
purposes is determined by Statement of Finan- security must be ‘‘investment grade’’ (that is,
cial Accounting Standards No. 133 (FAS 133), rated BBB or higher) and must be marketable.
‘‘Accounting for Derivatives and Hedging Banks may not deal in or underwrite corporate
Activities.’’ (See section 2120.1, ‘‘Accounting,’’ bonds.
for further discussion.)
REFERENCES
RISK-BASED CAPITAL Fabozzi, Frank, and T. Dessa, eds. The Hand-
WEIGHTING book of Fixed Income Securities. Chicago:
Irwin Professional Publishing, 1995.
Corporate notes and bonds should be weighted Fabozzi, Frank, and Richard Wilson. Corporate
at 100 percent. For specific risk weights for Bonds. Frank J. Fabozzi Associates, 1996.
qualified trading accounts, see section 2110.1, ‘‘How Do Corporate Spread Curves Move Over
‘‘Capital Adequacy.’’ Time?’’ Salomon Brothers, July 1995.
September 2001 Trading and Capital-Markets Activities Manual
Page 6
Municipal Securities
Section 4050.1
GENERAL DESCRIPTION types of notes issued include tax anticipation
notes (TANs), revenue anticipation notes (RANs),
Municipal securities are interest-bearing obliga- tax and revenue anticipation notes (TRANs),
tions issued by local governments or their grant anticipation notes (GANs), and bond
political subdivisions (such as cities, towns, anticipation notes (BANs).
villages, counties, or special districts) or by state
governments, agencies, or political subdivi-
sions. These governmental entities can borrow
at favorable rates because the interest income
CHARACTERISTICS AND
from most municipal securities generally receives FEATURES
advantageous treatment under federal income
tax rules. There are important restrictions on Municipal bonds are typically issued in denomi-
these tax advantages, however, and banks are nations of $5,000, known as the par value or
subject to different tax treatment than other face value amount of the bond. Municipal bonds
investors. are generally issued in serial maturities. A
typical offering is made up of different maturi-
The two principal classifications of municipal ties which allow the issuer to spread out debt
securities are general obligation bonds and service and stay within financial requirements.
revenue bonds. General obligation bonds are In recent years, however, term bonds have
secured by the full faith and credit of an issuer become increasingly popular. Term bonds are
with taxing power. General obligation bonds bonds comprising a large part or all of a par-
issued by local governments are generally ticular issue which comes due in a single matu-
secured by a pledge of the issuer’s specific rity. The issuer usually agrees to make periodic
taxing power, while general obligation bonds payments into a sinking fund for mandatory
issued by states are generally based on appro- redemption of term bonds before maturity or for
priations made by the state’s legislature. In the payment at maturity. Most municipal bonds are
event of default, the holders of general obliga- issued with call provisions which give the issuer
tion bonds have the right to compel a tax levy or flexibility in controlling its borrowing costs
legislative appropriation to satisfy the issuer’s through the early retirement of debt.
obligation on the defaulted bonds. A prime feature of municipal securities had
Revenue bonds are payable from a specific been the exemption of their interest from federal
source of revenue, so that the full faith and income taxation. However, two significant
credit of an issuer with taxing power is not restrictions have been imposed on the tax bene-
pledged. Revenue bonds are payable only from fits of owning municipal securities. First, begin-
specifically identified sources of revenue. Pledged ning in 1986, all taxpayers became subject to the
revenues may be derived from operation of the alternative minimum tax (AMT), which was
financed project, grants, and excise or other intended to provide an upper limit on the degree
taxes. Industrial development bonds are a com- to which individuals and corporations can pro-
mon example of revenue bonds. These bonds are tect their income from taxation. Interest income
municipal debt obligations issued by a state or from private-activity securities issued since then
local government (or a development agency) to is potentially subject to the AMT. Second,
finance private projects that generate tax rev- investors became unable to deduct interest
enues. The debt service on these bonds is expense incurred in funding tax-advantaged
dependent on the lease income generated by the securities, a measure that was intended to remove
project or facility. In certain instances, industrial the benefit of borrowing funds from others to
development bonds may be categorized as loans invest in municipal securities. In this regard,
(see the instructions to the call report). special federal tax rules apply to bank holdings
In addition to municipal and industrial devel- of municipal securities, including the manner in
opment bonds, state and local governmental which the amount of nondeductible interest
entities issue short-term obligations in the form expense is calculated. Exceptions to these vari-
of notes. These debt obligations are generally ous limitations apply only to tax-exempt obliga-
issued to bridge the gap between when expenses tions issued after August 1986 that are issued by
are paid and tax revenues are collected. The small entities and are not private-activity bonds.
Trading and Capital-Markets Activities Manual February 1998
Page 1
4050.1 Municipal Securities
The state and local income taxation treatment by the SEC. Examination and enforcement of
of municipal securities varies greatly from state MSRB standards is delegated to the NASD for
to state. Many states and local governments securities firms and to the appropriate federal
exempt interest income only on those bonds and banking agency (Federal Reserve, OCC, or
notes issued by government entities located FDIC) for banking organizations.
within their own boundaries.
Secondary Market
USES Municipal securities are not listed on or traded
in exchanges; however, there are strong and
Municipal securities have traditionally been held active secondary markets for municipal securi-
primarily for investment purposes by investors ties that are supported by municipal bond deal-
who would benefit from income that is advan- ers. These traders buy and sell to other dealers
taged under federal income tax statutes and and investors and for their own inventories. The
regulations. This group includes institutional bond broker’s broker also serves a significant
investors such as insurance companies, mutual role in the market for municipal bonds. These
funds, commercial banks, and retail investors. brokers are a small number of interdealer bro-
The value of the tax advantage and, therefore, kers who act as agents for registered dealers and
the attractiveness of the security increase when dealer banks. In addition to using these brokers,
the income earned is also advantaged under state many dealers advertise municipal offerings for
and local tax laws. Wealthy individuals and the retail market through the Blue List. The Blue
corporations face the highest marginal tax rates List is published by Standard & Poor’s Corpo-
and, therefore, stand to receive the highest ration and lists securities and yields or prices of
tax-equivalent yields on these securities. Private bonds and notes being offered by dealers.
individuals are the largest holders of municipal
securities, accounting for three-fourths of these
securities outstanding.
Market Participants
Market participants in the municipal securities
DESCRIPTION OF industry include underwriters, broker-dealers,
MARKETPLACE brokers’ brokers, the rating agencies, bond
insurers, and investors. Financial advisors, who
Issuing Practices advise state and local governments for both
competitive and negotiated offerings, and bond
State and local government entities can market counsel, who provide opinions on the legality of
their new bond issues by offering them publicly specific obligations, are also important partici-
or placing them privately with a small group of pants in the industry. The underwriting business
investors. When a public offering is selected, the primarily consists of a small number of large
issue is usually underwritten by investment broker-dealers, typically with retail branch sys-
bankers and municipal bond departments of tems, and a large number of regional under-
banks. The underwriter may acquire the securi- writers and broker-dealers with ties to local
ties either by negotiation with the issuer or by governments and who specialize in placing debt
award on the basis of competitive bidding. The in their individual regions.
underwriter is responsible for the distribution of
the issue and accepts the risk that investors
might fail to purchase the issues at the expected Market Transparency
prices. For most sizable issues, underwriters join
together in a syndicate to spread the risk of the Price transparency in the municipal securities
sale and gain wider access to potential investors. industry varies depending on the type of security
Standards and practices for the municipal and the issuer. Prices for public issues are more
securities activities of banks and other market readily available than prices for private place-
participants are set by the Municipal Securities ments. Two publications quote prices for
Rulemaking Board (MSRB), a congressionally municipal securities: The Bond Buyer and the
chartered self-regulatory body that is overseen Blue List.
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Municipal Securities 4050.1
PRICING the municipal index employed in the swap
transaction. Municipal swaps are relatively new
Municipal securities are priced either on a yield and are not widespread in the industry. As a
or dollar basis depending on the issue. Securities result, their use as hedging vehicles is limited.
that are priced on a dollar basis are quoted as a
percentage of the par value. A bond that is
traded and quoted as a percentage of its par RISKS
value is called a ‘‘dollar bond.’’ Municipal
securities, however, are generally traded and Credit Risk
quoted in terms of yields because there are so
many issues of different maturities. A bond Municipal securities activities involve differing
quoted at 6.751-6.50 percent means that a degrees of credit risk depending on the financial
dealer is willing to purchase the bond to yield capacity of the issuer or economic obligor.
6.75 percent and will sell it to yield 6.50 percent. Noteworthy cases in which municipal securities
To compare the yield of a municipal security have been unable to perform as agreed range
with that of a taxable bond, the yield of the from New York City in the 1970s and WPPSS (a
maturity must be adjusted to account for a Washington state power utility) in the 1980s to
number of factors that may be unique to the more recent examples. For revenue bonds, the
individual investor. For example, a fully taxable ability to perform depends primarily on the
equivalent (FTE) yield would consider the rel- success of the project or venture funded by the
evant federal, state, and local marginal tax rates bond. Trends in real estate values, fiscal man-
of the investor; specific characteristics of the agement, and the size of the tax base bear
security; the applicability of the alternative mini- directly on the issuer’s ability to service general
mum tax (AMT); the ability to deduct interest obligation bonds.
expense associated with funding the acquisition; An important starting point in performing a
and other elements of the institution’s tax status. credit review of a potential issuer is to obtain a
(These factors are discussed more fully in the legal opinion that the issuing entity has the legal
‘‘Characteristics and Features’’ subsection.) authority to undertake the obligation. The entity
must also have the capacity to repay as well as
the willingness to perform, both influenced not
only by financial factors but by political factors.
HEDGING Since some issuers depend on legislatures or
voters to approve bond issues or new funding,
Generally, the special features and unique credit analysis can become problematic; issuers
potential tax advantages of municipal securities could default on their bond obligations despite
make it difficult to construct an ideal hedge. The having the funds to service debt. These political
municipal bond futures contract from the Chi- issues may reach beyond the direct jurisdiction
cago Board of Trade (and corresponding options) of the issuing entity, including decisions made
is frequently used to hedge positions in munici- by state legislatures or Congress. Therefore, to
pal bonds. These contracts are cash settled to the fully evaluate market risk, market participants
value of the Bond Buyer Index, an index of must monitor how political and legislative fac-
actively traded municipal bonds, whose compo- tors may affect a security’s default risk.
sition changes frequently. The market for these The lack of standardized financial statements
exchange contracts is not very liquid, however, and the large number of different issuers (as
and the possibility of basis risk may be large. many as 50,000 entities issue municipal bonds)
Municipal securities also can be hedged using also make credit analysis of municipal securities
more liquid Treasury securities, futures, and more difficult. This heightens the importance of
options. Treasury securities can be used to the role of the rating agencies and bond insurers
mitigate exposure to yield-curve risk; however, in comparison to other markets. Larger issuers
the significant basis risk present in the municipal/ of municipal securities are rated by nationally
Treasury securities price relationship would recognized rating agencies. Other issuers achieve
remain unhedged. Some dealers use over-the- an investment-grade rating through the use of
counter municipal swaps to hedge interest-rate credit enhancements such as insurance from a
risk. This would reduce basis risk to the rela- municipal bond insurance company or a letter of
tionship between the security being hedged and credit issued by a financial institution. Credit
Trading and Capital-Markets Activities Manual September 2001
Page 3
4050.1 Municipal Securities
enhancements are often used to improve the ACCOUNTING TREATMENT
credit rating of a security, thereby lowering the
interest that the issuer must pay. The accounting treatment for investments in
municipal securities is determined by the Finan-
cial Accounting Standards Board’s Statement of
Financial Accounting Standards No. 115 (FAS
Liquidity Risk 115), ‘‘Accounting for Certain Investments in
Debt and Equity Securities,’’ as amended by
One of the problems in the municipal market Statement of Financial Accounting Standards
is the lack of ready marketability for many No. 140 (FAS 140), ‘‘Accounting for Transfers
municipal issues. Many municipal bonds are and Servicing of Financial Assets and Extin-
relatively small issues, and most general obliga- guishments of Liabilities.’’ Accounting treat-
tion issues are sold on a serial basis, which in ment for derivatives used as investments or for
effect breaks the issues up into smaller com- hedging purposes is determined by Statement of
ponents. Furthermore, a large percentage of Financial Accounting Standards No. 133 (FAS
municipal securities are purchased by retail 133), ‘‘Accounting for Derivatives and Hedging
investors and small institutions that tend to hold Activities.’’ (See section 2120.1, ‘‘Accounting,’’
securities to maturity. Overall, smaller issues for further discussion.)
and those with thin secondary markets often
experience liquidity difficulties and are therefore
subject to higher risk. RISK-BASED CAPITAL
WEIGHTING
General obligations, BANs, and TANs have a
Interest-Rate Risk and Market Risk 20 percent risk weight. Municipal revenue bonds
and RANs have a 50 percent risk weight.
Like other fixed-income securities, fixed-income Industrial development bonds are rated at
municipal securities are subject to price fluctua- 100 percent. For specific risk weights for quali-
tions based on changes in interest rates. The fied trading accounts, see section 2110.1, ‘‘Capi-
degree of fluctuation depends on the maturity tal Adequacy.’’
and coupon of the security. Variable-rate issues
are typically tied to a money market rate, so
their interest-rate risk will be significantly less. LEGAL LIMITATIONS FOR BANK
Nonetheless, since bond prices and interest rates INVESTMENT
are inextricably linked, all municipal securities
involve some degree of interest-rate risk. The limitations of 12 USC 24 (section 5136 of
the Revised Statutes) apply to municipal secu-
Holders of municipal securities are also
rities. Municipal securities that are general
affected by changes in marginal tax rates. For
obligations are type I securities and may be
instance, a reduction in marginal tax rates would
purchased by banks in unlimited amounts.
lower the tax-equivalent yield on the security,
Municipal revenue securities, however, are either
causing the security to depreciate in price.
type II or type III securities. The purchase of
type II and type III securities is limited to
10 percent of equity capital and reserves for
each obligor. That limitation is reduced to 5
Prepayment or Reinvestment Risk percent of equity capital and reserves for all
obligors in the aggregate when the judgment of
Call provisions will affect a bank’s interest-rate the obligor’s ability to perform is based predomi-
exposure. If the issuer has the right to redeem nantly on reliable estimates versus adequate
the bond before maturity, the risk of an adverse evidence.
effect on the bank’s exposure is greater. The
security is most likely to be called when rates
have moved in the issuer’s favor, leaving the REFERENCES
investor with funds to invest in a lower-interest-
rate environment. Fabozzi, Frank J., Sylvan G. Feldstein, Irving
September 2001 Trading and Capital-Markets Activities Manual
Page 4
Municipal Securities 4050.1
M. Pollack, and Frank G. Zarb, ed. The sional Publishing, 1995.
Municipal Bond Handbook. Homewood, Ill.: Municipal Securities Rulemaking Board. Glos-
Dow Jones-Irwin, 1983. sary of Municipal Securities Terms. 1st ed.
Feldstein, Sylvan G., Frank J. Fabozzi, and Washington, D.C.: 1985.
T. Dessa Fabozzi. ‘‘Chapter 8: Municipal Public Securities Association. Fundamentals of
Bonds.’’ The Handbook of Fixed Income Municipal Bonds. 4th ed. New York: 1990.
Securities. 4th ed. Chicago: Irwin Profes-
Trading and Capital-Markets Activities Manual September 2001
Page 5
Eurodollar Certificates of Deposit
Section 4055.1
GENERAL DESCRIPTION branches of money-center U.S. banks, large
British banks, and branches of major Canadian
A Eurodollar certificate of deposit (Eurodollar and Japanese banks. Only the largest banks with
CD) is a negotiable dollar-denominated time strong international reputations usually sell Euro-
deposit issued by a U.S. bank located outside the dollar CDs. Since the advent of the medium-
United States or by a foreign bank located term note market, the Eurodollar CD market has
abroad. Dollars deposited in international bank- been on a decline and is now a relatively illiquid
ing facilities (IBFs) in the United States are also market.
considered Eurodollars. Eurodollar CDs are sold by the issuing bank
at face value either directly to investors or
depositors or through CD dealers and brokers.
Settlement is on a two-day basis and occurs at
CHARACTERISTICS AND the New York correspondents of the issuers’ and
FEATURES investors’ banks.
Eurodollar CDs are not FDIC-insured. Euro-
dollar deposits are generally free from domestic
(U.S.) regulation and reserve requirements, and PRICING
are not subject to other fees imposed by the
FDIC. Most Eurodollar CDs are issued in Eurodollar CDs are priced off the London Inter-
denominations over $1 million. Although their bank Offered Rate (LIBOR). Their yields are
maturities must be at least seven days, and most generally slightly higher than yields for domes-
CDs are issued for three to six months, there is tic CDs to compensate the investor for the
no upward limit on the term. Issuing banks slightly higher risk.
cannot purchase their own CDs. Eurodollar CDs are quoted and sold on an
interest-bearing basis on an actual 360-day basis.
The bid/offer quotes are in 16ths (for example,
12 7/16). The quotes directly translate to rates
USES on the given Eurodollar CD. Thus, bid/offer
rates of 12 7/16 and 12 3/16 would roughly
The primary reason for issuing in the Eurodollar translate to a bid interest rate of 12.4375 percent
market (besides the basic reason to issue a and an offer rate of 12.1875 percent, respec-
CD—to provide a source of funds) is the lower tively, giving the dealer a spread of .25 percent.
cost of funds available as a result of the elimi-
nation of regulatory costs and reserve require-
ments. Buyers, on the other hand, can take
advantage of the slightly higher yields while HEDGING
maintaining reasonable liquidity. Eurodollar CD
issuers subsequently take the funds received Eurodollar futures may be used to hedge Euro-
from the issuance and redeposit them with other dollar time deposits. Eurodollar futures are one
foreign banks; invest them; retain them to of the most actively traded futures contracts in
improve reserves or overall liquidity; or lend the world.
them to companies, individuals, or governments
outside the United States.
RISKS
DESCRIPTION OF The risks associated with purchasing Eurodollar
MARKETPLACE CDs include credit risk, sovereign risk, and
liquidity risk. To reduce credit risk, a detailed
The Eurodollar CD market is centered in Lon- analysis should be performed on all Eurodollar
don. Activity also takes place in offshore CD issuers in which the investor has invested.
branches, including those in Nassau and the Although the instruments themselves are not
Cayman Islands. Issuers include the overseas rated, most issuers are rated by either Thompson
Trading and Capital-Markets Activities Manual September 2001
Page 1
4055.1 Eurodollar Certificates of Deposit
Bankwatch (for domestic banks) or IBCA, Ltd. countries. For specific risk weights for qualified
(for foreign banks). trading accounts, see section 2110.1, ‘‘Capital
The secondary market for Eurodollar CDs is Adequacy.’’
less developed than the domestic CD market.
The current perception of the issuer’s name, as
well as the size and maturity of the issue, may
affect marketability. LEGAL LIMITATIONS FOR BANK
INVESTMENT
Owning Eurodollar CDs is authorized under the
ACCOUNTING TREATMENT ‘‘incidental powers’’ provisions of 12 USC 24
(7th). Banks may legally hold these instruments
The Financial Accounting Standards Board’s
without limit.
Statement of Financial Accounting Standards
No. 115 (FAS 115), ‘‘Accounting for Certain
Investments in Debt and Equity Securities,’’ as
amended by Statment of Financial Accounting REFERENCES
Standards No. 140 (FAS 140), ‘‘Accounting for
Transfers and Servicing of Financial Assets and Cook, Timothy Q., and Robert LaRoche, eds.
Extinguishments of Liabilities,’’ determines the Instruments of the Money Market. 7th ed.
accounting treatment for investments in Euro- Richmond, Va.: Federal Reserve Bank of
dollar CDs. Accounting treatment for deriva- Richmond, 1993.
tives used as investments or for hedging pur- Munn, Glenn G. et al. Encyclopedia of Bank-
poses is determined by Statment of Financial ing Finance. 9th ed. Rolling Meadows, Ill.:
Accounting Standards No. 133 (FAS 133), Bankers Publishing Company, 1991.
‘‘Accounting for Derivatives and Hedging Oppenheim, Peter K. ‘‘The Eurodollar Mar-
Activities.’’ (See section 2120.1, ‘‘Accounting,’’ ket.’’ International Banking. 6th ed. Washing-
for further discussion.) ton, D.C.: American Bankers Association,
1991.
Stigum, Marcia. The Money Market. 3rd ed.
RISK-BASED CAPITAL Homewood, Ill.: Business One Irwin, 1990.
WEIGHTING
In general, a 20 percent risk weighting is appro-
priate for depository institutions based in OECD
September 2001 Trading and Capital-Markets Activities Manual
Page 2
Asset-Backed Securities and Asset-Backed Commercial Paper
Section 4105.1
GENERAL DESCRIPTION for collecting the cash flows generated by the
securitized assets—principal, interest, and fees
Asset-backed securities (ABS) are debt instru- net of losses and any servicing costs as well as
ments that represent an interest in a pool of other expenses—and for passing them along to
assets. Technically, mortgage-backed securities the investors in accord with the terms of the
(MBS) can be viewed as a subset of ABS, but securities. The servicer processes the payments
the term ‘‘ABS’’ is generally used to refer to and administers the borrower accounts in the
securities in which underlying collateral consists pool.
of assets other than residential first mortgages The structure of an asset-backed security and
such as credit card and home equity loans, the terms of the investors’ interest in the collat-
leases, or commercial mortgage loans. Issuers eral can vary widely depending on the type of
are primarily banks and finance companies, collateral, the desires of investors, and the use of
captive finance subsidiaries of nonfinancial cor- credit enhancements. Often ABS are structured
porations (for example, GMAC), or specialized to reallocate the risks entailed in the underlying
originators such as credit card lenders (for collateral (particularly credit risk) into security
example, Discover). Credit risk is an important tranches that match the desires of investors. For
issue in asset-backed securities because of the example, senior subordinated security structures
significant credit risks inherent in the underlying give holders of senior tranches greater credit
collateral and because issuers are primarily pri- risk protection (albeit at lower yields) than
vate entities. Accordingly, asset-backed securi- holders of subordinated tranches. Under this
ties generally include one or more credit structure, at least two classes of asset-backed
enhancements, which are designed to raise the securities are issued, with the senior class hav-
overall credit quality of the security above that ing a priority claim on the cash flows from the
of the underlying loans. underlying pool of assets. The subordinated
Another important type of asset-backed secu- class must absorb credit losses on the collateral
rity is commercial paper issued by special- before losses can be charged to the senior
purpose entities. Asset-backed commercial paper portion. Because the senior class has this prior-
is usually backed by trade receivables, though ity claim, cash flows from the underlying pool of
such conduits may also fund commercial and assets must first satisfy the requirements of the
industrial loans. Banks are typically more active senior class. Only after these requirements have
as issuers of these instruments than as investors been met will the cash flows be directed to
in them. service the subordinated class.
ABS also use various forms of credit enhance-
ments to transform the risk-return profile of
CHARACTERISTICS AND underlying collateral, including third-party credit
FEATURES enhancements, recourse provisions, overcollat-
eralization, and various covenants. Third-party
An asset-backed security is created by the sale credit enhancements include standby letters of
of assets or collateral to a conduit, which credit, collateral or pool insurance, or surety
becomes the legal issuer of the ABS. The bonds from third parties. Recourse provisions
securitization conduit or issuer is generally a are guarantees that require the originator to
bankruptcy-remote vehicle such as a grantor cover any losses up to a contractually agreed-
trust or, in the case of an asset-backed commer- upon amount. One type of recourse provision,
cial paper program, a special-purpose entity usually seen in securities backed by credit card
(SPE). The sponsor or originator of the collat- receivables, is the ‘‘spread account.’’ This
eral usually establishes the issuer. Interests in account is actually an escrow account whose
the trust, which embody the right to certain cash funds are derived from a portion of the spread
flows arising from the underlying assets, are between the interest earned on the assets in the
then sold in the form of securities to investors underlying pool of collateral and the lower
through an investment bank or other securities interest paid on securities issued by the trust.
underwriter. Each ABS has a servicer (often the The amounts that accumulate in this escrow
originator of the collateral) that is responsible account are used to cover credit losses in the
Trading and Capital-Markets Activities Manual February 1998
Page 1
4105.1 Asset-Backed Securities and Asset-Backed Commercial Paper
underlying asset pool, up to several multiples of the underlying pool of loans when credit losses
historical losses on the particular asset collater- rise.
alizing the securities. A bank or other issuer may play more than
Overcollateralization is another form of credit one role in the securitization process. An issuer
enhancement that covers a predetermined amount can simultaneously serve as originator of loans,
of potential credit losses. It occurs when the servicer, administrator of the trust, underwriter,
value of the underlying assets exceeds the face provider of liquidity, and credit enhancer. Issu-
value of the securities. A similar form of credit ers typically receive a fee for each element of
enhancement is the cash-collateral account, the transaction.
which is established when a third party deposits Institutions acquiring ABS should recognize
cash into a pledged account. The use of cash- that the multiplicity of roles that may be played
collateral accounts, which are considered by by a single firm—within a single securitization
enhancers to be loans, grew as the number of or across a number of them—means that credit
highly rated banks and other credit enhancers and operational risk can accumulate into signifi-
declined in the early 1990s. Cash-collateral cant concentrations with respect to one or a
accounts provide credit protection to investors small number of firms.
of a securitization by eliminating ‘‘event risk,’’
or the risk that the credit enhancer will have its
credit rating downgraded or that it will not be
able to fulfill its financial obligation to absorb TYPES OF SECURITIZED ASSETS
losses.
An investment banking firm or other organi- There are many different varieties of asset-
zation generally serves as an underwriter for backed securities, often customized to the terms
ABS. In addition, for asset-backed issues that and characteristics of the underlying collateral.
are publicly offered, a credit-rating agency will The most common types are securities collater-
analyze the policies and operations of the origi- alized by revolving credit-card receivables, but
nator and servicer, as well as the structure, instruments backed by home equity loans, other
underlying pool of assets, expected cash flows, second mortgages, and automobile-finance
and other attributes of the securities. Before receivables are also common.
assigning a rating to the issue, the rating agency
will also assess the extent of loss protection
provided to investors by the credit enhance- Installment Loans
ments associated with the issue.
Although the basic elements of all asset- Securities backed by closed-end installment loans
backed securities are similar, individual transac- are typically the least complex form of asset-
tions can differ markedly in both structure and backed instruments. Collateral for these ABS
execution. Important determinants of the risk typically includes leases, automobile loans, and
associated with issuing or holding the securities student loans. The loans that form the pool of
include the process by which principal and collateral for the asset-backed security may have
interest payments are allocated and down- varying contractual maturities and may or may
streamed to investors, how credit losses affect not represent a heterogeneous pool of borrow-
the trust and the return to investors, whether ers. Unlike a mortgage pass-through instrument,
collateral represents a fixed set of specific assets the trustee does not need to take physical pos-
or accounts, whether the underlying loans are session of any account documents to perfect
revolving or closed-end, under what terms security interest in the receivables under the
(including maturity of the asset-backed instru- Uniform Commercial Code. The repayment
ment) any remaining balance in the accounts stream on installment loans is fairly predictable,
may revert to the issuing company, and the since it is primarily determined by a contractual
extent to which the issuing company (the actual amortization schedule. Early repayment on these
source of the collateral assets) is obligated to instruments can occur for a number of reasons,
provide support to the trust/conduit or to the with most tied to the disposition of the under-
investors. Further issues may arise based on lying collateral (for example, in the case of an
discretionary behavior of the issuer within the ABS backed by an automobile loan, the sale of
terms of the securitization agreement, such as the vehicle). Interest is typically passed through
voluntary buybacks from, or contributions to, to bondholders at a fixed rate that is slightly
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Asset-Backed Securities and Asset-Backed Commercial Paper 4105.1
below the weighted average coupon of the loan transaction. Issuers are further required to revalue
pool, allowing for servicing and other expenses the asset periodically to take account of changes
as well as credit losses. in fair value that may occur due to interest rates,
actual credit losses, and other factors relevant to
the future stream of excess yield. The account-
ing and capital implications of these transactions
Revolving Credit are discussed further below.
Unlike closed-end installment loans, revolving
credit receivables involve greater uncertainty
about future cash flows. Therefore, ABS struc- Asset-Backed Commercial Paper
tures using this type of collateral must be more
complex to afford investors more comfort in A number of larger banks have started using a
predicting their repayment. Accounts included new structure, a ‘‘special-purpose entity (SPE),’’
in the securitization pool may have balances that which is designed to acquire trade receivables
grow or decline over the life of the ABS. and commercial loans from high-quality (often
Accordingly, at maturity of the ABS, any remain- investment-grade) obligors and to fund those
ing balances revert to the originator. During the loans by issuing (asset-backed) commercial paper
term of the ABS, the originator may be required that is to be repaid from the cash flow of the
to sell additional accounts to the pool to main- receivables. Capital is contributed to the SPE by
tain a minimum dollar amount of collateral if the originating bank which, together with the
accountholders pay down their balances in high quality of the underlying borrowers, is
advance of predetermined rates. sufficient to allow the SPE to receive a high
Credit card securitizations are the most preva- credit rating. The net result is that the SPE’s cost
lent form of revolving-credit ABS, although of funding can be at or below that of the
home equity lines of credit are a growing source originating bank itself. The SPE is ‘‘owned’’ by
of ABS collateral. Credit card ABS are typically individuals who are not formally affiliated with
structured to incorporate two phases in the life the bank, although the degree of separation is
cycle of the collateral: an initial phase during typically minimal.
which the principal amount of the securities These securitization programs enable banks
remains constant, and an amortization phase to arrange short-term financing support for their
during which investors are paid off. A specific customers without having to extend credit
period of time is assigned to each phase. Typi- directly. This structure provides borrowers with
cally, a specific pool of accounts is identified in an alternative source of funding and allows
the securitization documents, and these specifi- banks to earn fee income for managing the
cations may include not only the initial pool of programs. As the asset-backed commercial paper
loans but a portfolio from which new accounts structure has developed, it has been used to
may be contributed. finance a variety of underlying loans—in some
cases, loans purchased from other firms rather
The dominant vehicle for issuing securities
than originated by the bank itself—and as a
backed by credit cards is a master-trust structure
remote-origination vehicle from which loans
with a ‘‘spread account,’’ which is funded up to
can be made directly. Like other securitization
a predetermined amount through ‘‘excess
techniques, this structure allows banks to meet
yield’’—that is, interest and fee income less
their customers’ credit needs while incurring
credit losses, servicing, and other fees. With
lower capital requirements and a smaller bal-
credit card receivables, the income from the
ance sheet than if it made the loans directly.
pool of loans—even after credit losses—is gen-
erally much higher than the return paid to
investors. After the spread account accumulates
to its predetermined level, the excess yield USES
reverts to the issuer. Under GAAP, issuers are
required to recognize on their balance sheet an Issuers obtain a number of advantages from
excess yield asset that is based on the fair value securitizing assets, including improving their
of the expected future excess yield; in principle, capital ratios and return on assets, monetizing
this value would be based on the net present gains in loan value, generating fee income by
value of the expected earnings stream from the providing services to the securitization conduit,
Trading and Capital-Markets Activities Manual April 2001
Page 3
4105.1 Asset-Backed Securities and Asset-Backed Commercial Paper
closing a potential source of interest-rate risk, difficult to hedge. One source of potential
and increasing institutional liquidity by provid- unpredictability, however, is the risk that accel-
ing access to a new source of funds. Investors eration or wind-down provisions would be trig-
are attracted by the high credit quality of ABS, gered by poor credit quality in the asset pool—
as well as their attractive returns. essentially, a complex credit-quality option that
pays off bondholders early if credit losses exceed
some threshold level.
DESCRIPTION OF For issuers, variability in excess yield (in
MARKETPLACE terms of carrying value) or in the spread account
(in terms of income) can represent a material
The primary buyers for ABS have been insur- interest-rate risk, particularly if the bonds pay
ance companies and pension funds looking for interest on a variable-rate basis while the under-
attractive returns with superior credit quality. lying loans are fixed-rate instruments. While the
New issues often sell out very quickly. Banks risk can be significant, the hedging solutions are
typically are not active buyers of these securi- not complex (that is, dollar-for-dollar in notional
ties. The secondary market is active, but new terms). Potential hedging strategies include the
issues currently trade at a premium to more use of futures or forwards, forward rate agree-
seasoned products. ments (FRAs), swaps, or more complex options
Market transparency can be less than perfect, or swaptions. In the case of home equity loans or
especially when banks and other issuers retain other revolving credits for which the pool earn-
most of the economic risk despite the securiti- ings rate is linked to prime while the ABS
zation transaction. This is particularly true when interest rate is not, prime LIBOR swaps or
excess yield is a significant part of the transac- similar instruments could be used to mitigate
tion and when recourse (explicit or implicit) is a basis risk. Note that the presence of interest-rate
material consideration. The early-amortization risk may have credit-quality ramifications for
features of some ABS also may not be fully the securities, since tighter excess yield and
understood by potential buyers. spread accounts would reduce the ability of the
structure to absorb credit losses.
An asset-backed commercial paper (ABCP)
program can lead to maturity mismatches for the
PRICING issuer depending on the pricing characteristics
ABS carry coupons that can be fixed (generally of the commercial loan assets. Similarly, the
yielding between 50 and 300 basis points over presence of embedded options—such as prepay-
the Treasury curve) or floating (for example, 15 ment options, caps, or floors—can expose the
basis points over one-month LIBOR). Pricing is ABCP entity to options risk. These risks can be
typically designed to mirror the coupon charac- hedged through use of options, swaptions, or
teristics of the loans being securitized. The other derivative instruments. As with home
spread will vary depending on the credit quality equity ABS, prime-based commercial loans
of the underlying collateral, the degree and could lead to basis-risk exposure, which can be
nature of credit enhancement, and the degree of hedged using basis swaps.
variability in the cash flows emanating from the
securitized loans.
RISKS
HEDGING
Credit Risk
Given the high degree of predictability in their
cash flows, the hedging of installment loans and Credit risk arises from (1) losses due to defaults
revolving-credit ABS holdings is relatively by the borrowers in the underlying collateral and
straightforward and can be accomplished either (2) the issuer’s or servicer’s failure to perform.
through cash-flow matching or duration hedg- These two elements can blur together as, for
ing. Most market risk arises from the perceived example, in the case of a servicer who does not
credit quality of the collateral and the nature and provide adequate credit-review scrutiny to the
degree of credit enhancement, a risk that may be serviced portfolio, leading to a higher incidence
April 2001 Trading and Capital-Markets Activities Manual
Page 4
Asset-Backed Securities and Asset-Backed Commercial Paper 4105.1
of defaults. ABS are rated by major rating Operations Risk
agencies.
Operations risk arises through the potential for
misrepresentation of loan quality or terms by the
Market Risk originating institution, misrepresentation of the
nature and current value of the assets by the
Market risk arises from the cash-flow character- servicer, and inadequate controls over disburse-
istics of the security, which for most ABS tend ments and receipts by the servicer.
to be predictable. Rate-motivated prepayments
are a relatively minor phenomenon due to the
small principal amounts on each loan and the
relatively short maturity. The greatest variability ACCOUNTING TREATMENT
in cash flows comes from credit performance,
The Financial Accounting Standards Board’s
including the presence of wind-down or
Statement of Financial Accounting Standards
acceleration features designed to protect the
No. 115 (FAS 115), ‘‘Accounting for Certain
investor in the event that credit losses in the
Investments in Debt and Equity Securities,’’ as
portfolio rise well above expected levels.
amended by Statement of Financial Accounting
Standards No. 140 (FAS 140), ‘‘Accounting for
Transfers and Servicing of Financial Assets and
Interest-Rate Risk Extinguishments of Liabilities,’’ determines the
accounting treatment for investments in govern-
Interest-rate risk arises for the issuer from the
ment agency securities. Accounting treatment
relationship between the pricing terms on the
for derivatives used as investments or for hedg-
underlying loans and the terms of the rate paid
ing purposes is determined by Statement of
to bondholders, and from the need to mark to
Financial Accounting Standards No. 133 (FAS
market the excess servicing or spread-account
133), ‘‘Accounting for Derivatives and Hedging
proceeds carried on the balance sheet. For the
Activities.’’ (See section 2120.1, ‘‘Accounting,’’
holder of the security, interest-rate risk depends
for further discussion.)
on the expected life or repricing of the ABS,
with relatively minor risk arising from embed-
ded options. The notable exception is valuation
of the wind-down option. RISK-BASED CAPITAL
WEIGHTING
Liquidity Risk For the holder of ABS, a 100 percent risk
weighting is assigned for corporate issues
Liquidity risk can arise from increased per- and a 20 percent rating for state or municipal
ceived credit risk, like that which occurred in issues. Under risk-based capital regulations, a
1996 and 1997 with the rise in reported delin- transfer of assets is a ‘‘true sale’’ as long as the
quencies and losses on securitized pools of banking organization (1) retains no risk of
credit cards. Liquidity can also become a major loss and (2) has no obligation to any party
concern for asset-backed commercial paper pro- for the payment of principal or interest on the
grams if concerns about credit quality, for exam- assets transferred. Unless these conditions are
ple, lead investors to avoid the commercial met, the banking organization is deemed to have
paper issued by the special-purpose entity. For sold the assets with recourse; thus, capital
these cases, the securitization transaction may generally must be held against the entire risk-
include a ‘‘liquidity facility,’’ which requires the weighted amount of the assets sold unless (1) the
facility provider to advance funds to the SPE if transaction is subject to the low-level capital
liquidity problems arise. To the extent that the rule or (2) the loans securitized are small-
bank originating the loans is also the provider of business loans and receive preferential treat-
the liquidity facility, and that the bank is likely ments. Assets sold in which an interest-only
to experience similar market concerns if the receivable is recognized under FAS 140, or
loans it originates deteriorate, the ultimate prac- in which the spread account is recognized on
tical value of the liquidity facility to the trans- the balance sheet and provides credit enhance-
action may be questionable. ment to the assets sold, are deemed to have
Trading and Capital-Markets Activities Manual September 2001
Page 5
4105.1 Asset-Backed Securities and Asset-Backed Commercial Paper
been sold with recourse. In the case of asset- 25 percent of a bank’s capital and surplus for
backed commercial paper, capital generally must any one issuer. In addition to being able to
be held against the entire risk-weighted amount purchase and sell type IV securities, subject to
of any guarantee, other credit enhancement, or the above limitations, a bank may deal in those
liquidity facility provided by the bank to the type IV securities which are fully secured by
special-purpose entity. type I securities.
Type V securities consist of all ABS that are
not type IV securities. Specifically, they are
defined as marketable, investment-grade-rated
LEGAL LIMITATIONS FOR BANK securities that are not type IV and are ‘‘fully
INVESTMENTS secured by interests in a pool of loans to
numerous obligors and in which a national bank
Asset-backed securities can be either type IV could invest directly.’’ They include securities
or type V securities. Type IV securities were backed by auto loans, credit card loans, home
added as bank-eligible securities in 1996 prima- equity loans, and other assets. Also included are
rily in response to provisions of the Riegle residential and commercial mortgage securities
Community Development and Regulatory as described in section 3(a)(41) of the Securities
Improvement Act of 1994 (RCDRIA), which Exchange Act of 1934 (15 USC 78c(a)(41))
removed quantitative limits on a bank’s ability which are not rated in one of the two highest
to buy commercial mortgage and small-business- investment-grade rating categories, but are still
loan securities. In summary, type IV securities investment-grade. A bank may purchase or sell
include the following asset-backed securities type V securities for its own account provided
that are fully secured by interests in a pool (or the aggregate par value of type V securities
pools) of loans made to numerous obligors: issued by any one issuer held by the bank does
not exceed 25 percent of the bank’s capital and
• investment-grade residential-mortgage-related surplus.
securities offered or sold pursuant to section
4(5) of the Securities Act of 1933 (15 USC
77d(5)) REFERENCES
• residential-mortgage-related securities, as
described in section 3(a)(41) of the Securities SR-97-21, ‘‘Risk Management and Capital
Exchange Act of 1934, (15 USC 78c(a)(41)) Adequacy of Exposures Arising from
that are rated in one of the two highest Secondary-Market Credit Activities.’’ July
investment-grade rating categories 1997.
• investment-grade commercial mortgage secu- SR-96-30, ‘‘Risk-Based Capital Treatment of
rities offered or sold pursuant to section 4(5) Asset Sales with Recourse.’’ November 1996.
of the Securities Act of 1933 (15 USC 77d(5)) SR-92-11, ‘‘Asset-Backed Commercial Paper
• commercial mortgage securities as described Programs.’’ April 1992.
in section 3(a)(41) of the Securities Exchange Dierdorff, Mary D., and Annika Sandback.
Act of 1934 (15 USC 78c(a)(41)) that are ‘‘ABCP Market Overview: 1996 Was Another
rated in one of the two highest investment- Record-Breaking Year.’’ Moody’s Structured
grade rating categories Finance Special Report. 1st Quarter 1997.
• investment-grade, small-business-loan securi- Kavanaugh, Barbara, Thomas R. Boemio, and
ties as described in section 3(a)(53)(A) of the Gerald A. Edwards, Jr. ‘‘Asset-Backed Com-
Securities Exchange Act of 1934 (15 USC mercial Paper Programs.’’ Federal Reserve
78c(a)(53)(A)) Bulletin. February 1992, pp. 107–116.
Moody’s Structured Finance Special Report.
For all type IV commercial and residential ‘‘More of the Same. . .or Worse? The
mortgage securities and for type IV small- Dilemma of Prefunding Accounts in Automo-
business-loan securities rated in the top two bile Loan Securitizations." August 4, 1995.
rating categories, there is no limitation on the Rosenberg, Kenneth J., J. Douglas Murray, and
amount a bank can purchase or sell for its own Kathleen Culley. ‘‘Asset-Backed CP’s New
account. Type IV investment-grade small- Look.’’ Fitch Research Structured Finance
business-loan securities that are not rated in the Special Report. August 15, 1994.
top two rating categories are subject to a limit of Silver, Andrew A., and Jay H. Eisbruck. ‘‘Credit
September 2001 Trading and Capital-Markets Activities Manual
Page 6
Asset-Backed Securities and Asset-Backed Commercial Paper 4105.1
Card Master Trusts: The Risks of Account Card Securitizations: Catching Up with Wind-
Additions.’’ Moody’s Structured Finance Spe- Downs.’’ Moody’s Structured Finance Spe-
cial Report. December 1994. cial Report. November 1994.
Silver, Andrew A., and Jay H. Eisbruck. ‘‘Credit van Eck, Tracy Hudson. ‘‘Asset-Backed Securi-
Card Master Trusts: Assessing the Risks of ties.’’ In The Handbook of Fixed Income
Cash Flow Allocations.’’ Moody’s Structured Securities. Fabozzi, F., and T.D. Fabozzi.
Finance Special Report. May 26, 1995. Chicago: Irwin Professional Publishers, 1995.
Stancher, Mark, and Brian Clarkson. ‘‘Credit
Trading and Capital-Markets Activities Manual September 2001
Page 7
Residential Mortgage–Backed Securities
Section 4110.1
GENERAL DESCRIPTION investors by collecting and proportionally
distributing monthly cash flows generated by
A mortgage loan is a loan which is secured by homeowners making payments on their home
the collateral of a specified real estate property. mortgage loans. The pass-through certificate
The real estate pledged with a mortgage can be represents a sale of assets to the investor, thus
divided into two categories: residential and non- removing the assets from the balance sheet of
residential. Residential properties include houses, the issuer.
condominiums, cooperatives, and apartments.
Residential real estate can be further subdivided
into single-family (one- to four-family) and Collateralized Mortgage Obligations
multifamily (apartment buildings in which more and Real Estate Mortgage Investment
than four families reside). Nonresidential prop- Conduits
erty includes commercial and farm properties.
Common types of mortgages which have been Collateralized mortgage obligations (CMOs)
securitized include traditional fixed-rate level- and real estate mortgage investment conduit
payment mortgages, graduated-payment mort- (REMICs) securities represent ownership inter-
gages, adjustable-rate mortgages (ARMs), and ests in specified cash flows arising from under-
balloon mortgages. lying pools of mortgages or mortgage securities.
Mortgage-backed securities (MBS) are prod- CMOs and REMICs involve the creation, by the
ucts that use pools of mortgages as collateral for issuer, of a single-purpose entity designed to
the issuance of securities. Although these secu- hold mortgage collateral and funnel payments of
rities have been collateralized using many types principal and interest from borrowers to inves-
of mortgages, most are collateralized by one- to tors. Unlike pass-through securities, however,
four-family residential properties. MBS can be which entail a pro rata share of ownership of all
broadly classified into four basic categories: underlying mortgage cash flows, CMOs and
REMICs convey ownership only of cash flows
1. mortgage-backed bonds assigned to specific classes based on established
2. pass-through securities principal distribution rules.
3. collateralized mortgage obligations and real
estate mortgage investment conduits
4. stripped mortgage-backed securities Stripped Mortgage-Backed Securities
Stripped mortgage-backed securities (SMBS)
Mortgage-Backed Bonds entail the ownership of either the principal or
interest cash flows arising from specified mort-
Mortgage-backed bonds are corporate bonds gages or mortgage pass-through securities.
which are general obligations of the issuer. Rights to the principal are labeled POs (princi-
These bonds are credit enhanced through the pal only), and rights to the interest cash flows
pledging of specific mortgages as collateral. are labeled IOs (interest only).
Mortgage-backed bonds involve no sale or con-
veyance of ownership of the mortgages acting as
collateral. CHARACTERISTICS AND
FEATURES
Pass-Through Securities Products Offered under Agency
Programs
A mortgage-backed pass-through security pro-
vides its owner with a pro rata share in under- The Government National Mortgage Associa-
lying mortgages. The mortgages are typically tion (GNMA or Ginnie Mae), Federal Home
placed in a trust, and certificates of ownership Loan Mortgage Corporation (FHLMC or Freddie
are sold to investors. Issuers of pass-through Mac), and the Federal National Mortgage Asso-
instruments primarily act as a conduit for the ciation (FNMA or Fannie Mae) are the three
Trading and Capital-Markets Activities Manual February 1998
Page 1
4110.1 Residential Mortgage–Backed Securities
main government-related institutions which Public Securities Association
securitize like groups of mortgages for sale to Prepayment Rates
investors. Major mortgage-purchasing programs
sponsored by these three agencies are listed Mortgagors have the option to prepay the prin-
below. cipal balance of their mortgages at any time. The
value of the prepayment option to investors and
mortgagors depends on the level of interest rates
Abbreviation Description
and the volatility of mortgage prepayments.
Prepayment rates depend on many variables,
GNMA and their response to these variables can be
30-YR 30-year single-family programs unpredictable. The single biggest influence on
15-YR 15-year single-family programs
prepayment rates is the level of long-term mort-
GPMs Graduated-payment programs
gage rates; mortgage prepayments generally
PROJ Loans Project-loan programs
ARMs Single-family adjustable-rate increase as long-term rates decrease. While
programs future long-term rates are not known, higher
volatility in long-term interest rates means lower
FNMA rates are more likely, making the prepayment
30-YR SF 30-year single-family programs option more valuable to the mortgagor. This
30-YR MF 30-year multifamily programs higher value of the prepayment option is reflected
30-YR FHA/ in lower mortgage security prices, as mortgage
VA FHA/VA 30-year single- and investors require higher yields to compensate
multifamily programs for increased prepayment risk.
15-YR 15-year single-family programs The importance of principal prepayment to
SF ARMs Single-family adjustable-rate the valuation of mortgage securities has resulted
programs in several standardized forms of communicating
MF ARMs Multifamily adjustable-rate the rate of prepayments of a mortgage security.
programs One standard form is that developed by the
Balloons Balloon-payment seven-year Public Securities Association (PSA). The PSA
programs standard is more accurately viewed as a bench-
Two-step Five- and seven-year two-step
mark or reference for communicating prepay-
programs
ment patterns. It may be helpful to think of the
FHLMC PSA measurement as a kind of speedometer,
30-YR 30-year single-family programs used only as a unit for measuring the speed of
15-YR 15-year single-family programs prepayments.
TPMs Tiered-payment single-family For a pool of mortgage loans, the PSA stan-
programs dard assumes that the mortgage prepayment rate
ARMs Single-family adjustable-rate increases at a linear rate over the first 30 months
programs following origination, then levels off at a con-
MF Multifamily programs stant rate for the remaining life of the pool.
5- & 7-year Under the PSA convention, prepayments are
balloons Balloon-payment, five- to assumed to occur at a 0.2 percent annual rate in
seven-year programs the first month, 0.4 percent annual rate in the
second month, escalating to a 6.0 percent annual
While the majority of outstanding mortgage rate by month 30. The PSA’s annualized pre-
loans are structured as 30-year fixed-rate loans, payment rate then remains at 6.0 percent over
in recent years the size of the 15-year, fixed-rate the remaining life of the mortgage pool (see
sector has grown. Declining interest rates and a chart 1). Using this convention, mortgage pre-
steep yield curve have led many borrowers to payment rates are often communicated in mul-
refinance or prepay existing 30-year, higher- tiples of the PSA standard of 100 percent. For
coupon loans and replace them with a shorter example, 200 percent PSA equals two times the
maturity. This experience also has demonstrated PSA standard, whereas 50 percent PSA equals
the prepayment risk inherent in all mortgages. one-half of the PSA standard.
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Residential Mortgage–Backed Securities 4110.1
Mortgage Pass-Through Securities Nonagency pass-throughs are composed of
specific pools and do not trade on a TBA basis.
Mortgage pass-through securities are created New issues settle on the date provided in the
when mortgages are pooled together and sold as prospectus. In the secondary market, these
undivided interests to investors. Usually, the securities trade on an issue-specific basis and
mortgages in the pool have the same loan type generally settle on a corporate basis (three
and similar maturities and loan interest rates. business days after the trade).
The originator (for instance, a bank) may con-
tinue to service the mortgage and will ‘‘pass
through’’ the principal and interest, less a ser- Collateralized Mortgage Obligations
vicing fee, to an agency or private issuer of
mortgage-backed securities. Mortgages are then Since 1983, mortgage pass-through securities
packaged by the agency or private issuer and and mortgages have been securitized as collat-
sold to investors. The principal and interest, eralized mortgage obligations (CMOs).1 While
less guaranty and other fees are then ‘‘passed pass-through securities share prepayment risk
through’’ to the investor, who receives a pro rata on a pro rata basis among all bondholders,
share of the resulting cash flows. CMOs redistribute prepayment risk among dif-
Every agency pass-through pool is unique, ferent classes or tranches. The CMO securitiza-
distinguished by features such as size, prepay- tion process recasts prepayment risk into classes
ment characteristics, and geographic concentra- or tranches. These tranches have risk profiles
tion or dispersion. Most agency pass-through ranging from extremely low to significantly high
securities, however, trade on a generic or to-be- risk. Some tranches can be relatively immune to
announced (TBA) basis. In a TBA trade, the prepayment risk, while others bear a dispropor-
seller and buyer agree to the type of security, tionate share of the risk associated with the
coupon, face value, price, and settlement date at underlying collateral.
the time of the trade, but do not specify the CMO issuance has grown dramatically
actual pools to be traded. Two days before throughout the 1980s and currently dominates
settlement, the seller identifies the specific pools the market for FNMA and FHLMC pass-
to be delivered to satisfy the commitment. throughs or agency collateral. Given the dra-
Trading in agency pass-throughs may take place matic growth of the CMO market and its com-
on any business day, but TBA securities usually plex risks, this subsection discusses the structures
settle on one specific date each month. The and risks associated with CMOs.
Public Securities Association releases a monthly In 1984, the Treasury ruled that multiple-
schedule that divides all agency pass-throughs class pass-throughs required active manage-
into six groups, each settling on a different day. ment; this resulted in the pass-through entities’
Agency pass-throughs generally clear through being considered corporations for tax purposes
electronic book-entry systems. rather than trusts. Consequently, the issuer was
no longer considered a grantor trust, and the
income was taxed twice: once at the issuer level
Chart 1—PSA Model and again at the investor level. This ruling
ultimately had complex and unintended ramifi-
cations for the CMO market.
Conditional Prepayment Rate (%) The issue was ultimately addressed in the Tax
14
Reform Act of 1986 through the creation of real
200% PSA
12 estate mortgage investment conduits (REMICs).
These instruments are essentially tax-free vehi-
10
cles for issuing multiple-class mortgage-backed
8 securities. REMIC is a tax designation; a REMIC
100% PSA may be originated as a trust, partnership, or
6
other entity.
50% PSA 4
2
0 1. Today almost all CMOs are structured as real estate
0 30 60 90 120 150 180 210 240 270 300 330 360 mortgage investment conduits (REMICs) to qualify for desir-
Mortgage Age (Months) able tax treatment.
Trading and Capital-Markets Activities Manual February 1998
Page 3
4110.1 Residential Mortgage–Backed Securities
The Tax Reform Act of 1986 allowed for a divided into four tranches, labeled A, B, C, and
five-year transition during which mortgage- Z. Tranche A might receive the first 25 percent
backed securities could be issued pursuant of principal payments and have an average
to existing Treasury regulations. However, as of maturity, or average life, of one to three years.2
January 1, 1992, REMICs became the sole Tranche B, with an average life of between three
means of issuing multiple-class mortgage- and seven years, would receive the next 25 per-
backed securities exempt from double taxation. cent of principal. Tranche C, receiving the
As a practical matter, the vast majority of CMOs following 25 percent of principal, would have an
carry the REMIC designation. Indeed, many average life of 5 to 10 years. The Z tranche,
market participants use the terms ‘‘CMO’’ and receiving the final 25 percent, would be an
‘‘REMIC’’ interchangeably. ‘‘accrual’’ bond with an average life of 15 to
CMOs do not trade on a TBA basis. New- 20 years.3
issue CMOs settle on the date provided in the The sequential pay structure was the first step
prospectus and trade on a corporate basis (three in creating a mortgage yield curve, allowing
business days after the trade) in the secondary mortgage investors to target short, intermediate,
market. Common CMO structures include or long maturities. Nevertheless, sequential pay
sequential pay, PACs, TACs, and floaters and structure maturities remained highly sensitive to
inverse floaters as described below. prepayment risks, as prepayments of the under-
lying collateral change the cash flows for each
Sequential pay structure. The initial form of tranche, affecting the longer-dated tranches most,
CMO structure was designed to provide more especially the Z tranche. If interest rates declined
precisely targeted maturities than the pass- and prepayment speeds doubled (from 100 per-
through securities. Now considered a relatively cent PSA to 200 percent PSA as shown on chart
simple design for CMOs, the sequential pay 2), the average life of the A tranche would
structure dominated CMO issuance from 1983 change from 35 months to 25 months, but the
(when the first CMO was created) until the late average life of the Z bond would shift from
1980s. In the typical sequential pay deal of the 280 months to 180 months. Hence, the change in
1980s (see chart 2), mortgage cash flows were the value of the Z bond would be similarly
greater than the price change of the A tranche.
Chart 2—Four-Tranche Sequential Planned amortization class (PAC) structure.
Pay CMO The PAC structure, which now dominates CMO
issuance, creates tranches, called planned amor-
Monthly Payment, Thousands of Dollars
1.5
tization classes, with cash flows that are pro-
200 Percent PSA tected from prepayment changes within certain
Tranche A limits. However, creating this ‘‘safer’’ set of
Tranche B 1.0 tranches necessarily means that there must be
Tranche C
other tranches, called ‘‘support’’ bonds, that are
by definition more volatile than the underlying
Tranche Z
.5 pass-throughs. While the PAC tranches are rela-
tively easy to sell, finding investors for higher-
yielding, less predictable support bonds has
0 been crucial for the success of the expanding
CMO market.
1.5 Chart 3 illustrates how PACs are created. In
100 Percent PSA the example, the estimated prepayment rate
for the mortgages is 145 percent of the PSA
1.0
standard, and the desired PAC is structured to
.5
2. Average life, or weighted average life (WAL), is defined
as the weighted average number of years that each principal
dollar of the mortgage security remains outstanding.
0 3. Unlike the Z tranche, the A, B, and C tranches receive
0 60 120 180 240 300 360 regular interest payments in the early years before the princi-
Month pal is paid off.
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Residential Mortgage–Backed Securities 4110.1
be protected if prepayments slow to 80 percent protection can break down from extremely high,
PSA or rise to 250 percent PSA. The PACs extremely low, or extremely volatile prepay-
therefore have some protection against both ment rates.
‘‘extension risk’’ (slower than expected prepay- A PAC bond classified as PAC 1 in a CMO
ments) and ‘‘call risk’’ (faster than expected structure has the highest cash-flow priority and
prepayments). In order to create this 80 to 250 the best protection from both extension and
percent ‘‘PAC range,’’ principal payments are prepayment risk. In the past, deals have also
calculated for 80 percent PSA and 250 percent included super PACs, another high-protection,
PSA. lower-risk-type tranche distinguished by
The area underneath both curves indicates extremely wide bands. The mechanisms that
that amount of estimated principal that can be protect a PAC tranche within a deal may dimin-
used to create the desired PAC tranche or ish, and its status may shift more toward the
tranches. That is, as long as the prepayment support end of the spectrum. The extent of a
rates are greater than 80 percent PSA or less support-type role that a PAC might play depends
than 250 percent PSA, the four PACs will in part on its original cash-flow priority status
receive their scheduled cash flows (represented and the principal balances of the other support
by the shaded areas). tranches embedded within the deal. Indeed, as
This PAC analysis assumes a constant prepay- prepayments accelerated in 1993, support
ment rate of between 80 and 250 percent of the tranches were asked to bear the brunt, and many
PSA standard over the life of the underlying disappeared. A PAC III, for example, became a
mortgages. Since PSA speeds can change every pure support tranche, foregoing any PAC-like
month, this assumption of a constant PSA speed characteristics in that case.
for months 1 to 360 is never realized. If prepay- A variation on the PAC theme has emerged in
ment speeds are volatile, even within the PAC the scheduled tranche (SCH). Like a PAC, an
range, the PAC range itself may narrow over SCH has a predetermined cash-flow collar, but it
time. This phenomenon, termed ‘‘effective PAC is too narrow even to be called a PAC III. An
band,’’ affects longer-dated PACs more than SCH tranche is also prioritized within a deal
short-maturity PACs. Thus, PAC prepayment using the above format, but understand that its
initial priority status is usually below even that
of a PAC III. These narrower band PAC-type
bonds were designed to perform well in low-
Chart 3—Principal Payments volatility environments and were popular in late
Monthly Payment, in Thousands of Dollars 1992 and early 1993. At that time, many inves-
2.0 tors failed to realize what would happen to the
145 Percent PSA tranche when prepayments violated the band.
Tranche A
1.5 In chart 3, the four grey shaded areas repre-
Support Tranche
sent the PAC structure, which has been divided
Tranche B into four tranches to provide investors with an
1.0
Tranche C instrument more akin to the bullet maturity of
Tranche D Treasury and corporate bonds.4 The two support
.5
tranches are structured to absorb the full amount
of prepayment risk to the extent the prepayment
0
rate for the PAC tranches is within the specified
range of 80 to 250 percent PSA. The second
2.0 panel of chart 3 shows principal cash flows at
Multi-PAC Redemption Schedule
with a Range of 80%–250% PSA the original estimated speed of 145 percent PSA,
1.5 which are divided between the PAC and support
bonds throughout the life of the underlying
1.0 mortgages.
.5
0 4. Treasury and corporate bonds usually return principal to
0 60 120 180 240 300 360 investors at stated maturity; the PAC structure narrows the
Month time interval over which principal is returned to the investors.
Trading and Capital-Markets Activities Manual February 1998
Page 5
4110.1 Residential Mortgage–Backed Securities
Chart 4 shows how both PACs and the sup- than PAC bonds.5 Conversely, PAC bond inves-
port tranches react to different prepayment tors are willing to give up yield in order to
speeds. The average lives of the support bonds reduce their exposure to prepayment risk or
in this example could fluctuate from 11⁄2 to negative convexity. Nevertheless, PAC bond
25 years depending on prepayment speeds. Sim- holders are exposed to prepayment risk outside
ply put, support-bond returns are diminished the protected range and correspondingly receive
whether prepayment rates increase or decrease yields above those available on comparable
(a lose-lose proposition). To compensate holders Treasury securities. In extreme cases, even PAC
of support bonds for this characteristic (some- tranches are subject to prepayment risk. For
times referred to as ‘‘negative convexity’’), example, at 500 percent PSA (see the third panel
support bonds carry substantially higher yields of chart 4), the PAC range is broken. The
support bonds fail to fully protect even the first
PAC tranche; principal repayment accelerates
sharply at the end of the scheduled maturity of
PAC A.
Chart 4—Principal Payments
Targeted amortization tranche structure. A tar-
Monthly Payment, Thousands of Dollars geted amortization tranche (TAC) typically offers
2.0
80 Percent PSA protection from prepayment risk but not exten-
sion risk. Similar to the cash-flow schedule of
PAC A
1.5 a PAC that is built around a collar, a TAC’s
PAC B
schedule is built around a single pricing speed,
PAC C and the average life of the tranche is ‘‘targeted’’
PAC D 1.0 to that speed. Any excess principal paid typi-
Support cally has little effect on the TAC; its targeted
Tranche speed acts as a line of defense. Investors in
.5
TACs, however, pay the price for this defense
with their lack of protection when rates increase,
0 subjecting the tranche to potential extension
risk.
2.0
250 Percent PSA Floaters and inverse floaters. CMOs and REMICs
can include several floating-rate classes. Floating-
1.5
rate tranches have coupon rates that float with
movements in an underlying index. The most
1.0 widely used indexes for floating-rate tranches
are the London Interbank Offered Rate (LIBOR)
and the Eleventh District Cost of Funds Index
.5 (COFI). While LIBOR correlates closely with
interest-rate movements in the domestic federal
0 funds market, COFI has a built-in lag feature
and is slower to respond to changes in interest
2.0 rates. Thus, the holders of COFI-indexed float-
500 Percent PSA ers generally experience a delay in the effects of
changing interest-rate movements.
1.5
1.0
5. Price/yield curves for most fixed-income securities have
a slightly convex shape, hence the securities are said to
possess convexity. An important and desirable attribute of the
.5 convex shape of the price/yield curve for Treasury securities
is that prices rise at a faster rate than they decline. Mortgage
price/yield curves tend to be concave, especially in the range
0 of premium prices, and are said to possess negative convexity.
0 60 120 180 240 300 360 Securities with negative convexity rise in price at a slower rate
Month than they fall in price.
February 1998 Trading and Capital-Markets Activities Manual
Page 6
Residential Mortgage–Backed Securities 4110.1
Since most floating-rate tranches are backed sensitive to prepayment rates than the under-
by fixed-rate mortgages or pass-through securi- lying pass-throughs.6 Despite the increased
ties, floating-rate tranches must be issued in exposure to prepayment risk, these instruments
combination with some kind of ‘‘support.’’ The have proved popular with several groups of
designed support mechanism on floaters is an investors. For example, mortgage servicers may
interest-rate cap, generally coupled with a sup- purchase POs to offset the loss of servicing
port bond or inverse floater. If interest rates rise, income from rising prepayments. IOs are often
where does the extra money come from to pay used as a hedging vehicle by fixed-income
higher rates on the floating CMO tranches? The portfolio managers because the value of IOs
solution is in the form of an inverse floating-rate rises when prepayments slow—usually in rising
tranche. The coupon rate on the inverse tranche interest-rate environments when most fixed-
moves opposite of the accompanying floater income security prices decline.
tranche, thus allowing the floater to pay high Two techniques have been used to create IOs
interest rates. The floater and the inverse tranches and POs. The first, which dominates outstand-
‘‘share’’ interest payments from a pool of fixed- ings in IOs and POs, strips pass-throughs into
rate mortgage securities. If rates rise, the coupon their interest and principal components, which
on the floater moves up; the floater takes more are then sold as separate securities. As of
of the shared interest, leaving less for the October 1993, approximately $65 billion of the
inverse, whose coupon rate must fall. If rates supply of outstanding pass-throughs had been
fall, the rate on the floater falls, and more money stripped into IOs and POs.7 The second tech-
is available to pay the inverse floater investor nique, which has become increasingly popular
and the corresponding rate on the inverse rises. over the past few years, simply slices off an
Effectively, the interest-payment characteris- interest or principal portion of any CMO tranche
tics of the underlying home mortgages have not to be sold independently. In practice, IO slices,
changed; another tranche is created where risk is called ‘‘IOettes,’’ 8 far outnumber PO slices.
shifted. This shifting of risk from the floater Since IOs and IOettes produce cash flows in
doubles up the interest-rate risk in the inverse proportion to the mortgage principal outstand-
floater, with enhanced yield and price ramifica- ing, IO investors are hurt by fast prepayments
tions as rates fluctuate. If rates fall, the inverse and aided by slower prepayments. The value of
floater receives the benefit of a higher-rate- POs rises when prepayments quicken and falls
bearing security in a low-rate environment. when prepayments slow because of the increases
Conversely, if rates rise, that same investor pays in principal cash flows coupled with the deep
the price of holding a lower-rate security in a discount price of the PO.
high-rate environment. As with other tranche IOs and IOettes are relatively high-yielding
types, prepayments determine the floating cash tranches that are generally subject to consider-
flows and the weighted average life of the able prepayment volatility. For example, falling
instrument (WAL). interest rates and rising prepayment speeds in
With respect to floaters, the two most impor- late 1991 caused some IOs (such as those
tant risks are the risk that the coupon rate will backed by FNMA 10 percent collateral) to fall
adjust to its maximum level (cap risk) and the up to 40 percent in value between July and
risk that the index will not correlate tightly with December. IOs also declined sharply on several
the underlying mortgage product. Additionally, occasions in 1992 and 1993 as mortgage rates
floaters that have ‘‘capped out’’ and that have moved to 20- and 25-year lows, resulting in very
WALs that extend as prepayments slow may high levels of prepayment. CMO dealers use
experience considerable price depreciation. IOettes to reduce coupons on numerous tranches,
allowing these tranches to be sold at a discount
Stripped Mortgage-Backed Securities:
6. This counterintuitive result arises because IO and PO
Interest-Only and Principal-Only prices are negatively correlated.
7. Of this amount, FNMA has issued $26 billion, FHLMC
Interest-only (IO) and principal-only (PO) secu- $2.3 billion, and private issuers $6.5 billion.
rities are another modification of the mortgage 8. Securities and Exchange Commission regulations forbid
pure IO slices within CMOs. IO slices therefore include
pass-through product. This market is referred to nominal amounts of principal and are termed ‘‘IOettes.’’ As a
as the stripped mortgage-backed securities practical matter, IOettes have the price performance charac-
(SMBS) market. Both IOs and POs are more teristics of IOs.
Trading and Capital-Markets Activities Manual February 1998
Page 7
4110.1 Residential Mortgage–Backed Securities
(as preferred by investors). In effect, much of To the extent that banks do operate as market
the call risk is transferred from these tranches to makers, the risks are more diverse and challeng-
the IOette. ing. The key areas of focus for market makers
The fact that IO prices generally move are risk-management practices associated with
inversely to most fixed-income securities makes trading, hedging, and funding their inventories.
them theoretically attractive hedging vehicles in The operations and analytic support staff required
a portfolio context. Nevertheless, IOs represent for a bank’s underwriting operation are much
one of the riskiest fixed-income assets available greater than those needed for its more traditional
and may be used in a highly leveraged way to role of investor.
speculate about either future interest rates or Regulatory restrictions limit banks’ owner-
prepayment rates. Given that their value rises ship of high-risk tranches. These tranches are so
(falls) when interest rates increase (decrease), complex that the most common approaches and
many financial institutions, including banks, techniques for hedging interest-rate risks could
thrifts, and insurance companies, have pur- be ineffective. High-risk tranches are so elabo-
chased IOs and IOettes as hedges for their rately structured and highly volatile that it is
fixed-income portfolios, but such hedges might unlikely that a reliable hedge offset exists.
prove problematic as they expose the hedger to Hedging these instruments is largely subjective,
considerable basis risk. and assessing hedge effectiveness becomes
extremely difficult. Examiners must carefully
assess whether owning such high-risk tranches
reduces a bank’s overall interest-rate risk.
USES
Both pass-through securities and CMOs are
purchased by a broad array of institutional DESCRIPTION OF
customers, including banks, thrifts, insurance MARKETPLACE
companies, pension funds, mortgage ‘‘bou-
tiques,’’9 and retail investors. CMO underwriters Primary Market
customize the majority of CMO tranches for
specific end-users, and customization is espe- The original lender is called the mortgage orig-
cially common for low-risk tranches. Since this inator. Mortgage originators include commercial
customization results from investors’ desire to banks, thrifts, and mortgage bankers. Origina-
either hedge an existing exposure or to assume a tors generate income in several ways. First, they
specific risk, many end-users perceive less need typically charge an origination fee, which is
for hedging. For the most part, end-users gen- expressed in terms of basis points of the loan
erally adopt a buy-and-hold strategy, perhaps in amount. The second source of revenue is the
part because the customization makes resale profit that might be generated from selling a
more difficult. mortgage in the secondary market, and the profit
is called secondary-marketing profit. The mort-
gage originator may also hold the mortgage in
its investment portfolio.
Uses by Banks
Within the mortgage securities market, banks Secondary Market
are predominately investors or end-users rather
than underwriters or market makers. Further- The process of creating mortgage securities
more, banks tend to invest in short to inter- starts with mortgage originators which offer
mediate maturities. Indeed, banks aggressively consumers many different types of mortgage
purchase short-dated CMO tranches, such as loans. Mortgages that meet certain well-defined
planned amortization classes, floating-rate criteria are sold by mortgage originators to
tranches, and adjustable-rate mortgage securities. conduits, which link originators and investors.
These conduits will pool like groups of mort-
9. Mortgage boutiques are highly specialized investment
gages and either securitize the mortgages and
firms which typically invest in residuals and other high-risk sell them to an investor or retain the mortgages
tranches. as investments in their own portfolios. Both
February 1998 Trading and Capital-Markets Activities Manual
Page 8
Residential Mortgage–Backed Securities 4110.1
government-related and private institutions act prepayment rates. Despite the application of
in this capacity. Ginnie Mae; Freddie Mac, and highly sophisticated interest-rate simulation
Fannie Mae are the three main government- techniques, results from diverse proprietary
related conduit institutions; all of them purchase prepayment models and assumptions about future
conforming mortgages which meet the under- interest-rate volatility still drive valuations. The
writing standards established by the agencies for subjective nature of mortgage valuations makes
being in a pool of mortgages underlying a marking to market difficult due to the dynamic
security that they guarantee. nature of prepayment rates, especially as one
Ginne Mae is a government agency, and the moves farther out along the price-risk con-
securities it guarantees carry the full faith and tinuum toward high-risk tranches. Historical
credit of the U.S. government. Fannie Mae and price information for various CMO tranche
Freddie Mac are government-sponsored agen- types is not widely available and, moreover,
cies; securities issued by these institutions are might have limited value given the generally
guaranteed by the agencies themselves and are different methodologies used in deriving mort-
generally assigned an AAA credit rating partly gage valuation.
due to the implicit government guarantee.
Mortgage-backed securities have also been
issued by private entities such as commercial
banks, thrifts, homebuilders, and private con- Decomposition of MBS
duits. These issues are often referred to as
private label securities. These securities are not A popular approach to analyzing and valuing a
guaranteed by a government agency or GSE. callable bond involves breaking it down into its
Instead, their credit is usually enhanced by pool component parts—a long position in a noncall-
insurance, letters of credit, guarantees, or over- able bond and a short position in a call option
collateralization. These securities usually receive written to the issuer by the investor. An MBS
a rating of AA or better. investor owns a callable bond, but decomposing
Private issuers of pass-throughs and CMOs it is not as easy as breaking down more tradi-
provide a secondary market for conventional tional callables. The MBS investor has written a
loans which do not qualify for Freddie Mac and series of put and call options to each homeowner
Fannie Mae programs. There are several reasons or mortgagor. The analytical challenge facing an
why conventional loans may not qualify, but the examiner is to determine the value and risk
major reason is that the principal balance exceeds profile of these options and their contribution to
the maximum allowed by the government (these the overall risk profile of the portfolio. Com-
are called ‘‘jumbo’’ loans in the market). pounding the problem is the fact that mortgagors
Servicers of mortgages include banks, thrifts, do not exercise these prepayment options at the
and mortgage bankers. If a mortgage is sold to a same time when presented with identical situa-
conduit, it can be sold in total, or servicing tions. Most prepayment options are exercised at
rights may be maintained. The major source of the least opportune time from the standpoint of
income related to servicing is derived from the the MBS investor. In a falling-rate environment,
servicing fee. This fee is a fixed percentage of a homeowner will have a greater propensity to
the outstanding mortgage balance. Consequently, refinance (or exercise the option) as prevailing
if the mortgage is prepaid, the servicing fee will mortgage rates fall below the homeowner’s
no longer accrue to the servicer. Other sources original note (as the option moves deeper into
of revenue include interest on escrow, float the money). Under this scenario, the MBS
earned on the monthly payment, and late fees. investor receives a cash windfall (principal pay-
Also, servicers who are lenders often use their ment) which must be reinvested in a lower-rate
portfolios of borrowers as potential sources to environment. Conversely, in a high- or rising-
cross-sell other bank products. rate environment, when the prevailing mortgage
rate is higher than the mortgagor’s original term
rate, the homeowner is less apt to exercise the
option to refinance. Of course, the MBS investor
PRICING would like nothing more than to receive his or
her principal and be able to reinvest that princi-
Mortgage valuations are highly subjective pal at the prevailing higher rates. Under this
because of the unpredictable nature of mortgage scenario, the MBS investor holds an instrument
Trading and Capital-Markets Activities Manual February 1998
Page 9
4110.1 Residential Mortgage–Backed Securities
with a stated coupon that is below prevailing negative one.11 If that were the case, the value of
market rates and relatively unattractive to poten- a pass-through security would always be hedged
tial buyers. with respect to interest rates. However, IOs and
Market prices of mortgages reflect an expected POs do represent extremities in MBS theory
rate of prepayments. If prepayments are faster and, properly applied, can be used as effective
than the expected rate, the mortgage security is risk-reduction tools. Because the value of the
exposed to call risk. If prepayments are slower prepayment option and the duration of an IO and
than expected, the mortgage securities are PO are not constant, hedges must be continually
exposed to extension risk (similar to having managed and adjusted.
written a put option). Thus, in practice, mort- In general, a decline in prepayment speeds
gage security ownership is comparable to own- arises largely from rising mortgage rates, with
ing a portfolio of cash bonds and writing a fixed-rate mortgage securities losing value. At
combination of put and call options on that the same time, IO securities are rising in yield
portfolio of bonds. Call risk is manifested in a and price. Thus, within the context of an overall
shortening of the bond’s effective maturity or portfolio, the inclusion of IOs serves to increase
duration, and extension risk manifests itself in yields and reduce losses in a rising-rate environ-
the lengthening of the bond’s effective maturity ment. More specifically, IOs can be used to
or duration. hedge the interest-rate risk of Treasury strip
securities. As rates increase, an IO’s value
increases. The duration of zero-coupon strips
Option-Adjusted Spread Analysis equals their maturity, while IOs have a negative
duration.12 Combining IOs with strips creates a
For a further discussion of option-adjusted spread portfolio with a lower duration than a position in
(OAS) analysis or optionality in general, see strips alone.13
section 4330.1, ‘‘Options.’’ POs are a means to synthetically add discount
(and positive convexity) to a portfolio, allowing
it to more fully participate in bull markets. For
example, a bank funding MBS with certificates
HEDGING of deposit (CDs) is exposed to prepayment risk.
If rates fall faster than expected, mortgage
Hedging mortgage-backed securities ultimately holders (in general) will exercise their prepay-
comes down to an assessment of one’s expecta- ment option while depositors will hold their
tion of forward rates (an implied forward curve). higher-than-market CDs as long as possible.
A forward-rate expectation can be thought of as The bank could purchase POs as a hedge against
a no-arbitrage perspective on the market, serv- its exposure to prepayment and interest-rate
ing as a pricing mechanism for fixed-income risk. As a hedging vehicle, POs offer preferable
securities and derivatives, including MBS. alternatives to traditional futures or options; the
Investors who wish to hedge their forward-rate performance of a PO is directly tied to actual
expectations can employ strategies which involve prepayments, thus the hedge should experience
purchasing the underlying security and the use potentially less basis risk than other cross-
of swaps, options, futures, caps, or combinations market hedging instruments.
thereof to hedge duration and convexity risk.10
With respect to intra-portfolio techniques,
one can employ IOs and POs as hedge vehicles.
Although exercise of the prepayment option RISKS
generally takes value away from the IO class Prepayment Risk
and adds value to the PO class, IOs and POs
derived from the same pool of underlying mort- All investors in the mortgage sector share a
gages do not have a correlation coefficient of common concern: the mortgage prepayment
11. Zissu, Anne, and Charles Austin Stone. ‘‘The Risks of
10. Davidson, Andrew S., and Michael D. Herskovitz. MBS and Their Derivatives.’’ Journal of Applied Corporate
Mortgage Backed Securities—Investment Analysis and Finance, Fall 1994.
Advanced Valuation Techniques. Chicago: Probus Publishing, 12. Ibid., p. 102.
1994. 13. Ibid., p. 104.
February 1998 Trading and Capital-Markets Activities Manual
Page 10
Residential Mortgage–Backed Securities 4110.1
option. This option is the homeowner’s right to pass-throughs have little credit risk.14 Approxi-
prepay a mortgage any time, at par. The prepay- mately 90 percent of all outstanding pass-
ment option makes mortgage securities different through securities have been guaranteed by
from other fixed-income securities, as the timing Ginnie Mae, Fannie Mae, and Freddie Mac.15
of mortgage principal repayments is uncertain. This credit guarantee gives ‘‘agency’’ pass-
The cash-flow uncertainty that derives from through securities and CMOs a decisive advan-
prepayment risk means that the maturity and tage over nonagency pass-throughs and CMOs,
duration of a mortgage security are uncertain. which comprise less than 10 percent of the
For investors, the prepayment option creates an market.
exposure similar to that of having written a call In general, nonagency pass-through securities
option. That is, if mortgage rates move lower, and CMOs use mortgages that are ineligible for
causing mortgage bond prices to move higher, agency guarantees. Issuers can also obtain credit
the mortgagor has the right to call the mortgage enhancements, such as senior subordinated struc-
away from the investor at par. tures, insurance, corporate guarantees, or letters
While lower mortgage interest rates are the of credit from insurance companies or banks.
dominant economic incentive for prepayment, The rating of the nonagency issue then partially
idiosyncratic, noneconomic factors to prepay a depends upon the rating of the insurer and its
mortgage further complicate the forecasting of credit enhancement.
prepayment rates. These factors are sometimes
summarized as the ‘‘five D’s’’: death, divorce,
destruction, default, and departure (relocation). Settlement and Operational Risk
Prepayments arising from these causes may lead
to a mortgage’s being called away from the The most noteworthy risk issues associated with
investor at par when it is worth more or less than the trading of pass-through securities is the
par (that is, trading at a premium or discount). forward settlement and operational risk associ-
ated with the allocation of pass-through trades.
Most pass-through trading occurs on a forward
basis of two to three months, often referred to as
Funding and Reinvestment Risk ‘‘TBA’’ or ‘‘to be announced’’ trading.16 During
this interval, participants are exposed to coun-
The uncertainty of the maturities of underlying terparty credit risk.
mortgages also presents both funding and rein- Operating risk grows out of the pass-through
vestment risks for investors. The uncertainty of seller’s allocation option that occurs at settle-
a mortgage security’s duration makes it difficult ment. Sellers in the TBA market are allowed a
to obtain liabilities for matched funding of these 2.0 percent delivery option variance when meet-
assets. This asset/liability gap presents itself ing their forward commitments. That is, between
whether the mortgage asset’s life shortens or 98 and 102 percent of the committed par amount
lengthens, and it may vary dramatically. may be delivered. This variance is provided to
Reinvestment risk is normally associated with ease the operational burden of recombining
duration shortening or call risk. Investors receive various pool sizes into round trading lots.17 This
principal earlier than anticipated, usually as a delivery convention requires significant opera-
result of declines in mortgage interest rates; the tional expertise and, if mismanaged, can be a
funds can then be reinvested only at the new
lower rates. Reinvestment risk is also the oppor-
tunity cost associated with lengthening dura-
tions. Mortgage asset durations typically extend 14. Credit risk in a pass-through stems from the possibility
as rates rise. This results in lower investor that the homeowner will default on the mortgage and that the
foreclosure proceeds from the resale of the property will fall
returns as they are unable to reinvest at the now short of the balance of the mortgage.
higher rates. 15. For a full explanation of the minor differences between
these agencies, see chapter 5 in Fabozzi, The Handbook of
Mortgage-Backed Securities, 1995.
16. In the forward mortgage pass-through trading, or TBA
Credit Risk trading, the seller announces the exact pool mix to be
delivered the second business day before settlement day.
17. ‘‘Good delivery’’ guidelines are promulgated by the
While prepayments expose pass-throughs and Public Securities Association in its Uniform Practices
CMOs to considerable price risk, most MBS publication.
Trading and Capital-Markets Activities Manual February 1998
Page 11
4110.1 Residential Mortgage–Backed Securities
source of significant risk in the form of failed are exceeded. Even floating-rate tranches face
settlements and unforeseen carrying costs. risks, especially when short-term rates rise sig-
nificantly and floaters reach their interest-rate
caps. At the same time, long rates may rise and
Price Volatility in High-Risk CMOs prepayments slow, causing the floaters’ maturi-
ties to extend significantly since the floater is
When the cash flow from pass-through securi- usually based on a support bond. Under such
ties is allocated among CMO tranches, prepay- circumstances, floater investors could face sig-
ment risk is concentrated within a few volatile nificant losses.
classes, most notably residuals, inverse floaters, In addition to possible loss of market value,
IOs and POs, Z bonds, and long-term support these safe tranches may lose significant liquidity
bonds. These tranches are subject to sharp price under extreme interest-rate movements. These
fluctuations in response to changes in short- and tranches are currently among the most liquid
long-term interest rates, interest-rate volatility, CMOs. Investors who rely on this liquidity
prepayment rates, and other macroeconomic when interest-rate volatility is low may find it
conditions. Some of these tranches—especially difficult to sell these instruments to raise cash in
residuals and inverse floaters—are frequently times of financial stress. Nevertheless, investors
placed with a targeted set of investors willing to in these tranches face lower prepayment risk
accept the extra risk. These classes are also than investors in either mortgage pass-throughs
among the most illiquid bonds traded in the or the underlying mortgages themselves.
CMO market.
These high-risk tranches, whether held by
dealers or investors, have the potential to incur Cap Risk
sizable losses (and sometimes gains) within a
short period of time.18 Compounding this price The caps in many floating-rate CMOs and ARMs
risk is the difficulty of finding effective hedging are an embedded option. The value of floating-
strategies for these instruments. Using different rate CMOs or ARMs is equal to the value of an
CMOs to hedge each other can present prob- uncapped floating-rate security less the value of
lems. Although pass-through securities from the cap. As the coupon rate of the security
different pools tend to move in the same direc- approaches the cap rate, the value of the option
tion based on the same event, the magnitude of increases and the value of the security falls. The
these moves can vary considerably, especially if rate of change is non-linear and increases as the
the underlying mortgage pools have different coupon approaches the cap. As the coupon rate
average coupons.19 equals or exceeds the cap rate, the security will
exhibit characteristics similar to those of a
fixed-rate security, and price volatility will
increase. All else being equal, securities with
Risks in ‘‘Safe’’ Tranches coupon rates close to their cap rates will tend to
exhibit greater price volatility than securities
Investors may also be underestimating risks in with coupon rates farther away from their cap
some ‘‘safe’’ tranches, such as long-maturity rates. Also, the tighter the ‘‘band’’ of caps and
PACs, PAC 2s, and 3s, and floaters, because floors on the periodic caps embedded in ARMs,
these tranches can experience abrupt changes in the greater the price sensitivity of the security
their average lives once their prepayment ranges will be. The value of embedded caps also
increases with an increase in volatility. Thus, all
else being equal, higher levels of interest-rate
volatility will reduce the value of the floating-
rate CMO or ARM.
18. Examples of single-firm losses include a $300 million
to $400 million loss by one firm on POs in the spring of 1987;
more recently, several firms have lost between $50 million and
$200 million on IO positions in 1992 and 1993. FFIEC Regulations Concerning
19. For a discussion of the idiosyncratic prepayment Unsuitable Investments
behavior of pass-throughs, see Sean Becketti and Charles S.
Morris, The Prepayment Experience of FNMA Mortgage-
Backed Securities. New York University Salomon Center, The Federal Financial Institutions Examination
1990, pp. 24–41. Council (FFIEC) issued a revised policy state-
February 1998 Trading and Capital-Markets Activities Manual
Page 12
Residential Mortgage–Backed Securities 4110.1
ment concerning securities activities for mem- Extinguishments of Liabilities.’’ Accounting
ber banks. These rules became effective Febru- treatment for derivatives used as investments or
ary 10, 1992, for member banks and bank for hedging purposes is determined by State-
holding companies under the Board’s jurisdic- ment of Financial Accounting Standards No.
tion. A bank’s CMO investments are deemed 133 (FAS 133), ‘‘Accounting for Derivatives
unsuitable if— and Hedging Activities.’’ (See section 2120.1,
‘‘Accounting,’’ for further discussion.)
• the present weighted average life (WAL) is
greater than 10 years,
• the WAL extends more than four years or RISK-BASED CAPITAL
shortens more than six years for a parallel WEIGHTING
interest-rate shift of up and down 300 basis
points, or Pass-through securities are assigned the follow-
• the price changes by more than 17 percent ing weights:
from the asking price for a parallel interest-
rate shift of up and down 300 basis points. GNMA (Ginnie Mae) 0
FNMA (Fannie Mae) 20 percent
An affirmation of any of these three parameters FHLMC (Freddie Mac) 20 percent
means that the bond in question (1) may be Private label 50–100 percent
considered high risk and (2) may not be a
suitable investment for banks or bank holding Collaterialized mortgage obligations are assigned
companies. An institution holding high-risk the following weights:
securities must demonstrate that they reduce
overall interest-rate risk for the bank. Backed by Ginnie Mae,
Floating-rate CMOs with coupons tied to Fannie Mae, or
indexes other than LIBOR (sometimes called Freddie Mac
‘‘mismatched floaters’’) are generally exempt securities 20–100 percent
from the average-life and average-life-sensitivity
tests. Given the degree of price sensitivity asso- Backed by whole loans
ciated with these securities, however, institu- or private-label
tions that purchase non-LIBOR-indexed floaters pass-throughs 50–100 percent
must maintain documentation showing that they
understand and are able to monitor the risks of Stripped MBS are assigned a 100 percent risk
these instruments. The documentation should weighting.
include a prepurchase analysis and at least an
annual analysis of the price sensitivity of the
security under both parallel and nonparallel
shifts of the yield curve. See the Commercial LEGAL LIMITATIONS FOR BANK
Bank Examination Manual for more informa- INVESTMENTS
tion on the FFIEC testing parameters detailed
above.
Pass-Through Securities
Ginnie Mae, Fannie Mae, and Freddie Mac
pass-through securities are type I securities.
ACCOUNTING TREATMENT Banks can deal in, underwrite, purchase, and sell
these securities for their own accounts without
The accounting treatment for investments in limitation.
mortgage-backed securities is determined by the
Financial Accounting Standards Board’s State-
ment of Financial Accounting Standards No. CMOs and Stripped MBS
115 (FAS 115), ‘‘Accounting for Certain Invest-
ments in Debt and Equity Securities,’’ as CMOs and stripped MBS securitized by small
amended by Statement of Financial Accounting business–related securities and certain residential-
Standards No. 140 (FAS 140), ‘‘Accounting for and commercial-related securities rated Aaa and
Transfers and Servicing of Financial Assets and Aa are type IV securities. As such, a bank may
Trading and Capital-Markets Activities Manual September 2001
Page 13
4110.1 Residential Mortgage–Backed Securities
purchase and sell these securities for its own Cilia, Joseph. Advanced CMO Analytics for
account without limitation. CMOs and stripped Bank Examiners—Practical Applications
MBS securitized by small business–related Using Bloomberg. Product Summary. Chicago:
securities rated A or Baa are also type IV Federal Reserve Bank of Chicago, May 1995.
securities and are subject to an investment Davidson, Andrew S., and Michael D.
limitation of 25 percent of a bank’s capital and Herskovitz. Mortgage-Backed Securities—
surplus. Banks may deal in type IV securities Investment Analysis and Advanced Valuation
which are fully secured by type I transactions Techniques. Chicago: Probus Publishing,
without limitations. 1994.
CMOs and stripped MBS securitized by cer- Fabozzi, Frank J., ed. The Handbook of Mortgage-
tain residential- and commercial-mortgage- Backed Securities. Chicago: Probus Publish-
related securities rated A or Baa are type V ing, 1995.
securities. For type V securities, the aggregate
par value of a bank’s purchase and sales of the Fabozzi, Frank J. Valuation of Fixed-Income
securities of any one obligor may not exceed Securities. Summit, N.J.: Frank J. Fabozzi
25 percent of its capital and surplus. Associates, 1994.
Klinkhammer, Gunner, Ph.D. ‘‘Monte Carlo
Analytics Provides Dynamic Risk Assess-
ment for CMOs.’’ Capital Management
REFERENCES Sciences, Inc. October 1995.
Bartlett, William W. Mortgage-Backed Securi- Kopprasch, Robert W. ‘‘Option Adjusted Spread
ties. Burr Ridge, Ill.: Irwin Publishing, 1994. Analysis: Going Down the Wrong Path?’’
Becketti, Sean, and Charles S. Morris. The Financial Analysts Journal. May/June 1994.
Prepayment Experience of FNMA Mortgage- Zissu, Anne, and Charles Austin Stone. ‘‘The
Backed Securities. New York: New York Risks of MBS and Their Derivatives.’’ Jour-
University Salomon Center, 1990. nal of Applied Corporate Finance. Fall 1994.
September 2001 Trading and Capital-Markets Activities Manual
Page 14
Australian Commonwealth Government Bonds
Section 4205.1
GENERAL DESCRIPTION because (1) they offer high yields relative to
those available on other sovereign debt instru-
The Australian Treasury issues Australian ments and (2) the Australian bond market is
Commonwealth Government Bonds (CGBs) to regarded as stable. Although the bond market
finance the government’s budget deficit and to has a substantial foreign participation, due to
refinance maturing debt. Since 1982, bonds have its attractive yield and a much shorter period
been issued in registered form only, although of time required for the bonds to mature, the
some outstanding issues may be in bearer form. majority of CGB investors are domestic. U.S.
The principal and interest on CGBs are guaran- banks purchase CGBs to diversify their port-
teed by the Commonwealth Government of folios, speculate on currency and Australian
Australia. interest rates, and to hedge Australian-
denominated currency positions and positions
along the Australian yield curve.
CHARACTERISTICS AND
FEATURES
CGBs, with maturities ranging from one to DESCRIPTION OF
20 years, are issued every six to eight weeks in MARKETPLACE
an average tender size totaling A$800 million.
Most CGBs are noncallable, fixed-coupon secu- Issuing Practices
rities with bullet maturities. The Australian
Treasury has issued some indexed-linked bonds
with either interest payments or capital linked to CGBs are issued periodically on an as-needed
the Australian consumer price index. However, basis, typically every six to eight weeks. Gen-
there are few of these issues and they tend to be erally, issuance is through a competitive tender
very illiquid. CGBs can be issued with current whereby subscribers are invited to submit bids
market coupons, but in many cases the Austra- as they would in an auction. Issue size is
lian Treasury will reopen existing issues. announced one day before the tender day. Bids,
Interest for government bonds is paid semi- which are sent to the Reserve Bank of Australia
annually on the 15th day of the month, and it is through the Reserve Bank Information Transfer
calculated on an actual/365 day-count basis. System (RBITS), are submitted to the Reserve
Coupon payments that fall on weekends or Bank of Australia on a semiannual, yield-to-
public holidays are paid on the next business maturity basis. Specific information on the issue
day. Semiannual coupon payments are precisely is announced later on the tender day, such as the
half the coupon rate. Bonds that have more than amounts tendered and issued, the average and
six months left to maturity settle three business range of accepted bids, and the percentage of
days after the trade date (T+3). Bonds with less bids allotted at the highest yield.
than six months left to maturity may settle on
the same day, provided they are dealt before
noon; otherwise, they settle the next day.
Secondary Market
While CGBs are listed on the Australian Stock
USES Exchange, nearly all trading takes place over the
counter (OTC), by screen or direct trading. The
Australian banks are the largest single group of primary participants in the secondary market are
investors in outstanding CGB issues. They use authorized dealers and share brokers. OTC trans-
these securities to meet regulatory capital actions must be in amounts of A$250,000 or
requirements. The Australian pension industry more. Stock-exchange transactions are essen-
holds CGBs mainly as investment vehicles. In tially limited to retail transactions under A$1 mil-
addition, CGBs are viewed as attractive invest- lion. Usually, authorized dealers trade bonds
ment vehicles by many foreign investors which are within five years of maturing.
Trading and Capital-Markets Activities Manual September 2001
Page 1
4205.1 Australian Commonwealth Government Bonds
Market Participants RISKS
Sell Side Liquidity Risk
Authorized dealers are the primary participants The CGB market is considered fairly active and
in the sell side of the CGB market. liquid. Trading volume among the benchmark
bonds is about equal, although the three-year
and 10-year benchmark issues tend to have the
Buy Side most turnover.
Australian banks and other financial institutions
are the largest single group of investors in Interest-Rate Risk
CGBs. These entities usually hold large quan-
tities of shorter-term government bonds for CGBs are subject to price fluctuation resulting
regulatory purposes, as these securities may be from interest-rate volatility. Generally, longer-
included in the prime asset ratios of banks. In term bonds have more price volatility than
addition, a variety of other domestic investors shorter-term instruments. If an institution has a
participate in the CGB market. large concentration of long-term maturities, it
The Australian bond market has been known may be subject to unwarranted interest-rate risk.
to attract substantial foreign participation over
the years, primarily because it is regarded as a
stable market which offers relatively high yields. Foreign-Exchange Risk
In general, foreign market participants are insti-
tutional investors, such as securities firms, life Currency fluctuations may affect the bond’s
insurance companies, banks, and fund managers. yield as well as the value of coupons and
principal paid in U.S. dollars. A number of
factors may influence a country’s foreign-
Market Transparency exchange rate, including its balance of payments
and prospective changes in that balance; infla-
tion and interest-rate differentials between that
Prices tend to be active and liquid. Price trans-
country and the United States; the social and
parency is enhanced by the dissemination of
political environment, particularly with regard
prices by several information vendors including
to the impact on foreign investment; and central
Reuters and Telerate.
bank intervention in the currency markets.
PRICING Political Risk
CGBs are quoted in terms of yield and rounded A change in the political environment, withhold-
to three decimal places to determine gross price ing tax laws, or market regulation can have an
for settlement purposes. While tick size is adverse impact on the value and liquidity of an
equivalent to one basis point, yields are often investment in foreign bonds. Investors should be
quoted to the half basis point. familiar with the local laws and regulations
governing foreign bond issuance, trading, trans-
actions, and authorized counterparties.
HEDGING
ACCOUNTING TREATMENT
Interest-rate risk may be hedged by taking an
offsetting position in other government bonds or The accounting treatment for investments in
by using interest-rate forward, futures, options, foreign debt is determined by the Financial
or swap contracts. Foreign-exchange risk may Accounting Standards Board’s Statement of
be hedged by using foreign-currency derivatives Financial Accounting Standards No. 115 (FAS
and swaps. 115), ‘‘Accounting for Certain Investments in
September 2001 Trading and Capital-Markets Activities Manual
Page 2
Australian Commonwealth Government Bonds 4205.1
Debt and Equity Securities,’’ as amended by LEGAL LIMITATIONS FOR BANK
Statement of Financial Accounting Standards INVESTMENT
No. 140 (FAS 140), ‘‘Accounting for Transfers
and Servicing of Financial Assets and Extin- Australian CGBs are a type III security. As such,
guishments of Liabilities.’’ Accounting treat- a bank’s investment is limited to 10 percent of
ment for derivatives used as investments or for its equity capital and reserves.
hedging purposes is determined by Statement of
Financial Accounting Standards No. 133 (FAS
133), ‘‘Accounting for Derivatives and Hedging
Activities.’’ (See section 2120.1, ‘‘Accounting,’’ REFERENCES
for further discussion.)
de Caires, Bryan, ed. The Guide to International
Capital Markets 1990. London: Euromoney
Publications PLC, 1990.
RISK-BASED CAPITAL Crossan, Ruth, and Mark Johnson, ed. The
WEIGHTING Guide to International Capital Markets 1991.
London: Euromoney Publications PLC, 1991.
Australian CGBs are assigned to the 0 percent J.P. Morgan Securities. Government Bond Out-
risk-weight category. lines. 9th ed. April 1996.
Trading and Capital-Markets Activities Manual September 2001
Page 3
Canadian Government Bonds
Section 4210.1
GENERAL DESCRIPTION USES
The federal government of Canada issues bonds, Canadas are held for investment, hedging, and
known as ‘‘Canadas,’’ to finance its public debt. speculative purposes by both domestic (Cana-
The Canadian government bond market is the dian) and foreign investors. U.S. banks purchase
sixth largest in the world, with about C$270 Canadas to diversify their portfolios, speculate
billion (U.S.$195 billion) in bonds outstanding on currency and Canadian interest rates, and
as of April 1996. Overall, this market is struc- hedge Canadian-denominated currency positions
turally similar to the U.S. bond market, particu- and positions along the Canadian yield curve.
larly with regard to the types of securities
issued. Canadas come in a wide variety of
maturities ranging from 2 to 30 years. Recently, DESCRIPTION OF
the longer maturity bonds have increased in MARKETPLACE
popularity.
Issuing Practices
Canadas are issued by two methods: by allot-
ment and auction. With the allotment system,
CHARACTERISTICS AND the amount, coupon, and issue price for each of
FEATURES the maturity tranches is announced after consul-
tation with the primary distributors. The Bank of
Canadas are issued at a price close to par value Canada pays a commission to all primary dis-
and are denominated in C$1,000, C$25,000, tributors who are responsible for placing the
C$100,000, and C$1 million allotments. Cana- issue.
das are available in bearer form with coupons The auction system is very similar to the U.S.
attached or in registered form. All new Canadian system. On the Thursday before the regular
bonds are issued with bullet maturities and are Wednesday auction, the Bank of Canada
not callable; there is one callable issue outstand- announces details, including the size, maturity,
ing that matures in 1998. All Canadas have fixed and delivery date for the upcoming auction, and
coupons ranging from 3 percent to 18 percent. active open market trading begins on a yield
Real return bonds, inflation-indexed bonds, were basis. The coupon for new issues is not known
introduced in December 1991 and are currently until auction results are released, and it is set
issued once per quarter. Principal and coupon at the nearest 1⁄4 percent increment below the
payments for these bonds are linked to the auction average. The Bank of Canada accepts
Canadian consumer price index. both competitive and noncompetitive bids from
Interest on Canadas is paid semiannually and primary distributors. However, it will only accept
is accrued from the previous coupon date one noncompetitive bid, which may have a
(exclusive) to the settlement date (inclusive) up maximum value of C$2 million.
to a maximum value of 181.5 days. As a result, On the auction date, bids are submitted to the
the value date is always the same as the settle- Bank of Canada and primary distributors receive
ment date. New issues may offer short first bonds up to 20 percent of the total amount
coupons, but not long first coupons. Interest on issued based on the competitiveness of their
short first coupons is accrued from the dated bids. The delivery date and dated date are
date to the first coupon date. Any ‘‘reopened’’ usually ten days to two weeks after the auction.
bonds include the accrued interest in the issue Issues typically range from C$100 million to
price to ensure that the new tranches carry the C$8.8 billion, and any issue may be reopened by
same coupons as the existing bond and trade the Department of Finance based on market
indistinguishably. Canadas with remaining conditions.
maturities of less than three years settle two
market days after the trade date (T+2), while
Canadas with maturities over three years Secondary Market
settle three market days after the trade date
(T+3). Canadas are not listed on any stock exchanges
Trading and Capital-Markets Activities Manual February 1998
Page 1
4210.1 Canadian Government Bonds
but trade in over-the-counter (OTC) markets HEDGING
24 hours a day. Settlement occurs through a
book-entry system between market participants Interest-rate risk on Canadas may be hedged
and the Canadian Depository for Securities using interest-rate swaps, forwards, futures (such
(CDS). Therefore, Canadas may trade when- as futures on 10-year and 5-year Canadas, which
issued without an exchange of cash. are traded on the Montreal Stock Exchange),
and options (such as options on all Canadas
issues, which are traded on the MSE). Hedging
Market Participants may also be effected by taking a contra position
Sell Side in another Canadian government bond. Foreign-
exchange risk may be hedged through the use of
Primary distributors include investment dealers currency forwards, futures, swaps, and options.
and Canadian chartered banks. The effectiveness of a particular hedge depends
on the yield curve and basis risk. For example,
hedging a position in a 10-year Canadas future
Buy Side with an overhedged position in a 5-year bond
may expose the dealer to yield-curve risk. Hedg-
A wide range of investors use Canadas for ing a 30-year bond with a Canadas future
investing, hedging, and speculation, including exposes the dealer to basis risk if the historical
domestic banks, trust and insurance companies, price relationships between futures and cash
and pension funds. The largest Canadian holders markets are not stable. Also, if a position in
of Canadas are trust pension funds, insurance notes or bonds is hedged using an over-the-
companies, chartered banks, and the Bank of counter option, the relative illiquidity of the
Canada. option may diminish the effectiveness of the
Foreign investors are also active participants hedge.
in the Canadian government bond market. In
general, foreign market participants are institu-
tional investors such as banks, securities firms, RISKS
life insurance companies, and fund managers.
Liquidity Risk
The Canadian bond market is considered to be
Market Transparency one of the most liquid bond markets in the
world, with Canadas traded actively in both
Price transparency is relatively high for Canadas
domestic and international capital markets. Most
and several information vendors disseminate
investment dealers in Canadas will make mar-
prices to the investing public. Trading of Cana-
kets on all outstanding issues. The most liquid
das, both domestically and internationally, is
issues are the short-term issues of less than
active and prices are visible.
10 years, but several 15-year and 30-year Cana-
das are actively traded and very liquid. All
government bond issues are reasonably liquid
PRICING when their outstanding size, net of stripping, is
over C$1 billion. ‘‘Orphaned’’ issues, small
Bonds trade on a clean-price basis (net of
issues that are not reopened, are the only Cana-
accrued interest) and are quoted in terms of a
das that are very illiquid because they are not
percentage of par value, with the fraction of a
actively traded.
percent expressed in decimals. Canadas typi-
cally trade with a 1⁄8- to 1⁄4-point spread between
bid and offer prices. Canadas do not trade
ex-dividend. If a settlement date occurs in the Interest-Rate Risk
two weeks preceding a coupon payment date,
the seller retains the upcoming coupon but must Canadas are subject to price fluctuations due to
compensate the buyer by postdating a check changes in interest rates. Longer-term issues
payable to the buyer for the amount of the tend to have more price volatility than shorter-
coupon payment. term issues and, therefore, a large concentration
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Canadian Government Bonds 4210.1
of longer-term maturities in a bank’s portfolio derivatives used as investments or for hedging
may subject the bank to a high degree of purposes is determined by Statement of Finan-
interest-rate risk. cial Accounting Standards No. 133 (FAS 133),
‘‘Accounting for Derivatives and Hedging
Activities.’’ (See section 2120.1, ‘‘Accounting,’’
Foreign-Exchange Risk for further discussion.)
Due to the low volatility of the Canadian dollar
exchange rate, there has been a low level of RISK-BASED CAPITAL
foreign-exchange risk associated with Canadian WEIGHTING
bonds. To the extent that this risk exists, it can
be easily reduced by using foreign-currency Canadas are assigned to the 0 percent risk-
derivatives instruments as described above. weight category.
Political Risk
LEGAL LIMITATIONS FOR BANK
A change in the political environment, withhold- INVESTMENT
ing tax laws, or market regulation can have an
adverse impact on the value and liquidity of an Canadas are type III securities. As such, a
investment in foreign bonds. Investors should be bank’s investment in them is limited to 10 per-
familiar with the local laws and regulations cent of its equity capital and reserves.
governing foreign bond issuance, trading, trans-
actions, and authorized counterparties.
REFERENCES
ACCOUNTING TREATMENT Crossan, Ruth, and Mark Johnson, ed. ‘‘Cana-
dian Dollar.’’ The Guide to International Capi-
The accounting treatment for investments in tal Markets 1991. London: Euromoney Pub-
foreign debt is determined by the Financial lications PLC, 1991, pp. 37–49.
Accounting Standards Board’s Statement of Fabozzi, Frank J. Bond Markets, Analysis, and
Financial Accounting Standards No. 115 (FAS Strategies. 3d ed. Upper Saddle River, N.J.:
115), ‘‘Accounting for Certain Investments in Prentice-Hall, 1996.
Debt and Equity Securities,’’ as amended by Fabozzi, Frank J., and T. Dessa Fabozzi, ed. The
Statment of Financial Accounting Standards No. Handbook of Fixed Income Securities. 4th ed.
140 (FAS 140), ‘‘Accounting for Transfers and New York: Irwin, 1995.
Servicing of Financial Assets and Extinguish- J.P. Morgan Securities. Government Bond Out-
ments of Liabilities.’’ Accounting treatment for lines. 9th ed. April 1996.
Trading and Capital-Markets Activities Manual September 2001
Page 3
French Government Bonds and Notes
Section 4215.1
GENERAL DESCRIPTION France’s Saturne system. Internationally, BTANs
and BTFs settle three days after the trade date.
The French Treasury is an active issuer of three Like OATS, BTANs and BTFs may also be
types of government debt securities, which cover cleared through Euroclear or Cedel. Interest on
all maturities. Obligation Assimilable du Tresor all government bonds and notes is calculated
(OATs), issued since 1985, are the French gov- using a 30/360-day count convention in which
ernment’s long-term debt instruments with each month is assumed to have 30 days.
maturities of up to 30 years. Bons du Tresor a Since May 1991, French government securi-
Taux Fixe et Interest Annuel (BTANs) are ties primary dealers, Specialistes en Valuers du
medium-term, fixed-rate notes with maturities Tresor (SVTs), have been allowed to strip most
of up to five years. The French Treasury also long-term OATs. Primary dealers may strip
issues discount Treasury bills, Bons du Tresor a OATs denominated in either FFr or ECUs and
Taux Fixe et Interest Precomptes (BTFs), with subsequently reconstitute them. All stripped cou-
maturities of up to one year. In addition, an pons carry a face value of FFr 5 (ECU 1.25).
active market for stripped OATs has developed This is done to ensure the fungibility of receipts
since May 1991. Stripping involves separating a that have the same maturities but are derived
bond’s interest and principal payments into from OATs of different maturities.
several zero-coupon bonds.
French government securities are mainly
denominated in French francs (FFr). However, USES
the Treasury has also been issuing OATs and
BTANs in European Currency Units (ECUs) French government securities are used for invest-
since 1989 and 1993, respectively. Until 1985, ment, hedging, and speculative purposes. They
the French Treasury issued bonds known as are considered attractive for investment pur-
Emprunts d’Etats. However, these bonds are poses by foreign and domestic investors because
approaching the end of their trading life and are of the market’s liquidity, lack of credit risk, and
illiquid. The following discussion will focus on wide range of maturities and structures (for
OATs, BTANs, BTFs, and stripped securities. example, fixed vs. floating rate). Foreign inves-
tors often choose to invest internationally to
enhance the diversification of their investment
CHARACTERISTICS AND portfolios or derive higher returns. Stripped
FEATURES OATs can be used as tools for hedging or asset
liability management purposes, for example, to
The French Treasury issues OATs in units of FFr immunize a portfolio in terms of interest-rate
2,000 (ECU 500), with maturities of up to risk. Speculators also use OATs, BTANs, and
30 years. Most OATs carry a fixed interest rate stripped OATs to take positions on the direction
and have bullet maturities. However, some OATs of interest-rate changes and yield curve shifts.
are issued with floating rates that are referenced Finally, there is an active market for futures and
to various short-term or long-term indexes. OATs options on French government securities traded
generally pay interest annually. OATs are settled on the Marche a terme international de France
three days after the trade date (T+3), both (Matif), the Paris financial futures exchange.
domestically and internationally. OATs are
cleared through the SICOVAMs Relit system
domestically, while OATs that settle internation- DESCRIPTION OF
ally are cleared through Euroclear or Cedel. MARKETPLACE
BTANs and BTFs are issued in units of FFr 1
million (ECU 1,000). All BTANs are fixed-rate, Issuing Practices
bullet maturity notes with maturities of up to
five years. Interest on BTANs is paid annually The French Treasury issues OATs, BTANs, and
on the 12th of the month. Domestic settlement BTFs through Dutch Auction. The Treasury
for BTANs and BTFs usually occurs one day usually issues tranches of securities that are part
after the trade date (T+1) through the Bank of of a single borrowing line. The auction schedule
Trading and Capital-Markets Activities Manual February 1998
Page 1
4215.1 French Government Bonds and Notes
is generally announced several months in wide range of institutional investors, both inter-
advance. Securities are supplied at the price or national and domestic. This includes insurance
effective rate tendered by the bidder rather than companies, pension funds, mutual funds, and
the marginal price or rate. The highest bids are commercial and investment banks.
filled first, followed by lower bids. Although
bidding is open to any institution that has an
account with the SICOVAM, Saturne, or Bank Market Transparency
of France, SVTs account for 90 percent of the
securities bought in the primary market. SVTs The market of French government bonds is
also quote two-way prices on a when-issued active and market transparency is relatively high
basis several business days before an auction. for most issues. The French Treasury regularly
publishes the debt issuance schedule and other
information on the management of its debt.
Secondary Market Auction results, trading information, and prices
for most issues are available on interdealer
There is an active secondary market for most broker screens such as Reuters, Telerate, and
issues of French government securities. OATs, Bloomberg.
BTANs, and BTFs are listed on the Paris Stock
Exchange, but are principally traded over the
counter. SVTs are responsible for making mar-
kets in these securities and account for most of
PRICING
the trading activity. However, other broker-
OATs are quoted as a percentage of par to two
dealers, banks, and specialized financial institu-
decimal places. For example, the price quote of
tions are also active participants in the second-
106.85 refers to an OAT that is trading at
ary market. Since 1994, the repo market in
106.85 percent of its par value. Strips are quoted
French government securities has grown consid-
on the basis of their yield. BTANs and BTFs are
erably. The repo market, also managed by the
quoted on an annual-yield basis to two decimal
SVTs, allows investors to finance short-term
places.
positions.
Market Participants HEDGING
Sell Side The interest-rate risk of French government
securities can be hedged in the futures or options
Since 1987, a network of primary government market at the Matif or by taking a contra
securities dealers, known as Specialistes en position in another French government security.
Valuers de Tresor (SVTs), has managed the Swaps and options can also be used to hedge
market for French government securities. The interest-rate risk. The effectiveness of a particu-
SVTs work closely with the French Treasury in lar hedge is dependent on yield curve and basis
determining issuance policy, market conditions, risk. For example, hedging a position in a
and prices. SVTs are required to quote prices for five-year note with an overhedged position in a
clients and other primary dealers in tradeable three-year note may expose the dealer to yield
securities and are responsible for the mainte- curve risk. Hedging a 30-year bond with a
nance of liquid primary and secondary markets. treasury bond future exposes the dealer to basis
In exchange, the French Treasury permits SVTs risk if historical price relationships between
to strip and reconstitute OATs and participate in futures and cash markets are not stable. Also, if
noncompetitive bidding. a position in notes or bonds is hedged using an
OTC option, the relative illiquidity of the option
may diminish the effectiveness of the hedge.
Buy Side International investors are also exposed to
foreign-exchange risk. Foreign-exchange risk
French government securities are used for invest- can be hedged using currency forwards, futures,
ment, hedging, and speculative purposes by a swaps, or options. An international investor can
February 1998 Trading and Capital-Markets Activities Manual
Page 2
French Government Bonds and Notes 4215.1
use a series of forward foreign-exchange con- French franc. Several factors affect the volatility
tracts corresponding to each of the coupon of a foreign-exchange rate, including the coun-
payments and the final principal payment to try’s balance of payments and prospective
hedge this risk. Swaps, futures contracts, or changes in that balance, inflation and interest-
currency options, traded either on the Matif or rate differentials between countries, the social
OTC, can also be used to hedge currency risk. and political environment, relative changes in
the money supply, and central bank intervention
in the currency markets. Traditionally, the French
RISKS foreign-exchange rate has been relatively stable.
Liquidity Risk
French bonds are among the most liquid in
Political Risk
Europe. Because the French Treasury issues
A change in the political environment, withhold-
OATs and BTANs as tranches of existing bonds,
ing tax laws, or market regulation can have an
most bond issues have sizable reserves and
adverse impact on the value and liquidity of an
liquidity. SVTs make a market in French gov-
investment in foreign bonds. Investors should be
ernment bonds, a practice that enhances liquid-
familiar with the local laws and regulations
ity of the market. The most recently issued
governing foreign bond issuance, trading, trans-
10-year OAT generally serves as the benchmark,
actions, and authorized counterparties.
and is thus the most liquid of these issues. For
the medium-term market, the most recent issues
of two- and five-year BTANs serve as the
benchmark. Next to the U.S. Treasury strip ACCOUNTING TREATMENT
market, French strips are the most liquid in the
world. As stated above, the face value of all The accounting treatment for investments in
stripped OATs is FFr 5 ensuring the fungibility foreign debt is determined by the Financial
of coupons of different maturities. Because pri- Accounting Standards Board’s Statement of
mary dealers may reconstitute strips at any time, Financial Acounting Standards No. 115 (FAS
their liquidity is comparable to the reference 115), ‘‘Accounting for Certain Investments in
OAT. Debt and Equity Securities,’’ as amended by
Statement of Financial Accounting Standards
No. 140 (FAS 140), ‘‘Accounting for Transfers
Interest-Rate Risk and Servicing of Financial Assets and Extin-
guishments of Liabilities.’’ Accounting treat-
From the perspective of an international inves- ment for derivatives used as investments or for
tor, the market risk of French government bonds hedging purposes is determined by Statement of
consists primarily of interest-rate risk and Financial Accounting Standards No. 133 (FAS
foreign-exchange risk. The interest-rate risk of a 133), ‘‘Accounting for Derivatives and Hedging
French government bond depends on its dura- Activities.’’ (See section 2120.1, ‘‘Accounting,’’
tion and the volatility of French interest rates. for further discussion.)
Bonds with longer durations are more price
sensitive to changes in interest rates than bonds
with shorter durations. Because they are zero-
coupon instruments, French strips have longer
RISK-BASED CAPITAL
durations than OATs of comparable maturity, WEIGHTING
and they are more volatile.
French government bonds and notes are assigned
to the 0 percent risk-weight category.
Foreign-Exchange Risk
From the perspective of an international inves- LEGAL LIMITATIONS FOR BANK
tor, the total return from investing in French INVESTMENT
government securities is partly dependent on the
exchange rate between the U.S. dollar and the French government bonds and notes are type III
Trading and Capital-Markets Activities Manual September 2001
Page 3
4215.1 French Government Bonds and Notes
securities. A bank’s investment in them is lim- Fabozzi, Frank J., and T. Dessa Fabozzi, ed. The
ited to 10 percent of its equity capital and Handbook of Fixed Income Securities. 4th ed.
reserves. New York: Irwin, 1995.
French Treasury. ‘‘Documents on French Finan-
cial Markets.’’ Retrieved January 1997 from
REFERENCES the Internet.
Fabozzi, Frank J., and Franco Modigliani. Capi- J.P. Morgan Securities. Government Bond Out-
tal Markets: Institutions and Instruments. lines. 9th ed. April 1996.
Englewood Cliffs, N.J.: Prentice-Hall, 1992.
Fabozzi, Frank J. Bond Markets, Analysis, and
Strategies. 3d ed. Upper Saddle River, N.J.:
Prentice-Hall, 1996.
September 2001 Trading and Capital-Markets Activities Manual
Page 4
German Government Bonds and Notes
Section 4220.1
GENERAL DESCRIPTION medium-term notes with four- to six-year matu-
rities (Schätze) were issued irregularly by the
The federal government of Germany issues federal government, the Unity Fund, and the
several types of securities: bonds (Bunds), notes Federal Post Office and Railway. However, in
(Bobls and Schätze) and Treasury discount paper 1995, the Ministry of Finance decided to dis-
(U-Schätze). Government agencies such as the continue the issuance of these securities to
Federal Post Office and the Federal Railway create more transparency in the market. All
have also issued bonds (Posts and Bahns) and Bobls and existing Schätze issues are fixed-
notes (Schätze). In addition, with the unification coupon securities with bullet maturities.
of West and East Germany in October 1990, the Stock-exchange settlement takes place two
German Unity Fund began to issue Unity Fund market days after trade date (T+2). International
bonds (Unities) and notes (Schätze). The out- settlement takes place three business days after
standing debt issues of the Post Office, Railway, trade date (T+3). As of January 1, 1994, German
and Unity Fund have since been folded into the federal government notes and bonds no longer
so-called Debt Inheritance Fund, which has led trade ex-coupon. They trade on a cum-coupon
to an explicit debt service of these issues through basis; the purchaser of the bond pays the seller
the federal government. Hence, these issues are accrued interest from the last coupon date to
guaranteed by the full faith and credit of the settlement. Interest is accrued on a 30/360-day-
federal government. All government-guaranteed count basis in which each month is assumed to
securities are available in book-entry form only. have 30 days and a year is assumed to have 360
The government also issues U-Schätze, zero- days.
coupon Treasury notes with maturities of one to
two years which may not be purchased by
foreigners, and short-term Treasury bills, with USES
one-half- to one-year maturities, which may be
purchased by foreigners. However, the second- German government bonds and notes are used
ary market for these instruments is small and for investment, hedging, and speculative pur-
does not attract substantial foreign investment. poses. Foreign investors, including U.S. banks,
Therefore, the following discussion will focus often purchase German government securities as
on bonds and notes. a means of diversifying their securities port-
folios. In particular, the low credit risk and deep
liquidity of German government bonds and
CHARACTERISTICS AND notes encourages the use of these instruments as
FEATURES non-U.S. investment vehicles. German govern-
ment securities may also be used to hedge
Bunds are issued regularly, usually in deutsche- German interest-rate risk or foreign-currency
marks (DM) 20 billion to DM 30 billion blocks, risk related to positions in deutschemarks. Specu-
with maturities ranging from 8 to 30 years. lators may use German government bonds to
Bunds are issued in a minimum denomination of take positions on changes in the level and term
DM 1,000, and a typical issue carries a maturity structure of German interest rates or on changes
of 10 years. Bunds are redeemable in a lump in the foreign-exchange rates between Germany
sum at maturity at face value (bullet structure) and the United States. Because it is a deep and
with interest paid annually. Until 1990, all bonds efficient market, some German futures contracts
issued by the federal government and other and options are priced relative to Bund issues.
public authorities were noncallable and bore a
fixed coupon. However, since February 1990,
some callable floating-rate bonds have been DESCRIPTION OF
issued. MARKETPLACE
Special five-year federal notes (Bobls) have
been issued by the federal government since Issuing Practices
1979, but foreign investment in these securities
has been permitted only since 1988. In the past, Bunds are issued using a combination of syndi-
Trading and Capital-Markets Activities Manual February 1998
Page 1
4220.1 German Government Bonds and Notes
cation and bidding procedures. Part of the Secondary Market
issue is offered at fixed terms to the members of
the Federal Bond Consortium, which consists of German bonds are listed and traded on all eight
German banks, foreign banks in Germany, and German stock exchanges seven days after they
the Deutsche Bundesbank (German Central are issued. Bobl issues are officially listed on the
Bank). The Bundesbank is the lead bank in the stock exchanges after the initial selling period of
syndicate and determines the allocation of the one to three months. In addition to the stock-
offerings among the syndicate members. These exchange transactions, substantial (OTC) over-
allocations are changed infrequently. During the-counter trading occurs. In Germany, the
the syndicate meeting, the coupon rate, matur- secondary market for both stocks and bonds is
ity, and issue price are determined by the gov- primarily an interbank market.
ernment and syndicate, although the total size For some issues, prices are fixed once during
of the issue is unknown. Syndicate members stock-exchange hours (stock-exchange fixing
receive a fee from the government for takes place from 11:00 a.m. to 1:30 p.m. Green-
selling bonds received through syndicate wich mean time +1). However as of October 3,
negotiations. 1988, variable trading was introduced at the
A further tranche is issued to the syndicate German stock exchanges for Bunds, Bobls,
by means of an American-style auction. The Bahns, and Posts issued after January 2, 1987,
terms—coupon rate, maturity, and settlement with a minimum size of DM 2 billion. The Unity
date—are the same as those determined in the Fund issues also participate. After the fixing of
syndicate meeting, although the overall size of the prices on the stock exchanges, the securities
the issue is not specified. The German Central are traded on the OTC market (OTC hours are
Bank accepts bids starting with the highest price from 8:30 a.m. to 5:30 p.m.). Bunds are typi-
and accepts lower bids until the supply of cally quoted in the OTC market on the basis of
securities it wishes to sell is depleted. Noncom- a difference from the fixing price, for example, a
petitive bids may also be submitted, which are price quote of −10 means a price of 10 pfennigs
filled at the average accepted price of the auc- (1⁄100 of a DM) less than the fixing price.
tion. The size of the issue is announced after the Seventy to 80 percent of the secondary-
auction. The difference between the issue size market trading of Bunds, Bahns, and Posts takes
and the amount that has been issued through the place in the OTC market. About 75 percent of
underwriting syndicate plus the auction is Bobl trading takes place in the OTC market, as
retained by the Bundesbank for its bond market does most Schätze trading. However, the stock
operations. markets are important because the prices deter-
Bobls are issued on a standing-issue basis mined there provide standard, publicly available
(similar to a tap form in which a fixed amount of benchmarks.
securities at a fixed price is issued when market
conditions are considered favorable) with stated
coupon and price. During the initial selling
period, which may last a few months, the price Market Participants
is periodically adjusted by the Ministry of
Finance to reflect changes in market conditions. Sell Side
The sales of a given series are terminated when
either the issuing volume has been exhausted or The underwriting of public authority bonds is
the nominal interest rate has moved too far away done by the Federal Bond Syndicate, which
from the going market rate. The new series is consists of German banks, foreign banks in
launched within a short period of time. Only Germany, and the Deutsche Bundesbank (Ger-
domestic private individuals and domestic non- man Central Bank). German banks are respon-
profit institutions are permitted to purchase the sible for placing Bobls with qualified investors.
issues in the primary market. German banks
(which cannot purchase these securities for their
own account) receive a commission for selling Buy Side
the bonds to qualified investors. After the selling
period is over and an issue is officially listed on Domestic banks are the largest holders of
the German stock exchange, the securities may German bonds, and private German individuals
be purchased by any investor. are the second largest investment group due in
February 1998 Trading and Capital-Markets Activities Manual
Page 2
German Government Bonds and Notes 4220.1
part to the propensity of German households to RISKS
save and invest their savings. German insurance
companies are also major holders of German Liquidity Risk
bonds, as are German investment funds. Foreign
investors, such as U.S. commercial and invest- The German government bond market is the
ment banks, insurance companies, and money third largest bond market in the world and is
managers also hold German government considered the most liquid government bond
securities. market after the U.S. government bond market.
Bunds are the most liquid and actively traded
bond issues in Germany. Unities issued by the
German Unity Fund are generally as liquid as
Market Transparency Bunds, but Bahn and Post issues of government
agencies are fairly limited compared with the
The market for German government bonds and federal government’s bonds. Therefore, these
notes is active and liquid, and price transparency agency securities tend to be less liquid and
is considered to be relatively high for these generally trade at a higher yield than Bunds.
securities. Several vendors, including Reuters The on-the-run (most recent) Bund issue is
and Telerate, disseminate price information to the most liquid of its category and serves as the
the investing public. benchmark. The most liquid area of the Bund
yield curve is in the eight- to-10-year maturity
range, as most Bund issues carry a 10-year
maturity. Similar to Bunds, on-the-run Bobls are
PRICING the most liquid type of note. Off-the-run prices
are not as transparent as current coupon securi-
Bonds and notes are quoted as a percentage of ties, which makes these issues less liquid and
par to two decimal places. For example, a price trading more uncertain. Of course, larger issues
of 98.25 means that the price of the bond or note of bonds and notes are generally more liquid
is 98.25 percent of par. Bonds are traded on a than smaller ones.
price basis, net of accrued interest (clean). At the stock exchange, the German Central
Prices generally move in increments of five Bank makes a market in Bunds, Bobls, Unities,
pfennigs. The bid/offer spread is usually eight and Post issues. The German Central Bank is
pfennigs for liquid issues and 15 pfennigs for responsible for maintaining an orderly second-
less-liquid issues. For notes, bid/offer spreads ary market in these securities and regularly
are five to 10 pfennigs for liquid issues. intervenes to support or regulate their prices.
This tends to increase the liquidity in the market
for these issues. However, the Bundesbank is
HEDGING not responsible for stabilizing Schätze prices.
For this reason, these securities tend to be much
Interest-rate risk can be hedged using swaps, less liquid than Bunds or Bobls; their issue sizes
forwards, futures, or options, or by taking a are also normally much smaller. The Railway
contra position in another German government Bank makes a market in Bahn issues, which
security. The effectiveness of a particular hedge enhances the liquidity of these issues.
is dependent on yield-curve and basis risk. For
example, hedging a position in a five-year note
with an overhedged position in a three-year note Interest-Rate Risk
may expose the dealer to yield-curve risk. Hedg-
ing a 30-year bond with a bond future exposes German bonds and notes are subject to price
the dealer to basis risk if the historical price fluctuations due to changes in German interest
relationships between futures and cash markets rates. The variation in the term structure of
are not stable. Also, if a position in notes and interest rates accounts for the greatest amount of
bonds is hedged using an OTC option, the local market risk related to foreign bonds.
relative illiquidity of the option may diminish Longer-term issues have more price volatility
the effectiveness of the hedge. Foreign-exchange due to interest-rate fluctuations than do shorter-
risk may be hedged with currency swaps, for- term instruments. Therefore, a large concentra-
wards, futures, and options. tion of long-term maturities may subject a bank’s
Trading and Capital-Markets Activities Manual September 2001
Page 3
4220.1 German Government Bonds and Notes
investment portfolio to unwarranted interest-rate No. 140 (FAS 140), ‘‘Accounting for Transfers
risk. and Servicing of Financial Assets and Extin-
guishments of Liabilities.’’ Accounting treat-
ment for derivatives used as investments or for
Foreign-Exchange Risk hedging purposes is determined by Statement of
Financial Accounting Standards No. 133 (FAS
Currency fluctuations can account for up to 133), ‘‘Accounting for Derivatives and Hedging
two-thirds of the return and risk of an unhedged Activities.’’ (See section 2120.1, ‘‘Accounting,’’
international fixed-income portfolio. There are for further discussion.)
two types of currency risk related to foreign
bonds: (1) the coupons and face value are paid
in the foreign currency, which means that any
change in the exchange rate affects the bond’s
RISK-BASED CAPITAL
value to the U.S. investor, and (2) the bond’s WEIGHTING
yield may be affected by currency movements.
A number of factors exert a direct influence German government bonds and notes are
on foreign-exchange rates, including the balance assigned to the 0 percent risk-weight category.
of payments and prospective changes in that
balance; inflation and interest-rate differentials
between Germany and the United States; the LEGAL LIMITATIONS FOR BANK
social and political environment in Germany,
particularly with regard to the impact on foreign
INVESTMENT
investment; and central bank intervention in the
German government bonds and notes are type III
currency markets. Historically, German exchange
securities. As such, a bank’s investment in them
rates have been very stable.
is limited to 10 percent of its equity capital and
reserves.
Political Risk
A change in the political environment, withhold- REFERENCES
ing tax laws, or market regulation can have an
adverse impact on the value and liquidity of an Fabozzi, Frank J., and Franco Modigliani. Capi-
investment in foreign bonds. Investors should be tal Markets: Institutions and Instruments.
familiar with the local laws and regulations Englewood Cliffs, N.J.: Prentice-Hall, 1992.
governing foreign bond issuance, trading, trans- Fabozzi, Frank J. Bond Markets, Analysis, and
actions, and authorized counterparties. Strategies. 3d ed. Upper Saddle River, N.J.:
Prentice-Hall, 1996.
Fabozzi, Frank J., and T. Dessa Fabozzi, ed. The
ACCOUNTING TREATMENT Handbook of Fixed Income Securities. 4th ed.
New York: Irwin, 1995.
The accounting treatment for investments in J.P. Morgan Securities. Government Bond Out-
foreign debt is determined by the Financial lines. 9th ed. April 1996.
Accounting Standards Board’s Statement of Urich, Thomas J. U.K., German and Japanese
Financial Accounting Standards No. 115 (FAS Government Bond Markets. Monograph
115), ‘‘Accounting for Certain Investments in Series in Finance and Economics. New York:
Debt and Equity Securities,’’ as amended by New York University Salomon Center at the
Statement of Finanical Accounting Standards Leonard N. Stern School of Business, 1990.
September 2001 Trading and Capital-Markets Activities Manual
Page 4
Irish Government Bonds
Section 4225.1
GENERAL DESCRIPTION system, and the rest of the bonds are issued by
regular auctions. Taps are sales of a fixed
Irish government bonds (IGBs) are issued by the amount of securities at a fixed price when
National Treasury Management Agency market conditions are considered favorable. The
(NTMA), which is responsible for the manage- type of bond and size of the tap issue are
ment of Ireland’s national debt. Bonds are communicated to the market, but the price is
issued to fund the government’s borrowing only communicated to the primary dealers who
requirements and to fund maturing bond issues. bid by telephone. The auction system has both a
competitive and noncompetitive element. The
competitive auction is open to all investors who
CHARACTERISTICS AND may bid directly or via a primary dealer or
FEATURES stockbroker. Following the auction, noncompeti-
tive bids are filled at the average auction price.
Bonds are issued in maturities of 5, 10, and Only primary dealers may submit noncompeti-
20 years. Issues are transferable in any amount tive bids.
and are listed and traded on the Irish stock
exchange. Fixed-rate bonds issued before 1993
pay interest semiannually, while bonds issued Secondary Market
since then pay interest annually. Coupons on
variable-rate bonds are paid quarterly. Interest is IGBs are listed on the Dublin, Cork, and London
accrued from the coupon payment date to the Stock Exchanges. They are also traded in the
settlement date, and bonds go ex-dividend on over-the-counter (OTC) market.
the Wednesday nearest to three weeks before the
coupon is paid. Interest is computed using the
actual/365 day-count convention on semiannual
coupon bonds and using the 30/365 day-count Market Participants
convention on annual coupon bonds. Settlement Sell Side
is done the day after the trade date (T+1)
domestically and three days after the trade date Six primary dealers quote firm bid and offer
(T+3) internationally. IGBs are available in prices in each of a specified list of eight bonds.
registered form and are cleared through the In return for their market-making services, the
Central Bank of Ireland Securities Settlement NTMA provides these dealers with exclusive
System (CBISS). access to the supply of bonds issued in tap form.
The designated brokers are CS First Boston,
UBS Ltd., Davy, Goodbody, NCB, and Riada.
USES
Irish government bonds and notes are used for Buy Side
investment, hedging, and speculative purposes,
by both domestic (Irish) and foreign investors The principal holders of IGBs are domestic
and traders. U.S. banks purchase Irish govern- (Irish) and foreign institutional investors, such
ment bonds to diversify their portfolios, specu- as banks, securities firms, insurance companies,
late on currency and Irish interest rates, and pension funds, and money managers.
hedge Irish-denominated currency positions and
positions along the Irish yield curve.
Market Transparency
DESCRIPTION OF
MARKETPLACE Price transparency is relatively high for Irish
government securities as a result of the structure
Issuing Practices of the primary dealer system, which enhances
liquidity. Several information vendors dissemi-
About 80 percent of issuance is by the tap nate prices to the investing public.
Trading and Capital-Markets Activities Manual September 2001
Page 1
4225.1 Irish Government Bonds
PRICING familiar with the local laws and regulations
governing foreign bond issuance, trading, trans-
Bonds are quoted as a percent of par to two actions, and authorized counterparties.
decimal places. The price paid by the buyer does
not include accrued interest. The bid/offer spread
ranges from .05 to .20 basis points, depending ACCOUNTING TREATMENT
on the liquidity of the issue.
The accounting treatment for investments in
foreign debt is determined by the Financial
HEDGING Accounting Standards Board’s Statement of
Financial Accounting Standards No. 115 (FAS
Interest-rate risk may be hedged by taking 115), ‘‘Accounting for Certain Investments in
contra positions in government securities or by Debt and Equity Securities,’’ as amended by
using swaps or futures. Foreign-exchange risk Statement of Financial Accounting Standards
can be hedged by using currency swaps, futures, No. 140 (FAS 140), ‘‘Accounting for Transfers
or forward rate agreements. and Servicing of Financial Assets and Extin-
guishments of Liabilities.’’ Accounting treat-
ment for derivatives used as investments or for
RISKS hedging purposes is determined by Statement of
Finanical Accounting Standards No. 133 (FAS
Liquidity Risk 133), ‘‘Accounting for Derivatives and Hedging
Activities.’’ (See section 2120.1, ‘‘Accounting,’’
Active portfolio management, the wide range of for further discussion.)
coupons and maturities available, and the devel-
opment of a trading, rather than a purely invest-
ment outlook, among Irish investors has increased
the liquidity of the Irish government bond mar- RISK-BASED CAPITAL
ket. The large issues tend to be very liquid WEIGHTING
throughout the yield curve, particularly the eight
bonds in which the primary dealers are obliged Irish government bonds are assigned to the
to make markets. 0 percent risk-weight category.
Interest-Rate Risk LEGAL LIMITATIONS FOR BANK
INVESTMENT
IGBs are exposed to interest-rate risk as a result
of the inverse relationship between bond prices Irish government bonds are type III securities.
and interest rates. Longer-term issues have more As such, a bank’s investment in them is limited
price volatility than short-term instruments. to 10 percent of its equity capital and reserves.
Foreign-Exchange Risk REFERENCES
Currency fluctuations may affect the bond’s Crossan, Ruth, and Mark Johnson, ed. The
yield as well as the value of coupons and Guide to International Capital Markets 1991.
principal paid in U.S. dollars. London: Euromoney Publications PLC,
pp. 37–49, 1991.
Fabozzi, Frank J., and Franco Modigliani. Capi-
Political Risk tal Markets: Institutions and Instruments.
Englewood Cliffs, N.J.: Prentice-Hall, 1992.
A change in the political environment, withhold- J.P. Morgan Securities. Government Bond Out-
ing tax laws, or market regulation can have an lines. 9th ed. April 1996.
adverse impact on the value and liquidity of an Kemp, L.J. A Guide to World Money and Capi-
investment in foreign bonds. Investors should be tal Markets. New York: McGraw Hill, 1981.
September 2001 Trading and Capital-Markets Activities Manual
Page 2
Irish Government Bonds 4225.1
Linnane, Carmel. ‘‘Death Knell Tolls for Irish O’Sullivan, Jane. ‘‘Ireland Begins Market Mak-
Futures Exchange.’’ Reuters European Busi- ing in Government Bonds.’’ Reuters Euro-
ness Report. August 8, 1996. pean Business Report. December 4, 1995.
Trading and Capital-Markets Activities Manual April 2001
Page 3
Italian Government Bonds and Notes
Section 4230.1
GENERAL DESCRIPTION Treasury notes with options, or Certificati del
Tesoro con Opzione (CTOs), are fixed-coupon
The Italian Treasury issues bonds, notes, and securities with an embedded put. The embedded
bills, which are guaranteed by the Italian option in the CTO permits investors to redeem
government. These securities are issued with the bond halfway through nominal maturity, and
maturities ranging from three months to 30 it is designed to encourage investors to extend
years in a wide variety of structures. These their investment horizons. Any request for
structures include Treasury bonds, Treasury refunding must be forwarded within an 11-day
floating-rate notes, Treasury notes with a put period beginning precisely one month before the
option, and short-term Treasury bills. The Trea- scheduled date for anticipated redemption. The
sury also issues notes and bills denominated bonds are issued in maturities similar to BTPs.
in European Currency Units (ECUs). Govern- The Treasury has not issued any CTOs since
ment securities are issued in book-entry form May 1992.
but may be converted to bearer form following Treasury notes denominated in ECUs, or
issuance. Certificati del Tesoro in ECU (CTEs), were
introduced by the Italian government in 1982 as
part of an effort to diversify the instruments
issued for financing public deficits. They are
CHARACTERISTICS AND fixed-coupon ECU-denominated bonds issued in
denominations of ECU 5,000, 10,000, 100,000,
FEATURES 500,000, and 1 million, generally with a
Treasury bonds, or Buoni del Tesero Poliennali five-year maturity. The foreign-currency weight-
(BTPs), are fixed-coupon medium- to long-term ing of the CTEs is attractive to investors who
government bonds with semiannual dividend fear devaluation of Italian exchange rates.
payments. These bonds have played an impor- Interest on these bonds is paid in the form of
tant role in financing the Treasury, especially deferred annual coupons in ECUs or, at the
after the establishment of the Telematic Market holder’s request, in an ECU-equivalent lira
for government bonds, which provides the amount.
liquidity necessary for these instruments. These Domestic and international settlement of Ital-
bonds are issued with 5-, 10-, and 30-year ian government bonds takes place three business
maturities in denominations of lire 5, 10, 50, dates after the trade date (T+3). The only
100, 500, and 1,000 million. Interest on these exception is BOTs, which settle two business
bonds is paid through deferred semiannual dates after the trade date (T+2). Italian govern-
coupons. ment bonds with a coupon can be settled via
Treasury floating-rate notes, or Certificati di Euroclear or Cedel. Settlement through Euro-
Credito del Tesoro (CCTs), are floating-rate clear and Cedel takes five days. Interest is
notes indexed to T-bill rates. CCTs are generally calculated using a 30/360-day count in which
issued in denominations of lire 5, 10, 50, each month is assumed to have 30 days.
100, 500, and 1,000 million, with 7-year matu-
rities, although 5- and 10-year notes have also
become popular. Interest on these bonds is paid
through deferred semiannual or annual dividend USES
coupons, with rates indexed to Italian Treasury
Bill (BOT) yields. For BOTs issued after Decem- Italian government securities are used for invest-
ber 1994, the coupon is calculated by adding a ment, hedging, and speculative purposes. While
spread of 30 basis points to the six-month T-bill investors may buy Italian bonds as part of
recorded in the last auction. For issues before diversifying their investment portfolios, the
December 1994, the coupon is calculated by bonds may also be used to hedge positions that
adding a spread of 30 basis points to the average are sensitive to movements in interest rates.
gross semiannual yields of one-year BOTs auc- Speculators, on the other hand, may use long-
tioned in the second and third months preceding term bonds to take positions on changes in the
the coupon period. level and term structure of interest rates.
Trading and Capital-Markets Activities Manual February 1998
Page 1
4230.1 Italian Government Bonds and Notes
DESCRIPTION OF and CCTs are sold on the third day of the
MARKETPLACE auctions.
The Bank of Italy may reopen issues, that is,
Issuing Practices sell new tranches of existing bonds, until the
level outstanding reaches a certain volume,
Italian government bonds are issued via a mar- generally over lire 10 trillion. After that thresh-
ginal auction, in which there is no base price. old volume is reached, a new bond must be
Each allotment is made at the marginal accepted issued. If an issue is reopened, the Bank of Italy
bid which represents the stop-out price, below issues new tranches of securities with the same
which no bids are considered. Partial allotments maturities, coupons, and repayment characteris-
may be given at the stop-out price if the amount tics as existing debt. The ability to reopen issues
bid at that price exceeds the amount not covered improves liquidity and avoids the potential poor
by the higher-priced bids. Each participant is pricing of securities that often occurs when a
limited to three bids. The exclusion price, or the market is flooded with one very large issue.
price below which no bids will be accepted, is
calculated by listing the bids in decreasing order
and proceeding as follows:
If the amount of competitive bids is greater Secondary Market
than or equal to the amount offered—
Italian government bonds can be traded on any
of the following: the Milan Stock Exchange, the
• take the amount of bids (in a decreasing price
telematic government bond spot market (Mer-
order) needed to cover half the offered amount,
cato Telematico dei Titoli di Stato or MTS), and
• calculate the weighted average of the above
the over-the-counter (OTC) market. Bonds may
set of bids, and
be traded on the Milan Stock Exchange if they
• subtract 200 basis points from the weighted
are transformed into bearer bonds (at least six
average to obtain the exclusion price.
months after being issued). The stock exchange
is the reference market for the small saver as
If the amount of competitive bids is less than the
only small dealings are transacted there. At the
amount offered—
end of the day, the exchange publishes an
official list of the prices and volumes of trading.
• take half of the bids in a decreasing price
The MTS is the reference market for profes-
order,
sional dealers.
• calculate the weighted average of the above
set of bids, and
• subtract 200 basis points from the weighted
average to obtain the exclusion price. MARKET PARTICIPANTS
Once the exclusion yield is calculated, bids Sell Side
are accepted in decreasing order of price. Bids
are accepted to the point that covers the amount Only banks authorized by the government of
to be offered up to the stop-out price. Partial Italy may act as primary dealers of Italian
allotments may be given at the stop-out price if government bonds. Branches of foreign banks
the amount bid at that price exceeds the amount and nonfinancial institutions can also act as
not covered by the higher-priced bids. Noncom- dealers, provided they are residents in the Euro-
petitive bids may also be accepted and awarded pean Union and subject to comparable financial
at the average of accepted competitive bids plus regulations.
a Treasury spread.
The Treasury makes an announcement of
auction dates annually and also makes a quar- Buy Side
terly announcement of the types of bonds and
minimum issue sizes to be offered in the fol- A wide range of investors use Italian govern-
lowing three months. The auctions are held at ment bonds for investing, hedging, and specu-
the beginning and middle of the month. Gener- lation. This includes domestic banks, nonfinan-
ally, 3- and 5-year bills are sold on the same cial corporate and quasi-corporate public and
day, 10- and 30-year bonds are sold together, private enterprises, insurance companies, and
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Italian Government Bonds and Notes 4230.1
private investors. Foreign investors, including bonds is hedged using an OTC option, the
U.S. commercial banks, securities firms, insur- relative illiquidity of the option may diminish
ance companies, and money managers, are also the effectiveness of the hedge.
active in the Italian government bond market.
RISKS
Market Transparency
Liquidity Risk
The Italian government bond market is an active
one. Price transparency is relatively high for The Italian bond market is one of the most liquid
Italian government securities as several infor- markets in the world. Liquidity is maintained by
mation vendors, including Reuters, disseminate 40 market makers, which include 16 specialists,
prices to the investing public. top-tier market makers (Morgan Guaranty,
Milan), and 24 other market makers who are
obligated to quote two-way prices. Ten market
makers have privileged access to the Bank of
PRICING Italy on the afternoon of an auction to buy extra
bonds at the auction price. The purchases are
Prices and yields of Italian government securi-
subject to a limit set by the Bank. For instance,
ties are stated as a percentage of par to two
if a particular issue were oversubscribed and
decimal places. For instance, a price of 97.50
prices were likely to shoot up, the selected
means that the price of the bond is 97.50 percent
market makers would be able to buy more of the
of par. The price spread is generally narrow due
same bond and maintain or increase market
to the efficiency of the market.
liquidity.
Bonds trade on a clean-price basis, quoted net
As discussed above, the Bank of Italy may
of accrued interest. Italian government bonds do
reopen issues until they reach a certain volume
not trade ex-dividend. Interest on Italian bonds
before selling a new bond. The ability to reopen
is accrued from the previous coupon date to the
issues improves liquidity and avoids the unfa-
settlement date (inclusive). In this regard, Italian
vorable pricing which may occur if the market is
bonds pay an extra day of interest compared
flooded with one very large issue. Liquidity is
with other bond markets.
also maintained by limiting the number of gov-
ernment entities that issue debt. In the case of
Italy, only the central government may issue
HEDGING debt securities.
Italian government bonds can be hedged for
interest-rate risk in the Italian futures market
(Mercato Italiano Futures or MIF) as well as the Interest-Rate Risk
London International Financial Futures Exchange
(LIFFE). The MIF and LIFFE offer futures on Italian government bonds are subject to price
10-year Italian government securities, and the fluctuations due to changes in interest rates.
MIF offers futures on five-year Italian govern- Longer-term issues have more price volatility
ment securities. The LIFFE also offers OTC than shorter-term instruments. Therefore, a large
options on individual bonds as well as options concentration of longer-term maturities in an
on futures contracts. OTC forwards and swaps investment portfolio may increase interest-rate
can also be used to hedge interest-rate risk. risk.
The effectiveness of a hedge depends on the
yield-curve and basis risk. For example, hedging
a position in a five-year note with an overhedged Foreign-Exchange Risk
position in a two-year note may expose the
dealer to yield-curve risk. Hedging a 30-year From a U.S. investor’s perspective, there are two
bond with an Italian bond future exposes the types of risk related to foreign bonds: (1) the
dealer to basis risk if the historical price rela- coupons and face value are paid in the foreign
tionships between futures and cash markets are currency, which means that any change in the
not stable. Additionally, if a position in notes or exchange rate affects the bond’s value to the
Trading and Capital-Markets Activities Manual September 2001
Page 3
4230.1 Italian Government Bonds and Notes
U.S. investor, and (2) the bond’s yield may be Financial Accounting Standards No. 133 (FAS
affected by currency movements. A number of 133), ‘‘Accounting for Derivatives and Hedging
factors exert a direct influence on foreign- Activities.’’ (See section 2120.1, ‘‘Accounting,’’
exchange rates, including the balance of pay- for further discussion.)
ments and prospective changes in that balance;
inflation and interest-rate differentials between
Italy and the United States; the social and
political environment in Italy, particularly with
RISK-BASED CAPITAL
regard to the impact on foreign investment; and WEIGHTING
central bank intervention in the currency markets.
Italian government bonds and notes are assigned
to the 0 percent risk-weight category.
Political Risk
A change in the political environment, withhold- LEGAL LIMITATIONS FOR BANK
ing tax laws, or market regulation can have an INVESTMENT
adverse impact on the value and liquidity of an
investment in foreign bonds. Investors should be Italian government notes and bonds are type III
familiar with the local laws and regulations securities. As such, a bank’s investment in them
governing foreign bond issuance, trading, trans- is limited to 10 percent of its equity capital and
actions, and authorized counterparties. reserves.
ACCOUNTING TREATMENT REFERENCES
The accounting treatment for investments in Banca d’Italia. Economic Bulletin. Number 23,
foreign debt is determined by the Financial October 1996.
Accounting Standards Board’s Statement of Euromoney. ‘‘The Banca d’Italia Under Siege.’’
Financial Accounting Standards No. 115 (FAS July 1995.
115), ‘‘Accounting for Certain Investments in Euromoney. ‘‘Central Banks, How Central Banks
Debt and Equity Securities,’’ as amended by Play the Market.’’ September 1992.
Statement of Financial Accounting Standards Fabozzi, Frank J. Bond Markets, Analysis, and
No. 140 (FAS 140), ‘‘Accounting for Transfers Strategies. 3d ed. Upper Saddle River, N.J.:
and Servicing of Financial Assets and Extin- Prentice-Hall, 1996.
guishments of Liabilities.’’ Accounting treat- Roche, David. ‘‘Against the Tide Europe’s Sub-
ment for derivatives used as investments or for merging Bond Market.’’ October 1994.
hedging purposes is determined by Statement of
September 2001 Trading and Capital-Markets Activities Manual
Page 4
Japanese Government Bonds and Notes
Section 4235.1
GENERAL DESCRIPTION considerably from month to month. However,
the most common issue sizes are yen (¥) 50,000,
Japanese government bonds (JGBs) are issued ¥ 100,000, ¥ 1 million, ¥ 10 million, and
by the Japanese national government. The Min- ¥ 100 million. Medium-term coupon bonds
istry of Finance (MOF) authorizes the issuance make interest payments semiannually, and
of coupon and non-coupon-bearing JGBs in a redemption is on the 20th day of the month in
variety of maturities: long-term (10 and which the bond matures.
20 years) and medium-term (two through five Previously, trades in JGBs were settled on the
years). The MOF also issues short-term Trea- 5th, 10th, 15th, 20th, 25th and 30th of each
sury bills, which are issued at a discount with a month, based on trade date. This convention has
maturity of 180 days. JGBs are guaranteed by been replaced by a T+7 (trade date plus seven
the Japanese national government and, there- Japanese business days) settlement method as of
fore, are considered to have very little credit September 19, 1996.
risk.
USES
CHARACTERISTICS AND
FEATURES Domestic and foreign investors use JGBs for
investment, hedging, and speculative purposes.
The two types of long-term bonds are ‘‘long- U.S. investors, including commercial banks, may
term’’ and ‘‘super long-term.’’ The long-term purchase JGBs to speculate on interest rates or
bond, the most common, has a maturity of foreign-exchange rates, to diversify portfolios,
10 years, and the super long-term bond has a to profit from spreads between U.S. and Japa-
20-year maturity. Both long-term and super nese interest rates, and to hedge various
long-term bonds are numbered serially. They are positions.
referred to by number and issue month (for
example, #182 August) rather than by maturity
and coupon. JGB issues are categorized as
construction bonds, deficit financing bonds, or DESCRIPTION OF
refunding bonds, although there is no difference MARKETPLACE
among these bonds from an investment
perspective. Issuing Practices
JGBs are typically issued in registered form
but they may be converted to bearer form within The Bank of Japan (BOJ) is responsible for
two market days of issue. Exchange transactions issuing JGBs in an aggregate amount not to
of registered bonds must be issued in blocks of exceed the limit set by the MOF. JGBs are
1,000. There are no such restrictions for bearer issued monthly by the BOJ by competitive
bonds. JGBs have bullet maturities and are auction and syndicate. A syndicate comprising
callable at any time, although call provisions are banks, life insurance companies, and securities
rarely exercised. Ten-year JGBs maturing after firms underwrite 40 percent of each 10-year
mid-1997 pay interest on the standard March/ issue. The remaining 60 percent are issued via
September or June/December semiannual cou- competitive auction. The coupon size and issue
pon cycle. Twenty-year JGBs, however, pay size are announced on the day of the auction
interest only in March and September. Since after consultation with the syndicate. The aver-
new issues can appear monthly, the practice of age auction price determines the price of the
using quarterly coupon dates leads to odd first syndicated portion. No firm may bid for more
coupons for both 10- and 20-year JGBs. than 30 percent of the tranche issued via com-
The two types of medium-term bonds are petitive auction. All 20-year bonds are issued
coupon bonds and five-year discount, or zero- via fully competitive auction. Medium-term cou-
coupon, bonds. Medium-term coupon bonds are pon bonds are issued primarily through public
issued with maturities of two, three, and four subscriptions, but a certain portion are issued
years. Issue sizes of both types of bonds vary through fixed-rate private placements.
Trading and Capital-Markets Activities Manual February 1998
Page 1
4235.1 Japanese Government Bonds and Notes
Secondary Market Market Participants
Most JGBs are listed on the Japanese stock Sell Side
exchanges, although the majority of JGB trading
JGBs are issued through a syndicate consisting
occurs in the over-the-counter (OTC) market.
of domestic (Japanese) banks, life insurance
While the OTC market is characterized by very
companies, other domestic financial institutions,
large trading volume, stock-exchange trading is
and some foreign securities firms.
important in that it enhances transparency in
pricing—the Tokyo Stock Exchange closing
prices serve as a public pricing source for JGBs.
Long-term government bonds account for the Buy Side
largest share of secondary-market trading of
government securities, partly because they have A wide range of domestic and foreign investors
higher credit ratings and greater marketability use JGBs for investing, hedging, and specula-
than shorter maturity JGBs. In the secondary tion. Japanese financial institutions, particularly
market, the broker and investor negotiate the city, long-term credit, regional banks and insur-
‘‘invoice price,’’ which includes commissions ance companies, tend to be the largest investors
for the agent. in yen-denominated bonds, although corporate
and individual investors are very active inves-
The secondary market for JGBs has some tors in the medium-term government bond mar-
unusual features. The first relates to the bench- ket. Foreign investors, such as U.S. commercial
mark or bellwether bond issue. In the U.S. banks, securities firms, insurance companies,
Treasury market, the on-the-run issue (that is, and money managers, are also active in the
the most recently auctioned issue for a given Japanese government bond market.
maturity) is the benchmark issue for each
maturity. However, the Japanese benchmark
issue is determined through an informal process
that occurs over a few weeks. Benchmark issue
characteristics are as follows: (1) a coupon that MARKET TRANSPARENCY
is near the prevailing rate, (2) a large outstand-
ing amount (approximately ¥ 1.5 trillion or Price transparency is relatively high for JGBs.
more), (3) a wide distribution or placement after JGBs are actively traded and pricing informa-
its issue, and (4) remaining maturity that is very tion is available from a variety of price infor-
close to 10 years. mation services, including Reuters and Telerate.
Another unusual feature of the JGB market is
the so-called reverse coupon effect. In most
bond markets, high-coupon bonds trade at a
higher yield than low-coupon bonds of the same PRICING
duration. This ‘‘coupon effect,’’ which varies
with the duration of the bond as well as over JGB prices are quoted in yield, specifically on
time, is often attributed to such institutional the basis of simple yield, in basis points. Market
factors as different taxation of capital gains and price is calculated from simple yield. The fol-
ordinary income. In Japan, however, there is a lowing formulas are used to calculate price and
strong preference for high-coupon bonds. As a yield:
result, high-coupon bonds trade at lower yields
than low-coupon bonds for the same duration Ys = [C + (100 − P / T] / P, or
(the ‘‘reverse coupon effect’’). This effect occurs P = [(C * T) + 100] / [1 + (T * Ys)],
in spite of the Japanese tax code that requires
income tax to be paid on coupon income but where
generally not on capital gains on Japanese gov-
ernment bonds. Banks prefer coupon interest Ys = simple yield
because banks’ current income ratios are closely C = coupon stated in decimal form
monitored by Japanese bank regulators. P = price
T = time to maturity = number of days to
maturity/365
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Japanese Government Bonds and Notes 4235.1
Discount Bonds is less liquid because such bonds are typically
purchased by individuals and investment trust
Discount bonds are quoted on a simple-yield funds, which tend to be buy-and-hold investors.
basis, which is different from the simple yield The existence of a large and active JGB futures
used on coupon bonds. Simple yield is used for market enhances the liquidity of these issues.
discount bonds with a maturity of less than one
year, but the formula is adjusted to reflect the
fact that discount bonds do not pay interest.
Annually compounded yield is used for discount Interest-Rate Risk
bonds with a maturity greater than one year.
The yield on a discount bond with less than Like all bonds, the price of JGBs will change in
one year remaining to maturity is the value of Ys the opposite direction from a change in interest
that solves— rates. If an investor has to sell a bond before the
maturity date, an increase in interest rates will
P = 100 / (1 + T + Ys). mean the realization of a capital loss (selling the
bond below the purchase price). This risk is by
The yield on a discount bond with more than far the major risk faced by an investor in the
one year remaining to maturity is the value of bond market. Interest-rate risk tends to be greater
Ym that solves— for longer-term issues than for shorter-term
issues. Therefore, a large concentration of long-
P = 100 / (1 + Ym)t, term maturities may subject a bank’s investment
portfolio to unwarranted interest-rate risk.
where t is the number of days to maturity
(excluding leap days) divided by 365.
Foreign-Exchange Risk
HEDGING A non-dollar-denominated bond (a bond whose
payments are made in a foreign currency) has
Because of the multiple risks associated with unknown U.S. dollar cash flows. The dollar-
positions in foreign government bonds, inves- equivalent cash flows depend on the exchange
tors may need to hedge one position in several rate at the time the payments are received. For
markets using various instruments. Interest-rate example, a U.S. bank that purchases a 10-year
risk related to JGBs is typically hedged by JGB receives interest payments in Japanese yen.
taking contra positions in other government If the yen depreciates relative to the U.S. dollar,
bonds or by investing in interest-rate forwards, fewer dollars will be received than would have
futures, options, or swaps. Similarly, foreign- been received if there had been no depreciation.
exchange risk can be reduced by using currency Alternatively, if the yen appreciates relative to
forwards, futures, options, or swaps. the U.S. dollar, the investor will benefit by
receiving more dollars than otherwise. Over the
last few years, volatility in the U.S.-Japanese
exchange rate has been particularly high, pri-
RISKS marily due to the Japanese banking crisis.
Liquidity Risk
The market for longer-term JGBs tends to be Political Risk
more liquid than for the shorter-term issues,
although liquidity has improved for the shorter- A change in the political environment, withhold-
term issues in the past few years. The bench- ing tax laws, or market regulation can have an
mark 10-year JGB still accounts for the majority adverse impact on the value and liquidity of an
of trading volume in the secondary market and investment in foreign bonds. Investors should be
therefore enjoys the best liquidity. JGBs issued familiar with the local laws and regulations
more recently also tend to be more liquid than governing foreign bond issuance, trading, trans-
older issues. The market for medium-term bonds actions, and authorized counterparties.
Trading and Capital-Markets Activities Manual September 2001
Page 3
4235.1 Japanese Government Bonds and Notes
ACCOUNTING TREATMENT III securities. As such, a bank’s investment in
them is limited to 10 percent of its equity capital
The accounting treatment for investments in and reserves.
foreign debt is determined by the Financial
Accounting Standards Board’s Statement of
Financial Accounting Standards No. 115 (FAS
115), ‘‘Accounting for Certain Investments in REFERENCES
Debt and Equity Securities,’’ as amended by
Statement of Financial Accounting Standards Credit Suisse First Boston Research. ‘‘The Yen
No. 140 (FAS 140), ‘‘Accounting for Transfers Bond Markets.’’ 1988.
and Servicing of Financial Assets and Extin- Fabozzi, Frank J., and T. Dessa Fabozzi, ed. The
guishments of Liabilities.’’ Accounting treat- Handbook of Fixed Income Securities. 4th ed.
ment for derivatives used as investments or for New York: Irwin, 1995.
hedging purposes is determined by Statement of Fabozzi, Frank J. Bond Markets, Analysis, and
Financial Accounting Standards No. 133 (FAS Strategies. 3d ed. Upper Saddle River, N.J.:
133), ‘‘Accounting for Derivatives and Hedging Prentice-Hall, 1996.
Activities.’’ (See section 2120.1, ‘‘Accounting,’’ J.P. Morgan Securities. Government Bond Out-
for further discussion.) lines. 9th ed. April 1996.
Merrill Lynch Capital Markets Research. ‘‘Japa-
nese Yen Bond Market.’’ Merrill Lynch Guide
RISK-BASED CAPITAL to International Fixed Income Investing, 1989.
WEIGHTING Tatewaki, Kazuo. Banking and Finance in
Japan. 1991.
Japanese government bonds and yields are Troughton, Helen. ‘‘The Impact of Deregula-
assigned to the 0 percent risk-weight category. tion.’’ Japanese Finance. Euromoney Publi-
cations, 1990.
Urich, Thomas J. U.K., German and Japanese
LEGAL LIMITATIONS FOR BANK Government Bond Markets. Monograph Series
INVESTMENT in Finance and Economics. New York: New
York University Salomon Center at the
Japanese government bonds and notes are type Leonard N. Stern School of Business, 1990.
September 2001 Trading and Capital-Markets Activities Manual
Page 4
Spanish Government Bonds
Section 4240.1
GENERAL DESCRIPTION ish Treasury publishes the auction calendar at
the beginning of the year. On the first Tuesday
The Spanish Treasury issues medium- and long- of the month, the 3- and 10-year bonds are
term bonds, Bonos del Estado (Bonos) and issued. The 5- and 15-year bonds are issued on
Obligaciones del Estado (Obligaciones), which the following Wednesday. Each issue is sold in
are guaranteed by the Spanish government. at least three competitive tenders. Bids are
Since 1987, these bonds have been issued in submitted before 10:30 a.m. on the auction date.
book-entry form only. Auction results are announced at 11:30 a.m. on
the same day on Reuters page BANCN. Pay-
ments generally occur on the 15th of the same
month.
CHARACTERISTICS AND At the beginning of each issue, the Treasury
FEATURES fixes the coupon to be paid for at least the next
three auctions. After all bids are made, the
Bonos are issued with maturities of three or five
Treasury fixes the total issue amount and allo-
years, while Obligaciones are issued with matu-
cates bids from the highest price to a cut-off
rities of 10 or 15 years. Both types of bonds are
price. The total issue amount is not disclosed.
issued in denominations of 10,000 pesetas (pta).
The lowest bid submitted is referred to as the
Bonos and Obligaciones are noncallable with
marginal price of the issue. Bids between the
bullet maturities and can be issued with either
average and the marginal price are filled at the
annual or semi-annual coupons. All Spanish
price the bidders submitted. Bids above the
government bonds bear a fixed coupon. Domes-
average are filled at the average price bid.
tic settlement takes place the market date after
the trade date (T+1), while international settle- If the Treasury announces a target issuance
ment takes place seven calendar days following level and the volume awarded during the initial
the trade date (T+7). Settlement is done on a bidding stage is equal to or higher than 70
delivery-against-payment basis for all transac- percent of the target level—but does not reach
tions between interbank market participants. the target issuance level—the Treasury has the
Bonos and Obligaciones are also eligible for right, but not the obligation, to hold a second
settlement through Euroclear and Cedel. Interest auction exclusively with the primary dealers. In
is calculated using an actual/365-day count. this case, every primary dealer must submit bids
for an amount at least equal to—
(target issuance level − the volume awarded) /
USES the number of primary dealers.
Historically, Bonos and Obligaciones have been If the target issuance level is met with the first
used as medium- and long-term investments. bidding stage or if the Treasury does not
However, in the early 1990s, the trading volume announce a target issuance level, primary deal-
of these bonds doubled as banks and corpora- ers may submit up to three additional bids.
tions began to use Bonos and Obligaciones for These bids cannot have yields higher than the
cash-management purposes. These securities can average yield during the first bidding stage. In
also be used for hedging and speculative this scenario, the Treasury must accept bids
purposes. equal to at least 10 percent of the volume
awarded during the first bidding stage if it had
accepted more than 50 percent of the bids. If it
DESCRIPTION OF had accepted less than 50 percent of the bids, the
Treasury must accept bids equal to at least
MARKETPLACE 20 percent of the volume awarded during the
Issuing Practices first bidding stage.
Interest begins to accrue from a date nomi-
Currently, all Bonos and Obligaciones are issued nated by the Treasury. Historically, the date has
through monthly competitive auctions. The Span- been set so that the first coupon period will
Trading and Capital-Markets Activities Manual February 1998
Page 1
4240.1 Spanish Government Bonds
be exactly one year. Thus, tranches issued before firms, insurance companies, and money manag-
the nominated date have an irregular period ers also hold outstanding bonds.
during which they trade at a discount without
accrued interest.
MARKET TRANSPARENCY
Several information vendors disseminate price
Secondary Market information on Spanish government bonds.
Reuters and Telerate provide pricing informa-
About 40 percent of all transactions are ex- tion for Bonos and Obligaciones. A Telerate
ecuted through a system of interdealer brokers service called ‘‘38494’’ provides the latest auc-
(blind brokers) instituted by the Bank of Spain. tion information. Reuters carries bond prices,
In the secondary market, only entities desig- dealer prices, the latest auction results, and
nated as ‘‘primary dealers’’ can deal directly Spanish Treasury pages.
with the Bank of Spain. For example, if a
customer wants to buy a bond that a dealer does
not have in inventory, a primary dealer can go to PRICING
the Bank of Spain to obtain the bond. Nonpri-
mary dealers would have to obtain the bonds Bonos and Obligaciones are quoted on a per-
through interdealer trading. Interdealer trading centage of par basis in eighths. Bid/offer spreads
is executed through information screens. Amounts are typically 5 to 10 basis points for actively
and prices are quoted, but counterparties are not traded issues and about 20 basis points for
disclosed. illiquid issues. Bonos and Obligaciones do not
Competitive tenders must be at least pta trade ex-dividend, but they do trade before the
50 million in the interbank market and pta Treasury nominates a date to begin coupon
100 million in the blind-broker system. Trading accruals. The period before the nomination date
volume in the secondary market varies between is referred to as the irregular period. Because
pta 500 million and pta 1 billion. Trading hours there is no accrued interest until a coupon
are between 9:00 a.m. to 5:00 p.m. local time payment date is nominated by the Treasury,
through blind brokers, and at any hour through issues outstanding before the nomination are
regular brokers. priced at a discount and adjustments to yield
must be made accordingly. The following price/
yield relationship holds during the irregular
period:
Market Participants PV0 = PV1 / (1 + y)(n / 365),
Sell Side where
PV1 = standard price/yield on the nominated
As noted above, the dealers of government date
securities are classified as either primary dealers y = annual internal rate of return
or nonprimary dealers. The Bank of Spain
n = the number of days until the end of the
designates primary dealers with whom they
irregular period
will conduct business. Other dealers obtain
government securities through interdealer
trading.
HEDGING
Buy Side Foreign-currency and interest-rate risk may be
hedged by using derivative instruments such as
The primary holders of Bonos and Obligaciones forwards, futures, swaps, or options. Interest-
are private and savings banks. The Bank of rate risk may also be hedged by taking an
Spain, corporations, and foreign investors, offsetting position in another Spanish fixed-
including U.S. commercial banks, securities income security.
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Spanish Government Bonds 4240.1
RISKS actions, and authorized counterparties.
Liquidity Risk
Liquidity risk is increased when market volumes ACCOUNTING TREATMENT
of a security are low. In the case of Bonos and
Obligaciones, market volumes have been vola- The accounting treatment for investments in
tile as investor objectives and strategies change, foreign debt is determined by the Financial
for example, when banks and corporations began Accounting Standards Board’s Statement of
to use Bonos and Obligaciones as cash- Financial Accounting Standards No. 115 (FAS
management instruments rather than as medium- 115), ‘‘Accounting for Certain Investments in
term investments. Therefore, these bonds may Debt and Equity Securities," as amended by
experience varying levels of liquidity. Liquidity Statement of Financial Accounting Standards
may also be a function of how close to maturity No. 140 (FAS 140), ‘‘Accounting for Transfers
a bond issue is. In other words, more recently and Servicing of Financial Assets and Extin-
issued bonds tend to be more liquid than bonds guishments of Liabilities.’’ Accounting treat-
that have been traded in the market for a longer ment for derivatives used as investments or for
period of time. hedging purposes is determined by Statement of
Financial Accounting Standards No. 133 (FAS
133), ‘‘Accounting for Derivatives and Hedging
Activities.’’ (See section 2120.1, ‘‘Accounting,’’
Interest-Rate Risk for further discussion.)
Interest-rate risk is derived from price fluctua-
tions caused by changes in interest rates. Longer-
term issues have more price volatility than RISK-BASED CAPITAL
shorter-term issues. A large concentration of WEIGHTING
long-term maturities may subject a bank’s invest-
ment portfolio to greater interest-rate risk. Spanish government bonds are assigned to the
0 percent risk-weight category.
Foreign-Currency Risk
From the perspective of an international inves-
LEGAL LIMITATIONS FOR BANK
tor, the total return from investing in Spanish INVESTMENT
government securities is partly dependent on the
exchange rate between the U.S. dollar and the Spanish government bonds are type III securi-
Spanish peseta. Several factors affect the vola- ties. As such, a bank’s investment in them is
tility of a foreign-exchange rate including the limited to 10 percent of its equity capital and
following: the country’s balance of payments reserves.
and prospective changes in that balance; infla-
tion and interest-rate differentials between coun-
tries; the social and political environment; rela- REFERENCES
tive changes in the money supply; and central
bank intervention in the currency. Fabozzi, Frank J. Bond Markets, Analysis, and
Strategies. 3d ed. Upper Saddle River, N.J.:
Prentice-Hall, 1996.
Political Risk Fabozzi, Frank J., and T. Dessa Fabozzi, ed. The
Handbook of Fixed Income Securities. 4th ed.
A change in the political environment, withhold- New York: Irwin, 1995.
ing tax laws, or market regulation can have an Fabozzi, Frank J., and Franco Modigliani. Capi-
adverse impact on the value and liquidity of an tal Markets: Institutions and Instruments.
investment in foreign bonds. Investors should be Englewood Cliffs, N.J.: Prentice-Hall, 1992.
familiar with the local laws and regulations J.P. Morgan Securities. Government Bond Out-
governing foreign bond issuance, trading, trans- lines. 9th ed. April 1996.
Trading and Capital-Markets Activities Manual September 2001
Page 3
Swiss Government Notes and Bonds
Section 4245.1
GENERAL DESCRIPTION currency risk that is related to its positions in
Swiss francs. Speculators may use Swiss gov-
Swiss government notes (SGNs) and bonds ernment bonds to take positions on changes in
(SGBs), also known as confederation notes and the level and term structure of Swiss interest
bonds, are fully guaranteed debt obligations of rates or on changes in the foreign-exchange
the Swiss government. The Swiss government rates between Switzerland and the United States.
debt market has historically been relatively small
as a result of the country’s low level of debt and
its balanced-budget policy. The Swiss govern- DESCRIPTION OF
ment does not engage in open market operations
because of the high degree of liquidity in the
MARKETPLACE
banking system. However, budget deficits in
recent years have resulted in an increase in the Issuing Practices
volume of activity. Bonds and notes are issued
through the Swiss National Bank in bearer form The Swiss Treasury issues debt through a Dutch
only. auction, and allocations are made to the highest
bidders in descending order until the supply of
securities the Treasury wishes to sell is depleted.
The lowest accepted tender price is considered
CHARACTERISTICS AND the clearing price. The debt-issuance calendar is
FEATURES announced at the beginning of each year. Cur-
rently, issuance takes place on the fourth Thurs-
Bonds have average maturity ranges of seven to day of every second month.
20 years and are issued in denominations
of Swiss franc (SFr) 1,000, SFr 5,000, and
SFr 100,000. Notes have average maturities of Secondary Market
three to seven years and are issued in denomi-
nations of SFr 50,000 and SFr 100,000. Both SGBs are listed on the Swiss stock exchanges in
bonds and notes are fixed-coupon securities Zurich, Geneva, and Basel, as well as on the
redeemable at par (bullets). Interest is paid over-the-counter (OTC) market. SGNs are traded
annually and there are no odd first coupons. over the counter only.
Most issues are callable, but many recent issues
do not have a call feature. Settlement is based on
Euroclear (an international clearing organiza-
tion) conventions, three days after the trade date Market Participants
(T+3). Interest is calculated using the 30E+/360
day-count convention. If a starting date is the Sell Side
31st, it is changed to the 30th, and an end date
that falls on the 31st is changed to the 1st. The main dealers of SGBs are the Union Bank
of Switzerland, Credit Suisse, and the Swiss
Bank Corporation. The Swiss National Bank
does not allow non-Swiss banks to underwrite or
USES manage issues.
Swiss government bonds and notes are used for
investment, hedging, and speculative purposes. Buy Side
Foreign investors, including U.S. banks, often
purchase Swiss government securities as a means Many investors, foreign and domestic, are
of diversifying their securities portfolios. The attracted to the Swiss bond market because
low credit risk and liquidity of Swiss govern- of the strength of the Swiss economy, the
ment bonds encourage their use. Swiss govern- country’s low inflation rates, and the stability
ment securities may also be used to hedge an of its political environment and currency, all of
investor’s exposure to Swiss interest rates or which contribute to a stable and low-risk
Trading and Capital-Markets Activities Manual September 2001
Page 1
4245.1 Swiss Government Notes and Bonds
government bond market. Investors include bond prices and interest rates. Longer-term issues
banks, securities firms, insurance companies, have more price volatility than short-term instru-
and money managers. ments. However, the Swiss capital market is
characterized by relatively low and stable inter-
est rates.
Market Transparency
The market of SGBs and SGNs is fairly active. Foreign-Exchange Risk
Price transparency is relatively high for Swiss
government securities since several information Currency fluctuations may affect the bond’s
vendors, including Reuters and Telerate, dissemi- yield as well as the value of coupons and
nate prices to the investing public. principal paid in U.S. dollars. The Swiss franc is
one of the strongest currencies in the world as a
result of the strength of the Swiss economy and
the excess liquidity in the banking system.
PRICING Volatility of Swiss foreign-exchange rates has
Notes and bonds are quoted as a percentage of historically been low.
par to two decimals. For example, a quote of
98.16 would mean a price that is 98.16 percent
of par value. The price quoted does not include Political Risk
accrued interest. Notes and bonds do not trade
A change in the political environment, withhold-
ex-dividend.
ing tax laws, or market regulations can have an
adverse impact on the value and liquidity of an
investment in foreign bonds. Investors should
HEDGING be familiar with the local laws and regulations
governing foreign bond issuance, trading, trans-
Interest-rate risk may be hedged by taking actions, and authorized counterparties.
contra positions in other government securities
or by using interest-rate swaps, forwards,
options, or futures. Foreign-exchange risk can
be hedged by using currency swaps, forwards,
ACCOUNTING TREATMENT
futures, or options. The accounting treatment for investments in
foreign debt is determined by the Financial
Accounting Standards Board’s Statement of
RISKS Financial Accounting Standards No. 115 (FAS
115), ‘‘Accounting for Certain Investments in
Liquidity Risk Debt and Equity Securities,’’ as amended by
Statement of Financial Accounting Standards
The market for SGBs is more liquid than SGNs No. 140 (FAS 140), ‘‘Accounting for Transfers
due to a lower number of SGN issues. Bonds and Servicing of Financial Assets and Extin-
typically trade in a liquid market for the first few guishments of Liabilities.’’ Accounting treat-
months after they are issued. However, after a ment for derivatives used as investments or for
few months on the secondary market, liquidity hedging purposes is determined by Statement of
tends to decrease as a result of the fact that issue Financial Accounting Standards No. 133 (FAS
size is relatively small. In addition, liquidity is 133), ‘‘Accounting for Derivatives and Hedging
hampered by buy-and-hold investment practices Activities.’’ (See section 2120.1, ‘‘Accounting,’’
and by federal and cantonal taxes levied on for further discussion.)
secondary transactions.
RISK-BASED CAPITAL
Interest-Rate Risk WEIGHTING
SGBs and SGNs are subject to interest-rate risk Swiss government notes and bonds are assigned
as a result of the inverse relationship between to the 0 percent risk-weight category.
September 2001 Trading and Capital-Markets Activities Manual
Page 2
Swiss Government Notes and Bonds 4245.1
LEGAL LIMITATIONS FOR BANK Guide to International Capital Markets 1991.
INVESTMENT London: Euromoney Publications PLC, 1991.
Fabozzi, Frank J., and Franco Modigliani. Capi-
Swiss government notes and bonds are type III tal Markets: Institutions and Instruments.
securities. As such, a bank’s investment in them Englewood Cliffs, N.J,: Prentice-Hall, 1992.
is limited to 10 percent of its equity capital and J.P. Morgan Securities. Government Bond Out-
reserves. lines. 9th ed.
Kemp, L.J. A Guide to World Money and
REFERENCES Capital Markets. New York: McGraw Hill,
1981.
Crossan, Ruth, and Mark Johnson, ed. The
Trading and Capital-Markets Activities Manual September 2001
Page 3
United Kingdom Government Bonds
Section 4250.1
GENERAL DESCRIPTION USES
United Kingdom government bonds, known as Gilts are used for investment, hedging, and
‘‘gilts’’ or ‘‘gilt-edged stocks,’’ are Sterling- speculative purposes by domestic and foreign
denominated bonds issued by the Bank of entities. While foreign investors may buy gilts
England (BOE) on behalf of the Treasury. The as a means of diversifying their investment
bonds are unconditionally guaranteed by the portfolios, gilts may also be used to hedge
U.K. government and, therefore, are considered positions that are sensitive to movements in
to have very low credit risk. Shorts are those U.K. interest rates or foreign-exchange rates.
gilts having 0 to 5 years remaining to maturity; Speculators, on the other hand, may use long-
mediums, 5 to 15 years; and longs, over 15 term bonds to take positions on changes in the
years. The securities are generally held in reg- level and term structure of interest rates.
istered form in the domestic settlement system.
The securities can also be held via Euroclear and
Cedel.
DESCRIPTION OF
MARKETPLACE
Issuing Practices
CHARACTERISTICS AND The BOE issues a debt management report in
FEATURES March of each year, which lays out gilt-issuance
plans for the fiscal year running from April to
Gilts come in a variety of structures. Conven- March. The report represents the Treasury’s
tional gilts or ‘‘straights’’ are noncallable bullet forecast of the gilts that need to be sold and also
issues that pay interest semiannually. These details the percentage of issuance expected to
bonds comprise around 80 percent of the out- fall into each area of the maturity spectrum.
standing gilt-edged securities. The government Complete details of the auction, including the
also issues callable gilts, so called ‘‘double- amount and terms of gilt to be auctioned and
dated’’ gilts, which may be called at the govern- other information, are announced eight days
ment’s discretion anytime after the designated before the auction. Gilt-edged market makers
call date. In addition to these bonds, a number (GEMMs) quote prices on a when-issued basis.
of nonconventional gilt issues are considered Deals cannot be settled until the business day
to be of minor importance because of their after the auction when trading in the newly
insignificant issue sizes and lack of liquidity. issued bonds officially begins. The existence of
Such nonconventional issues include convert- a shadow market, however, ensures that the
ible gilts (in which short-dated bonds may be market can trade to a level where new bonds
converted to longer-dated bonds), index-linked will be easily absorbed, limiting the chances of
gilts, and irredeemable gilts (consols). Most gilt a surplus inventory of bonds.
issues pay a fixed coupon. Floating-rate gilts, During the auction process, bids are accepted
first issued in March 1994, have coupon on a competitive and a noncompetitive basis.
payments linked to the London Interbank Competitive bids are for a minimum of £500,000
Bid Rate (LIBID). Unlike fixed-rate gilts, inter- and can be made at any price. Bids are accepted
est on floating-rate gilts is paid quarterly to going from the highest price to the lowest price
investors. until the bank exhausts the amount of securities
Settlement in the gilt market is usually done it wants to sell. If the issue size is not large
on the market date following the trade date enough to satisfy demand at the lowest accepted
(T+1), although two-day and seven-day settle- price, bidders get a proportion of their requests.
ments are also fairly common. Deals are nor- In such a bid, the BOE cannot give more than
mally cleared through the Bank of England’s 25 percent of the amount offered to any one
Central Gilt Office (CGO). The CGO is linked bidder. Noncompetitive bids vary between
to Euroclear and Cedel. Interest is calculated £1,000 and £500,000 per bidder. Bonds are
using an actual/365-day count. allocated to noncompetitive bidders at a price
Trading and Capital-Markets Activities Manual February 1998
Page 1
4250.1 United Kingdom Government Bonds
equal to that of the weighted average of bids Buy Side
filled in the competitive auction.
The BOE also sells a fixed amount of securi- A wide range of investors use U.K. government
ties at a fixed price (tap form). This form of bonds for investing, hedging and speculation.
issuance allows the BOE to respond to market This includes banks, nonfinancial corporate and
demand and add liquidity to the market. More quasi-corporate public and private enterprises,
specifically, tap issues are normally done from pension funds, charities, pension arms of life
the supply of bonds that have not been sold at an insurance companies, and private investors. The
auction. Typically, bonds are held back with the largest holders of gilts are domestic entities, but
intent to sell them when demand has improved foreign investors, including U.S. banks, are also
or when there is an increased need for funds. In active participants in the market.
a tap issuance, stock is issued to GEMMs in
the form of ‘‘tranchettes,’’ typically up to
£500 million. Market Transparency
Payment for gilts may be made in full or
in part. In a partly paid auction, competitive The gilt market is active and price transparency
bidders are required to deposit a portion of the is relatively high for these securities. Several
amount bid, with the rest due after issue as information vendors disseminate prices to the
specified in the prospectus. In a partly paid investing public, including Reuters.
auction, the first coupon payment and the
market price reflect the partly paid status of
the gilt. After the installments are cleared as PRICING
per the prospectus, the partly paid distinction
disappears. Prices are quoted as a percent of par in 32nds.
For example, a price of 98:16 means that the
price of the bond is 98.5 percent of par value
(98 16/32). Prices are quoted on a clean-price
Secondary Market basis, net of accrued interest. The settlement
price takes accrued interest into account so that
U.K. gilts are traded on the London Stock the total price equals the clean price plus or
Exchange, International Stock Exchange, and minus the accrued interest. The bid/offer spreads
London International Financial Futures Exchange tend to be extremely thin. For liquid issues with
(LIFFE). Gilts can be traded 24 hours a day. a maturity of up to seven years, the spread is
Generally, gilts are traded on the International normally 1/16 or less; for liquid issues with
Stock Exchange between the hours of 9 a.m. and longer maturities, the spread is normally 1/16 to
5 p.m. and on the LIFFE between the hours of 1/8.
8:30 a.m. and 4:15 p.m. and between 4:30 p.m.
and 6:00 p.m. The typical transaction size in
the secondary market varies between £5 to HEDGING
£100 million.
U.K. gilts may be hedged for foreign-exchange
risk using foreign-exchange options, forwards,
and futures. These securities can be hedged for
Market Participants interest-rate risk by taking a contra position in
another gilt or by using derivative instruments
Sell Side such as forwards, swaps, futures, or options.
Currently, the LIFFE gilt futures contract is the
The primary dealers of U.K. government bonds most heavily traded hedging instrument. The
are known as gilt-edged market makers or effectiveness of a particular hedge depends on
GEMMs. GEMMs quote the exact size, amount, the yield curve and basis risk. For example,
and terms of the issuance beginning eight days hedging a position in a six-year note with an
before an auction, thereby creating a ‘‘shadow over-hedged position in a two-year bill may
market.’’ At this time, they quote prices on a expose the dealer to yield curve risk. Hedging a
when-issued basis. 30-year bond with a bond future exposes the
February 1998 Trading and Capital-Markets Activities Manual
Page 2
United Kingdom Government Bonds 4250.1
dealer to basis risk if the historical price rela- Political Risk
tionships between futures and cash markets are
not stable. A change in the political environment, withhold-
ing tax laws, or market regulation can have an
adverse impact on the value and liquidity of an
RISKS investment in foreign bonds. Investors should be
familiar with the local laws and regulations
Liquidity Risk governing foreign bond issuance, trading, trans-
actions, and authorized counterparties.
Gilts trade in an active and liquid market.
Liquidity in the market is ensured by the BOE,
which is responsible for maintaining the liquid- ACCOUNTING TREATMENT
ity and efficiency of the market and, in turn,
supervises the primary dealers of gilts. GEMMs, The Financial Accounting Standards Board’s
who act as primary dealers, are required to quote Statement of Financial Accounting Standards
two-way prices at all times. An increase in No. 115 (FAS 115), ‘‘Accounting for Certain
foreign investment activity in the gilt market has Investments in Debt and Equity Securities,’’ as
led to a substantial increase in competition and amended by Statement of Financial Accounting
enhanced liquidity. Standards No. 140 (FAS 140), ‘‘Accounting for
Liquidity is also enhanced through the BOE’s Transfers and Servicing of Financial Assets and
ability to reopen auctions and tap issues. The Extinguishments of Liabilities,’’ determines the
ability to reopen issues improves liquidity and accounting treatment for investments in foreign
avoids the unfavorable pricing that may occur debt. Accounting treatment for derivatives used
when the market is flooded with one very large as investments or for hedging purposes is deter-
issue. A tap issue, as explained above, allows mined by Statement of Financial Accounting
the BOE to relieve market shortage of a particu- Standards No. 133 (FAS 133), ‘‘Accounting for
lar bond. An active repo market allows market Derivatives and Hedging Activities.’’ (See sec-
makers (GEMMs) to fund their short positions, tion 2120.1, ‘‘Accounting,’’ for further
and it improves turnover in the cash market, discussion.)
attracting international players familiar with the
instrument, which further improves liquidity.
RISK-BASED CAPITAL
WEIGHTING
Foreign-Exchange Risk
United Kingdom government bonds are assigned
Currency movements have the potential to affect to the 0 percent risk-weight category.
returns of fixed-income investments whose
interest and principal are paid in foreign curren-
cies. The devaluation of a foreign currency
relative to the U.S. dollar would not only affect LEGAL LIMITATIONS FOR BANK
a bond’s yield, but would affect bond pay-offs in INVESTMENT
U.S. dollar terms. Some factors that may affect
the U.K. foreign-exchange rate include— United Kingdom government bonds are type III
securities. As such, a bank’s investment in them
• wider exchange-rate mechanism bands, which is limited to 10 percent of its equity capital and
increase the risk of holding high-yielding reserves.
currencies;
• central bank intervention in the currency
markets; REFERENCES
• speculation about the European economic and
monetary union and its potential membership, Euromoney. The 1996 Research Guide to
which puts European currencies under pres- London. December 1995.
sure vis-à-vis the deutsche mark; and Euromoney. Central Banks, How Central Banks
• endemic inflation in the United Kingdom. Play the Market. September 1992.
Trading and Capital-Markets Activities Manual September 2001
Page 3
4250.1 United Kingdom Government Bonds
Fabozzi, Frank J. Bond Markets, Analysis, and Submerging Bond Markets. October 1994.
Strategies. 3d ed. Upper Saddle River, N.J.: Urich, Thomas J. U.K., German and Japanese
Prentice-Hall, 1996. Government Bond Markets. Monograph Series
Fabozzi, Frank J., and T. Dessa Fabozzi, ed. in Finance and Economics. New York: New
The Handbook of Fixed Income Securities. York University Salomon Center at the
4th ed. New York: Irwin, 1995. Leonard N. Stern School of Business, 1990.
J.P. Morgan Securities. Government Bond Walker, Rupert G. Can Gilts Get Glitzier?
Outlines. 9th ed. April 1996. December 1995.
Roche, David. Against the Tide: Europe’s
September 2001 Trading and Capital-Markets Activities Manual
Page 4
Brady Bonds and Other Emerging-Markets Bonds
Section 4255.1
GENERAL DESCRIPTION • Front-loaded interest-reduction bonds pro-
vide a temporary interest-rate reduction. These
In 1989, the Brady plan, named after then-U.S. bonds have a low fixed-interest rate for a few
Treasury Secretary Nicholas Brady, was years and then step up to market rates until
announced to restructure much of the debt of maturity.
developing countries that was not being fully • Debt conversion bonds (DCBs) and new money
serviced due to economic constraints. The plan bonds are exchanged for bonds at par and
provided debt relief to troubled countries and, in yield a market rate. Typically, DCBs and new
theory, opened access to further international money bonds pay LIBOR + 7⁄8. These bonds
financing. It also provided the legal framework are amortized and have an average life of
to securitize and restructure the existing bank between 10 and 15 years. DCBs and new
debt of developing countries into bearer bonds. money bonds are structured to give banks an
Linking collateral to some bonds gave banks the incentive to inject additional capital. For each
incentive to cooperate with the debt reduction dollar of new money bond purchased, an
plan. investor converts existing debt into a new
Brady bonds are restructured bank loans. money bond at a fixed proportion determined
They comprise the most liquid market for below- by the Brady agreement. DCBs and new
investment-grade debt (though a few Brady money bonds are normally uncollateralized.
countries have received investment-grade debt
ratings) and are one of the largest debt markets The terms of local debt market instruments
of any kind. Banks are active participants in the also vary widely, and issues are denominated in
Brady bond market. Once strictly an interbank either local or foreign currency such as U.S.
market, the Brady market has evolved into one dollars. Brief descriptions of instruments in
with active participation from a broad investor Argentina, Brazil, and Mexico follow.
base.
CHARACTERISTICS AND Argentina
FEATURES
Letes are Argentine Treasury bills. They are
Brady bonds have long-term maturities, and offered on a discount basis and have maturities
many have special features attached. Callable of 3, 6, and 12 months. Auctions are held on a
bonds or step-up coupons are among the most monthly basis.
common features. Others pay additional sources
of income based on various economic factors
or the price of oil. Listed below are the indi-
vidual characteristics of several types of Brady Brazil
bonds:
Currently, the primary internal debt instruments
• Par bonds have fixed coupons or coupon issued in Brazil are so-called BBC bonds, which
schedules and bullet maturities of 25 to are issued by the central bank. As of mid-1996,
30 years. Typically, these bonds have principal- BBC bonds were being issued in 56-day denomi-
payment and rolling interest-rate guarantees. nations, up from 35-, 42-, and 49-day denomi-
Because pars are loans exchanged at face nations. Total outstandings as of June 30, 1996,
value for bonds, debt relief is provided by a were U.S.$49.9 billion, and these instruments
lower interest payment. are highly liquid. The central bank also issues
• Discount bonds have floating-rate coupons bills and notes known as LTNs and NTNs that
typically linked to LIBOR. These bonds have have maturities up to one year (though one NTN
principal and rolling interest-rate guarantees. has been issued as of this writing with a two-
Bond holders receive a reduced face amount year maturity). LTNs and NTNs are less liquid
of discount bonds, thereby providing debt and have smaller outstandings (U.S.$34.4 and
relief. U.S.$18.2 billion, respectively) than BBC bonds.
Trading and Capital-Markets Activities Manual February 1998
Page 1
4255.1 Brady Bonds and Other Emerging-Markets Bonds
Mexico ment securities with a face value of U.S.$1,000.
At the investors’ option, they are payable in
Ajustabonos dollars, and they are issued at a discount.
Maturities include 28, 91, 182, and 364 days.
Though issuance of these bonds has been halted,
ajustabonos are peso-denominated Treasury
bonds. They are indexed to inflation and pay a UDIbonos
real return over the Mexican consumer price
index (CPI). These bonds are longer-term instru- During the week of May 27, 1996, the Mexican
ments with maturities of 1,092 days (three central bank sold three-year UDIbonos for the
years) and 1,820 days (five years). Ajustabonos first time. They are inflation-adjusted bonds
pay a quarterly real rate coupon over the CPI denominated in accounting units or UDIs (a
and are tax exempt to foreign investors. As of daily inflation index), which change in value
May 1996, U.S.$5.6 billion ajustabonos remained every day. These instruments replaced the ajust-
outstanding. abonos. UDIbonos pays interest semiannually
and offer holders a rate of return above the
inflation rate. They are auctioned biweekly and
Bondes may have limited liquidity.
Bondes are floating-rate, peso-denominated gov-
ernment development bonds. They have matu-
rities of 364 and 728 days. Bondes pay interest
every 28 days at the higher of the 28-day cetes
USES
rate or the retail pagares rate, calculated by the
Brady bonds and local debt market instruments
central bank. They are auctioned weekly and are
can be used for investment, hedging, and specu-
tax exempt to foreign investors. The total amount
lation. Speculators will often take positions on
outstanding as of mid-1996 was approximately
the level and term structure of sovereign interest
U.S.$5 billion.
rates. Arbitragers will take positions based on
their determination of mispricing.
Cetes
Cetes are government securities and are the
equivalent of Mexican T-bills. They are denomi- DESCRIPTION OF
nated in pesos and are sold at a discount. Cetes MARKETPLACE
have maturities of 28, 91, 182, 364, and 728
days (though this maturity is presently discon- Issuing Practices
tinued). Cetes are highly liquid instruments and
have an active repo market. A Brady deal exchanges dollar-denominated
The capital gain for these instruments is loans for an agreed-upon financial instrument.
determined by the difference between the amor- These instruments include various debt instru-
tized value and the purchase price; the day- ments, debt equity swaps, and asset swaps. At
count convention is actual/360-day. Auctions the close of a collateralized Brady deal (not all
are held weekly by the central bank for the 28- Brady bonds are collateralized), collateral is
through 364-day maturities. Foreign investors primarily posted in the form of U.S. Treasury
are exempted from paying taxes on these zero-coupon bonds and U.S. Treasury bills. The
instruments. market value of this collateral depends on the
yield of 30-year U.S. Treasury strips and tends
to increase as the bond ages. Developing coun-
Tesobonos tries have also used their own resources for
collateral as well as funds from international
Though these instruments are not currently being donors, the World Bank, and the International
issued, they comprised the majority of debt Monetary Fund (IMF) to support their Brady
offerings in the time leading up to the 1994 peso deals. Local debt instruments are subject to the
crisis. Tesobonos are dollar-indexed govern- issuing practices of each individual country.
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Brady Bonds and Other Emerging-Markets Bonds 4255.1
Market Participants terms can lead to basis risk.
Hedging strategies for Brady bonds are often
The number of market participants in each focused on decomposing the sovereign risk from
emerging market differs with the characteristics the U.S. rate risk and on neutralizing the latter.
of each market, such as regulatory barriers, For example, a long fixed-coupon Brady bond
liquidity constraints, and risk exposures. How- position is exposed to the risk that U.S. rates will
ever, there are many participants in the Brady rise and Brady prices will fall. A hedge aimed at
bond market. Securitization of Brady bonds immunizing U.S. rate risk can be established
enables banks to diversify and transfer some of with a short U.S. Treasury, Treasury futures, or
their country exposures to other banks. New forward position.
market participants in the Brady market include
investment banks as well as traditional commer-
cial banks, mutual funds, pension funds, hedge RISKS
funds, insurance companies, and some retail
investors. Sovereign Risk
One of the most significant risks related to
Market Transparency trading of LDC debt is sovereign risk. This
includes political, regulatory, economic stabil-
For many instruments, prices are available on ity, tax, legal, convertibility, and other forms of
standard quote systems such as Bloomberg, risks associated with the country of issuance.
Reuters, and Telerate. In addition, many brokers Real risk is that of potential controls or taxes on
can quote prices on less developed country foreign investment. While there is no way to
(LDC) debt instruments. For all but the most predict policy shifts, it can help to be familiar
liquid Brady bonds and internal debt instru- with any current controls and to closely follow
ments, however, transparency can be very lim- the trend of inflation.
ited.
Liquidity Risk
PRICING Liquidity risk is the risk that a party may not be
able to unwind its position. In emerging mar-
Pricing for the various LDC issues differs across kets, liquidity risk can be significant. During the
instruments and countries. The price of a Brady Mexican peso crisis, bids on various instruments
bond is quoted on its spread over U.S. Treasur- were nonexistent. Portfolio values of Latin
ies. Standard bond pricing models are often used American instruments plunged. In the OTC
to price the uncollateralized bond and unsecuri- market, options are far less liquid than cash
tized traded bank loans, with emphasis on the bonds. As a result, option positions are often
credit risk of the issuers (sovereign risk) in held to expiry rather than traded.
determining whether a sufficient risk premium is
being paid. Most of the volatility in Brady bonds
comes from movement in the spread over U.S. Interest-Rate Risk
Treasuries.
Debt issues of various countries are subject to
price fluctuations because of changes in
HEDGING sovereign-risk premium in addition to changes
in market interest rates and changes in the shape
Over-the-counter (OTC) options are the primary of the yield curve. Spreads between U.S. rates
vehicles to hedge Brady bonds. Because the and sovereign rates capture this sovereign-risk
volume of the OTC options market is approxi- premium. In general, the greater the uncertainty
mately one-tenth that of the cash Brady bond of future payoffs, the greater the spread between
market, liquidity is relatively poor. country rates and U.S. rates. This spread will not
Cash instruments from the identical sovereign necessarily be stable, however, making interest-
issuer can be used to hedge positions. However, rate risk at least equivalent to that found in U.S.
as in other hedging situations, mismatch of Treasury instruments.
Trading and Capital-Markets Activities Manual September 2001
Page 3
4255.1 Brady Bonds and Other Emerging-Markets Bonds
ACCOUNTING TREATMENT liabilities booked in that currency are assigned a
100 percent risk weight. Also, all claims on
LDC debt that remains in the form of a loan and non-OECD state or local governments are
does not meet the definition of a security in the assigned to the 100 percent risk category.
Financial Accounting Standards Board’s State-
ment of Financial Accounting Standards No.
115 (FAS 115), ‘‘Accounting for Certain Invest-
ments in Debt and Equity Securities,’’ should LEGAL LIMITATIONS FOR BANK
be reported and accounted for as a loan. If INVESTMENT
the loan was restructured in a troubled-debt
restructuring involving a modification of terms, Obligations which are guaranteed by a depart-
and the restructured loan meets the definition of ment or an agency of the U.S. government, if the
a security in FAS 115, then the instrument obligation commits the full faith and credit of
should be accounted for according to the provi- the United States for the repayment of the
sions of FAS 115. obligation, are type I securities and are not
The accounting treatment for investments in subject to investment limitations. Also, obliga-
foreign debt is determined by FAS 115, as tions guaranteed by the Canadian government
amended by Statement of Financial Accounting are classified as type I securities.
Standards No. 140 (FAS 140), ‘‘Accounting for Obligations guaranteed by other OECD coun-
Transfers and Servicing of Financial Assets and tries which are classified as investment-grade
Extinguishments of Liabilities.’’ Accounting are type III securities. A bank’s investment is
treatment for derivatives used as investments or limited to 10 percent of its capital and surplus.
for hedging purposes is determined by State- Non-investment-grade LDC debt may be pur-
ment of Financial Accounting Standards No. chased under a bank’s ‘‘reliable estimates’’
133 (FAS 133), ‘‘Accounting for Derivatives bucket. If a bank concludes, on the basis of
and Hedging Activities.’’ (See section 2120.1, reliable estimates, that an obligor will be able to
‘‘Accounting,’’ for further discussion.) perform, and the security is marketable, it can
purchase the security notwithstanding its
investment-grade rating. Such securities are sub-
RISK-BASED CAPITAL ject to a 5 percent limit of a bank’s capital and
WEIGHTING surplus for all securities purchased under this
authority.
Claims that are directly and unconditionally
guaranteed by an OECD-based central govern-
ment or a U.S. government agency are assigned
to the zero percent risk category. Claims that are REFERENCES
not unconditionally guaranteed are assigned to
the 20 percent risk category. A claim is not Cline, William. International Debt Reexamined.
considered to be unconditionally guaranteed by Washington, D.C.: Institute for International
a central government if the validity of the Economics, February 1995.
guarantee depends on some affirmative action Emerging Markets Traders Association. 1995
by the holder or a third party. Generally, secu- Debt Trading Volume Survey. May 1, 1996.
rities guaranteed by the U.S. government or its Gosain, Varun (Paribas Capital Markets).
agencies and securities that are actively traded ‘‘Derivatives on Emerging Market Sovereign
in financial markets are considered to be uncon- Debt Instruments.’’ Derivatives & Synthetics.
ditionally guaranteed. Chicago and Cambridge: Probus Publishing.
Claims on, or guaranteed by, non-OECD McCann, Karen, and Mary Nordstrom. The
central governments which do not represent Unique Risks of Emerging Markets
local currency claims that are unconditionally or Investments—A Perspective on Latin America.
conditionally guaranteed by non-OECD central Chicago: Federal Reserve Bank of Chicago,
governments to the extent that the bank has 1996.
September 2001 Trading and Capital-Markets Activities Manual
Page 4
Foreign Exchange
Section 4305.1
GENERAL DESCRIPTION excess of assets are called a net ‘‘short’’ posi-
tion. A long position in a foreign currency which
Foreign exchange (FX) refers to the various is depreciating will result in an exchange loss
businesses involved in the purchase and sale of relative to book value because, with each day,
currencies. This market is among the largest in that position (asset) is convertible into fewer
the world and business is conducted 24 hours a units of local currency. Similarly, a short posi-
day in most of the financial centers. The major tion in a foreign currency which is appreciating
participants are financial institutions, corpora- represents an exchange loss relative to book
tions, and investment and speculative entities value because, with each day, satisfaction of that
such as hedge funds. Any financial institution position (liability) will cost more units of local
which maintains due from bank balances, com- currency.
monly known as ‘‘nostro’’ accounts, in foreign The net open position consists of both balance-
countries in the local currency can engage in sheet accounts and contingent liabilities. For
foreign exchange. The volume in this market has most financial institutions, the nostro accounts
been estimated to be the equivalent of $1 trillion represent the principal assets; however, foreign-
a day. currency loans as well as any other assets or
liabilities that are denominated in foreign cur-
rency, which are sizeable in certain financial
CHARACTERISTICS AND institutions, must be included. All forward/
FEATURES futures foreign-exchange contracts outstanding
are contingents. When a contract matures, the
The FX market is divided into spot, forward, entries are posted to a nostro account in the
swap, and options segments. Each of these appropriate currency.
segments is discussed in the following Each time a financial institution enters into a
subsections. spot foreign-exchange contract, its net open
position is changed. For example, assume that
Bank A opens its business day with a balanced
Spot net open position in pound sterling (assets plus
purchased contracts equal liabilities plus sold
Buying and selling FX at market rates for contracts). This is often referred to as a ‘‘flat’’
immediate delivery represents spot trading. Gen- position. Bank A then receives a telephone call
erally, spot trades in foreign currency have a from Bank B requesting a ‘‘market’’ in sterling.
‘‘value date’’ (maturity or delivery date) of two Because it is a participant in the interbank
to five business days (one day for Canada). foreign-exchange trading market, Bank A is a
Foreign-exchange rates that represent the cur- ‘‘market maker.’’ This means it will provide
rent market value for the currency are known as Bank B with a two-sided quote consisting of its
spot rates. The risk of spot trading results from bid and offer for sterling. If a different currency
exchange-rate movements that occur while the was requested, European terms would be the
financial institution’s position in foreign cur- opposite since the bid and offer would be for
rency is not balanced with regard to the currency dollars instead of the foreign currency. In deter-
it has bought and sold. Such unbalanced posi- mining the market given, Bank A’s trader of
tions are referred to as net open positions. sterling will determine where the market is
presently (from brokers and/or other financial
institutions), attempt to anticipate where it is
Net Open Positions headed, and determine whether Bank B is plan-
ning to buy or sell sterling.
A financial institution has a net open position in
a foreign currency when its assets, including
spot and forward/futures contracts to purchase,
and its liabilities, including spot and forward/ Forward Transactions
futures contracts to sell, in that currency are not
equal. An excess of assets over liabilities is A forward transaction differs from a spot trans-
called a net ‘‘long’’ position, and liabilities in action in that the value date is more than two to
Trading and Capital-Markets Activities Manual February 1998
Page 1
4305.1 Foreign Exchange
five business days in the future. The maturity of a corporation or a financial institution. Swaps
a forward foreign-exchange contract can be a also provide a mechanism for a financial insti-
few days, months, or even years in some tution to accommodate the outright forward
instances. In practice, dates that are two years or transactions executed with customers or to bridge
more in the future are usually referred to as the gaps in the maturity structure of outstanding
long-dated forward market or the long-term FX spot and forward contracts.
(LTFX) market. The exchange rate is fixed at the The two value dates in a swap transaction can
time the transaction is agreed on. However, be any two dates. But, in practice, markets exist
nostro accounts are not debited or credited, that only for a limited number of standard maturities.
is, no money actually changes hands, until the One of these standard types is called a spot-
maturity date of the contract. There will be a against-forward swap. In a spot-against-forward
specific exchange rate for each forward matu- swap transaction, a trader buys or sells a cur-
rity, and each of those rates will generally differ rency for the spot value date and simultaneously
from today’s spot exchange rate. If the forward sells or buys it back for a value date a week, a
exchange rate for a currency is higher than the month, or three months later.
current spot rate, the currency is trading at a Another type of transaction of particular inter-
premium for that forward maturity. If the for- est to professional market-making financial
ward rate is below the spot rate, then the institutions is called a tomorrow-next swap or a
currency is trading at a discount. For instance, rollover. These are transactions in which the
sterling with a value date of three months is at a dealer buys or sells a currency for value the next
discount if the spot rate is $1.75 and the three- business day and simultaneously sells or buys it
month forward rate is $1.72. back for value the day after. A more sophisti-
cated type of swap is called a forward-forward
in which the dealer buys or sells currency for
Foreign-Exchange Swaps one future date and sells or buys it back for
another future date. Primarily, multinational
Financial institutions that are active in the banks specialize in transactions of this type.
foreign-exchange market find that interbank out-
right forward currency trading is inefficient and
engage in it infrequently. Instead, for future Options
maturities, financial institutions trade among
themselves as well as with some corporate The foreign-exchange options market includes
customers on the basis of a transaction known as both plain vanilla and exotic transactions. See
a foreign-exchange swap. A swap transaction is section 4330.1, ‘‘Options,’’ for a general discus-
a simultaneous purchase and sale of a certain sion. Most options activity is plain vanilla.
amount of foreign currency for two different
value dates. The key aspect is that the financial
institution arranges the swap as a single trans- USES
action with a single counterparty, either another
financial institution or a nonbank customer. This Foreign exchange is used for investment, hedg-
means that, unlike outright spot or forward ing, and speculative purposes. Most banks use it
transactions, a trader does not incur a net open to service customers and also to trade for their
position since the financial institution contracts own account. Corporations use the FX market
both to pay and to receive the same amount of mainly to hedge their foreign-exchange exposure.
currency at specified rates. Note that a foreign-
exchange swap is different from a foreign-
currency swap, because the currency swap
involves the periodic exchange of interest pay- DESCRIPTION OF
ments. See the discussion in section 4335.1, MARKETPLACE
‘‘Currency Swaps.’’
Market Participants
A foreign-exchange swap allows each party
to use a currency for a period in exchange for Sell Side
another currency that is not needed during that
time. Thus, the swap offers a useful investment The majority of U.S. banks restrict their foreign-
facility for temporary idle currency balances of exchange activities to serving their customers’
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Foreign Exchange 4305.1
foreign-currency needs. The banks will simply investors, and speculators. Corporations use this
sell the currency at a rate slightly above the market to hedge their assets and liabilities in-
market and subsequently offset the amount and curred as a result of their overseas operations.
maturity of the transaction through a purchase Investors (for example, international mutual
from another correspondent bank at market funds) use this market to gain exposure to
rates. This level of activity involves virtually no markets and sometimes to hedge away the
risk exposure as currency positions are covered currency risk of their equity portfolios.
within minutes. For these banks, a small profit is
usually generated from the rate differential, but
the activity is clearly designated as a service Market Transparency
center rather than a profit center.
Usually, the larger the financial institution, Price transparency is very high. The prices for
the greater the emphasis placed on foreign- most of the markets are disseminated through
exchange activity. For instance, while serving various vendors such as Reuters and Telerate.
the needs of corporate customers is still a
priority, most regional banks also participate in
the interbank market. These banks may look at
the trading function as a profit center as well as PRICING
a service. Such banks usually employ several
experienced traders and may take positions in Two methods are used to quote foreign-exchange
foreign currencies based on anticipated rate rates. The method used depends on the currency.
movements. These banks use their involvement
in the interbank market to get information about • American quote. Number of foreign-currency
the various markets. For most of these partici- units per U.S. dollar (for example, 105 yen per
pants, the trading volume in the interbank market dollar). Most currencies are quoted using this
constitutes the bulk of the volume. (In some convention.
cases, the interbank volume is about 80 to • European quote. Number of U.S. dollars per
90 percent of total volume). Multinational banks foreign-currency unit (for example, $1.60 per
assume by far the most significant role in the British pound sterling). British and Irish
foreign-exchange marketplace. While still serv- pounds and Australian and New Zealand dol-
ing customer needs, these banks engage heavily lars are the most common currencies using
in the interbank market and look to their foreign- this convention.
exchange trading operation for sizeable profits.
These banks trade foreign exchange on a global
basis through their international branch networks. Spot FX
One of the major changes in the structure of
the foreign-exchange market over the past few Most institutions will quote both a bid and an
years has been the increase in the use of elec- offer. When, for example, Bank A quotes ster-
tronic market-making and execution systems. In ling at $1.7115-25, it is saying that it will buy
the past, most interbank dealing was done (bid) sterling at $1.7115 or sell (offer) sterling at
through the interbank brokers’ system; however, $1.7125. If Bank B’s interest is to buy sterling
advances in technology have made it more and the given quote is appealing, it will buy
efficient for market participants to use electronic sterling from Bank A at $1.7125 (Bank A’s offer
systems. (Among the more popular systems are price). Note that while Bank B may choose to
Reuters and EBS (Electronic Brokering Sys- buy, sell, or pass as it wishes, it must do business
tems).) These developments have decreased the on the terms established by Bank A. These terms
number of errors that are common in the use of will be in Bank A’s favor. As soon as Bank B
the brokers’ market (for example, the use of announces it will purchase sterling at $1.7125,
points and error checks) and have also cut down Bank A acquires a net open position (short) in
on the costs of doing business. sterling. Bank A must then decide whether to
hold its short position (in anticipation of a
decline in sterling) or cover its position. If it
Buy Side wishes to cover, it may call another bank and
purchase the amount it sold to Bank B. How-
The buy side consists of corporate hedgers, ever, as the calling bank, Bank A would buy its
Trading and Capital-Markets Activities Manual February 1998
Page 3
4305.1 Foreign Exchange
sterling from the offered side of the quote it of $1.80, the swap rate on a three-month con-
receives and must buy it at $1.7125 or less to tract would be a premium of 135 points. If that
avoid a loss. interest-rate differential increases to 4 percent
(by a drop in the sterling rate or an increase in
the dollar rate), the premium would increase to
180 points. Therefore, a trader who bought
Foreign-Exchange Swaps sterling three months forward at 135 points
premium could now sell it at 180 points pre-
In foreign-exchange swap transactions, the trader mium, or at a profit of 45 points (expressed as
is only interested in the difference between spot .0045).
and forward rates—the premium or discount— Thus, the dealer responsible for forward trad-
rather than the outright spot and forward rates ing must be able to analyze and project dollar
themselves. Premiums and discounts expressed interest rates as well as interest rates for the
in points ($0.0001 per pound sterling or currency traded. Additionally, because forward
DM 0.0001 per dollar) are called swap rates. If premiums or discounts are based on interest-rate
the pound spot rate is $1.8450 and the six-month differentials, they do not reflect anticipated
forward rate is $1.8200, the dollar’s six-month movements in spot rates.
premium is 250 points ($0.0250). If the pound
spot rate is $1.8450 and the six-month forward
rate is $1.8625, the dollar’s six-month discount
is 175 points ($0.0175). HEDGING
Since, in a swap transaction, a trader is Spot FX
effectively borrowing one currency and lending
the other for the period between the two value Banks engaged in trading in the spot market will
dates, the premium or discount is often evalu- acquire net open positions in the course of
ated in terms of percent per annum. For the dealing with customers or other market makers.
examples above, the premium of 250 points is The bank must then decide whether to hold its
equivalent to 2.71 percent per annum, while the open position (in anticipation of a move in the
discount of 175 points is equivalent to 1.90 currency) or cover its position. If it wishes to
percent per annum. To calculate the percentage cover, the bank may call another bank and either
premium for the first case— buy or sell the currency needed to close its open
position.
• take the swap rate ($0.0250), Financial institutions engaging in interbank
• multiply by 12 months and divide by six spot trading will often have sizeable net open
months (a per annum basis), positions, though many for just brief periods of
• divide by the spot rate ($1.8450), and time. No matter how skilled the trader, each
• multiply by 100 (to get a percent basis). institution will have occasional losses. Knowing
when to close a position and take a small loss
This formula can be expressed as— before it becomes large is a necessary trait for a
competent trader. Many financial institutions
% per annum = employ a ‘‘stop-loss policy,’’ whereby a net
open position must be covered if losses from it
Premium or Discount * 12 reach a certain level. While a trader’s forecast
* 100 may ultimately prove correct within a day or
Spot rate * no. of months
of forward contract week, rapid rate movements often cause a loss
within an hour or even minutes. Also, access to
Forward rates (premiums or discounts) are up-to-the-minute information is vital for involve-
solely influenced by the interest-rate differen- ment in spot trading. Financial institutions that
tials between the two countries involved. As a lack the vast informational resources of the
result, when the differential changes, forward largest multinationals may be particularly vul-
contracts previously booked could now be cov- nerable to sudden spot rate movements. As a
ered at either a profit or loss. For example, result, examiners should closely review finan-
assume an interest-rate differential between ster- cial institutions in which foreign-exchange
ling and dollars of 3 percent (with the sterling activities consist primarily of interbank spot
rate lower). Using this formula, with a spot rate trading.
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Foreign Exchange 4305.1
Forwards or buying an equivalent amount of the same
currency, the institution is exposed to the risk
Active trading financial institutions will gener- that the exchange rate might move against it.
ally have a large number of forward contracts That risk exists even if the dealer immediately
outstanding. The portfolio of forward contracts seeks to cover the position because, in a market
is often called a forward book. Trading forward in which exchange rates are constantly chang-
foreign exchange involves projecting interest- ing, a gap of just a few minutes can be long
rate differentials and managing the forward enough to transform a potentially profitable
book to be compatible with these projections. transaction into a loss. Since exchange-rate
Forward positions are generally managed on a movements can consistently run in one direc-
gap basis. Normally, financial institutions will tion, a position carried overnight or over a
segment their forward books into 15-day periods number of days entails greater risk than one
and show the net (purchased forward contracts carried a few minutes or hours.
less sold ones) balance for each period. Volumes At any time, the trading function of a financial
and net positions are usually segregated into institution may have long positions in some
15-day periods for only the first three months, currencies and short positions in others. These
with the remainder grouped monthly. The trader positions do not offset each other, even though,
will use the forward book to manage his or her in practice, the price changes of some currencies
overall forward positions. do tend to be correlated. Traders in institutions
A forward book in an actively traded currency recognize the possibility that the currencies in
may consist of numerous large contracts but, which they have long positions may fall in value
because of the risks in a net open position, total and the currencies in which they have short
forward purchases will normally be approxi- positions may rise. Consequently, gross trading
mately equal to total forward sales. What mat- exposure is measured by adding the absolute
ters in reviewing a forward book is the distribu- value of each currency position expressed in
tion of the positions among periods. For example, dollars. The individual currency positions and
if a forward book in sterling has a long net the gross dealing exposure must be controlled to
position of 3,200,000 for the first three months avoid unacceptable risks.
and is short a net 3,000,000 for the next four To accomplish this, management limits the
months, the forward book is structured antici- open positions dealers may take in each cur-
pating a decline in dollar interest rates as com- rency. Practices vary among financial institu-
pared with sterling interest rates since these sold tions, but, at a minimum, limits are established
positions could be offset (by purchase of a on the magnitude of open positions which can
forward contract to negate the sold forward be carried from one day to the next (overnight
position) at a lower price—either through limits). Several institutions set separate limits
reduced premium or increased discount. See the on open positions dealers may take during the
subsection below for a discussion of the risks day. These are called ‘‘daylight limits.’’ Formal
encountered in hedging foreign-exchange limits on gross dealing exposure also are
exposure. established by some institutions, while others
review gross exposure more informally. The
various limits may be administered flexibly, but
the authority to approve a temporary departure
RISKS from a limit is typically reserved for a senior
officer.
Exchange-Rate Risk For management and control purposes, most
financial institutions distinguish between posi-
Exchange-rate (market) risk is an inevitable tions arising from actual foreign-exchange trans-
consequence of trading in a world in which actions (trading exposure) and the overall
foreign-currency values move up and down in foreign-currency-translation exposure of the
response to shifting market supply and demand. institution. The former includes the positions
When a financial institution’s dealer buys or recorded by the institution’s trading operations
sells a foreign currency from another financial at the head office and at offices abroad. In
institution or a nonbank customer, exposure addition to trading exposure, overall exposure
from a net open position is created. Until the incorporates all the institution’s assets and
time that the position can be covered by selling liabilities denominated in foreign currencies,
Trading and Capital-Markets Activities Manual February 1998
Page 5
4305.1 Foreign Exchange
including loans, investments, deposits, and the maturing later. At the same time, management
capital of foreign branches. relies on officers abroad, domestic money mar-
ket experts, and its economic research depart-
ment to provide ongoing analysis of interest-rate
Maturity Gaps and Interest-Rate Risk trends.
Interest-rate risk arises whenever mismatches or
gaps occur in the maturity structure of a finan- Credit and Settlement Risk
cial institution’s foreign-exchange forward book.
Managing maturity mismatches is an exacting When a financial institution books a foreign-
task for a foreign-exchange trader. exchange contract, it faces a risk, however
In practice, the problem of handling mis- small, that the counterparty will not perform
matches is complex. Eliminating maturity gaps according to the terms of the contract. To limit
on a contract-by-contract basis is impossible for credit risk, a careful evaluation of the creditwor-
an active trading institution. Its foreign-exchange thiness of the customer is essential. Just as no
book may include hundreds of outstanding con- financial institution can lend unlimited amounts
tracts, with some maturing each business day. to a single customer, no institution would want
Since the book is changing continually as new to trade unlimited amounts of foreign exchange
transactions are made, the maturity gap structure with one counterparty.
also changes constantly. Credit risk arises whenever an institution’s
While remaining alert to unusually large mis- counterparty is unable or unwilling to fulfill its
matches in maturities that call for special action, contractual obligations—most blatantly when a
traders generally balance the net daily payments corporate customer enters bankruptcy or an
and receipts for each currency through the use of institution’s counterparty is declared insolvent.
rollovers. Rollovers simplify the handling of the In any foreign-exchange transaction, each coun-
flow of maturing contracts and reduce the num- terparty agrees to deliver a certain amount of
ber of transactions needed to balance the book. currency to the other on a particular date. Every
Reliance on day-to-day swaps is a relatively contract is immediately entered into the finan-
sound procedure as long as interest-rate changes cial institution’s foreign-exchange book. In bal-
are gradual and the size and length of maturity ancing its trading position, a financial institution
gaps are controlled. However, it does leave the counts on that contract being carried out in
financial institution exposed to sudden changes accordance with the agreed-upon terms. If the
in relative interest rates between the United contract is not liquidated, then the institution’s
States and other countries. These sudden changes position is unbalanced and the institution is
influence market quotations for swap trans- exposed to the risk of changes in the exchange
actions and, consequently, the cost of bridging rates. To put itself in the same position it would
the maturity gaps in the foreign-exchange book. have been in if the contract had been performed,
The problem of containing interest-rate risk is an institution must arrange for a new trans-
familiar to major money market banks. Their action. The new transaction may have to be
business often involves borrowing short-term arranged at an adverse exchange rate. The trustee
and lending longer-term to benefit from the for a bankrupt company may perform only on
normal tendency of interest rates to be higher for contracts which are advantageous to the com-
longer maturities. But in foreign-exchange trad- pany and disclaim those contracts which are
ing, it is not just the maturity pattern of interest disadvantageous. Some dealers have attempted
rates for one currency that counts. In handling to forestall such arbitrary treatment through the
maturity gaps, the differential between interest execution of legally recognized bilateral netting
rates for two currencies is decisive, making the agreements. Examiners should determine whether
problem more complex. dealers have such agreements in place and
To control interest-rate risk, senior manage- whether they have a favorable legal opinion as
ment generally imposes limits on the magnitude to their effectiveness, particularly in cross-
of mismatches in the foreign-exchange book. border situations.
Procedures vary, but separate limits are often set Another form of credit and settlement risk
on a day-to-day basis for contracts maturing stems from the time-zone differences between
during the following week or two and for each the United States and foreign nations. Inevita-
consecutive half-monthly period for contracts bly, an institution selling sterling, for instance,
February 1998 Trading and Capital-Markets Activities Manual
Page 6
Foreign Exchange 4305.1
must pay pounds to a counterparty before it will 2. an estimate of the potential future credit
be credited with dollars in New York. In the exposure over the remaining life of each
intervening hours, a company can go into bank- contract.
ruptcy or an institution can be declared insol-
vent. Thus, the dollars may never be credited. The conversion factors are as follows.
Settlement risk has become a major source of
concern to various supervisory authorities be- Credit-Conversion
cause many institutions are not aware of the Remaining Maturity Factor
extent of the risks involved. The Bank for One year or less 1.00%
International Settlements (BIS) has laid out the Five years or less 5.00%
various risks in a paper that was published in Greater than five years 7.50%
July 1996.
Managing credit risk is the joint responsibility If a bank has multiple contracts with a coun-
of the financial institution’s trading department terparty and a qualifying bilateral contract with
and its credit officers. A financial institution the counterparty, the bank may establish its
normally deals with corporations and other current and potential credit exposures as net
institutions with which it has an established credit exposures. (See section 2110.1, ‘‘Capital
relationship. Dealing limits are set for each Adequacy.’’) For institutions that apply market-
counterparty and are adjusted in response to risk capital standards, all foreign-exchange trans-
changes in its financial condition. In addition, actions are included in value-at-risk (VAR) cal-
most institutions set separate limits on the value culations for market risk.
of contracts that can mature on a single day with
a particular customer. Some institutions, recog-
nizing that credit risk increases as maturities
lengthen, restrict dealings with certain custom- LEGAL LIMITATIONS FOR BANK
ers to spot transactions or require compensating INVESTMENT
balances on forward transactions. An institu-
tion’s procedures for evaluating credit risk and Foreign-exchange contracts are not considered
minimizing exposure are reviewed by supervi- investment securities under 12 USC 24(7th).
sory authorities as part of the regular examina- However, the use of these instruments is con-
tion process. sidered to be an activity incidental to banking,
within safe and sound banking practices.
ACCOUNTING TREATMENT
REFERENCES
The accounting treatment for foreign-exchange
contracts is determined by the Financial Account- Das, Satyajit. Swap and Derivative Financing.
ing Standards Board’s Statement of Financial Chicago: Probus Publishing, 1993.
Accounting Standards (SFAS) No. 133, Federal Financial Institutions Examination Coun-
‘‘Accounting for Derivatives and Hedging cil. Uniform Guidelines on Internal Control
Activities.’’ (See section 2120.1, ‘‘Accounting,’’ for Foreign Exchange in Commercial Banks.
for further discussion.)
The New York Foreign Exchange Committee.
Reducing Foreign Exchange Settlement Risk.
RISK-BASED CAPITAL October 1994.
WEIGHTING The New York Foreign Exchange Committee.
Guidelines for Foreign Exchange Trading
The credit-equivalent amount of a foreign- Activities. January 1996.
exchange contract is calculated by summing— Schwartz, Robert J., and Clifford W. Smith, Jr.,
eds. The Handbook of Currency and Interest
1. the mark-to-market value (positive values Rate Risk Management. New York Institute of
only) of the contract and Finance, 1990.
Trading and Capital-Markets Activities Manual April 2001
Page 7
Forwards
Section 4310.1
GENERAL DESCRIPTION USES
Forwards are financial contracts in which two Market participants use forwards to (1) hedge
counterparties agree to exchange a specified market risks, (2) arbitrage price discrepancies
amount of a designated product for a specified within and between markets, (3) take positions
price on a specified future date or dates. Banks on future market movements, and (4) profit by
are active participants in the forward market. acting as market makers. Financial institutions,
Forwards differ from futures (discussed sepa- money managers, corporations, and traders use
rately in this manual) in that their terms are not these instruments for managing interest-rate,
standardized and they are not traded on orga- currency, commodity, and equity risks. While
nized exchanges. Because they are individually most large financial institutions are active in the
negotiated between counterparties, forwards can interest-rate and foreign-exchange markets, only
be customized to meet the specific needs of the a handful of financial institutions have expo-
contracting parties. sures in commodities or equities.
Hedging Interest-Rate Exposure
CHARACTERISTICS AND Financial institutions use forwards to manage
FEATURES the risk of their assets and liabilities, as well as
off-balance-sheet exposures. Asset-liability man-
Forwards are over-the-counter (OTC) contracts agement may involve the use of financial for-
in which a buyer agrees to purchase from a wards to lock in spreads between borrowing and
seller a specified product at a specified price for lending rates. For example, a financial institu-
delivery at a specified future time. While for- tion may sell an interest-rate forward contract in
ward contracts can be arranged for almost any advance of an anticipated funding to lock in the
product, they are most commonly used with cost of funds. If LIBOR subsequently increases,
currencies, securities, commodities, and short- the short position will increase in value, offset-
term debt instruments. (Forwards on short-term ting the higher spot interest cost that the finan-
debt instruments, or ‘‘forward rate agreements,’’ cial institution will have to pay on its funding.
are discussed separately in this manual.) Com- Forward contracts may be used to hedge
mitments to purchase a product are called long investment portfolios against yield curve shifts.
positions, and commitments to sell a product are Financial institutions can hedge mortgage port-
called short positions. folios by selling GNMA forwards, and govern-
Foreign-exchange forward contracts consti- ment bond dealers may sell forwards to hedge
tute the largest portion of the forward market. their inventory. Pension and other types of
They are available daily in the major currencies benefits managers may hedge a fixed future
in 30-, 90-, and 180-day maturities, as well as liability by selling forwards or may hedge an
other maturities depending on customer needs. expected receipt by buying forwards. When
Contract terms specify a forward exchange rate, offsetting swaps with the necessary terms cannot
a term, an amount, the ‘‘value date’’ (the day the be found, interest-rate swap dealers may also
forward contract expires), and locations for use forwards, as well as Eurodollar futures and
payment and delivery. The date on which the Treasury futures, to hedge their unmatched
currency is actually exchanged, the ‘‘settlement commitments.
date,’’ is generally two days after the value date
of the contract.
In most instances, foreign-exchange forwards Hedging Foreign-Exchange Exposure
settle at maturity with cash payments by each
counterparty. Payments between financial insti- Corporations engaged in international trade may
tutions arising from contracts that mature on use foreign-currency contracts to hedge pay-
the same day are often settled with one net ments and receipts denominated in foreign cur-
payment. rencies. For example, a U.S. corporation that
Trading and Capital-Markets Activities Manual February 1998
Page 1
4310.1 Forwards
exports to Germany and expects payment in Secondary Market
deutschemarks (DM) could sell DM forwards to
eliminate the risk of a depreciation of the DM at Once opened, forwards tend not to trade because
the time that the payment arrives. A corporation of their lack of standardization, the presence
may also use foreign-exchange contracts to of counterparty credit risk, and their limited
hedge the translation of its foreign earnings for transferability.
presentation in its financial statements.
Financial institutions use foreign-exchange
forwards to hedge positions arising from their Market Transparency
foreign-exchange dealing businesses. An insti-
tution that incurs foreign-exchange exposure The depth of the interest-rate and foreign-
from assisting its customers with currency risk exchange markets and the interest-rate parity
management can use offsetting contracts to relationships help ensure transparency of for-
reduce its own exposure. A financial institution ward prices. Market makers quote bid/ask
can also use forwards to cover unmatched cur- spreads, and brokers bring together buyers and
rency swaps. For example, a dealer obligated sellers, who may be either dealers or end-users.
to make a series of DM payments could buy a Brokers distribute price information over the
series of DM forwards to reduce its exposure to phone and via electronic information systems.
changes in the DM/$ exchange rate.
PRICING
Arbitrage In general, the value of a long forward contract
position equals the spot price minus the contract
Risk-free arbitrage opportunities in which a price. For example, forward (and spot) foreign-
trader can exploit mispricing across related mar- exchange rates are quoted in the number of units
kets to lock in a profit are rare. However, for of the foreign currency per unit of the domestic
brief periods of time, pricing in the forward currency. Forward foreign-exchange rates depend
market may not be consistent with pricing in the on interest-rate parity among currencies. Interest-
cash market. For example, if DM forwards are rate parity requires the forward rate to be that
overpriced relative to the rates implied by rate which makes a domestic investor indifferent
interest-rate parity relationships, a trader could to investing in the home currency versus buying
borrow dollars, sell them against spot DM, foreign currency at the spot rate, investing it in
purchase a DM deposit, and sell the DM for- a foreign time deposit, and subsequently con-
ward. This arrangement would lock in a risk- verting it back to domestic currency at the
free return. forward rate. The interest-rate parity relation-
ship can be expressed as—
F = S × [1 + r(F)] / [1 + r(D)],
DESCRIPTION OF
MARKETPLACE where F is the forward rate, S is the spot rate,
r(D) is the domestic interest rate, and r(F) is the
Primary Market foreign interest rate. Currency rates are foreign
currency per unit of domestic currency. For
Forward contracts are not standardized. Market example, assume the 180-day dollar ($) interest
makers such as banks, investment banks, and rate is 5 percent, the 180-day DM interest rate is
some insurance companies arrange forward con- 10 percent, and the DM/$ spot rate is 1.3514
tracts in various amounts, including odd lots, to (DM per dollar). A dollar-based investor can
suit the needs of a particular counterparty. Bro- borrow dollars at 5 percent, sell them against
kers, who arrange forward contracts between DM at the DM/$ spot rate of 1.3514, and invest
two counterparties for a fee, are also active in the DM at a 10 percent rate of return. When the
the forward market. End-users, including banks, investment matures, the DM proceeds can be
corporations, money managers, and sovereign reconverted to dollars at the forward rate of
institutions, use forwards for hedging and specu- 1.4156 DM for each dollar, giving the investor a
lative purposes. total dollar return of 5 percent, which is the
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Forwards 4310.1
same return available in dollar deposits. In this contract has positive market value. In other
instance, the forward rate is higher than the spot words, credit risk in forwards arises from the
rate to compensate for the difference between possibility that a contract has positive replace-
DM- and dollar-based interest rates. The differ- ment cost and the counterparty to the contract
ence between the domestic and foreign interest fails to perform its obligations. The value of a
rates is referred to as the ‘‘cost of carry.’’ contract is generally zero at inception, but it
changes as the market price of the product
underlying the forward changes. If the institu-
HEDGING tion holds a contract that has positive market
value (positive replacement cost) that the coun-
Positions in forwards can be offset by cash- terparty defaults on, the institution would forfeit
market positions as well as other forward or this value. To counter this risk, weak counter-
futures position. A financial institution’s expo- parties may be required to collateralize their
sure from a foreign-exchange forward contract commitments. Counterparties dealing with finan-
can be split into a spot-currency component and cial institutions may be required to maintain
an interest-rate differential between the two compensating balances or collateral. Because of
currencies. For the spot foreign-exchange com- their credit risk and the lack of standardization,
ponent, consider a three-month long forward forwards generally cannot be terminated or trans-
position that receives sterling (£) and pays ferred without the consent of each party.
dollars (in three months, the institution receives As part of their risk management, financial
sterling and pays dollars). This position is com- institutions generally establish credit lines for
parable to the combination of receiving a three- each trading counterparty. For foreign exchange
month dollar deposit and making a three-month (spot and forward), the lines are most often
sterling loan. The forward position implicitly expressed in notional terms. These credit lines
locks in a spread between the lending and include global counterparty limits, daily coun-
borrowing rates while exposing the institution to terparty settlement limits, and maturity limits.
future £/$ spot rates. Some sophisticated financial institutions use
To eliminate the currency and interest-rate credit-equivalent risk limits rather than notional
exposure, the financial institution can either amounts for their foreign-exchange exposure.
enter into an offsetting forward or take a short For interest-rate risk, financial institutions usu-
position in sterling. By entering into a three- ally express their exposure in credit equivalents
month forward contract to deliver sterling against of notional exposure. Financial institutions may
dollars, the financial institution could virtually require a less creditworthy counterparty to pledge
eliminate its currency exposure. Alternatively, collateral and supplement it if the position
the institution could borrow three-month ster- moves against the counterparty.
ling, sell it, and invest the dollar proceeds in a
three-month deposit. When the long £/$ forward
comes due, the institution can use the maturing Market Risk
dollar deposit to make its payment and apply the
sterling proceeds to the repayment of the ster- The risk of forward contracts should be evalu-
ling loan. ated by their effect on the market risk of the
overall portfolio. Institutions that leave posi-
RISKS tions in the portfolio unhedged may be more
exposed to market risk than institutions that
Users and providers of forwards face various ‘‘run a matched book.’’ A financial institution
risks, which must be well understood and care- may choose to leave a portion of its exposure
fully managed. The risk-management methods uncovered to benefit from expected price changes
applied to forwards and futures may be similar in the market. However, if the market moves
to those used for other derivative products. against the institution’s prediction, the institu-
tion would incur losses.
Credit Risk
Basis Risk
Generally, a party to a forward contract faces
credit risk to the degree that its side of the Basis risk is the potential for loss from changes
Trading and Capital-Markets Activities Manual April 2001
Page 3
4310.1 Forwards
in the price or yield differential between instru- RISK-BASED CAPITAL
ments in two markets. Although risk from WEIGHTING
changes in the basis tends to be less than that
arising from absolute price movements, it can The credit-equivalent amount of a forward con-
sometimes represent a substantial source of risk. tract is calculated by summing—
Investors may set up hedges, which leave them
vulnerable to changes in basis between the 1. the mark-to-market value (positive values
hedge and the hedged instrument. only) of the contract and
Yield-curve risk may also arise by holding
long and short positions with equal durations but 2. an estimate of the potential future credit
different maturities. Although such arrange- exposure over the remaining life of each
ments may protect against a parallel yield-curve contract.
shift, they may leave investors exposed to the
risk of a nonparallel shift causing uneven price The conversion factors are below.
changes. In foreign currency, basis risk arises
from changes in the differential between interest Credit-Conversion
rates of two currencies. Remaining Maturity Factor
One year or less 0.00%
Five years or less 0.50%
Liquidity Risk Greater than five years 1.50%
Forwards are usually not transferable without If a bank has multiple contracts with a counter-
the consent of the counterparty and may be party and a qualifying bilateral contract with the
harder to liquidate than futures. To eliminate the counterparty, the bank may establish its current
exposure of a contract, a customer may have to and potential credit exposures as net credit
buy an offsetting position if the initial dealer exposures. (See section 2110.1, ‘‘Capital Ade-
does not want to unwind or allow the transfer of quacy.’’) For institutions that apply market-risk
the contract. capital standards, all foreign-exchange transac-
tions are included in value-at-risk (VAR) calcu-
lations for market risk.
Clearing and Settlement Risk
In OTC markets, clearing and settlement occur
on a bilateral basis thereby exposing counter-
parties to intraday and overnight credit risks. To LEGAL LIMITATIONS FOR BANK
reduce these risks as well as transactions costs, INVESTMENTS
many financial institutions have bilateral netting
arrangements with their major counterparties. Forwards are not considered investments under
Position netting allows counterparties to net 12 USC 24 (seventh). The use of these instru-
their payments on a given day, but does not ments is considered to be an activity incidental
discharge their original legal obligations for the to banking, within safe and sound banking
gross amounts. Netting by novation replaces practices.
obligations under individual contracts with a
single new obligation.
REFERENCES
ACCOUNTING TREATMENT
Andersen, Torben. Currency and Interest Rate
The accounting treatment for foreign-exchange Hedging. Simon and Schuster, 1993.
forward contracts is determined by the Financial
Beidleman, Carl. Financial Swaps. Dow Jones-
Accounting Standards Board’s Statement of
Irwin, 1985.
Financial Accounting Standards (SFAS) No.
133, ‘‘Accounting for Derivatives and Hedging Hull, John C. Options, Futures and Other
Activities.’’ (See section 2120.1, ‘‘Accounting,’’ Derivative Securities. 2d ed. Prentice Hall,
for further discussion.) 1989.
April 2001 Trading and Capital-Markets Activities Manual
Page 4
Forward Rate Agreements
Section 4315.1
GENERAL DESCRIPTION confirm the FRA in writing. FRAs are custom-
ized to meet the specific needs of both parties.
A forward rate agreement (FRA) is an over-the- They are denominated in a variety of currencies
counter (OTC) contract for a cash payment at and can have customized notional principal
maturity based on a market (spot) rate and a amounts, maturities, and interest periods. The
prespecified forward rate. The contract specifies British Bankers’ Association (BBA) has devel-
how the spot rate is to be determined (this is oped standards for FRAs, called Forward Rate
sometimes called the reference rate). If the spot Agreements of the BBA (FRABBA) terms, which
rate is higher than the contracted rate, the seller are widely used by brokers and dealers. The
agrees to pay the buyer the difference between standards include definitions, payment and con-
the prespecified forward rate and the spot rate firmation practices, and various rights and
prevailing at maturity, multiplied by a notional remedies in case of default. Under these stan-
principal amount. If the spot rate is lower than dards, counterparties execute a master agree-
the forward rate, the buyer pays the seller. The ment, under which they agree to execute their
notional principal, which is not exchanged, rep- FRA transactions.
resents a Eurocurrency deposit of a specified
maturity or tenor, which starts on the day the
FRA matures. The cash payment is the present USES
value of the difference between the forward rate
and the spot rate prevailing at the settlement Hedging
date times the notional amount. This payment is
due at the settlement date. Buying and selling FRAs are often used as a hedge against future
FRAs is sometimes called taking and placing movement in interest rates. Like financial futures,
FRAs, respectively. FRAs with maturities longer they offer a means of managing interest-rate risk
than a year are called long-dated FRAs. that is not reflected on the balance sheet and,
FRAs are usually settled at the start of the therefore, generally requires less capital.
agreed-upon period in the future. At this time, FRAs allow a borrower or lender to ‘‘lock in’’
payment is made of the discounted present value an interest rate for a period that begins in the
of the interest payment corresponding to the future (assuming no change in the basis), thus
difference between the contracted fixed rate (the effectively extending the maturity of its liabili-
forward rate at origination) and the prevailing ties or assets. For example, a financial institution
reference rate (the spot rate at maturity). For that has limited access to funds with maturities
example, in a six-against-nine-month (6x9) FRA, greater than six months and has relatively longer-
the parties agree to a three-month rate that is to term assets can contract for a six-against-twelve-
be netted in six months’ time against the pre- month FRA, and thus increase the extent to
vailing three-month reference rate, typically which it can match asset and liability maturities
LIBOR. At settlement (after six months), the from an interest-rate risk perspective. By using
present value of the net interest rate (the differ- this strategy, the financial institution determines
ence between the spot and the contracted rate) is today the cost of six-month funds it will receive
multiplied by the notional principal amount to in six months’ time. Similarly, a seller of an
determine the amount of the cash exchanged FRA can lengthen the maturity profile of its
between the parties. The basis used in discount- assets by determining in advance the return on a
ing is actual/360-day for all currencies except future investment.
pounds sterling, which uses an actual/365-day
count convention.
Trading
Banks and other large financial institutions
CHARACTERISTICS AND employ FRAs as a trading instrument. Market
FEATURES makers seek to earn the bid/ask spread through
buying and selling FRAs. Trading may also take
An FRA can be entered into either orally or in the form of arbitrage between FRAs and interest-
writing. Each party is, however, required to rate futures or short-term interest-rate swaps.
Trading and Capital-Markets Activities Manual February 1998
Page 1
4315.1 Forward Rate Agreements
DESCRIPTION OF (1.07) = (1.06).5(1 + 6R12).5
MARKETPLACE
6R12 = 8.00%
Primary Market
There is little evidence that arbitrage opportuni-
Commercial banks are the dominant player in ties exist between the FRA and deposit markets
the FRA market, both as market makers and after taking into account bid/offer spread and
end-users. Nonfinancial corporations have also transactions costs.
become significant users of FRAs for hedging
purposes. Most contracts are originated in
London and New York, but all major European
Valuation at Settlement
financial centers have a significant share of
Settlement on an FRA contract is made in
volume. Market transparency is high in the FRA
advance, that is at the settlement date of the
market, and quotes for standard FRA maturities
contract. The settlement sum is calculated by
in most currencies can be obtained from sources
discounting the interest differential due from the
such as Telerate and Bloomberg.
maturity date to the settlement date using the
A significant amount of trading in FRAs is relevant market rate.
done through brokers who operate worldwide. Let f = the FRA rate (as a decimal), s = the
The brokers in FRAs usually deal in Euros and spot rate at maturity (as a decimal), t = the tenor
swaps. The principal brokers are Tullet & Tokyo of the notional principal in number of days, P =
Foreign Exchange; Garvin Guy Butler; Godsell, the notional principal, and V = the sum due at
Astley & Pearce; Fulton Prebon; and Eurobrokers. settlement. Assume that the basis is actual/360-
day. The interest due the buyer before discount-
ing is (s − f)P(t/360). The discount factor is 1 −
Secondary Market s(t/360). V is the sum due at settlement:
The selling of an existing FRA consists of
V = [(s − f)P(t/360)][1 − s(t/360)]
entering into an equal and opposite FRA at a
forward rate offered by a dealer or other party at
For example, consider a $10 million three-
the time of the sale. The secondary market in
against-six-month FRA with a forward rate of
FRAs is very active and is characterized by a
6.00 percent and a spot rate at maturity of 6.50
significant amount of liquidity and market
percent.
transparency.
V = [$10mm(.065 − .06)(91/360)]
[1 − ((.065)(91/360))]
PRICING
Initial Cost V = $12,431.22
A payment of $12,431.22 would be made by the
When an FRA is initiated, the FRA rate is
seller to the buyer of the FRA at settlement.
set such that the value of the contract is zero,
since no money is exchanged, except perhaps
a small arrangement fee (which may not be HEDGING
payable until settlement). Forward rates are
directly determined from spot rates. For exam- Market Risk
ple, the rate on a 6-against-12-month FRA will
be derived directly from rates on 6- and 12- Eurodollar futures are usually used to hedge the
month deposits. (This rate derived from the market risk of FRA positions. However, the only
yield curve is termed an implied forward rate.) perfect economic hedge for an FRA is an
As an example, suppose the 6-month Eurodollar offsetting FRA with the same terms.
deposit rate is 6.00 percent and the 12-month
Eurodollar deposit rate is 7.00 percent. The rate
on a 6-against-12-month FRA would be derived Credit Risk
by finding the 6-month forward rate, 6 months
hence (6R12): Letters of credit, collateral, and other credit
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Forward Rate Agreements 4315.1
enhancements can be required to mitigate the 5 percent (sometimes 10 percent) of the notional
credit risks of FRAs. In practice, however, this is principal amount. The 5 percent credit exposure
rarely done because the credit risk of FRAs is is a rule of thumb adopted for administrative
very low. ease, and it represents the approximate potential
loss from counterparty default if the reference
interest rate for a three-month future period
RISKS moves against the financial institution by 20
percentage points before the settlement date. For
Interest-Rate Risk an agreement covering a six-month future inter-
val, the 5 percent charge to a counterparty’s
The interest-rate risk (or market risk) of an FRA
credit limit represents exposure against approxi-
is very similar to a short-term debt instrument
mately a 10 percentage point movement in the
with maturity equal to the interest period of the
reference interest rate.
FRA. For example, a six-against-nine-month
FRA has a price sensitivity similar to that of a
three-month debt instrument (approximate dura-
tion of one-fourth of a year). ACCOUNTING TREATMENT
The accounting treatment of single-currency
Liquidity Risk forward interest-rate contracts, such as forward
rate agreements, is determined by the Financial
Liquidity risk (the likelihood that one cannot Accounting Standards Board’s Statement of
close out a position) is low. The FRA markets Financial Accounting Standards (SFAS) No.
are very liquid, although generally not as liquid 133, ‘‘Accounting for Derivatives and Hedging
as the futures markets. Activities.’’ (See section 2120.1, ‘‘Accounting,’’
for further discussion.)
Credit Risk
The credit risk of FRAs is small but greater than RISK-BASED CAPITAL
the credit risk of futures contracts. The credit WEIGHTING
risk of futures is minimal because of daily
margining and the risk management of the The credit-equivalent amount of an FRA con-
futures clearing organizations. If an FRA coun- tract is calculated by summing—
terparty fails, a financial institution faces a loss
equal to the contract’s replacement cost. The 1. the mark-to-market value (positive values
risk of loss depends on both the likelihood of an only) of the contract and
adverse movement of interest rates and the 2. an estimate of the potential future credit
likelihood of default by the counterparty. For exposure over the remaining life of each
example, suppose a financial institution buys an contract.
FRA at 10 percent to protect itself against a rise
in LIBOR. By the settlement date, LIBOR has The conversion factors are below.
risen to 12 percent, but the counterparty defaults.
The financial institution therefore fails to receive Credit-Conversion
anticipated compensation of 2 percent per annum Remaining Maturity Factor
of the agreed notional principal amount for the One year or less 0.00%
period covered by the FRA. Note that the Five years or less 0.50%
financial institution is not at risk for the entire Greater than five years 1.50%
notional principal amount, but only for the net
interest-rate differential. If a bank has multiple contracts with a coun-
FRAs raise the same issues about measuring terparty and a qualifying bilateral contract with
credit-risk exposure as interest-rate swaps. the counterparty, the bank may establish its
Because the periods covered by FRAs are typi- current and potential credit exposures as net
cally much shorter, many institutions calculate credit exposures. (See section 2110.1, ‘‘Capital
the credit exposure on FRAs as a flat rate against Adequacy.’’) For institutions that apply market-
the counterparty’s credit limit, for example, risk capital standards, all foreign-exchange trans-
Trading and Capital-Markets Activities Manual April 2001
Page 3
4315.1 Forward Rate Agreements
actions are included in value-at-risk (VAR) cal- REFERENCES
culations for market risk.
Andersen, Torben. Currency and Interest Rate
Hedging. Simon and Schuster, 1993.
LEGAL LIMITATIONS FOR BANK Das, Satyajit. Swap and Derivative Financing.
INVESTMENTS Chicago: Probus Publishing, 1993.
Francis, Jack, and Avner Wolf. The Handbook
FRAs are not considered investments under
of Interest Rate Risk Management. Irwin Pro-
12 USC 24 (seventh). The use of these instru-
fessional Publishing, 1994.
ments is considered to be an activity incidental
to banking, within safe and sound banking Stigum, Marcia. The Money Market. Dow Jones-
practices. Irwin, 1990.
April 2001 Trading and Capital-Markets Activities Manual
Page 4
Financial Futures
Section 4320.1
GENERAL DESCRIPTION Margin
Futures contracts are exchange-traded agree- In addition, all exchanges require a good faith
ments for delivery of a specified amount and deposit or margin in order to buy or sell a
quality of a particular product at a specified futures contract. The amount of margin will vary
price on a specified date. Futures contracts are from contract to contract and from exchange to
essentially exchange-traded forward contracts exchange. The required margin deposit may also
with standardized terms. Futures exchanges vary depending on the type of position held. The
establish standardized terms for futures con- margin requirement is meant to ensure that
tracts so that buyers and sellers only have to adequate funds are available to cover losses in
agree on price. the event of adverse price changes. Margin
Unlike the over-the-counter (OTC) derivative requirements are determined and administered
markets, futures contracts are required by U.S. by the exchange’s clearinghouse.
law to trade on federally licensed contract mar- As an example of how margin requirements
kets that are regulated by the Commodity Futures operate, consider a deutschemark (DM) 125,000
Trading Commission (CFTC). Banks may invest futures contract against the dollar with a price of
in futures for their own account or act as a $.68/DM. One trader takes a long DM position,
futures broker through a futures commission meaning that it will receive DM 125,000 and
merchant (FCM) subsidiary. The two generic pay $85,000 in December. Another trader takes
types of futures contracts are commodity futures a short DM position, such that it will pay the
(such as coffee, cocoa, grain, or rubber) and DM 125,000 in return for $85,000. Each trader
financial futures (that is, currencies, interest puts up an initial margin of $4,250, which is
rates, and stock indexes). This section focuses invested in U.S. Treasuries in margin accounts
on financial futures. held at each trader’s broker. Time passes and the
$/DM rate increases (the DM decreases in value)
so that the trader with the long DM position
must post additional margin. When the spot rate
subsequently reaches $.61/DM, the long trader
CHARACTERISTICS AND decides to cut his losses and close out his
FEATURES position. Ignoring the limited effect of prior
fluctuations in margin, the long trader’s cumu-
Terms lative loss measures $8,750 ($.68/DM − $.61/
DM) × DM 125,000).
All futures contracts have the following stan-
dardized terms: specific product, quality (or
grade), contract size, pricing convention, and Exchanges
delivery date. The following is an example of
the terms on a futures contract for U.S. Treasury Futures contracts are traded on organized
notes traded on an exchange such as the Chicago exchanges around the world. Exchanges for the
Board of Trade (CBOT). major futures contracts in currencies, interest
rates, and stock indexes are discussed below.
Product: 10-year Treasury notes
Contract size: $100,000 Currency Futures
Price quoted: 32nds of 100 percent
Delivery date: Any business day of delivery In the United States, futures contracts trade in
month (March, June, Septem- the International Monetary Market (IMM) of the
ber, or December, depending on Chicago Mercantile Exchange (CME) in the
the particular contract) major currencies, including the deutschemark,
Deliverable Japanese yen, British pound, Canadian dollar,
grade: Any U.S. Treasury notes with and Swiss franc. Overseas, the most active
maturity of 61⁄2 to 10 years currency futures exchanges are the London
Trading and Capital-Markets Activities Manual February 1998
Page 1
4320.1 Financial Futures
International Financial Futures Exchange maintenance margin, the counterparty must put
(LIFFE) and the Singapore International Mone- up additional collateral.
tary Exchange (SIMEX). Under some circumstances, traders that have
positions in a variety of futures and options on
futures can have their margin determined on a
Interest-Rate Futures portfolio basis. This process takes into account
the natural offsets from combinations of posi-
The IMM and the CBOT list most of the tions which may reduce the total margin required
fixed-income futures in the United States. Con- of a market participant. The industry has devel-
tracts on longer-term instruments, such as Trea- oped a scenario-based portfolio margining sys-
sury notes (2-, 5-, and 10-year) and Treasury tem called SPARTM which stands for the Stan-
bonds (30-year), are listed on the CBOT. Futures dard Portfolio Analysis of Risk.
on short-term instruments such as Eurodollar Many futures contracts specify settlement in
deposits and Treasury bills trade on the IMM. cash, rather than by physical delivery, upon
There are also futures on bond indexes such as expiration of the contract. Cash settlement has
those for municipal bonds, corporate bonds, the advantage of eliminating the transaction
Japanese government bonds, and British gilts. costs of purchasing and delivering the under-
As with currencies, the most active overseas lying instruments. Examples of cash-settled con-
exchanges are in London and Singapore. tracts are futures on Eurodollars, municipal
bond indexes, and equity indexes.
Stock-Index Futures
USES
In the United States, stock-index futures are
available for the S&P 500 (CME), Major Market Market participants use futures to (1) hedge
Index (CME), New York Stock Exchange Com- market risks, (2) arbitrage price discrepancies
posite Index (New York Futures Exchange), and within and between markets, (3) take positions
Nikkei 225 Index (CME). Overseas, there are on future market movements, and (4) profit by
futures on many of the major equity markets, acting as market makers (forwards) or brokers
including the Nikkei (Osaka and Singapore (futures). Financial institutions, money manag-
Futures Exchanges), DAX (LIFFE), and FTSE ers, corporations, and traders use these instru-
100 (LIFFE). ments for managing interest-rate, currency,
commodity, and equity risks. While most large
financial institutions are active in the interest-
rate and foreign-exchange markets, only a hand-
Clearinghouses ful of financial institutions have exposures in
commodities or equities.
Clearinghouses provide centralized, multilateral
netting of an exchange’s futures contracts. Cen-
tralized clearing, margin requirements, and daily
settlement of futures contracts substantially Hedging
reduce counterparty credit risk. A futures
exchange operates in tandem with a clearing- Futures are used to hedge the market risk of an
house that interposes itself between a contract’s underlying instrument. For example, financial
counterparties and, thus, guarantees payment to institutions often face interest-rate risk from
each. borrowing short-term and lending long-term. If
In addition, customers in futures markets post rates rise, the institution’s spread will decrease
collateral, known as initial margin, to guarantee or even become negative. The institution can
their performance on the obligation. At the end hedge this risk by shorting a futures contract on
of each day, the futures position is marked to a fixed-income instrument (such as a Treasury
market with gains paid to or losses deducted security) maturing at the same time as the asset.
from (variation margin payments) the margin If rates rise, the futures position will increase in
account. The balance in a margin account cannot value, providing profit to offset the decrease in
fall below a minimum level (known as mainte- net interest spread on the cash position. If rates
nance margin). If the position falls below the fall, however, the value of the futures contract
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Financial Futures 4320.1
will fall, offsetting the increase in the institu- to readjust the composition of a fixed-income
tion’s interest-rate spread. portfolio in response to a particular outlook on
interest rates. For example, a manager anticipat-
ing an increase in interest rates can shorten
portfolio duration to reduce the risk of loss by
Arbitrage selling Treasury bond or bill futures. Currency
futures could be used to reduce or increase
Risk-free arbitrage opportunities in which a
currency risk in an international portfolio. Equity
trader can exploit mispricing across related mar-
index futures can be used to adjust a portfolio’s
kets to lock in a profit are rare. For brief periods
exposure to the stock market.
of time, pricing in the futures market may be
inconsistent with pricing in the cash market. For
example, if DM futures are overpriced relative
to the rates implied by interest-rate parity rela- Market Making or Brokering
tionships, a trader could borrow dollars, sell
them against spot DM, purchase a DM deposit, A financial institution can also attempt to profit
and sell the DM future. This arrangement would by holding itself out as a market maker or
lock in a risk-free return. broker, providing two-way prices (bid and offer)
to the market. While earning the bid offer
spread, the institution will either hedge the
resulting positions or choose to hold the position
Positioning to speculate on expected price movements.
Traders and investors can use futures for specu-
lating on price movements in various markets.
Futures have the advantage of lower transac- DESCRIPTION OF
tions costs and greater leverage than many MARKETPLACE
cash-market positions. Speculators may make
bets on changes in futures prices by having The combination of contract standardization,
uncovered long or short positions, combinations centralized clearing, and limited credit risk
of long and short positions, combinations of promotes trading of futures on exchanges such
various maturities, or cash and futures positions. as the CBOT, CME, and LIFFE. In the United
Speculators may profit from uneven shifts in the States, futures exchanges traditionally use the
yield curve, fluctuations in exchange rates, or ‘‘open outcry’’ method of trading, whereby
changes in interest-rate differentials. traders and floor brokers, standing in pits on the
For example, a speculator expecting stock trading floor, shout out or use hand signals to
prices to increase buys 10 contracts on the S&P indicate their buy and sell orders and prices.
500 index for March delivery at a price of $420. Technological innovation and the desire for
Each contract covers 500 times the price of the after-hours trading have fostered the develop-
index, thereby giving the speculator immediate ment of electronic trading systems. These sys-
control of over $2.1 million (420 × 500 × 10) of tems have become quite popular overseas, espe-
stock. By February, the index increases to 440, cially on newer exchanges. For example,
giving the speculator an unrealized profit of GLOBEX is an electronic trading system that
$100,000 ((440 − 420) × 500 × 10). The market currently provides after-hours trading of con-
is still bullish, so the speculator decides to hold tracts listed on the CME and the MATIF (Marche
the contract for several more weeks, anticipating a Terme International de France) in Paris. The
more profits. Instead, negative economic news LIFFE after-hours trade-matching system is
drives the index down to 405 and induces the called APT, and the CBOT system is called
speculator to close out his position, leaving a Project A. In addition to these electronic trading
loss of $75,000. systems, several exchanges have extended trad-
Money managers use financial futures as an ing hours through exchange linkages. The oldest
asset-allocation tool. Futures allow managers to and most well-known linkage is the mutual
shift the fixed-income, currency, and equity offset system between the CME and the SIMEX
portions of their portfolios without having to for Eurodollar futures contracts. SIMEX has
incur the costs of transacting in the cash market. similar arrangements with the International
A fixed-income manager may use bond futures Petroleum Exchange (IPE). LIFFE has announced
Trading and Capital-Markets Activities Manual February 1998
Page 3
4320.1 Financial Futures
plans for futures linkages with the CBOT and where F is the futures price, P is the cash price
the CME. of the deliverable security, r is the short-term
Customers submit their buy or sell orders collateralized borrowing rate (or repo rate), and
through registered commodity brokers known as y is any coupon interest paid on the security
FCMs. Several large domestic and foreign banks divided by P. To understand the relationship
and bank holding companies have established between spot and futures prices, imagine an
their own FCM subsidiaries. Most of these investor who borrows at the repo rate, takes a
subsidiaries are also clearing members of the long position in the underlying bond, and sells a
major commodity exchange clearinghouses and bond future. At the maturity of the futures
have an established floor staff working on the contract, the investor can deliver the bond to
clearinghouse’s associated futures exchange. In- satisfy the futures contact and use the cash
stitutional customers often place their orders proceeds from the short futures position to repay
directly with the FCM’s phone clerks on the the borrowing. In competitive markets, the
exchange floor. The clerk signals the order to a futures price will be such that the transaction
pit broker (usually an independent contractor of does not produce arbitrage profits.
the FCM). The pit broker completes the trans- For foreign-exchange futures, the cost-of-
action with another member of the exchange and carry can be derived from the differential
then signals a confirmation back to the phone between the interest rates of the domestic and
clerk who verbally relates the trade information foreign currencies. When foreign interest rates
back to the customer. The trade is then pro- exceed domestic rates, the cost-of-carry is nega-
cessed by the FCM for trade matching, clearing, tive. The spread that could be earned on the
and settlement. An FCM’s back-office clerks difference between a short domestic position
usually recap the customer’s transactions at the and a long foreign position would subsidize the
end of day with the customer’s back-office staff. combined positions. For the no-arbitrage condi-
Paper confirmation is mailed out the following tion to hold, therefore, a comparable futures
day; however, on-line confirmation capability is position (domestic per foreign) must cost less
becoming increasingly common. than the cash (spot) position.
HEDGING
PRICING
Hedge Ratio
As with forward rates, futures prices are derived
from arbitrage-free relationships with spot prices, The hedge ratio is used to calculate the number
taking into account carrying costs for correspond- of contracts required to offset the interest-rate
ing cash-market goods. With commodities, risk of an underlying instrument. The hedge
carrying costs include storage, insurance, trans- ratio is normally constructed by determining the
portation, and financing costs. The cost-of-carry price sensitivity of the hedged item and the price
for financial instruments consists mostly of sensitivity of the futures contract. A ratio of
financing costs, though it may also include some these price sensitivities is then formulated to
fixed costs such as custody fees. The cost-of- determine the number of futures contracts needed
carry concept when referred to in the context of to match the price sensitivity of the underlying
futures contracts is known as the basis (that is, instrument.
the difference between the cash price for a
commodity or instrument and its corresponding
futures price). Interest-Rate Exposure
In the case of fixed-income, interest-rate
futures, the cost-of-carry represents the differ- Financial institutions use futures to manage the
ence between the risk-free, short-term interest risk of their assets and liabilities, as well as
rate and the yield on the underlying instrument. off-balance-sheet exposures. Asset/liability man-
The price of a fixed-income future can be agement may involve the use of futures to lock
expressed by the formula: in spreads between borrowing and lending rates.
For example, a financial institution may sell
F = P + [P × (r − y)], Eurodollar futures in advance of an anticipated
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Financial Futures 4320.1
funding to lock in the cost of funds. If LIBOR RISKS
subsequently increases, the short futures posi-
tion will increase in value, offsetting the higher Users and brokers of futures face various risks,
spot interest cost that the financial institution which must be well understood and carefully
will have to pay on its funding. managed. The risk-management methods applied
These contracts may be used to hedge invest- to futures (or forwards) may be similar to those
ment portfolios against yield-curve shifts. Finan- used for other derivative products.
cial institutions can hedge mortgage portfolios
by selling futures contracts (or GNMA for-
wards), and government bond dealers may sell
Treasury futures to hedge their inventory. Pen-
Credit Risk
sion and other types of benefits managers may
hedge a fixed future liability by selling futures, Unlike OTC derivative contracts, the credit risk
or they may hedge an expected receipt by associated with a futures contract is minimal.
buying futures. The credit risk in futures is less because the
clearinghouse acts as the counterparty to all
Interest-rate swap dealers use futures (or for- transactions on a given exchange. An exchange’s
wards) to hedge their exposures because directly clearinghouse may be a division of the exchange,
offsetting swaps with the necessary terms cannot as in the case of the CME, or may be a
be found easily. The dealers rely on Eurodollar separately owned and operated entity, such as
futures, Treasury futures, and floating-rate agree- the Chicago Board of Trade Clearing Corpora-
ments (a type of interest-rate forward) to hedge tion (BOTCC) or the London Clearing House
their unmatched commitments. For example, a (LCH). In addition to the credit protection a
dealer obligated to pay LIBOR may sell Euro- futures clearinghouse receives from prospective
dollar futures to protect itself against an increase (initial) margin and the daily contract revalua-
in interest rates. tions and settlement (marking to market), a
clearinghouse is usually supported by loss-
sharing arrangements with its clearing member
firms. These loss-sharing provisions may take
Foreign-Exchange Exposure the form of limited liability guarantees (‘‘pass-
the-hat rules’’ (BOTCC, LCH)) or unlimited
Corporations engaged in international trade may liability guarantees (‘‘good-to-the-last-drop
use foreign-currency contracts to hedge pay- rules’’ (CME, NYMEX, SIMEX)). Because of
ments and receipts denominated in foreign cur- these safeguards, no customer has lost money
rencies. For example, a U.S. corporation that due to default on a U.S. futures exchange.
exports to Germany and expects payment in DM In addition, customer-account segregation
could sell DM futures (or forwards) to eliminate significantly reduces the risk a customer faces
the risk of lower DM spot rates at the time that with regard to excess margin funds on deposit
the payment arrives. A corporation may also use with its FCM. Segregation is required for U.S.
foreign-exchange contracts to hedge the transla- futures brokers but is less common overseas.
tion of its foreign earnings for presentation in its However, even with customer-account segrega-
financial statements. tion, FCM customers are exposed to the per-
Financial institutions use foreign-exchange formance of the FCM’s other customers. Unlike
futures (or forwards) to hedge positions arising a U.S. broker-dealer securities account, the
from their businesses dealing in foreign exchange. futures industry does not have a customer insur-
An institution that incurs foreign-exchange ance scheme such as the Securities Investor
exposure from assisting its customers with cur- Protection Corporation (SIPC). The exchanges
rency risk management can use offsetting con- and their clearinghouses often maintain small
tracts to reduce its own exposure. A financial customer-guarantee funds, but disbursement
institution can also use futures (or forwards) to from these funds is discretionary.
cover unmatched currency swaps. For example, Finally, clearinghouses maintain their margin
a dealer obligated to make a series of DM funds in their accounts at their respective settle-
payments could buy a series of DM futures (or ment banks. These accounts are not unique and
forwards) to reduce its exposure to changes in carry the same credit risks as other demand
the DM/$ exchange rate. deposit accounts at the bank. For this reason, the
Trading and Capital-Markets Activities Manual April 2001
Page 5
4320.1 Financial Futures
European Capital Adequacy Directive assigns shift, they may leave investors exposed to the
futures and options margins a 20 percent risk- risk of a nonparallel shift causing uneven price
based capital treatment. changes.
Liquidity Risk
Market Risk
Because of the multilateral netting ability of a
Because futures are often used to offset the futures clearinghouse, futures markets are gen-
market risk of other positions, the risk of these erally more liquid than their equivalent OTC
contracts should be evaluated by their effect on derivative contracts. However, experience varies
the market risk of the overall portfolio. Institu- with each product and market. In the futures
tions that leave positions in the portfolio markets, most liquidity is found in near-term
unhedged may be more exposed to market risk contracts and can be rather thin in the more
than institutions that ‘‘run a matched book.’’ A distant contracts.
financial institution may choose to leave a por-
tion of its exposure uncovered to benefit from
expected price changes in the market. If the Clearing and Settlement Risk
market moves against the institution’s predic-
tion, the institution would incur losses. In OTC markets, clearing and settlement occurs
on a bilateral basis, exposing counterparties to
intraday and overnight credit risks. To reduce
these risks as well as transactions costs, many
Basis Risk financial institutions have bilateral netting
arrangements with their major counterparties.
Basis risk is the potential for loss from changes Position netting allows counterparties to net
in the price or yield differential between instru- their payments on a given day, but does not
ments in two markets. Although risk from discharge their original legal obligations for the
changes in the basis tends to be less than that gross amounts. Netting by novation replaces
arising from absolute price movements, it can obligations under individual contracts with a
sometimes represent a substantial source of risk. single new obligation.
With futures, basis may be defined as the
price difference between the cash market and a
futures contract. As a contract matures, the basis
fluctuates and gradually decreases until the ACCOUNTING TREATMENT
delivery date, when it equals zero as the futures
price and the cash price converge. Basis on The accounting treatment for foreign-currency
interest-rate futures can vary due to changes in futures contracts is determined by the Financial
the shape of the yield curve, which affects the Accounting Standards Board’s Statement of
financing rate for holding the deliverable secu- Financial Accounting Standards (SFAS) No.
rity before delivery. In foreign currency, basis 133, ‘‘Accounting for Derivatives and Hedging
risk arises from changes in the differential Activities.’’ (See section 2120.1, ‘‘Accounting,’’
between interest rates of two currencies. for further discussion.)
Investors may set up hedges with futures,
which leave them vulnerable to changes in basis
between the hedge and the hedged instrument. RISK-BASED CAPITAL
For example, Treasury note futures could be WEIGHTING
sold short to hedge the value of a medium-term
fixed-rate corporate loan. If market forces cause The credit-equivalent amount of a financial
credit spreads to increase, the change in value of futures contract is calculated by summing—
the hedge may not fully offset the change in
value of the corporate bond. 1. the mark-to-market value (positive values
Yield-curve risk may also arise by holding only) of the contract and
long and short positions with equal durations but 2. an estimate of the potential future credit
different maturities. Although such arrange- exposure over the remaining life of each
ments may protect against a parallel yield-curve contract.
April 2001 Trading and Capital-Markets Activities Manual
Page 6
Financial Futures 4320.1
The conversion factors are below. ever, in taking delivery of nonfinancial products,
the bank may need to place the physical com-
Credit-Conversion modity in other real estate owned (OREO). In
Remaining Maturity Factor addition, the bank may not engage in the buying
One year or less 0.00% and selling of physical commodities or hold
Five years or less 0.50% itself out as a dealer or merchant in physical
Greater than five years 1.50% commodities.
If a bank has multiple contracts with a counter-
party and a qualifying bilateral contract with the
counterparty, the bank may establish its current REFERENCES
and potential credit exposures as net credit
exposures. (See section 2110.1, ‘‘Capital Fabozzi, Frank, and Dessa. The Handbook of
Adequacy.’’) Fixed Income Securities. 4th ed. Irwin Profes-
sional Publishing, 1995.
Kolb, Robert. Inside the Futures Markets. Kolb
LEGAL LIMITATIONS FOR BANK Publishing Co. 1991.
INVESTMENTS Stigum, Marcia. The Money Market. 3rd ed.
Dow Jones-Irwin, 1990.
Banks may invest in any futures contract. How-
Trading and Capital-Markets Activities Manual April 2001
Page 7
Interest-Rate Swaps
Section 4325.1
GENERAL DESCRIPTION CHARACTERISTICS AND
FEATURES
Interest-rate swaps are over-the-counter (OTC)
derivative contracts in which two parties agree Swap Terminology and Conventions
to exchange interest cash flows or one or more
notional principal amounts at certain times in An interest-rate swap is an off-balance-sheet,
the future according to an agreed-on formula. OTC contractual agreement in which two coun-
The cash flows may be in the same currency or terparties agree to make interest payments to
a different currency. The formula defines the each other, based on an amount called the
cash flows using one or more interest rates and notional principal. In an interest-rate swap, only
one or more hypothetical principal amounts the interest payments are exchanged; the notional
called notional principal amounts. principal is not exchanged, it is used only to
calculate the interest payments. Each counter-
As an example, suppose that Company A party’s set of payments is called a leg or side of
and Bank B enter into a three-year interest- the swap. The fixed-rate payer has bought the
rate swap, in which Bank B agrees to pay a swap, or is long the swap. Conversely, the
6 percent fixed rate (quoted on a 30/360- floating-rate payer has sold the swap, or is short
day count basis) on a notional principal of the swap. The counterparties make service pay-
$100 million, every six months, on January 1 ments at agreed-on periods during the swap’s
and July 1. In return, Company A agrees to pay tenor. The payer of a fixed leg makes service
U.S. dollar six-month LIBOR on the same dates, payments at a fixed price (or rate). The payer of
on the same notional principal. Thus, the cash a floating leg makes payments at a floating price
flows on the swap will have semiannual fixed- that is periodically reset using a reference rate,
rate payments of $300,000 going to Company A which is noted on specific reset dates. The actual
on each January 1 and July 1, and floating dates on which payments are made are payment
payments based on the prevailing level of U.S. dates.
dollar six-month LIBOR on each January 1 and The reference floating rate in many interest-
July 1 going to Bank B. These semiannual cash rate swap agreements is the London Interbank
flows will be exchanged for the three-year life Offered Rate (LIBOR). LIBOR is the rate of
of the swap. interest offered on short-term interbank deposits
in Eurocurrency markets. These rates are deter-
Banks, corporations, sovereigns, and other mined by trading between banks, and they
institutions use swaps to manage their interest- change continuously as economic conditions
rate risks, reduce funding costs (fixed or float- change. One-month, three-month, six-month,
ing), or speculate on interest-rate movements. and one-year maturities are the most common
Banks (commercial, investment, and merchant) for LIBOR quoted in the swaps market. Other
also act as swaps dealers or brokers in their role floating-rate indexes common to the swaps mar-
as financial intermediaries. As a dealer, a bank ket include prime, commercial paper, T-bills,
offers itself as a counterparty to its customers. and the 11th District Cost of Funds Index
As a broker, a bank finds counterparties for its (COFI).
customers, in return for a fee. A day count convention for the fixed-rate and
floating-rate payments is specified at the begin-
The interest-rate swaps market has grown ning of the contract. The standard convention is
rapidly since its inception in the early 1980s. As to quote the fixed leg on a semiannual 30/360-
of March 1995, interest-rate swaps accounted day basis, and to quote LIBOR on an actual/
for 69 percent of the market in interest-rate 360-day basis. The fixed and floating legs,
derivatives, in terms of notional principal however, can be quoted on any basis agreed to
outstanding. The notional principal outstanding by the counterparties.
in swaps at this date was $18.3 trillion. The The date that the swap is entered into is called
gross market value of these swaps was $562 bil- the trade date. The calculation for the swap
lion, or 87 percent of all interest-rate derivative starts on its settlement date (effective or value
contracts. date). Unless otherwise specified in the agree-
Trading and Capital-Markets Activities Manual February 1998
Page 1
4325.1 Interest-Rate Swaps
ment, the settlement date on U.S. dollar interest- counterparties to lock in a fixed rate (as a
rate swaps is two days after the trade date. The payer or receiver) at the time of contract
swap ends on its termination or maturity date. origination, but to postpone the setting of the
The period of time between the effective and floating rate and the calculation of cash flows
termination dates is the swap’s tenor or maturity. until some time in the future. These swaps are
often used to hedge future debt refinancings or
anticipated issuances of debt.
Swap Agreement • The amortizing swap has a notional principal
which is reduced at one or more points in time
Swaps are typically initiated through telephone before the termination date. These swaps are
conversations and confirmed by fax, telex, or often used to hedge the interest-rate exposure
letter (a confirmation). Both parties are legally on amortizing loans, such as project-finance
bound by the initial agreement and complete loans.
documentation is not exchanged until later. Swap • The accreting swap has a notional principal
contracts are usually executed according to the which is increased at one or more points in
standards of the International Swaps and Deriva- time before the termination date. These swaps
tives Association (ISDA) or the British Bankers are often used to hedge the interest-rate expo-
Association’s Interest-Rate Swaps (BBAIRS). sure on accreting loans, such as the draw-
The complete documentation of a particular down period on project-finance loans.
swap consists of the confirmation; a payment
schedule (in a format standardized by ISDA or • The zero-coupon swap is a fixed-for-floating
BBAIRS); and a master swap agreement that swap in which no payments are made on the
uses standard language, assumptions, and pro- fixed leg until maturity. These swaps are often
visions. As a rule, counterparties execute one used to hedge the exposure on a zero-coupon
master agreement to cover all their swaps. Thus, instrument.
two different swaps may have different confir- • Callable, putable, and extendible swaps are
mations and payment schedules but may use the swaps with embedded options in which one
same master agreement. The master agreements party has the right, but not the obligation, to
cover many issues, such as (1) termination extend or shorten the tenor of the swap. As
events; (2) methods of determining and assess- the counterparty has sold an option to the
ing damages in case of default or early termina- swap dealer in these transactions, the swaps
tion; (3) netting of payments; (4) payment loca- will have a lower fixed rate in the case of a
tions; (5) collateral requirements; (6) tax and fixed-rate payer and a higher fixed rate in
legal issues; and (7) timely notification of the case of a fixed-rate receiver. The counter-
changes in address, telex numbers, or other party is, however, subject to call or extension
information. risk.
• The seasonal swap has different payment
dates for the two legs (which may both be
Types of Swaps fixed), usually tied to the counterparties’ cash-
flow needs. These swaps are often used to
This general swap structure permits a wide create synthetic cash flows when actual cash
variety of generic swaps. Common types of flows change over time. This technique is
interest-rate swaps are outlined below. called deseasoning. For example, suppose
Firm A expects to make $120 million a year,
• The generic (or plain vanilla) swap has a fixed or on average $10 million a month, but also
and a floating leg; the notional amount and expects to earn on average $15 million a
payments are all in the same currency. month in June, July, and August; $5 million a
• The basis (or floating-for-floating) swap has month in May, September, and October; and
two floating legs, each tied to a different $10 million a month in the remaining months.
reference rate. These instruments are often It can enter into a seasonal swap in which it
used to reduce basis risk for a balance sheet pays $5 million a month in June, July, and
that has assets and liabilities based on differ- August, when its revenues are high, and
ent indexes. receives $5 million a month in May, Sep-
• The forward swap has a settlement at some tember, and October, when its revenues are
agreed-on future date. A forward swap allows low.
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Interest-Rate Swaps 4325.1
USES Cash Flows on Transaction
Interest-rate swaps are used for hedging, invest- Assumed cost of money
ment, and speculative purposes. Interest-rate market deposits (pays) −3-month LIBOR
swaps are also used to reduce funding costs and Swap inflow (receives) +3-month LIBOR
arbitrage purposes. Examples of how banks use
interest-rate swaps for asset/liability manage- Swap outflow (pays) −12.00%
ment, investment purposes, and speculation are Loan interest inflow
shown below. (receives) +12.50%
Net position with hedge +50 basis points
Asset/Liability Management: Closing While the bank has effectively locked in a
the Balance-Sheet Gap positive 50 basis point spread, it remains subject
to basis risk between the three-month U.S. dollar
Suppose a bank has a $30 million, five-year, LIBOR rate which it is receiving in the swap
fixed-rate loan asset with a semiannual coupon and the weekly money market rates which it
of 12.5 percent which it has funded with $30 mil- pays to its depositors.
lion of money market deposits. The bank is
faced with a balance-sheet gap—the asset has a
fixed rate of interest, but the cost of the under-
lying liability resets every week. The risk faced Investment Uses: Transforming a
by the bank is that a rise in short-term interest Fixed-Rate Asset into a Floating-Rate
rates will cause the cost of its liabilities to rise Basis
above the yield on the loan, causing a nega-
tive spread. The bank can use a fixed-for- Interest-rate swaps are often used by investment
floating interest-rate swap to achieve a closer managers to create synthetic assets, often in
match between its interest income and interest response to temporary arbitrage opportunities
expense, thereby reducing its interest-rate risk between the cash and derivative markets. A
(see figure 1). plain vanilla interest-rate swap can be used to
As shown in figure 1, the bank has entered transform the yield on a fixed- (floating-) rate
into a five-year interest-rate swap in which it asset such as a corporate bond into a floating-
pays a dealer 12 percent and receives three- (fixed-) rate asset.
month U.S. dollar LIBOR. In effect, the bank As an example, suppose that the investment
has locked in a positive spread of 50 basis manager of Company B has a five-year fixed-
points. rate bond which yields 13.5 percent. Also,
suppose that the investment manager has a
strong view that interest rates will rise, but does
not want to sell the bond because its credit
quality could improve substantially in the future.
Figure 1 To position the portfolio for a rise in rates
without selling the bond, the investment man-
ager can enter into an interest-rate swap in
ASSET which Company B pays a fixed rate of 12 per-
$30m five-year
fixed-rate loan
at 12.5% semiannual
Fixed rate 12%
semiannual
Figure 2
five years
BANK COUNTERPARTY Fixed-rate asset
Three-month Yield 13.5%
$ LIBOR
LIABILITY Fixed rate 12%
$30m money market COMPANY B BANK
rates set weekly
90-day T-bill
Trading and Capital-Markets Activities Manual February 1998
Page 3
4325.1 Interest-Rate Swaps
cent and receives a floating rate based on the Figure 3—Using Plain Vanilla Swaps to
90-day T-bill rate, effectively creating a syn- Leverage Interest-Rate Exposure
thetic floating-rate security yielding the 90-day
Net cash flow for asset holder, thousands of dollars
T-bill rate plus 150 basis points (see figure 2). 5
4
Cash Flows on Transaction
3
Fixed rate on bond (receives) +13.50%
Fixed rate on swap (pays) −12.00% 2
Floating-rate 90-day T-bill
(receives) +90-day T-bill 1
Net Rate Received by 0
0
Company B 90-day T-bill + 1.50% No swaps 1 swap 3 swaps
Change in Interest Rates
Speculation: Positioning for the Interest rates unchanged End-user has $100,000
asset indexed to LIBOR.
Interest rates decrease
Expectation of Rate Movements Interest rates increase 2% In the swaps, the end-
user pays LIBOR and
receives fixed con-
Interest-rate swaps can be used to take a position verts asset to fixed-rate
on interest-rate movements. In this example, an basis.
end-user establishes positions with swaps,
believing that interest rates will fall in a six- swap based on a notional principal amount of
month period. The end-user believes that short- $100,000 (equal to the amount invested in the
term interest rates will decrease, but does not asset), in which the investor pays a floating rate
want to sell its floating-rate asset. The end-user and receives a fixed rate. This swap is effec-
can therefore enter into an interest-rate swap to tively a hedge which transforms the floating-rate
receive a fixed rate of interest and pay a floating asset return to a fixed-rate basis so that the asset
rate of interest, thereby converting the floating- return remains constant under all interest-rate
rate asset to a fixed-rate basis. scenarios.
Figure 3 shows the cash flow to an end-user The third cluster of bars on the horizontal axis
who has a $100,000 asset indexed to LIBOR, (the ‘‘3 swaps’’ scenario) demonstrates the return
under various interest-rate scenarios for a period from the investor’s ‘‘leveraged’’ speculation that
of six months. The vertical axis shows the short-term interest rates will decrease. Here, the
end-user’s net cash flow after six months, and investor enters into three interest-rate swaps
the horizontal axis shows different interest-rate based on a notional principal of $100,000 (which
exposure strategies, ranging from holding the is equivalent to one swap based on a notional
asset without entering into interest-rate swaps to principal of $300,000), in which the investor
entering into swaps to pay LIBOR and receive a pays a floating rate and receives a fixed rate.
fixed rate. Again, the first swap effectively transforms the
In each of the three clusters of bars on the floating-rate asset to a fixed-rate basis; in the
horizontal axis, the return to the end-user under second and third swaps, the investor receives
different interest-rate scenarios is displayed (from (pays) the differential between the fixed and
left to right) for no change in interest rates, a floating rates in the swap. Hence, if interest rates
2.00 percent decrease in interest rates, and a decrease 2.00 percent and the investor has
2.00 percent increase in interest rates. As can be entered into three interest-rate swaps (the middle
seen from the middle bar in the first cluster (the bar in the third cluster), the asset return is
‘‘no swaps’’ scenario), if the investor is correct increased substantially compared to just holding
and short-term interest rates decrease, the return onto the asset (the middle bar in the first cluster).
on the asset will fall dramatically. However, if the investor is wrong, and interest
The second cluster of bars on the horizontal rates increase 2.00 percent after three interest
axis (the ‘‘1 swap’’ scenario) shows the asset rates have been entered into, the return on the
return after the investor has entered into one asset will be zero.
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Interest-Rate Swaps 4325.1
DESCRIPTION OF short-term market rates. The class also includes
MARKETPLACE borrowers who have fixed-rate debt outstanding
and prefer to convert it to floating-rate debt.
Primary Market Institutions such as life insurance companies,
pension funds, wealthy investors, and managed
The primary market for interest-rate swaps trust accounts are notable examples of natural
consists of swap dealers, swap brokers, and fixed-rate receivers.
end-users.
Brokers and Dealers Secondary Market
Financial institutions, such as commercial banks, If a counterparty wishes to terminate, or unwind,
investment banks, and insurance companies, act an existing swap position in the secondary
as dealers in interest-rate swaps. Banks are market, it must do so by one of three methods:
a natural intermediary in the swaps market swap reversal, swap assignment, or swap buy-
because of their exposure to interest-rate move- back (also called close-out or cancellation).
ments and their expertise in analyzing customer In a swap reversal, a counterparty of a swap
credit risk. enters into an offsetting swap with the same
Swap brokers are paid a fee for arranging a terms as the original swap. For example, if Firm
swap transaction between two counterparties. A is in a fixed-for-floating swap, paying 10 per-
Swap brokers do not take positions and do not cent on $10 million notional for U.S. dollar
act as a counterparty to a swap transaction. three-month LIBOR, with one year to maturity,
the offsetting swap would be a one-year floating-
for-fixed swap, paying U.S. dollar three-month
End-Users LIBOR for 10 percent on $10 million notional.
If market rates have changed since the position
End-users of interest-rate swaps include finan- was initiated, which is likely, a mirror offsetting
cial institutions, corporations, sovereigns, position cannot be established unless a fee is
government-sponsored enterprises (GSEs), and paid to establish the off-market mirror transac-
money managers. Banks who are dealers often tion. For instance, in the example above, if
also use swaps in an end-user capacity for one-year rates at the time that the mirror swap is
asset/liability management, funding, and invest- traded are 8 percent, the counterparty will have
ment purposes. End-users use interest-rate swaps to pay a fee of approximately $185,000 to enter
for hedging, investment, and speculative pur- into the mirror trade ((10 percent − 8 percent) ×
poses. They also often use interest-rate swaps to $10 million discounted at 8 percent). The coun-
reduce funding costs. terparty does not cancel the first swap; it adds a
The nature of an end-user’s business often second swap to its books at the cost of increas-
determines whether he or she will wish to be a ing default risk.
fixed-rate receiver or a fixed-rate payer. Fixed- In a swap assignment, a counterparty finds a
rate payers are often firms whose minimum cash new counterparty who is willing to assume its
flows are reasonably predictable regardless of position in the swap. Swap assignments require
the level of interest rates. This class includes the acquiescence of the other counterparty to the
manufacturing and distribution firms in the swap. At the time of the assignment, a payment
developed countries, financial institutions with representing the net present value of the swap is
large portfolios of fixed-rate assets, and national made either to or from the new assigned coun-
agencies of certain developed countries that terparty. For example, using the example above
have difficulty accessing fixed-rate funds. in which Firm A is in a 10 percent one-year
Fixed-rate receivers are often highly sensitive fixed-for-floating swap, Firm A can assign its
to changes in short-term market rates of interest. position in the swap to a new counterparty—
This class includes large money-center or Counterparty B (usually a dealer). In this case,
regional banks that have large portfolios of as the swap has a negative mark-to-market value
floating-rate assets. The interest rates on the for Firm A, Firm A will be required to make a
assets held in their loan portfolios may be payment of $185,000 to Counterparty B. Coun-
indexed to U.S. prime rates, LIBOR, or other terparty B then assumes Firm A’s position in the
Trading and Capital-Markets Activities Manual February 1998
Page 5
4325.1 Interest-Rate Swaps
swap with the original counterparty. A key issue on a semiannual bond-equivalent yield basis)
in swap sales is the creditworthiness of the firm as the price for receiving the floating-interest-
or dealer who will assume the swap. If the rate index flat (no basis points are added to or
creditworthiness is poor, the other counterparty subtracted from the floating rate). For example,
may not agree to the sale. if an investor wants to receive a floating rate,
In a buy-back, one of the counterparties to a such as LIBOR, the fixed rate it will have to pay
swap sells the swap to the other counterparty. would be the current on-the-run Treasury yield
Unlike the swap assignment example above, for the appropriate maturity category of the
buy-backs are between the original counterpar- swap, plus a basis point spread over that yield
ties and do not involve a third party. Buy-backs (on-the-runs are the securities of the relevant
usually involve a payment which is based on the maturity that were most recently auctioned).
mark-to-market value of the swap at the time of This basis point spread over the relevant Trea-
the buy-back. In the example above, Firm A sury is called the swap spread. For example,
would be required to make a payment of assuming that the on-the-run two-year Treasury
$185,000 to the other original counterparty to yield is 6.00 percent and a two-year swap is
terminate the swap. quoted at 18/20 (bid/offer), then a fixed-rate
receiver would pay the dealer LIBOR and receive
a fixed rate of 6.18 percent, and a fixed-rate
payer would pay the dealer 6.20 percent to
Market Transparency receive LIBOR flat.
It is important to distinguish between the
Market transparency in the swaps market is swap spread and the bid/offer spread (discussed
generally high. Market quotes are readily avail- above in the primary market information). The
able on sources such as Telerate and Bloomberg. swap spread is the spread over the Treasury
Increased competition has, in part, led to the yield to pay or receive fixed while the bid/offer
narrowing of bid/offer spreads on plain vanilla spread is the difference between the fixed rate
deals. For instance, in the early 1980s, bid/offer which must be paid to the market maker and
spreads were in the 40 to 50 basis point range the fixed rate that the market maker will pay.
for deals under five years, and liquidity was The swap spread represents the difference
almost nonexistent for deals beyond 10 years. between investment-grade spreads (from Euro-
Today, spreads have narrowed to 1 to 3 basis dollar futures and corporate bond markets) and
points for swaps under 10 years, and liquidity the risk-free rate of Treasury securities. This
has increased significantly on swaps beyond spread adjustment is appropriate because non-
10 years. U.S.-government swap counterparties typically
Liquidity in the secondary market is high but cannot borrow at risk-free Treasury rates. The
is somewhat less than in the primary market supply and demand for fixed-rate funds also
because it is cumbersome to unwind existing influences the swap spread. For instance, if there
positions. To make the secondary market more is a predominance of fixed-rate payers in the
liquid, several people have proposed the cre- market, swap spreads will increase as the demand
ation of a clearing corporation similar to the for paying fixed on swaps will exceed the supply
clearing corporations for futures and options. If of dealers willing to book these swaps, thus
this happens, the disadvantages for end-users bidding up the spread.
would be less customization and more regula- Swaps are priced relative to other funding and
tion. The advantages would be reduction in investment vehicles with the same type of
default (credit) risk and increased transparency. exposure. For shorter maturities, in which liquid
interest-rate futures contracts are available, swaps
are priced relative to futures contracts. Swaps of
one- to five-year maturities are generally priced
PRICING relative to Eurodollar futures.
At longer maturities, swaps are priced relative
Market Conventions and Terminology to rates in alternative traditional fixed- and
floating-rate instruments. For instance, swap
The market convention for pricing swaps is to spreads for 5- to 10-year maturities are roughly
quote the fixed rate in terms of a basis point equivalent to investment-grade (single A or
spread over the Treasury rate (usually quoted higher) corporate spreads over U.S. Treasuries.
February 1998 Trading and Capital-Markets Activities Manual
Page 6
Interest-Rate Swaps 4325.1
Pricing Using Eurodollar Futures R0 = spot LIBOR to first futures expiration
Contracts F1 = first futures contract (100 − futures price)
Fn = futures rate for the last relevant contract
An interest-rate swap can be thought of as in the strip
a series of forward contracts. As such, if for- Di = actual number of days in each period
ward rates are observable, a swap can be priced
as a series of these forward contracts. Eurodollar R = ([1 + .0575(91/ 360)]
futures contracts are observable, liquid market
forward rates for U.S. dollar LIBOR. As the × [1 + .0593(91/ 360)]
fixed rate on a swap is simply the blended × [1 + .0618(91/ 360)]
forward rates for each floating reset date, swaps
can be priced by reference to the Eurodollar × [1 + .064(91/ 360)] − 1)
strip (a series of Eurodollar futures contracts) × 360 / 364
out to the maturity date of the swaps contract.
For example, consider a hypothetical one-year R = 6.21%
swap starting March 19, 1997, and terminating
March 18, 1998 (March to March contract The above example is simplified because the
dates). swap begins and terminates on contract expira-
tion dates. However, a similar methodology
Step 1: Determine forward rates by reference to incorporating stub periods can be used to price
the one-year Eurodollar strip. swaps which do not fall on contract expiration
dates by using the following generalized formula:
[1 + R0 (D0 / 360)]
Month Futures Price Rate × [1 + F1(D1/ 360)]
March ’97 5.75% ×...
(spot 3-month × [1 + Fn(D/ 360)]
LIBOR)
= [1 + R (365/ 360)]N
June ’97 94.07 5.93% × [1 + R (Dr / 360)]
(100 − 94.07)
where
September ’97 93.82 6.18%
(100 − 93.82) Dr = total number of days in the partial-year
period of the strip
December ’97 93.60 6.40% N = number of whole years in the strip
(100 − 93.60)
Swaps are often priced using the Eurodollar
strip for maturities of five years or less when
Step 2: Calculate the swap rate based on the liquidity in the Eurodollar strip is high.
following formula:
R = ([1 + R0(D0 / 360)] Pricing Using Zero-Coupon
× [1 + F1(D1/ 360)] Methodology
×...
A zero-coupon methodology, another method
× [1 + Fn(Dn/ 360)] − 1) used to value swap contracts, is often used to
× 360 / 365 value swaps with maturities greater than five
years. Unlike a yield-to-maturity (YTM) method
where in which each cash flow is valued at a constant
discount rate, a zero-coupon methodology dis-
R = Eurodollar strip rate (swap rate) stated as counts each cash flow by a unique zero-coupon
an annualized money market yield (spot) rate. A zero-coupon rate (zero) can be
Trading and Capital-Markets Activities Manual February 1998
Page 7
4325.1 Interest-Rate Swaps
thought of as the YTM of a zero-coupon bond. ing the coupon rate on the first-period instru-
As such, the return in period n on a zero-coupon ment by the zero-coupon rate which gives a
bond can be derived by making n period invest- price equal to par.
ments at the current forward rates. For instance,
the discount factors for a three-period instru- 100 = (100 + c1)/(1 + z 1),
ment priced on a YTM basis would be derived as where
follows.
c1 = coupon rate on first-period instrument
YTM discount factors: z 1 = zero coupon rate for first period.
[1/ (1 + YTM)] + [1/ ( YTM ) 2 ] + [1/ ( YTM ) 3], The first-period zero rate and the second-period
coupon swap rate are then used to calculate the
where YTM = constant yield-to-maturity rate. second-period zero rate (z2) using the following
relationship:
The discount factors for a three-period instru-
ment priced on a zero-coupon basis would be 100 = [c 2 / (1 + z 1)] + [(100 + c2)/ (1 + z 2) 2],
derived as follows.
where
Zero-coupon discount factors:
c2 = coupon rate on second-period instrument
[1/ (1 + S0 )] + [1/ (1 + S0 )(1 + 1 f2)] z1 = zero-coupon rate for period 1
+ [1/(1 + S 0)(1 + 1 f2)(1 + 2 f3)], z 2 = zero-coupon rate for period 2.
where This process is then continued to calculate an
entire zero-rate curve. Zero rates for all other
S 0 = Spot zero rate at time 0 dates can then be calculated by interpolation.
As an example of the zero-coupon pricing
1 f2 = forward rate for time period 1 to 2 methodology, consider the following simplified
2 f3 = forward rate for time period 2 to 3. example for a $100 million two-year amortizing
fixed-for-floating interest-rate swap, quoted on
Zero-coupon swap rates can be calculated an annual basis. The swap amortized by $50 mil-
either from the price of an appropriate zero- lion at the end of year one, and amortizes to zero
coupon swap or from a series of forward rates at the end of year two.
such as the Eurodollar futures strip. The market
in zero-coupon swaps, however, is not active Step 1: Construct the cash-swap yield curve for
and zero-coupon prices are not observable. How- two years.
ever, zero-coupon swap rates can be derived
from observable coupon-bearing swaps trading
in the market using a technique called bootstrap- On-the-
ping. Once zero-coupon swap rates have been Run
derived, an interest-rate swap can be priced Treasury Swap Swap Rate
similar to a fixed-rate bond by solving for the Maturity Yield Spread (Offer)
swap rate which, when discounted by the appro-
priate zero-coupon rates, will equate the swap to 1 year 4.80% .18%–.20% 5.00%
par. 2 year 5.70% .28%–.30% 6.00%
The first step in the bootstrapping method is
to construct a swap yield curve based on coupon-
paying swaps trading in the market. Once this Step 2: Derive the zero-coupon rates by the
yield curve has been constructed, the coupon bootstrap method.
rates on the swaps can be used to calculate zero
swap rates. Based on the observable first-period Using the coupon swap rates from the swap
swap rate, a zero rate can be derived for the first yield curve above, the first-period zero-coupon
period. Often, this rate may already be stated on rate can be solved using the bootstrap method:
a zero-coupon basis, such as six-month LIBOR
(coupons are not paid on the instrument). The 100 = 105/ (1 + z 1)
first period zero rate (z 1) is derived by discount- z 1 = 5.00%
February 1998 Trading and Capital-Markets Activities Manual
Page 8
Interest-Rate Swaps 4325.1
Likewise, using the above cash-market swap In this example, as rates have risen since the
rates to solve for the zero rate in year 2 by the inception of the swap, the fixed-rate payer
bootstrap method: would receive a fee of $630,000 for terminating
the swap.
100 = [6.00 / (1.05)] + [106 /(1 + z 2)2
z 2 = 6.02%
HEDGING
Step 3: Using iteration, solve for the swap-
coupon rate which equates the cash flows on Any firm that has a position in swaps is exposed
the swap to par using the zero rates obtained in to interest-rate, basis, and credit risks (discussed
step 2 as the discount factors. below). From a dealer standpoint, these risks are
ideally hedged by entering immediately into
$100mm = [$50mm mirror (offsetting) swaps, which eliminate expo-
+ (100mm * Swap Coupon) sure to these risks. However, in practice, dealers
÷ (1.05)] warehouse swap positions and hedge residual
exposure with Eurodollar futures, forward rate
+ [$50mm agreements, or Treasuries until offsetting swaps
+ (50mm * Swap Coupon) can be established. End-users who have a swaps
÷ (1.0602)2] book face the same risks, and apply the same
techniques, as dealers.
Swap-Coupon Rate = 5.65%
Pricing Unwinds Hedging Interest-Rate and Basis Risk
After a swap has been entered into, the mark- Interest-rate risk in a swap portfolio is the risk
to-market (MTM) value can be calculated by that an adverse change in interest rates will
discounting the remaining cash flows on the cause the value of the portfolio to decline. Basis
swap by the appropriate zero-coupon rates pre- risk arises from an imperfect correlation between
vailing at the time of the termination of the the hedge instrument and the instrument being
swap. The resulting value, above or below par, hedged. Interest-rate and basis risk can be hedged
would then represent the amount which would one swap at a time (‘‘microhedging’’), or a
be either received or paid to terminate the swap. portfolio (set) of swaps can be hedged (‘‘mac-
For example, using the amortizing swap exam- rohedging’’). Microhedging is rare today. In
ple above, suppose that after one year, the macrohedging, the overall risks of the portfolio
counterparty who is a fixed-rate payer in the (or subsets of it) are evaluated and hedged using
swap wishes to terminate the swap. At the time, offsetting interest-rate swaps and other interest-
one-year swap rates are 7.00 percent. The mark- rate derivatives. Residual exposures are hedged
to-market value of the swap would be calculated in the Eurodollar futures or Treasury markets.
as follows: Most dealers dynamically hedge the residual
exposure of their swap portfolio by adjusting the
Step 1: Determine the one-year (time remaining hedge position as interest rates change.
to maturity) zero-coupon rate. Risk managers usually take into account the
effect of various interest-rate changes on the
100 = 107/(1.07) profitability of a swap book—for example, when
z 1 = 7.00% interest rates change by 5, 10, 50, or 100 basis
points. Dealers usually hedge for an arbitrary
Step 2: Discount remaining cash flows on the movement in rates, such as 50 basis points,
swap by the zero rate obtained in step 1. which generally depends on senior manage-
ment’s risk appetite.
Price of Swap = [$50mm + ($50mm × .0565)]
÷ (1.07)
Hedging Credit Risk
Price of Swap = $49.37 mm
The main techniques by which credit risk is
MTM Value = $50 mm − $49.37 mm = $630,000 hedged are (1) to require collateral if a counter-
Trading and Capital-Markets Activities Manual April 2001
Page 9
4325.1 Interest-Rate Swaps
party is out of money; (2) to establish termina- market. This dealer has established the price
tion clauses in the master agreement for assess- sensitivities of a longer-term liability and a
ment of damages in the event of default; (3) to floating-rate asset. The price risk here is that if
net payments (when several swaps are outstand- short-term interest rates decrease, the dealer
ing with the same counterparty), according to would be receiving less on the asset but still
terms established in a master netting agreement paying out the same amount on the liability.
(or master agreement); and (4) to sell the swap This interest-rate exposure could be hedged by
to another party. buying Eurodollar futures (or by being long
Hedging the credit risk of a swap book is Treasuries of the same maturity as the swap).
difficult for a number of reasons. First, since Then, if short-term interest rates decrease, the
there is no formal secondary market in swaps, it gain on the hedge should offset the loss on the
may not be immediately possible to trade out of swap.
a position. Second, assumptions about the cer-
tainty of cash flows and the level and term
structure of interest rates are implicit in swap Basis Risk
valuation. If these assumptions do not hold, the
value of a swap book may not behave as A major form of market risk that dealers are
expected, depending on how it is hedged. Third, exposed to is basis risk. Dealers have to hedge
to the extent to which some contracts are cus- the price exposure of swaps they write until
tomized, they may be difficult to value accu- offsetting swaps are entered into, and the hedges
rately and to hedge. may not be perfect.
If risk models are used to estimate a market Basis risk affects profitability. The bid/offer
maker’s potential future credit exposure, the spread is the profit a dealer can make on a
assumptions between the risk-management model hedged swap book, but the dealer can earn less
and the credit-risk model should be consistent. than this due to basis risk.
As is the case for risk management, it is impor-
tant to understand the assumptions in the model
in order to estimate potential credit risk. Sources of Basis Risk
When a dealer hedges swaps that have some
RISKS credit risk with instruments of little or no credit
risk (Treasuries), it creates basis risk. For
The principal risks in swap contracts are interest- instance, dealers often hedge swaps with matu-
rate, basis, credit, and legal and operating risk. rities of five or more years with Treasuries. The
For participants entering into highly customized risks in the swaps usually include credit risks,
transactions, liquidity risk may be important which are reflected in the floating rate(s). Since
because hedging or an assignment of the con- Treasuries are credit-risk-free securities, they do
tract may be difficult. not provide a perfect hedge; this is a source of
basis risk for the dealer, since there can be
divergence between the two rates. Dealers are
Interest-Rate Risk exposed to TED (Treasury-Eurodollar) spread
risk when they hedge swaps of shorter maturi-
Interest-rate risk for swaps is the risk that an ties with Treasuries. In essence, the price of
adverse change in interest rates causes the swap’s Eurodollar futures can change, which will cause
market value to decline. The price risk of swap spreads to change even if Treasury prices
interest-rate swaps is analogous to that of bonds. remain the same, since the swap spread is linked
In fact, a swap can be described as an exchange to the difference between the Eurodollar and
of two securities: a hypothetical fixed-rate bond Treasury markets.
and a floating-rate note. The swap involves the
simultaneous exchange of these two securities
of equal amount and maturity, in which netting Credit Risk
of principal payments at origination and matu-
rity results in no principal cash flow. Along After the swap is executed, changes in interest
these lines, a swap dealer who makes fixed-rate rates cause the swap to move in the money for
payments is considered to be short the bond one counterparty and out of the money for the
April 2001 Trading and Capital-Markets Activities Manual
Page 10
Interest-Rate Swaps 4325.1
other. For example, an increase in market inter- and then simulate values based on changes in
est rates would increase the floating-rate pay- this variable. In practice, a single market vari-
ments from a swap, causing the value of the able is not usually the only factor that causes a
swap to the fixed-rate payer to rise, and the contract’s value to change. However, other fac-
value of the swap to the floating-rate payer to tors that might affect the value are generally
fall. of secondary importance. In addition, if the
As no principal amount is exchanged in an secondary-market variables are not highly cor-
interest-rate swap contract, credit risk is signifi- related with the primary risk source, their impact
cantly less than it is on instruments in which on market value is further reduced.
principal is at risk. Credit-related loss can occur Estimating PkCE for a single contract can be
when the counterparty of an in-the-money swap complex. Accurately estimating PkCE for a
defaults. The credit loss would be limited to the portfolio of contracts executed with one coun-
present value of the difference between the terparty can be so analytically difficult or com-
original and current market rates over the remain- putationally intensive that it is not always
ing maturity of the contract, which is called the feasible. A trade-off has to be made between
replacement cost of the swap. For example, if a the ideal methodology and the computational
dealer had originally swapped fixed payments at demands.
8.5 percent for six-month LIBOR for seven Other factors which affect potential credit
years, and the current market rate for the same exposure include the shape and level of the yield
transaction is 10 percent, the actual loss when a curve, the frequency of payments, the maturity
counterparty defaulted at the end of the first year of the transaction, and whether collateral has
would be the present value of 1.5 percent over been posted. In addition, the changing credit
six years on the notional principal amount of the quality of counterparties can affect potential
swap. credit risk.
Credit risk is a function of both current credit
exposure and potential future credit exposure.
The example above only illustrates current credit Legal Risk
exposure. Potential future exposure depends
primarily on the volatility of interest rates. One Legal risk arises from the possibility that a
approach to estimating peak potential credit swap contract will not be enforceable or legally
exposure (PkCE) is to perform a full-blown binding on the counterparty. For instance, the
Monte Carlo simulation on a counterparty’s enforcement of netting agreements with foreign
portfolio. This strategy has many appealing counterparties varies by country and may expose
features and is the most statistically rigorous. In a counterparty to risk in case of nonenforce-
essence, the model is calculating ‘‘maximum’’ ability. As such, the adequacy of legal documen-
potential market value of the transaction, given tation, including master swap agreements and
a set of market conditions and a set confidence netting agreements, should be reviewed.
interval. However, problems arise from having
to assume desired correlations among variables
when making multiple simulations of market ACCOUNTING TREATMENT
conditions. These correlations need to hold true
over the life of the contract and be adjusted for The accounting treatment for swap instruments
the introduction of new instruments. Aside from is determined by the Financial Accounting Stan-
these methodology problems, it is almost impos- dards Board’s Statement of Financial Account-
sible to run the necessary number of simulated ing Standards (SFAS) No. 133, ‘‘Accounting for
portfolio market values within response times Derivatives and Hedging Activities.’’ (See sec-
acceptable to the trading floor. Also, Monte tion 2120.1, ‘‘Accounting,’’ for further
Carlo simulations do not readily highlight the discussion.)
specific sources of potential exposure or suggest
ways to neutralize this exposure.
An alternative to the full-blown Monte Carlo RISK-BASED CAPITAL
strategy can be characterized as the ‘‘primary WEIGHTING
risk-source approach.’’ This approach attempts
to identify the market variable that is the pri- The credit-equivalent amount of an interest-rate
mary source of changes in the contract’s value swap contract is calculated by summing—
Trading and Capital-Markets Activities Manual April 2001
Page 11
4325.1 Interest-Rate Swaps
1. the mark-to-market value (positive values REFERENCES
only) of the contract and
2. an estimate of the potential future credit Arditti, Fred D. Derivatives. Harvard Business
exposure over the remaining life of each School Press, 1996.
contract. Beidelman, Carl R., ed. Interest Rate Swaps.
Homewood, Ill.: Dow Jones-Irwin, 1990.
The conversion factors are as follows. Das, Satyajit. Swap and Derivative Financing.
Credit-Conversion Chicago: Probus Publishing, 1994.
Remaining Maturity Factor Fabozzi, Frank J., ed. The Handbook of Fixed
Income Securities. 2d ed. Homewood, Ill.:
One year or less 0.00% Dow Jones-Irwin, 1987.
Five years or less 0.50% Global Derivatives Study Group. Derivatives:
Greater than five years 1.50% Practices and Principles. The Group of Thirty,
July 1994.
If a bank has multiple contracts with a counter- Hull, John C. Options, Futures and Other
party and a qualifying bilateral contract with Derivative Securities. 2d ed. Prentice-Hall,
the counterparty, the bank may establish its 1993.
current and potential credit exposures as net Marshall, John F., and Kenneth R. Kapner. The
credit exposures. (See section 2110.1, ‘‘Capital Swaps Market. 2d ed. Miami, Fla.: Kolb
Adequacy.’’) Publishing, 1993.
Smithson, C., C. Smith, and S. Wilford.
Managing Financial Risk: A Guide to Deriva-
LEGAL LIMITATIONS FOR BANK tive Products, Financial Engineering and
INVESTMENTS Value Maximization. Richard D. Irwin, 1995.
Swaps are not considered investments under
12 USC 24 (seventh). The use of these instru-
ments is considered to be an activity incidental
to banking within safe and sound banking
practices.
April 2001 Trading and Capital-Markets Activities Manual
Page 12
Options
Section 4330.1
GENERAL DESCRIPTION when the price of the asset is less than the
exercise price.
Options transfer the right but not the obligation 3. Expiration date. Options are ‘‘wasting assets’’;
to buy or sell an underlying asset, instrument, or they are only good for a prespecified amount
index on or before the option’s exercise date at of time. The date after which they can no
a specified price (the strike price). A call option longer be exercised is known as the expira-
gives the option purchaser the right but not the tion date.
obligation to purchase a specific quantity of the 4. Long or short position. Every option contract
underlying asset (from the call option seller) on has a buyer and a seller. The buyer is said to
or before the option’s exercise date at the strike have a long option position, while the seller
price. Conversely, a put option gives the option has a short option position. This is not the
purchaser the right but not the obligation to sell same as having a long or short position in the
a specific quantity of the underlying asset (to the underlying instrument, index, or rate. A bank
put option seller) on or before the option’s which is long puts on government bonds has
exercise date at the strike price. bought the right to sell government bonds at
The designation ‘‘option’’ is only applicable a given strike price. This gives the bank
to the buyer’s status in the transaction. An protection from falling bond prices. Con-
option seller has an obligation to perform, while versely, if the bank were short puts, it would
a purchaser has an option to require perfor- be obligating itself to purchase government
mance of the seller and will only do so if it bonds at a specific price.
proves financially beneficial. 5. American or European. The two major clas-
Options can be written on numerous instru- sifications of options are American and Euro-
ments. Commercial banks are typically involved pean. American options can be exercised on
most with interest-rate, foreign-exchange, and any date after purchase, up to and including
some commodity options. Options can be used the final expiration date. European options
in bank dealer activities, in a trading account, or can be exercised only on the expiration date
to hedge various risks associated with the under- of the contract. Because American options
lying instruments or portfolio. give the holder an additional privilege of
early exercise, they will generally be more
valuable than European options. Most
exchange options are American, while most
CHARACTERISTICS AND over-the-counter (OTC) options are European.
FEATURES 6. Premium. The price paid for an option is
referred to as the option’s premium. This
A basic option has six essential characteristics, premium amount is a dynamic measure of
as described below. the factors which affect the option’s value.
Therefore, options with identical contract
1. Underlying security. An option is directly terms can trade at a multitude of different
linked to and its value is derived from a premium levels over time. Premium has two
specific security, asset, or reference rate. components: time value and intrinsic value.
Thus, options fit into the classification of Intrinsic value refers to the amount of value
‘‘derivative instruments.’’ The security, asset, in the option if it were exercised today. Time
index, or rate against which the option is value is the difference between the total
written is referred to as the option’s under- premium and the intrinsic value; it encom-
lying instrument. passes the uncertainty of future price moves.
2. Strike price. The strike price is the price at The time value of an option is a function of
which an option contract permits its owner to the security’s volatility (or risk); the current
buy or sell the underlying instrument. The level of interest rates; and the option’s
strike price is also referred to as the exercise maturity (or time to expiration). The option’s
price. A call option is said to be in the money positive time value gradually approaches zero
when the price of the underlying asset exceeds at expiration, with the option price at expi-
the strike price. A put option is in the money ration equal to its intrinsic value.
Trading and Capital-Markets Activities Manual February 1998
Page 1
4330.1 Options
For example, a long call option with a A typical knock-in put option has a barrier
strike price of $50 on an underlying security price which is higher than the strike price. Thus,
which is trading at $52 has an intrinsic value the put only comes into existence when and
of $2. If the option is trading for a total price if the barrier price is reached. A knock-
of $3.50, $1.50 of the price ($3.50 − $2.00) out call barrier price is generally below the
would be time value, reflecting the fact that strike price. A $60 call with a $52 barrier would
the underlying security may further increase cease to exist if at any time during the option’s
in value before the option’s expiration. Not life the security traded $52 or lower. Because
all options will have an intrinsic value com- of this cancelable feature, barrier options
ponent; often the entire premium amount is trade for lower premiums than conventional
time value. options.
An important issue for barrier options is the
frequency with which the asset price is moni-
tored for the purposes of testing whether the
Exotic Options barrier has been reached. Often the terms of the
contract state that the asset price is observed
In the past few years, the growth of so-called once a day at the close of trading.
‘‘exotic’’ derivative products has been signifi-
cant. Options have been no exception, and many Bermudan options give the holder the right to
varied types of exotic options exist today which exercise on multiple but specified dates over the
are traded in the OTC markets. Some of the option’s life.
more common exotic options are discussed Binary options, also called digital options, are
below. characterized by discontinuous payoffs. The
In general, markets for many of the exotic option pays a fixed amount if the asset expires
options are not as liquid as their more generic above the strike price, and pays nothing if it
counterparts. Thus, a quoted price may not be a expires below the strike price. Regardless of
good indication of where actual liquidation of how much the settlement price exceeds the
the trade could take place. strike price, the payoff for a binary option is
Asian options, also called average-price fixed.
options, depend on the average price of the Contingent-premium options are options on
underlying security during the life of the option. which the premium is paid only if the option
For example, a $60 call on a security which expires in the money. Because of this feature,
settled at $65 but traded at an average price of these premiums tend to be higher than those for
$63.5 during the option’s life would be worth conventional options. The full premium is also
only $3.50 at expiration, not $5. Because of this paid at expiration, regardless of how in the
feature, which essentially translates into lower money the option is. Thus, the premium paid
volatility, Asian options tend to trade for a lower can be significantly higher than the profit
premium than conventional options. These returned from the option position.
options are generally cash settled, meaning that Installment options are options on which the
the actual underlying does not change hands. total premium is paid in installments, with the
They belong in the category known as path- actual option issued after the final payment.
dependent options, meaning that the option’s However, the buyer can cancel the payments
payoff depends on the path taken by the under- before any payment date, losing only the pre-
lying security before the option’s expiration. mium paid to date and not the full premium
Barrier options, are options which either amount.
come into existence or cease to exist based on a Lookback options, also in the category of
specified (or barrier) price on the underlying path-dependent, give call buyers the right to
instrument. This also puts them in the category purchase the security for the lowest price attained
of path-dependent options. The two basic types during the option’s life. Likewise, put sellers
of barrier options are knock-in and knock-out. A have the right to sell the security for the highest
knock-in option, either put or call, comes into price attained during the option’s life. The
existence only when the underlying asset’s price underlying asset in a lookback option is often a
reaches a specified level. A knock-out option, commodity. As with barrier options, the value of
either put or call, ceases to exist when the barrier a lookback can depend on the frequency with
price is reached. which the asset price is monitored.
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Options 4330.1
USES A cap, which is written independent of a
borrowing arrangement, acts as an insurance
Options can be used for hedging or speculative policy by capping the borrower’s exposure (for
purposes. Hedgers can use options to protect a fee, the option premium) to higher borrowing
against price movements in an underlying costs if interest rates rise. This is equivalent to
instrument or interest-rate exposure. Speculators the cap writer selling the purchaser a call on
can use options to take positions on the level of interest rates. Above the cap rate, the purchaser
market volatility (if delta-hedged with the under- is entitled to remuneration from the cap writer
lying instrument) or the direction and scope of for the difference between the higher market rate
price movements in the underlying asset. and the cap rate. Often caps have a sequence of
The asymmetric payoff profile of an option is (three-month) expiration dates. Each of these
a unique feature that makes it an attractive three-month pieces is known as a caplet. A bank
hedging vehicle. For example, an investor with a looking to ensure that it does not pay above a
long position in an underlying asset can buy a specified rate on its LIBOR-based liabilities can
put option to offset losses from the long position achieve this objective by purchasing an interest-
in the asset if its price falls. In this instance, the rate cap.
investor’s position in the asset will be protected A floor is the opposite of a cap and sets a
at the strike price of the option, and yet the minimum level on interest rates. Thus, it is like
investor will still gain from any rise in the a put option on interest rates. If interest rates fall
asset’s value above the strike price. Of course, below the floor rate, the purchaser is entitled to
this protection against loss combined with the remuneration from the floor writer for the dif-
ability to gain from appreciation in the asset’s ference between the lower market rate and the
value carries a price—the premium the investor floor rate. An asset manager with floating-rate
pays for the option. In this sense, the purchase of LIBOR assets can purchase a floor to ensure that
an option to hedge an underlying exposure is his or her return on the asset does not fall below
analogous to the purchase of insurance.1 the level of the floor.
Options may also be used to gain exposure to An option strategy consisting of selling a
a desired market for a limited amount of capital. floor and buying a cap is referred to as an
For instance, by purchasing a call option on a interest-rate collar. Collars specify both the
Treasury security, a portfolio manager can cre- upper and lower limits for the rate that will be
ate a leveraged position on a Treasury security charged. It is usually constructed so that the
with limited downside. For the cost of the option price of the cap equals the price of the floor,
premium, the portfolio manager can obtain making the net cost of the collar zero. Caps and
upside exposure to a movement in Treasury floors are also linked to other indexes such as
rates on the magnitude of the full underlying constant maturity Treasury rates (CMT), com-
amount. mercial paper, prime, 11th District Cost of
Many banks sell interest-rate caps and floors Funds Index (COFI), and Treasury bills.
to customers. Banks also frequently use caps
and floors to manage their assets and liabilities.
Caps and floors are essentially OTC interest-rate
options customized for a borrower or lender. DESCRIPTION OF
Most caps and floors reference LIBOR (and thus MARKETPLACE
are effectively LIBOR options). Eurodollar
options are essentially the exchange-traded Options trade both on exchanges and OTC. The
equivalent of caps and floors. vast majority of exchange options are American,
while most OTC options tend to be European.
Exchange-traded (or simply traded) options are
generally standardized as to the underlying asset,
1. Note that the investor’s position in this example, a long expiration dates, and exercise prices. OTC
position in the underlying asset and a purchased put option,
has exactly the same payoff profile as a position consisting of options are generally tailored to meet a custom-
only a purchased call option. This example illustrates the er’s specific needs.
ability to combine options and the underlying asset in com- Banks, investment banks, and certain insur-
binations that can replicate practically any desired payoff
profile. For example, a purchased call combined with a written
ance companies are active market makers in
put, both with the same exercise price, have the same exposure OTC options. End-users of options include
profile as a long position in the underlying asset. banks, money managers, hedge funds, insurance
Trading and Capital-Markets Activities Manual February 1998
Page 3
4330.1 Options
companies, corporations, and sovereign from dealers or a public information source. The
institutions. maturity of the option and the strike price are
known from the terms of the option contract.
Assuming that the price of an asset follows a
random walk, Black and Scholes derived their
PRICING formula for pricing a call option on that asset
given the current spot price (St) at time t, the
In terms of valuation and risk measurement, exercise price (X), the option’s remaining time
instruments with option characteristics differ to maturity (T), the probability distribution (stan-
significantly from other assets. In particular, dard deviation) of the asset price (σ), and a
options require an assessment of the probability constant interest rate r. Specifically, the price C
distribution of possible movements in the at time t of a call option with a strike price of X
relevant market-risk factors. Changes in the which matures at time T is—
expected volatility of an instrument’s price will
affect the value of the option. Option values not C(St ,t; X,T,σ,r) = St N(d + σ√ T − t)
only vary with the degree of expected volatility
in the price of the underlying asset, but also vary − Xe−r (T − t)N(d),
with the price of the underlying in a decidedly
asymmetric way. where N(d) is the probability that a standardized
Although the supply and demand for options normally distributed random variable takes on a
is what directly determines their market prices, value less than d, and
option valuation theory plays a crucial role in
informing market participants on both sides of
ln(St /X) + (r − σ2/2)(T − t)
the market. A number of valuation techniques d=
are used by market participants and are described σ√T − t.
below.
The easiest way to understand this formula is
as the present value of the expected difference
between the future price of the underlying asset
Approaches to Option Valuation and the exercise price, adjusted for the probabil-
Black-Scholes ity of exercise. In other words, it is the expected
value of the payoff, discounted to the present at
The ‘‘standard’’ model used to value options is the risk-free rate. The first term in the Black-
the Black-Scholes option pricing model. Based Scholes equation is the present value of the
on a few key assumptions—including that asset expected asset price at expiration given that the
prices follow a ‘‘random walk’’ (they fluctuate option finishes in the money. The standard
randomly up or down), the risk-free interest rate normal term, N(d), is the probability that the
remains constant, and the option can be exer- option expires in the money; hence, the entire
cised only at expiration—the Black-Scholes second term, Xe − r(T − t)N(d), is the present
model can incorporate all the main risk concepts value of the exercise price times the probability
of options and, therefore, provides a useful basis of exercise.
for discussion. In practice, many financial The key unknown in the formula is future
institutions use more sophisticated models, in volatility of the underlying asset price. There are
some cases proprietary models. two ways of estimating this price. First, it can be
The Black-Scholes formula for the value of a estimated directly from historical data on the
call option depends on five variables: (1) the asset price, for example, by calculating the
price of the underlying asset, (2) the time to standard deviation of daily price changes over
expiration of the option, (3) the exercise price, some recent period. When calculating volatility
(4) the risk-free interest rate (the interest rate on using historical prices, different estimates of
a financial institution deposit or a Treasury bill volatility may be arrived at (and consequently,
of the same maturity as the option), and (5) the also different estimates of an option’s value),
asset’s expected volatility. Of the five variables, depending on the historical period chosen and
only four are known to market participants. The other factors. Hence, the historical period used
asset price and the deposit or Treasury bill rate in volatility estimates should be chosen with
of the appropriate maturity can be ascertained some care.
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Options 4330.1
Alternatively, volatility can be estimated by falls. The amount of the rise or fall at each event
using the Black-Scholes formula, together with point depends on the volatility of the underlying
the market prices of options, to back out the asset price. Each path of the variable—from the
estimate of volatility implicit in the market price valuation date through each event point until
of the option, given the four known variables. expiration—then leads to an ultimate profit or
This is called the implied volatility of the option. loss for the option holder. The value of the
Note that the use of implied volatility may not option is then the ‘‘average’’ present value of
be appropriate for thinly traded options due to these various ultimate outcomes.
the wide variation of options prices in thin The binomial approach is attractive because it
markets. is capable of pricing a wider variety of options
Some institutions use a combination of both than Black-Scholes. For example, a binomial
historical and implied volatilities to arrive at an model can allow for a different value function to
appropriate estimate of expected volatility. be applied at different points in time or for
Examiners should determine if management and options with multiple exercise dates. The bino-
the traders understand the benefits and shortcom- mial model is used by some to value options
ings of both the estimated implied volatility and because it is perceived to be a more reasonable
historical methods of calculating volatility, con- representation of observed prices in particular
sidering that the values derived under either or markets. It is also used to check the accuracy of
both methods may be appropriate in certain modifications to the Black-Scholes model. (The
instances and not appropriate in others. In any Ho-Lee model of interest-rate options, for exam-
case, the method used to estimate volatility ple, is an elaboration of a binomial model.) In
should be conservative, independent of indi- addition, although it requires more computing
vidual traders, and not subject to manipulation time than the Black-Scholes model, the bino-
in risk and profitability calculations. The last mial model can be more easily adapted for
point is especially important because volatilities computer use than other still more rigorous
are a critical component for calculating option techniques. Under the same restrictive assump-
values for internal control purposes. tions described above, the binomial model and
the Black-Scholes formula will produce identi-
cal option values.
Other Closed-Form Models
Since the publication of Black-Scholes, other Monte Carlo Simulations
widely-used formula-based valuation techniques
have been developed for use by market makers A final approach to valuing options is simply to
to value European options as well as options on value them using a large sample of randomly
interest-bearing assets. These techniques include drawn potential future movements in the asset
the Hull and White model and the Black, price, and calculate the average or expected
Derman, and Toy (BDT) model. These models value of the option. The random draws are based
are often described as no-arbitrage models and on the expected volatility of the asset price so
are designed so that the model is, or can be that a sufficiently large sample will (by the Law
made, consistent with the current term structure of Large Numbers) accurately portray the
of interest rates. Other models, such as the Cox, expected value of the option, considering the
Ingersoll, and Ross (CIR) model, apply other entire probability distribution of the asset price.
disciplines to the term structure but allow prices The advantage of this technique is that it
to evolve in a way that need not be consistent allows for different value functions under differ-
with today’s term structure of interest rates. ent conditions, particularly if the value of an
instrument at a point in time depends in part on
past movements in market-risk factors. Thus, for
Binomial Model example, the value of a collateralized mortgage
obligation security at a point in time will depend
An alternative technique used to value options is in part on the level of rate-motivated mortgage
the binomial model. It is termed ‘‘binomial’’ prepayments that have taken place in the past,
because it is constructed as a ‘‘tree’’ of succes- making Monte Carlo simulation the valuation
sive event points in which each branch has two technique market participants prefer. Because of
possible events: the asset price either rises or the time and computer resources required, this
Trading and Capital-Markets Activities Manual February 1998
Page 5
4330.1 Options
technique is generally reserved for the most option may become in the money (profitable for
complex option valuation problems. the holder to exercise); thus the vega is typically
positive. As noted above, market participants
rely on implied rather than historical volatility in
this type of analysis and measurement.
Sensitivity of Market Risk for
Options
Theta
Given the complexity of the market risk arising
from options, and the different models of option The theta of an option, or a portfolio of options,
valuation, a set of terms has evolved in the is the measure of how much an option position’s
market and in academic literature that now value changes as the option moves closer to its
serves as a common language for discussing expiration date (simply with the passage of
options risk. The key terms (loosely known as time). The more time remaining to expiration,
‘‘the greeks’’) are described below. Each term is the more time for the option to become profit-
linked to one of the key variables needed to able to the holder. As time to expiration declines,
price an option, as described earlier; however, option values tend to decline.
there is no ‘‘greek’’ for the exercise price.
Rho
Delta and Gamma
The rho of an option, or a portfolio of options, is
Delta and gamma both describe the sensitivity the measure of how much an option’s value
of the option price with respect to changes in the changes in response to a change in short-term
price of the underlying asset. The delta of an interest rates. The impact of rho risk is more
option is the degree to which the option’s value significant for longer-term or in-the-money
will be affected by a (small) change in the price options.
of the underlying instrument. As such, the esti-
mate of an instrument’s delta can be used to
determine the appropriate option hedge ratio for HEDGING
an unhedged position in that instrument.
Gamma refers to the degree to which the Financial institutions using options may choose
option’s delta will change as the instrument’s from basically three hedging approaches:
price changes. The existence of gamma risk
means that the use of delta hedging techniques is 1. hedging on a ‘‘perfectly matched’’ basis,
less effective against large changes in the price 2. hedging on a ‘‘matched-book’’ basis, and
of the underlying instrument. While a delta- 3. hedging on a portfolio basis.
hedged short option position is protected against
small changes in the price of the underlying
asset, large price changes in either direction will Hedging on a Perfectly Matched
produce losses (though of smaller magnitude Basis
than would have occurred had the price moved
against a naked written option). Some financial institutions prefer to trade and
hedge options on a perfectly matched basis. In
this instance, the financial institution arranges
Vega an option transaction only if another offsetting
option transaction with exactly the same speci-
The vega of an option, or a portfolio of options, fications (that is to say, the same underlying
is the sensitivity of the option value to changes asset, amount, origination date, and maturity
in the market’s expectations for the volatility of date) is simultaneously available. The trade-off
the underlying instrument. An option value is in trading options on a perfectly matched basis
heavily dependent upon the expected price vola- is that the financial institution may miss oppor-
tility of the underlying instrument over the life tunities to enter into deals while it is waiting to
of the option. If expected volatility increases, for find the perfect match. However, many risks are
example, there is a greater probability that an reduced or eliminated when options and other
February 1998 Trading and Capital-Markets Activities Manual
Page 6
Options 4330.1
instruments are traded on a perfectly matched Risk-management or hedging models deter-
basis. In any event, the financial institution mine the amount of exposure remaining in the
continues to assume credit risk when hedging on portfolio after taking into consideration offset-
a perfectly matched basis. ting transactions currently in the book. Offset-
ting transactions using futures, swaps, exchange-
traded options, the underlying asset, or other
transactions are then entered into to reduce the
portfolio’s residual risk to a level acceptable to
Hedging on a Matched-Book Basis the institution. Portfolio hedging permits finan-
cial institutions to act more effectively as market
As a practical matter, managing a portfolio of makers for options and other traded instruments,
perfectly matched transactions is seldom pos- entering into transactions as requested by cus-
sible because of the difficulty in finding two tomers. It is also more efficient and less costly
customers with perfectly offsetting needs. Less than running a matched book since there is less
than perfectly matched hedging, called the need to exactly match the particulars of a
matched-book hedging, attempts to approximate transaction with an offsetting position.
the perfectly matched approach. In matched-
book hedging, all or most of the terms of the
offsetting transactions are close but not exactly RISKS
the same, or transactions are booked ‘‘tempo-
rarily’’ without an offsetting transaction. Credit Risk
For example, a financial institution may enter One of the key risks in an option transaction is
into an option transaction with a customer even the risk that the counterparty will default on its
if an offsetting OTC option transaction with obligation to perform.2 Accordingly, credit risk
similar terms is not available. The financial arises when financial institutions purchase
institution may temporarily hedge the risk asso- options, not when they write (sell) options. For
ciated with that option by using futures and example, when a financial institution sells a put
exchange-traded options, or forward contracts. or call option, it receives a premium for assum-
When an appropriate offsetting transaction ing the risk that it may have to perform if the
becomes available, the temporary hedge is option moves in the money and the buyer
unwound. In reality, it may be some time before chooses to exercise. On the other hand, when a
an offsetting transaction occurs, and it may financial institution purchases a put or call
never occur. Typically, institutions that run a option, it is exposed to the possibility that the
matched book establish position limits on the counterparty may not perform if the option
amount of residual exposure permitted. By moves in the money.
offering transactions on a matched-book basis, When estimating the credit risk associated
financial institutions are able to assist their with an option contract, some institutions calcu-
customers without waiting for a counterparty late credit risk under a worst-case scenario. To
with simultaneous, offsetting needs to appear. develop this scenario, financial institutions typi-
cally rely on statistical analysis. In essence, the
financial institution attempts to project, within a
certain confidence level, how far, in dollar
terms, the option can move in the money. This
Hedging on a Portfolio Basis amount represents the ‘‘maximum potential loss
exposure’’ if the counterparty (option seller)
More sophisticated institutions usually find it defaults on the option contract and the financial
more practical to hedge their exposure on a institution is required to replace the transaction
portfolio basis when trading options (and other in the market. For a discussion of other ways
traded instruments) in more liquid markets, such financial institutions measure credit risk, see
as those for interest rates and foreign exchange.
Portfolio hedging does not attempt to match
each transaction with an offsetting transaction, 2. This discussion of credit risk is relevant for over-the-
but rather attempts to minimize and control the counter products. Exchange-traded options are guaranteed by
residual price exposure of the entire portfolio. a clearing organization and have minimal credit risk.
Trading and Capital-Markets Activities Manual April 2001
Page 7
4330.1 Options
section 2020.1, ‘‘Counterparty Credit and Pre- the earlier expiration months when the bulk of
settlement Risk.’’ trading occurs.
Some exchange-traded contracts limit how far
prices can move on any given day. When the
Settlement Risk market has moved ‘‘limit up’’ or ‘‘limit down’’
for the day, trading ceases until the next day.
The importance of settlement risk may vary These limits cause illiquidity in certain instances.
materially among countries, depending on the Hedging contracts with such limited price-
settlement procedures used. In the United States, movement potential may not adequately protect
for example, transactions are typically settled on the holders against large changes in the value of
a net payment basis, with payment being made underlying asset prices. Examiners should review
to only one party to the contract. The beneficiary the financial institution’s policies and proce-
of the payment incurs the credit risk that the dures to determine whether the financial institu-
counterparty will not make payment and will tion recognizes problems that these limits could
default, but does not face the greater settlement create (for example, ineffective hedges). This
risk that a one-sided exchange of securities will review should also determine whether the finan-
occur. Examiners should determine what settle- cial institution has contingency plans for dealing
ment procedures are used by the markets in with such situations.
which the financial institution participates and
should determine what procedures the financial
institution takes to minimize any settlement risk.
For further discussion of settlement-risk issues, ACCOUNTING TREATMENT
see section 2020.1, ‘‘Counterparty Credit and
Presettlement Risk.’’ The accounting treatment for option contracts is
determined by the Financial Accounting Stan-
dards Board’s Statement of Financial Account-
Liquidity Risk ing Standards (SFAS) No. 133, ‘‘Accounting for
Derivatives and Hedging Activities.’’ (See sec-
The financial institution’s ability to offset or tion 2120.1, ‘‘Accounting,’’ for further
cancel outstanding options contracts is an discussion.)
important consideration in evaluating the useful-
ness and safety and soundness of its options Purchased Options
activities. OTC options contracts are often illiq-
uid since they can only be canceled by agree- The purchaser of an option has the right, but not
ment of the counterparty. If the counterparty the obligation, to purchase a fixed amount of the
refuses to cancel an open contract, the financial underlying instrument according to the terms of
institution must either find another party with the option contract. If a purchased option is held
which to enter an offsetting contract or go to one as a trading asset or otherwise does not qualify
of the exchanges to execute a similar, but for hedge accounting, it should be marked to
offsetting, contract. On the other hand, if a market. Options that qualify for hedge account-
counterparty defaults and the financial institu- ing should record unrealized gains and losses in
tion is unable to enter into an offsetting contract the appropriate period to match the recognition
because of market illiquidity, then the default of the revenue or expense item of the hedged
will expose the financial institution to unex- item. The premium paid on options qualifying
pected market risk. as hedges generally are amortized over the life
Exchanges also do not ensure liquidity. First, of the option.
not all financial contracts listed on exchanges
are heavily traded. While some contracts have
greater trading volume than the underlying cash Written Options
markets, others trade infrequently. In addition,
even with actively traded futures and options The writer of an option is obligated to perform
contracts, the bulk of trading occurs in the first according to the terms of the option contract.
or second expiration month. Thus, to be able to Written options are generally presumed to be
offset open contracts quickly as needs change, speculative and, therefore, should be marked to
the financial institution must take positions in market through the income statement.
April 2001 Trading and Capital-Markets Activities Manual
Page 8
Options 4330.1
RISK-BASED CAPITAL exposures. (See section 2110.1, ‘‘Capital
WEIGHTING Adequacy.’’)
The credit-equivalent amount of an option con-
tract is calculated by summing—
LEGAL LIMITATIONS FOR BANK
1. the mark-to-market value (positive values INVESTMENTS
only) of the contract and
2. an estimate of the potential future credit Options are not considered investment securities
exposure over the remaining life of each under 12 USC 24 (seventh). However, the use of
contract. these contracts is considered to be an activity
incidental to banking within safe and sound
The conversion factors are listed below. banking principles.
Interest Exchange
Remaining Maturity Rate Rate REFERENCES
One year or less 0.00% 1.00% Hull, John C. Options, Futures, and Other
Five years or less 0.50% 5.00% Derivative Securities. 2d ed. New York: Pren-
Greater than five years 1.50% 7.5% tice Hall, 1993.
McCann, Karen. Options: Beginning and Inter-
mediate Issues. Federal Reserve Bank of
If a bank has multiple contracts with a counter- Chicago, November 1994.
party and a qualifying bilateral contract with the McMillan, Lawrence G. Options as a Strategic
counterparty, the bank may establish its current Investment. 2d ed. New York: Institute of
and potential credit exposures as net credit Finance, 1986.
Trading and Capital-Markets Activities Manual April 2001
Page 9
Currency Swaps
Section 4335.1
GENERAL DESCRIPTION 2 million semiannual dividend payment from its
German subsidiary can execute an annuity swap
A currency swap is a private over-the-counter with a dealer in which it will make semiannual
(OTC) contract which commits two counterpar- payments of DM 2 million and receive semi-
ties to exchange, over an agreed period, two annual payments of $300,000—thus locking in a
streams of interest payments denominated in dollar value of its DM-denominated dividend
different currencies, and, at the end of the payments.
period, to exchange the corresponding principal A zero-coupon swap involves no periodic
amounts at an exchange rate agreed upon at the payments (representing ‘‘coupon’’ payments).
start of the contract. The term ‘‘currency swap’’ Rather, these cash flows are incorporated into
can sometimes be used to refer to foreign- the final exchange of principal. Cross-currency
exchange swaps. Foreign-exchange swaps refers zero-coupon swaps are equivalent to a long-
to the practice of buying or selling foreign dated forward contract and are used to hedge
currency in the spot market and simultaneously long-dated currency exposures when the
locking in a forward rate to reverse that trans- exchange-traded and OTC foreign-exchange
action in the future. Foreign-exchange swaps, market may not be liquid.
unlike currency swaps, do not involve interest An amortizing cross-currency swap is struc-
payments—only principal amounts at the start tured with a declining principal schedule, usu-
and maturity of the swap. ally designed to match that of an amortizing
asset or liability. Amortizing cross-currency
swaps are typically used to hedge a cross-border
project-financing loan in which the debt is paid
down over a series of years as the project begins
CHARACTERISTICS AND to generate cash flow.
FEATURES
The term ‘‘currency swap’’ is used to describe
interest-rate swaps involving two currencies. Plain Vanilla Example
The strict application of the term is limited to
fixed-against-fixed interest-rate swaps between Figure 1 illustrates the most simple example of
currencies. Cross-currency swaps, a generic a currency swap. An institution enters into a
variation of the currency swap, involve an currency swap with a counterparty to exchange
exchange of interest streams in different curren- U.S. dollar interest payments and principal for
cies, at least one of which is at a floating rate of offsetting cash flows in German DM.
interest. Those swaps that exchange a fixed rate
against a floating rate are generally referred to as
cross-currency coupon swaps, while those that Figure 1—Plain Vanilla Currency
exchange floating-against-floating using differ- Swap
ent reference rates are known as cross-currency DM interest
basis swaps.
End-user $ interest Dealer
Other types of cross-currency swaps include
annuity swaps, zero-coupon swaps, and amor- DM principal at maturity
tizing swaps. In cross-currency annuity swaps,
$ principal at maturity
level cash-flow streams in different currencies
are exchanged with no exchange of principal at
maturity. Annuity swaps are priced such that the
level payment cash-flow streams in each cur- As illustrated, there are three stages to a cur-
rency have the same net present value at the rency swap. The first stage is an initial exchange
inception of the transaction. Annuity swaps are of principal at an agreed rate of exchange,
often used to hedge the foreign-exchange expo- usually based on the spot exchange rate. The
sure resulting from a known stream of cash initial exchange may be on either a notional
flows in a foreign currency. For example, a U.S. basis (no physical exchange of principal) or a
corporation which receives a deutschemark (DM) physical exchange basis. The initial exchange is
Trading and Capital-Markets Activities Manual February 1998
Page 1
4335.1 Currency Swaps
important primarily to establish the quantity of more, because of the credit risk involved, many
the respective principal amounts for the purpose customers prefer only to deal with the highest-
of calculating the ongoing payments of interest rated institutions. In fact, most of the investment
and for the re-exchange of principal amounts banking dealers book these swaps in special-
under the swap. Most commonly, the initial purpose, ‘‘AAA’’-rated, derivative product
exchange of principal is on a notional basis. subsidiaries.
The second stage involves the exchange of
interest. The counterparties exchange interest
payments based on the outstanding principal Buy Side
amounts at the respective fixed interest rates
agreed on at the outset of the transaction. The The end-users of currency swaps are mainly
third stage entails the re-exchange of principal. financial institutions and corporations. These
On maturity, the counterparties re-exchange prin- firms can enter into a swap either to alter their
cipal at the original exchange rate agreed on at exposures to market risk, enhance the yields of
the execution of the swap. their assets, or lower their funding costs.
USES Quoting Conventions
Currency swaps create exposures to the risk of Currency swaps are generally quoted in terms of
changes in exchange rates and interest rates. all-in prices, that is, as absolute annual fixed
Therefore, they can be used to take risk posi- percentage interest rates. Swap intermediaries
tions based on expectations about the direction may quote two all-in prices for each currency
in which the exchange rate, interest rates, or swap, for example, 6.86–6.96 percent for the
both will move in the future. Firms can alter the U.S. dollar leg and 7.25–7.35 percent for the
exposures of their existing assets or liabilities to DM leg. This is a two-way price, meaning a dual
changes in exchange rates by swapping them quotation consisting of a buying and selling
into foreign currency. Also, a reduction in bor- price for each instrument. The terms buying and
rowing costs can be achieved by obtaining more selling can be ambiguous in the case of swaps;
favorable financing in a foreign currency and the terms paying and receiving should be used
using currency swaps to hedge the associated instead. In currency swaps, that is, fixed-against-
exchange-rate risks. Conversely, a firm can fixed swaps, both sides of the swap should be
enhance the return on its assets by investing in specified. It may not be obvious which side of a
the higher-yielding currency and hedging with two-way price is being paid and which is being
currency swaps. received.
DESCRIPTION OF Trading
MARKETPLACE Since the market for currency swaps is a highly
customized OTC market, most of the trading is
Market Participants done by telephone. In negotiating swaps, key
Sell Side financial details are agreed on orally between
dealers. Key details are confirmed in writing.
Most of the major international financial insti- In the early days of the swaps market, inter-
tutions are willing to enter into currency swaps. mediaries tried to avoid the risk of acting as
However, the group of those institutions acting principals by acting as arrangers of swap deals
as market makers (that is, quoting firm buying between end-users. Arrangers act as agents,
and selling prices for swaps in all trading introducing matching counterparties to each other
conditions) is limited to a handful of the most and then stepping aside. Arrangers were typi-
active swap participants who make markets for cally merchant and commercial banks. Arrange-
interest-rate swaps in the major currencies. Even ment continues to be a feature of currency
this group is focused largely on swaps involving swaps. Brokers act as agents, arranging deals by
U.S. dollar LIBOR as one of the legs. Further- matching swap counterparties, but they do not
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Currency Swaps 4335.1
participate in the actual transactions. Brokers do Value of currency swap =
not earn dealing spreads, but are paid a flat fee PVcurrency B cash flow
based on the size of the deal. Brokers disclose PVcurrency A cash flow −
indicative swap price information over networks Exchange rateB/A
such as Reuters and Telerate.
The market for currency swaps has become The cash flows above (the streams of interest
more complex and diverse. Commercial banks and principal payments) are functions of the
have begun entering this market as principal current market exchange rate, which is used to
intermediaries to provide their expertise in translate net present values into the same cur-
assessing credit risk to end-users of swaps. rency, and the current market interest rates,
Many end-users lack credit analysis facilities which are used to discount future cash flows.
and prefer having credit exposure to a large
financial intermediary rather than to another Calculating the present value of the stream of
end-user counterparty. However, in several cases, fixed interest payments is done as follows:
the credit rating of the financial intermediary is
not strong enough for a particular end-user. For N
Σ n + Vn ,
Cn P
this reason, a large number of these swaps are PVfixed interest + principal =
booked in the AAA subsidiaries. n=1 V
The secondary market for currency swaps is
more limited than the market for single-currency where Vn = [1 + (day count / 360 × I)]n
interest-rate swaps due to the credit risk involved. and Cn = fixed interest cash flow at time n
There are cases in which a buyer of a swap has P = principal cash flow
assigned it to a new counterparty (that is, the I = prevailing annual market interest
buyer substitutes one of the original counterpar- rate
ties). Recently, assignment has been by nova- N = years to maturity
tion, meaning that the swap contract to be n = settlement period number
assigned is in fact terminated and a new but day count = number of days between regular
identical contract is created between the remain- coupon payments
ing counterparty and the assignee.
For example, a $/DM currency swap is used
with these specifications:
Market Transparency Remaining life = 3 years
$ fixed interest rate = 5% APR
A large volume of currency swaps consists of DM fixed interest rate = 9% APR
customized transactions whose pricing is sensi- $ principal = $100 million
tive to credit considerations. Consequently, the DM principal = DM 170 million
actual pricing of these swaps is less transparent Agreed-upon swap
than it is for single-currency interest-rate swaps. exchange rate = 1.700 DM/$
Price information is distributed over screen- Current prevailing rates:
based communication networks, such as Reuters 3-year DM interest rate = 8% APR
and Telerate, but this consists primarily of 3-year $ interest rate = 6% APR
broker’s indicative prices for plain vanilla cross- Spot exchange rate = 1.5 DM/$
currency transactions.
The PV of the deutschemark part of the trans-
action would be—
PRICING PV = DM 174,381,065.
A currency swap is valued as the present value To find the PV of the dollar cash flow, the
(PV) of the future interest and principal pay- following constants are known:
ments in one currency against the PV of future
interest and principal payments in the other N = 3 (years)
currency, denominated in the same currency: I = 6% APR
Trading and Capital-Markets Activities Manual February 1998
Page 3
4335.1 Currency Swaps
such that— the foreign currency of a liability is expected to
depreciate (in the example above, if the dollar is
PV = $97,326,988. expected to depreciate) or the domestic currency
is expected to appreciate, a currency swap
The value of the swap is the difference would restrict currency gains. In such cases, the
between the PVs of the deutschemark and dollar only risk that would need to be hedged against
cash flows. To calculate the difference, first would be interest-rate risk, in which case engag-
convert the DM leg to dollar amounts, using the ing in a domestic currency interest-rate swap
spot exchange rate of 1.5: would be appropriate. (In these hedges, assump-
tions must be made about the movement of the
(DM 174,381,065/1.50 =) $116,254,043 exchange rate. The swap counterparty is still
− $97,326,988 = $18,927,055. exposed to exchange-rate risk, but is hedging
only interest-rate risk based on an assumption
The pricing of currency swaps is similar to about the exchange rate.)
that used for interest-rate swaps, with the differ-
ence that the exchange rate has to be accounted
for in assessing cash flows. A currency swap in
which the two counterparties are both paying
RISKS
fixed interest should have a net present value of Market Risk
zero at inception. The fixed interest rate is set at
inception accordingly. For a cross-currency swap A currency swap that is not hedged or used as a
in which at least one side is paying a floating hedge exposes the institution to dual market
interest rate, implied forward interest rates are risks: exchange-rate risk and interest-rate risk.
used to price the swap. Exchange-rate risk refers to movements in the
prices of a swap’s component parts (specifically,
the spot rate), while interest-rate risk is caused
by movements in the corresponding market
HEDGING interest rates for the two currencies.
Currency swaps are used to manage interest-rate
risk and currency risk. A company with mainly
deutschemark revenues that has borrowed fixed- Liquidity Risk
rate dollars is faced with the prospect of cur-
rency appreciation or depreciation, which would As stated earlier, the market for currency swaps
affect the value of its interest payments and is confined to a small number of institutions and
receipts. In this example, the prospect of a dollar is very credit intensive. Reversing out of a trade
appreciation would mean that the DM revenue at short notice can be very difficult, especially
would have to increase in order to raise enough for the more complicated structures. Occasion-
(stronger) dollars to repay the fixed-rate (dollar) ally, an institution can go to the original coun-
loan. The German firm could hedge its exposure terparty, resulting in the cancellation or novation
to the appreciating dollar by entering into a of the trade, which frees up credit limits needed
DM/$ currency swap. for some other transaction.
Furthermore, if the German company expects
not only that the dollar will appreciate but that
German interest rates will fall, then a cross- Credit Risk
currency swap could be used. The German firm
could swap fixed-rate dollars for floating-rate Credit risk in currency swaps may be particu-
marks to take advantage of the expected fall in larly problematic. Whereas interest-rate swaps
German interest rates, as well as hedge against involve the risk of default on interest payments
exchange-rate risk. only, for currency swaps, credit and settlement
In the example above, initial exchange of risk also extends to the payment of principal.
principal is not needed. Exchange of principal is The consequences of an actual default by a
needed only when a swap counterparty needs to currency-swap counterparty depends on what
acquire foreign currency or needs to convert the swap is being used for. If the currency swap
new borrowing from one currency to another. If is being used to hedge interest-rate and currency
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Currency Swaps 4335.1
risk, the default of one counterparty would leave If a bank has multiple contracts with a coun-
the other counterparty exposed to the risk being terparty and a qualifying bilateral contract with
hedged. This could translate into an actual cost the counterparty, the bank may establish its
if any of those risks are actually realized. If the current and potential credit exposures as net
swap is held to take advantage of expected rate credit exposures. (See section 2110.1, ‘‘Capital
movements, the default of a counterparty would Adequacy.’’) For institutions applying market-
mean that any potential gains would not be risk capital standards, all foreign-exchange trans-
realized. actions are included in value-at-risk (VAR) cal-
culations for general market risk.
ACCOUNTING TREATMENT LEGAL LIMITATIONS FOR BANK
INVESTMENT
The accounting treatment for foreign-currency
transactions, including currency swaps, is deter- Currency swaps are not considered investments
mined by the Financial Accounting Standards under 12 USC 24 (seventh). However, the use of
Board’s Statement of Financial Accounting Stan- currency swaps is considered to be an activity
dards (SFAS) No. 133, ‘‘Accounting for Deriva- incidental to banking, within safe and sound
tives and Hedging Activities.’’ (See section banking practices.
2120.1, ‘‘Accounting,’’ for further discussion.)
REFERENCES
RISK-BASED CAPITAL Balducci, V., K. Doraiswami, C. Johnson, and
WEIGHTING J. Showers. Currency Swaps: Corporate Appli-
cations and Pricing Methodology. Salomon
The credit-equivalent amount of a currency-
Brothers, September 1990.
swap contract is calculated by summing—
Coopers & Lybrand. Currency Swaps. IFR
Publishing, 1993.
1. the mark-to-market value (positive values
New York Foreign Exchange Committee. Guide-
only) of the contract and
lines for Foreign Exchange Trading Activities.
2. an estimate of the potential future credit March 1996.
exposure over the remaining life of each Smith, Clifford W., Jr., Charles W. Smithson,
contract. and D. Sykes Wilford. Managing Financial
Risk. New York: Harper Collins, 1990.
The conversion factors are listed below. Schwartz, Robert J., and Clifford W. Smith, Jr.,
eds. The Handbook of Currency and Interest
Credit-Conversion Rate Risk Management. New York Institute of
Remaining Maturity Factor Finance, 1990.
One year or less 1.00%
Five years or less 5.00%
Greater than five years 7.50%
Trading and Capital-Markets Activities Manual April 2001
Page 5
Swaptions
Section 4340.1
GENERAL DESCRIPTION buyer and the seller. Maturities for swaptions
typically range from one month to two years on
Options on swap contracts (swaptions) are over- the option and up to 10 years on the swap. The
the-counter (OTC) contracts providing the right option component of the swaption can be des-
to enter into an interest-rate swap. In exchange ignated to be exercised only at its expiration
for a one-time, up-front fee, the buyer of the date (a European swaption—the most common
swaption has the right, but not the obligation, to type), on specific prespecified dates (a Ber-
enter into a swap at an agreed-on interest rate at mudan swaption), or at any time up to and
a specified future date for an agreed-on period of including the exercise date (an American
time and interest rate. As such, swaptions swaption).
exhibit all of the same characteristics inherent in Swaptions are generally quoted with refer-
options (including asymmetric risk-return ences to both the option and swap maturity. For
profiles). example, a quote of ‘‘3 into 5’’ references a
In general, an interest-rate call swaption gives 3-year option into a 5-year swap, for a total term
the purchaser the right to receive a specified of eight years. Terms can be arranged for almost
fixed rate, the strike rate, in a swap and to pay any tenor from a 3-month to a 10-year option, or
the floating rate for a stated time period. (In even longer. In general, the 5-year into 5-year
addition to interest rates, swaptions can be swaption might be considered the end of the
traded on any type of swap, such as currencies, very liquid market. Longer-tenor instruments
equities, and physical commodities.) An interest- (for example, 10-year into 20-year) are not
rate put swaption gives the buyer the right to pay uncommon but do not display the same degree
a specific fixed interest rate in a swap and to of liquidity. As with options, active swaption
receive the floating rate for a stated time period. dealers are really speculating on volatility more
Conversely, the writer of a call swaption sells than market direction.
the right to another party to receive fixed (the
writer will thus be obligated to pay fixed if the
option is exercised), while the writer of a put
swaption sells the right to another party to pay Important Variations
fixed (the writer will thus be obligated to receive
fixed if the option is exercised). Cancelable Swaps
Cancelable (callable or putable) swaps are popu-
lar types of swaptions. In exchange for a pre-
mium, a callable swap gives the fixed-rate payor
CHARACTERISTICS AND the right, at any time before the strike date, to
FEATURES terminate the swap and extinguish the obligation
to pay the present value of future payments. A
Swaptions are typically structured to exchange a putable swap, conversely, gives the fixed-rate
stream of floating-rate payments for fixed-rate receiver the right to terminate the swap. (In
payments in one currency. The fixed rate is contrast, a counterparty in a plain vanilla swap
identified as the strike yield and is constant may be able to close out a swap before maturity,
throughout the life of the swaption, while float- but only by paying the net present value of
ing rates are based on a variety of indexes future payments.) Cancelable swaptions are typi-
including LIBOR, Eurodollar futures, commer- cally used by institutions that have an obligation
cial paper, and Treasury bills. in which they can repay principal before the
The swap component of a swaption is not maturity date on the obligation, such as callable
restricted to the fixed versus floating format. bonds. Cancelable swaps allow companies to
As with simple swaps, the structure of swap- avoid maturity mismatches between (1) assets
tions may vary. For a discussion of swap and liabilities with prepayment options and (2)
variations, see section 4325.1, ‘‘Interest-Rate the swaps put in place to hedge them. A ‘‘3x5
Swaps.’’ cancelable swap’’ would describe a five-year
Swaption maturities are not standardized, as swap that may be terminated by one of the
all swaptions are OTC transactions between the counterparties after three years.
Trading and Capital-Markets Activities Manual February 1998
Page 1
4340.1 Swaptions
Extendible Swaps A firm has $100 million of 11 percent fixed-
rate debt which matures May 15, 2002, and is
In exchange for a premium, extendible swaps callable May 15, 1999. The company sells to a
allow the owner of the option to extend the tenor bank a $100 million notional principal European
of an already-existing swap. If a firm has assets call swaption with a strike yield of 11, an option
or liabilities whose maturities are uncertain, an exercise date of May 15, 1999, and an under-
extendible swap allows the investor to hedge the lying swap maturity date of May 15, 2002. In
associated price risk more precisely. return for this swaption, the firm receives $4 mil-
lion. The company has sold to the bank the right
to enter into a swap to receive a fixed rate of 11
Amortizing or Accreting Swaptions and pay a floating rate. As a result of the sale,
the firm’s financing cost is reduced by $4 mil-
Two additional instruments, amortizing and lion, the amount of the premium. From the
accreting swaptions, are useful for real estate– bank’s perspective, a fee was paid for the right
related or project-finance-related loans. Amor- to receive fixed-rate payments that may be
tizing and accreting swaptions represent options above market yields at the exercise date of
to enter into an amortizing or accreting swap, May 15, 1999.
where the principal amount used to calculate
If, at May 15, 1999 (the call date), the
interest-rate payments in the swap decreases or
company’s three-year borrowing rate is 10, the
increases during the life of the obligation. Spe-
debt will be called and the bank will exercise the
cifically, the notional amount of the underlying
call swaption against the firm. The company
swap decreases (amortizes) or increases (ac-
becomes a fixed-rate payer at 11 percent on a
cretes) depending on loan repayments or draw-
three-year interest-rate swap from May 15, 1999,
downs. For example, the swaption can be con-
through May 15, 2002, while receiving the
structed to give the owner of the option some
floating rate from the bank. The firm will now
flexibility in reducing the prepayment risk asso-
attempt to refinance its debt at the same or lower
ciated with a loan.
floating rate than it receives from the bank. As
long as the floating rate that the company
receives does not fall below the firm’s net
refinancing cost, the monetization of the call
USES lowers net borrowing costs because the firm
Swaptions are most commonly used to enhance starts out paying 11 percent interest and is still
the embedded call option value in fixed-rate paying 11 percent interest, but has received the
callable debt and to manage the call risk of $4 million premium.
securities with embedded call features. Swap- If, on the other hand, the company’s three-
tions may be used to provide companies with an year funding rate, as of May 15, 1999, is
alternative to forward, or deferred, swaps, allow- 11 percent or higher, the bank will allow the
ing the purchaser to benefit from favorable option to expire and the firm will not call the
interest-rate moves while offering protection debt. The company will continue to fund itself
from unfavorable moves. Swaptions are also with fixed-rate debentures at 11 percent, but the
used to guarantee a maximum fixed rate of $4 million premium will reduce its effective
interest on anticipated borrowing. borrowing cost.
Enhancing Embedded Call Option Managing the Call Risk of Securities
Value in Fixed-Rate Callable Debt with Embedded Call Features
Through a swaption, the bond issuer sells the Investors also use swaptions to manage the
potential economic benefit arising from the abil- call risks of securities with embedded call
ity to call the bonds and refinance at lower features. For example, an investor buys a
interest rates. This technique, known as ‘‘call seven-year $100 million bond that has a 12
monetization,’’ is effectively the sale (or early coupon and is callable after five and wishes
execution) of debt-related call options. The to purchase protection against the bonds’ being
following example illustrates call monetization. called. Thus, in year four, the investor purchases
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Swaptions 4340.1
from a bank a one-year European call swaption, DESCRIPTION OF
with a strike yield of 12 and a swap maturity of MARKETPLACE
two years based on a notional principal of $100
million. The firm pays the bank a $1 million Swaptions are OTC-traded instruments, and they
up-front fee for this option. In this case, the can easily be customized to suit a particular
higher the strike yield, the higher the up-front investor’s needs. The market is very active and
fee will be. can be loosely coupled with other markets (for
At year five, if two-year floating rates are 10, example, Eurodollar caps and floors and the
the bond will be called, and the investor will OTC bond options market) in certain maturities.
exercise the swaption. The investor will reinvest In addition, there is a very active secondary
its money at the current floating rate of 10, market.
pass along the 10 interest to the bank, and In general, U.S. dollar swaptions with an
receive 12 from the bank. Thus, the investor option component of less than five years can be
guarantees that it will not earn less than 12 on thought of as relatively short-term; the five-year
its investment. If, on the other hand, two-year to seven-year maturity is considered medium-
floating rates are above 12, the bonds will not term, with 10-year and longer options being
be called and the investor will let the option considered long-term and displaying relatively
expire. more limited liquidity. A tenor such as a 10-year
into 10-year swaption can be thought of as the
upper bound on the liquid market.
Guaranteeing a Maximum Interest
Rate on Variable-Rate Borrowing
PRICING
An additional use of swaptions is to guarantee The pricing of swaptions relies on the develop-
a maximum interest rate on variable-rate bor- ment of models that are on the cutting edge of
rowing. A company, for example, issues a two- options theory. Dealers differ greatly in the
year $10 million floating-rate note. The firm models they use to price such options, and the
does not want to pay more than 10 interest so analytical tools range from modified Black-
it purchases from a bank a one-year European Scholes to binomial lattice versions to systems
put swaption for the right to enter into a based on Monte Carlo simulations. As a result,
one-year swap in which it will pay a fixed rate bid/ask spreads vary greatly, particularly from
(strike yield) of 10 on a notional principal of more complicated structures that cannot be eas-
$10 million. The bank, on the other hand, agrees ily backed off in the secondary markets. The
to pay floating-rate interest payments to the price of a swaption, known as the premium,
firm if the option is exercised. The company depends on several factors: the expected shape
pays the bank an up-front fee of $100,000 for of the yield curve, the length of the option and
this option. swap periods, the strike yield’s relationship to
At the end of the first year, if the floating rate market interest rates, and expected interest-rate
increases to 12, the firm will exercise the option volatility.
and pay 10 interest to the bank, and the bank
will pay the current floating rate of 12 to the
company. While this option will cost the firm
$100,000, it will save $200,000 in interest costs HEDGING
((12 − 10) × $10 million). Therefore, in total, the
company will save $100,000. Once the option is Swaptions are often hedged using Eurodollar
exercised, however, the firm cannot return to futures, Treasuries, and interest-rate swaps.
floating rates even if floating rates should fall Market participants have introduced a variety
below 10 (unless the company reverses the of features to mitigate counterparty credit
swap, which can be very expensive). On the risk, such as cash settlement and posting of
other hand, if the floating rate is below 10 at cash collateral. Of these, cash settlement, in
the end of the first year, the firm will let which the seller pays the net present value of
the option expire and continue to pay a floating the swap to the buyer upon exercise of the
rate. option, has been the most common. Cash settle-
Trading and Capital-Markets Activities Manual April 2001
Page 3
4340.1 Swaptions
ment has two significant benefits: (1) it limits 1. the mark-to-market value (positive values
the length of credit exposure to the life of the only) of the contract and
option and (2) banks are not required to allocate 2. an estimate of the potential future credit
capital for the swap, since neither party actually exposure over the remaining life of each
enters into the swap. contract.
The conversion factors are listed below:
RISKS
Credit-Conversion
The risks of purchasing or selling a swaption Remaining Maturity Factor
include the price and credit risks associated with One year or less 0.00
both swaps and options. For a more detailed Five years or less 0.50
discussion of the risks connected with these Greater than five years 1.50
instruments, see sections 4325.1 and 4330.1,
‘‘Interest-Rate Swaps’’ and ‘‘Options,’’ If a bank has multiple contracts with a counter-
respectively. party and a qualifying bilateral contract with the
As a hybrid instrument, a swaption generates counterparty, the bank may establish its current
two important exposures: the probability of and potential credit exposures as net credit
exercise and the credit risk emerging from the exposures. (See section 2110.1, ‘‘Capital
swap. The first risk is a function of the option’s Adequacy.’’)
sensitivity to the level and volatility of the
underlying swap rates. The swaption’s credit
risk is the cost to one counterparty of replacing
the swaption in the event the other counterparty LEGAL LIMITATIONS FOR BANK
is unable to perform. INVESTMENTS
As mentioned earlier, liquidity risk is most
pronounced for swaptions with option compo- Swaptions are not considered investments under
nents of greater than 10 years. However, swap- 12 USC 24 (seventh). The use of these instru-
tions with five-year option components will ments is considered to be an activity incidental
have greater liquidity than those with 10-year to banking within safe and sound banking prac-
option components. tices.
ACCOUNTING TREATMENT REFERENCES
The accounting treatment for swaptions is deter- Arditti, Fred D. Derivatives. Harvard Business
mined by the Financial Accounting Standards School Press, 1996.
Board’s Statement of Financial Accounting Stan- Burghardt, Belton, Lane, Luce, and McVey.
dards (SFAS) No. 133, ‘‘Accounting for Deriva- ‘‘Options on Swaps.’’ Eurodollar Futures and
tives and Hedging Activities.’’ (See section Options. Discount Corporation of New York
2120.1, ‘‘Accounting,’’ for further discussion.) Futures, 1991.
Das, Satyajit. Swap and Derivative Financing.
Chicago: Probus Publishing, 1994.
RISK-BASED CAPITAL Fabozzi, Frank, and Dessa. The Handbook of
WEIGHTING Fixed Income Securities. 4th ed. Irwin, 1995.
Hull, John C. Options, Futures and Other
The credit-equivalent amount of a swaption Derivative Securities. 2d ed. Prentice-Hall,
contract is calculated by summing— 1993.
April 2001 Trading and Capital-Markets Activities Manual
Page 4
Equity Derivatives
Section 4345.1
GENERAL DESCRIPTION • Stock index futures are futures on various
stock indexes and are traded on most of the
The term ‘‘equity derivatives’’ refers to the major exchanges.
family of derivative products whose value is • Stock index options are options on either the
linked to various indexes and individual securi- cash value of the indexes or on the stock index
ties in the equity markets. Equity derivitives futures.
include stock index futures, options, and swaps. • Equity options are options on the individual
As in the interest-rate product sector, the over- stocks and are also traded on most major
the-counter (OTC) and futures markets are exchanges.
closely linked. Banks are involved in these • Warrants are longer-term options on either
markets in a variety of ways, depending on their individual stocks or on certain indexes. They
customer base. Some banks are actively involved are popular in Europe and Asia (especially
as market makers in all products, while others Japan).
only use this market to satisfy customer needs or • Equity-index-linked notes are fixed-income
as part of a structured financial transaction. securities issued by a corporation, bank, or
sovereign in which the principal repayment of
the note at maturity is linked to the perfor-
mance of an equity index. The formula for
CHARACTERISTICS AND principal repayment can reflect a long or short
FEATURES position in an equity index and can also
provide an exposure to the equity market
Equity derivatives range in maturity from three
which is similar to an option or combination
months to five years or longer. The maturities in
of options.
the OTC market are generally longer than those
• Other instruments include ADRs (American
in the futures market. However, maturities in the
Depository Receipts), and SPDRs (S&P 500
futures market are gradually changing with the
Depository Receipts).
development of the LEAPs (Long-Term Equity
• Index arbitrage is strictly not a product, but an
AnticiPation) market on the exchanges. As with
activity; however, it is an important part of the
other futures markets, there is a movement
equity derivatives market. As its name implies,
towards more flexibility in the maturities and
index arbitrage is the trading of index futures
strike prices of equity derivitives.
against the component stocks.
The following are the major instruments that
comprise the equity derivatives market and are
As these markets have developed, various
available for most major markets around the
enhancements have been made to them, such as
world:
the introduction of futures on individual stocks.
Some of the more structured deals that banks are
• Equity swaps are transactions in which an
involved in use more than one of the above
exchange of payments referenced to the change
products.
in a certain index and an interest rate are
exchanged and are usually based on a fixed
notional amount. For example, counterparty A
may pay a spread over LIBOR to counterparty USES
B and receive the return on a specified equity
index. These swaps are documented using Equity derivatives are used for investment, hedg-
standard ISDA documentation. Some of these
transactions also have a currency component currency at a spot exchange rate set at the start of the contract.
and in many cases are done as quantos.1 The investor holding a quanto option obtains participation in
a foreign equity or index return, denominated in the domestic
currency. Currency exchange rates are fixed at issuance by
setting the option payoff in the investor’s base currency as a
1. Quantos (guaranteed exchange-rate options/quantity- multiple of the foreign equity or index rate of return. The rate
adjusting options) are cross-border equity or equity index of return determining the payoff can be positive (calls) or
options that eliminate currency-exchange-rate exposure on an negative (puts). Guaranteed-exchange-rate put options are
option or option-like payout by translating the percentage more common in some markets than guaranteed exchange-
change in the underlying into a payment in the investor’s base rate call options.
Trading and Capital-Markets Activities Manual February 1998
Page 1
4345.1 Equity Derivatives
ing, and speculative purposes. The growth in decline in the index, but will not be able to
this market has coincided with developments in participate in future upside movement in the
other derivative markets. Users and customers index. Unlike the put option, the futures contract
of the banks have shown increased interest in does not involve an up-front payment of a
equity derivitive products for purposes ranging premium.
from hedging to speculation. Some of the major Equity-linked options are also used by port-
users of these products are investment funds. folio managers to gain exposure to an equity
Some banks also use them to hedge their index- market for a limited amount of capital. For
linked certificates of deposit (CDs) (these are instance, by purchasing a call option on an
longer-term CDs, whose principal is guaranteed equity index, a portfolio manager can create a
and whose yield is linked to the return on a leveraged position in an equity index with lim-
certain stock index, for example, S&P 500). ited downside. For the cost of the option pre-
Some corporations also use equity derivatives to mium, the portfolio manager will obtain upside
lower the yield on their issuance of securities. exposure to an equity market on the magnitude
Some speculators (hedge funds) might use equity of the full underlying amount.
swaps or options to speculate on the direction of
equity markets.
Equity-index-linked swaps are often used as
an overlay to a portfolio of fixed-income assets DESCRIPTION OF
to create a synthetic equity investment. For MARKETPLACE
example, a portfolio manager may have a fixed-
income portfolio whose yield is based on LIBOR. Sell Side
The manager can enter into an equity-index-
linked swap with a bank counterparty in which The major sell-side participants in this market
the manager pays the bank LIBOR and receives can be divided into three groups: investment
the return on an equity index, plus or minus a banks, exchanges, and commercial banks. Invest-
spread. If the portfolio manager earns a positive ment banks have the greatest competitive advan-
spread on the LIBOR-based investments, an tages in these markets because of their customer
equity-index-linked swap may result in an over- base and the nature of their businesses and,
all return which beats the market index to which therefore, have the largest market share. While
the portfolio manager is evaluated. For example, commercial banks have much of the necessary
if the LIBOR-based portfolio yields LIBOR + technical expertise to manage these instruments,
20 basis points, and the manager enters into an they are hampered by regulations and lack of a
equity-index-linked swap in which he or she customer base.
pays LIBOR flat and receives the return on the The underlying instruments for equity deriva-
equity index flat, the manager will receive a tive products are primarily the various stock
return on the equity index plus 20 basis points, indexes traded around the world. Even though
thus outperforming the index. In this way, equity- there is a lot of activity in the individual stock
index-linked swaps allow portfolio managers to options, banks are mostly active in the deriva-
transfer expertise in managing one class of tives market on the various indexes. Their
assets to another market. involvement in the market for individual stocks
Equity-index options, warrants, and futures is affected by various regulations restricting
are often used as hedging vehicles. A portfolio bank ownership of individual equities.
manager, for example, can protect an existing
indexed equity portfolio against a decline in the
market by purchasing a put option on the index
or by selling futures contracts on the index. In Buy Side
the case of the put option, the portfolio will be
protected from a decline in the index, while Buy-side participants in the equity derivatives
being able to participate in any future upside market include money managers; hedge funds;
movement of the index. The protection of the insurance companies; and corporations, banks,
put option, however, involves the cost of a and finance companies which issue equity secu-
premium which is paid to the seller of the rities. Commercial banks are not very active
option. In the case of selling futures contracts on users of equity derivatives because of regula-
the index, the portfolio is protected against a tions restricting bank ownership of equities.
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Equity Derivatives 4345.1
PRICING perfectly correlated with the instrument being
hedged.
Because of the large volumes traded in equity
derivatives markets, the pricing of most of these
products is very transparent and widely Interest-Rate Risk
disseminated—at least for the products that are
based on the equity markets of the major indus- Interest-rate risk in equity derivative products
trialized countries. This transparency does not can be substantial, especially for those transac-
hold true for the prices in some of the develop- tions with relatively long maturities. The im-
ing countries or those countries which are highly plied interest rate is a very important component
regulated. The pricing of some of these products in the calculation of the forward prices of the
is also affected by tax considerations and regu- index. For hedges that use futures to closely
latory constraints for certain cross-border trans- match the maturities of the transaction, interest-
actions. As with some of the other derivative rate risk is minimized because the price of the
markets, there is less transparency for structured future already has an implied interest rate.
products, especially those that involve some of Interest-rate risk may arise in those transactions
the swaps that include exotic options in both the in which the maturity of the transaction is longer
interest-rate and index components. than the maturity of the hedges which are
available. In swap transactions, this may affect
the hedging of implied forward cash flows. In
certain cross-border transactions, additional risks
HEDGING arise from the necessity of hedging the nondo-
mestic interest-rate component.
Since banks’ activities with customers often
involve nonstandard maturities and amounts,
equity derivatives instruments are often hedged Volatility Risk
using exchange-traded instruments. The hedges
take the form of combinations of the products A substantial portion of transactions in the
that are available on the relevant exchanges and equity derivatives market have option compo-
also involve the interest-rate markets (swaps and nents (both plain vanilla and, increasingly, vari-
futures) to hedge out the interest-rate risk inher- ous exotic types, especially barrier options). In
ent in equity derivatives. certain shorter-dated transactions, hedges are
The risks of individual equity securities, or a available on the exchanges. But when the
basket of equity securities are often hedged by maturity is relatively long, the options may
using futures or options on an equity index. This carry substantial volatility risks. These risks
hedge may be over- or underweighted based on may be especially high in certain developing
the expected correlation between the index and equity markets, in which the absolute level of
the individual security or basket of securities. To volatility is high and the available hedges lack
the extent that the underlying and the hedge liquidity.
instrument are not correlated as expected, the
hedge may not be effective and may lead to
incremental market risk on the trade. Liquidity Risk
Liquidity risk is not significant for most equity
derivative products in the major markets and for
RISKS products with maturities of less than a year.
Liquidity risk increases for longer maturities
Market Risk and for those transactions linked to emerging
markets.
Market risk in equity derivative products arises
primarily from changes in the prices of the
underlying indexes and their component stocks. Currency Risk
There is also correlation risk associated with
hedging certain transactions with the most liquid Currency risk is relevant for cross-border and
instrument available, which may be less than quanto products. As these transactions are often
Trading and Capital-Markets Activities Manual April 2001
Page 3
4345.1 Equity Derivatives
dynamically hedged by the market maker, cur- The conversion factors are listed below.
rency risk can be significant when there are
Credit-Conversion
extreme movements in the currency.
Remaining Maturity Factor
One year or less 6.00%
Five years or less 8.00%
ACCOUNTING TREATMENT Greater than five years 10.00%
The accounting treatment for equity derivatives,
If a bank has multiple contracts with a counter-
except those indexed to a company’s own stock,
party and a qualifying bilateral contract with the
is determined by the Financial Accounting Stan-
counterparty, the bank may establish its current
dards Board’s Statement of Financial Account-
and potential credit exposures as net credit
ing Standards (SFAS) No. 133, ‘‘Accounting for
exposures. (See section 2110.1, ‘‘Capital
Derivatives and Hedging Activities.’’ (See sec-
Adequacy.’’)
tion 2120.1, ‘‘Accounting,’’ for further discus-
sion.) Derivatives indexed to a company’s own
stock can be determined by Accounting Prin- LEGAL LIMITATIONS FOR BANK
ciples Board (APB) Opinion No. 18, ‘‘The
Equity Method of Accounting for Investments
INVESTMENTS
in Common Stock,’’ and SFAS 123, ‘‘Account-
Equity derivatives are not considered invest-
ing for Stock-Based Compensation.’’
ments under 12 USC 24 (seventh). A bank must
receive proper regulatory approval before it
engages in certain types of equity-linked
RISK-BASED CAPITAL activities.
WEIGHTING
The credit-equivalent amount of an equity REFERENCES
derivative contract is calculated by summing—
Allen, Julie A., and Janet L. Showers. Equity-
1. the mark-to-market value (positive values Index-Linked Derivatives, An Investor’s Guide.
only) of the contract and Salomon Brothers, April 1991.
2. an estimate of the potential future credit Federal Reserve Bank of Chicago. The Equity
exposure over the remaining life of each Derivatives Market: A Product Summary.
contract. February, 1997.
April 2001 Trading and Capital-Markets Activities Manual
Page 4
Credit Derivatives
Section 4350.1
GENERAL DESCRIPTION Total-Rate-of-Return Swaps
Credit derivatives are off-balance-sheet financial In a total-rate-of-return (TROR) swap, one coun-
instruments that permit one party (the benefi- terparty (Bank A) agrees to pay the total return
ciary) to transfer the credit risk of a reference on an underlying reference asset to its counter-
asset, which it typically owns, to another party party (Bank B) in exchange for LIBOR plus a
(the guarantor) without actually selling the spread. Most often, the reference asset is a
asset. In other words, credit derivatives allow corporate or sovereign bond or a traded com-
users to ‘‘unbundle’’ credit risk from financial mercial loan. Since many commercial loans are
instruments and trade it separately. based on the prime rate, both ‘‘legs’’ of the swap
Based on dealer estimates, the market for float with market rates. In this manner, credit
credit derivatives approached $40 billion in risk is essentially isolated and potential interest-
1996, with total-return swaps and default puts rate risk is generally limited to some form of
(including default swaps and outright put basis risk (for example, prime vs. LIBOR).
options) accounting for more than half of the TROR swaps are intended to be an efficient
market. The average transaction size is rather means of transferring or acquiring credit expo-
small at $10 million to $25 million, while the sure without actually consummating a cash trans-
average tenor of transactions is less than two action. This feature may be desirable if a bank
years. The tenor of new transactions is length- (Bank A) has credit exposure to a borrower
ening, however, and swaps up to five years are which it would like to reduce while retaining the
not uncommon. While the slowly expanding borrower as a customer, preserving the banking
market for credit derivatives has encouraged relationship. Also, entities which are not able to
dealers and end-users to enter the market, bear the administrative costs of purchasing or
secondary-market activity is very limited. administering loans, or loan participations, may
still acquire exposure to these loans through
TROR swaps (Bank B).
CHARACTERISTICS AND In the example in figure 1, Bank A receives a
FEATURES LIBOR-based payment in exchange for paying
out the return on an underlying asset. The total
In general, credit derivatives have three distin- return payments due to Bank B include not only
guishing features: the contractual cash flows on the underlying
assets, but also any appreciation or depreciation
1. the transfer of the credit risk associated with of that underlying asset that occurs over the life
a reference asset through contingent pay- of the swap. Periodically (usually quarterly), the
ments based on events of default and, usu- asset’s market price is determined by an agreed-
ally, the prices of instruments before, at, and upon mechanism. Bank B would pay Bank A
shortly after default (reference assets are for any depreciation in the value of the
most often traded sovereign and corporate
debt instruments or syndicated bank loans)
2. the periodic exchange of payments or the
payment of a premium rather than the pay-
ment of fees customary with other off- Figure 1—Total-Rate-of-Return Swap
balance-sheet credit products, such as letters Cash Flow
of credit and
Appreciation
3. the use of an International Swap Derivatives Bank A Bank B
Association (ISDA) master agreement and (Beneficiary) (Guarantor)
LIBOR +
the legal format of a derivatives contract X bp and
Depreciation
Cash
Credit derivatives fall into three basic trans- Flow
action types: total-rate-of-return swaps, credit-
default swaps, and credit-default notes. Pres- Reference
ently, total-rate-of-return swaps are the most Asset
commonly used credit derivatives.
Trading and Capital-Markets Activities Manual February 1998
Page 1
4350.1 Credit Derivatives
underlying asset while receiving any apprecia- one of its creditors. Often, a default event is
tion. Consequently, for the term of the swap, it is defined so as to apply to any class of outstanding
as if Bank B actually owns the reference asset securities of the reference obligor in excess of a
that resides on Bank A’s balance sheet. specified amount. In other words, a default can
At the maturity of the swap, or in the event of be triggered if the reference asset defaults or if
default of the underlying asset, the swap is any material class of securities issued by the
terminated1 and the underlying asset is priced underlying obligor defaults.
for purposes of determining the final swap In an alternative structure, two banks may
obligations. The post-default price of the asset is exchange the total return on underlying groups
most often determined by a poll of asset dealers of loans. For example, a large money-center
or by direct market quotation, if available. bank may receive the total return on a concen-
Often, the final price will be the average of trated loan portfolio of a regional bank in
sample prices taken over time to mitigate any exchange for the total return on a more diversi-
post-default volatility in the reference asset’s fied group of loans held by the money-center
value. bank. These types of swaps may be readily
If Bank B is not satisfied with the pricing of marketable to smaller banks that are seeking to
the asset upon maturity of the swap or default comply with the concentration of credit limita-
(that is, believes the valuation is too low), then tions of section 305(b) of the Federal Deposit
Bank B will often have the option of purchasing Insurance Corporation Improvement Act
the underlying reference asset directly from (FDICIA).
Bank A and pursuing a workout with the bor-
rower directly. However, it is not clear how
often Bank B would choose to purchase the Credit-Default Swaps
underlying instrument, particularly if the swap
vehicle were used to avoid direct acquisition in In a credit-default swap, one counterparty (Bank
the first place. A) agrees to make payments of X basis points of
The final termination payment is usually based notional amount, either per quarter or per year,
on the following formula: in return for a payment in the event of the
default of a prespecified reference asset (or
Final Payment = Dealer Price − Notional Amount name). (See figure 2.) Since the payoff of a
credit-default swap is contingent on a default
The notional amount is essentially the price of event (which may include bankruptcy, insol-
the reference asset when the credit derivative is vency, delinquency, or a credit-rating down-
initiated. If the dealer price is greater than the grade), calling the structure a ‘‘swap’’ may be a
notional amount, then the asset has appreciated misnomer; the transaction more closely resembles
and Bank A must pay Bank B this difference to an option.
settle the swap. On the other hand, if the dealer As with TROR swaps, the occurrence of
price is below the notional amount, either depre- default in credit-default swaps is contractually
ciation (for example, downgrade or default) or well defined. Usually, the default event must be
principal reduction (for example, amortization, publicly verifiable. The default definition must
prepayment) has occurred, and Bank B owes be specific enough to exclude events whose
Bank A this difference. Therefore, the final
payment (either at maturity or upon default)
ultimately defines the nature and extent of the Figure 2—Credit-Default Swap
transfer of credit risk.
Default events are described in the transaction X bp per
quarter
documentation, usually the trade confirmation. Bank A Bank B
These events may include bankruptcy, payment (Beneficiary) (Guarantor)
Contingent
defaults, breached covenants in loan or bond Default
documentation, or even the granting of signifi- Payment
cant security interests by the reference obligor to
1. Alternatively, the swap may continue to maturity with Reference
payments based on quarterly changes in the post-default asset Asset
price.
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Credit Derivatives 4350.1
inclusion would be undesirable, such as when a Figure 3—Credit-Default Note
reference name is delinquent due to the inten-
tional withholding of a payment in a legal
dispute that does not affect the creditworthiness
Market
of the organization. Further, a materiality thresh-
old may be involved; that is, a default event
must have occurred, and the cumulative loss on Treasuries,
the underlying must be greater than Y percent. Agencies,
Principal AAA
The materiality thresholds increase the likeli- Corporate
Paper
hood that only significant changes in credit
quality will trigger the default payment (rather X bps
Issuing
than small fluctuations in value that tend to Bank Vehicle
occur over time). Contingent
Default
Finally, upon default, the ‘‘swap’’ is termi- Payment
nated and a default payment is calculated. The LIBOR +
Principal
default payment is often calculated by sampling Y bps
dealer quotes or observable market prices over
some prespecified period after default has
Default-
occurred. Alternatively, the default payment Protected Investor
may be specified in advance as a set percentage Asset(s)
of notional (for example, 25, 50, or 100 per-
cent). Such swaps are usually referred to as
binary swaps; they either pay the prespecified
amount or nothing, depending on whether default often a trust. The proceeds of the note purchase
occurs. Binary swaps are often used when the are used by the trust to purchase paper of the
reference asset is not liquid but when loss in the highest credit quality: Treasuries, agencies, or
event of default is otherwise subject to estima- AAA corporate paper. The note is structured
tion. For example, if the reference asset is a such that a default by the underlying reference
senior, unsecured commercial bank loan, and instrument(s) or name(s) results in a reduction
such loans have historically recovered 80 per- of the repayment of principal to the investor.
cent of face value in the event of default, a Default payments are calculated in the same
binary default swap with a 20 percent contingent manner as for TROR and credit-default swaps.
payout may be appropriate. In return for the contingent default payment, the
arranging bank pays a spread to the investor
When the counterparty making the default
through the issuing vehicle. The investor, mean-
payment (guarantor) is unhappy with the valu-
while, receives a premium yield over LIBOR for
ation, the option to purchase the reference asset
accepting the default risk of the underlying
is often available. On the other hand, some
instrument(s) or name(s). (See figure 3.)
versions of default swaps may allow the bene-
ficiary to put the asset to the guarantor in the
event of default rather than receive a cash
payment. Finally, when there is more than one USES
underlying instrument (or name), which is often
found in a ‘‘basket’’ structure, the counterparty Both total rate-of-return swaps and credit-
making the contingent default payment is default swaps are used to transfer the credit risk
exposed to only the first instrument or name to of the asset(s) referenced in the transaction. The
default. counterparty seeking to transfer the credit risk
(the beneficiary) often owns the reference asset.
The counterparty receiving the credit risk of the
reference asset (the guarantor) is able to do so
Credit-Default Notes without purchasing the reference asset directly.
Banks may use credit derivatives in several
A credit-default note is a structural note and is ways. They may elect to receive credit exposure
the on-balance-sheet equivalent of a credit- (provide protection) for a fee or in exchange for
default swap. In a credit-default note, an inves- credit exposure which they already hold in an
tor purchases a note from an issuing vehicle, effort to better diversify their credit portfolios.
Trading and Capital-Markets Activities Manual February 1998
Page 3
4350.1 Credit Derivatives
Banks may also elect to receive credit exposure buyers and sellers of credit derivatives. Pension
through credit derivatives rather than through funds and money managers have also acted as
some other transaction structure due to the counterparties to credit-derivative transactions.
relative yield advantage (arbitrage of cash-
market pricing) of derivatives.
Alternatively, banks may use credit deriva- Market Transparency
tives to reduce either individual credit exposures
or credit concentrations in their portfolios. In Currently, there is no market transparency in the
other words, the banks are purchasing credit pricing or volume of credit derivatives. Most
protection from another institution. Banks may transactions are highly structured, negotiated
use credit derivatives to synthetically take a deals between sophisticated counterparties. One
short position in an asset which they do not wish money-center bank has made price quotes pub-
to sell outright. From the bank customer’s per- licly available for several transactions structures
spective, credit derivatives may be written to that reference the obligors most often found in
allow nonbank counterparties to obtain access to current transactions or in whom there is the most
bank loan exposures and related returns either as interest at the time. However, pricing transpar-
a new asset class (for credit diversification) or ency is poor.
without up-front funding (perhaps to obtain Further, regulatory and public reporting stan-
greater leverage). In the last example, the bank dards for credit derivatives have not yet been
is essentially performing traditional credit inter- established. Consequently, the level of business
mediation using a new off-balance-sheet vehicle. activity is also not readily transparent. The
Finally, banks may seek to establish them- estimates of the market size and composition
selves as dealers in credit derivatives. Rather available to date are the result of surveys con-
than pursuing credit portfolio efficiency or port- ducted by credit-derivatives dealer banks (for
folio yield enhancement, dealer banks will seek example, CIBC/Wood-Gundy) or industry groups
to profit from buying and selling credit deriva- (for example, the British Bankers’ Association).
tives exposures quite apart from their portfolio At year-end 1996, the market for credit deriva-
management goals. Dealer banks may or may tives was estimated to be $40 billion.
not hold the assets referenced in their credit-
derivative transactions, depending on their risk
tolerance, credit views, and (ultimately) their
ability to offset contracts in the marketplace. PRICING
To understand credit-derivative pricing and how
different prices for reference assets might be
DESCRIPTION OF obtained for different counterparties, consider
MARKETPLACE the following example. A bank offers to provide
default protection to another bank on a five-year
Issuing Practices loan to a BBB-rated borrower. Since reliable
default and recovery data for pricing credit
Credit derivatives are transacted by banks, derivatives are not available, credit-derivatives
securities firms, and insurance companies through providers rely on credit spreads to price these
financial contracts traded over the counter. The products. One of the more common pricing
size of the marketplace is fairly small, with up to techniques is to price an asset swap of the
15 organizations actively transacting in credit reference asset. In an asset swap, a fixed-for-
derivatives by year-end 1996. Due to the small floating interest-rate swap is used to convert a
size and name-specific nature of the credit- fixed-rate instrument (here, a BBB-rated note)
derivative market, there is very little secondary- into a floating-rate instrument. The spread above
market support. LIBOR required for this conversion to take
place is related to the creditworthiness of the
reference borrower. That is, the lower the cred-
Market Participants itworthiness of the reference borrower, the
greater the spread above LIBOR to complete the
Commercial and investment banks, insurance asset swap. Hence, if LIBOR is viewed as a base
companies, and hedge funds are active as both rate at which the most creditworthy institutions
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Credit Derivatives 4350.1
can fund themselves, then the spread above credit considerations. In the example in figure 2,
LIBOR represents the ‘‘credit premium,’’ or the if the credit quality of the guarantor counter-
cost of default risk, associated with that particu- party (Bank B) was a concern to the beneficiary
lar reference asset. (Bank A), the beneficiary might negotiate pay-
The credit premium is the most fundamental ment of a lower spread (fee) than 47 basis points
component of pricing. The credit premium is to compensate for counterparty risk.
meant to capture the default risk of the reference Often, differences in funding costs between
asset. Often, the credit premium is the periodic counterparties also affect pricing. A counter-
payment rate required by market participants in party that could obtain credit exposure through
exchange for providing default protection. In a direct acquisition of the asset on a favorable
total-return swap, LIBOR plus this credit pre- basis due to funding advantages might require a
mium is paid in exchange for receiving the total higher return for taking on the same exposure
return on the underlying reference asset. Intu- through a default swap, which is priced by
itively, the owner of the reference asset, who analogy to an asset swap. Operational consider-
receives LIBOR plus the credit premium, is ations, such as the inability of a guarantor
being compensated for funding costs and default counterparty to actually own the asset, may
risk of the reference asset. result in a pricing premium for the risk seller
Furthermore, assume the reference asset is a (protection buyer) who can own the asset. Simi-
BBB-rated, senior unsecured note of five-year larly, tax consequences may have an impact on
maturity yielding 6.50 percent. Further, assume transaction pricing. For example, a beneficiary
that the asking price for a five-year, fixed-for- may wish to reduce credit exposure to an obligor
floating interest-rate swap is 6.03 percent against without actually selling the reference asset to
LIBOR flat. To complete the asset swap, the avoid triggering an unfavorable taxable event,
interest-rate swap legs need to be increased by such as a taxable gain or a capital loss that is not
47 basis points each to convert the reference fully deductible. Clearly, these considerations
asset to a floating-rate instrument. (See figure 4.) may have an impact on the price which the
Consequently, 47 basis points is the credit pre- protection buyer (risk seller) is willing to pay.
mium, or the implied market price to be charged,
per year, for providing default protection on this
BBB-rated reference asset. Alternatively, LIBOR
plus 47 basis points would be the price to be HEDGING
paid in a TROR swap for receiving the total
return on this asset for five years. Credit derivatives may be hedged in two basic
However, the borrower-specific factors that ways: users may match (or offset) their credit-
produced the implied market price of 47 basis derivative contracts, or they may use a cash
points for the default swap are not the only position in the reference asset to hedge their
factors considered in pricing. The spread may be contracts.
adjusted for any number of factors which are The ideal hedging strategy for dealers is to
unique to the counterparties. For example, the match positions, or to conduct ‘‘back-to-back’’
spread may need to be adjusted for counterparty trading. Many deals actually are backed to back
with offsetting transactions as a result of the
highly structured nature of deals. That is, dealer
Figure 4—Asset Swap banks won’t enter into a credit-derivative trade
unless a counterparty willing to enter the offset-
LIBOR + ting transaction has been identified. Alterna-
47 basis points
Swap
tively, the credit-derivative-trading function may
Investor
Dealer back to back trades with an internal counterparty
6.03% +
47 basis points (for example, the bank’s own loan book).
6.50% Because the secondary-market support for credit
bond Cost of Default Protection:
yield derivatives is characterized by substantial illi-
47 basis points
quidity, credit positions which are taken through
Other Factors:
• Taxes credit derivatives may be ‘‘warehoused’’ for
Note • Administrative costs substantial periods of time before an offsetting
• Funding costs
• Counterparty credit trade can be found. Banks often set trading
• Portfolio characteristics limits on the amount and time period over which
Trading and Capital-Markets Activities Manual February 1998
Page 5
4350.1 Credit Derivatives
they will warehouse reference-asset credit expo- Finally, two other hedging issues are worth
sures in credit-derivative transactions. considering. First, it is not uncommon for banks
The second basic hedging practice is to own to hedge a balance-sheet asset with a credit
the underlying reference asset. Essentially, the derivative that references a different asset of the
risk-selling bank hedges by going long the same obligor. For example, a bank may hedge a
reference asset and going short the swap. This loan to ABC Company that is highly illiquid
is the simplest form of matched trading and with a credit-default swap that references the
is illustrated by Bank A in figures 1 and 2. publicly traded debt of ABC Company. The fact
Generally, whether or not the bank owned the that the public debt is more liquid and has public
reference asset before it entered the swap is pricing sources available makes it a better ref-
a good indication of the purpose of the swap. If erence asset than the loan. However, the bank is
the bank owned the asset before executing exposed to the difference in the recovery values
the swap, it has most likely entered the swap of the loan and the debt if ABC Company
for risk-management reasons. If the bank defaults. Second, it is very common for the term
acquired the asset for purposes of transacting of the credit derivative to be less than the term
the swap, it is more likely to be accommodating of the reference asset. For example, a two-year
a customer. credit default swap could be written on a five-
Interestingly, hedging a credit derivative in year bond. In this case, the last three years of
the cash market is not common when the cash credit risk on the underlying bond position
position required is a short. Generally speaking, would not be hedged. The appropriate supervi-
going short the reference asset and long the sory treatment for credit derivatives is provided
swap is problematic. To show this, consider in SR-96-17 (see section 3020.1, ‘‘Securitiza-
what happens in a declining market: The long tion and Secondary-Market Credit Activities’’).
credit-derivative position (total-return receiver)
declines in value, while the short cash position
rises in value as the market falls. Unfortunately, RISKS
most lenders of a security which is falling in
value will not agree to continually lend and Credit Risk
receive back a security that is undergoing a
sustained depreciation in value. Since most Banks using credit derivatives are exposed to
short sales are very short term (in fact, over- two sources of credit risk: counterparty credit
night), the short cash hedge becomes unavail- risk and reference-asset credit risk. In general,
able when needed most—when there is a pro- the most significant risk faced by banks in credit
longed decline in the value of the reference derivatives will be their credit exposure to the
asset. For this reason, a short credit-derivative reference asset.
position may be superior to a short cash position When a bank acquires credit exposure through
that must be rolled over. a credit-derivative transaction, it will be exposed
A third and less common practice is to simply primarily to the credit risk of the reference asset.
add or subtract the notional amount of long or As with credit risk that is acquired through
short positions, respectively, to or from estab- direct purchase of assets, banks should perform
lished credit lines to reference obligors. This is sufficient credit analysis of all reference assets
the least sophisticated risk-management treat- to which they will be exposed through credit-
ment and is inadequate for trading institutions as derivative transactions. The financial analysis
it does not address counterparty risks. This performed should be similar to that done for
method may be used effectively in conjunction processing a loan or providing a letter of credit.
with other methods and is useful in determining Further, banks should have procedures in place
total potential credit exposure to reference to limit their overall exposure to certain borrow-
obligors. ers, industries, or geographic regions, regardless
At some point, the potential exists for credit- of whether exposures are taken through cash
derivatives dealers to apply a portfolio risk- instruments or credit-derivative transactions.
management model that recognizes diversifi- Examiners should be aware that the degree of
cation and allows hedging of residual portfolio reference-asset credit risk transferred in credit-
risks. However, the fundamental groundwork derivative transactions varies significantly. For
for quantitative modeling approaches to credit example, some credit derivatives are structured
derivatives is still in development. so that a payout only occurs when a predefined
February 1998 Trading and Capital-Markets Activities Manual
Page 6
Credit Derivatives 4350.1
event of default or a downgrade below a pre- ologies. Therefore, price risk is a function of
specified credit rating occurs. Other credit market rates as well as prevailing supply and
derivatives may require a payment only when a demand conditions in the credit-derivative
defined default event occurs and a predeter- market.
mined materiality (or loss) threshold is exceeded. The relative newness of the market for credit
Default payments may be based on an average derivatives and the focus of some products on
of dealer prices for the reference asset during events of default makes it difficult for banks to
some period of time after default using a pre- hedge these contingent exposures. For example,
specified sampling procedure or may be speci- banks that sell default swaps will probably make
fied in advance as a set percentage of the payments quite infrequently because events of
notional amount of the reference asset. Lastly, default are rare. Hence, the payoff profile for a
the terms of many credit-derivative transactions default swap includes a large probability that
are shorter than the maturity of the underlying default will not occur and a small probability
asset and, therefore, provide only temporary that a default will occur with unknown conse-
credit protection to the beneficiary. In these quences. This small probability of a default
cases, some of the credit risk of the reference event is difficult for banks to hedge, especially
asset is likely to remain with the asset holder as the reference asset deteriorates in financial
(protection buyer). condition.
Alternatively, a bank may own an asset whose
risk is passed on to a credit-derivative counter-
party. As such, the bank will only lose money if Liquidity Risk
the asset deteriorates and the counterparty is
unable to fulfill its obligations. Therefore, banks Typically, liquidity risk is measured by the size
using credit derivatives to reduce credit expo- of the bid/ask spread. Similar to other new
sure will be exposed primarily to counterparty products, credit derivatives may have higher
risk. Because the ultimate probability of a loss bid/ask spreads because transaction liquidity is
for the bank is related to the default of both the somewhat limited. Banks buying credit deriva-
reference credit and the inability of a counter- tives should know that their shallow market
party to meet its contractual obligations, banks depth could make it hard to offset positions
should seek counterparties whose financial con- before a credit derivative’s contract expires.
dition and credit standing are not closely corre- Accordingly, banks selling credit derivatives
lated with those of the reference credit. must evaluate the liquidity risks of credit deriva-
In all credit-derivative transactions, banks tives and assess whether some form of reserves,
should assess the financial strength of their such as close-out reserves, is needed.
counterparty before entering into a credit- Banks using credit derivatives should include
derivative transaction. Further, the financial the cash-flow impact of credit derivatives into
strength of the counterparty should be moni- their regular liquidity planning and monitoring
tored throughout the life of the contract. In some systems. Banks should also include all signifi-
cases, banks may deem it appropriate to require cant sources and uses of cash and collateral
collateral from certain counterparties or for related to their credit-derivative activity into
specific types of credit-derivative transactions. their cash-flow projections. Lastly, the contin-
gency funding plans of banks should assess
the effect of any early termination agreements or
Market Risk collateral/margin arrangements, along with any
particular issues related to specific credit-
derivative transactions.
While banks face significant credit exposure
through credit-derivative transactions, signifi-
cant market risk is also present. The prices of
credit-derivative transactions will fluctuate with Legal Risk
changes in the level of interest rates, the shape
of the yield curve, and credit spreads. Further- Because credit derivatives are new products that
more, because of the illiquidity in the market, have not yet been tested from a legal point of
credit derivatives may not trade at theoretical view, many questions remain unanswered. At a
prices suggested by asset-swap pricing method- minimum, banks should ensure that they and
Trading and Capital-Markets Activities Manual February 1998
Page 7
4350.1 Credit Derivatives
their counterparties have the legal and regula- as of March 31, 1997. Examiners should
tory authority to participate in credit-derivative determine that any transfer risk received or
transactions before committing to any contrac- passed on in a credit-derivative structure is
tual obligations. Moreover, banks should ensure captured in the bank’s regulatory transfer risk
that any transactions they enter into are in reports.
agreement with all relevant laws governing their • Ensure that the bank maintains documentation
activities. for its accounting policies for credit deriva-
While standard documentation for credit tives; examiners should determine whether the
derivatives has yet to be developed, participat- bank has consulted with outside accountants
ing banks should use standardized documenta- when determining its accounting policies and
tion as soon as it becomes available. ISDA has procedures for credit derivatives. Addition-
been developing a standardized master agree- ally, examiners should assess the bank’s mark-
ment for use with credit-derivative transactions. to-market, profit recognition, and hedge-
Banks should have their legal counsel review all accounting practices.
credit-derivative contracts to confirm that they • Review management’s strategy for using credit
are legally sound and that all terms, conditions, derivatives, assessing the impact on the bank’s
and contingencies are clearly addressed. risk profile and ensuring that adequate internal
controls have been established for the conduct
of all trading and end-user activities in credit
derivatives.
Examiner Guidance • Review risk-management practices to ensure
that bank systems capture and trading desks
When reviewing credit derivatives, examiners report all credit exposures to senior manage-
should consider the credit risk of the reference ment, including counterparty and reference-
asset as the primary risk. A bank providing asset exposures from credit derivatives.
credit protection through a credit derivative can • Ensure that risk-management reports are done
become as exposed to the credit risk of the on a timely basis and are disseminated to the
reference asset as it would if the asset were on appropriate personnel.
its own balance sheet. Thus, for supervisory • Assess the bank’s treatment of credit deriva-
purposes, the exposure typically should be tives for purposes of legal lending limits, that
treated as if it were a letter of credit or other is, when should the bank use credit derivatives
off-balance-sheet guarantee. For example, this to lower borrower concentrations and which
treatment would apply when determining an type of credit derivative should the bank use.
institution’s overall credit exposure to a bor- Further, examiners should ensure that the
rower when evaluating concentrations of credit. bank is in compliance with all regulatory
In addition, examiners should perform the lending limits.
following procedures. • Review the bank’s asset quality and loan-loss
reserve policies with respect to credit deriva-
• Review SR-96-17. tives and any reference assets owned. Exam-
• Note the bank’s credit-derivative activities iners should ensure that assets protected by
and ascertain (1) the level of credit-derivative credit derivatives that are nonperforming are
activity, (2) the types of counterparties, (3) the recognized in internal credit reports and assess
typical underlying reference assets, (4) the how the bank’s loan-loss reserves are affected
structures and maturities of the transactions, by the use of credit derivatives. Moreover,
(5) why management is using these instru- examiners should ensure that the bank’s clas-
ments, and (6) whether the bank’s credit sification system is reasonable given the types
exposure is being increased or reduced. of credit-derivatives structures used, the degree
• Evaluate whether the bank subjects its credit- to which credit risk is transferred, and the
derivatives activities to a thorough, multi- creditworthiness of its credit-derivative
functional new-product review and determine counterparties.
if senior management is aware of and approves • Procure and review relevant marketing mate-
the activities undertaken. rials and policies regarding sales practices.
• Ensure that credit derivatives are reported Dealers should assess the financial character
correctly for regulatory purposes based on and sophistication of all counterparties. Since
amendments to the call report and the FRY-9C credit derivatives are new and complex instru-
February 1998 Trading and Capital-Markets Activities Manual
Page 8
Credit Derivatives 4350.1
ments, dealers should provide end-users with 20 percent risk category if the guarantor is a
information sufficient to understand the risks bank, or the 100 percent risk category if the
associated with particular credit-derivative guarantor is a bank holding company.
structures. Whether the credit derivative is considered an
eligible guarantee for purposes of risk-based
capital depends on the degree of credit protec-
ACCOUNTING TREATMENT tion actually provided. As explained earlier, the
amount of credit protection actually provided by
The accounting treatment for certain credit a credit derivative may be limited depending on
derivatives is determined by the Financial the terms of the arrangement. For example, a
Accounting Standards Board’s Statement of relatively restrictive definition of a default event
Financial Accounting Standards (SFAS) No. or a materiality threshold that requires a com-
133, ‘‘Accounting for Derivatives and Hedging parably high percentage of loss to occur before
Activities.’’ (See section 2120.1, ‘‘Accounting,’’ the guarantor is obliged to pay could effectively
for further discussion.) limit the amount of credit risk actually trans-
ferred in the transaction. If the terms of the
credit-derivative arrangement significantly limit
the degree of risk transference, then the benefi-
RISK-BASED CAPITAL ciary bank cannot reduce the risk weight of the
WEIGHTING ‘‘protected’’ asset to that of the guarantor bank.
On the other hand, even if the transfer of credit
The appropriate risk-based capital treatment for risk is limited, a banking organization providing
credit-derivative transactions is included in limited credit protection through a credit deriva-
SR-96-17. The appropriate treatment for credit tive should hold appropriate capital against the
derivatives under the market-risk capital amend- reference exposure while it is exposed to the
ment to the BIS Accord is not finalized as of this credit risk of the reference asset. See section
writing. As a general rule, SR-96-17 provides 3020.1, ‘‘Securitization and Secondary-Market
the appropriate capital treatment for credit Credit Activities.’’
derivatives which are carried in the banking Banking organizations providing a guarantee
book and for institutions which are not subject through a credit derivative may mitigate the
to the market-risk rules. credit risk associated with the transaction by
Under SR-96-17, credit derivatives generally entering into an offsetting credit derivative with
are to be treated as off-balance-sheet direct another counterparty, a so-called ‘‘back-to-
credit substitutes. The notional amount of the back’’ position. Organizations that have entered
contract should be converted at 100 percent to into such a position may treat the first credit
determine the credit-equivalent amount to be derivative as guaranteed by the offsetting trans-
included in risk-weighted assets of the guaran- action for risk-based capital purposes. Accord-
tor.2 A banking organization providing a guar- ingly, the notional amount of the first credit
antee through a credit-derivative transaction derivative may be assigned to the risk category
should assign its credit exposure to the risk appropriate to the counterparty providing credit
category appropriate to the obligor of the refer- protection through the offsetting credit-derivative
ence asset or any collateral. On the other hand, arrangement (for example, to the 20 percent risk
a banking organization that owns the reference category if the counterparty is an OECD bank).
asset upon which credit protection has been In some instances, the reference asset in the
acquired through a credit derivative may, under credit-derivative transaction may not be identi-
certain circumstances, assign the unamortized cal to the underlying asset for which the bene-
portion of the reference asset to the risk category ficiary has acquired credit protection. For exam-
appropriate to the guarantor, for example, the ple, a credit derivative used to offset the credit
exposure of a loan to a corporate customer may
2. Guarantor banks which have made cash payments rep- use a publicly traded corporate bond of the
resenting depreciation on reference assets may deduct such customer as the reference asset, whose credit
payments from the notional amount when computing credit- quality serves as a proxy for the on-balance-
equivalent amounts for capital purposes. For example, if a
guarantor bank makes a depreciation payment of $10 on a
sheet loan. In such a case, the underlying asset
$100 notional total-rate-of-return swap, the credit-equivalent will still generally be considered guaranteed for
amount would be $90. capital purposes as long as both the underlying
Trading and Capital-Markets Activities Manual April 2001
Page 9
4350.1 Credit Derivatives
asset and the reference asset are obligations of transactions involving two or more legal entities
the same legal entity and have the same level of within the same banking organization, the pos-
seniority in bankruptcy. In addition, banking sibility of such transactions exists. Transactions
organizations offsetting credit exposure in this between or involving affiliates raise important
manner would be obligated to demonstrate to supervisory issues, especially whether such
examiners that (1) there is a high degree of arrangements are effective guarantees of affiliate
correlation between the two instruments; (2) the obligations, or transfers of assets and their
reference instrument is a reasonable and suffi- related credit exposure between affiliates. There-
ciently liquid proxy for the underlying asset so fore, banking organizations should consider
that the instruments can be reasonably expected carefully the existing supervisory guidance on
to behave similarly in the event of default; and interaffiliate transactions before entering into
(3) at a minimum, the reference asset and credit-derivative arrangements involving affili-
underlying asset are subject to mutual cross- ates, especially when substantially the same
default provisions. A banking organization that objectives could be achieved using traditional
uses a credit derivative, which is based on a guarantee instruments.
reference asset that differs from the protected Legal lending limits are established by indi-
underlying asset, must document the credit vidual states for state-chartered banks and by the
derivative being used to offset credit risk and Office of the Comptroller of the Currency (OCC)
must link it directly to the asset or assets whose for national banks. Therefore, the determination
credit risk the transaction is designed to offset. of whether credit derivatives are guarantees to
The documentation and the effectiveness of the be included in the legal lending limits are the
credit-derivative transaction are subject to purview of the state banking regulators and the
examiner review. Banking organizations provid- OCC.
ing credit protection through such arrangements
must hold capital against the risk exposures that
are assumed.
REFERENCE
LEGAL LIMITATIONS FOR BANK Board of Governors of the Federal Reserve
INVESTMENT System. SR-96-17, ‘‘Supervisory Guidance
for Credit Derivatives.’’ August 12, 1996.
While examiners have not seen credit-derivative
April 2001 Trading and Capital-Markets Activities Manual
Page 10
Collateralized Loan Obligations
Section 4353.1
GENERAL DESCRIPTION Figure 1—Collateralized Loan
Obligation
Collateralized loan obligations (CLOs) are
securitizations of large portfolios of secured or
Money Market
unsecured corporate loans made to commercial SPV
and industrial customers of one or more lending (Trust or Senior
Corporation)
banks. CLOs offer banking institutions a means Transferor/ Mezzanine
of achieving a broad range of financial objec- Bank
Loan Subordinated
tives, including, but not limited to, the reduction Portfolio
of credit risk and regulatory capital require- Equity
ments, access to an efficient funding source for
lending or other activities, increased liquidity,
and increased returns on assets and equity.
Furthermore, institutions are able to realize
these benefits without disrupting customer rela- Typically, the asset-backed securities issued
tionships. CLO structures generally fall into two by the trust or SPV consist of one or more
categories: cash-flow structures and market- classes of rated debt securities, one or more
value structures. Cash-flow structures are trans- unrated classes of debt securities that are gener-
actions in which the repayment and ratings of ally treated as equity interests, and a residual
the CLO debt securities depend on the cash flow equity interest. These tranches generally have
from the underlying loans. Market-value struc- different rates of interest and projected weighted
tures are distinct from cash-flow structures in average lives to appeal to different types of
that credit enhancement is achieved through investors. They may also have different credit
specific overcollateralization levels assigned to ratings. It is common for the bank to retain a
each underlying asset. Most bank CLOs have subordinated or equity interest in the securitized
been structured as cash-flow transactions. assets to provide the senior noteholders with
additional credit enhancement. This provision of
To date, most bank-sponsored CLOs have
credit support by the sponsoring bank triggers
been very large transactions—typically ranging
regulatory ‘‘low-level recourse’’ capital treatment.
from $1 billion to $6 billion—undertaken by
Conceptually, the underlying assets collater-
large, internationally active banking institutions.
alizing the CLO’s debt securities consist of
However, as the CLO market evolves and the
whole commercial loans. In reality, the under-
relative costs decline, progressively smaller
lying assets frequently consist of a more diverse
transactions may become feasible, and the uni-
mix of assets which may include participation
verse of banks that can profitably use the CLO
interests, structured notes, revolving credit
structure will increase significantly.
facilities, trust certificates, letters of credit, and
guarantee facilities, as well as synthetic forms of
credit.
One or more forms of credit enhancement are
CHARACTERISTICS AND almost always necessary in a CLO structure to
FEATURES obtain the desired credit ratings for the most
highly rated debt securities issued by the CLO.
In a CLO transaction, loans are sold, partici- The types of credit enhancements used by CLOs
pated, or assigned into a trust or other bankruptcy- are essentially the same as those used in other
remote special-purpose vehicle (SPV), which, asset-backed securities structures—‘‘internal’’
in turn, issues asset-backed securities consisting credit enhancement provided by the underlying
of one or more classes, or tranches. Alterna- assets themselves (such as subordination, excess
tively, a CLO may be synthetically created spread, and cash collateral accounts) and
through the use of credit derivatives, for exam- ‘‘external’’ credit enhancement provided by third
ple, default swaps or credit-linked notes, that are parties (principally financial guaranty insurance
used to transfer the credit risk of the loans into issued by monoline insurers). In the past, most
the trust or SPV and, ultimately, into the capital bank CLOs have relied on internal credit
markets. enhancement.
Trading and Capital-Markets Activities Manual March 1999
Page 1
4353.1 Collateralized Loan Obligations
Bank CLOs can be further divided into linked generate less excess spread. The CLO
and de-linked structures. In a linked structure, master trust also needs to be structured to
the sponsoring bank provides some degree of mitigate the resulting mismatches between the
implicit or explicit credit support to the transac- maturities of heterogeneous collateral assets and
tion as a means of improving the credit rating of liabilities, and to pay all series by their stated
some or all of the tranches. While such credit maturities.
linkage may improve the pricing of a transac- The master trust structure can be contrasted
tion, the bank’s provision of credit support may with other types of trusts, such as the grantor’s
constitute recourse for risk-based capital pur- and owner’s trusts, that restrict the types of
poses, thus increasing the capital cost of the asset-backed securities that can be issued or
transaction. In contrast, the CLO issuer in a have other limitations. The simplest trust form
de-linked structure relies entirely on the under- requires the straight pass-through of the cash
lying loan assets and any third-party credit flows from trust assets to investors without any
enhancement for the credit ratings of the debt restructuring of those cash flows.
securities. A distinguishing feature of CLOs using the
CLO transactions are evolving into highly master trust structure is the transferor’s (seller’s)
customized and complex structures. Some trans- interest, which represents the selling bank’s
actions that may appear similar on the surface required retained interest in the assets trans-
differ greatly in the degree to which credit risk ferred to the master trust. One purpose of the
has been transferred from the bank to the inves- transferor’s interest in credit card securitizations
tor. In some cases, the actual transference of is to ensure that the principal balance of assets in
credit risk may be so limited that the securitiza- the trust is more than sufficient to match the
tion meets the regulatory definition of ‘‘asset principal balance of notes that have been issued
sales with recourse,’’ thus requiring the bank to to investors. In addition, the transferor’s interest
hold capital against the securitized assets. is essentially a ‘‘shock absorber’’ for fluctua-
tions in principal balances due to addi-
tional draws under credit facilities and principal
paydowns, whether scheduled or not. In defini-
tional terms, the transferor’s interest is equal
TYPES to the total trust assets less the investors’ inter-
est, or that portion of the pool allocated to
CLOs Using the Master Trust backing the notes issued to investors. The issu-
Structure ing bank is usually required to maintain its
transferor’s interest at a predetermined percent-
CLOs are complex transactions that typically age of the overall trust size, usually 3 to 6 per-
use a master trust structure. Historically, the cent in a CLO transaction. As such, the transf-
master trust has been used for revolving, short- eror’s interest within the master trust framework
term assets such as credit card receivables. This is on an equal footing with the investors’
format affords the issuer a great deal of flexibil- interest.
ity in structuring notes with different repayment However, the use of a master trust structure
terms and characteristics, and provides for the and the creation of a transferor’s interest in a
ongoing ability to transfer assets and offer mul- CLO transaction may create some unique prob-
tiple series, which allows for greater diversifi- lems. The very existence of the two interests
cation and minimized transaction costs. Conse- (transferor’s and investors’), the nonhomogene-
quently, securitizations through a master trust ity of the loans being securitized, and the
structure are often assigned series numbers, such comparatively concentrated nature of commer-
as 1998-1, 1998-2, etc., to identify each specific cial loan portfolios suggest that the distribution
securitization. These transactions may have many of those loans between the two interests must be
interrelated components that make them particu- reviewed and monitored carefully. It is critical to
larly difficult to analyze. understand the basis for the distribution of
CLO master trust applications need to be credits between the two interests and the condi-
carefully designed. In contrast to typical master tions under which this distribution may change
trust assets such as credit card receivables, over the life of the securitization in order to
corporate loan portfolios are less diversified, determine whether the transaction contains
cash flows are not as smooth, and lower yields embedded recourse to the bank.
March 1999 Trading and Capital-Markets Activities Manual
Page 2
Collateralized Loan Obligations 4353.1
Figure 2—CLO Master-Trust payments due investors on the asset-backed
Structure notes issued. The residual yield is called excess
spread and is usually available to fund investor
Transferor’s Investors’ Interest
losses.1
Interest Priority
Money Market
Senior Synthetic CLO Securitizations
Mezzanine
Subordinated Recent innovations in securitization design have
Equity resulted in a class of synthetic securitization that
Cash-Collateral Account involves different risk characteristics than the
Excess Spread
standard CLOs described above. One type of
synthetic securitization uses credit derivatives to
Reflects exposure typically retained by issuing bank. transfer a loss potential in a designated portfolio
of credit exposures to the capital markets. The
intent of the transaction is to transfer credit risk
Common Features of CLO Master-Trust on a specific reference portfolio of assets to the
Structures capital markets and to achieve a capital charge
on the reference portfolio that is significantly
In order for issuers of CLOs to attract institu- lower than 8 percent.
tional investors, for example, insurance compa- In the example in figure 3, the banking
nies and pension funds, the securities being organization identifies a specific portfolio of
issued are often rated. Rating agencies consider credit exposures, which may include loan com-
the credit quality and performance history of the mitments, and then purchases default protection
securitized loan portfolio in determining the from a special-purpose vehicle. In this case, the
credit rating to be assigned, as well as the
structure of the transaction and any credit
enhancements supporting the transaction.
Figure 3—Synthetic CLO
In CLO transactions, the three most common Securitization
forms of credit enhancement are (1) subordina-
tion, (2) the funding of a cash-collateral account, Fees
and (3) the availability of any excess spread on Issuing Bank SPV Conduit
the transaction to fund investor losses. Subordi- Pledged
nation refers to securitization transactions that Credit Portfolio Treasuries
issue securities of different seniority, that is, Default
senior noteholders are paid before subordinated Protection
noteholders. It is common for the issuing bank
Cash
to retain the most junior tranche of the investor Proceeds Notes
notes. This interest is included in the investors’
interest. It is distinct from the transferor’s inter-
est and is held on the transferor’s balance sheet Investors
as an asset. Thus, third-party investors gain
assurance that the bank will maintain the credit Aaa Notes
quality of the loans when the bank retains the Ba2 Notes
first-loss exposure in the investor interest.
In addition to retaining the most junior tranche
of investor notes, the bank may fund a cash-
collateral account. The cash-collateral account 1. Note that any loss position that a bank retains in its own
securitization is subject to low-level-recourse capital treat-
functions as another layer of credit protection ment. A loss position would include retention of the most
for the investors’ interest. If there is a shortfall junior investor notes, the cash-collateral account, and excess
in loan collections in any period that prevents spread, if recorded as an asset on the bank’s balance sheet.
asset-backed noteholders from being paid, the (See Statement of Financial Accounting Standards No. 140
(FAS 140), ‘‘Accounting for Transfers and Servicing of
cash collateral account may be drawn down. Financial Assets and Extinguishments of Liabilities,’’ for
Finally, the yield of the loans placed in the more information on the sale of assets and the recording of
trust often exceeds the total coupon interest resulting assets and liabilities on the balance sheet.)
Trading and Capital-Markets Activities Manual September 2001
Page 3
4353.1 Collateralized Loan Obligations
credit risk on the identified reference portfolio is The institution has the option to call any of the
transferred to the SPV through the use of credit- CLNs before maturity so long as they are
default swaps. In exchange for the credit pro- replaced by CLNs that meet individual obligor
tection, the institution pays the SPV an annual and portfolio limits. These limits include con-
fee. centration limits, maturity limits, and credit-
To support its guarantee, the SPV sells credit- quality standards that must be met to maintain
linked notes (CLNs) to investors and uses the the credit ratings of the notes. If the CLNs no
cash consideration to purchase Treasury notes longer meet collateral guidelines, there are early-
that are then pledged to the banking organiza- amortization provisions that will cause the trans-
tion to cover any default losses.2 CLNs are action to wind down early.
obligations whose principal repayment is condi- If any obligor linked to a CLN in the SPV
tioned upon the default or nondefault of a defaults, the institution will call the note and
referenced asset. The CLNs may consist of more redeem it based either on the post-default mar-
than one tranche, for example, Aaa-rated senior ket value of the reference security of the
notes and Ba2-rated subordinated notes, and are defaulted obligor or on a fixed percentage of par
issued in an amount that is sufficient to cover that reflects the average historical recovery rate
some multiple of expected losses—typically, for senior unsecured debt. The fixed percentage
about 7 percent of the notional amount of the method is used when the linked obligor has no
reference portfolio. publicly traded debt. Finally, the term of each
There may be several levels of loss in a CLN is set such that the credit exposure to
synthetic securitization. The first-loss position which it is linked matures before the CLN,
may be a small cash reserve that accumulates ensuring that the CLN will be in place for the
over a period of years and is funded from the full term of the exposure to which it is linked.
excess of the SPV’s income (that is, the yield on Synthetic CLO structures differ from many
the Treasury securities plus the fee for the traditional CLO structures in two significant
credit-default swap) over the interest paid to ways:
investors on the notes. The investors in the SPV
assume a second-loss position through their 1. In most CLO structures, assets are actually
investment in the SPV’s notes. Finally, the transferred into the SPV. In the synthetic
banking organization retains the risks associated securitizations, the underlying exposures that
with any credit losses in the reference portfolio make up the reference portfolio remain on
that exceed the first- and second-loss positions. the institution’s balance sheet. The credit risk
is transferred into the SPV through credit-
In figure 3, default swaps on each of the default swaps or CLNs. In this way, the
obligors in the reference portfolio are executed institution is able to avoid sensitive client
and structured to pay the average default losses relationship issues arising from loan-transfer
on all senior, unsecured obligations of defaulted notification requirements, loan-assignment
borrowers. Typically, no payments are made provisions, and loan-participation restric-
until maturity, regardless of when a reference tions. Client confidentiality may also be main-
obligor defaults. A variation of this structure tained. The CLN-backed synthetic CLO also
uses CLNs to transfer the credit risk from the simplifies the legal work involved by avoid-
transferring bank to the SPV instead of using ing the transfer of collateral and the creation
credit-default swaps as in the above structure. In or perfection of a security interest in anything
turn, the SPV issues a series of floating-rate other than the CLN.
notes (‘‘notes’’) in several tranches to investors. 2. In many CLO structures, the opportunity to
The notes are then collateralized by a pool of remove credit risk from—or add credit risk
CLNs, with each CLN representing one obligor to—the underlying collateral pool is severely
and its credit-risk exposure (such as bonds, limited. In the CLN-backed CLO, the insti-
loans, or counterparty exposure). Thus, the dol- tution may actively manage the pool of
lar amount of notes issued to investors equals CLNs, thereby managing the credit risk of
the notional amount of the reference portfolio. the linked exposures on an ongoing basis. In
this way, the structure can be used to free up
credit lines for core clients with whom the
2. The names of corporate obligors included in the refer- institution would like to conduct more
ence portfolio may be disclosed to investors in the CLNs. business.
September 2001 Trading and Capital-Markets Activities Manual
Page 4
Collateralized Loan Obligations 4353.1
RISK-TRANSFERENCE ISSUES guidelines, principal repayments on loans may
be withheld from the transferor during the
revolving period. Thereafter, if the deficiencies
Reallocation of Cash Flows remain uncorrected, the funds thus withheld
may be available to pay down investor notes.
One of the provisions commonly associated Examiners need to carefully review the condi-
with complex CLOs is the provision for the tions under which cash flows are reallocated and
reallocation of cash flows under certain circum- circumstances under which normal flows are
stances. Cash-flow reallocation may take a num- interrupted to determine the overall impact on
ber of forms, but is usually provided to ensure the credit-risk transference achieved in CLOs.
that senior noteholders get paid before junior
noteholders. For example, if loan collections are
insufficient to fund the payments of the senior
notes of a CLO and other credit enhancements
have been exhausted, or the securitization has Early Amortization
entered an amortization phase, the servicer may
be required to redirect payments from junior A standard feature of CLO securitizations is a
noteholders to senior noteholders. In some struc- provision for early amortization. Early amorti-
tures, principal payments on loans that are zation provisions are designed to protect note-
originally allocated to paying down the principal holders in the event the loans in the trust
balance of the junior notes may be reallocated to experience significant difficulty, diminishing the
the payment of current (or delinquent) interest prospects for repayment of investor notes. When
on senior notes. This recharacterization of prin- an early amortization event occurs (for example,
cipal to interest may be a source of recourse if defaults in the loan pool reach a certain prede-
investor note balances are not reduced for the termined level), collections on the underlying
principal payment, due to the fact that a loan loans are reallocated so that investors are paid
underlying the investor interest has paid off and off at an accelerated rate. Typically, cash flows
is no longer available to support outstanding are allocated based on the proportional share of
investor principal balances. Therefore, the bank the trust that the transferor and investor interests
will be required to provide new loans to back the represent when the early amortization event
investors’ interest, either from the transferor’s occurs. The allocation percentage thereafter
interest or from its own balance sheet. remains fixed. This mechanism works to favor
Another distinguishing feature of CLOs that the investor interest, as additional drawdowns
use the master trust structure is the revolving on facilities in the trust cause the transferor
period. During the revolving period of a CLO, interest to increase (that is, additional lending
the investor notes are only paid interest, that is, under existing lines participated into the trust is
the notes have not yet entered the amortization assigned to the transferor’s interest). Therefore,
phase.3 However, some of the underlying loan the size of the transferor interest grows rapidly
balances are actually being repaid during this relative to the size of the investor interest, but
time. During the revolving period, such repay- cash flow from the entire pool of trust assets
ments are automatically reinvested in new loans continues to be allocated based on the fixed
to maintain the principal balance of loans back- percentage that was determined when the early
ing the investor notes. In some securitizations, amortization event occurred. For example,
this allocation of cash flows may be interrupted. assume the current allocation based on the
Specifically, under certain conditions, such as a relative size of investors’ and transferor’s inter-
deteriorating collection rate, a collateral defi- est is 80 percent and 20 percent, respectively. If
ciency, or noncompliance with rating-agency early amortization were triggered, this percent-
age would be used to allocate all future principal
collections, regardless of the actual relative size
of the transferor and investor interests at any
3. Investor notes may either mature at a point in time or future date. While the existence of early amor-
may amortize over a specific period, usually one year. In either tization provisions has not been treated as
case, principal payments on the underlying loans may begin to
accumulate a few months before maturity or the commence-
recourse for regulatory purposes, early amorti-
ment of an amortization period in order to provide additional zation is viewed in the marketplace as a form of
assurance that contractual principal payments can be made. credit enhancement. Credit-rating agencies indi-
Trading and Capital-Markets Activities Manual March 1999
Page 5
4353.1 Collateralized Loan Obligations
cate that such provisions can reduce the amount formed into interests in the securitization vehi-
of credit enhancements or recourse needed to cle (trust or other SPV), and all of the securities
secure a given rating by more than half. issued to investors are rated equal to—or higher
While early amortization provisions alone than—the average rating of the loans in the pool.
have not been deemed recourse to the bank, they The only other interests in the pool are retained
have been recognized as creating conditions that by the issuing bank, that is, the subordinated
might result in the transferring bank’s retaining piece of the investor interest and the transferor’s
a degree of credit risk.4 When a securitization interest. These interests are typically unrated.
triggers an early amortization event, the bank However, since the investor securities are all
has two choices. It can allow the early amorti- rated above the average loan rating of the loan
zation to proceed, causing the securitization to pool, one could reasonably presume that the
unwind. If a bank were to allow an early implicit credit rating of the bank’s retained
amortization to occur, its access to the asset- interests are lower than average. Further, since
backed market in the future could become the dollar volume of the bank’s retained interest
impaired and more expensive. Alternatively, the is usually much smaller than the investors’
bank may choose to voluntarily correct the interest, one might reasonably conclude that the
deficiency leading to the early amortization implicit credit rating of these interests is much
condition. Banks may be willing to support their lower than the investor interest. In such cases, it
securitizations, notwithstanding any legal obli- is not clear whether the investors have assumed
gation to do so, to preserve their name in the a meaningful portion of the credit risk of the
marketplace. However, such actions may have underlying loans. Hence, the issue is not recourse
regulatory capital implications. in the traditional sense, but whether significant
transference of risk has occurred in the first
place.
In some situations, certain trust covenants
Other Issues may function as credit support, leading to
recourse to the securitizing bank. For example,
the trust may require the bank to maintain the
In some CLO transactions, it may be unclear average credit rating of the loans in the trust.
whether a significant portion of underlying credit This may be accomplished by a requirement to
risk has been passed along to investors in the remove deteriorating loans from the trust and
asset-backed securities. Assume that a $4 billion replace them with higher-quality loans. Alterna-
CLO has been completed in which the average tively, the deteriorating loans may be ‘‘reallo-
underlying loan is rated BB. Further, assume cated’’ to the transferor’s interest, with the bank
that interests in these loans were segregated into providing new loans of higher quality to the
a traditional CLO structure (see figure 4). In this trust to back the investors’ interest. In either
case, the underlying loan pool has been trans- case, the potential for recourse to the issuing
bank is significant.5
To obtain a favorable credit rating, covenants
Figure 4—Distribution of Risks may place limitations on the amount of credit
Priority extended to a particular industry as well as on
I
A Tranche AAA the maximum exposure to any particular obli-
n Rated AAA
v S
e h B Tranche gor. For example, rating agencies may require
s a Rated AA/A
t r C Tranche that total credit exposure to any particular indus-
o e Rated BBB
r D Tranche
Loan Portfolio try not exceed 5 percent of the trust in order for
’s Rated BB Average Rating: the notes issued to achieve a particular rating.
B S E Tranche BB
a h Unrated Any exposures over the limit may be assigned to
n a Transferor’s Interest
k r Unrated CCC
’s e
Trust Certificates Asset Pool
Rating Characteristics Rating Characteristics
5. One factor in determining whether transactions include
recourse is the sharing of loss that occurs when deteriorating
assets are sold from the trust. If the loss is shared proportion-
4. See SR-97-21, ‘‘Risk Management and Capital Adequacy ately between investor and transferor interests, it is less likely
of Exposures Arising from Secondary Market Credit Activi- that the transaction will be deemed to have recourse to the
ties,’’ July 11, 1997. bank.
March 1999 Trading and Capital-Markets Activities Manual
Page 6
Collateralized Loan Obligations 4353.1
the transferor’s interest as an ‘‘overconcentra- USES
tion’’ amount. Because revolving credit facili-
ties vary in size over time and their balances Banks have used CLOs to achieve a number of
tend to be large, industry overconcentration different financial objectives, including the
appears to be common in these structures. The important goal of maximizing the efficient use
end result is that the investors’ interest remains of their economic capital in the context of the
well diversified at all times, while the transfer- current regulatory capital rules. Considering the
or’s interest absorbs all overconcentration small margins on commercial loans relative to
amounts. In this case, the risk of the transferor’s other banking assets, the high risk-based capital
interest and the investors’ interest is not the requirement of these loans, especially those of
same. However, such industry concentration investment-grade quality, makes holding them a
limits by themselves generally will not result in less profitable or efficient use of capital for some
a determination that the bank is providing banks. Using a CLO to securitize and sell a
recourse to the trust. portfolio of commercial loans can free up a
Similarly, trust documents may limit the significant amount of capital that can be used
exposure of any particular obligor in the trust. more profitably for other purposes, such as
Obligor concentration limits may become prob- holding higher-yielding assets, holding lower
lematic when the limit assigned is a function of risk-weighted assets, making acquisitions, pay-
the credit rating of the obligor. When a credit in ing dividends, and repurchasing stock. As a
the trust is downgraded below a defined thresh- result, this redeployment of capital can have the
old level, the ‘‘excess’’ exposure to the obligor effect of reducing capital requirements, and/or
may either be removed from the trust by the improving return on equity and return on assets.
issuing bank or may be assigned to an over- Issuers also obtain other advantages by using
concentration amount within the transferor’s CLOs and synthetic securitizations, including
interest. In this case, it is not only possible that accessing more favorable capital-market fund-
the transferor is absorbing credit exposures that ing rates and, in some cases, transferring credit
exceed industry concentration limits (as described risk; increasing institutional liquidity; monetiz-
above), but it may also absorb exposures to ing gains in loan value; generating fee income
credits that are deteriorating. If these require- by providing services to the SPV; and eliminat-
ments function in a manner that tends to reallo- ing a potential source of interest-rate risk. In
cate deteriorating credits to the transferor’s inter- addition, CLOs can be used for balance-sheet
est before default, the transaction may meet the management and credit-risk hedging, that is,
regulatory definition of asset sales with securitizations enable the sponsor to transfer
recourse. assets with certain credit-quality, spread, and
In addition to the common structural features liquidity characteristics from the balance sheet
described above, there may be other conditions while preserving relationships with borrowers.
under which loan balances may be reallocated In this manner, the bank can reduce its exposure
between transferor and investor interests. Fur- to risk concentrations.
ther, unique contractual requirements may specify From the viewpoint of investors, CLO spreads
how losses will be shared between the two are attractive compared with those of other,
interests in the event of default (or some other more commoditized asset classes and can offer
defined credit event). Through these contractual portfolio-diversification benefits. The various
provisions, the bank may continue to have tranches represent a significant arbitrage oppor-
significant or contingent exposure to the securi- tunity to yield- seeking investors, and investment-
tized assets. grade CLOs can provide a spread premium to
In summary, while examiners may be able to investors who are limited by regulatory or invest-
highlight recourse issues, it is not always clear ment restrictions from directly purchasing indi-
where the lines should be drawn, as the mecha- vidual non-investment-grade securities. In addi-
nisms involved in these transactions are not tion, the performance history of CLOs has so far
always transparent. The issue is further compli- been favorable—an important factor in attract-
cated by the fact that banking organizations ing investors, especially in the lower, supporting
outside the United States are engaging in these mezzanine or equity tranches in a CLO capital
transactions, and the treatment applied by for- structure. These subordinated investors demand
eign bank supervisory authorities may not par- a premium return that is commensurate with the
allel U.S. supervisory treatment. higher risk they bear.
Trading and Capital-Markets Activities Manual March 1999
Page 7
4353.1 Collateralized Loan Obligations
DESCRIPTION OF address cash-flow mismatches between the pay-
MARKETPLACE ment characteristics of the CLO debt obligations
and the underlying loans, such as differences in
The primary buyers for CLO securities have frequency of payments, payment dates, interest-
been insurance companies and pension funds rate indexes (basis risk), and interest-rate reset
seeking attractive returns with high credit qual- risk.
ity. To date, banking organizations typically
have not been not active buyers of these secu-
rities. The secondary market is less fully devel-
oped and less active than the market for more RISKS
traditional types of asset-backed securities. How-
ever, as the market grows and expands globally Credit risk in CLOs and synthetic securitizations
to spread-seeking investors, CLO securities are arises from (1) losses due to defaults by the
becoming more liquid. borrowers in the underlying collateral and
Market transparency can be less than perfect, (2) the issuer’s or servicer’s failure to perform.
especially when banks and other issuers retain These two elements can blur together, for exam-
most of the economic risk despite the securiti- ple, a servicer who does not provide adequate
zation transaction. In addition, the early amorti- credit-review scrutiny of the serviced portfolio,
zation features of some CLO transactions may leading to a higher incidence of defaults. CLOs
not be fully understood by potential buyers. and synthetic securitizations are rated by major
ratings agencies.
Market risk arises from the cash-flow charac-
teristics of the security. The greatest variability
PRICING in cash flows comes from credit performance,
Securities issued in CLOs and synthetic securi- including the presence of wind-down or accel-
tizations carry coupons that can be fixed (gen- eration features designed to protect the investor
erally yielding between 50 and 300 basis points in the event that credit losses in the portfolio rise
over the Treasury curve) or floating (for exam- well above expected levels. For certain dynamic
ple, 15 basis points over one-month LIBOR). CLO structures that allow for active manage-
Pricing is typically designed to reflect the cou- ment, adequate disclosure should be made
pon characteristics of the loans being securi- regarding a manager’s ability to sell assets that
tized. The spread will vary depending on the may have appreciated or depreciated in value.
credit quality of the underlying collateral, degree This trading flexibility represents an additional
and nature of the credit enhancement, and degree level of risk to investors because an investor is
of variability in the cash flows emanating from exposed to the collateral manager’s decisions.
the securitized loans. As a result, there may be a greater risk in CLOs
(versus, for example, credit card securitizations)
that its rating can change over time as the
composition of the asset pool deteriorates.
HEDGING Interest-rate risk arises for the issuer from the
relationship between the pricing terms on the
CLO issuers often use a variety of hedging underlying loans and the terms of the rate paid
instruments, including interest-rate swaps, cur- to noteholders, as well as from the need to mark
rency swaps, and other derivatives, to hedge to market the excess servicing or spread-account
against various types of risk. For example, if the proceeds carried on the balance sheet. For the
underlying assets are not denominated in U.S. holder of the security, interest-rate risk depends
dollars, currency risk may be hedged with swaps, on the expected life or repricing of the security,
caps, or other hedging mechanisms. Convertibil- with relatively minor risk arising from embed-
ity risk is considered for certain currencies in ded options. The notable exception is the valu-
which the sovereign may be likely to impose ation of the wind-down option.
currency restrictions. In such cases, certain cur- Liquidity risk can arise from credit deteriora-
rencies may not be permitted in the collateral tion in the asset pool when early amortization
pool regardless of the hedging mechanisms in provisions are triggered. In that situation, the
place. Hedging instruments may also be used to seller’s interest is effectively subordinated to the
March 1999 Trading and Capital-Markets Activities Manual
Page 8
Collateralized Loan Obligations 4353.1
interests of the other investors by the payment- securitization of receivables. These standards
allocation formula applied during early amorti- address (1) when a transaction qualifies as a sale
zation. Other investors effectively get paid first, for accounting purposes and (2) the treatment of
and the seller’s interest will therefore absorb a excess spread and servicing assets arising from a
disproportionate share of losses. Also, closure of securitization transaction when a sale is deemed
the securitization conduit can create liquidity to have occurred.
problems for the seller because the seller must
then fund a steady stream of new receivables.
When a conduit becomes unavailable due to
early amortization, the seller must either find RISK-BASED CAPITAL
another buyer for the receivables or have receiv- WEIGHTING
ables accumulate on its balance sheet, creating
the need for another source of funding. In The current capital treatment for the standard
addition, these factors can create an incentive master-trust CLO described in this section has
for the seller to provide implicit recourse— three components. First, banks use the low-level-
credit enhancement above and beyond any pre- recourse rule when calculating capital charges
existing contractual obligation—to prevent early against any first-loss exposures they retain. Thus,
amortization. Although incentives to provide the most junior tranche would carry a dollar-
implicit recourse are present in other types of for-dollar capital charge up to 8 percent of the
securitizations to some extent, the early- investor interest. Second, banks receive transf-
amortization feature of CLOs creates additional eror certificates for their investments in the trust
and more direct financial incentives to prevent through the transferor’s interest. As this repre-
its occurrence because of concerns about dam- sents the bank’s proportional share in a larger
age to the seller’s reputation if one of its pool of assets, 8 percent capital is held against
securitizations performs poorly. the transferor’s interest. Finally, the loan facili-
Operational risk arises through the potential ties which the bank has assigned or participated
for misrepresentation of loan quality or terms by into the trust typically are not fully drawn. The
the originating institution, misrepresentation of bank maintains capital for its commitment to
the nature and current value of the assets by the lend up to the limit of these facilities. If the
servicer, and inadequate controls over disburse- transferring bank that sponsors the CLO retains
ments and receipts by the servicer. a subordinated tranche that would provide credit
protection, then the low-level-recourse rule
would apply, that is, dollar-for-dollar capital
generally would be assessed on the retained risk
ACCOUNTING TREATMENT exposure. This is also true if an interest-
only receivable representing the future spread is
Holder booked as a receivable on the transferring bank’s
balance sheet. If the sale of assets is accounted
The accounting treatment for investments in for, in part or in its entirety, as a servicing asset
CLOs and synthetic securitizations is deter- under FAS 140, then the capital charge takes the
mined by the Financial Accounting Standards form of a tier 1 capital limitation. The current
Board’s Statement of Financial Accounting Stan- capital treatment limits the total amount of
dards No. 115 (FAS 115), ‘‘Accounting for mortgage- and nonmortgage-servicing assets that
Certain Investments in Debt and Equity Securi- can be included in tier 1 capital to no more than
ties,’’ as amended by Statement of Financial 100 percent. It further limits the amount of
Accounting Standards No. 140 (FAS 140), nonmortgage-servicing assets that can be included
‘‘Accounting for Transfers and Servicing of in tier 1 capital to no more than 25 percent.
Financial Assets and Extinguishments of Liabili- Examiners should evaluate whether the trans-
ties.’’ See section 2120.1, ‘‘Accounting,’’ for feror’s interest is of lower credit quality than the
further discussion. investors’ interest and, if so, determine whether
the 8 percent capital charge against the
on-balance-sheet amount is sufficient given the
Seller issuing institution’s risk exposure. If examiners
determine that the transferor’s interest is effec-
FAS 140 covers the accounting treatment for the tively subordinated to the investors’ interest and
Trading and Capital-Markets Activities Manual September 2001
Page 9
4353.1 Collateralized Loan Obligations
thus provides credit protection to the issued and counterparty exposures. Since the notehold-
securities, then the low-level-recourse treatment ers are exposed to the full amount of credit risk
may be appropriate. SR-96-17, ‘‘Supervisory associated with the individual reference obli-
Guidance for Credit Derivatives,’’ provides some gors, all of the credit risk of the reference
guidance for the capital treatment of synthetic portfolio is shifted from the sponsoring banking
securitizations. organization to the capital markets. The dollar
Synthetic CLOs can raise questions about the amount of notes issued to investors equals the
appropriate capital treatment when calculating notional amount of the reference portfolio. In
the risk-based and leverage capital ratios. Capi- the example shown in figure 1, this amount is
tal treatments for three synthetic transactions $1.5 billion.
follow. If the obligor linked to a CLN in the SPV
defaults, the sponsoring banking organization
will call the individual CLN and redeem it based
Transaction 1—Entire Notional on the repayment terms specified in the note
Amount of Reference Portfolio Is agreement. The term of each CLN is set so that
Hedged the credit exposure (to which it is linked)
matures before the maturity of the CLN, which
In the first type of synthetic securitization, the ensures that the CLN will be in place for the full
sponsoring banking organization, through a syn- term of the exposure to which it is linked.
thetic CLO, hedges the entire notional amount An investor in the notes issued by the SPV is
of a reference asset portfolio. An SPV acquires exposed to the risk of default of the underlying
the credit risk on a reference portfolio by pur- reference assets, as well as to the risk that the
chasing credit-linked notes (CLNs) issued by sponsoring banking organization will not repay
the sponsoring banking organization. The SPV principal at the maturity of the notes. Because of
funds the purchase of the CLNs by issuing a the linkage between the credit quality of the
series of notes in several tranches to third-party sponsoring banking organization and the issued
investors. The investor notes are in effect col- notes, a downgrade of the sponsor’s credit rating
lateralized by the CLNs. Each CLN represents most likely will result in the notes also being
one obligor and the banking organization’s downgraded. Thus, a banking organization
credit-risk exposure to that obligor, which could investing in this type of synthetic CLO should
take the form of bonds, commitments, loans, assign the notes to the higher of the risk cate-
Figure 1—Transaction 1
Bank SPV $1.5 billion
$1.5 billion cash cash proceeds
$1.5 billion proceeds Holds portfolio
credit portfolio of CLNs
$1.5 billion
of CLNs
issued by
bank
$1.5 billion
of notes
X-year Y-year
notes notes
September 2001 Trading and Capital-Markets Activities Manual
Page 10
Collateralized Loan Obligations 4353.1
Figure 2—Transaction 2
Default payment and
pledge of Treasuries
Bank SPV
$5 billion Holds $400 million
credit portfolio $5 billion of credit-default swaps of pledged Treasuries
and annual fee
$400 million $400 million
of CLNs of cash
Senior
notes
Junior
notes
gories appropriate to the underlying reference Transaction 2—High-Quality, Senior
assets or the issuing entity. Risk Position in Reference Portfolio
For purposes of risk-based capital, the spon- Is Retained
soring banking organizations may treat the cash
proceeds from the sale of CLNs that provide In the second type of synthetic CLO transaction,
protection against underlying reference assets as the sponsoring banking organization hedges a
cash collateralizing these assets.6 This treatment portion of the reference portfolio and retains a
would permit the reference assets, if carried on high-quality, senior risk position that absorbs
the sponsoring banking organization’s books, to only those credit losses in excess of the junior-
be assigned to the zero percent risk category to loss positions. For some noted synthetic CLOs,
the extent that their notional amount is fully the sponsoring banking organization used a
collateralized by cash. This treatment may be combination of credit-default swaps and CLNs
applied even if the cash collateral is transferred to transfer to the capital markets the credit risk
directly into the general operating funds of the of a designated portfolio of the organization’s
banking organization and is not deposited in a credit exposures. Such a transaction allows
segregated account. The synthetic CLO would the sponsoring banking organization to allocate
not confer any benefits to the sponsoring bank- economic capital more efficiently and to
ing organization for purposes of calculating its significantly reduce its regulatory capital
tier 1 leverage ratio, however, because the ref- requirements.
erence assets remain on the organization’s bal- In the structure illustrated in figure 2, the
ance sheet. sponsoring banking organization purchases de-
fault protection from an SPV for a specifically
identified portfolio of banking-book credit ex-
posures, which may include letters of credit and
6. The CLNs should not contain terms that would signifi- loan commitments. The credit risk on the iden-
cantly limit the credit protection provided against the under- tified reference portfolio (which continues to
lying reference assets, for example, a materiality threshold
that requires a relatively high percentage of loss to occur remain in the sponsor’s banking book) is trans-
before CLN payments are adversely affected, or a structuring ferred to the SPV through the use of credit-
of CLN post-default payments that does not adequately pass default swaps. In exchange for the credit pro-
through credit-related losses on the reference assets to inves- tection, the sponsoring banking organization
tors in the CLNs.
Trading and Capital-Markets Activities Manual April 2001
Page 11
4353.1 Collateralized Loan Obligations
pays the SPV an annual fee. The default swaps underlying reference assets.8 The sponsoring
on each of the obligors in the reference portfolio banking organization must include in its risk-
are structured to pay the average default losses weighted assets its retained senior exposure in
on all senior unsecured obligations of defaulted the reference portfolio, to the extent these under-
borrowers. To support its guarantee, the SPV lying assets are held in its banking book. The
sells CLNs to investors and uses the cash portion of the reference portfolio that is collat-
proceeds to purchase U.S. government Treasury eralized by the pledged Treasury securities may
notes. The SPV then pledges the Treasuries to be assigned a zero percent risk weight. Unless
the sponsoring banking organization to cover the sponsoring banking organization meets the
any default losses.7 The CLNs are often issued stringent minimum conditions for transaction 2
in multiple tranches of differing seniority and in as outlined in the subsection ‘‘Minimum Condi-
an aggregate amount that is significantly less tions’’ (below), the remainder of the portfolio
than the notional amount of the reference port- should be risk weighted according to the obligor
folio. The amount of notes issued typically is set of the exposures.
at a level sufficient to cover some multiple of When the sponsoring banking organization
expected losses, but well below the notional has virtually eliminated its credit-risk exposure
amount of the reference portfolio being hedged. to the reference portfolio through the issuance of
There may be several levels of loss in this CLNs, and when the other minimum require-
type of synthetic securitization. The first-loss ments are met, the sponsoring banking organi-
position may consist of a small cash reserve, zation may assign the uncollateralized portion of
sufficient to cover expected losses. The cash its retained senior position in the reference
reserve accumulates over a period of years and portfolio to the 20 percent risk weight. However,
is funded from the excess of the SPV’s income to the extent that the reference portfolio includes
(that is, the yield on the Treasury securities plus loans and other on-balance-sheet assets, the
the credit-default-swap fee) over the interest sponsoring banking organization would not
paid to investors on the notes. The investors in realize any benefits in the determination of its
the SPV assume a second-loss position through leverage ratio.
their investment in the SPV’s senior and junior In addition to the three stringent minimum
notes, which tend to be rated AAA and BB, conditions, the Federal Reserve may impose
respectively. Finally, the sponsoring banking other requirements as it deems necessary to
organization retains a high-quality, senior risk ensure that a sponsoring banking organization
position that would absorb any credit losses in has virtually eliminated all of its credit expo-
the reference portfolio that exceed the first- and sure. Furthermore, the Federal Reserve retains
second-loss positions. the discretion to increase the risk-based capital
Typically, no default payments are made until requirement assessed against the retained senior
the maturity of the overall transaction, regard- exposure in these structures if the underlying
less of when a reference obligor defaults. While asset pool deteriorates significantly.
operationally important to the sponsoring bank- Federal Reserve staff will make a case-by-
ing organization, this feature has the effect of case determination, based on a qualitative review,
ignoring the time value of money. Thus, the as to whether the senior retained portion of a
Federal Reserve expects that when the reference sponsoring banking organization’s synthetic
obligor defaults under the terms of the credit securitization qualifies for the 20 percent risk
derivative and when the reference asset falls weight. The sponsoring banking organization
significantly in value, the sponsoring banking must be able to demonstrate that virtually all the
organization should, in accordance with gener- credit risk of the reference portfolio has been
ally accepted accounting principles, make transferred from the banking book to the capital
appropriate adjustments in its regulatory reports markets. As they do when banking organiza-
to reflect the estimated loss that takes into tions are engaging in more traditional securiti-
account the time value of money.
For risk-based capital purposes, the banking 8. Under this type of transaction, if a structure exposes
organizations investing in the notes must assign investing banking organizations to the creditworthiness of a
them to the risk weight appropriate to the substantive issuer, for example, the sponsoring banking orga-
nization, then the investing banking organizations should
assign the notes to the higher of the risk categories appropriate
7. The names of corporate obligors included in the refer- to the underlying reference assets or the sponsoring banking
ence portfolio may be disclosed to investors in the CLNs. organization.
April 2001 Trading and Capital-Markets Activities Manual
Page 12
Collateralized Loan Obligations 4353.1
zation activities, examiners must carefully evalu- Reserve may impose additional requirements or
ate whether the sponsoring banking organization conditions as deemed necessary to ascertain that
is fully capable of assessing the credit risk it a sponsoring banking organization has suffi-
retains in its banking book and whether it is ciently isolated itself from the credit-risk expo-
adequately capitalized given its residual risk sure of the hedged reference portfolio.
exposure. The Federal Reserve will require the
sponsoring banking organization to maintain Condition 1—Demonstration of transfer of vir-
higher levels of capital if it is not deemed to be tually all the risk to third parties. Not all
adequately capitalized given the retained residual transactions structured as synthetic securitiza-
risks. In addition, a sponsoring banking organi- tions transfer the level of credit risk needed to
zation involved in synthetic securitizations must receive the 20 percent risk weight on the retained
adequately disclose to the marketplace the effect senior position. To demonstrate that a transfer of
of its transactions on its risk profile and capital virtually all of the risk has been achieved,
adequacy. sponsoring banking organizations must—
The Federal Reserve may consider a sponsor-
ing banking organization’s failure to require the • produce credible analyses indicating a transfer
investors in the CLNs to absorb the credit losses of virtually all the credit risk to substantive
that they contractually agreed to assume to be an third parties;
unsafe and unsound banking practice. In addi- • ensure the absence of any early-amortization
tion, such a failure generally would constitute or other credit-performance-contingent
‘‘implicit recourse’’ or support to the transac- clauses;10
tion, which results in the sponsoring banking • subject the transaction to market discipline
organization’s losing preferential capital treat- through the issuance of a substantive amount
ment on its retained senior position. of notes or securities to the capital markets;
If a sponsoring banking organization of a • have notes or securities rated by a nationally
synthetic securitization does not meet the strin- recognized credit rating agency;
gent minimum conditions, it may still reduce the • structure a senior class of notes that receives
risk-based capital requirement on the senior risk the highest possible investment-grade rating,
position retained in the banking book by trans- for example, AAA, from a nationally recog-
ferring the remaining credit risk to a third-party nized credit rating agency;
OECD bank through the use of a credit deriva- • ensure that any first-loss position they retain
tive. Provided the credit-derivative transaction in the form of fees, reserves, or other credit
qualifies as a guarantee under the risk-based enhancement—which effectively must be
capital guidelines, the risk weight on the senior deducted from capital—is no greater than a
position may be reduced from 100 percent to reasonable estimate of expected losses on the
20 percent. Sponsoring banking organizations reference portfolio; and
may not enter into nonsubstantive transactions • ensure that they do not reassume any credit
that transfer banking-book items into the trading risk beyond the first-loss position through
account to obtain lower regulatory capital another credit derivative or any other means.
requirements.9
Condition 2—Demonstration of ability to evalu-
Minimum Conditions ate remaining banking-book risk exposures and
provide adequate capital support. To ensure that
The following stringent minimum conditions are the sponsoring banking organization has adequate
those that the sponsoring banking organizations capital for the credit risk of its unhedged expo-
must meet to use the synthetic securitization sures, it is expected to have adequate systems
capital treatment for transaction 2. The Federal that fully account for the effect of these trans-
actions on its risk profiles and capital adequacy.
9. For instance, a lower risk weight would not be applied to
In particular, the sponsoring banking organiza-
a nonsubstantive transaction in which the sponsoring banking
organization (1) enters into a credit-derivative transaction to
pass the credit risk of the senior retained portion held in its 10. Early-amortization clauses may generally be defined
banking book to an OECD bank, and then (2) enters into a as features that are designed to force a wind-down of a
second credit-derivative transaction with the same OECD securitization program and rapid repayment of principal to
bank, in which it reassumes into its trading account the credit asset-backed securities investors if the credit quality of the
risk initially transferred. underlying asset pool deteriorates significantly.
Trading and Capital-Markets Activities Manual April 2001
Page 13
4353.1 Collateralized Loan Obligations
tion’s systems should be capable of fully differ- ments), transferred exposures, and exposures
entiating the nature and quality of the risk retained to facilitate transfers (credit enhance-
exposures it transfers from the nature and qual- ments). The stress tests must demonstrate that
ity of the risk exposures it retains. Specifically, the level of credit enhancement is sufficient to
to gain capital relief sponsoring banking orga- protect the sponsoring banking organization
nizations are expected to— from losses under scenarios appropriate to the
specific transaction.
• have a credible internal process for grading
credit-risk exposures, including the following: Condition 3—Provide adequate public disclo-
— adequate differentiation of risk among risk sures of synthetic CLO transactions regarding
grades their risk profile and capital adequacy. In their
— adequate controls to ensure the objectivity 10-K and annual reports, sponsoring banking
and consistency of the rating process organizations must adequately disclose to the
— analysis or evidence supporting the accu- marketplace the accounting, economic, and regu-
racy or appropriateness of the risk-grading latory consequences of synthetic CLO transac-
system; tions. In particular, sponsoring banking organi-
• have a credible internal economic capital- zations are expected to disclose—
assessment process that defines them to be
adequately capitalized at an appropriate insol- • the notional amount of loans and commit-
vency probability and that readjusts, as nec- ments involved in the transaction;
essary, their internal economic capital • the amount of economic capital shed through
requirements to take into account the effect of the transaction;
the synthetic securitization transaction. (In • the amount of reduction in risk-weighted assets
addition, the process should employ a suffi- and regulatory capital resulting from the trans-
ciently long time horizon to allow necessary action, both in dollar terms and in terms of the
adjustments in the event of significant losses. effect in basis points on the risk-based capital
The results of an exercise demonstrating that ratios; and
the organization is adequately capitalized after • the effect of the transaction on the distribution
the securitization transaction must be pre- and concentration of risk in the retained port-
sented for examiner review.); folio by risk grade and sector.
• evaluate the effect of the transaction on the
nature and distribution of the nontransferred
banking-book exposures. This analysis should Transaction 3—First-Loss Position Is
include a comparison of the banking book’s Retained
risk profile and economic capital requirements
before and after the transaction, including the In the third type of synthetic transaction, the
mix of exposures by risk grade and by busi- sponsoring banking organization may retain a
ness or economic sector. (The analysis should subordinated position that absorbs the credit risk
also identify any concentrations of credit risk associated with a first loss in a reference port-
and maturity mismatches. Additionally, the folio. Furthermore, through the use of credit-
sponsoring banking organization must default swaps, the sponsoring banking organiza-
adequately manage and control the forward tion may pass the second- and senior-loss
credit exposure that arises from any maturity positions to a third-party entity, most often an
mismatch. The Federal Reserve retains the OECD bank. The third-party entity, acting as an
flexibility to require additional regulatory capi- intermediary, enters into offsetting credit-default
tal if the maturity mismatches are substantive swaps with an SPV, thus transferring its credit
enough to raise a supervisory concern. More- risk associated with the second-loss position to
over, as stated above, the sponsoring banking the SPV.11 The SPV then issues CLNs to the
organization must demonstrate that it meets its capital markets for a portion of the reference
internal economic capital requirement subse-
quent to the completion of the synthetic
securitization.); and 11. Because the credit risk of the senior position is not
transferred to the capital markets but remains with the
• perform rigorous and robust forward-looking intermediary bank, the sponsoring banking organization should
stress testing on nontransferred exposures ensure that its counterparty is of high credit quality, for
(remaining banking-book loans and commit- example, at least investment grade.
April 2001 Trading and Capital-Markets Activities Manual
Page 14
Collateralized Loan Obligations 4353.1
Figure 3—Transaction 3
Credit-default-swap
fee (basis points per year)
SPV
Intermediary
OECD Bank Holds $400 million
of pledged Treasuries
Default payment and
pledge of Treasuries
Default payment
and pledge of $400 million $400 million
Treasuries equal of CLNs of cash
Credit-default-
to $400 million to
swap fee
cover losses above
1% of the Senior
reference assets notes
Sponsoring
Banking
Organization
Junior
notes
$5 billion credit
portfolio
portfolio and purchases Treasury collateral to The second approach employs a literal read-
cover some multiple of expected losses on the ing of the capital guidelines to determine the
underlying exposures. sponsoring banking organization’s risk-based
Two alternative approaches could be used to capital charge. In this instance, the 1 percent
determine how the sponsoring banking organi- first-loss position retained by the sponsoring
zation should treat the overall transaction for banking organization would be treated as a
risk-based capital purposes. The first approach guarantee, that is, a direct credit substitute,
employs an analogy to the low-level-capital rule which would be assessed an 8 percent capital
for assets sold with recourse. Under this rule, a charge against its face value of 1 percent. The
transfer of assets with recourse that contractu- second-loss position, which is collateralized by
ally is limited to an amount less than the Treasury securities, would be viewed as fully
effective risk-based capital requirements for the collateralized and subject to a zero percent
transferred assets is assessed a total capital capital charge. The senior-loss position guaran-
charge equal to the maximum amount of loss teed by the intermediary bank would be assigned
possible under the recourse obligation. If this to the 20 percent risk category appropriate to
rule applied to a sponsoring banking organiza- claims guaranteed by OECD banks.13
tion retaining a 1 percent first-loss position on a The second approach may result in a higher
synthetically securitized portfolio that would risk-based capital requirement than the dollar-
otherwise be assessed 8 percent capital, the for-dollar capital charge imposed by the first
sponsoring banking organization would be approach, depending on whether the reference
required to hold dollar-for-dollar capital against
the 1 percent first-loss risk position. The spon-
soring banking organization would not be 13. If the intermediary is a banking organization, then it
assessed a capital charge against the second- and could place both sets of credit-default swaps in its trading
account and, if subject to the Federal Reserve’s market-risk
senior-risk positions.12 capital rules, use its general market-risk model and, if
approved, specific-risk model to calculate the appropriate
risk-based capital requirement. If the specific-risk model has
12. The sponsoring banking organization would not realize not been approved, then the sponsoring banking organization
any benefits in the determination of its leverage ratio since the would be subject to the standardized specific-risk capital
reference assets remain on its balance sheet. charge.
Trading and Capital-Markets Activities Manual April 2001
Page 15
4353.1 Collateralized Loan Obligations
portfolio consists primarily of loans to private secured by interests in a pool (or pools) of loans
obligors or undrawn long-term commitments. made to numerous obligors:
The latter generally have an effective risk-based
capital requirement one-half of the requirement • investment-grade residential-mortgage-related
for loans because these commitments are con- securities offered or sold pursuant to section
verted to an on-balance-sheet credit-equivalent 4(5) of the Securities Act of 1933 (15 USC
amount using the 50 percent conversion factor. 77d(5))
If the reference pool consists primarily of drawn • residential-mortgage-related securities as
loans to private obligors, then the capital described in section 3(a)(41) of the Securities
requirement on the senior-loss position would Exchange Act of 1934 (15 USC 78c(a)(41))
be significantly higher than if the reference that are rated in one of the two highest
portfolio contained only undrawn long-term investment-grade rating categories
commitments. As a result, the capital charge for • investment-grade commercial mortgage secu-
the overall transaction could be greater than the rities offered or sold pursuant to section 4(5)
dollar-for-dollar capital requirement set forth in of the Securities Act of 1933 (15 USC 77d(5))
the first approach. • commercial mortgage securities as described
Sponsoring banking organizations will be in section 3(a)(41) of the Securities Exchange
required to hold capital against a retained first- Act of 1934 (15 USC 78c(a)(41)) that are
loss position in a synthetic securitization equal rated in one of the two highest investment-
to the higher of the two capital charges resulting grade rating categories
from application of the first and second • investment-grade, small-business-loan securi-
approaches, as discussed above. Further, although ties as described in section 3(a)(53)(A) of the
the sponsoring banking organization retains only Securities Exchange Act of 1934 (15 USC
the credit risk associated with the first-loss 78(a)(53)(A))
position, it still should continue to monitor all
the underlying credit exposures of the reference Type V securities consist of all asset-backed
portfolio to detect any changes in the credit-risk securities that are not type IV securities. Spe-
profile of the counterparties. This is important to cifically, they are defined as marketable,
ensure that the sponsoring banking organization investment-grade-rated securities that are not
has adequate capital to protect against unex- type IV and are ‘‘fully secured by interests in a
pected losses. Examiners should determine pool of loans to numerous obligors and in which
whether the sponsoring banking organization a national bank could invest directly.’’ CLOs
has the capability to assess and manage the and synthetic securitizations are generally clas-
retained risk in its credit portfolio after the sified as type V securities. A bank may purchase
synthetic securitization is completed. For risk- or sell type V securities for its own account
based capital purposes, banking organizations provided the aggregate par value of type V
investing in the notes must assign them to the securities issued by any one issuer held by the
risk weight appropriate to the underlying refer- bank does not exceed 25 percent of the bank’s
ence assets.14 capital and surplus.
LEGAL LIMITATIONS FOR BANK
INVESTMENTS REFERENCES
Asset-backed securities can be either type IV or Board of Governors of the Federal Reserve
type V securities. Type IV securities include the System. SR-96-17, ‘‘Supervisory Guidance for
following asset-backed securities that are fully Credit Derivatives.’’ August 12, 1996.
Board of Governors of the Federal Reserve
14. Under this type of transaction, if a structure exposes System. SR-97-21, ‘‘Risk Management and
investing banking organizations to the creditworthiness of a Capital Adequacy of Exposures Arising from
substantive issuer, for example, the sponsoring banking orga- Secondary Market Credit Activities." July 11,
nization, then the investing banking organizations should
assign the notes to the higher of the risk categories appropriate
1997.
to the underlying reference assets or the sponsoring banking
organization. Kohler, Kenneth E. ‘‘Collateralized Loan Obli-
April 2001 Trading and Capital-Markets Activities Manual
Page 16
Collateralized Loan Obligations 4353.1
gations: A Powerful New Portfolio Management
Tool for Banks.’’ The Securitization Conduit.
vol. 1, no. 2, 1998.
Iftikhar, Hyder U., Bolger, Rita M., and Leung,
Corwin. ‘‘How S&P Evaluates Commercial
Loan–Backed Securitizations.’’ The Journal of
Lending & Credit Risk Management. July 1996.
Trading and Capital-Markets Activities Manual April 2001
Page 17
Commodity-Linked Transactions
Section 4355.1
GENERAL DESCRIPTION energy, and transportation companies, that want
to lock in future costs or revenues by entering
The term commodity-linked transaction is used into a contract at a given price.
to denote all transactions that have a return In general, financial institutions view
linked to the price of a particular commodity or commodity-linked transactions as a financial
to an index of commodity prices. The term risk-management service for customers with
commodity-derivative transaction refers exclu- commodity-price exposure, similar to the foreign-
sively to transactions that have a return linked to exchange and interest-rate risk management
commodity prices or indexes and for which products that banks have historically offered.
there is no exchange of principal. Over-the-counter (OTC) transactions can be tai-
The term commodity encompasses both tradi- lored to the customer’s needs and, therefore,
tional agricultural products, base metals, and offer more flexibility than exchange-traded con-
energy products, so that all those transactions tracts, particularly for longer-term insurance.
that cannot be characterized as interest or Examples of commodity-linked products
exchange-rate contracts under the Basle Accord offered by banks include commodity-linked
are designated commodity transactions. Pre- deposits, commodity-linked loans, commodity-
cious metals, which have been placed into the linked swaps, and commodity-linked options.
foreign-exchange-rate category in deference to Examples of these products and the ways in
market convention, are not included. which hedgers and speculators use these prod-
ucts are described below.
CHARACTERISTICS AND Commodity-Linked Deposits
FEATURES
The following is an example of a deposit with
A commodity-linked contract specifies exactly the return linked to a commodity index:
the type or grade of the commodity, the amount,
and the future delivery or settlement dates. In A $100,000 one-year deposit has a return
these transactions, the interest, principal, or linked to the price of oil. The deposit pays at
both, or the payment streams in the case of maturity either (1) a guaranteed minimum return
swaps, is linked to a price of a commodity or of 3 percent or (2) 90 percent of any gain in the
related index. However, given that banks are not market index (relative to an index rate set at the
allowed to trade in the underlying physical outset of the transaction) of oil over the life of
commodity (with the exception of gold) without the deposit, whichever is greater. The depositor
special permission, these contracts are settled is able to benefit from a rise in the price of oil
for cash. (however, by only 90 percent of the rise that
Factors that affect commodity prices and risk would have been received if he or she had
are numerous and of many different origins. purchased the physical oil). The asset is less
Macroeconomic conditions, local disturbances, risky compared to the purchase of the actual
weather, supply and demand imbalances, and physical oil because the principal is protected
labor strikes are examples of factors that have a against a fall in the price of oil.
direct impact on commodity prices. In many
other traded markets, such factors would have a
more indirect effect.
Commodity-Linked Loans
The following is an example of a loan with
USES interest payments linked to a commodity index:
Commodity-linked markets offer participants a A financial institution lends an oil company
way to hedge or take positions in future com- $1 million for five years with interest payments
modity prices. Market participants include com- linked to the price of oil as opposed to a
modity producers or users, such as mining, conventional loan at 8 percent. The initial oil
Trading and Capital-Markets Activities Manual February 1998
Page 1
4355.1 Commodity-Linked Transactions
index is set at $20 per barrel. Interest payments As a further example, suppose a utility com-
are the greater of 4 percent or the excess of any pany wishes to protect itself from rising oil
gain in the market price of oil relative to the $20 prices and enters into a commodity-swap agree-
per barrel base, up to a maximum of 25 percent. ment with a bank. The utility company will pay
The borrower pays a lower interest rate com- a fixed price and receive a floating price linked
pared to a non-commodity-linked loan when oil to an index of the price of oil. Thus, the utility
prices fall, but shares the upside potential of its trades its upside potential if oil prices fall for the
oil revenues with the lender when the price of assurance that it will not pay a price above that
oil rises. agreed on at the inception of the trade.
Commodity-Linked Swaps Commodity-Linked Options
Commodity-linked options convey the right to
Commodity-linked swaps are defined as an buy (call) or sell (put) the cash-equivalent
agreement between two counterparties to make amount of an underlying commodity at a fixed
periodic exchanges of cash based on the follow- exercise price (there is no physical delivery of
ing terms: the underlying commodity). The purchase of a
commodity-linked call by an oil user, for exam-
• notional quantity (for example, number of ple, sets a cap on the price of oil that the user
barrels or tons) of the specified commodity will pay. If oil prices rise, the oil user will
• index, based on a defined grade and type of exercise the call option, which is the right to buy
commodity, whose prevailing price is publicly oil at the lower exercise price. The seller of a
quoted call option may have a long position in a given
• fixed price agreed to by the counterparties underlying commodity, thus selling off the upside
(The fixed price is usually above the spot price potential of the commodity in exchange for the
per unit for the defined commodity at the date premium paid by the purchaser of the call.
the swap is consummated.) The purchase by an oil producer of a put
• at specified intervals during the term of the option indexed to the price of oil sets a floor on
swap, there are settlement dates at which the the price of oil that the producer will receive.
counterparties agree to a net exchange of cash The bought put therefore allows the holder to
(The amount of cash to be exchanged is establish a minimum price level on the under-
determined as follows: lying commodity. If the price of oil in the open
— One counterparty is the fixed price payer. market falls below the strike price of the option,
At each settlement date, the fixed price the oil producer will exercise the put to lock in
payer owes the counterparty the notional the strike price.
amount of the contract multiplied by the
fixed price.
— The other counterparty is the floating-rate DESCRIPTION OF
price payer. At each settlement date, the MARKETPLACE
floating price payer owes the counterparty
the notional amount multiplied by the index Commodity-linked derivatives are traded in both
price prevailing on the settlement date.) the exchange and OTC markets. There are
several fundamental differences between the
As an example, suppose an oil company futures exchanges and the OTC markets for
wishes to protect itself against a decline in oil commodities. First, futures contracts may entail
prices and enters into a commodity-swap agree- delivery of the physical commodity upon expi-
ment with a bank. The company will receive a ration of the contract, whereas OTC contracts
fixed price and pay a floating price linked to an generally are settled for cash. Second, futures
index of the price of oil. Thus, the company contracts are standardized, while OTC contracts
trades the upside potential of rising oil prices for are tailored, often specifying commodities and
the assurance that it will not receive a price maturities that are not offered on the exchanges.
below the fixed price agreed on at the inception Third, the OTC market typically handles only
of the trade. large transactions, whereas exchanges may
February 1998 Trading and Capital-Markets Activities Manual
Page 2
Commodity-Linked Transactions 4355.1
accommodate transactions as small as the value little forecasting power, however. Forward prices
of a single contract in a given commodity. As a have not been proven to be accurate forecasts of
result, the OTC commodity markets tend to be future spot prices.
less liquid than the exchanges, but at the same The theory of contango holds that the natural
time they offer products that can be more hedgers are the purchasers of a commodity,
customized to meet the users’ specific needs. rather than the suppliers. In the case of wheat,
grain processors would be viewed as willing to
pay a premium to lock in the price that they
Market Participants must pay for wheat. Because long hedgers will
agree to pay high futures prices to shed risk, and
Primary players in the commodity markets are because speculators require a premium to enter
commodity producers and end- users, hedge into the short position, the contango theory
funds and mutual funds, and investment and holds that forward prices must exceed the
commercial banks. Commercial banks are rela- expected future spot price.
tively small players in the commodity markets; The contrasting theory of contango is back-
it is estimated that they account for roughly 5 to wardation. This theory states that natural hedg-
10 percent of trading activity in the domestic ers for most commodities will want to shed risk,
energy sector and even less in agricultural com- such as wheat farmers who want to lock in
modities. However, these banks fill an important future wheat prices. These farmers will take
niche by acting as intermediaries between pro- short positions to deliver wheat in the future at a
ducers and users of oil and gas products, which guaranteed price. To induce speculators to take
is also important for market participants. Banks the corresponding long positions, the farmers
apply tested risk-management techniques and need to offer speculators an expectation of
market-making skills, which has helped to profit. The theory of backwardation suggests
increase liquidity in the markets. Additionally, that future prices will be bid down to a level
the ability of banks, acting as financial interme- below the expected spot price.
diaries, to transform risks has enabled entities to Any commodity will have both natural long
hedge attendant exposures (for example, credit hedgers and short hedgers. The compromise
risk) which are a component of energy transac- traditional view, called the ‘‘net hedging hypoth-
tions, though not directly related to the price of esis,’’ is that the forward price will be less than
energy. the expected future spot price when short hedg-
ers outnumber long hedgers and vice versa. The
side with the most natural hedgers will have to
pay a premium to induce speculators to enter
Market Transparency into enough contracts to balance the natural
supply of long and short hedgers.
For all exchange-traded commodity products, The future price of an energy product is
transparency is high. In the OTC markets, wide determined by many factors. The no-arbitrage,
variations of transparency exist based on the cost-of-carry model predicts that futures prices
product, volume traded, grade, delivery point, will differ from spot prices by the storage and
maturity, and other factors. financing costs relevant to inventory. The future
spot price is the only source of uncertainty in the
basic model. Carry is the sum of the riskless
PRICING interest rate and the marginal cost of storage.
Because carry is always positive, the cost-of-
Similar to the term structure of interest rates, carry model predicts that energy prices will
commodity price curves exist which convey always be in contango.
information about future expectations. In addi- Empirical evidence suggests, however, that
tion, they reflect the prevailing yield curve the term structure of energy is not fully explained
(cost-of-carry) and storage costs. by carry. The term structure of energy prices is
Energy prices are said to be in ‘‘contango’’ not always in contango. Oil and natural gas
when the forward prices are greater than expected markets often become backwardated due to
spot prices at some future date; prices are said to external factors or supply concerns. Further, the
be in ‘‘backwardation’’ when future spot prices market rarely shows full carrying charges. In
exceed forward prices. The term structure has other words, futures prices as predicted by a
Trading and Capital-Markets Activities Manual February 1998
Page 3
4355.1 Commodity-Linked Transactions
cost-of-carry model generally exceed those example, if a financial institution enters into
observed in the market, even when prices are in swap agreements for its own account with one
contango. counterparty, it may not be able to establish a
matching offsetting transaction immediately.
Therefore, it may wish to hedge its commodity-
price risk in the futures or related markets until
HEDGING an offsetting swap can be written. When an
exact offset is found, the two swaps are matched
Participants in the OTC commodity markets and the hedge position is unwound.
may have more difficulty hedging their positions Some financial institutions may seek a matched
than participants in the foreign-exchange and book by the end of the day, while others are
interest-rate markets because of the shallowness willing to carry an open swap for weeks or to
and illiquidity of OTC commodity markets. It is rely on other hedging techniques, such as hedg-
also difficult to match the terms and maturities ing on a portfolio basis. For example, a financial
of exchange-traded futures hedges with OTC institution may hedge the commodity-price
commodities instruments. exposure of the entire portfolio of independently
To hedge the spot risk associated with contracted swaps without ever seeking exactly
commodity-linked transactions, traders will off- offsetting transactions. Hedging models help to
set a long position with a short position. The determine the amount of exposure already offset
choice of the hedge instrument used generally by the transactions currently in the book. The
depends on (1) market conditions, that is, residual exposure is then hedged using exchange-
whether the financial institution has a natural traded futures and options so that it is reduced to
offsetting position; (2) the risk appetite of the less than the position limits established by the
institution; and (3) cost. Because exchange- financial institution’s management. Some of the
traded futures contracts are standardized, they most serious financial-institution participants in
are usually cheaper than the equivalent OTC the commodity swap market are hedging on a
contracts and are normally the preferred hedge portfolio basis.
instrument. However, the margin and collateral The use of futures and options to hedge an
requirements of exchange-traded contracts may individual commodity-linked transaction, or a
mean that OTC contracts have lower transac- portfolio of such transactions, does not elimi-
tions costs than futures traded on exchanges. nate the residual basis risk resulting from differ-
Moreover, the terms of a futures contract will ences between the movements in the prices of
rarely be identical to the terms of an OTC two commodities used to offset one another.
contract, leaving the financial institution with When risk managers or traders cannot profitably
residual risk. execute a hedge in the same commodity, they
Commodity swaps, in particular, may be may use a second commodity whose price tends
entered into on a perfectly matched basis, with to move in line with the first. Such a hedge is
the financial institution guaranteeing the pay- necessarily imperfect and cannot eliminate all
ments of two parties with equal and opposite risk. For example, prospective oil hedgers may
interests. In a perfectly matched transaction, the incur basis risk because of discrepancies between
financial institution writes a separate, offsetting the nature of the underlying instrument (for
long-term swap contract with each party, incor- example, a crude oil futures contract versus a jet
porating a margin to cover costs and the risk of fuel swap) or the location of the deliverable-
counterparty default, and closes simultaneously grade commodity (for example, North Sea oil
both sides of the transaction. When engaging in versus West Texas Intermediate oil).
matched commodity swaps, a financial institu-
tion is exposed to commodity-price risk only
when the counterparty on one side of a matched
transaction defaults, and the financial institution RISKS
must enter the market to hedge or rebalance its
book. Many of the risks associated with commodity-
However, the need to match transactions per- linked activities are similar to those connected
fectly at all times would limit the ability of with interest-rate and foreign-exchange prod-
financial institutions to serve their customers ucts. Price, counterparty credit, and delivery
and to compete in the existing market. For risks all exist. In the case of commodity-linked
February 1998 Trading and Capital-Markets Activities Manual
Page 4
Commodity-Linked Transactions 4355.1
transactions, these risks may be further exagger- (more than one year) crude oil, the OTC market
ated due to illiquidity, volatility, and forward is superior to exchange-traded markets in terms
pricing problems. of liquidity.
Basis Risk Volatility Risk
One of the primary risks facing investors in Commodity prices can be much more volatile
commodity-linked transactions is basis risk— than interest rates or foreign-currency rates,
the risk of a movement in the price of a specific although this is sensitive to the time period and
commodity relative to a movement in the price market conditions. The smaller size of the com-
of the commodity-linked transaction. The defi- modity markets is partially responsible for the
nition of commodity that is often used to signify heightened volatility of commodity prices.
like, interchangeable products cannot be applied Changes in supply or demand can have a more
freely. Variances of grade, delivery location, and dramatic effect on prices in smaller markets, as
delivery time frame—among other things—give reflected in the measured volatility. Thus, a
rise to numerous basis issues which must be disruption in any one source of supply may
carefully managed. Price risk can be reduced by greatly affect the price since many commodities
hedging with either exchange-traded or OTC are dominated by only a few suppliers. In
contracts. However, if contract terms are not addition, the fact that only a few suppliers exist
equivalent, substantial basis risk can result. can result in prices that are subject to manipu-
Types of basis risk include, but are not limited lation. Demand for commodities can also depend
to, grade risk; location risk; calendar (nearby heavily on economic cycles.
versus deferred-month) risk; stack-and-roll risk
(hedging deferred obligations in nearby months
on a rolling basis); and, in the energy markets,
risks associated with crack spreads (the price
differential between refined and unrefined
ACCOUNTING TREATMENT
products). The accounting treatment for commodity-linked
transactions is determined by the Financial
Accounting Standards Board’s Statement of
Liquidity Risk Financial Accounting Standards (SFAS) No.
133, ‘‘Accounting for Derivatives and Hedging
The OTC-commodity derivative markets are Activities.’’ (See section 2120.1, ‘‘Accounting,’’
generally much less liquid than the foreign- for further discussion.)
exchange and interest-rate derivative markets,
since commodity-linked derivative products are
currently offered by relatively few financial
institutions. As a result of the shallow nature of RISK-BASED CAPITAL
the market, liquidity usually drops off for con- WEIGHTING
tracts on forward prices beyond one year.
In addition to their relative scarcity, OTC The credit-equivalent amount of a commodity-
commodity-linked transactions are customized linked contract is calculated by summing—
to meet the needs of the user. This characteristic
of the market exacerbates the ability of a finan- 1. the mark-to-market value (positive values
cial institution to hedge commodity-linked only) of the contract and
derivative transactions; perfectly offsetting 2. an estimate of the potential future credit
instruments are rarely available in the OTC exposure over the remaining life of each
market and there may be a significant degree of contract.
basis risk when hedging with exchange-traded
instruments. For purposes of hedging long-dated The conversion factors are as follows.
Trading and Capital-Markets Activities Manual April 2001
Page 5
4355.1 Commodity-Linked Transactions
0–1 Years 1–5 Years Over 5 Years
Gold contracts 1.0% 5.0% 7.5%
Other precious metals 7.0% 7.0% 8.0%
Other commodities 10.0% 12.0% 15.0%
If a bank has multiple contracts with a coun- REFERENCES
terparty and a qualifying bilateral contract with
the counterparty, the bank may establish its Bodie, Kane, and Marcus. Investments. Richard
current and potential credit exposures as net C. Irwin, Inc., 1993.
credit exposures. (See section 2110.1, ‘‘Capital
Das, Satyajit. Swap and Derivative Financing.
Adequacy.’’)
Chicago: Probus Publishing, 1993.
Falloon, William. ‘‘A Market Is Born.’’ Manag-
LEGAL LIMITATIONS FOR BANK ing Energy Price Risk. London: Risk Publi-
cations, Financial Engineering, Ltd., 1995.
INVESTMENTS
McCann, Karen, and Mary Nordstrom. Energy
Commodity derivatives are not considered Derivatives: Crude Oil and Natural Gas.
investments under 12 USC 24 (seventh). A bank Federal Reserve Bank of Chicago, December
must receive proper regulatory approvals before 1995.
engaging in commodity-linked activities.
April 2001 Trading and Capital-Markets Activities Manual
Page 6
Subject Index
A Nonmember banks, state, 3040.1
Regulatory reports, 2130.5
Accounting, 2060.1, 2120.1 Securities, restrictions on holdings of, 3000.1
See also specific type of financial instrument.
Equity investments, 3040.1 Basis risk—See specific type of financial
Examination objectives, 2120.2 instrument.
Examination procedures, 2120.3
Financial-statement disclosures, 2120.5 Board of directors and senior management
Hedge accounting treatment, 2120.1 Ethics of, 2150.1
Internal control questionnaire, 2120.4 Risk-management responsibilities of, 2000.1
Mortgage-backed securities, 4110.1 • Equity investments, 3040.1
Securities and securitization, 3000.1, 3020.1 • Futures commission merchants, 3030.1
• Interest-rate risk, 3010.1
Adjusted trading, 3000.1 • Securities and securitization, 3000.1, 3020.1
Affiliates, 3000.1 Bonds
Brady and emerging-markets, 4255.1
Arbitrage Corporate, 4045.1
Financial futures, 4320.1 Foreign government
Forwards, 4310.1 • Argentine, 4255.1
• Australian, 4205.1
Asset securitization, 3020.1 • Brazilian, 4255.1
• Canadian, 4210.1
Audits, 2000.1 • French, 4215.1
Back-office trading operations, 2060.1 • German, 4220.1
Futures commission merchants, 3030.1 • Irish, 4225.1
Internal, 2000.1
• Italian, 4230.1
Risk management, 2000.1
• Japanese, 4235.1
Securities, investment, 3000.1
• Mexican, 4255.1
• Spanish, 4240.1
• Swiss, 4245.1
B • United Kingdom, 4250.1
Treasury, U.S., 4020.1
Back-office trading operations, 2060.1
Examination objectives, 2060.2 Brokers and dealers—See Securities.
Examination procedures, 2060.3
Internal control questionnaire, 2060.4
Bank holding companies
Commercial paper activities, 4010.1 C
Equity investments, 3040.1
Futures commission merchant activities, CAMELS ratings, 3010.1
3030.1
Liquidity, contingency planning, 2030.1 Capital adequacy, 2110.1
Regulatory reports from, 2130.5 Asset securitizations, 3020.1
Section 20 subsidiaries of, 2140.1 Equity investments, 3040.1
Banks and banking organizations Certificates of deposit, 4055.1
Equity investments, 3040.1
Investments, legal limits on—See specific type Clearinghouses, futures exchange, 3030.1,
of financial instrument. 4320.1
Large complex banking organizations, capital
adequacy of, 2110.1 Clearing risk—See Settlement risk.
Trading and Capital-Markets Activities Manual September 2002
Page 1
Subject Index
Codes of conduct, 2150.1—See also Ethics of • Internal control questionnaire, 2020.4
trading institutions and personnel. • Large complex banking organizations,
2110.1
Collateral • Off-market or prefunded derivatives
Agreements, 2070.1 transactions, 2020.1
Arrangements, 2020.1 • Securities and securitization, 3000.1, 3020.1
Secondary-market activities, 3020.1
Collateralized loan obligations (CLOs),
4353.1 Credit derivatives, 4350.1
Synthetic, 2110.1, 4353.1 Capital treatment of, 2110.1
Collateralized mortgage obligations Currency swaps, 4335.1
(CMOs), 4110.1
Commercial paper, 3020.1, 4010.1
Asset-backed, 4105.1 D
Commodities, 3030.1 Dealers, securities, 2050.1
Contracts, calculating credit-equivalent Selection of, 3000.1
amounts for, 2110.1
Price risk of, 2010.1 Derivatives
Trading adviser for, 3030.1 Accounting for, 2120.1, 2120.5
Transactions linked to, 4355.1 Capital adequacy treatment, 2110.1
Credit, 4350.1
Compensation, 3040.1 • SR-letters, 3020.1
Equity, 4345.1
Computer systems, 2040.1 Interaffiliate derivative transactions, 3000.1
Off-market or prefunded transactions, 2020.1
Confidentiality, 2150.1 Suitability of, 2070.1
Confirmations, trade, 2060.1 Documentation, 2070.1
Conflicts of interest—See Ethics of trading
institutions and personnel.
E
Contingency planning, 2030.1
Earnings—See Financial performance.
Corporate notes and bonds, 4045.1
End-user activities—See Securities.
Counterparties, unnamed, 2020.1
Equity investments, 3040.1
Counterparty credit risk, 2020.1, 2021.1 Derivatives, 2120.1, 4345.1
Equity-price risk, 2010.1
Credit Examination objectives, 3040.2
Credit-equivalent amounts, calculating for Examination procedures, 3040.3
derivatives, 2110.1 Noninvestment business transactions, 3040.1
Enhancements, 2020.1, 3020.1
Ratings, 3020.1 Ethics of trading institutions and personnel,
Risk 2150.1
• See also specific type of financial Examination objectives, 2150.2
instrument. Examination procedures, 2150.3
• Counterparty credit, 2020.1, 2021.1 Front-office trading operations, 2050.1
• Examination objectives, 2020.2 Internal control questionnaire, 2150.4
• Examination procedures, 2020.3
• Futures commission merchants, 3030.1 Eurodollar certificates of deposit, 4055.1
September 2002 Trading and Capital-Markets Activities Manual
Page 2
Subject Index
Examinations Forwards—See Futures and forwards.
Asset securitization, 3020.1
Futures commission merchants, 3030.1 Front-office trading operations, 2050.1
Interest-rate risk, 3010.1 Examination objectives, 2050.2
Large complex banking organizations, capital Examination procedures, 2050.3
adequacy assessment, 2110.1 Internal control questionnaire, 2050.4
Objectives, procedures, and
questionnaires—See specific examination Funding-liquidity risk, 2030.1
topic.
Preparation for, pre-examination review, Futures and forwards, 4310.1, 4320.1
1000.0 See also Futures commission merchants.
SEC and other agencies, 2140.1 Accounting for, 2120.1
Exchanges, trading on, 3030.1
Exchange-traded instruments Financial futures, 4320.1
Counterparty credit risk of, 2020.1 Foreign exchange, 4305.1
Financial futures, 4320.1
Liquidity risk of, 2030.1 Futures commission merchants, 3030.1
Examination objectives, 3030.2
Examination procedures, 3030.3
F
Federal Financial Institutions Examination
G
Council (FFIEC) Gains trading, 3000.1
Regulations, unsuitable investments, 4110.1
Reports required by, 2130.1, 2130.5
Federal funds, 4005.1 H
Federal Reserve Act, 3000.1, 3040.1 Hedge funds, 2020.1
Financial holding companies (FHCs), 3040.1 Hedging
See also specific type of financial instrument.
Financial performance, 2100.1 Equity investments, 3040.1
Examination objectives, 2100.2 Hedge accounting treatment, 2120.1
Examination procedures, 2100.3 Liquidity risk of, 2030.1
Internal control questionnaire, 2100.4
Historical-rate rollovers, 2020.1
Financial statements, 2120.5
Holdback reserves, 2100.1
FOCUS reports—See Securities and
Exchange Commission.
Foreign-currency instruments, 2120.1, I
2120.5
Income, 2100.1
Foreign exchange (FX), 4305.1 See also Reporting, financial.
Nondeliverable forward (NDF) transactions,
legal risk of, 2070.1 Insider information, 2150.1
Risks of, 2010.1, 2021.1
• See also specific type of financial Institutions, trading, 1010.1
instrument. See also Board of directors and senior
management and specific area of
Forward rate agreements, 4315.1 institution.
Trading and Capital-Markets Activities Manual September 2002
Page 3
Subject Index
Interest-rate risk, 2010.1, 3010.1 Asset securitization, 3000.1, 3020.1
Large complex banking organizations, 2110.1 Examination objectives, 2030.2
Management of, 3010.1 Examination procedures, 2030.3
• Examination objectives, 3010.2 Futures commission merchants, 3030.1
• Examination procedures, 3010.3 Internal control questionnaire, 2030.4
• Internal control questionnaire, 3010.4
Interest-rate swaps, 4325.1
Internal audit—See Audits. M
Internal controls Management information systems (MIS),
Back-office trading operations, 2060.1 2040.1
Equity investments, 3040.1 Counterparty credit risk, 2020.1
Futures commission merchants, 3030.1 Equity investments, 3040.1
Interest-rate risk, 3010.1 Examination objectives, 2040.2
Investment securities and end-user activities, Examination procedures, 2040.3
3000.1 Futures commission merchants, 3030.1
Questionnaires for examining—See specific Internal control questionnaire, 2040.4
examination topic. Liquidity risk, 2030.1
Risk management, general, 2000.1 Operations and systems risk, 2040.1
Securities and securitization, 3000.1, 3020.1 Reports to management, adequacy of, 2060.1,
2100.1, 3020.1
Internal models—See Models. Securities, 3000.1, 3020.1
International trading operations and
Management of trading institutions—See
transactions
Board of directors and senior
See also Bonds, Foreign-currency instruments,
management.
Foreign exchange, Notes.
Futures commission merchants, 3030.1
Securities, 2140.1, 3000.1 Margin requirements, 3030.1
Settlement of foreign payments, 2060.1 Financial futures, 4320.1
Investments Market risk, 2010.1
See also specific type of financial instrument. See also specific type of financial instrument.
Equity, 3040.1 Capital adequacy, 2110.1
Limitations on, 3000.1, 4105.1 Credit derivatives, SR-letter, 3020.1
Suitability of, 2070.1 Examination objectives, 2010.2
Examination procedures, 2010.3
Investors, institutional, 2020.1 Futures commission merchants, 3030.1
Interest-rate risk, 3010.1
Internal control questionnaire, 2010.4
Large complex banking organizations, 2110.1
L Limits, 2010.1
Liquidity risk, 2030.1
Legal risk, 2070.1
See also specific type of financial instrument. Measures of, 2010.1
Examination objectives, 2070.2 Securities, investment, 3000.1
Examination procedures, 2070.3 Simulations, 2010.1
Off-market or prefunded derivative
transactions, 2020.1 Master agreements, 2070.1
Securities and securitization, 3000.1, 3020.1
Master-trust structures, 4353.1
Liquidity risk, 2030.1
See also specific type of financial instrument. Merchant banking, 3030.1, 3040.1
September 2002 Trading and Capital-Markets Activities Manual
Page 4
Subject Index
Models Risk-management operations, 2000.1
Equity investments, 3040.1
Options valuation, 4330.1 Over-the-counter (OTC) instruments—See
Pricing, 2100.1 Securities.
Risk-measurement, 2040.1
• Market risk, 2110.1
P
Mortgage-backed securities, 4110.1
Pair-offs, 3000.1
Municipal securities, 4050.1
Personnel of trading institutions
Back-office roles, 2060.1
Compensation of equity investment staff,
N 3040.1
Ethics and conduct of, 2150.1
Netting agreements, 2110.1
Expertise and competence of, 2040.1, 2050.1
Accounting for, 2120.1
Front-office roles, 2050.1
Legal risk, 2070.1
Operational issues, 2070.1
Political risk—See specific type of financial
instrument.
New-product approval, 2040.1, 2070.1,
3000.1
Portfolio companies, 3040.1
Notes
Pre-examination review—See Examinations.
Corporate, 4045.1
Credit-default, 4350.1
Prefunded derivative transactions, 2020.1
Foreign government
• French, 4215.1
Presettlement risk, 2020.1
• German, 4220.1
• Italian, 4230.1
Pricing, 2100.1
• Japanese, 4235.1
See also specific type of financial instrument.
• Swiss, 4245.1
Structured, 4040.1
Products, trading
U.S. Treasury, 4020.1
New, 2040.1, 2070.1, 3000.1
Revaluation of, 2060.1, 2100.1
Risks of, 2030.1
O Suitability of, 2070.1
Off-market derivative transactions, 2020.1 Profits and losses—See Financial
performance.
Operations and systems risk
See also Back-office trading operations,
Front-office trading operations, R
Management information systems.
Large complex banking organizations, 2110.1 Ratings, credit, 3020.1
New products, 2040.1, 3000.1
Records, transaction, 2040.1, 2050.1, 2060.1,
Options, 4330.1 2070.1
Commodity-linked, 4355.1
Deep-in-the-money, 2020.1 Regulations
Foreign-exchange, 4305.1 Compliance with, 2140.1, 3040.1
Market risk, 2010.1 • Examination objectives, 2140.2
• Futures commission merchants, 3030.1
Organizational structure, 1010.1
Front-office trading operations, 2050.1 Regulation Y, 3030.1, 3040.1
Trading and Capital-Markets Activities Manual September 2002
Page 5
Subject Index
Reporting, financial, 2120.1, 2120.5 Securities, 3000.1
Back-office trading operations, 2060.1 Sound practices for, overview, 2000.1
Equity investments, 3040.1
FFIEC reports, 2130.1, 2130.5
Financial performance, 2100.1
Financial-statement disclosures, 2120.5 S
Front-office trading operations, 2050.1
FR Y-series reports, 2130.5 Secondary-market credit activities, 3020.1
Futures commission merchants, 3030.1 See also specific type of financial activity.
Management, reports to, 3040.1
Regulatory requirements, 2130.1, 2130.5, Securities
2140.1 See also Derivatives and specific type of
• See also Regulations. financial instrument.
• Accounting standards and guidelines for, Accounting, 2120.1
2120.1 Affiliates, purchased from, 3000.1
• Examination objectives, 2130.2 Agency, U.S. government, 4035.1
• Examination procedures, 2130.3 Asset-backed, 3020.1, 4105.1
• Internal control questionnaire, 2130.4 Broker-dealers, 2140.1
Risk measurement and reporting, 3000.1 Brokers
• Futures commission merchants, 3030.1 • Brokers’ points, unacceptable trading
• Interest-rate risk, 3010.1 practice, 2050.1
• Commissions and fees, 2060.1
Repurchase agreements (repos), 4015.1 • Futures commission merchants, risks
Accounting for, 2120.1 associated with, 3030.1
• Swap, 4325.1
Classifications of, 3000.1
Reputation risk, 3030.1
Dealers, 2050.1
Off-market or prefunded derivative
• Selection of, 3000.1
transactions, 2020.1
Exchange-traded instruments
• Counterparty credit risk of, 2020.1
Reserves, 2100.1, 2030.1
• Liquidity risk of, 2030.1
Inflation-indexed, U.S. Treasury, 4030.1
Risk-based capital measure, 2110.1
Investment, 3000.1
See also specific type of financial instrument. • Examination objectives, 3000.2
Asset securitization, 3020.1 • Examination procedures, 3000.3
Equity investments, 3040.1 • Internal control questionnaire, 3000.4
Spread accounts, SR-letter, 3020.1 • Practices, unsuitable, 2050.1, 3000.1
Synthetic collateralized loan obligations, • Suitability of, 2070.1
4353.1 Municipal, 4050.1
New products, 2040.1, 2070.1, 3000.1
Risk management, 2000.1 Over-the-counter instruments
See also specific type of risk. • Counterparty credit risk of, 2020.1
Asset securitizations, 2110.1, 3020.1 • Liquidity risk of, 2030.1
Capital adequacy considerations, 2110.1 Residential mortgage-backed, 4110.1
Counterparty credit risk, 2020.1, 2021.1 Trading, 2120.1
Equity investments, 2010.1, 3040.1 U.S. government, 4020.1, 4025.1, 4030.1
Financial holding companies, 3040.1
Funding-liquidity risk, 2030.1 Securities and Exchange Commission (SEC)
Futures commission merchants, 3030.1 Accounting requirements of, 2120.1, 2120.5
Market risk, simulations for, 2010.1 FOCUS reports, 2130.1, 2130.5, 2140.1
Noninvestment business transactions, 3040.1
Off-market or prefunded derivative Securitization of assets, 3020.1
transactions, 2020.1
Organization, 1010.1 Self-regulatory organizations (SROs),
Overview, preparation for examination, 1000.1 2140.1, 3030.1
September 2002 Trading and Capital-Markets Activities Manual
Page 6
Subject Index
Settlement risk, 2021.1 T
Extended settlement, 3000.1
Financial futures, 4320.1 Tickets, trading, 2060.1
Forwards, 4310.1
Trademark products, 4025.1
Short sales, 3000.1
Trading transactions
Small business investment companies, Confirmation of, 2060.1
3040.1 Consummation of, 2050.1
Discrepancies and disputed trades, 2060.1
Special-purpose vehicles (SPVs), 2020.1 Documentation, 2070.1
Synthetic collateralized loan obligations, Income, attribution of, 2100.1
2110.1, 4353.1 Legal structure of firm engaging in, 1010.1
Netting agreements, 2070.1
Specific risk, 2110.1 Off-market or prefunded derivatives, 2020.1
Reconciliation, 2060.1
SR-letters, Federal Reserve, 3020.1 Reporting of, 2050.1
Settlement, 2060.1
Staff—See Personnel of trading institutions. Spot, 4305.1
Suitability of, 2070.1
Stress testing Unacceptable trading practices, 2050.1, 3000.1
Interest-rate risk, 3010.1 Valuation of positions, 2100.1
Market risk, 2010.1
Securities and securitization, 3000.1, 3020.1 Training, 2050.1
Front-office operations, 2050.1
STRIPS, U.S. Treasury, 4025.1
Treasury, U.S.
Structured notes, 4040.1 Bills, notes, and bonds, 4020.1
Inflation-indexed securities, 4030.1
Swaps STRIPS, 4025.1
Credit-equivalent amounts for, 2110.1
Currency, 4335.1 Trigger events, 2070.1
Interest-rate, 2120.1, 4325.1
Netting of, 2110.1
Off-market, 2020.1
Prepaid, 2020.1 V
Reverse zero-coupon, 2020.1
Zero-coupon, 2020.1 Valuation, 2100.1
Swaptions, 4340.1 Value-at-risk, 2010.1, 2110.1
Systems risk—See Back-office trading
operations, Front-office trading W
operations, Management information
systems. When-issued trading, 3000.1
Trading and Capital-Markets Activities Manual September 2002
Page 7
You might also like
- Law and Practice of International Finance - University Edition - Part3No ratings yetLaw and Practice of International Finance - University Edition - Part3188 pages
- Legal Concepts Lecture (5) - DerivativesNo ratings yetLegal Concepts Lecture (5) - Derivatives77 pages
- Alternate Types of Investments Bonds 2009No ratings yetAlternate Types of Investments Bonds 200940 pages
- Hidden in Plain Sight The Hunt For Banking CapitalNo ratings yetHidden in Plain Sight The Hunt For Banking Capital11 pages
- Chapter 9 Unincorporated Business EntitiesNo ratings yetChapter 9 Unincorporated Business Entities8 pages
- Draft Format of Agreement: in Annexure-INo ratings yetDraft Format of Agreement: in Annexure-I13 pages
- Acquisition and Leverage Finance Review Luxembourg100% (1)Acquisition and Leverage Finance Review Luxembourg23 pages
- Jackson's $70-Mil Loan... Trustee Malnik, BofA Note and Sony100% (1)Jackson's $70-Mil Loan... Trustee Malnik, BofA Note and Sony10 pages
- House Hearing, 110TH Congress - Foreign Government Investment in The U.S. Economy and Financial SectorNo ratings yetHouse Hearing, 110TH Congress - Foreign Government Investment in The U.S. Economy and Financial Sector165 pages
- Prudent Private Wealth Management SolutionsNo ratings yetPrudent Private Wealth Management Solutions5 pages
- Lecture 2 Financial System and InstrumentsNo ratings yetLecture 2 Financial System and Instruments44 pages
- Financial Early Warning System Model and Data Mining Application For Risk Detection 2012 Expert Systems With ApplicationsNo ratings yetFinancial Early Warning System Model and Data Mining Application For Risk Detection 2012 Expert Systems With Applications16 pages
- A Bill: in The House of RepresentativesNo ratings yetA Bill: in The House of Representatives22 pages
- IRS Letter To ACA Request For Guidance On Issuing 1099-C To Consumers100% (1)IRS Letter To ACA Request For Guidance On Issuing 1099-C To Consumers6 pages
- Frequently Asked Questions About Medium-Term Note ProgramsNo ratings yetFrequently Asked Questions About Medium-Term Note Programs13 pages
- Advanced Scenario 6 - Quincy and Marian Pike (2018)No ratings yetAdvanced Scenario 6 - Quincy and Marian Pike (2018)10 pages
- Debtsecuritisation 150617072044 Lva1 App6891No ratings yetDebtsecuritisation 150617072044 Lva1 App689126 pages
- Isbursement Uidelines and Ractices: General Guideline100% (1)Isbursement Uidelines and Ractices: General Guideline4 pages
- Trading and Capital-Markets Activities Manual, Federal Reserve SystemNo ratings yetTrading and Capital-Markets Activities Manual, Federal Reserve System672 pages
- Electronic Trading New Hong Kong Regulations in 2014No ratings yetElectronic Trading New Hong Kong Regulations in 20146 pages
- TSX - 20221201 - RFC Amendments To TSX Company ManualNo ratings yetTSX - 20221201 - RFC Amendments To TSX Company Manual9 pages
- 091-RBI Circular - Investment by Foreign Portfolio InvestorsNo ratings yet091-RBI Circular - Investment by Foreign Portfolio Investors6 pages
- Board Directors Guide To Do Liability Insurance November 2020No ratings yetBoard Directors Guide To Do Liability Insurance November 202020 pages
- Five Star Business LTD Annual Report Mar 24100% (1)Five Star Business LTD Annual Report Mar 24234 pages
- Common Structures of Asset-Backed Securities and Their RisksNo ratings yetCommon Structures of Asset-Backed Securities and Their Risks8 pages
- 6.investors Preferences Towards Equity IndiabullsNo ratings yet6.investors Preferences Towards Equity Indiabulls78 pages
- Legislacion de Lodos de Perforacion 29 B Lousiana - June2010No ratings yetLegislacion de Lodos de Perforacion 29 B Lousiana - June2010127 pages
- 1A. Statement in Support of The Application - Rev.1No ratings yet1A. Statement in Support of The Application - Rev.125 pages
- Cs Executive - CMSL - Super 50 - QuestionsNo ratings yetCs Executive - CMSL - Super 50 - Questions100 pages
- Switzerland: The Worst Seems To Be Over For Swiss IndustryNo ratings yetSwitzerland: The Worst Seems To Be Over For Swiss Industry5 pages