Learning Center
Plans & pricing Sign in
Sign Out

Fourth Quarter 2010 SRC Insights


Fourth Quarter 2010 / Volume 15 Issue 2


                                                                                Federal reserve Bank oF PhiladelPhia


 Revisions to Payment System Risk
 Policy to be Implemented in 2011
 by Jay Karlyn, PSR Specialist, and Glenn Fuir, Manager

           n September 30, 2010, the Federal Reserve Board (Board)
           announced that it will implement changes to its Payment System
           Risk (PSR) policy on March 24, 2011. The changes were approved
 in late 2008 to reflect the need for Federal Reserve Banks (Reserve Banks)
 to provide intraday credit to improve intraday liquidity management and
 payment flows for the banking system while continuing to mitigate credit
 exposures stemming from daylight overdrafts. The purpose of this article
 is to serve as a refresher on the administration of payment system risk by
 the Reserve Banks and to highlight the impacts of upcoming PSR policy
 changes scheduled to take effect on March 24.
                                                                                                    Supervision Spotlight:
                                                                                               2    Improving Bank Supervision
 One of the primary objectives of the PSR policy was to implement a pro-
 gram to oversee the use of intraday credit by the Federal Reserve and                              Business Combination Challenges:
 to define the methodology that Reserve Banks must use to minimize their                            GAAP Accounting Rules, FDIC-
 credit risk exposures. The revised PSR policy allows Reserve Banks to
                                                                                               6    Assisted Acquisitions, and
                                                                                                    Bargain Purchases
 mitigate credit risk by:

                                                                                                    From the Examiner’s Desk:
 •	 Providing intraday credit to healthy institutions (those that satisfy safety                    Qualitative Factors and the
        and soundness requirements)                                                            9    Allowance for Loan and Lease
 •	     Establishing limits on the amount of Federal Reserve intraday credit                        Losses in Community Banks
        that an institution may use
 •	     Allowing Reserve Banks to place risk controls on account activity to                        Potential Money Laundering
        protect themselves from the risk of loss
                                                                                               14   Threats in the Third District
 •	     Giving institutions incentive to voluntarily pledge collateral to secure
        daylight overdrafts through a revised fee structure                                         The Ws of Accounting
                                                                                               17   Standards Update 2010-20

                                                                     ...continued on page 19                                                                                             SRC Insights 1
SRC Insights is published quar-
terly and is distributed to institu-
tions supervised by the Federal
Reserve Bank of Philadelphia.
                                                 Supervision Spotlight
The current and prior issues of
SRC Insights are available at
the Federal Reserve Bank of                     Improving Bank Supervision
Philadelphia’s website at www.
                                                by Michael E. Collins, Executive Vice President             Sugges-
tions, comments, and requests

for back issues are welcome in                                                                   anking has always been,
writing, by telephone (215-574-                                                                  and will remain, a dynamic
3769), or by e-mail (joanne.                                                                     and innovative business. In
                                                                                          order to effectively regulate a rap-             Please
                                                                                          idly-changing financial services in-
address all correspondence to:
                                                                                          dustry, the basic core mission and
Joanne Branigan, Federal Re-
                                                                                          broad strategies of supervision and
serve Bank of Philadelphia, SRC                                                           regulation should remain relatively
- 7th Floor, Ten Independence                                                             constant, while the policies and
Mall, Philadelphia, PA 19106-                                                             practices must continually adapt,
1574.                                                                                     evolve, and improve.

Editor ....................Joanne Branigan
                                                                                   The recession and financial crisis
                                                                                   provided a period of reflection for
Editor ..................... Katrina Johnston
                                                                                   businesses and consumers. Gaps
Designer................ Theresa Fleming
                                                                                   and weaknesses in the risk man-
                                                agement capabilities of firms and in the supervision and regulatory
The views expressed in this                     process became apparent. The legislative response was to enact the
newsletter are those of the au-                 Dodd-Frank Wall Street Reform and Consumer Protection Act, the most
thors and are not necessarily                   sweeping regulatory reform since the Great Depression. Supervisory
those of this Reserve Bank or the               agencies have also been considering the lessons learned, addressing
Federal Reserve System.                         weaknesses, implementing action plans, and undergoing constructive
                                                transformation. No supervisory regime was entirely untouched by the

                                                Supervision and Regulation
                                                It is important to first recognize the distinction between supervision
                                                and regulation. Although the terms are often used interchangeably,
                                                they are, in fact, two distinct, although complementary, functions. Bank
                                                regulation refers to the laws and rules that govern the industry, while
                                                bank supervision involves the monitoring, inspection, and examination
                                                of banking organizations to assess their condition, risk management
                                                capacity, and compliance with relevant laws and regulations. Both are
                                                essential to a safe and sound financial system.

2   SRC Insights                                                                                 
Prominent professor Edward Kane describes the                         Emergence of a “New Normal”
ongoing “regulatory dialectic,” saying “Regulation is                 Today’s supervision will aim to de-risk the industry by
best understood as a dynamic game of action and re-                   being out in front of emerging risks, monitoring lead-
sponse, in which either regulators or regulatees may                  ing indicators excess, and responding promptly in or-
make a move at any time. In this game, regulatees                     der to eliminate or mitigate potential negative conse-
tend to make more moves than regulators do. More-                     quences. Determining the optimal timing, approach,
over, regulatee moves tend to be faster and less pre-                 and forcefulness of the response still remains a chal-
dictable, and to have less-transparent consequences                   lenge. When weaknesses are identified, supervisors
than those that regulators make.”1                                    will be more vigilant in requiring corrective action be-
                                                                      fore the weaknesses impact capital.
The Need to Reform Supervision
The Bank for International Settlements (BIS) cap-                     The “new normal” for supervision is characterized by
tured the crux of the matter in its 2008-2009 annual                  key enhancements and mandates, including the fol-
report: “For all their enduring virtues, markets have                 lowing:
failed in some very important ways. It is now ap-
parent that as the financial system has grown and                     Defining, learning, and applying new rules and
become more complex, it has come to need a more                       regulations. A regulation that, on its surface, may
comprehensive set of rules to ensure that it functions                contribute to the banking system’s efficiency and
smoothly. Ensuring that a decentralized financial sys-                stability can also harbor hidden costs and perverse
tem operates safely and efficiently does not simply                   outcomes if it fails to factor in banks’ incentives and
mean more regulation or more centralization; rather,                  reactions. The regulatory agencies are now working
it means better regulation and better supervision that                to set up balanced, but effective rules around the
induce the private sector to improve incentives, risk                 regulation framework. A key objective as reforms are
management and governance.”2                                          implemented will be to ensure that the regime allows
                                                                      for innovation—an important engine for growth—
As Chairman Bernanke indicated, “Even before pas-                     while employing a prudent and flexible regulatory
sage of reform legislation, the Federal Reserve has                   system. The majority of the rule-writing phase will be
been overhauling its supervision and regulation of                    completed over the next 12 to 18 months. Outcomes
banking organizations and working to strengthen fi-                   of this phase will likely shape the practices and per-
nancial market infrastructures and practices. We will                 formance of the industry for years to come. The Fed-
be focused and diligent in carrying out our responsi-                 eral Reserve Bank of Philadelphia’s well-established
bilities under the new law.”3                                         program of forums and outreach has helped bankers
                                                                      stay abreast of the latest developments. It also allows
Many of the fundamental principles that support pruden-               an opportunity to directly engage and interact with
tial oversight proved effective and will remain intact. How-          bankers and to solicit their valuable insights and per-
ever, lessons learned have already spurred changes.                   spectives on the issues. It is imperative that bankers
                                                                      voice their concerns and opinions during this time.
    Kane, Edward, “Extracting Nontransparent Safety Net
    Subsidies by Strategically Expanding and Contracting a            Macroprudential supervision. The term “macropru-
    Financial Institution’s Accounting Balance Sheet,” Journal        dential supervision” refers to the “use of prudential
    of Financial Services Research, Vol. 36, Issue 2, December        tools with the explicit objective of promoting the sta-
    2009, available online at
    Nontransparent%20Safety%20Net%20Subsidies.pdf.                    bility of the financial system as a whole, not neces-
    BIS Annual Report 2008/09, available online at       sarily of the individual institutions within it. Naturally,
                                                                      most of the tools lie with the regulation and supervi-
    Statement by Chairman Ben S. Bernanke, available online at www.          sion of individual institutions. The main challenge is                                                                                            SRC Insights 3
to achieve a better balance in their use, with the aim              sis is based on market intelligence and macroeco-
of successfully marrying the two perspectives.”4 Bet-               nomic information, and focuses on developments in
ter insight into correlation, pro-cyclicality, and inter-           important asset markets, other financial intermediar-
dependencies in financial markets is needed. In ad-                 ies, and macroeconomic developments and potential
dition, understanding the risks inherent in new prod-               imbalances.”5 Therefore, supervision staff and exam-
ucts is necessary, with additional emphasis placed                  iners must have greater access to a broader array of
on the role of innovation in a firm’s risk appetite and             relevant data sources and analytics.
as a key driver of earnings.
                                                                    In light of the recent events, the use of stress test-
Extensions of regulatory authority. Having proper                   ing has gained greater prominence as a key element
authority is a prerequisite for conducting thorough                 of effective risk management, which should be em-
and effective supervision. This aspect has been                     ployed in both liquidity and capital planning at finan-
largely strengthened through the legislative pro-                   cial institutions. Stress tests should also be a routine
cess. For example, the Dodd-Frank Act addresses                     part of assessing real estate risk and other credit risk
“Fed-lite” issues. The provi-                                                                in the loan portfolio. Stress
sions will broaden the Federal                                                               tests do not require sophisti-
Reserve’s authority to require               In light of the recent                          cated models, but should be
reports from a BHC and its
subsidiaries and to examine
                                           events, the use of stress                         commensurate with the size,
                                                                                             complexity, and risk profile of
the functionally-regulated sub-                 testing has gained                           the institution. It is important to
                                                                                             recognize that low-likelihood,
                                           greater prominence as a
sidiaries. It also requires the
Federal Reserve to examine                                                                   highly-adverse situations may
each non-“functionally-regu-               key element of effective                          be infrequent, but they are not
lated” subsidiary. This process                                                              outside the realm of possibility,
encompasses the Fed’s re-                  risk management, which                            and management should plan
sponsibility and accountability
for oversight of systemically-
                                               should be employed                            accordingly.

important financial institutions.             in both liquidity and                       Greater sharing of infor-
Tools to unwind systemically-
important institutions and cri-
                                                capital planning at                       mation between agencies.
                                                                                          The new regulatory structure
sis-related policy interventions             financial institutions.                      has been strengthened, but
are also required.                                                                        not necessarily simplified. In-
                                                                                          creased coordination among
Increased availability and effective use of data. Ef-               the agencies will be necessary. National and inter-
fective bank supervision must be seen by banks as a                 national regulators and policymakers will be more
continuous presence. This is mainly achieved through                engaged and coordinated, and future regulatory re-
off-site monitoring, both micro- and macro-prudential               gimes are likely to evolve around a firm’s functions
in scope. Reliable and timely data becomes crucial to               and products rather than by how it is chartered.
making informed decisions. “Macro-prudential analy-
                                                                    More emphasis on incentive compensation. Com-
                                                                    pensation practices and, specifically, incentive com-
    Clement, Piet, “The Term “Macroprudential”: Origins and
    Evolution,” available online at      pensation received intense public scrutiny and drew
    qt1003h.pdf.                                                    significant criticism during the recent financial crisis.
    “Toward a Framework for Financial Stability,” International
                                                                    Policymakers and regulators have responded by tak-
    Monetary Fund, available online at
    ft/wefs/toward/index.htm.                                       ing measures to ensure that future compensation

4    SRC Insights                                                                                 
practices are managed prudently and discourage ex-         When a material loss review is conducted after a
cessive risk-taking.                                       bank failure, examiners are often criticized for identi-
                                                           fying detrimental risks and rising concentrations early,
On June 21, 2010, the federal banking regulators (the      but not acting quickly or forcefully enough to alter
agencies) issued final interagency guidance (final         the course of events. Taking away the punchbowl is
guidance) on sound incentive compensation prac-            rarely an easy process, even when ultimately it may
tices for banking organizations. The adoption of the       be in the best interest of all involved. Acting during
final guidance is fully consistent with the agencies’      “good” times, when risk is still building but not neces-
statutory mandate to protect the safety and sound-         sarily reflected in the performance numbers, is often
ness of banking organizations.                             a source of contention and brings about accusations
                                                           that examiners are overzealous or are predicting the
Banking organizations must ensure that their incen-        future outcomes of economic or market activity. There
tive compensation practices properly balance risk          should be reasonable and logical justification for the
and reward. Incentive compensation plans should not        decision and clear lines of accountability. Examiners
promote short-term gains while disregarding longer-        must be empowered to make choices and draw con-
term risks, and potential risks should be considered       clusions based on a logical and consistent approach
from an enterprisewide perspective.                        and in a manner that is vetted at various levels.

Developing a stronger “will to act.” In their pa-          Final Thoughts
per “The Making of Good Supervision: Learning to           Supervision and regulation continue to adapt and
Say No,”6 Jose Viñals and Jonathan Fiechter iden-          improve. A proper balance that limits moral hazard,
tify key elements of good supervision as being in-         yet minimizes the risks of being overly burdensome,
trusive, skeptical, proactive, comprehensive, adap-        must be maintained. The lessons learned from the
tive, and conclusive. The authors also suggest that        recent crisis will help advance the evolution of super-
the “ability” to supervise, which requires appropriate     vision, make the overall financial system more resil-
resources, authority, organization, and constructive       ient, and ultimately benefit all involved.
working relationships with other agencies, must be
complemented by the “will” to act. Supervisors must
be willing and empowered to take timely and effec-
                                                               Viñals, Jose, and Fiechter, Jonathan, “The Making of Good
                                                               Supervision: Learning to Say No,” IMF Staff Position Note,
tive action, to intrude on decision-making, to question        May 18, 2010, available online at
common wisdom, and to make unpopular decisions.                spn/2010/spn1008.pdf.


The online version of SRC Insights is generally available several weeks in advance of the print version. Bookmark
the home page for SRC Insights: <>. Please
Note: The pdf document of each issue is posted online when the print version is mailed.

To sign up for e-mail subscription service for SRC Insights and other Federal Reserve Bank of Philadelphia publi-
cations, news, and events, go to: <>.                                                                                        SRC Insights 5
Business Combinations Challenges: GAAP Accounting
Rules, FDIC-Assisted Acquisitions, & Bargain Purchases
by William Lenney, Regulatory Applications Specialist

        uring the past few years, business combina-                 mated purchase gains for certain institutions, espe-
        tions have become increasingly complex due                  cially during the period when provisional estimates
        to Generally Accepted Accounting Principles                 are recorded.
(GAAP) changes, FDIC-assisted acquisitions, and
bargain purchases. ASC Topic 805, Business Com-                     ASC Topic 805 continued the movement toward the
binations (formerly FAS 141 R), replaced FAS 141,                   greater use of fair values in financial reporting and in-
introducing significant changes in the accounting for               creased transparency through expanded disclosures.
and reporting of business acquisitions.1 In addition,               It changed how business acquisitions are accounted
during the past few years, FDIC-assisted transac-                   for and impact financial statements at the acquisi-
tions have increased, and due to their nature, struc-               tion date and in subsequent periods. Further, certain
ture, and timing, they have created a large number of               changes introduce more volatility into earnings and
bargain purchases.                                                  thus may impact a company’s acquisition strategy.

Interagency Supervisory Guidance on Bargain Pur-                    Supervisory Considerations
chases and FDIC- and NCUA-Assisted Acquisitions                     The movement toward the greater use of fair values in
was established on June 7, 2010. Although the guid-                 financial reporting for business combinations requires
ance concentrates on bargain purchases, it is also                  a high level of accounting and fair value measure-
pertinent to business combinations in general. The                  ment expertise. Acquirers should ensure that they
guidance does not add to or modify existing regulatory              have qualified personnel to perform due diligence.
reporting requirements issued by the agencies or cur-               Management should establish strong corporate gov-
rent accounting requirements under GAAP. This article               ernance and internal controls to ensure compliance
will discuss some of the supervisory concerns around                with complex accounting requirements and regula-
bargain purchases and business combinations.                        tory requirements related to a business combination.
                                                                    Management is encouraged to understand applicable
What Is a Bargain Purchase?                                         regulatory reporting and supervisory factors, such as
A bargain purchase takes place when the fair value                  fair value, measurement period, and required applica-
of acquired net assets in a business combination ex-                tions prior to consummating a business combination.
ceeds the consideration paid by the acquirer. Under
current guidance, rather than recognizing this “bar-                Fair value and measurement period. Due to the
gain purchase” value as negative goodwill, compa-                   significant impact that fair value estimates can have
nies now record a gain on the income statement.                     on goodwill, earnings, and capital, management
Bargain purchases are raising supervisory consider-                 should have the appropriate written fair value mea-
ations related to the reliability of valuations and esti-           surement policies and procedures to report fair val-
                                                                    ues in accordance with ASC Topic 820, Fair Value
                                                                    Measurements and Disclosures. If management
    December 4, 2007, the Financial Accounting Standards Board      does not have the requisite expertise, it should seek
    (FASB) issued ASC Topic 805. The standard became effective
    for acquisitions consummated on or after the beginning of the   an expert opinion.
    first annual reporting period (beginning on or after December
    15, 2008).

6    SRC Insights                                                                               
The measurement period is the period after the acqui-     tive acquirer. The due diligence review is limited to
sition date during which the acquirer may adjust the      2 ½ to 3 days and is usually performed by four to
provisional amounts recognized for a business combi-      six individuals. The acquiring institution should care-
nation. The measurement period ends as soon as the        fully read the purchase and assumption agreement.
acquirer either receives the information it was seeking   On April 1, 2010, the FDIC lowered its loss-sharing
about facts and circumstances that existed as of the      coverage for purchases and assumptions from 95 to
acquisition date or learns that more information is not   80 percent, so the risk of losses has increased for an
obtainable. However, the measurement period shall         acquiring institution.
not exceed one year from the acquisition date.
                                                          GAAP accounting. ASC Topic 805 has changed
Business combination applications. The acquiring          many well-established business combination ac-
institution must submit the appropriate application to    counting practices and significantly impacts how ac-
its primary regulator and any                                                 quisition transactions are reflect-
appropriate state regulator for
approval prior to consummating
                                          The acquiring                       ed in the financial statements. It
                                                                              affects the allowance for loan
the transaction. The acquirer           institution must                      and lease losses (ALLL), capi-
should submit one pro forma
balance sheet with two sets of
                                     submit the appropriate                   tal, regulatory capital, goodwill,
                                                                              acquisition-related     expenses,
pro forma capital calculations          application to its                    and earnings.

                                     primary regulator and
when the business combination
results in a bargain purchase.                                                    ASC Topic 805 requires that
The first set of pro forma cal-       any appropriate state                       receivables, including loans,
culations should include the in-                                                  acquired in a business combi-
crease in capital due to the bar-    regulator for approval                       nation be recorded at fair value.
gain purchase, while the second
set should exclude any esti-
                                     prior to consummating                        Separate valuation allowances
                                                                                  are not recognized on assets
mated gain from the proposed             the transaction.                         that are recorded at fair value as
business combination and any                                                      of the acquisition date. The de-
bargain purchase gains from prior business combi-         termined fair value of the acquired loans and leases,
nations still within the measurement period.              as defined in ASC Topic 820, become the new book
                                                          value, which is the basis to assess future reserve re-
Since there may be concerns about the quality and         quirements. It is important to note that some acquir-
composition of capital for a bargain purchase during      ing institutions have found that the elimination of the
the measurement period, conditions may be imposed         ALLL for the loans at the acquired institution has a
in regulatory approvals, such as excess capital re-       negative impact on the total risk-based capital of the
quirements, dividend limitations, independent audits      newly combined entity, since the ALLL is a compo-
or agreed-upon procedures requirements, indepen-          nent of tier 2 capital.
dent valuations, and legal lending limits.
                                                          Subsequent to the measurement period, a loan loss
FDIC-assisted transactions. FDIC-assisted trans-          reserve should be established for these loans in ac-
actions have extremely short time frames for bidding      cordance with existing ALLL guidance. Additional
and closing acquisitions, while important information     analysis, such as historical and peer group, may be
about the failing bank, such as examination ratings,      required to determine the effect of acquisition-related
board minutes, employee information, and employ-          loans on the historical loss rates, coverage ratios,
ment contracts, may not be available to the prospec-      and allowance ratios. Institutions may need to imple-                                                                               SRC Insights 7
ment new systems to segregate acquisition-related          the acquisition, and communicate to stakeholders. For
loans from the originated portfolio.                       more information, Interagency Supervisory Guidance
                                                           on Bargain Purchases and FDIC- and NCUA-Assisted
The acquirer shall account for transaction or acqui-       Acquisitions is available online at www.federalreserve.
sition-related costs (e.g., finder’s fees, advisory, le-   gov/boarddocs/srletters/2010/sr1012.htm.
gal, accounting, valuation, or other professional or
consulting fees) as expenses, which differs from the       Business combinations during times of uncertainty
treatment under previous GAAP. The acquirer would          and volatility can be extremely challenging, but re-
defer these costs under previous GAAP by adding            warding in the long run for an astute acquirer. Nov-
them to the purchase price, which typically increased      elist Louisa May Alcott once said “I am not afraid
recorded goodwill. The expensing of transaction costs      of storms, for I am learning to sail my ship.” Before
under ASC Topic 805 reduces an acquirer’s earnings         embarking on an acquisition, prospective acquirers
and capital, as the expenses are recognized.               should realize that there is a steep learning curve,
                                                           and that it is challenging to navigate through the com-
Conclusion                                                 plexities of GAAP accounting, FDIC-assisted acquisi-
ASC Topic 805 affects how companies negotiate and          tions, and bargain purchases.
structure transactions, model financial projections of

                   Visit the Philadelphia Fed’s website at
                   •	 Find resources, information, and contacts more quickly
                   •	 Keep up-to-date with RSS feeds and e-mail alerts
                   •	 Listen to podcasts and watch videos on economic and educational topics
                   •	 And more

                 Note: The Bank Resources pages offer a variety of information,
                guidance and tools for Financial Institutions related to regulatory
               reporting, financial services and Bank Supervision and Regulation.

8   SRC Insights                                                                     
Examiner’s Desk
           From The

Qualitative Factors and the Allowance for
Loan and Lease Losses in Community Banks
Sharon Wells, Examiner, and Trevor Gaskins, CPA, Assistant Examiner

         his is the first of two articles associated with the   Mechanically, the process typically begins with an
         analysis of the Allowance for the Allowance            institution identifying and applying historical net
         for Loan and Lease Losses (ALLL). This                 charge-off rates to homogeneous loan pools based
article discusses improving the analysis of qualitative         upon actual experience. This is the base point on
factors under ASC 450-20 (formerly FAS 5). Based                which an institution then applies environmental fac-
on a variety of observations made by examiners, this            tors that would likely cause estimated losses to be
article identifies some areas of weakness and also              different from the historical loss experience. This is
discusses suggested measures and “best practices”               normally applied as an “adjustment” to the historical
outlined within regulatory guidance to help financial           loss rate pursuant to the requirements outlined in the
institutions further develop their methodologies.               Commercial Bank Examination Manual under Sec-
During early 2011, we will expand our discussion                tion 2070.1, Allowance for Loan and Lease Losses,
of the ALLL to include a refresher on impairment                “Measurement of Estimated Credit Losses.”
analysis and the ASC 310-10-35 Accounting by
Creditors for Impairment of a Loan portion of the               This portion of the ALLL methodology can be chal-
ALLL (formerly FAS 114).                                        lenging. Some challenges that have been observed
                                                                in Portfolio Segmentation, Selection of Specific Envi-
Current regulatory guidance under SR 01-17, Inter-              ronmental Factors are as follows:
agency Policy Statement on the Allowance for Loan
and Leases (the guidance), requires that the ALLL               Portfolio Segmentation:
methodology must estimate credit losses on groups               • Portfolio segmentation into “homogeneous” pools
of loans with similar risk characteristics (homoge-               is often less granular than needed. This limits the
neous pools) in accordance with Generally Accepted                ability to capture the unique behavioral character-
Accounting Principles (GAAP) under ASC 450-20,                    istics that vary the degree of inherent risk or in-
Accounting for Contingencies. This is accomplished                crease the likelihood of loss.
through the use of qualitative, or “environmental,”             • Materiality is measured by a loan portfolio’s con-
factors.                                                          tribution to total assets, not its relevance to risk-
                                                                  based capital.
Environmental factors are used to reflect changes in
the collectability of the portfolio not captured by the         Selection of Specific Environmental Factors:
historical loss data. These factors augment actual              • Environmental factors are not well supported and
loss experience and help to estimate the probability               documented.
of loss with in a loan portfolio based upon emerging            • Environmental factors selected to adjust historical
or inherent risk trends.                                           loss rates are often limited or are broadly or too
                                                                   narrowly applied.                                                                                   SRC Insights 9
• Environmental factors are premised upon highly          Portfolio Segmentation
  intuitive, subjective “opinion”-based factors or lim-   Lack of adequate portfolio segmentation, over-use
  ited strictly to suggested guidance examples.           of subjective and unsupported variables, and a lack
• The same environmental factors are applied              of understanding of unique inherent risk characteris-
  across all portfolio sectors regardless of their spe-   tics within various loan pools may lead to an under-
  cific influence (or lack thereof) on the portfolio.     funded ALLL. Therefore, institutions seeking a more
• Documentation supporting the relevancy of each          thoughtful evaluation of estimated losses should
  environmental factor is sometimes weak.                 consider the following when developing a compre-
• Concentrations are applied only for the commer-         hensive ALLL methodology.
  cial real estate (CRE) sector (because it is the sub-
  ject of the guidance under SR 07-01, Interagency        Portfolio segmentation is one of the key elements
  Guidance on Concentrations in Commercial Real           to a sufficient ALLL methodology under the regula-
  Estate).                                                tory guidance. Under the guidance, “management
                                                                               should segment the loan port-
Assigning Quantitative Values
• Support for values is not
                                         Lack of adequate                      folio by identifying risk char-
                                                                               acteristics that are common to
  documented or based upon                    portfolio                        groups of loans.” In general,
  comprehensive          analysis.
  Values used to make the ad-          segmentation, over-                     many Third District state mem-
                                                                               ber banks segment their portfo-
  justment to historical losses          use of subjective                     lios into very broad categories,
  are often not well correlated                                                which typically mirror major
  to the “risk.”                         and unsupported                       segments highlighted within
• Factors are aggregated, and          variables, and a lack                   the call report.
  a single flat environmental
  factor value is applied across         of understanding                       Broad grouping of loan types
  all loan pools. Values for en-
  vironmental factors may not
                                        of unique inherent                      may be appropriate for some
                                                                                institutions depending upon
  vary based upon the unique            risk characteristics                    the breadth (or lack) of prod-
  risks inherent to each loan
                                       within various loan                      uct offerings. However, for in-
                                                                                stitutions with extensive lend-
• “Caps,” or limits, on val-           pools may lead to an                     ing capabilities, this approach
  ues assigned to factors are
  sometimes applied based              underfunded ALLL.                        may obscure underlying risk
                                                                                behaviors that are driving risk
  upon risk severity (low, me-                                                  within the loan portfolio. These
  dium, high) that does not allow for rising trends       behaviors can become diluted when aggregation
  over time, i.e., risk continues to increase, but the    occurs. The extent of additional segmentation de-
  assigned value has been maximized and cannot            pends on the size of the institution and the nature,
  be increased due to the “cap.”                          scope, and risk of its lending activities (e.g., new
• Values for qualitative factors are assigned and         products, significant changes to underwriting, origi-
  then weighted, imposing an additional “cap.”            nation in new markets, etc.). In general, the more
• Use of “negative values” and values for one loan        highly developed an institution’s management in-
  pool are netted off of values for factors affecting     formation systems (MIS) and data mining capabili-
  another pool.                                           ties, the more accurately risk identification will be for
• Assume that the sum of all qualitative factors must     ALLL purposes.
  equal 100 percent or 1.

10   SRC Insights                                                                     
For example, institutions may want to consider other       Environmental Factors and Values
loan pools, such as:                                       No matter what factors management chooses to
• Loans in certain poorly-performing markets or ge-        emphasize in the ALLL analysis, management must
   ographies where a concentration exists                  support the actual values for environmental factors
• Subordinate loan positions (i.e., junior lien posi-      that affect historical loss rates. Management must
   tions for commercial portfolios, etc.)                  account for and document its inputs for determining
• Unsecured loans                                          these values and must have policies and procedures
• Open-ended construction loans                            for executing a change in these values.
• Asset-based loans (ABLs)
• Bridge loans or swing loans                              To illustrate how broadly institutions are assigning
• Unpermitted and not yet zoning-approved land             values for qualitative factors, the authors reviewed a
   and development loans (dirt loans)                      number of ALLL methodologies for Third District Insti-
• Mezzanine loans                                          tutions. No reviewed institution expanded qualitative
• Agricultural loans                                       factors outside those highlighted in the guidance. In
• Non-recourse loans                                       addition, some determined that some factors did not
• Floor-plan loans                                         even apply, even though, for items such as concen-
• Out-of-market loans                                      trations, the organization actually had high exposure
• Purchased loan participations                            risk in certain concentrated sectors.
• Loans underwritten during a certain time period
   (where weak or lax practices may have existed)          Certainly, management must ensure that assigned
• Home equity loans                                        values for estimated loss are appropriate, and that
• Loans where repayment/collateral is subject to           the cause and effect of these drivers can be tracked
   completion risk                                         over time and changed depending upon circumstanc-
                                                           es and trends. If the process is too random or subjec-
Suggested Environmental Factors                            tive, or if the changes in values do not keep pace with
The guidance provides several examples of fun-             the impact of increased risk, then institutions will find
damental environmental factors that an institution         the ALLL to be inadequate and potentially directional-
should consider, as represented below. Presented           ly inconsistent. This can result in regulatory criticism
as an expanded reinforcement of the guidance, Ex-          as well and may ultimately result in supervisory re-
hibit I (found on the following page) suggests other       quirements for increased capital levels, potential limi-
common risk or loss drivers that could be considered       tations on dividends, or other enforcement actions to
when evaluating inherent risk that may drive losses in     ensure the safety and soundness of an institution.
a loan portfolio. Best practice would be to prepare an
institution-specific and customized risk assessment        Recent Accounting Developments
of each portfolio sector based upon the unique char-       At the time of the writing of this article, the Financial
acteristics and loss drivers of that loan portfolio. One   Accounting Standards Board (FASB) has proposed
example would be to evaluate the underlying causes         amendments to disclosures under ASC 450. The pro-
of loss each time a loss is recorded and maintain that     posed amendments seek to broaden financial state-
intelligence for ongoing monitoring and review. Mi-        ment reporting regarding the types of contingencies
gration analysis for certain sectors, portfolios, pools,   required to be disclosed. In addition, the proposed
etc. may also help to identify issues sooner rather        amendments increase qualitative and quantitative
than later. This information could be analyzed to de-      descriptions of those contingencies within the notes
termine whether it justifies an adjustment to historical   of the financial statements, specifically surrounding
loss rates for ALLL purposes.                              loss contingencies related to litigation proceedings.
                                                           While the possibility exists that this proposal may en-                                                                               SRC Insights 11
                                                     Exhibit I
     Factors         Drivers

     Lending         •	     Changes in lending policies and procedures
     Policies and    •	     Changes in underwriting standards and collection
     Procedures      •	     Charge-off and recovery practices
                     •	     Increased speculative lending
                     •	     Increased lending in high-risk products or markets
                     •	     Origination of loans with marginal debt coverage ratios (DCRs)
                     •	     High loan-to-value (LTV) ratios
                     •	     Increased granting of unsecured lending
                     •	     Subprime lending
                     •	     Preponderance of loans approved with exceptions
                     •	     Loans to high-risk industries not normally permitted by policy
                     •	     High degree of loan documentation waivers, deficiencies, or an abundance of matured
                            loans (refinance risk)
                     •	     Financial statement exceptions or originations without them

     Business        •	     Economic factors (national, local behavior, or both, if applicable)
     Conditions      •	     Should consider a variety of drivers, such as inflation, consumer price index (CPI),
                            interest rate environment, housing starts, bankruptcy rates, producer price index (PPI), etc.
                     •	     Should reflect distinctions among geographies (material)
                     •	     Industry/Sector trends (manufacturing, investment real estate, hospitality, etc.)
                     •	     Regional business closings

     Loan Profiles   •	     Use supportable proxies for new loan products for which actual historical loss
     and Volume             experience or risk profiles are not available
                     •	     Consider infrastructure issues with rapidly-growing portfolios
                     •	     Consider effect of newly-introduced innovative product types with little risk behavior
                            history causing risk in the “unknown”
                     •	     Premiums should be incorporated for high-volume, high-risk areas vs. “bread-and-
                            butter” lending
                     •	     High level of participation risk (one step removed or “agent” risk)
                     •	     Impact of loans subject to maturity or refinance risk

     Lending Staff   •	   Economics on turnover rates and loss of expertise
                     •	   Absence of qualified staff for workout activities
                     •	   Training issues
                     •	   General lending experience and experience in assigned lending sector
                     •	   Length of employment with the organization

     Problem Loan    •	 Volume and severity of past due, adversely-classified, or criticized loans
     Trends          •	 Foreclosure rates
                     •	 Level of troubled debt restructurings and modifications

                                                                                            Continued on the following page...

12    SRC Insights                                                                             
  Loan Review             •	 Depth and breadth of scope and penetration. Problem loans included? Loss passes
  Quality                    review? Selective sample of passes? All portfolios? All lenders?
                          •	 Changes in scoping
                          •	 Quality
                          •	 Experience of team
                          •	 Staffing levels
                          •	 Degree to which staff detects documentation deficiencies and exceptions
                          •	 Findings on consistency or inconsistency in assignment of risk ratings

  Collateral              •	   Lack of collateral/unsecured status
                          •	   Type of collateral (trade assets, intangibles, etc.) or lack thereof
                          •	   Declining valuation environment
                          •	   Trend of other factors that affect collateral protection (occupancy, environmental
                               considerations, rent rate declines, number of loans with outstanding taxes – inability
                               to track taxes, documentation deficiencies and unperfected interests, poor collateral
                               administration program, etc.)

  Credit                  •	 Not just limited to commercial real estate
  Concentrations          •	 Measured by the impact to capital, not as a percentage of total assets
                          •	 Diverse analysis—loan types, borrower concentrations, geographic emphasis, sector
                             emphasis, etc.

  Competition,            •	 Impact from ratings agencies
  Law, and                •	 Impact of public enforcement actions
  Regulation              •	 General regulatory environment from agency oversight
                          •	 Regulatory environment on certain loan sectors (new environmental laws, healthcare
                             reform, etc.)
                          •	 Degree of risk-taking prompted by competitive pressure
                          •	 Participation risk – participant squabbles, legal action, etc.

hance the disclosures related to qualitative factors,                nomic conditions, 3) the development of supportable
the current version under consideration does not ap-                 values for all environmental factors, and 4) the ability
pear to have a material impact on financial account-                 to fully understand the fundamental behaviors and
ing and reporting of estimated loan and lease losses                 underlying risk of each portfolio sector.
and related disclosures.
                                                                     If you would like additional information or have ques-
Summary                                                              tions about ASC 450-20 and the ALLL, please con-
Development of well-supported and appropriate en-                    tact Sharon D. Wells ( at
vironmental factors for homogenous loan pools when                   (215) 574-2548 or Trevor Gaskins (trevor.gaskins@
determining the ALLL requires 1) meaningful and             at (215) 574-6093. Third District institu-
thoughtful consideration of all of the environmental                 tions are also encouraged to contact their assigned
factors to which a particular portfolio is currently vul-            portfolio manager with related institution-specific
nerable, 2) the ability to segment the loan portfolio                questions or concerns as they pertain to this subject
into pools that behave similarly under certain eco-                  matter.                                                                                         SRC Insights 13
Potential Money Laundering Threats in the Third District
by H. Robert Tillman, Special Advisor1

          uring the past two years, the economy has                        are already operating in Pennsylvania, with several
          weakened many banks and businesses                               more scheduled to open. Millions of consumers are
          across the country. While such banks and                         projected to patronize the Pennsylvania casinos, gen-
businesses in the Third District are increasing their                      erating over $3 billion per year in gross revenue. This
efforts to strengthen their financial condition in a still-                makes Pennsylvania the third largest casino market in
weak economy, the individuals and criminals trying to                      the United States3 out of the 40 states that currently
take advantage of these weaknesses are also increas-                       permit casinos.4
ing their efforts. Anti-money laundering compliance
and protecting against vulnerabilities are still critical                  While these new casinos create jobs and help stimulate
components to keeping banks safe and sound. This                           the economy, they also bring potential fraud and mon-
article explores some of the potential money launder-                      ey laundering-related activities to the Third District. A
ing threats that exist in the Third District.                              breakdown of Suspicious Activity Reports (SARs) filed
                                                                                                  by states/territories indicates
The Third District covers the
state of Delaware, southern
                                                During the past decade,                           that New Jersey casinos filed
                                                                                                  the highest number of SAR-
New Jersey, and eastern Penn-                    the Third District has                           Cs (26 percent), while Nevada
sylvania and includes several
areas that are designated as
                                                 experienced growth in                            ranked second (18 percent).5 In
                                                                                                  the most recent analytical study
High Intensity Financial Crime                   business startups and                            on the gambling industry, U.S.
Areas (HIFCAs) or High In-
tensity Drug Trafficking Areas
                                                expansions, particularly                          Treasury Financial Crime En-
                                                                                                  forcement Network (FinCEN)
(HIDTAs).2 In New Jersey, all                      in cities where the                            staff identified 40,409 SAR-Cs
                                                                                                  filed by casinos and card clubs
                                                 population has grown.
26 counties are designated as
HIFCAs. In addition, the city of                                                                  from January 1, 2004, through
Camden in Camden County,                                                                          December 31, 2008. These
New Jersey, and Chester, Delaware, and Philadelphia                        SAR-Cs reported an aggregate of over $900 million in
Counties in Pennsylvania are designated as HIDTAS.                         suspicious activity. The last year of the review, 2008,
                                                                           reflects the highest percentage of SAR-Cs filed (28
During the past decade, the Third District has expe-                       percent), and the percentage of the total dollar amount
rienced growth in business startups and expansions,                        was nearly 28 percent—more than twice that in 2004.6
particularly in cities where the population has grown.
Even during the recession, the Third District attracted                    Forty percent of the total SAR-Cs provided suspicious
several casinos, and gambling-related activities are no                    activity amounts between $10,001 and $50,000 per per-
longer limited to Atlantic City, New Jersey. The Penn-                     son. Thirty percent of the sampled narratives reported
sylvania casino industry is growing rapidly; 10 casinos                    patrons conducting a series of transactions that involved
                                                                           minimal or no casino play. Specific examples include:

     Christine Astillero, Analyst, contributed research to this article.
     White House Office of National Drug Control Policy, available         4
                                                                               Charles Steele, FinCEN Deputy Director, U.S. House Committee
     online at                  on Ways and Means Testimony, May 19, 2010, p. 5.
3                                                                          5
     Pennsylvania Tourism website:                      Steele testimony, p. 6.
     (November 5, 2010).                                                   6
                                                                               Steele testimony, p. 6.

14     SRC Insights                                                                                         
•    Cashing out chips when the casino had no record                   Third District are among the top 10 states for the high-
     of the individuals having bought or played with                   est number of SARs filed from 1996–2009. Delaware
     chips.                                                            ranks fifth, behind California, New York, Texas, and
•    Buying chips with cash, casino credit, credit card                Florida. New Jersey ranks seventh and Pennsylvania
     advances, wired funds, or funds withdrawn from                    ninth. In 2009, the activities reported the most in Dela-
     safekeeping accounts, but playing minimally or not                ware included check-kiting, check card fraud, check
     playing at all. The subjects then cashed out the                  fraud, and identity theft. In New Jersey, the activities
     chips or left the casino with unredeemed chips.                   reported the most included structuring, check fraud,
•    Receiving wired funds from a depository institution               mortgage loan fraud, and counterfeit checks. In Penn-
     into an individual’s casino front money account and               sylvania, they included structuring, check fraud, coun-
     then requesting that the funds be wired to another                terfeit checks, and false statements.9
     bank account without playing.
•    Frequently depositing money orders or casino                      The Third District also includes a diverse combination
     checks from other casinos into front money ac-                    of business activity, ranging from cash-intensive small
     counts, buying in and playing minimally or not play-              retailers and nonprofits, gas stations with quick stops,
     ing, and then cashing out through issuance of a                   and small farms to some of the largest firms and bro-
     casino check.                                                     kerages in the country executing large wire transfers
•    Converting currency into redeemable cash tickets                  daily. According to the July 2010 Financial Action Task
     by feeding bills (usually $20s) into slot machine bill            Force (FATF) Report, “Terrorist organisations also de-
     acceptors and then printing out TITO tickets and                  rive funding from a variety of criminal activities ranging
     cashing out the tickets,7 typically for large denomi-             in scale and sophistication from low-level crime to in-
     nation bills.8                                                    volvement in serious organized crime.”10

A small percentage of frauds against a casino were                     The FATF Report mentioned that a 2009 FATF Stra-
also reported. For example, patrons cashed out or at-                  tegic Surveillance Survey showed the most commonly
tempted to cash out stolen, forged, or altered checks,                 identified sources as: financial crime11 (particularly
as well as counterfeited $20 and $100 bills. Fraud                     fraud); trafficking in narcotics, cigarettes, weapons,
through checks consisted of payments on markers                        human beings, or diamonds; and petty crime. The
typically with personal checks that were returned un-                  survey reported that “Terrorist organisations raise
paid to a casino due to insufficient funds or accounts                 funds through legitimate and illicit activities but more
closed at depository institutions.                                     commonly through a mixture of both” and noted “fund
                                                                       raising/donation, charities and non-profit organisations
The suspicious activity associated with the growth                     (NPOs) and small cash-intensive businesses as the
in gambling activities in the Third District adds to an                most prevalent legitimate sources.”12
existing high level of suspicious activities reported by
banks since 1996. According to the last FinCEN study
of SARs filed by depositories, all three states in the                 9
                                                                            Steele testimony, p. 8.
                                                                            FinCEN, “SAR Activity Review - By The Numbers,” Issue 14,
                                                                            June 2010.
                                                                            Consistent with this, a number of mutual evaluation reports
    Slot machines or video lottery terminals allow customers to             showed narcotics trafficking to be the most prevalent criminal
    play on credits from bills, tickets, or coins. The machines only        activity used to raise terrorist funds. This is followed by fraud,
    dispense tickets and not coins. The Ticket in/Ticket Out (TITO)         then smuggling and extortion. “Financial Action Task Force
    tickets, which can have any stated monetary value, can be               Report: Global Money Laundering & Terrorist Financing Threat
    inserted into an electronic gambling device that has the TITO           Assessment,” July 2010, p. 8.
    function and can be played in such a device or cashed out with     12
                                                                            Consistent with this, charities and NPOs continue to be the
    a cashier or at a kiosk.                                                leading source of funds as reported in Mutual Evaluation
    Steele testimony, p. 7.                                                 Reports. (FATF Report, p. 9)                                                                                                      SRC Insights 15
The 2009 survey also showed an increased use of In-                    ment is high, and foreclosures have increased. When
ternet-based systems and new payment methods and                       large numbers of people begin to experience financial
abuse of new forms of payment methods, although                        difficulty, there is often an increase in the number of
the adoption of such new or emerging technology by                     fraudulent or illegal activities. Since January 2009,
criminals can be seen as increasing in line with the                   a number of fraudulent or money laundering-related
trends in society as a whole. The survey also showed                   activities have occurred in the Third District. These
that some jurisdictions have seen new or increasing                    activities have included drug cartel operatives, an il-
use of complicated commercial structures and trusts                    legal gambling enterprise, a prostitution ring, phish-
for money laundering.13                                                ing scams, human trafficking, Ponzi schemes, identity
                                                                       theft, bank fraud, and illegal sports gambling, to name
The Third District has also continued to experience                    a few. More importantly, some of these activities have
growth in businesses that operate heavily in cash.                     occurred in various towns across the entire region, not
While a business should not be considered high risk                    just the major metropolitan areas like Atlantic City and
just because it accepts cash, cash intensity is one fac-               Philadelphia.
tor among several that should be considered when
assessing risk. These cash businesses include the                      As banks continue to place substantial attention on
traditional money service business, such as check                      capital, earnings, and business growth, it is also very
cashers and money remitters, along with unregistered                   important for bank management and the board to pay
money transfer operations. They also include bars, li-                 close attention to BSA/AML compliance. Given poten-
quor stores, gas stations and mini-marts, amusement                    tial threats of money laundering and terrorist activity,
parks, water parks, and several children’s entertain-                  a thorough risk assessment process, continual suspi-
ment centers.                                                          cious activity monitoring and reporting systems, auto-
                                                                       mated BSA/AML systems, and a strong overall BSA/
While some of these establishments are subject to                      AML compliance program are a good defense against
small-dollar, high-volume cash transactions, others in-                vulnerability to potential threats.
clude higher dollar transactions and allow the purchase
of cash equivalents as the method of playing games,
purchasing food, and enjoying other amenities. More
recently, even agricultural and farmland businesses
have been identified as having fraudulent activity, as
harvest production and sale numbers can be inflated
to hide the receipt of illegal funds that are subse-
quently deposited into bank accounts. The growth in
import/export businesses, prepaid card agents, and
the potential for Internet gaming companies (given the
increased growth in gaming activity in Pennsylvania)
also raise the risk level in the Third District.

Finally, like most metropolitan areas, the economy
also influences activity in the Third District. Unemploy-

     Examples include complicated commercial structures and trusts
     involving off-shore entities and front companies, professional
     advisers, complicit bankers, use of fictitious loans and trade-
     based money laundering (TBML), and the co-mingling of licit
     and illicit funds. (FATF Report p. 9)

16     SRC Insights                                                                               
The Ws of Accounting Standards Update 2010-20
Receivables (Topic 310): Disclosures About the Credit
Quality of Financing Receivables and the Allowance for
Credit Losses by Becky Goodwin, Examiner

         he global financial crisis has prompted several                    ing-type organizations that currently measure a large
         regulatory and accounting changes designed                         number of financing receivables at amortized cost will
         to increase clarity, qualify credit quality, and                   be affected more than brokers and dealers at securi-
provide for timely recognition of losses. In July 2010,                     ties and investment companies that currently measure
the Financial Accounting Boards Standard (FASB)                             most financing receivables at fair value. Additionally,
issued Accounting Standards Update 2010-20 (ASU                             the effect will be less significant for many commercial
2010-20). The update is specifically related to Disclo-                     and industrial entities whose financing receivables are
sures About the Credit Quality of Financing Receiv-                         primarily short-term trade accounts receivable.1
ables and the Allowance for Credit Losses. This ar-
ticle will outline the purpose and requirements of ASU                      The definition of financing receivables is as follows: A
2010-20.                                                                    contractual right to receive money, on demand or on
                                                                            fixed or determinable dates, that is recognized as an as-
According to FASB, the purpose of ASU 2010-20 is to                         set in the entity’s statement of financial position. Thus,
provide financial statement users with greater transpar-                    examples of financing receivables include 1) loans,
ency about an entity’s allowance for credit losses and                      2) trade accounts receivable, 3) notes receivable, 4)
the credit quality of its financing receivables. As such,                   credit cards, and 5) lease receivables (other than op-
ASU 2010-20 requires affected entities to disclose cer-                     erating leases) related to a lessor’s rights to payment
tain credit quality indicators, such as past due informa-                   from non-operating leases that must be recognized as
tion and modifications to their financing receivables.1                     assets under the guidance in ASC 840, Leases.2

Who Is Affected?                                                            Financing receivables are not 1) debt securities, 2) un-
ASU 2010-20 applies to both public and nonpublic en-                        conditional promises to give, or 3) acquired beneficial
tities with financing receivables, excluding short-term                     interests or the transferor’s beneficial interests in se-
trade accounts receivable or receivables measured at                        curitized financial assets.3
fair value or at the lower of cost or fair value. The ex-
tent of the impact depends on the relative significance                     What Are a Financial Institution’s Responsibilities?
of financing receivables to an entity’s operations and                      Disclosures must now be provided to help users of fi-
financial position. It is anticipated that traditional bank-                nancial statements analyze and evaluate the following:

    FASB Accounting Standards Update No. 2010-20, Disclosures About the Credit Quality of Financing Receivables and the Allowance for
    Credit Losses, available online at
    “On The Horizon,” Grant Thornton, July 27, 2010, available online at
    Sarno, John; Zelic, Ana; and McKinney, Stephen, “FASB Goes “ALLL”-In, Requires Entities to Show Their Cards: Board Enhances Disclosures
    About the Credit Quality of Financing Receivables and the Allowance for Credit Losses,” Deloitte Heads Up, Vol. 17, Issue 24, July 22, 2010,
    available online at                                                                                                        SRC Insights 17
• The nature of credit risk inherent in the entity’s          and their effect on the allowance for credit losses
  portfolio of financing receivables                        • Significant purchases and sales of financing re-
• How that risk is analyzed and assessed in deter-            ceivables during the reporting period disaggregat-
  mining the allowance for credit losses                      ed by portfolio segment
• The rationale for changes in determining the ad-
  equacy of the allowance for credit losses                 Current disclosure requirements have also been
                                                            amended to require an institution to provide the fol-
Disclosures should be provided on a disaggregated           lowing on a disaggregated basis:
basis or divided into constituent parts for the portfolio
segment and class of financing receivable. A portfo-        • A roll-forward schedule of the allowance for credit
lio segment is defined as the level at which an entity        losses from the beginning of the reporting period to
develops and documents a sys-                                                    the end of the reporting period
tematic method for determining
its allowance for credit losses.
                                         Disclosures should                      on a portfolio segment basis,
                                                                                 with the ending balance further
Classes of financing receiv-              be provided on a                       disaggregated on the basis of
ables generally are disaggre-
gated or separated from the ag-
                                       disaggregated basis or                    the impairment method
                                                                                 • For each disaggregated
gregate portfolio, and the infor-     divided into constituent                   ending balance in the item

                                       parts for the portfolio
mation provided should enable                                                    above, the related recorded
the reader to better understand                                                  investment in financing receiv-
the characteristic and degree of        segment and class of                     ables
exposure to credit risk associ-                                                  • The nonaccrual status of fi-
ated with financing receivables.        financing receivable.                    nancing receivables by class of
                                                                                 financing receivables
Specifically, the amendments of ASU 2010-20 re-             • Impaired financing receivables by class of financ-
quire the following additional disclosures about fi-          ing receivables
nancing receivables:
                                                            When Are These Requirements Effective?
• Credit quality indicators of financing receivables at     The provisions within ASU 2010-20 will become ef-
  the end of the reporting period by class of financ-       fective for public entities for the interim and annual
  ing receivables                                           reporting periods after December 15, 2010. For non-
• The aging of past due financing receivables at the        public entities, disclosures are effective on or after
  end of the reporting period by class of financing         annual reporting periods ending on or after Decem-
  receivables                                               ber 15, 2011. Comparative disclosures for earlier
• The nature and extent of troubled debt restructur-        periods are encouraged but not required for earlier
  ings that occurred during the period by class of          periods that ended before adoption.
  financing receivables and their effect on the allow-
  ance for credit losses                                    ASU 2010-20 is available in full at For
• The nature and extent of financing receivables            information on accounting issues, please contact
  modified as troubled debt restructurings within           Manager Eddy Hsiao ( at
  the previous 12 months that defaulted during the          (215)574-3772.
  reporting period by class of financing receivables

18   SRC Insights                                                                     
Revisions to Payment System Risk Policy
to be Implemented in 2011 ...continued from page 1
Provision of Intraday Credit                                cap refers to the maximum allowable daylight over-
to Healthy Institutions                                     draft (in dollar terms) that a DI’s Federal Reserve ac-
A daylight overdraft occurs whenever an institution         count may have at any point in time. The dollar value
fails to maintain a sufficient balance in its Federal Re-   of a DI’s net debit cap is determined by multiplying
serve account throughout the day to cover payment           the DI’s risk-based capital by the multiple from its as-
activities, such as funds transfers, incoming book-en-      signed cap category. Six cap categories are defined
try securities transfers, ACH transactions, and check       in the PSR policy: zero, exempt-from-filing, de mini-
payments. The Federal Reserve acknowledges the              mis, average, above average, and high. Aside from
appropriateness of providing a certain level of intra-      the zero cap, daylight overdraft cap levels range from
day credit in order to ensure that the payments and         0.2 times the DI’s risk-based capital for an exempt
securities settlement systems                                                        cap (i.e., up to $10 million) to
function smoothly. By provid-
ing intraday credit or allowing           The revised PSR                            2.25 times risk-based capital
                                                                                     for a high cap.
depository institutions (DIs)           policy will maintain
to incur daylight overdrafts,
                                        the utilization of an
                                                                                   Under the new PSR policy, the
the Federal Reserve can                                                            more narrowly defined two-
help avoid payment system             institution’s single-day                     week average cap multiples
gridlock. This has become in-                                                      previously in effect will be elim-
creasingly important as large        net debit cap; however,                       inated, allowing institutions
dollar transactions are being
pushed to later in the day.
                                        it will now apply to                       with average, above average,
                                                                                   or high caps to utilize their full
                                       the sum total of both                       daylight overdraft capacity ev-
Under the revised PSR policy,
Reserve Banks will provide in-
                                          collateralized and                       ery day. As in the past, in order
                                                                                   to qualify for a net debit cap
traday credit to healthy depos-      uncollateralized daylight                     of average, above average,
itory institutions (DIs) for no
fee for daylight overdrafts that              overdrafts.                          or high, a healthy institution
                                                                                   must perform a comprehen-
are collateralized. Otherwise,                                                     sive self-assessment covering
institutions that incur uncollateralized daylight over-     four separate components: 1) creditworthiness, 2) in-
drafts will be charged 50 basis points. Additionally,       traday funds management and controls, 3) customer
the new PSR policy seeks to minimize the impact on          credit policies and controls, and 4) operating controls
institutions that use small amounts of daylight credit;     and contingency procedures. The self-assessment
therefore, a biweekly daylight overdraft fee waiver of      process requires the institution to evaluate each of
$150 will take effect.                                      the aforementioned components and establish a rec-
                                                            ommended cap based on the internal assessment.
Limits on the Amount of Federal                             The recommended cap should be reviewed and ap-
Reserve Intraday Credit                                     proved by the DI’s board of directors and is subject
The revised PSR policy will maintain the utilization of     to review for appropriateness by the Reserve Bank.
an institution’s single-day net debit cap; however, it
will now apply to the sum total of both collateralized      If a DI has unusual liquidity pressures or processes
and uncollateralized daylight overdrafts. A net debit       high transaction volumes (such as with a mortgage                                                                                SRC Insights 19
servicing operation), that institution may need to uti-     certain institutions and are permitted to reject Fed-
lize daylight overdraft capacity beyond its established     wire funds transfers, ACH credit originations, or net
net debit cap. If this occurs, the existing PSR policy      settlement system transactions that would cause or
allows a DI to apply for “maximum daylight overdraft        increase a DI’s daylight overdraft position.
capacity” (max cap). Justification is required for a
max cap, and in this case, the DI would be required         As a reminder, it is especially important for individu-
to pledge collateral to specifically cover daylight over-   als who manage an institution’s daily cash position to
draft activity in excess of its net debit cap. Under the    be attentive to payment activities throughout the day
new policy, the previous guideline that required insti-     and their effects on the Reserve Bank account bal-
tutions to investigate acceptable alternatives to ad-       ance. Institutions that exceed their net debit caps will
dress their increased liquidity needs before consider-      face restrictions placed on them by Reserve Banks,
ing a max cap will be eliminated, although the pro-         thereby limiting their flexibility to conduct daily pay-
cess for establishing a max cap will remain the same.       ment operations.

Primary Risk Controls Included                              Collateral and Revised Fee Structure
in Intraday Credit Policy                                   The revised PSR policy introduces voluntary collat-
On a daily basis, Federal Reserve Banks offer pay-          eralization of daylight credit. Collateralizing daylight
ment services to DI customers and, as a result, may         overdrafts benefits both Reserve Banks and DIs. Col-
be exposed to risk of loss when they process pay-           lateral mitigates the credit risk Reserve Banks incur
ments for institutions that hold accounts with them.        by extending daylight credit, and it allows DIs to elimi-
As previously mentioned, intraday credit is primarily       nate or minimize the fee paid for daylight credit. The
used by depository institutions to cover temporary          collateral acceptance criteria and margins applicable
shortages in their Federal Reserve accounts caused          for daylight credit purposes are the same as those
by outgoing Fedwire transfers, incoming book-entry          currently used for the discount window.3
securities transfers, processed checks, and ACH
transactions. Whenever a Reserve Bank processes             The revised PSR policy introduces major changes to
these transactions, it becomes susceptible to a direct      daylight overdraft pricing, as follows:4
risk of loss caused by a depository institution that is
unable to eliminate its daylight overdraft position be-     •    A zero fee will apply to collateralized daylight
fore the end of the business day.                                overdrafts for institutions with regular access to
                                                                 the discount window.
The PSR policy has always enabled Reserve Banks             •    A 50 basis point fee will apply to uncollateralized
to control credit risk exposures associated with day-            daylight overdrafts for institutions with regular ac-
light overdrafts in a number of ways. First, institu-            cess to the discount window.
tions must meet safety and soundness requirements,          •    A 150 basis point penalty fee will be assessed for
which are usually substantiated through the exami-               daylight overdrafts incurred by institutions that do
nation process. Secondly, daylight overdraft caps                not have regular access to the discount window
control the amount of intraday credit an institution             and are not eligible for intraday credit (also re-
may utilize. Moreover, Reserve Banks are permitted               ferred to as penalty fee institutions).
to limit their intraday credit risk exposures by imple-
menting other account controls, as necessary. For
instance, a Reserve Bank may require a particular           3
                                                                Collateral Guidelines and a listing of the most commonly
DI to prefund certain debit transactions, pledge col-           pledged asset types are available at http://www.
lateral, or maintain a minimum clearing account bal-        4
ance. Reserve Banks may also impose zero caps on                cfm?hdrID=22&dtIID=59

20   SRC Insights                                                                              
•   A fee waiver of $150 (per reserve maintenance       reduce negative account balances to determine the
    period) will be subtracted from an institution’s    institution’s uncollateralized overdraft position. This
    gross fees, excluding institutions subject to the   represents a change from the existing policy because
    penalty fee.                                        collateral is not currently considered in the determi-
                                                        nation of daylight overdraft amounts. Furthermore,
In the fee calculation, the value of unencumbered       individual daylight overdraft fees incurred during a
collateral pledged to the Reserve Banks (i.e., col-     reserve maintenance period will be added together
lateral not supporting discount window loans) will      and reduced by the $150 fee waiver.                                                                          SRC Insights 21
See the illustrative Comparison of Overdraft Charges                 serve Board. As in the past, Reserve Banks will con-
table for a more detailed view of the impact of the                  tinue to provide institutions with the needed flexibility
policy changes.                                                      to manage payment flows in the banking system while
                                                                     simultaneously mitigating credit risk exposures ema-
In this table, the DI would incur a lower overdraft                  nating from daylight overdrafts. However beginning on
charge for the maintenance period under the revised                  March 24, 2011, healthy institutions seeking to reduce
PSR policy due to a reduced average overdraft bal-                   daylight overdraft charges will be permitted to volun-
ance (net of the applied collateral) and due to the                  tarily apply unencumbered collateral against negative
$150 fee waiver. If, in the example shown, all over-                 balances incurred during each processing day.
draft balances had been collateralized, then no fees
would have been charged to the DI’s account under                    For more information on the revised PSR policy,
the revised policy.                                                  please contact PSR Specialist Jay Karlyn (jay.kar-
                                                            at (215) 574-6216. Frequently Asked
Final Thoughts                                                       Questions are available on the Federal Reserve Bank
The impending PSR policy changes addressed in this                   Discount Window & Payment System Risk Website at
article represent a strategic change for the Federal Re-   

                      Summary of Key PSR Policy Changes, effective March 24, 2011

                                               Existing Policy                          Revised Policy

     Collateral                                Required for problem institutions        Additional provision that explicitly
                                               and institutions with max caps only.     applies collateral pledged by healthy
                                               Collateral eligibility and margins       institutions to daylight overdrafts in
                                               same as discount window.                 their Reserve Bank accounts

     Fee for collateralized daylight           36 basis points                          Zero fee

     Fee for uncollateralized daylight         36 basis points                          50 basis points

     Deductible                                10 percent of an institution’s capital   Deductible is eliminated. Replaced
                                               measure                                  by zero fee for collateralized daylight
                                                                                        overdrafts and increased fee waiver.

     Fee waiver                                Up to $25 biweekly if total charges      $150 biweekly
                                               are less than or equal to $25

     Net debit cap                             Two-week average limit and higher        Two-week average limit is
                                               single-day limit                         eliminated; adjusted policy for
                                                                                        single-day limit

     Max cap                                   Additional collateralized capacity       Streamlined process for certain
                                               above net debit cap for self-            FBOs up to a limit; minor changes
                                               assessed institutions                    for all institutions

     Penalty fee for ineligible institutions   136 bps                                  150 bps

22     SRC Insights                                                                               

SR 10-16             Interagency Appraisal and Evaluation Guidelines

SR 10-15             Classification Requirements for Certain Cross-Border Facilities

SR 10-14             Implementation of Registration Requirements for Federal Mortgage Loan Originators

SR 10-13             Interagency Supervisory Guidance for Institutions Affected by the Deepwater Horizon Oil Spill

SR 10-12             Interagency Supervisory Guidance on Bargain Purchases and FDIC- and NCUA-Assisted


SR 10-11             Interagency Examination Procedures for Reviewing Compliance with the Unlawful Internet

                     Gambling Enforcement Act of 2006

SR 10-10             Interagency Guidance on Correspondent Concentration Risk Cross

SR 10-9              Release of the Revised Federal Financial Institutions Examination Council Bank Secrecy

                     Act/Anti-Money Laundering Examination Manual

SR 10-8              Suspicious Activity Report Filing Requirements for Banking Organizations Supervised by the

                     Federal Reserve

SR 10-7              Comments to the Basel Committee on Banking Supervision Regarding Proposals to Strengthen

                     the Resiliency of the Banking Sector

SR 10-6              Interagency Policy Statement on Funding and Liquidity Risk Management

SR 10-5              Interagency Guidance on Obtaining and Retaining Beneficial Ownership Information

SR 10-4              Clarification of the Risk Weight for Claims on or Guaranteed by the Federal Deposit Insurance


SR 10-3              FFIEC Retail Payment Systems Booklet

SR 10-2              Interagency Statement on Meeting the Needs of Creditworthy Small Business Borrowers

SR 10-1              Interagency Advisory on Interest Rate Risk

All SR Letters are available on the Board of Governors’ website at
        <>.                                                                                 SRC Insights 23
                               Supervision, Regulation and Credit Department
                                           Ten Independence Mall
                                           Philadelphia, PA 19106


        E-Mail Notification Service
        Would you like to read SRC Insights on our website up to three weeks before it is mailed?
        Sign up for our e-mail notification service today at <

24   SRC Insights                                                            

To top