Liabilities and Capital KB Federal Reserve

Document Sample
Liabilities and Capital KB Federal Reserve Powered By Docstoc
					Deposit Accounts
Effective date April 2011                                                    Section 3000.1

Deposits are funds that customers place with a      • the adequacy of current operations (staffing
bank and that the bank is obligated to repay on       and systems) and the location and size of
demand, after a specific period of time or after       banking quarters relative to the bank’s volume
expiration of some required notice period.            of business,
Deposits are the primary funding source for         • the degree of competition from banks and
most banks and, as a result, have a significant        nonbank financial institutions and their pro-
effect on a bank’s liquidity. Banks use deposits      grams to attract deposit customers, and
in a variety of ways, primarily to fund loans and   • the effects of the national economy and the
investments. Management should establish a            monetary and fiscal policies of the federal
procedure for determining the volatility and          government on the bank’s service area.
composition of the deposit structure to ensure
that funds are employed profitably, while allow-        The bank’s size and the composition of its
ing for their potential withdrawal. Therefore, a    market determine how formal its deposit pro-
bank’s management should implement pro-             gram should be. After a bank develops its
grams to retain and prudently expand the bank’s     deposit program, management must continue to
deposit base.                                       monitor the above factors and correlate any
   Bankers place great significance on the deposit   findings to determine if adjustments are needed.
structure because favorable operating results       The long-term success of any deposit program
depend, in part, on a core deposit base. Because    relates directly to the ability of management to
of competition for funds, the need for most         make adjustments at the earliest possible time.
individuals and corporations to minimize idle
funds, and the effect of disintermediation (the
movement of deposits to other higher-yielding
markets) on a bank’s deposit base, bank man-        DEPOSIT STRUCTURE
agement should adopt and implement a devel-
opment and retention program for all types of       Management should look not only at deposit
deposits.                                           growth but also at the nature of the deposit
                                                    structure. To invest deposited funds properly in
                                                    view of anticipated or potential withdrawals,
                                                    management must be able to determine what
DEPOSIT DEVELOPMENT AND                             percentage of the overall deposit structure is
RETENTION PROGRAM                                   centered in core deposits, in fluctuating or sea-
                                                    sonal deposits, and in volatile deposits. It is
Important elements of the examination process       important that internal reports with information
are the review of a bank’s deposit development      concerning the composition of the deposit struc-
and retention program and the methods used to       ture be provided to management periodically.
determine the volatility and composition of the     Management’s lack of such knowledge could
deposit structure. A bank’s deposit development     lead to an asset-liability mismatch, causing prob-
and retention program should include—               lems at a later date.
                                                       In analyzing the deposit structure, informa-
• a marketing strategy,                             tion gathered by the various examination proce-
• projections of deposit structure and associated   dures should be sufficient to allow the examiner
  costs, and                                        to evaluate the composition of both volatile and
• a formula for comparing results against           core deposits. Ultimately, the examiner should
  projections.                                      be satisfied with management’s efforts to plan
                                                    for the bank’s future.
To structure a deposit program properly, bank          Examiners must analyze the present and
management must consider many factors, some         potential effect deposit accounts have on the
of which include—                                   financial condition of the bank, particularly with
                                                    regard to the quality and scope of management’s
• the composition of the market-area economic       planning. The examiner’s efforts should be
  base,                                             directed to the various types of deposit accounts
• the ability to employ deposits profitably,         that the bank uses for its funding base. The

Commercial Bank Examination Manual                                                         April 2011
                                                                                              Page 1
3000.1                                                                               Deposit Accounts

examiners assigned to the areas of funds man-         the basis on which service charges on dormant
agement and to the analytical review of the           accounts are assessed and should document the
bank’s income and expenses should be informed         review. There have been occasions when exces-
of any significant change in interest-bearing          sive servicing charges have resulted in no pro-
deposit-account activity.                             ceeds being remitted at the time the account
                                                      became subject to escheat requirements. In these
                                                      cases, courts have required banks to reimburse
COST OF FUNDS                                         the state. (See also the ‘‘Dormant Accounts’’
                                                      discussion later in this section.)
Interest paid on deposits is generally the largest
expense to a bank. As a result, interest-bearing
deposit accounts employed in a marginally prof-       Bank Secrecy Act
itable manner could have significant and lasting
effects on bank earnings. The examiner should         Examiners should be aware of the Bank Secrecy
consider the following in evaluating the effect of    Act when examining the deposit area and should
interest-bearing deposit accounts on a bank’s         follow up on any unusual activities or arrange-
earnings:                                             ments noted. The act was implemented by the
                                                      Treasury Department’s Financial Recordkeep-
• an estimated change in interest expense result-     ing and Reporting of Currency and Foreign
  ing from a change in interest rates on deposit      Transactions Regulation. For further informa-
  accounts or a shift in funds from one type of       tion, see the FFIEC Bank Secrecy Act Examina-
  account to another                                  tion Manual, section 208.63 of the Federal
• service-charge income                               Reserve’s Regulation H, and the Financial
• projected operating costs                           Crimes Enforcement Network (FinCEN)’s Bank
• changes in required reserves                        Secrecy Act regulations at 31 CFR Chapter X.
• promotional and advertising costs                   Prior to March 1, 2011, FINCEN’s regulation
• the quality of management’s planning                was at 31 CFR 103. (See SR-11-4 and its
                                                      interagency attachment.)

ISSUES                                                Banking Hours and Processing of
                                                      Demand Deposits
The examiner should keep the following issues
in mind during an examination to ensure the           The Board’s Regulation CC (12 CFR 229),
bank is in compliance, where applicable.              ‘‘Availability of Funds and Collection of Checks,’’
                                                      and the Uniform Commercial Code (UCC) gov-
                                                      ern banking-day cutoff hours and the processing
Abandoned-Property Law                                of deposits. A ‘‘banking day’’ is that part of a
                                                      day on which an office of the bank is open to the
State abandoned-property laws generally are           public for carrying out substantially all of its
called escheat laws. Although escheat laws vary       banking functions. Saturdays, Sundays, and cer-
from state to state, they normally require a bank     tain specified holidays are not banking days
to remit the proceeds of any deposit account to       under Regulation CC, although such days might
the state treasurer when—                             be banking days under the UCC if a bank is
                                                      open for substantially all of its functions on
• the deposit account has been dormant for a          those days.
  certain number of years and                            Regulation CC requires a bank to make
• the owner of the account cannot be located.         deposited funds available for withdrawal within
                                                      a certain period after the banking day on which
  Service charges on dormant accounts should          they are received. Cash deposits, wire transfers,
bear a direct relationship to the cost of servicing   and certain check deposits that pose little risk to
the accounts, which ensures that the charges are      the depositary bank (such as Treasury checks
not excessive. A bank’s board of directors (or a      and cashier’s checks) generally are to be made
committee appointed by the board) should review       available for withdrawal by the business day

April 2011                                                         Commercial Bank Examination Manual
Page 2
Deposit Accounts                                                                               3000.1

after the day of deposit. The time when the             The joint interagency statement advises bank-
depositary bank must make other check deposits       ing organizations that the decision to accept or
available for withdrawal depends on whether the      reject an embassy or foreign government account
check is local or nonlocal to the depositary bank.   is theirs alone to make. The statement advises
As of September 1, 1990, proceeds of local and       that financial institutions should be aware that
nonlocal checks must be available for with-          there are varying degrees of risk associated with
drawal by the second and fifth business day           such accounts, depending on the customer and
following deposit, respectively. However, Regu-      the nature of the services provided. Institutions
lation CC allows a bank to set, within certain       should take appropriate steps to manage such
limits, cutoff hours, after which the bank will      risks consistent with sound practices and appli-
deem funds to be received on the next banking        cable anti-money-laundering laws and regula-
day for purposes of calculating the availability     tions. The advisory also encourages banking
date (12 CFR 229.19). Different cutoff-hour          organizations to direct questions about embassy
limits apply to different types of deposits.         banking to their primary federal bank regulators.
   For the purpose of allowing banks to process      (See SR-04-10.)
checks, the UCC provides that a bank may set a          On March 24, 2011, an interagency advisory
cutoff hour of 2 p.m. or later and that items        was issued to supplement SR-04-10, ‘‘Banking
received after that time will be considered          Accounts for Foreign Governments, Embassies,
received as of the next banking day (UCC             and Political Figures.’’ The supplemental advi-
section 4-108). Under both the UCC and Regu-         sory provides information to financial institu-
lation CC, both the banking day on which a bank      tions regarding the provision of account services
is deemed to have received a check and the           to foreign embassies, consulates and to foreign
cutoff hour affect the time frames within which      missions in a manner that fulfills the needs of
a bank must send the check through the forward-      those foreign governments while complying
collection and return processes.                     with the provisions of the Bank Secrecy Act
   A bank that fails to set its cutoff hour appro-   (BSA). It advises that financial institutions are
priately, does not make funds available within       expected to demonstrate the capacity to conduct
the appropriate time frames, or processes checks     appropriate risk assessments and implement the
in an untimely manner may be subject to civil        requisite controls and oversight systems to effec-
liability for not performing its duties in accor-    tively manage the risk identified in these rela-
dance with various provisions of Regulation CC       tionships with foreign missions. The advisory
and the UCC.                                         also confirms that it is the financial institution’s
                                                     decision to accept or reject a foreign mission
                                                     account. (See SR-11-6 and the attached supple-
                                                     mental interagency advisory.)
Banking Accounts for Foreign
Governments, Embassies, Missions,
and Political Figures                                Interagency Advisory on Accessing
                                                     Accounts from Foreign Governments,
On June 15, 2004, an interagency advisory            Embassies, and Foreign Political Figures
concerning the embassy banking business and
related banking matters was issued by the fed-       The 2004 interagency advisory answers ques-
eral banking and thrift agencies (the Board of       tions on whether financial institutions should
Governors of the Federal Reserve System, the         conduct business with foreign embassies and
Federal Deposit Insurance Corporation, the           whether institutions should establish account
Office of the Comptroller of the Currency, the        services for foreign governments, foreign embas-
Office of Thrift Supervision, and the National        sies, and foreign political figures. As it would
Credit Union Administration (the agencies)).         with any new account, an institution should
The advisory was issued in coordination with         evaluate whether or not to accept a new account
the U.S. Department of the Treasury’s Financial      for a foreign government, embassy, or political
Crimes Enforcement Network. The purpose of           figure. That decision should be made by the
the advisory is to provide general guidance to       institution’s management, under standards and
banking organizations regarding the treatment        guidelines established by the board of directors,
of accounts for foreign governments, foreign         and should be based on the institution’s own
embassies, and foreign political figures.             business objectives, its assessment of the risks

Commercial Bank Examination Manual                                                          April 2011
                                                                                               Page 3
3000.1                                                                               Deposit Accounts

associated with particular accounts or lines of       Foreign-Currency Deposits
business, and its capacity to manage those risks.
The agencies will not, in the absence of extraor-     Domestic depository institutions are permitted
dinary circumstances, direct or encourage any         to accept deposits denominated in foreign cur-
institution to open, close, or refuse a particular    rency. Institutions should notify customers that
account or relationship.                              such deposits are subject to foreign-exchange
                                                      risk. The bank should convert such accounts to
   Providing financial services to foreign gov-
                                                      the U.S. dollar equivalent for purposes of report-
ernments and embassies and to foreign political
                                                      ing to the Federal Reserve. Examination staff
figures can, depending on the nature of the
                                                      should ascertain that all reports are in order and
customer and the services provided, involve           should evaluate the bank’s use of such funds and
varying degrees of risk. Such services can range      its management of the accompanying foreign-
from account relationships that enable an             exchange risk. Accounts denominated in foreign
embassy to handle the payment of operational          currency are not subject to the requirements of
expenses, for example, payroll, rent, and utili-      Regulation CC. (See SR-90-03 (IB), ‘‘Foreign
ties, to ancillary services or accounts provided to   (Non–U.S.) Currency Denominated Deposits
embassy staff or foreign government officials.         Offered at Domestic Depository Institutions.’’)
Each of these relationships potentially poses
different levels of risk. Institutions are expected
to assess the risks involved in any such relation-
ships and to take steps to ensure both that such      International Banking Facilities
risks are appropriately managed and that the
                                                      An international banking facility (IBF) is a set
institution can do so in full compliance with its
                                                      of asset and liability accounts segregated on the
obligations under the BSA, as amended by the
                                                      books of a depository institution. IBF activities
USA Patriot Act, and the regulations promul-
                                                      are essentially limited to accepting deposits
gated thereunder.
                                                      from and extending credit to foreign residents
   When an institution elects to establish finan-      (including banks), other IBFs, and the institu-
cial relationships with foreign governments,          tions establishing the IBF. IBFs are not required
embassies, or foreign political figures, the agen-     to maintain reserves against their time deposits
cies, consistent with their usual practice of         or loans. The examiner should follow the special
risk-based supervision, will make their own           examination procedures in the international sec-
assessment of the risks involved in such busi-        tion of this manual when examining an IBF.
ness. As is the case with all accounts, the
institution should expect appropriate scrutiny by
examiners that is commensurate with the level
of risk presented by the account relationship. As     Deposits Insured by the Federal
in any case where higher risks are presented, the     Deposit Insurance Corporation
institution should expect an increased level of
review by examiners to ensure that the institu-       The Federal Deposit Insurance Corporation
tion has in place controls and compliance over-       (FDIC) is an independent agency of the U.S.
sight systems that are adequate to monitor and        government. The FDIC protects depositors
manage such risks, as well as personnel trained       against the loss of their insured deposits due to
in the management of such risks and in the            the failure of an insured bank, savings bank,
requirements of applicable laws and regulations.      savings association, insured branch of a foreign
   Institutions that have or are considering tak-     bank, or other depository institution whose
ing on relationships with foreign governments,        deposits are insured pursuant to the Federal
embassies, or political figures should ensure that     Deposit Insurance Corporation Act. If a deposi-
such customers are aware of the requirements of       tor’s accounts at one FDIC-insured depository
U.S. laws and regulations to which the institu-       institution total up to $250,000 (or the standard
tion is subject. Institutions should, to the maxi-    maximum deposit insurance amount [SMDIA]),
mum extent feasible, seek to structure such           the funds are fully insured and protected. A
relationships in order to conform them to con-        depositor can have more than the SMDIA at one
ventional U.S. domestic banking relationships so      insured depository institution and still be fully
as to reduce the risks that might be presented by     insured provided the accounts meet certain
such relationships.                                   requirements. In addition, federal law currently

April 2011                                                        Commercial Bank Examination Manual
Page 4
Deposit Accounts                                                                                                   3000.1

provides for insurance coverage of up to                         accounts,3 and any plan described in section
$250,000 or the SMDIA.                                           401(d) of the IRC, to the extent that participants
   The FDIC insurance covers all types of depos-                 and beneficiaries under such plans have a right
its received at an insured depository institution,               to direct the investment of assets held in indi-
including deposits in checking, negotiable order                 vidual accounts maintained on their behalf by
of withdrawal (NOW), and savings accounts;                       the plans.
money market deposit accounts; and time depos-                      Third, the Reform Act provided per-participant
its such as certificates of deposit (CDs). FDIC                   insurance coverage to employee benefit plan
deposit insurance covers the balance of each                     accounts, even if the depository institution at
depositor’s account, dollar-for-dollar, up to the                which the deposits are placed is not authorized
SMDIA, including the principal and any accrued                   to accept employee benefit plan deposits. The
interest through the date of an insured deposi-                  cost-of-living adjustment is to be calculated
tory institution’s closing.                                      according to the Personal Consumption Expen-
   Deposits in separate branches of an insured                   ditures Chain-type Price Index published by the
depository institution are not separately insured.               U.S. Department of Commerce and rounded
Deposits in one insured institution are insured                  down to the nearest $10,000.
separately from deposits in another insured insti-                  The Conforming Amendments Act created
tution. Deposits maintained in different catego-                 the term government depositor in connection
ries of legal ownership at the same depository                   with public funds described in and insured
institution can be separately insured. Therefore,                pursuant to section 11(a)(2) of the Federal
it is possible to have deposits of more than the                 Deposit Insurance Act (FDIA). (See 12 USC
SMDIA at one insured institution and still be                    1821(a)(2).) The Conforming Amendments Act
fully insured.                                                   provides that the deposits of a government
                                                                 depositor are insured in an amount up to the
                                                                 SMDIA, subject to the inflation adjustment
                                                                 described previously.
Deposit Insurance Reform Acts
On March 14, 2006, the FDIC amended its
deposit insurance regulations (effective April 1,                Deposit Insurance Rule Amendments
2006) by issuing an interim rule with a request                  Retirement and Employee Benefit Plan
for public comment on or before May 22, 2006.                    Accounts
(See 71 Fed. Reg. 14631, 71 Fed. Reg. 53550
(Sept. 12, 2006) and 12 CFR Part 330.) The                       When deposits from a retirement or employee
interim rule implemented applicable revisions to                 benefit plan (EBP)—such as a 401(k) retirement
the Federal Deposit Insurance Act made by the                    account, Keogh plan account, corporate pension
Federal Deposit Insurance Reform Act of 2005                     plan, or profit-sharing program—are entitled to
(Reform Act) and the Federal Deposit Insurance                   pass-through insurance, the SMDIA on FDIC
Reform Conforming Amendments Act of 2005                         insurance does not apply to the entire EBP
(the Conforming Amendments Act). The Reform                      account balance. Rather, the FDIC insurance
Act provided for consideration of inflation adjust-               coverage ‘‘passes through’’ to each owner or
ments (cost-of-living adjustment) to increase the                beneficiary, and the deposited funds of each
current SMDIA on a five-year cycle beginning                      individual EBP participant are insured up to the
on April 1, 2010.                                                SMDIA.
   Second, the Reform Act increased the deposit                     The Reform Act and the Conforming Amend-
insurance limit for accounts up to $250,000, also                ments Act, and the FDIC’s March 23, 2006,
subject to inflation adjustments. The types of                    interim rule eliminated the previous requirement
accounts included are individual retirement                      that pass-through coverage for employee benefit
accounts (IRAs),1 eligible deferred compensa-                    plan accounts be dependent on the capital level
tion plan accounts,2 and individual account plan                 of a depository institution where such deposits
                                                                 are placed. Pass-through coverage for employee
                                                                 benefit plan deposits was not available if the
   1. IRAs described in section 408(a) of the Internal Revenue
Code (IRC). (See 26 USC 408(a).)                                    3. Individual account plan accounts such as those defined
   2. Eligible deferred compensation plan accounts described     in section 3(34) of the Employee Retirement Income Security
in section 457 of the IRC. (See 26 USC 457.)                     Act.

Commercial Bank Examination Manual                                                                             April 2011
                                                                                                                  Page 5
3000.1                                                                               Deposit Accounts

deposits were placed with an institution that was     all deposits that are not transaction accounts,
not permitted to accept brokered deposits because     such as (1) savings deposits, that is, money
of the capital requirements. Insured institutions     market deposit accounts and other savings depos-
that are not ‘‘well capitalized’’ or ‘‘adequately     its, and (2) time deposits, that is, time certifi-
capitalized’’ are now prohibited by the Reform        cates of deposit and time deposits, open account.
Act from accepting employee benefit plan depos-        See Regulation D for specific definitions of the
its. Under the Reform Act, employee benefit            various deposit accounts.
plan deposits accepted by an insured depository
institution, even those prohibited from accepting
such deposits, are nonetheless eligible for pass-     Treasury Tax and Loan Accounts
through deposit insurance coverage. The rule’s
amendment (see 12 CFR 330.14) applies to all          Member banks may select either the ‘‘remittance-
employee benefit plan deposits, including em-          option’’ or the ‘‘note-option’’ method to forward
ployee benefit plan deposits placed before April       deposited funds to the U.S. Treasury. With the
1, 2006. The rule’s other requirements in section     remittance option, the bank remits the Treasury
330.14 continue to apply. In particular, only the     Tax and Loan (TT&L) account deposits to the
‘‘noncontingent’’ interests of plan participants in   Federal Reserve Bank the next business day
an applicable plan are eligible for pass-through      after deposit. The remittance portion is not
coverage. A ‘‘noncontingent interest’’ is an          interest-bearing.
interest that can be determined without the              The note option permits the bank to retain the
evaluation of contingencies other than life expec-    TT&L deposits. With the note option, the bank
tancy. The maximum coverage for accounts is           debits the TT&L remittance account for the
up to $250,000 or the SMDIA. These accounts           amount of the previous day’s deposit and simul-
continue to be made up of individual retirement       taneously credits the note-option account. Thus,
accounts (the traditional IRAs and the Roth           TT&L funds are now purchased funds evi-
IRAs); section 457 deferred compensation plan         denced by an interest-bearing, variable-rate,
accounts, ‘‘self-directed’’ Keogh plan accounts       open-ended, secured note callable on demand by
(or HR 10 accounts); and ‘‘self-directed’’ defined     Treasury. Rates paid are 1⁄4 of 1 percent less than
contribution plan accounts, which are primarily       the average weekly rate on federal funds. Inter-
40l(k) plan accounts. The term self-directed          est is calculated on the weekly average daily
means that the plan participants have the right to    closing balance in the TT&L note-option account.
direct how their funds are invested, including        Although there is no required maximum note-
the ability to direct that the funds be invested at   option ceiling, banks may establish a maximum
an FDIC-insured institution.                          balance by providing written notice to the Fed-
                                                      eral Reserve Bank. As per 31 CFR 203.24, the
                                                      TT&L balance requires the bank to pledge
                                                      collateral to secure these accounts, usually from
Reserve Requirements                                  its investment portfolio. The note option is not
                                                      included in reserve-requirement computations
The Monetary Control Act of 1980 and the              and is not subject to deposit insurance because it
Federal Reserve’s Regulation D, ‘‘Reserve             is classified as a demand note issued to the U.S.
Requirements of Depository Institutions,’’ estab-     Treasury, a type of borrowing.
lish two categories of deposits for reserve-
requirement purposes. The first category is the
transaction account, which represents a deposit
or account from which the depositor or account        POTENTIAL PROBLEM AREAS
holder is permitted to make orders of withdraw-
als by negotiable instrument, payment orders of       The following types of deposit accounts and
withdrawal, telephone transfer, or similar devices    related activities have above-average risk and,
for making payments to a third party or others.       therefore, require the examiner’s special
Transaction accounts include demand deposits,         attention.
NOW accounts, automatic transfer (ATS)
accounts, and telephone or preauthorized trans-
fer accounts. The second category is the non-
transaction deposit account, which includes

April 2011                                                         Commercial Bank Examination Manual
Page 6
Deposit Accounts                                                                                 3000.1

Bank-Controlled Deposit Accounts                      loss. The risk lies in inefficiency or misuse if the
                                                      accounts become overdrawn or if funds are
Bank-controlled deposit accounts, such as sus-        diverted for other purposes, such as the payment
pense, official checks, cash-collateral, dealer        of principal or interest on bank loans. Funds
reserves, and undisbursed loan proceeds, are          deposited to these accounts should be used only
used to perform many necessary banking func-          for their stated purposes.
tions. However, the absence of sound adminis-
trative policies and adequate internal controls
can cause significant loss to the bank. To ensure      Brokered Deposits
that such accounts are properly administered
and controlled, the directorate must ensure that      As defined in Federal Deposit Insurance Corpo-
operating policies and procedures are in effect       ration (FDIC) regulations, brokered deposits are
that establish acceptable purpose and use;            funds a depository institution obtains, directly or
appropriate entries; controls over posting            indirectly, from or through the mediation or
entries; and the length of time an item may           assistance of a deposit broker, for deposit into
remain unrecorded, unposted, or outstanding.          one or more deposit accounts (12 CFR 337.6).
Internal controls that limit employee access to       Thus, brokered deposits include both those in
bank-controlled accounts, determine the respon-       which the entire beneficial interest in a given
sibility for frequency of reconcilement, discour-     bank deposit account or instrument is held by a
age improper posting of items, and provide for        single depositor and those in which the deposit
periodic internal supervisory review of account       broker pools funds from more than one investor
activity are essential to efficient deposit            for deposit in a given bank deposit account.
administration.                                          Section 29 of the Federal Deposit Insurance
   The deposit suspense account is used to            Act (the FDI Act) (12 USC 1831f(g)(1)) and the
process unidentified, unposted, or rejected items.     FDIC’s regulations (12 CFR 337.6 (a)(5)) define
Characteristically, items posted to such accounts     deposit broker to mean—
clear in one business day. The length of time an
item remains in control accounts often reflects        • any person engaged in the business of placing
on the bank’s operational efficiency. This deposit       deposits, or facilitating the placement of depos-
type has a higher risk potential because the            its, of third parties with insured depository
transactions are incomplete and require manual          institutions or the business of placing deposits
processing to be completed. As a result of the          with insured depository institutions for the
need for human interaction and the exception            purpose of selling interests in those deposits to
nature of these transactions, the possibility of        third parties; and
misappropriation exists.                              • an agent or a trustee who establishes a deposit
   Official checks, a type of demand deposit,            account to facilitate a business arrangement
include bank checks, cashier’s checks, expense          with an insured depository institution to use
checks, interest checks, dividend-payment               the proceeds of the account to fund a prear-
checks, certified checks, money orders, and              ranged loan.
traveler’s checks. Official checks reflect the
bank’s promise to pay a specified sum upon             The term deposit broker does not include —
presentation of the bank’s check. Because
accounts are controlled and reconciled by bank        • an insured depository institution, with respect
personnel, it is important that appropriate inter-      to funds placed with that depository institution;
nal controls are in place to ensure that account      • an employee of an insured depository institu-
reconcilement is segregated from check origina-         tion, with respect to funds placed with the
tion. Operational inefficiencies, such as unre-          employing depository institution;
corded checks that have been issued, can result       • a trust department of an insured depository
in a significant understatement of the bank’s            institution, if the trust or other fiduciary rela-
liabilities. Misuse of official checks may result        tionship in question has not been established
in substantial losses through theft.                    for the primary purpose of placing funds with
   Cash-collateral, dealer differential or reserve,     insured depository institutions;
undisbursed loan proceeds, and various loan           • the trustee of a pension or other employee
escrow accounts are also sources of potential           benefit plan, with respect to funds of the plan;

Commercial Bank Examination Manual                                                            April 2011
                                                                                                 Page 7
3000.1                                                                                         Deposit Accounts

• a person acting as a plan administrator or an                 large amounts of funds through the issuance of
  investment adviser in connection with a pen-                  insured obligations undercuts market discipline.
  sion plan or other employee benefit plan                          The use of brokered deposits by sound,
  provided that person is performing managerial                 well-managed banks can play a legitimate role in
  functions with respect to the plan;                           the asset-liability management of a bank and
• the trustee of a testamentary account;                        enhance the efficiency of financial markets.
• the trustee of an irrevocable trust,4 as long as              However, the use of brokered deposits also can
   the trust in question has not been established               contribute to the weakening of a bank by
   for the primary purpose of placing funds with                allowing it to grow at an unmanageable or
   insured depository institutions;                             imprudent pace and can exacerbate the condition
• a trustee or custodian of a pension or profit-                 of a troubled bank. Consequently, without proper
  sharing plan qualified under section 401(d) or                 monitoring and management, brokered and other
  403(a) of the Internal Revenue Code of 1986                   highly rate-sensitive deposits, such as those
  (26 USC 401(d), 503(a)); or                                   obtained through the Internet, certificate of
• an agent or a nominee whose primary purpose                   deposit (CD) listing services, and similar adver-
  is not the placement of funds with depository                 tising programs, may be unstable sources of
  institutions; or                                              funding for an institution.
• an insured depository institution acting as an
  intermediary or agent of a U.S. government                       Deposits attracted over the Internet, through
  department or agency for a government-                        CD listing services, or through special advertis-
  sponsored minority or women-owned deposi-                     ing programs offering premium rates to custom-
  tory institution deposit program.                             ers without another banking relationship, require
                                                                special monitoring. Although these deposits may
   A small- or medium-sized bank’s dependence                   not fall within the technical definition of ‘‘bro-
on the deposits of customers who reside or                      kered’’ in 12 USC 1831f and 12 CFR 337.6,
conduct their business outside of the bank’s                    their inherent risk characteristics are similar to
normal service area should be closely monitored                 brokered deposits. That is, such deposits are
by the bank and analyzed by the examiner. Such                  typically attractive to rate-sensitive customers
deposits may be the product of personal rela-                   who may not have significant loyalty to the
tionships or good customer service; however,                    bank. Extensive reliance on funding products of
large out-of-area deposits are sometimes attracted              this type, especially those obtained from outside
by liberal credit accommodations or signifi-                     a bank’s geographic market area, has the poten-
cantly higher interest rates than competitors                   tial to weaken a bank’s funding position.
offer. Deposit growth that is due to liberal credit                Some banks have used brokered and Internet-
accommodations generally proves costly in terms                 based funding to support rapid growth in loans
of the credit risks taken relative to the benefits               and other assets. In accordance with the safety-
received from corresponding deposits, which                     and-soundness standards, a bank’s asset growth
may be less stable. Banks outside dynamic                       should be prudent and its management must
metropolitan areas are limited in growth because                consider the source, volatility, and use of the
they usually can maintain stable deposit growth                 funds generated to support asset growth. (See 12
only as a result of prudent reinvestment in the                 CFR 208 appendix D-1.)
bank’s service area. Deposit development and                       To compensate for the high rates typically
retention policies should recognize the limits                  offered for brokered deposits, institutions hold-
imposed by prudent competition and the bank’s                   ing them tend to seek assets that carry commen-
service area.                                                   surately high yields. These assets can often
   Historically, most banking organizations have                involve excessive credit risk or cause the bank
not relied on funds obtained through deposit                    to take on undue interest-rate risk through a
brokers to supplement their traditional funding                 mismatch in the maturity of assets and liabili-
sources. A concern regarding the activities of                  ties. The FDI Act (12 USC 1831f) includes
deposit brokers is that the ready availability of               certain restrictions on the use of brokered depos-
                                                                its to prohibit undercapitalized insured deposi-
                                                                tory institutions from accepting funds obtained,
   4. This exception does not apply to an agent or a trustee
who establishes a deposit account to facilitate a business
                                                                directly or indirectly, by or through any deposit
arrangement with an insured depository institution to use the   broker for deposit into one or more deposit
proceeds of the account to fund a prearranged loan.             accounts.

April 2011                                                                  Commercial Bank Examination Manual
Page 8
Deposit Accounts                                                                                            3000.1

Capital Categories                                    • does not meet the definition of a well capital-
                                                        ized bank.
For the purposes of section 29 of the FDI Act,
the regulations of the FDIC and the Federal           An adequately capitalized insured depository
Reserve (for the FDIC, 12 CFR 325.103 and for         institution may not accept, renew, or roll over
the Federal Reserve, 12 CFR 208.43) provide           any brokered deposit unless it has applied for
the definitions of well-capitalized, adequately        and been granted a waiver of this prohibition by
capitalized, and undercapitalized financial insti-     the FDIC. If the insured depository institution
tutions (banks). These definitions are tied to         has been granted a waiver by the FDIC, the
percentages of leverage and risk-based capital.       institution may accept, renew, or roll over a
Section 29 of the FDI Act limits the rates of         brokered deposit. The institution may not pay an
interest on brokered deposits that may be offered     effective yield on the deposit that exceeds, by
by insured depository institutions that are           more than 75 basis points: (1) the effective yield
adequately capitalized or undercapitalized.           paid on deposits of comparable size and matu-
                                                      rity, and for deposits accepted, within the insti-
                                                      tution’s normal market area5 or (2) the ‘‘national
Well-capitalized bank. A bank is deemed to be         rate’’ paid on deposits of comparable size and
well capitalized if it—                               maturity for deposits accepted outside the insti-
                                                      tution’s normal market area. The national rate is
• has a total risk-based capital ratio of 10.0        either 120 or 130 basis points of the current
  percent or greater;                                 yield on similar-maturity U.S. Treasury obliga-
• has a tier 1 risk-based capital ratio of 6.0        tions, depending on whether the deposit is FDIC
  percent or greater;                                 insured or more than half uninsured (the portion
• has a leverage ratio of 5.0 percent or greater;     of the deposit that is in excess of the FDIC-
  and                                                 insured limit, as detailed in the rule).
• is not subject to any written agreement, order,        If an FDIC-insured bank is adequately capi-
  capital directive, or prompt-corrective-action      talized and does not have a waiver from the
  directive issued by the Board pursuant to           FDIC, it may not use a broker to obtain deposits.
  section 8 of the FDI Act (12 USC 1818), the         The following rate restrictions on deposits also
  International Lending Supervision Act of 1983       apply: (1) the deposit rates may be no more than
  (12 USC 3907), or section 38 of the FDI Act         75 basis points over the effective yield on
  (12 USC 1831o), or any regulation thereunder,       deposits of comparable size and maturity within
  to meet and maintain a specific capital level        the bank’s normal market area and (2) the
  for any capital measure.                            deposit rates may not be based on a ‘‘national’’
A well-capitalized insured depository institution
may solicit and accept, renew, or roll over any
brokered deposit without restriction.                 Undercapitalized bank. A bank is deemed to
                                                      be undercapitalized if it—

Adequately capitalized bank. A bank is                • has a total risk-based capital ratio that is less
deemed to be adequately capitalized if it—              than 8.0 percent;
                                                      • has a tier 1 risk-based capital ratio that is less
• has a total risk-based capital ratio of 8.0 per-      than 4.0 percent;
  cent or greater;                                    • has a leverage ratio that is less than 4.0 per-
• has a tier 1 risk-based capital ratio of 4.0 per-     cent;6 or
  cent or greater;                                    • has a leverage ratio that is less than 3.0 per-
• has—
  — a leverage ratio of 4.0 percent or greater or        5. For deposits obtained through Internet solicitations, the
                                                      determination of the bank’s ‘‘normal market area’’ is particu-
  — a leverage ratio of 3.0 percent or greater if     larly problematic and difficult.
      the bank is rated composite 1 under the            6. An exception is available when (1) the bank the (the
      CAMELS rating system in the most recent         insured depository institution) has a leverage ratio of 3.0
                                                      percent or greater, (2) the bank is rated composite 1 under the
      examination of the bank and is not expe-        CAMELS rating system following its most-recent bank exami-
      riencing or anticipating significant growth;     nation, and (3) the bank is not experiencing or anticipating
      and                                             significant growth.

Commercial Bank Examination Manual                                                                      April 2011
                                                                                                           Page 9
3000.1                                                                              Deposit Accounts

  cent, if the bank is rated composite 1 under the   Risk-Management Expectations for
  CAMELS rating system in the most recent            Brokered Deposits
  examination of the bank and is not experienc-
  ing or anticipating significant growth.             On May 11, 2001, the Federal Reserve Board and
                                                     the other federal banking agencies (the agencies)
An undercapitalized insured depository institu-      issued a Joint Agency Advisory on Brokered and
tion may not accept, renew, or roll over any         Rate-Sensitive Deposits. The advisory sets forth
brokered deposit. Also, an undercapitalized          the following risk-management guidelines for
insured depository institution (and any employee     brokered deposits. The bank’s management is
of the institution) may not solicit deposits by      expected to implement risk-management sys-
offering an effective yield that exceeds by more     tems that are commensurate in complexity with
than 75 basis points the prevailing effective        the liquidity and funding risks that the bank
yields on insured deposits of comparable matu-       undertakes. (See SR-01-14.) Such systems should
rity in the institution’s normal market area or in   incorporate the following principles:
the market area in which such deposits are being
solicited.                                           • Proper funds-management policies. A good
                                                       policy should generally provide for forward
   Each examination should include a review for        planning, establish an appropriate cost struc-
compliance with the FDIC’s limitations on the          ture, and set realistic limitations and business
acceptance of brokered deposits and guidelines         strategies. It should clearly convey the board’s
on interest payments. The use of brokered depos-       risk tolerance and should not be ambiguous
its should be reviewed during all on-site exami-       about who holds responsibility for funds-
nations, even in those institutions not subject to     management decisions.
the FDIC’s restrictions. Given the potential risks
involved in using brokered deposits, the exami-      • Adequate due diligence when assessing deposit
nation should focus on the—                            brokers. Bank management should implement
                                                       adequate due diligence procedures before
• rate of growth and the credit quality of the         entering any business relationship with a
  loans or investments funded by brokered              deposit broker. The agencies do not regulate
  deposits;                                            deposit brokers.
• corresponding quality of loan files, documen-
  tation, and customer credit information;           • Due diligence in assessing the potential risk to
                                                       earnings and capital associated with brokered
• ability of bank management to adequately             or other rate-sensitive deposits, and prudent
  evaluate and administer these credits and            strategies for their use. Bankers should man-
  manage the resulting growth;                         age highly sensitive funding sources carefully,
                                                       avoiding excessive reliance on funds that may
• degree of interest-rate risk involved in the         be only temporarily available or which may
  funding activities and the existence of a pos-       require premium rates to retain.
  sible mismatch in the maturity or rate sensi-
  tivity of assets and liabilities;                  • Reasonable control structures to limit funding
• composition and stability of the deposit             concentrations. Limit structures should con-
  sources and the role of brokered deposits in         sider typical behavioral patterns for depositors
  the bank’s overall funding position and              or investors and be designed to control exces-
  strategy; and                                        sive reliance on any significant source(s) or
                                                       type of funding. This includes brokered funds
• effect of brokered deposits on the bank’s            and other rate-sensitive or credit-sensitive
  financial condition and whether the use of            deposits obtained through the Internet or other
  brokered deposits constitutes an unsafe and          types of advertising.
  unsound banking practice.
                                                     • Management information systems (MIS) that
The examiner should identify relevant concerns         clearly identify nonrelationship or higher-cost
in the examination report when brokered depos-         funding programs and allow management to
its amount to 5 percent or more of the bank’s          track performance, manage funding gaps, and
total deposits.                                        monitor compliance with concentration and

April 2011                                                       Commercial Bank Examination Manual
Page 10
Deposit Accounts                                                                                       3000.1

  other risk limits. At a minimum, MIS should                  tionship deposits and an aggressive growth
  include a listing of funds obtained through                  strategy
  each significant program, rates paid on each              •   inadequate internal audit coverage
  instrument and an average per program, infor-            •   inadequate information systems or controls
  mation on maturity of the instruments, and               •   identified or suspected fraud
  concentration or other limit monitoring and              •   high on- or off-balance-sheet growth rates
  reporting. Management also should ensure                 •   use of rate-sensitive funds not in keeping with
  that brokered deposits are properly reported in              the bank’s strategy
  the bank’s Consolidated Reports of Condition             •   inadequate consideration of risk, with man-
  and Income.7                                                 agement focus exclusively on rates
                                                           •   significant funding shifts from traditional fund-
• Contingency funding plans that address the                   ing sources
  risk that these deposits may not ‘‘roll over’’           •   the absence of adequate policy limitations on
  and provide a reasonable alternative funding                 these kinds of funding sources
  strategy. Contingency funding plans should               •   high loan delinquency rate or deterioration in
  factor in the potential for changes in market                other asset-quality indicators
  acceptance if reduced rates are offered on               •   deterioration in the general financial condition
  rate-sensitive deposits. The potential for trig-             of the institution
  gering legal limitations that restrict the bank’s        •   other conditions or circumstances warranting
  access to brokered deposits under Prompt                     the need for administrative action
  Corrective Action (PCA) standards, and the
  effect that this would have on the bank’s
  liability structure, should also be factored into
  the plan.                                                Check Kiting

   Examiners should assess carefully the liquidity-        Check kiting occurs when—
risk management framework at all banks. Banks
with meaningful reliance on brokered or other              • a depositor with accounts at two or more
rate-sensitive deposits should receive the appro-            banks draws checks against the uncollected
priate level of supervisory attention. Examiners             balance at one bank to take advantage of the
should not wait for PCA provisions to be trig-               float—that is, the time required for the bank of
gered or the viability of the bank to come into              deposit to collect from the paying bank, and
question, before raising relevant safety-and-              • the depositor initiates the transaction with the
soundness issues with regard to the use of these             knowledge that sufficient collected funds will
funding sources. If a determination is made that             not be available to support the amount of the
a bank’s use of these funding sources is not safe            checks drawn on all of the accounts.
and sound, or that these risks are excessive or
that they adversely affect the bank’s condition,              The key to this deceptive practice, the most
then the examiner or central point of contact              prevalent type of check fraud, is the ability to
should recommend to the Reserve Bank man-                  draw against uncollected funds. However, draw-
agement that it consider taking immediate appro-           ing against uncollected funds in and of itself
priate supervisory action. The following repre-            does not necessarily indicate kiting. Kiting only
sent potential red flags that may indicate the              occurs when the aggregate amount of drawings
need to take such action to ensure the risks               exceeds the sum of the collected balances in all
associated with brokered or other rate-sensitive           accounts. Nevertheless, since drawing against
funding sources are managed appropriately:                 uncollected funds is the initial step in the kiting
                                                           process, management should closely monitor
• ineffective management or the absence of                 this activity. The requirements of Regulation
  appropriate expertise                                    CC, Availability of Funds and Collection of
• a newly chartered institution with few rela-             Checks, increased the risk of check kiting, and
                                                           should be addressed in a bank’s policies and
  7. See the FFIEC bank Call Report and Instructions for
                                                              By allowing a borrower to draw against
Consolidated Reports of Condition and Income, Schedule     uncollected funds, the bank is extending credit
RC-E—Deposit Liabilities.                                  that should be subject to an appropriate approval

Commercial Bank Examination Manual                                                                  April 2011
                                                                                                      Page 11
3000.1                                                                              Deposit Accounts

process. Accordingly, management should               tices are conducted prudently. If undue or
promptly investigate unusual or unauthorized          undocumented credit risk is disclosed or if
activity since the last bank to recognize check       lending limits are exceeded, appropriate correc-
kiting and pay on the uncollected funds suffers       tive action should be taken.
the loss. Check kiting is illegal and all suspected
or known check kiting operations should be
reported pursuant to established Federal Reserve
policy. Banks should maintain internal controls       Deposit Sweep Programs or
to preclude loss from kiting, and the examiner        Master-Note Arrangements
should remember that in most cases kiting is not
covered under Blanket Bond Standard Form 24.          Deposit sweep programs or master-note arrange-
                                                      ments (sweep programs) can be implemented on
                                                      a bank level or on a parent bank holding
                                                      company (BHC) level. On a bank level, these
Delayed Disbursement Practices                        sweep programs exist primarily to facilitate the
                                                      cash-management needs of bank customers,
Although Regulation CC, Availability of Funds         thereby retaining customers who might other-
and Collection of Checks, stipulates time frames      wise move their account to an entity offering
for funds availability and return of items, delayed   higher yields. On a BHC level, the sweep
disbursement practices (also known as remote          programs are maintained with customers at the
disbursement practices) can present certain risks,    bank level, and the funds are upstreamed to the
especially concerning cashier’s checks, which         parent as part of the BHC’s funding strategy.
have next-day availability. Delayed disburse-         Sweep programs use an agreement with the
ment is a common cash management practice             bank’s deposit customers (typically corporate
that consists of arrangements designed to delay       accounts) that permits these customers to rein-
the collection and final settlement of checks by       vest amounts in their deposit accounts above a
drawing checks on institutions located substan-       designated level in overnight obligations of the
tial distances from the payee or on institutions      parent bank holding company, another affiliate
located outside the Federal Reserve cities when       of the bank, or a third party. These obligations
alternate and more efficient payment arrange-          include instruments such as commercial paper,
ments are available. Such practices deny deposi-      program notes, and master-note agreements.
tors the availability of funds to the extent that     (See SR-90-31.)
funds could otherwise have been available ear-           The disclosure agreement regarding the sale
lier. A check drawn on an institution remote          of the nondeposit debt obligations should include
from the payee often results in increased possi-      a statement indicating that these instruments are
bilities of check fraud and in higher processing      not federally insured deposits or obligations of
and transportation costs for return items.            or guaranteed by an insured depository institu-
   Delayed disbursement arrangements could            tion. In addition, banks and their subsidiaries
give rise to supervisory concerns because a bank      that have issued or plan to issue nondeposit debt
may unknowingly incur significant credit risk          obligations should not market or sell these
through such arrangements. The remote location        instruments in any public area of the bank where
of institutions offering delayed disbursement         retail deposits are accepted, including any lobby
arrangements often increases the collection time      area of the bank. This requirement exists to
for checks by at least a day. The primary risk is     convey the impression or understanding that the
payment against uncollected funds, which could        purchase of such obligations by retail depositors
be a method of extending unsecured credit to a        of the subsidiary bank can, in the event of
depositor. Absent proper and complete docu-           default, result in losses to individuals who
mentation regarding the creditworthiness of the       believed they had acquired federally insured or
depositor, paying items against uncollected funds     guaranteed obligations.
could be considered an unsafe or unsound bank-
ing practice. Furthermore, such loans, even if
properly documented, might exceed the bank’s
                                                      Bank Policies and Procedures
legal lending limit for loans to one customer.        Banking organizations with sweep programs
   Examiners should routinely review a bank’s         should have adequate policies, procedures, and
practices in this area to ensure that such prac-      internal controls in place to ensure that the

April 2011                                                        Commercial Bank Examination Manual
Page 12
Deposit Accounts                                                                                              3000.1

activity is conducted in a manner consistent with                   Funding Strategies
safe and sound banking principles and in accor-
dance with all banking laws and regulations.                        A key principle underlying the Federal Reserve’s
Bank policies and procedures should further                         supervision of banking organizations is that
ensure that deposit customers participating in a                    BHCs operate in a way that promotes the
sweep program are given proper disclosures and                      soundness of their subsidiary banks. BHCs are
information. When a sweep program is used as                        expected to avoid funding strategies or practices
part of a funding strategy for a BHC or a                           that could undermine public confidence in the
nonbank affiliate, examiners should ensure that                      liquidity or stability of their banks. Any funding
liquidity and funding strategies are carried out in                 strategy should maintain an adequate degree of
a prudent manner.                                                   liquidity at both the parent level and the subsid-
                                                                    iary bank level. Bank management should avoid,
                                                                    to the extent possible, allowing sweep programs
Application of Deposit Proceeds                                     to serve as a source of funds for inappropriate
                                                                    uses at the BHC or at an affiliate. Concerns exist
In view of the extremely short-term maturity of
                                                                    in this regard because funding mismatches can
most swept funds, banks and BHCs are expected
                                                                    exacerbate an otherwise manageable period of
to exercise great care when investing the pro-                      financial stress and, in the extreme, undermine
ceeds. Banks, from whom deposit funds are                           public confidence in a banking organization’s
swept, have a fiduciary responsibility to their                      viability.
customers to ensure that such transactions are
conducted properly. Appropriate uses of the
proceeds of deposit sweep funds are limited to                      Funding Programs
short-term bank obligations, short-term U.S.
government securities, or other highly liquid,                      In developing and carrying out funding pro-
readily marketable, investment-grade assets that                    grams, BHCs should give special attention to
can be disposed of with minimal loss of princi-                     the use of overnight or extremely short-term
pal.8 When deposit sweep funds are invested in                      liabilities, since a loss of confidence in the
U.S. government securities, appropriate agree-                      issuing organization could lead to an immediate
ments must be in place, required disclosures                        funding problem. Thus BHCs relying on over-
must be made, and daily confirmations must be                        night or extremely short-term funding sources
provided to the customer in accordance with the                     should maintain a sufficient level of superior-
requirements of the Government Securities Act                       quality assets (at a level at least equal to the
of 1986. Use of such proceeds to finance mis-                        amount of the funding sources’) that can be
matched asset positions, such as those involving                    immediately liquidated or converted to cash
leases, loans, or loan participations, can lead to                  with minimal loss.
liquidity problems and are not considered
appropriate. The absence of a clear ability to                      Dormant Accounts
redeem overnight or extremely short-term liabili-
ties when they become due should generally be                       A dormant account is one in which customer-
viewed as an unsafe and unsound banking                             originated activity has not occurred for a prede-
activity.                                                           termined period of time. Because of this inac-
                                                                    tivity, dormant accounts are frequently the target
                                                                    of malfeasance and should be carefully con-
   8. Some banking organizations have interpreted language          trolled by a bank. Bank management should
in a 1987 letter signed by the secretary of the Board as
condoning funding practices that may not be consistent with         establish standards that specifically outline the
the principles set forth in a subsequent supervisory letter dated   bank’s policy for the effective control of dor-
September 21, 1990, as well as with prior Board rulings. The        mant accounts, addressing—
1987 letter involved a limited set of facts and circumstances
that pertained to a particular banking organization; it did not
establish or revise Federal Reserve policies on the proper use      • the types of deposit categories that could
of the proceeds of short-term funding sources. In any event,          contain dormant accounts, including demand,
banking organizations should no longer rely on the 1987 letter        savings, and official checks;
to justify the manner in which they use the proceeds of sweep
programs. Banking organizations employing sweep programs
                                                                    • the length of time without customer-originated
are expected to ensure that these programs conform with the           activity that qualifies an account to be identi-
policies in this manual section.                                      fied as dormant;

Commercial Bank Examination Manual                                                                         April 2011
                                                                                                             Page 13
3000.1                                                                            Deposit Accounts

• the controls exercised over the accounts and     Payable-Through Accounts
  their signature cards, that is, prohibiting
  release of funds by a single bank employee;      A payable-through account is an accommoda-
  and                                              tion offered to a correspondent bank or other
• the follow-up by the bank when ordinary bank     customer by a U.S. banking organization whereby
  mailings, such as account statements and         drafts drawn against client subaccounts at the
  advertising flyers, are returned to the bank      correspondent are paid upon presentation by the
  because of changed addresses or other reasons    U.S. banking institution. The subaccount holders
  for failure to deliver.                          of the payable-through bank are generally non–
                                                   U.S. residents or owners of businesses located
                                                   outside of the United States. Usually the con-
Employee Deposit Accounts                          tract between the U.S. banking organization and
                                                   the payable-through bank purports to create a
Historically, examiners have discovered various    contractual relationship solely between the two
irregularities and potential malfeasance through   parties to the contract. Under the contract, the
review of employee deposit accounts. As a          payable-through bank is responsible for screen-
result, bank policy should establish standards     ing subaccount holders and maintaining ade-
that segregate or specially encode employee        quate records with respect to such holders. The
accounts and should encourage periodic internal    examiner should be aware of the potential effect
supervisory review. In light of these concerns,    of money laundering.
examiners should review related bank proce-
dures and practices, taking appropriate measures
when warranted.
                                                   Public Funds
                                                   Public funds generally represent deposits of the
Overdrafts                                         U.S. government, as well as state and political
The size, frequency, and duration of deposit-      subdivisions, and typically require collateral in
account overdrafts are matters that should be      the form of securities to be pledged against
governed by bank policy and controlled by          them. A bank’s reliance upon public funds can
adequate internal controls, practices, and         cause potential liquidity concerns if the aggre-
procedures. Overdraft authority should be          gate amount, as a percentage of total deposits, is
approved in the same manner as lending author-     material relative to the bank’s asset-liability
ity and should never exceed the employee’s         management practices. Another factor that can
lending authority. Systems for monitoring and      cause potential liquidity concerns relates to the
reporting overdrafts should emphasize a second-    volatile nature of these deposits.
ary level of administrative control that is           This volatility occurs because the volume of
distinct from other lending functions so account   public funds normally fluctuates on a seasonal
officers who are less than objective do not allow   basis due to timing differences between tax
influential customers to exploit their overdraft    collections and expenditures. A bank’s ability to
privileges. A bank’s payment of overdrafts of      attract public funds is typically based upon the
executive officers and directors of the bank is     government entity’s assessment of three key
generally prohibited under Regulation O. (See      points:
12 CFR 215.4(e).) It is the board of directors’    • the safety and soundness of the institution
responsibility to review overdrafts as they          with which the funds have been placed
would any other extension of credit. Overdrafts
                                                   • the yield on the funds being deposited
outstanding for more than 60 days, lacking
                                                   • that such deposits are placed with a bank that
mitigating circumstances, should be considered
                                                     can provide or arrange the best banking ser-
for charge-off. See SR-05-3/CA-05-2 and sec-
                                                     vice at the least cost
tion 2130.1 on the February 18, 2005,
Interagency Joint Guidance on Overdraft            Additionally, banks that offer competitive inter-
Protection Programs.                               est rates and provide collection, financial advi-
                                                   sory, underwriting, and data processing services
                                                   at competitive costs are frequently chosen as
                                                   depositories. Public funds deposits acquired

April 2011                                                     Commercial Bank Examination Manual
Page 14
Deposit Accounts                                                                               3000.1

through political influence should be regarded as       demand deposit account at the same bank used
particularly volatile. As a result, an examiner        to cover deficits or channel surplus funds
should pay particular attention to assessing the       relative to the ZBA; or
volatility of such funds in conjunction with the     • extended settlement, a cash-management
review of liquidity.                                   arrangement that does not require the corpo-
                                                       rate customer to provide same-day funds for
                                                       payment of its checks.
Zero-Balance Accounts
                                                        Because checks are covered before the close
Zero-balance accounts (ZBAs) are demand              of business on the day they arrive, the bank’s
deposit accounts used by a bank’s corporate          exposure is not reflected in the financial state-
customers through which checks or drafts are         ment. The bank, however, assumes risk by
received for either deposit or payment. The total
                                                     paying against uncollected funds, thereby creat-
amount received on any particular day is offset
                                                     ing unsecured extensions of credit during the
by a corresponding debit or credit to the account
                                                     day (which is referred to as a daylight overdraft
before the close of business to maintain the
balance at or near zero. ZBAs enable a corporate     between the account holder and the bank). If
treasurer to effectively monitor cash receipts and   these checks are not covered, an overdraft occurs,
disbursements. For example, as checks arrive         which will be reflected on the bank’s financial
for payment, they are charged to a ZBA with the      statement.
understanding that funds to cover the checks            The absence of prudent safeguards and a lack
will be deposited before the end of the banking      of full knowledge of the creditworthiness of
day. Several common methods used to cover            the depositor may expose the bank to large,
checks include—                                      unwarranted, and unnecessary risks. Moreover,
                                                     the magnitude of unsecured credit risk may
• wire transfers;                                    exceed prudent limits. Examiners should rou-
• depository transfer checks, a bank-prepared        tinely review cash-management policies and
  payment instrument used to transfer money          procedures to ensure that banks do not engage
  from a corporate account in one bank to            in unsafe and unsound banking practices, mak-
  another bank;                                      ing appropriate comments in the report of
• concentration accounts, a separate corporate       examination, as necessary.

Commercial Bank Examination Manual                                                          April 2011
                                                                                              Page 15
Deposit Accounts
Examination Objectives
Effective date November 2006                                                  Section 3000.2

1. To determine if the policies, practices, pro-     4. To determine if bank officers and employees
   cedures, and internal controls regarding             are operating in conformance with the bank’s
   deposit accounts are adequate.                       established guidelines.
2. To determine if the bank’s management             5. To evaluate the deposit structure and deter-
   implemented adequate risk-management sys-            mine its characteristics and volatility.
   tems for brokered and rate-sensitive deposits
                                                     6. To determine the scope and adequacy of the
   that are commensurate with the liquidity and
                                                        audit function.
   funding risks the bank has undertaken.
3. To determine if the bank’s policies, practices,   7. To determine compliance with applicable
   procedures, and internal controls (including         laws and regulations.
   compliance oversight, management report-          8. To initiate corrective action when policies,
   ing, and staff training) for account relation-       practices, procedures, or internal controls are
   ships involving foreign governments, foreign         deficient, or when violations of laws or
   embassies, and foreign political figures (as          regulations are noted.
   well as foreign-currency customer deposit
   accounts) are adequate for the varied risks
   posed by these accounts.

Commercial Bank Examination Manual                                                     November 2006
                                                                                              Page 1
Deposit Accounts
Examination Procedures
Effective date April 2012                                                  Section 3000.3

 1. Determine the scope of the examination of              • matured certificates of deposit without
    the deposit-taking function. In so doing,                an automatic renewal feature
    consider the findings of prior examinations,            • large-balance report
    related work prepared by internal and             b.   For official checks:
    external auditors, deficiencies in internal             • trial balance(s)
    controls noted within other bank functions,            • exception list
    and the requirements of examiners assigned        c.   For savings accounts:
    to review the asset/liability management               • trial balance
    and interest-rate risk aspects of the bank.            • unposted items
 2. If required by the scope, implement the                • overdrafts
    ‘‘Deposit Accounts’’ internal control                  • dormant accounts
    questionnaire.                                         • public funds
 3. Test the deposit function for compliance               • trust department funds
    with policies, procedures, and internal con-           • large-balance report
    trols in conjunction with performing the          d.   For other time deposits:
    remaining examination procedures. Also,                • trial balance(s)
    obtain a listing of any deficiencies noted in           • large-balance report
    the latest internal or external audit review,          • unposted items
    then determine if appropriate corrections              • public funds
    have been made.                                        • trust department funds
 4. In conducting the examination, use avail-              • money market accounts
    able bank copies of printouts plus transac-       e.   For certificates of deposit:
    tions journals or other visual media to                • trial balance(s)
    minimize expense to the bank. However, if              • unposted items
    copies of these reports are not available,             • public funds
    determine what information is necessary to             • certificates of $100,000 or more
    complete the examination procedures and                • negotiable certificates of deposit
    request that information from the bank.                • maturity reports
       Obtain or prepare, as applicable, the               • matured certificates of deposit
    reports indicated below, which are used for       f.   For deposit sweep programs or master-
    a variety of purposes, including the                   note arrangements, list individually by
    assessment of deposit volatility and liquidity,        deposit type and amount.
    the assessment of the adequacy of internal        g.   For brokered deposits, list individually
    controls, the verification of information on            by deposit type, including amount and
    required regulatory reports, and the assess-           rate.
    ment of loss.                                     h.   For bank-controlled accounts:
    a. For demand deposits and other transac-              • reconcilement records for all such
       tion accounts:                                        accounts
       • trial balance                                     • names and extensions of individuals
       • overdrafts                                          authorized to make entries to such
       • unposted items                                    • name and phone extension of recon-
       • nonsufficient-funds (NSF) report                     cilement clerk(s)
       • dormant accounts                             i.   For the bank’s foreign-currency cus-
       • public funds                                      tomer deposit accounts and the deposit
       • uncollected funds                                 accounts for foreign governments,
                                                           embassies, and political figures:
       • due to banks
                                                           • list of accounts and currency type
       • trust department funds                            • list of currency transactions over
       • significant activity                                 $10,000 for each account, and the
       • suspected kiting report                             copies of their Currency Transaction

Commercial Bank Examination Manual                                                       April 2012
                                                                                            Page 1
3000.3                                                 Deposit Accounts: Examination Procedures

            Report or its equivalent, since the pre-      • officer-approval limits have been
            vious examination (See 31 CFR                   established, and
            1010.330 and its examples.)                   • a formal system of review and approval
         • the most recent internal audit report            is in effect.
            covering the review of those accounts,     b. Determine whether the depository insti-
            the risks associated with the accounts,       tution has an overdraft-protection pro-
            the internal controls over those              gram and if it has adequate written poli-
            accounts, and the staff’s completion of       cies and procedures to address the credit,
            the Currency Transaction Report               operational, and other risks associated
         • the completed copies of the Report of          with those programs. See the February
            Foreign (Non-U.S.) Currency Depos-            18, 2005, interagency Joint Guidance on
            its, Form 2915, that have been submit-        Overdraft Protection Programs (SR-05-
            ted since the previous examination            3/CA-05-2). If the bank provides over-
 5.   Review the reconcilement of all types of            draft protection, perform the following
      deposit accounts. Verify the balances to            procedures:
      department controls and the general ledger.         • Obtain a master list of all depositors
      a. Determine if reconciliation items are              with formal overdraft protection.
         legitimate and if they clear within a            • Obtain a trial balance indicating
         reasonable time frame.                             advances outstanding and compare it
      b. Retain custody of all trial balances until         with the master list to ensure compli-
         items outstanding are resolved.                    ance with approved limits.
 6.   Review the reconciliation process for bank-         • Cross-reference the trial balance or
      controlled accounts, such as official checks           master list to examiner loan line sheets.
      and escrow deposits, by—                            • Review credit files on significant for-
      a. determining if reconciling items are               mal agreements not cross-referenced
         legitimate and if they clear within a              above.
         reasonable time frame;                           • Ascertain whether there is ongoing
      b. scanning activity in such accounts to              monitoring of overdrafts to identify
         determine the potential for improper               customers who may pose an undue
         diversion of funds for various uses, such          credit risk to the bank.
         as—                                              • Find out if the bank has incorporated
                                                            into its overdraft-protection program
         • political contributions,
                                                            prudent risk-management practices per-
         • loan payments (principal and interest),
                                                            taining to account repayment and the
                                                            suspension of a customer’s overdraft-
         • personal use; and                                protection services when the customer
      c. determining if checks are being pro-               does not satisfy repayment and eligi-
         cessed before their related credits.               bility requirements.
 7.   Review the bank’s operating procedures              • Determine whether overdrafts are prop-
      and reconciliation process relative to sus-           erly and accurately reported according
      pense accounts. Determine if—                         to generally accepted accounting prin-
      a. the disposition process of unidentified             ciples on the bank’s financial state-
         items is completed in a timely fashion;            ments and on its Reports of Condition
      b. reports are generated periodically to              and Income (Call Reports). Verify that
         inform management of the type, age, and            overdrafts are reported as loans on the
         amount of items in such accounts; and              Report of Condition.
      c. employees responsible for clearing               • Verify the existence of the bank’s
         suspense-account items are not shifting            loss-estimation procedures for over-
         the items between accounts.                        draft and fee balances. Determine if
 8.   Evaluate the effectiveness of the written             the procedures are adequately rigorous
      policies and procedures and of manage-                and if losses are properly accounted
      ment’s reporting methods regarding over-              for as part of (1) the allowance for loan
      drafts and drawings against uncollected               and lease losses (ALLL) or (2) the loss
      funds.                                                allowance for uncollectible fees (alter-
      a. Concerning overdrafts, determine if—               natively, the bank may recognize only

April 2012                                                     Commercial Bank Examination Manual
Page 2
Deposit Accounts: Examination Procedures                                                                     3000.3

           that portion of earned fees estimated to                          loan line sheets;
           be collectible), if applicable.1                               • review the credit files of depositors
        • When applicable, validate (1) whether                              with significant overdrafts, if avail-
           the bank’s overdraft commitments have                             able, or the credit files of depositors
           been assigned the correct conversion                              who frequently draw significant
           factor, (2) whether they are accurately                           amounts against uncollected funds, for
           risk- weighted by obligor, and (3) if                             those depositors not cross-referenced
           the commitment terms comply with                                  in the preceding step;
           the risk-based capital guidelines.                             • request management to charge off over-
        • Determine whether the bank has                                     drafts deemed to be uncollectible; and
           obtained assurances from its legal                             • submit a list of the following items to
           counsel that its overdraft-protection                             the appropriate examiner:
           program is fully compliant with all                               — overdrafts considered loss, indicat-
           applicable federal and state laws and                                 ing borrower and amount
           regulations, including the Federal Trade                           — aggregate amounts overdrawn
           Commission Act.                                                       30 days or more past due, for
        • When the bank contracts with third-                                    inclusion in past-due statistics
           party vendors to do information tech-                    9. Review the bank’s deposit development and
           nology work, determine if the bank                          retention policy, which is often included in
           conducted proper due diligence before                       the funds-management policy.
           entering into the contract and that it                      a. Determine if the policy addresses the
           followed the November 28, 2000,                                deposit structure and related interest
           guidance on the Risk Management of                             costs, including the percentages of time
           Outsourced Technology Services. (See                           deposits and demand deposits of—
           SR-00-17.)                                                     • individuals,
     c. Concerning drawings against uncol-                                • corporations, and
        lected funds, determine if—                                       • public entities.
        • the uncollected-funds report reflects                         b. Determine if the policy requires periodic
           balances as uncollected until they are                         reports to management comparing the
           actually received;                                             accuracy of projections with results.
        • management is comparing reports of                           c. Assess the reasonableness of the policy,
           significant changes in balances and                             and ensure that it is routinely reviewed
           activity volume with uncollected-funds                         by management.
           reports;                                                10. If a deposit sweep program or master-note
        • management knows the reasons why a                           arrangement exists, review the minutes of
           depositor is frequently drawing against                     the board of directors for approval of related
           uncollected funds;                                          policies and procedures.
        • a reporting system to inform senior                      11. For banks with deposit sweep programs or
           management of significant activity in                        master-note arrangements (sweep programs),
           the uncollected-funds area has been                         compare practices for adherence to approved
           instituted; and                                             policies and procedures. Review the
        • appropriate employees clearly under-                         following:
           stand the mechanics of drawing against                      a. The purpose of the sweep program: Is it
           uncollected funds and the risks                                strictly a customer-accommodation trans-
           involved, especially in the area of                            action, or is it intended to fund certain
           potential check-kiting operations.                             assets at the holding company level or
     d. After completing steps 8.a., 8.b., and                            at an affiliate? Review funding trans-
        8.c.—                                                             actions in light of liquidity and fund-
         • cross-reference       overdraft      and                       ing needs of the banking organization by
           uncollected-funds reports to examiner                          referring to section 4020.1.
                                                                       b. The eligibility requirements used by the
                                                                          bank to determine the types of customers
  1. Institutions may charge off uncollectible overdraft fees
against the ALLL if such fees are recorded with overdraft
                                                                          and accounts that may participate in a
balances as loans and if estimated credit losses on the fees are          sweep program, including—
provided for in the ALLL.                                                 • a list of customers participating in

Commercial Bank Examination Manual                                                                        April 2012
                                                                                                             Page 3
3000.3                                              Deposit Accounts: Examination Procedures

         sweep programs, with dollar amounts             the confirmation confirms specific
         of deposit funds swept on the date of           securities. If any other securities are
         examination, and                                substituted that result in a change of
       • the name of the recipient(s) of swept           issuer, maturity date, par amount, or
         funds.                                          coupon rate, another confirmation must
         — If the recipient is an affiliate of the        be issued at the end of the day during
             bank, include a schedule of the             which the substitution occurred.
             instruments into which the funds            Because the confirmation or safekeep-
             were swept, including the effective         ing receipt must list specific securities,
             maturity of these instruments.              ‘‘pooling’’ of securities for any type of
         — If the recipient is an unaffiliated            sweep program involving government
             third party, determine if the bank          securities is not permitted. Addition-
             adequately evaluates the third              ally, if funds are swept into other
             party’s financial condition at least         instruments, similar confirmation pro-
             annually. Also, verify if a fee is          cedures should be applied.)
             received by the bank for the trans-       • Conditions of the sweep program are
             action. If so, determine that the           stated clearly, including the dollar
             fee is disclosed in customer                amount (minimum or maximum
             documentation.                              amounts and incremental amounts),
    c. Whether the proceeds of sweep pro-                time frame of sweep, time of day the
       grams are invested only in short-term             sweep transaction occurs, fees pay-
       bank obligations; short-term U.S. govern-         able, transaction confirmation notice,
       ment securities; or other highly liquid,          prepayment terms, and termination
       readily marketable, investment-grade              notice.
       assets that can be disposed of with mini-       • The length of any single transaction
       mal loss of principal.                            under sweep programs in effect has not
    d. Whether the bank and its subsidiaries             exceeded 270 days and the amount is
       have issued or plan to issue nondeposit           $25,000 or more (as stipulated by SEC
       debt obligations in any public area of            policy). Ongoing sweep-program dis-
       the bank where retail deposits are                closures should occasionally be sent to
       accepted, including any lobby area of             the customer to ensure that the terms
       the bank.                                         of the program are updated and the
    e. Completed sweep-program documents to              customer understands the terms.
       determine the following:                     f. Samples of advertisements (newspaper,
       • Signed documents boldly disclose that         radio, television spots, etc.) by the bank
         the instrument into which deposit funds       for sweep programs to determine if the
         will be swept is not insured by the           advertisements—
         FDIC and is not an obligation of, or          • boldly disclose that the instrument into
         guaranteed by, the bank.                        which deposit funds are swept is not
       • Proper authorization for the instrument         insured by the FDIC and is not an
         exists between the customer and an              obligation of, or guaranteed by, the
         authorized representative of the bank.          bank, and
       • Signed documents properly disclose            • are not enclosed with insured deposit
         the name of the obligor and the type of         statements mailed to customers.
         instrument into which the depositor’s      g. Whether the sweep program has had a
         funds will be swept. If funds are being       negative effect on bank liquidity or has
         swept into U.S. government securities         the potential to undermine public confi-
         held by the banking organization,             dence in the bank.
         verify that adequate confirmations are         • Review the bank’s federal funds and
         provided to customers in accordance             borrowing activities to ascertain
         with the Government Securities Act of           whether borrowings appear high. If so,
         1986. (This act requires that all trans-        compare the bank’s borrowing activity
         actions subject to a repurchase agree-          with daily balances of aggregate sweep
         ment be confirmed in writing at the              transactions on selected dates to see if
         end of the day of initiation and that           a correlation exists.

April 2012                                                  Commercial Bank Examination Manual
Page 4
Deposit Accounts: Examination Procedures                                                    3000.3

       • If sweep activity is significant, compare        • whether the bank is paying current
          the rates being paid on swept deposits            market rates on CDs;
          with the yields received on the invested       • the dollar amount of brokered CDs, if
          funds and with the rates on other                 any; and
          overnight funding instruments, such as         • the dollar volume of deposits obtained
          federal funds, to determine if they are           as a result of special promotions.
          reasonable.                                 b. Federal Deposit Insurance Corporation
12. Forward the following to the examiner                Improvement Act of 1991 (12 USC
    assigned to asset/liability management:              1831F).
    a. the amount of any deposit decline or              • If the bank is undercapitalized, as
       deposit increase anticipated by manage-              defined in the FDIC’s regulation on
       ment (the time period will be determined             brokered deposits, ensure that it is not
       by the examiner performing asset/liability           accepting brokered deposits. (See 12
       management)                                          CFR 337.6.)
    b. a listing by name and amount of any               • If the bank is only adequately capital-
       depositor controlling more than 1 per-               ized, as defined in the FDIC’s regula-
       cent of total deposits                               tion and is accepting brokered depos-
    c. a listing, if available, by name and                 its, ensure that a waiver authorizing
       amount of any deposits held solely                   acceptance of such deposits has been
       because of premium rates paid (brokered              obtained from the FDIC and that the
       deposits)                                            bank is in compliance with the interest-
    d. the aggregate amount of brokered                     rate restrictions. (See 12 CFR
       deposits                                             337.6(b)(2) and (3).)
    e. a maturity schedule of certificates of          c. Determine if the bank has risk-
       deposit, detailing maturities within the          management systems to monitor and con-
       next 30, 60, 90, 180, and 360 days                trol its liquidity and funding risks that
    f. an assessment of the overall characteris-         are associated with the bank’s brokered
       tics and volatility of the deposit structure      and rate-sensitive deposits.
13. Analyze UBPR data on deposits and related         d. Ascertain if the bank’s risk-
    expense ratios, and compare with peer-               management systems for its brokered
    group norms to determine—                            and rate-sensitive deposits are adequate
    a. variations from the norm, and                     and if they are commensurate with the
    b. trends in the deposit structure with              complexity of its liquidity and funding
       respect to—                                       risks. Determine if the bank has the
       • growth patterns, and                            following:
       • shifts between deposit categories.              • proper funds-management policies;
14. Assess the volatility and the composition of         • adequate due diligence when assess-
    the bank’s deposit structure.                           ing the risks associated with deposit
    a. Review the list of time certificates of               brokers;
       deposit of $100,000 or more and related           • due diligence in assessing the potential
       management reports, including those on               risk to earnings and capital associated
       brokered deposits, to determine—                     with brokered or other rate-sensitive
       • whether concentrations of maturing                 deposits, and prudent strategies for
          deposits exist;                                   their use;
       • whether a concentration of deposits to          • reasonable control structures to limit
          a single entity exists;                           funding concentrations;
       • the aggregate dollar volume of accounts         • management information systems (MIS)
          of depositors outside the bank’s nor-             that clearly identify nonrelationship or
          mal service area, if significant, and the          higher-cost funding programs that allow
          geographic areas from which any sig-              management to track performance,
          nificant volume emanates;                          manage funding gaps, and monitor
       • the aggregate dollar volume of CDs                 compliance with concentration and
          that have interest rates higher than              other risk limits; and
          current publicly quoted rates within           • contingency funding plans that ad-
          the market;                                       dress the risk that these deposits may

Commercial Bank Examination Manual                                                       April 2012
                                                                                            Page 5
3000.3                                              Deposit Accounts: Examination Procedures

          not ‘‘roll over’’ and provide a reason-   compliance with the applicable laws and
          able alternative funding strategy.        regulations listed below:
    e. Review public funds and the bank’s           a. Regulation O (12 CFR 215), Loans to
       method of acquiring such funds to assess        Executive Officers, Directors, and Prin-
       whether the bank uses competitive bid-          cipal Shareholders of Member Banks.
       ding in setting the interest rate paid on       Review the overdraft listing to ensure
       public deposits. If so, does the bank           that the bank has not paid an overdraft on
       consider variables in addition to rates         any account of an executive officer or
       paid by competition in determining pric-        director, unless the payment is made
       ing for bidding on public deposits?             according to—
    f. Review appropriate trial balances for all       • a written, preauthorized, interest-
       other deposits (demand, savings, and              bearing extension of a credit plan that
       other time deposits). Review manage-              provides a method of repayment, or
       ment reports that relate to large deposits      • a written, preauthorized transfer from
       for individuals, partnerships, corpora-           another account of that executive offi-
       tions, and related deposit accounts to            cer or director.
       determine whether a deposit concentra-          Payment of inadvertent overdrafts in an
       tion exists.                                    aggregate amount of $1,000 or less is not
       • Select, at a minimum, the 10 largest          prohibited, provided the account is not
          accounts to determine if the retention       overdrawn more than five business days
          of those accounts depends on—                and the executive officer or director is
          — criticizable loan relationships;           charged the same fee charged to other
          — liberal service accommodations,            customers in similar circumstances. Over-
              such as permissive overdrafts and        drafts are extensions of credit and must
              drawings against uncollected funds;      be included when considering each insid-
          — interbank correspondent relation-          er’s lending limits and other extension-
              ships;                                   of-credit restrictions, as well as when
          — deposits obtained as a result of           considering the aggregate lending limit
              special promotions; and                  for all outstanding extensions of credit
          — a recognizable trend with respect          by the bank to all insiders and their
              to—                                      related interests.
              • frequent significant balance        b. 12 USC 1972(2), Loans to Executive
                fluctuations,                           Officers, Directors, and Principal Share-
              • seasonal fluctuations, and              holders of Correspondent Banks. Review
              • nonseasonal increases or de-           the overdraft listing to ensure that no
                creases in average balances.           preferential overdrafts exist from the bank
    g. Elicit management’s comments to deter-          under examination to the executive offi-
       mine, to the extent possible—                   cers, directors, or principal shareholders
       • the potential renewal of large CDs that       of the correspondent bank.
          mature within the next 12 months;         c. Section 22(e) of the Federal Reserve Act
       • if public fund deposits have been             (12 USC 376), Interest on Deposits of
          obtained through political influence;         Directors, Officers, and Employees.
       • if a significant dollar volume of              Obtain a list of deposit accounts, with
          accounts is concentrated in customers        account numbers, of directors, officers,
          engaged in a single business or indus-       attorneys, and employees. Review the
          try; and                                     accounts for any exceptions to standard
       • if there is a significant dollar volume        policies on service charges and interest
          of deposits from customers who do not        rates paid that would suggest self-dealing
          reside within the bank’s service area.       or preferential treatment.
15. Obtain information on competitive pres-         d. Sections 23A and 23B of the Federal
    sures and economic conditions and evaluate         Reserve Act (12 USC 371c), and Regu-
    that information, along with current deposit       lation W. Determine the existence of
    trends, to estimate its effect on the bank’s       any non-intraday overdrawn affiliate
    deposit structure.                                 accounts. If such overdrawn accounts are
16. Perform the following procedures to test for       identified, review for compliance with

April 2012                                                  Commercial Bank Examination Manual
Page 6
Deposit Accounts: Examination Procedures                                                         3000.3

       sections 23A and 23B of the act and with            foreign-exchange risk associated with
       Regulation W.                                       foreign-currency deposits.
    e. Regulation D (12 CFR 204), Reserve              18. For a bank that accepts accounts from
       Requirements of Depository Institutions.            foreign governments, embassies, and politi-
       Review the accuracy of the deposit data             cal figures, evaluate—
       used in the bank’s reserve-requirement              a. the existence and effectiveness of the
       calculation for the examination date.                  bank’s policies, procedures, compliance
       When a bank issues nondeposit, unin-                   oversight, and management reporting
       sured obligations that are classified as                with regard to such foreign accounts;
       ‘‘deposits’’ in the calculation of reserve          b. whether the bank and its staff have the
       requirements, examiners should deter-                  necessary controls, as well as the ability,
       mine if these items are properly catego-               to manage the risks associated with such
       rized. Ascertain that the TT&L remit-                  foreign accounts;
       tance option is included in the                     c. whether the bank’s board of directors
       computations for reserve requirements.                 and staff can ensure full compliance with
    f. 12 USC 501 and 18 USC 1004, False                      its obligations under the Bank Secrecy
       Certification of Checks. Compare several                Act, as amended by the USA Patriot Act,
       certified checks by date, amount, and                   and its regulations;
       purchaser with the depositors’ names                d. the adequacy of the level of training of
       appearing on uncollected-funds and over-               the bank’s personnel responsible for man-
       draft reports of the same dates to deter-              aging the risks associated with such for-
       mine that the checks were certified                     eign accounts and for ensuring that the
       against collected funds.                               bank is and remains in compliance with
    g. Uniform Commercial Code 4-108, Bank-                   the requirements of the applicable laws
       ing Hours and Processing of Items.                     and regulations; and
       • Determine the bank’s cutoff hour,                 e. the effectiveness of the bank’s program
          after which items received are                      that communicates its policies and pro-
          included in the processing for the next             cedures for such foreign accounts to
          ‘‘banking day,’’ to ensure that the cutoff          ensure that foreign government, embassy,
          hour is not earlier than 2:00 p.m.                  and political-figure customers are fully
       • If the bank’s cutoff hour is before 2:00             informed of the requirements of applica-
          p.m., advise management that fail-                  ble U.S laws and regulations.
          ure to process items received before a
                                                       19. Discuss overall findings with bank manage-
          2:00 p.m. cutoff may result in civil
                                                           ment. Prepare report comments on—
          liability for delayed handling of those
          items.                                           a. policy deficiencies,
    h. Local escheat laws. Determine if the                b. noncompliance with policies,
       bank is adhering to the local escheat laws          c. weaknesses in supervision and reporting,
       with regard to all forms of dormant                 d. violations of laws and regulations, and
       deposits, including official checks.                 e. possible conflicts of interest.
17. If applicable, determine if the bank is            20. Update workpapers with any information
    appropriately monitoring and limiting the              that will facilitate future examinations.

Commercial Bank Examination Manual                                                            April 2012
                                                                                                 Page 7
Deposit Accounts
Internal Control Questionnaire
Effective date November 2004                                                  Section 3000.4

Review the bank’s internal controls, policies,             tories of new-account documents and CDs,
practices, and procedures for demand and time              and do the inventories include an account-
deposit accounts. The bank’s systems should be             ability of numbers issued out of sequence
documented completely and concisely and                    or canceled prior to issuance?
should include, where appropriate, narrative           *4. Are CDs signed by a properly authorized
descriptions, flow charts, copies of forms used,            individual?
and other pertinent information.                        5. Are new-account applications and signa-
   For large institutions or those institutions that       ture cards reviewed by an officer?
have individual demand and time deposit book-
keeping functions, the examiner should consider
administering this questionnaire separately for        CLOSING DEPOSIT ACCOUNTS
each function, as applicable.
   Questions pertain to both demand and time            1. Are signature cards for closed accounts
deposits unless otherwise indicated. Negative              promptly pulled from the active-account
responses to the questions in this section should          file and placed in a closed file?
be explained, and additional procedures deemed          2. Are closed-account lists prepared? If so,
necessary should be discussed with the examiner-           how frequently?
in-charge. Items marked with an asterisk require        3. Is the closed-account list circulated to
substantiation by observation or testing.                  appropriate management?
                                                        4. Is verification of closed accounts, in the
                                                           form of statements of ‘‘goodwill’’ letters,
OPENING DEPOSIT ACCOUNTS                                   required? Are such letters mailed under
                                                           the control of someone other than a teller
 *1. Are new-account documents prenumbered?                or an individual who can make internal
     a. Are new-account documents issued in                entries to an account (such as a private
        strict numerical sequence?                         banker or branch manager)?
     b. Are the opening of new accounts and            *5. For redeemed CDs:
        access to unused new-account records               a. Are the CDs stamped paid?
        and certificate of deposit (CD) forms               b. Is the disposition of proceeds docu-
        handled by an employee who is not a                   mented to provide a permanent record
        teller or who cannot make internal                    as well as a clear audit trail?
        entries to customer accounts or the                c. Are penalty calculations on CDs and on
        general ledger?                                       other time deposits that are redeemed
 *2. Does the institution have a written ‘‘know-              before maturity rechecked by a second
     your-customer’’ policy?                                  employee?
     a. Do new-account applications require            *6. Except for deposit-account agreements that
        sufficient information to clearly identify          authorize the transfer of deposited funds to
        the customer?                                      other nondemand deposit accounts, are
     b. Are ‘‘starter’’ checks issued only                 matured CDs that are not automatically
        after the verification of data on new               renewable classified as demand deposits
        transaction-account applications?                  on the Call Report and on the Report of
     c. Are checkbooks and statements mailed               Transaction Accounts, Other Deposits and
        only to the address of record? If not, is          Vault Cash (FR 2900)?
        a satisfactory explanation and descrip-
        tion obtained for any other mailing
        address (post office boxes, a friend or         DEPOSIT-ACCOUNT RECORDS
        relative, etc.)?
     d. Are the employees responsible for open-        *1. Does the institution have documentation
        ing new accounts trained to screen                 supporting a current reconcilement of each
        depositors for signs of check kiting?              deposit-account category recorded on its
 *3. Does the bank perform periodic inven-                 general ledger, including customer accounts

Commercial Bank Examination Manual                                                      November 2004
                                                                                               Page 1
3000.4                                               Deposit Accounts: Internal Control Questionnaire

       and bank-controlled accounts such as             10. If the bank’s bookkeeping system is not
       dealer reserves, escrow, Treasury tax and            automated, are deposit bookkeepers
       loan, etc.? (Prepare separate workpapers             rotated?
       for demand and time accounts, listing each       11. Does the bank segregate the deposit
       account and the date and frequency of                account files of—
       reconcilement, the general-ledger balance,           a. employees and officers?
       the subsidiary-ledger balance, adjustments,          b. directors?
       and unexplained differences.)                        c. the business interests of employees and
 *2.   Are reconciliations performed by an indi-               officers, or interests controlled by
       vidual or group not directly engaged in                 employees and officers?
       accepting or preparing transactions or in            d. the business interests of directors, or
       data entry to customers’ accounts?                      interests controlled by directors?
 *3.   If the size of the bank precludes full               e. foreign goverments, embassies, and
       separation of duties between data entry                 political figures?
       and reconcilement, are reconcilement            *12. Are posting and check filing separated
       duties rotated on a formal basis, and is a           from statement preparation?
       record maintained to support such action?        13. Are statements mailed or delivered to all
 *4.   Are reconciliations reviewed by appropri-            customers as required by the bank’s
       ate independent management, especially in            deposit-account agreement?
       circumstances when full separation of           *14. Are customer transaction and interest state-
       duties is not evident?                               ments mailed in a controlled environment
 *5.   Are periodic reports prepared for manage-            that precludes any individual from receiv-
       ment, and do the reports provide an aging            ing any statement not specifically autho-
       of adjustments and differences and detail            rized by the customer or the institution’s
       the status of significant adjustments and             policy (for example, dormant-account
       differences?                                         statements)?
 *6.   Has management adequately addressed any
       significant or long-outstanding adjust-
       ments or differences?
 *7.   Is the preparation of input and the posting     DORMANT ACCOUNTS AND
       of subsidiary demand deposit records per-       RETURNED MAIL
       formed or adequately reviewed by persons
       who do not also—                                 *1. Does the bank have formal policies and
       a. accept or generate transactions?                  procedures for the handling of customers’
       b. issue official checks or handle funds-             transaction and interest statements that are
           transfer transactions?                           returned as undeliverable? Does the
       c. prepare or authorize internal entries             policy—
           (return items, reversals, and direct             a. require that statements be periodically
           charges, such as loan payments)?                    mailed on dormant accounts? If so, how
       d. prepare supporting documents required                often?
           for disbursements from an account?               b. prohibit the handling of dormant-
       e. perform maintenance on the accounts,                 account statements by (1) employees of
           such as changes of address, stop pay-               the branch where the account is assigned,
           ments, holds, etc.?                                 (2) the account officer, and (3) other
 *8.   Are in-process, suspense, interoffice, and               individuals with exclusive control of
       other accounts related to deposit accounts              accounts?
       controlled or closely monitored by persons           c. require positive action to follow up on
       who do not have posting or reconcilement                obtaining new addresses?
       duties?                                              d. place statements and signature cards for
 *9.   Are periodic reports prepared for manage-               accounts for which contact cannot be
       ment on open items in suspense and on                   re-established (the mail is returned more
       in-process, interoffice, overdrawn, and                  than once or is marked ‘‘deceased’’)
       other deposit accounts, and do the reports              into a controlled environment?
       include aging of items and the status of             e. require the bank to change the address
       significant items?                                       on future statements to the department

November 2004                                                      Commercial Bank Examination Manual
Page 2
Deposit Accounts: Internal Control Questionnaire                                            3000.4

        of the bank (the controlled environ-            c. require the customer to sign a statement
        ment) designated to receive returned               describing the purpose of the request
        mail?                                              and the proposed times for pickup, and
     f. require a written request from the cus-            designate the individuals authorized to
        tomer and verification of the customer’s            pick up the statement?
        signature before releasing an account           d. require the maintenance of signature
        from the controlled environment?                   cards for individuals authorized to pick
 *2. Are accounts for which contact cannot be              up statements, and compare the autho-
     re-established and that do not reflect recent          rized signatures with those who sign for
     activity removed from active files and                 statements held for pickup?
     clearly classified as dormant?                      e. prohibit the delivery of statements to
 *3. Before returning a dormant account to                 officers and employees requiring spe-
     active status, are transactions reactivating          cial attention unless it is part of the
     the account verified, and are independent              formal ‘‘hold-mail’’ function?
     confirmations obtained directly from the        *2. Is a central record of hold-mail arrange-
     customer?                                          ments maintained in a control area that
 *4. Does transfer from dormant to active sta-          does not originate entries to customers’
     tus require the approval of an officer who          accounts? Does the record identify each
     cannot approve transactions on dormant             hold-mail arrangement, the designated
     accounts?                                          location for pickup, and the scheduled
                                                        pickup times? Does the control area—
                                                        a. maintain current signature cards of
INACTIVE ACCOUNTS                                          individuals authorized to pick up
  1. Are demand accounts that have been inac-           b. obtain signed receipts showing the date
     tive for one year, and time accounts that             of pickup, and compare the receipts
     have been inactive for three years, classi-           with the signature cards?
     fied as inactive? If not, state the time            c. follow up on the status of statements
     period for classifying a demand or time               not picked up as scheduled?
     account as inactive.                           *3. Does management review activity in hold-
  2. Does the bank periodically review the              mail accounts that have not been picked up
     inactive accounts to determine if they             for extended periods of time (for example,
     should be placed in a dormant status, and          one year), and, when there is no activity,
     are decisions to keep such accounts in             place the accounts in a dormant status?
     active files documented?

HOLD MAIL                                           OVERDRAFTS
 *1. Does the institution have a formal policy      *1. Are overdraft authorization limits for offi-
     and procedure for handling statements and          cers formally established?
     documents that a customer requests not to      *2. Does the bank require an authorized offi-
     be mailed but that will be picked up at a          cer to approve overdrafts?
     location within the institution? Does the      *3. Is an overdraft listing prepared daily for
     policy—                                            demand deposit and time transaction
     a. require that statements will not be held        accounts?
        by an individual (an account officer,         4. For banks processing overdrafts that are
        branch manager, bookkeeper, etc.) who           not automatically approved (a ‘‘pay none’’
        could establish exclusive control over          system), is the nonsufficient-funds report
        entries to and the delivery of statements       circulated among bank officers?
        for customer accounts?                      *5. Are overdraft listings circulated among
     b. discourage such pickup arrangements             the officers?
        and grant them only after the customer       6. Are the statements of accounts with large
        provides a satisfactory reason for the          overdrafts reviewed for irregularities and
        arrangement?                                    prompt repayment?

Commercial Bank Examination Manual                                                  November 2004
                                                                                           Page 3
3000.4                                                 Deposit Accounts: Internal Control Questionnaire

  7. Is an aged record of large overdrafts                            eign accounts or lines of business,
     included in the monthly report to the board                      and
     of directors or its committee, and does the                   • capacity to manage those risks?
     report include the overdraft origination                 c.   Does the bank have adequate internal
     date?                                                         controls and compliance oversight sys-
  8. Is there an established schedule of service                   tems to monitor and manage the vary-
     charges?                                                      ing degrees of risks associated with
                                                                   such foreign accounts? Do these inter-
                                                                   nal controls and compliance systems
                                                                   ensure full compliance with the Bank
UNCOLLECTED FUNDS                                                  Secrecy Act, as amended by the USA
                                                                   Patriot Act, and its respective
 *1. Does the institution generate a daily report                  regulations?
     of drawings against uncollected funds for                d.   Does the bank have personnel that are
     demand deposit and time transaction                           sufficiently trained in the management
     accounts?                                                     of such risks and in the requirements of
     a. Is the computation of uncollected funds                    applicable laws and regulations?
        positions based on reasonable check-                  e.   Does the bank have policies and proce-
        collection criteria?                                       dures for ensuring that such foreign-
     b. Can the reports, or a separate account                     account customers receive adequate
        activity report, be used to detect potential               communications from the bank? Com-
        kiting conditions?                                         munications should ensure that these
     c. If reports are not generated for time                      customers are made fully aware of the
        transaction accounts, is a system in                       requirements of U.S laws and regula-
        place to control drawings against uncol-                   tions to which the bank is subject.
        lected funds?                                         f.   Does the bank seek to structure its
 *2. Do authorized officers review the                              relationships with such foreign-account
     uncollected-funds reports and approve                         customers so as to minimize the vary-
     drawings against uncollected funds within                     ing degrees of risks these customers
     established limits?                                           may pose?
 *3. Are accounts that frequently appear on the
     uncollected-funds or kite-suspect reports
     reviewed regardless of account balances?
     (For example, accounts with simultaneous            OTHER MATTERS
     large debits and credits can reflect low
     balances.)                                           *1. Are account-maintenance activities
                                                              (changes of address, status changes, rate
                                                              changes, etc.) separated from data entry
                                                              and reconciling duties?
ACCOUNTS FOR FOREIGN                                      *2. Do all internal entries other than service
GOVERNMENTS, EMBASSIES,                                       charges require the approval of appropri-
AND POLITICAL FIGURES                                         ate supervisory personnel?
                                                          *3. If not included in the internal or external
 1. For bank relationships with a foreign gov-                audit program, are employees’ and offi-
    ernment, embassy, or political figure:                     cers’ accounts, accounts of employees’
     a. Has the board of directors established                and officers’ business interests, and accounts
        standards and guidelines for manage-                  controlled by employees and officers peri-
        ment to use when evaluating whether or                odically reviewed for unusual or prohib-
        not the bank should accept such new                   ited activity?
        accounts?                                         *4. For unidentified deposits:
     b. Are the standards and guidelines con-                 a. Are deposit slips kept under dual
        sistent with the bank’s—                                 control?
        • own business objectives,                            b. Is the disposition of deposit slips
        • assessment of the varying degrees of                   approved by an appropriate officer?
          risks associated with particular for-           *5. For returned checks, unposted items, and

November 2004                                                         Commercial Bank Examination Manual
Page 4
Deposit Accounts: Internal Control Questionnaire                                                3000.4

       other rejects:                                         ‘‘hold-mail’’ program and kept under
       a. Are daily listings of such items                    dual control?
          prepared?                                        e. Are customers prohibited from with-
       b. Are all items reviewed daily, and is                drawing funds without a passbook? If
          disposition of items required within a              not, state the policy.
          reasonable time period? If so, indicate      13. For withdrawals from savings or other
          the time period.                                 time accounts:
       c. Are reports prepared for management              a. Are withdrawal tickets canceled daily?
          that show items not disposed of within           b. Are procedures in place to preclude
          the established time frames?                        overdrafts?
  6.   Are customers immediately notified in writ-          c. Are procedures in effect to place holds
       ing of deposit errors?                                 on, and to check for holds on, withdraw-
  7.   Does the bank require a customer’s signa-              als over a stated amount? If so, indicate
       ture for stop-payment orders?                          the amount.
  8.   For automatic transfer accounts:                14. For signature cards on demand and time
       a. Are procedures in effect that require            accounts:
          officer approval for transfers in excess          a. Are procedures in effect to guard against
          of the savings balance?                             the substitution of false signatures?
       b. For nonautomated systems, are trans-                Describe the procedures.
          fers made by employees who do not                b. Are signature cards stored to preclude
          also handle cash, execute external funds            physical damage?
          transfers, issue official checks singly, or       c. Are signatures compared for withdraw-
          post subsidiary records?                            als and cashed checks? Describe the
  9.   For telephone transfer accounts:                       procedures.
       a. Do depositors receive an individual
          identification code for use in making
       b. Are transfers made by employees who          OFFICIAL CHECKS, MONEY
          do not also handle cash, execute exter-      ORDERS, AND CERTIFIED
          nal funds transfers, issue official checks    CHECKS
          singly, or post subsidiary records?
*10.   If not included in the internal or external     *1. Are separate general-ledger accounts main-
       audit program, are accrual balances for the         tained for each type of official check?
       various types of deposits verified periodi-      *2. For each type of check issued:
       cally by an authorized official? If so,              a. Are multicopy checks and certified-
       indicate how often.                                     check forms used? If not, are
*11.   Are accounts with a ‘‘hold-balance’’                    detailed registers of disbursed checks
       status—those accounts on which court                    maintained?
       orders have been placed, those pledged as           b. Are all checks prenumbered and issued
       security to customers’ loans, those pend-               in sequence?
       ing the clearing of a large check, those for        c. Is check preparation and issuance
       which the owner is deceased, and those for              separate from recordkeeping?
       which the passbook has been lost—‘‘locked           d. Is the signing of checks in advance
       out’’ for transactions unless the transaction           prohibited?
       is approved by appropriate management?              e. Do procedures prohibit the issuance of
 12.   For passbook accounts:                                  a check before the credit is processed?
       a. Do all entries to passbooks contain          *3. Is the list authorizing bank personnel to
          teller identification?                            sign official checks kept current? Does the
       b. Under a window-posting system, are               list include changes in authorization limits,
          recording media and passbooks posted             delete employees who no longer work at
          simultaneously?                                  the bank, and indicate employees added to
       c. Are tellers prohibited from holding cus-         the list?
          tomers’ savings passbooks?                   *4. Are appropriate controls in effect over
       d. If customers’ passbooks are held, are            check-signing machines (if used) and cer-
          they maintained under the institution’s          tification stamps?

Commercial Bank Examination Manual                                                      November 2004
                                                                                               Page 5
3000.4                                              Deposit Accounts: Internal Control Questionnaire

 *5. Are voided checks and voided certified-                business day after deposit?
     check forms promptly defaced and filed             *3. Has the TT&L-account reconcilement
     with paid checks?                                     been completed in a timely manner and
 *6. If reconcilements are not part of the over-           approved by a supervisor?
     all deposit-reconciliation function—               4. Has adequate collateral been pledged to
     a. are outstanding checks listed and rec-             secure the TT&L account?
         onciled regularly to the general ledger?
         If so, state how often.
     b. is permanent evidence of reconcile-
         ments maintained?                            AUDIT
     c. is there clear separation between the
         preparation of checks, data entry, and        *1. Are deposit-account activities audited on a
         check reconcilement?                              sufficiently frequent basis?
     d. are the reconcilements reviewed regu-          *2. Does the scope of the audit program
         larly by an authorized officer?                    require, and do audit records support, sub-
     e. are reconcilement duties rotated on a              stantive testing or quantitative measure-
         formal basis in institutions where size           ments of deposit-account activities that, at
         precludes the full separation of duties           a minimum, include the matters set forth in
         between data entry and reconcilement?             this questionnaire?
     f. are authorized signatures and endorse-         *3. Does the audit program include a compre-
         ments checked by the filing clerk?                 hensive confirmation program with the
 *7. For supplies of official checks:                       customers of each deposit category main-
     a. Are records of unissued official checks             tained by the institution?
         maintained centrally and at each loca-        *4. Do audit department records support the
         tion storing them?                                execution of the confirmation program,
     b. Are periodic inventories of unissued               and do the records reflect satisfactory
         checks independently performed?                   follow-up of responses and of requests
     c. Do the inventories include a description           returned as undeliverable?
         of all checks issued out of sequence?         *5. Are audit and prior-examination recom-
     d. If users are assigned a supply, is that            mendations for deposit-account activities
         supply replenished on a consignment               appropriately addressed?
 *8. Are procedures in effect to preclude certi-
     fication of checks drawn against uncol-           CONCLUSION
     lected funds?
                                                       *1. Does the foregoing information provide an
                                                           adequate basis for evaluating internal con-
TREASURY TAX AND LOAN                                      trol in that deficiencies in areas not cov-
ACCOUNTS (31 CFR 203)                                      ered by this questionnaire do not signifi-
                                                           cantly impair any controls? Explain
  1. Do transfers from the remittance-option               negative answers briefly, and indicate any
     account to the Federal Reserve Bank occur             additional examination procedures deemed
     the next business day after deposit?                  necessary.
  2. When the note option is used, do transfers        *2. Are internal controls adequate on the basis
     from the Treasury Tax and Loan (TT&L)                 of a composite evaluation, as evidenced by
     demand deposit account occur the next                 answers to the foregoing questions?

November 2004                                                     Commercial Bank Examination Manual
Page 6
Borrowed Funds
Effective date October 2008                                                   Section 3010.1

Borrowed funds are a common and practical            its own merit to determine its purpose, effective-
method for banks of all sizes to meet customers’     ness, and stability. Some of the more frequently
needs and enhance banking operations. For the        used sources of borrowings are discussed below.
purposes of this section, borrowings exclude
long-term subordinated debt, such as capital
notes and debentures (discussed in ‘‘Assessment
of Capital Adequacy,’’ section 3020.1). Borrow-      COMMON SOURCES OF
ings may exist in a number of forms, both on a       BORROWINGS
direct and indirect basis. Common sources of
direct bank borrowings include Federal Home
Loan Bank credit lines, federal funds purchased,     Federal Home Loan Bank Borrowings
loans from correspondent banks, repurchase
agreements, negotiable certificates of deposit,
and borrowings from the Federal Reserve dis-         The Federal Home Loan Bank (FHLB) origi-
count window. These are discussed in some            nally served solely as a source of borrowings to
detail below. Other borrowings include bills         savings and loan companies. With the imple-
payable to the Federal Reserve, interest-bearing     mentation of the Financial Institutions Reform,
demand notes issued to the U.S. Treasury (the        Recovery, and Enforcement Act of 1989
Treasury tax and loan note option account),          (FIRREA), FHLB’s lending capacity was
mortgages payable, due bills, and other types of     expanded to include banks.
borrowed securities. Indirect forms of borrow-          Compared with borrowings from the discount
ings include customer paper rediscounted and         window of the Reserve Banks, borrowings from
assets sold with the bank’s endorsement or           the FHLB have fewer conditions. Both short-
guarantee or subject to a repurchase agreement.      term and long-term borrowings, with maturities
   The primary reasons a bank may borrow             ranging from overnight to 30 years, are avail-
include the following:                               able to institutions at generally competitive
                                                     interest rates. The flexibility of the facility
• To meet the temporary or seasonal loan or          enables bank management to use this source of
  deposit withdrawal needs of its customers, if      funds for the purpose of asset/liability manage-
  the borrowing period is temporary and the          ment, and it allows management to secure a
  bank is quickly restored to a position in which    favorable interest-rate spread. For example,
  the quantity of its principal earning assets and   FHLB borrowings may provide a lower-cost
  cash reserves is in proper relation to the         alternative to the conventional deposit, particu-
  requirements of its normal deposit                 larly in a highly competitive local market.
  volume.                                               Management should be capable of explaining
• To meet large and unanticipated deposit with-      the purpose of the borrowing transaction. The
  drawals that may arise during periods of           borrowing transaction should then be analyzed
  economic distress. The examiner should dis-        to determine whether the arrangement achieved
  tinguish between ‘‘large and unanticipated         the stated purpose or whether the borrowings are
  deposit withdrawals’’ and a predeterminable        a sign of liquidity deficiencies. Further, the
  contraction of deposits, such as the cessation     borrowing agreement between the institution
  of activities in a resort community or the         and the FHLB should be reviewed to determine
  withdrawal of funds on which the bank              the asset collateralizing the borrowings and the
  received adequate prior withdrawal notice.         potential risks presented by the agreement. In
  Those situations should be met through ample       some instances, the borrowing agreement may
  cash reserves and readily convertible assets       provide for collateralization by all assets not
  rather than borrowing.                             already pledged for other purposes.
• To manage liabilities effectively. Generally,         The types of collateral necessary to obtain an
  the effective use of this type of continuous       FHLB loan include residential mortgage loans
  borrowing is limited to money-center or large      and mortgage-backed securities. The composite
  regional banks.                                    rating of an institution is a factor in both the
                                                     approval for obtaining an FHLB loan and the
  It is important to analyze each borrowing on       level of collateral required.

Commercial Bank Examination Manual                                                        October 2008
                                                                                                Page 1
3010.1                                                                                    Borrowed Funds

Federal Funds Purchased                              periods of time. Agency-based federal funds
                                                     transactions are discussed in ‘‘Bank Dealer
The day-to-day use of federal funds is a rather      Activities,’’ section 2030.1.
common occurrence, and federal funds are con-
sidered an important money market instrument.
Many regional and money-center banks, acting         Loans from Correspondent Banks
in the capacity of correspondents to smaller
community banks, function as both providers          Small and medium-sized banks often negotiate
and purchasers of federal funds and, in the          loans from their principal correspondent banks.
process of these transactions, often generate a      The loans are usually for short periods and may
small return.                                        be secured or unsecured.
   A brief review of bank reserves is essential to
a discussion of the federal funds market. As a
condition of membership in the Federal Reserve       Repurchase Agreements
System, member banks are required to maintain
a portion of their deposits as reserves. Reserves    The terms ‘‘repurchase agreement’’1 (repo) and
can take the form of vault cash and deposits in      ‘‘reverse repurchase agreement’’ refer to a type
the Reserve Bank. The amount of these reserve        of transaction in which a money market partici-
balances is reported weekly or quarterly and         pant acquires immediately available funds by
computed on the basis of the daily average           selling securities and simultaneously agreeing to
deposit balances. For institutions that report       repurchase the securities after a specified time at
their reserves on a weekly basis, required           a given price, which typically includes interest
reserves are computed on the basis of daily          at an agreed-on rate. Such a transaction is called
average balances of deposits and Eurocurrency        a repo when viewed from the perspective of the
liabilities during a 14-day period ending every      supplier of the securities (the borrower), and a
second Monday. Institutions that report their        reverse repo or matched sale-purchase agree-
reserves on a quarterly basis compute their          ment when described from the point of view of
reserve requirement on the basis of their daily      the supplier of funds (the lender).
average deposit balances during a seven-day             Frequently, instead of resorting to direct bor-
computation period that begins on the third          rowings, a bank may sell assets to another bank
Tuesday of March, June, September, and Decem-        or some other party and simultaneously agree to
ber. (See 12 CFR 204.3(c)–(d).)                      repurchase the assets at a specified time or after
   Since member banks do not receive interest        certain conditions have been met. Bank securi-
on the reserves, banks prefer to keep excess         ties as well as loans are often sold under a repo
balances at a minimum to achieve the maximum         to generate temporary working funds. These
utilization of funds. To accomplish this goal,       kind of agreements are often used because the
banks carefully analyze and forecast their daily     rate on this type of borrowing is less than the
reserve position. Changes in the volume of           rate on unsecured borrowings, such as federal
required reserves occur frequently as the result     funds purchased.
of deposit fluctuations. Deposit increases require       The usual terms for the sale of securities
member banks to maintain more reserves; con-         under a repo require that, after a stated period of
versely, deposit decreases require less reserves.    time, the seller repurchase the securities at a
   The most frequent type of federal funds           predetermined price or yield. A repo commonly
transaction is unsecured for one day and repay-      includes a near-term maturity (overnight or a
able the following business day. The rate is         few days) and is usually arranged in large-dollar
usually determined by overall money market           amounts. The lender or buyer is entitled to
rates as well as by the available supply of and      receive compensation for use of the funds pro-
demand for funds. In some instances, when the        vided to its counterparty. The interest rate paid
selling and buying relationship between two          on a repo is negotiated based on the rates on the
banks is quite continuous, something similar to      underlying securities. U.S. government and
a line of credit may be established on a funds-      agency securities are the most common type of
availability basis. Although the most common
federal funds transaction is unsecured, the sell-
ing of funds can also be secured and for longer        1. See sections 2015.1, 2020.1, and 4170.1.

October 2008                                                       Commercial Bank Examination Manual
Page 2
Borrowed Funds                                                                                         3010.1

instruments sold under repurchase agreements,          financial condition of those institutions and
since those types of repos are exempt from             brokers with whom they engage in repurchase
reserve requirements.                                  transactions.
   Although standard overnight and term repo              ‘‘Retail repurchase agreements’’ (retail repos)2
arrangements in Treasury and federally related         for a time were a popular vehicle for some
agency securities are most prevalent, market           commercial banks to raise short-term funds and
participants sometimes alter various contract          compete with certain instruments offered by
provisions to accommodate specific investment           nonbanking competitors. For booking purposes,
needs or to provide flexibility in the designation      a retail repo is a debt incurred by the issuing
of collateral. For example, some repo contracts        bank that is collateralized by an interest in a
allow substitutions of the securities subject to       security that is either a direct obligation of or
the repurchase commitment. These are called            guaranteed as to principal and interest by the
‘‘dollar repurchase agreements’’ (dollar rolls),       U.S. government or an agency thereof. Retail
and the initial seller’s obligation is to repurchase   repos are issued in amounts not exceeding
securities that are substantially similar, but not     $100,000 for periods of less than 90 days. With
identical, to the securities originally sold.          the advent of money market certificates issued
Another common repo arrangement is called a            by commercial banks, the popularity of the retail
‘‘flex repo,’’ which, as implied by the name,           repo declined.
provides a flexible term to maturity. A flex repo           Both retail and large-denomination, whole-
is a term agreement between a dealer and a             sale repurchase agreements are in many respects
major customer in which the customer buys              equivalent to short-term borrowings at market
securities from the dealer and may sell some of        rates of interest. Therefore, banks engaging in
them back before the final maturity date.               repurchase agreements should carefully evaluate
   Bank management should be aware of certain          their interest-rate-risk exposure at various matu-
considerations and potential risks of repurchase       rity levels, formulate policy objectives in light
agreements, especially when entering into large-       of the institution’s entire asset and liability mix,
dollar-volume transactions with institutional          and adopt procedures to control mismatches
investors or brokers. Both parties in a term repo      between assets and liabilities. The degree to
arrangement are exposed to interest-rate risk. It      which a bank borrows through repurchase agree-
is a fairly common practice to have the collateral     ments also should be analyzed with respect to its
value of the underlying securities adjusted daily      liquidity needs, and contingency plans should
to reflect changes in market prices and to main-        provide for alternative sources of funds.
tain the agreed-on margin. Accordingly, if the
market value of the repo securities declines
appreciably, the borrower may be asked to              Negotiable Certificates of Deposit
provide additional collateral. Conversely, if the
market value of the securities rises substantially,    Certificates of deposit (CDs) have not been
the lender may be required to return the excess        legally defined as borrowings and continue to be
collateral to the borrower. If the value of the        reflected as deposits for reporting purposes.
underlying securities exceeds the price at which       However, the fundamental distinction between a
the repurchase agreement was sold, the bank            negotiable money market CD as a deposit or as
could be exposed to the risk of loss if the buyer      a borrowing is nebulous at best; in fact, the
is unable to perform and return the securities.        negotiable money market CD is widely recog-
This risk would obviously increase if the secu-        nized as the primary borrowing vehicle for
rities are physically transferred to the institution   many banks. Dependence on CDs as sources of
or broker with which the bank has entered into         funds is discussed in ‘‘Deposit Accounts,’’ sec-
the repurchase agreement. Moreover, if the             tion 3000.1.
securities are not returned, the bank could be
exposed to the possibility of a significant write-
off, to the extent that the book value of the
securities exceeds the price at which the securi-
ties were originally sold under the repurchase
agreement. For this reason, banks should avoid
pledging excessive collateral and obtain suffi-
cient financial information on and analyze the            2. See sections 2015.1, 2020.1, and 4170.1.

Commercial Bank Examination Manual                                                                October 2008
                                                                                                        Page 3
3010.1                                                                                               Borrowed Funds

Borrowings from the Federal Reserve                                 Primary Credit

In accordance with the Board’s Regulation A                         Reserve Banks may extend primary credit on a
                                                                    very short term basis (typically overnight) to
(12 CFR 201), the Federal Reserve Banks gen-
                                                                    depository institutions that the Reserve Banks
erally make credit available through the pri-
                                                                    judge to be in generally sound financial condi-
mary, secondary, and seasonal credit programs
                                                                    tion. Reserve Banks extend primary credit at a
to any depository institution that maintains trans-
                                                                    rate above the target federal funds rate of the
action accounts or nonpersonal time deposits.3                      Federal Open Market Committee. Minimal
However, the Federal Reserve expects deposi-                        administrative requirements apply to requests
tory institutions to rely on market sources of                      for overnight primary credit, unless some aspect
funds for their ongoing funding needs and to use                    of the credit request appears inconsistent with
these credit programs as a backup source of                         the conditions of primary credit (for example, if
funding rather than a routine one. An institution                   a pattern of behavior indicates strongly that an
that borrows primary credit may use those funds                     institution is using primary credit other than as a
to finance sales of federal funds, but secondary                     backup source of funding). Reserve Banks also
and seasonal credit borrowers may not act as the                    may extend primary credit to eligible institu-
medium or agent of another depository institu-                      tions for periods of up to several weeks if such
tion in receiving Federal Reserve credit except                     funding is not available from other sources.
with the permission of the lending Federal                          However, longer-term extensions of primary
Reserve Bank.                                                       credit will be subject to greater administration
   A Federal Reserve Bank is not obligated to                       than are overnight loans.
extend credit to any depository institution but                         Reserve Banks determine eligibility for pri-
may lend to a depository institution either by                      mary credit according to a uniform set of criteria
making an advance secured by acceptable col-                        that also is used to determine eligibility for
lateral or by discounting certain types of paper                    daylight credit under the Board’s Policy State-
described in the Federal Reserve Act. Although                      ment on Payments System Risk. These criteria
Reserve Banks now always extend credit in the                       are based mainly on examination ratings and
form of an advance, the Federal Reserve’s credit                    capitalization, although Reserve Banks also may
facility nonetheless is known colloquially as the                   use supplementary information, including market-
‘‘discount window.’’ Before lending to a deposi-                    based information when available. Specifically,
tory institution, a Reserve Bank can require any                    an institution that is at least adequately capital-
information it believes is appropriate to ensure                    ized and rated CAMELS 1 or 2 (or SOSA 1 and
that the assets tendered as collateral are accept-                  ROCA 1, 2, or 3) almost certainly would be
able. A Reserve Bank also should determine                          eligible for primary credit. An institution that is
prior to lending whether the borrowing institu-                     at least adequately capitalized and rated CAMELS
                                                                    3 (or SOSA 2 and ROCA 1, 2, or 3) generally
tion is undercapitalized or critically undercapi-
                                                                    would be eligible. An institution that is at least
talized. Operating Circular No. 10, ‘‘Lending,’’
                                                                    adequately capitalized and rated CAMELS 4 (or
establishes the credit and security terms for
                                                                    SOSA 1 or 2 and ROCA 4 or 5) would be
borrowings from the Federal Reserve.
                                                                    eligible only if an ongoing examination indi-
                                                                    cated a substantial improvement in condition.
                                                                    An institution that is not at least adequately
                                                                    capitalized, or that is rated CAMELS 5 (or
   3. In unusual and exigent circumstances and after consul-
tation with the Board, a Reserve Bank may extend credit to
                                                                    SOSA 3 regardless of the ROCA rating), would
individuals, partnerships, and corporations that are not deposi-    not be eligible for primary credit.
tory institutions if, in the judgment of the Reserve Bank, credit
is not available from other sources and failure to obtain credit
would adversely affect the economy. A Reserve Bank may
extend credit to a nondepository entity in the form of an           Secondary Credit
advance only if the advance is secured by a direct obligation
of the United States or a direct obligation of, or an obligation    Secondary credit is available to institutions that
that is fully guaranteed as to principal and interest by, any       do not qualify for primary credit. Secondary
agency of the United States. An extension of credit secured by
any other type of collateral must be in the form of a discount
                                                                    credit is available as a backup source of liquidity
and must be authorized by an affirmative vote of at least five        on a very short term basis, provided that the loan
members of the Board.                                               is consistent with a timely return to a reliance on

October 2008                                                                     Commercial Bank Examination Manual
Page 4
Borrowed Funds                                                                                                3010.1

market sources of funds. Longer-term secondary          house arrangement. Collateral may also be held
credit is available if necessary for the orderly        at the borrowing institution’s correspondent or
resolution of a troubled institution, although any      another third party. All book-entry collateral
such loan would have to comply with additional          must be held at the Federal Reserve Bank.
requirements for lending to undercapitalized and        Definitive collateral, not in bearer form, must be
critically undercapitalized institutions. Unlike        properly assigned and endorsed.
the primary credit program, secondary credit is
not a minimal administration facility because
Reserve Banks must obtain sufficient informa-            Lending to Undercapitalized and
tion about a borrower’s financial situation to           Critically Undercapitalized Depository
ensure that an extension of credit complies with        Institutions
the conditions of the program. Secondary credit
is available at a rate above the primary credit         Credit from any Reserve Bank to an institution
rate.                                                   that is ‘‘undercapitalized’’ may be extended or
                                                        outstanding for no more than 60 days during
                                                        which the institution is undercapitalized in any
Seasonal Credit                                         120-day period.4 An institution is considered
                                                        undercapitalized if it is not critically undercapi-
Seasonal credit is available under limited con-         talized under section 38 of the Federal Deposit
ditions to meet the needs of depository institu-        Insurance Act (the FDI Act) but is either deemed
tions that have seasonal patterns of movement in        undercapitalized under that provision and its
deposits and loans but that lack ready access to        implementing regulations or has received a com-
national money markets. In determining a deposi-        posite CAMELS rating of 5 as of the most
tory institution’s eligibility for seasonal credit,     recent examination. A Reserve Bank may make
Reserve Banks consider not only the institu-            or have outstanding advances or discounts to an
tion’s historical record of seasonal fluctuations        institution that is deemed ‘‘critically undercapi-
in loans and deposits, but also the institution’s       talized’’ under section 38 of the FDI Act and its
recent and prospective needs for funds and its          implementing regulations only during the five-day
liquidity conditions. Generally, only very small        period beginning on the date the institution
institutions with pronounced seasonal funding           became critically undercapitalized or after con-
needs will qualify for seasonal credit. Seasonal        sultation with the Board.
credit is available at a flexible rate that takes into
account the rate for market sources of funds.

Collateral Requirements                                 INTERNATIONAL BORROWINGS

All loans advanced by the Reserve Bank must             International borrowings may be direct or indi-
be secured to the satisfaction of the Reserve           rect. Common forms of direct international bor-
Bank. Collateral requirements are governed by           rowings include loans and short-term call money
Operating Circular No. 8. Reserve Banks re-             from foreign banks, borrowings from the Export-
quire a perfected security interest in all collat-      Import Bank of the United States, and over-
eral pledged to secure loans. Satisfactory collat-      drawn nostro (due from foreign banks—demand)
eral generally includes U.S. government and             accounts. Indirect forms of borrowing include
federal-agency securities, and, if they are of          notes and trade bills rediscounted with the
acceptable quality, mortgage notes covering one-        central banks of various countries; notes, accep-
to four-family residences; state and local gov-         tances, import drafts, or trade bills sold with the
ernment securities; and business, consumer, and         bank’s endorsement or guarantee; notes and
other customer notes. Traditionally, collateral is      other obligations sold subject to repurchase
held in the Reserve Bank vault. Under certain           agreements; and acceptance pool participations.
circumstances, collateral may be retained on the
borrower’s premises under a borrower-in-
                                                          4. Generally, a Reserve Bank also may lend to an under-
custody arrangement, or it may be held on the           capitalized institution during 60 calendar days after receipt of
borrower’s premises under the Reserve Bank’s            a certificate of viability from the Chairman of the Board of
exclusive custody and control in a field ware-           Governors or after consultation with the Board.

Commercial Bank Examination Manual                                                                         May 2003
                                                                                                             Page 5
3010.1                                                                               Borrowed Funds

ANALYZING BORROWINGS                                do not generally have ready access to alternative
                                                    sources of funds available to larger institutions
If a bank borrows extensively or in large           through the money and capital markets. Bro-
amounts, the examiner should thoroughly ana-        kered deposits generally carry higher interest
lyze the borrowing activity. An effective analy-    rates than alternative sources, and they tend to
sis includes a review of the bank’s reserve         be particularly susceptible to interest-rate changes
records, both required and maintained, to deter-    in the overall financial market. For further
mine the frequency of deficiencies at the closing    discussion of brokered deposits, see ‘‘Deposit
of reserve periods. The principal sources of        Accounts,’’ section 3000.1.
borrowings, range of amounts, frequency, length        Other indicators of deterioration in a bank’s
of time indebted, cost, and reasons for the         borrowing ability and overall creditworthiness
borrowings should be explored. The actual use       include, but are not limited to, requests for
of the funds should be verified.                     collateral on previously unsecured credit lines or
   Examiners should also analyze changes in a       increases in collateral margins, the payment of
bank’s borrowing position for signs of deterio-     above-market interest rates, or a shortening of
ration in its borrowing ability and overall cred-   maturities that is inconsistent with manage-
itworthiness. One indication of deterioration is    ment’s articulated balance-sheet strategies. If
the payment of large fees to money brokers to       the examiner finds that a bank’s borrowing
obtain funds because the bank is having diffi-       position is not properly managed, appropriate
culty obtaining access to conventional sources      comments should be included in the report of
of borrowings. These ‘‘brokered deposits’’ are      examination.
usually associated with small banks since they

May 2003                                                         Commercial Bank Examination Manual
Page 6
Borrowed Funds
Examination Objectives
Effective date May 1996                                                     Section 3010.2

1. To determine if the policies, practices, pro-   4. To determine compliance with laws and
   cedures, and internal controls for borrowed        regulations.
   funds are adequate.                             5. To initiate corrective action when policies,
2. To determine if bank officers are operating in      practices, procedures, or internal controls are
   conformance with the established guidelines.       deficient or when violations of laws or regu-
3. To determine the scope and adequacy of the         lations have been noted.
   audit function.

Commercial Bank Examination Manual                                                         May 1996
                                                                                             Page 1
Borrowed Funds
Examination Procedures
Effective date October 2008                                                   Section 3010.3

 1. If selected for implementation, complete or             rowing agreements for indications of
    update the Borrowed Funds section of the                deteriorating credit position by noting—
    Internal Control Questionnaire.                         • recent substantive changes in borrow-
 2. Based on the evaluation of internal controls              ing agreements,
    and the work performed by the internal/                 • increases in collateral to support bor-
    external auditors, determine the scope of the             rowing transactions,
    examination.                                            • general shortening of maturities,
 3. Test for compliance with policies, practices,           • interest rates exceeding prevailing mar-
    procedures, and internal controls in conjunc-             ket rates,
    tion with performing the remaining exami-               • frequent changes in lenders, and
    nation procedures. Also obtain a listing of             • large fees paid to money brokers.
    any audit deficiencies noted in the latest           c. If the bank has obtained funds from
    review done by internal/external auditors               money brokers (brokered deposits),
    from the examiner assigned to ‘‘Internal                determine—
    Control’’ and determine if appropriate cor-             • why such deposits were originally
    rections have been made.                                  obtained,
 4. Obtain the listing of accounts related to               • who the deposits were obtained from,
    domestic and international borrowed funds               • what the funds are used for,
    from the examiner assigned to ‘‘Examina-                • the relative cost of brokered deposits
    tion Strategy.’’                                          in comparison to alternate sources of
 5. Prepare or obtain a listing of borrowings, by             funds, and
    type, and—                                              • the overall effect of the use of
    a. agree or reconcile balances to depart-                 brokered deposits on the bank’s con-
        ment controls and general ledger, and                 dition and whether there appear to be
    b. review reconciling items for reason-                   any abuses related to the use of such
        ableness.                                             deposits.
 6. From consultation with the examiners                d. If there is an indication that the bank’s
    assigned to the various loan areas, deter-              credit position has deteriorated, ascertain
    mine that the following schedules were                  why.
    reviewed in the lending departments and          9. If the bank engages in the issuance of retail
    that there was no endorsement, guarantee,           repurchase agreements (retail repos), check
    or repurchase agreement which would                 for compliance with section 4170.1; also
    constitute a borrowing:                             2015.1 and 2020.1.
                                                    10. Determine the purpose of each type of
    a. participations sold
                                                        borrowing and conclude whether the bank’s
    b. loans sold in full since the preceding           borrowing posture is justified in light of
        examination                                     its financial condition and other relevant
 7. Based on the information obtained in steps          circumstances.
    5 and and 6, and through observation and        11. Provide the examiner assigned to ‘‘Asset/
    discussion with management and other                Liability Management’’ the following
    examining personnel, determine that all bor-        information:
    rowings are properly reflected on the books          a. A summary and an evaluation of the
    of the bank.                                            bank’s borrowing policies, practices, and
 8. If the bank engages in any form of borrow-              procedures. The evaluation should give
    ing which requires written borrowing                    consideration to whether the bank—
    agreement(s), complete the following:                   • evaluates interest-rate-risk exposure at
    a. Prepare or update a carry-forward work-                various maturity levels;
        paper describing the major terms of each            • formulates policy objectives in light of
        borrowing agreement, and determine that               the entire asset and liability mix, and
        the bank is complying with those terms.               liquidity needs;
    b. Review terms of past and present bor-                • has adopted procedures to control mis-

Commercial Bank Examination Manual                                                       October 2008
                                                                                               Page 1
3010.3                                                     Borrowed Funds: Examination Procedures

          matches between assets and liabilities;         b. low point
          and                                             c. average amounts outstanding
       • has contingency plans for alternate              d. frequency of borrowing and lending activ-
          sources of funds in the event of a                 ity, expressed in terms of number of days
          run-off of current funding sources.         13. Prepare, in appropriate report form, and
    b. An evaluation of the bank’s adherence to           discuss with appropriate management—
       established policies and procedures.               a. the adequacy of written policies regard-
    c. A repricing maturity schedule of                      ing borrowings;
       borrowings.                                        b. the manner in which bank officers are
    d. A listing of prearranged federal funds                operating in conformance with estab-
       lines and other lines of credit. Indicate             lished policy;
       the amount currently available under               c. the existence of any unjustified borrow-
       those lines, i.e., the unused portion of the          ing practices;
       lines.                                             d. any violation of laws or regulations; and
    e. The amount of any anticipated decline in           e. recommended corrective action when
       borrowings over the next                              policies, practices, or procedures are
       day period. (The time period will be                  deficient; violations of laws or regula-
       determined by the examiner assigned to                tions exist; or when unjustified borrow-
       ‘‘Asset/Liability Management.’’)                      ing practices are being pursued.
12. Prepare a list of all borrowings by category,     14. Update the workpapers with any informa-
    on a daily basis for the period since the             tion that will facilitate future examinations.
    last examination. Also, include on the list       15. Review the market value of collateral and
    short-term or overnight money market                  collateral-control arrangements for repur-
    lending activities such as federal funds              chase agreements to ensure that excessive
    sold and securities purchased under resale            collateral has not been pledged and that the
    agreement. For each category on the list,             bank is not exposed to excessive credit
    compute for the period between                        risks.
    a. high point

October 2008                                                      Commercial Bank Examination Manual
Page 2
Borrowed Funds
Internal Control Questionnaire
Effective date March 1984                                                    Section 3010.4

Review the bank’s controls, policies, practices          c. Prepare all supporting documents
and procedures for obtaining and servicing bor-             required for payment of debt?
rowed funds. The bank’s system should be             *4. Are subsidiary borrowed funds records
documented in a complete and concise manner              reconciled with the general ledger accounts
and should include, where appropriate, narrative         at an interval consistent with borrowing
descriptions, flowcharts, copies of forms used            activity, and are the reconciling items
and other pertinent information. Items marked            investigated by persons, who do not also:
with an asterisk require substantiation by obser-        a. Handle cash?
vation or testing.                                       b. Prepare or post to the subsidiary bor-
                                                            rowed funds records?

  1. Has the board of directors approved a
     written policy which:                           *5. Are individual interest computations
     a. Outlines the objectives of bank                  checked by persons who do not have
        borrowings?                                      access to cash?
     b. Describes the bank’s borrowing philos-        6. Is an overall test of the total interest paid
        ophy relative to risk considerations,            made by persons who do not have access
        i.e., leverage/growth, liquidity/income?         to cash?
     c. Provides for risk diversification in terms     7. Are payees on the checks matched to
        of staggered maturities rather than solely       related records of debt, note or debenture
        on cost?                                         owners?
     d. Limits borrowings by amount outstand-         8. Are corporate resolutions properly pre-
        ing, specific type or total interest              pared as required by creditors and are
        expense?                                         copies on file for reviewing personnel?
     e. Limits or restricts execution of borrow-      9. Are monthly reports furnished to the board
        ings by bank officers?                            of directors reflecting the activity of bor-
     f. Provides a system of reporting require-          rowed funds, including amounts outstand-
        ments to monitor borrowing activity?             ing, interest rates, interest paid to date and
     g. Requires subsequent approval of                  anticipated future activity?
     h. Provides for review and revision of
        established policy at least annually?        CONCLUSION
                                                     10. Is the foregoing information an adequate
RECORDS                                                  basis for evaluating internal control in that
                                                         there are no significant deficiencies in
 *2. Does the bank maintain subsidiary records           areas not covered in this questionnaire
     for each type of borrowing, including               that impair any controls? Explain negative
     proper identification of the obligee?                answers briefly, and indicate any addi-
 *3. Is the preparation, addition and posting of         tional examination procedures deemed
     the subsidiary borrowed funds records per-          necessary.
     formed or adequately reviewed by persons        11. Based on a composite evaluation, as
     who do not also:                                    evidenced by answers to the foregoing
     a. Handle cash?                                     questions, internal control is considered
     b. Issue official checks and drafts?                 (adequate/inadequate).

Commercial Bank Examination Manual                                                         March 1994
                                                                                               Page 1
Complex Wholesale Borrowings
Effective date May 2001                                                                      Section 3012.1

Commercial banks rely on wholesale borrow-                         the borrowing (or borrowings), and (3) identify
ings obtained from a number of financial inter-                     the potential risks presented by the agreement.
mediaries, including Federal Home Loan Banks,                      (See SR-01-8.)
other commercial banks, and securities firms.                          In addition to determining if a bank follows
These borrowings frequently have attractive fea-                   the sound-practice guidance for bank liability
tures and pricing. If properly assessed and                        management and funding in general, supervisors
prudently managed, they can enhance a bank’s                       should take the following steps, as appropriate,
funding options and assist in controlling interest-                when assessing a bank that has material amounts
rate and liquidity risks. Some of the reasons that                 of wholesale borrowings:
banks use these types of borrowings include the
initial low cost of funds when compared with                       • Review the bank’s borrowing contracts for
other liabilities with similar maturities. At the                    embedded options or other features that may
same time, certain wholesale borrowings have                         affect the bank’s liquidity and sensitivity to
become more complex, and some structures                             market risks. In addition, examiners should
include various types of embedded options.1 If                       review the collateral agreements for fees,
not thoroughly assessed and prudently managed,                       collateral-maintenance requirements (includ-
these more complex funding instruments have                          ing triggers for increases in collateral), and
the potential over time to significantly increase a                   other features that may affect the bank’s
bank’s sensitivity to market and liquidity risks.                    liquidity and earnings.
Maturity mismatches or the embedded options                        • Assess the bank’s management processes for
themselves can, in some circumstances, ad-                           identifying and monitoring the risks of the
versely affect a bank’s financial condition, espe-                    various terms of each borrowing contract,
cially when the terms and conditions of the                          including penalties and option features over
borrowings are misunderstood.                                        the expected life of the contract. Examiners
   A growing use of wholesale borrowings,                            should review for evidence that the bank’s
combined with the risks associated with the                          management, or an independent third party,
complex structures of some of these borrowings,                      completed stress tests (1) before the bank
makes it increasingly important for bank super-                      entered into the borrowing agreement (or
visors to assess the risks and risk-management                       agreements) and (2) periodically thereafter. If
processes associated with these sources of funds.                    the bank relies on independent third-party
The supervisory guidance provided below supple-                      testing, examiners should verify that manage-
ments and expands upon existing general guid-                        ment reviewed and accepted the underlying
ance on bank funding and borrowings.2 Where                          assumptions and test results. In any case,
appropriate, examiners should (1) review the                         management should not be relying solely on
provisions of each significant borrowing agree-                       the wholesaler’s stress-test results. Also, the
ment between the bank and the wholesale insti-                       stress tests employed should cover a reason-
tution, (2) determine what assets collateralize                      able range of contractual triggers and external
                                                                     events. Such triggers or events include interest-
                                                                     rate changes that may result in the exercise of
   1. Wholesale borrowings with embedded options may have
variable interest payments or average lives or redemption            embedded options or the bank’s termination
values that depend on external measures such as reference            of the agreement, which may entail prepay-
rates, indexes, or formulas. Embedded options include putable,       ment penalties. In general, stress-test results
callable, convertible, and variable rate advances with caps,         should depict the potential impact of these
floors, collars, step-ups, or amortizing features. In addition,
these types of borrowings may contain prepayment penalties.          variables on the individual borrowing facility,
   2. See the supervisory guidance for ‘‘Borrowed Funds,’’           as well as on the overall earnings and liquidity
section 3010.1; ‘‘Asset/Liability Management,’’ section 4020.1;      position of the bank.
and ‘‘Interest-Rate Risk Management,’’ section 4090.1. See
also the Trading and Capital-Markets Activities Manual,
                                                                   • Evaluate management processes for control-
sections 2030.1, ‘‘Liquidity Risk,’’ and 3010.1, ‘‘Interest-Rate     ling risks, including interest-rate risks arising
Risk Management.’’ In general, this guidance collectively            from the borrowings and liquidity risks. Proper
calls for supervisors to analyze the purpose, effectiveness,         controls include (1) hedges or other plans for
concentration exposure, and stability of borrowings and to
assess bank management’s understanding of liquidity and
                                                                     minimizing the adverse effects of penalties or
interest-rate risks associated with borrowing and funding            interest-rate changes and other triggers for
strategies.                                                          embedded options and (2) contingent funding

Commercial Bank Examination Manual                                                                          May 2001
                                                                                                              Page 1
3012.1                                                             Complex Wholesale Borrowings

  plans if borrowings or lines are terminated         plex wholesale borrowings should not be
  before the original expected maturity.              using this funding.
• Determine whether the asset/liability manage-
  ment committee or board of directors, as          Reliance on wholesale borrowings is consistent
  appropriate, is fully informed of the risks and   with safe and sound banking when management
  ramifications of complex wholesale-borrowing       understands the risks of these activities and has
  agreements before engaging in the transac-        systems and procedures in place to properly
  tions and on an ongoing basis.                    monitor and control the risks. Supervisors and
• Determine whether funding strategies for          examiners, however, should take appropriate
  wholesale borrowings, especially those with       steps to follow up on institutions that use com-
  embedded options, are consistent with both        plex funding instruments without adequately
  the portfolio objectives of the bank and the      understanding their risks or without proper risk-
  level of sophistication of the bank’s risk        management systems and controls. Examiners
  management. Banks without the technical           should also seek corrective action when funding
  knowledge and whose risk-management sys-          mechanisms or strategies are inconsistent with
  tems are insufficient to adequately identify,      prudent funding needs and objectives.
  assess, monitor, and control the risks of com-

May 2001                                                        Commercial Bank Examination Manual
Page 2
Complex Wholesale Borrowings
Examination Objectives
Effective date May 2001                                                     Section 3012.2

1. To review the terms of wholesale-borrowing      3. To determine if the bank’s board of directors
   contracts to identify embedded options or          or its asset/liability management committee
   other features that may affect the bank’s          is fully aware of the risks associated with and
   liquidity and sensitivity to market risks.         ramifications of engaging in complex
2. To assess management’s technical knowl-            wholesale-borrowing agreements.
   edge, systems, and processes for identifying,   4. To ascertain whether the bank’s wholesale-
   assessing, monitoring, and controlling the         borrowing funding and hedging strategies are
   risks (including liquidity risk and interest-      consistent with its portfolio objectives and
   rate risk) associated with wholesale borrow-       the level of management’s sophistication.
   ing, and to assess the bank’s stress-testing
   practices and contingency-funding plans.

Commercial Bank Examination Manual                                                         May 2001
                                                                                             Page 1
Complex Wholesale Borrowings
Examination Procedures
Effective date May 2001                                                         Section 3012.3

1. Review the bank’s borrowing contracts to                 reviewed and accepted the underlying
   identify embedded options or other features              assumptions and test results.
   that may affect the bank’s liquidity and         3.   Evaluate the management processes for con-
   sensitivity to market risks. Also review the          trolling risks, including (1) interest-rate risks
   collateral agreements to determine what fees,         arising from the borrowings and (2) liquidity
   collateral-maintenance requirements (includ-          risks.
   ing triggers for increases in collateral), and   4.   Determine if the asset/liability management
   other agreed-upon features may affect the             committee or board of directors, as appropri-
   bank’s liquidity and earnings.                        ate, is fully informed of the risks and rami-
2. Assess the bank’s management processes for            fications of complex wholesale-borrowing
   identifying and monitoring the risks of the           agreements both before engaging in the trans-
   various terms of each borrowing contract,             actions and on an ongoing basis.
   including penalties and option features over     5.   Determine if funding strategies for whole-
   the expected life of the contract.                    sale borrowings, especially those with
   a. Obtain and examine evidence to deter-              embedded options, are consistent with both
      mine whether the bank’s management, or             the portfolio objectives of the bank and the
      an independent third party, completed              level of sophistication of the bank’s risk
      stress tests before the bank entered into          management.
      the borrowing agreement (or agreements)       6.   Seek the corrective action taken by the insti-
      and periodically thereafter.                       tution when funding mechanisms or strate-
   b. If the bank relies on independent third-           gies are inconsistent with prudent funding
      party testing, verify that management              needs and objectives.

Commercial Bank Examination Manual                                                             May 2001
                                                                                                 Page 1
Deferred Compensation Agreements
Effective date May 2005                                                        Section 3015.1

As part of their executive compensation and           tax benefit payments and the amount initially
retention programs, banks and other financial          invested to purchase the BOLI in the notional
institutions (collectively referred to in this sec-   amount, the hypothetical earnings reflect an
tion as ‘‘institutions’’) often enter into deferred   estimate of what the institution could have
compensation agreements with selected employ-         earned if it had not invested in the BOLI or
ees. These agreements are generally structured        entered into the IRP with the employee. Each
as nonqualified retirement plans for federal           employee’s IRP may have a different notional
income tax purposes and are based on individual       amount on which the index is based. The indi-
agreements with selected employees.                   vidual IRP agreements also specify the retire-
   Institutions often purchase bank-owned life        ment age and vesting provisions, which can vary
insurance (BOLI) in connection with many of           from employee to employee.
their deferred compensation agreements. (See             An IRP agreement typically requires the
sections 4042.1 and 2210.1 for an explanation of      excess earnings that accrue before an employ-
the accounting for BOLI transactions). BOLI           ee’s retirement to be recorded in a separate
may produce attractive tax-equivalent yields          liability account. Once the employee retires, the
that offset some or all of the costs of the           balance in the liability account is generally paid
agreements.                                           to the employee in equal, annual installments
   Deferred compensation agreements are com-          over a set number of years (for example, 10 or
monly referred to as indexed retirement plans         15 years). These payments are commonly
(IRPs) or as revenue-neutral plans. The institu-      referred to as the primary benefit or pre-
tion’s designated management and accounting           retirement benefit.
staff that is responsible for the institution’s          An employee may also receive the excess
financial reporting must regularly review the          earnings that are earned after his or her retire-
accounting for deferred compensation agree-           ment. This benefit may continue until the
ments to ensure that the obligations under the        employee’s death and is commonly referred to
agreements are appropriately measured and             as the secondary benefit or post-retirement bene-
reported in accordance with generally accepted        fit. The secondary benefit is paid annually, once
accounting principles (GAAP). In so doing, the        the employee has retired, and is in addition to
management and accounting staff should apply          the primary benefit.
and follow Accounting Principles Board Opin-             Examiners should be aware that some insti-
ion No. 12, ‘‘Omnibus Opinion—1967,’’ as              tutions may not be correctly accounting for the
amended by Statement of Financial Accounting          obligations under an IRP. Because many insti-
Standards No. 106 (FAS 106), ‘‘Employers’             tutions were incorrectly accounting for IRPs, the
Accounting for Postretirement Benefits Other           federal banking and thrift agencies issued on
Than Pensions’’ (hereafter referred to as APB         February 11, 2004, an Interagency Advisory on
12).                                                  Accounting for Deferred Compensation Agree-
   IRPs are one type of deferred compensation         ments and Bank-Owned Life Insurance. (See
agreement that institutions enter into with           SR-04-4.) The guidance is stated here, except
selected employees. IRPs are typically designed       for the information on the reporting of deferred
so that the spread each year, if any, between the     compensation agreement obligations in the bank
tax-equivalent earnings on the BOLI covering          Call Reports and on changes in accounting for
an individual employee and a hypothetical earn-       those agreements. Examiners should determine
ings calculation is deferred and paid to the          whether an institution’s deferred compensation
employee as a post-retirement benefit. This            agreements are correctly accounted for. If the
spread is commonly referred to as excess earn-        accounting is incorrect, assurance should be
ings. The hypothetical earnings are computed on       obtained from the institution’s management that
the basis of a predefined variable index rate (for     corrections will be made in accordance with
example, the cost of funds or the federal funds       GAAP and the advisory’s instructions for
rate) times a notional amount. The notional           changes in accounting. The examiner’s findings
amount is typically the amount the institution        should be reported in the examination report.
initially invested to purchase the BOLI plus          Also report the nature of the accounting errors
subsequent after-tax benefit payments actually         and the estimated financial impact that correct-
made to the employee. By including the after-         ing the errors will have on the institution’s

Commercial Bank Examination Manual                                                            May 2005
                                                                                                Page 1
3015.1                                                                          Deferred Compensation Agreements

financial statements, including its earnings and                   the current rate of return on high-quality fixed-
capital position.                                                 income debt securities2 should be the acceptable
                                                                  discount rates to measure deferred compensa-
                                                                  tion agreement obligations. An institution must
ACCOUNTING FOR DEFERRED                                           select and consistently apply a discount-rate
                                                                  policy that conforms with GAAP.
COMPENSATION AGREEMENTS,                                             For each IRP, an institution should calculate
INCLUDING IRPs                                                    the present value of the expected future benefit
                                                                  payments under the IRP at the employee’s full
Deferred compensation agreements with select
                                                                  eligibility date. The expected future benefit
employees under individual contracts generally
                                                                  payments can be reasonably estimated. They
do not constitute post-retirement income plans
                                                                  should be based on reasonable and supportable
(that is, pension plans) or post-retirement health
                                                                  assumptions and should include both the pri-
and welfare benefit plans. The accounting for
                                                                  mary benefit and, if the employee is entitled to
individual contracts that, when taken together,
                                                                  excess earnings that are earned after retirement,
do not represent a post-retirement plan should
                                                                  the secondary benefit. The estimated amount of
follow APB 12. If the individual contracts, taken
                                                                  these benefit payments should be discounted
together, are equivalent to a plan, the plan
                                                                  because the benefits will be paid in periodic
should be accounted for under Statement of
                                                                  installments after the employee retires. The
Financial Accounting Standards No. 87,
                                                                  number of periods the primary and any second-
‘‘Employers’ Accounting for Pensions,’’ or under
                                                                  ary benefit payments should be discounted may
FAS 106.
                                                                  differ because the discount period for each type
   APB 12 requires that an employer’s obliga-
                                                                  of benefit payment should be based on the
tion under a deferred compensation agreement
                                                                  length of time during which each type of benefit
be accrued according to the terms of the indi-
                                                                  will be paid, as specified in the IRP.
vidual contract over the required service period
                                                                     After the present value of the expected future
to the date the employee is fully eligible to
                                                                  benefit payments has been determined, the insti-
receive the benefits, or the full eligibility date.
                                                                  tution should accrue an amount of compensation
Depending on the individual contract, the full
                                                                  expense and a liability each year from the date
eligibility date may be the employee’s expected
                                                                  the employee enters into the IRP until the full
retirement date, the date the employee entered
                                                                  eligibility date. The amount of these annual
into the contract, or a date between these two
                                                                  accruals should be sufficient to ensure that a
dates. APB 12 does not prescribe a specific
                                                                  deferred compensation liability equal to the
accrual method for the benefits under deferred
                                                                  present value of the expected benefit payments
compensation contracts, stating only that the
                                                                  is recorded by the full eligibility date. Any
‘‘cost of those benefits shall be accrued over that
                                                                  method of deferred compensation accounting
period of the employee’s service in a systematic
                                                                  that does not recognize some expense for the
and rational manner.’’ The amounts to be accrued
                                                                  primary benefit and any secondary benefit in
each period should result in a deferred compen-
                                                                  each year from the date the employee enters into
sation liability at the full eligibility date that
                                                                  the IRP until the full eligibility date is not
equals the then-present value of the estimated
                                                                  considered to be systematic and rational.
benefit payments to be made under the indi-
                                                                     Vesting provisions should be reviewed to
vidual contract.
                                                                  ensure that the full eligibility date is properly
   APB 12 does not specify how to select the
                                                                  determined because this date is critical to the
discount rate to measure the present value of the
                                                                  measurement of the liability estimate. Because
estimated benefit payments. Therefore, other
                                                                  APB 12 requires that the present value of the
relevant accounting literature must be consid-
                                                                  expected benefit payments be recorded by the
ered in determining an appropriate discount rate.
                                                                  full eligibility date, institutions also need to
An institution’s incremental borrowing rate1 and
                                                                  consider changes in market interest rates to
                                                                  appropriately measure deferred compensation
   1. Accounting Principles Board Opinion No. 21, ‘‘Interest
on Receivables and Payables,’’ paragraph 13, states in part          2. FAS 106, paragraph 186, states that ‘‘[t]he objective of
that ‘‘the rate used for valuation purposes will normally be at   selecting assumed discount rates is to measure the single
least equal to the rate at which the debtor can obtain financing   amount that, if invested at the measurement date in a portfolio
of a similar nature from other sources at the date of the         of high-quality debt instruments, would provide the necessary
transaction.’’                                                    future cash flows to pay the accumulated benefits when due.’’

May 2005                                                                          Commercial Bank Examination Manual
Page 2
Deferred Compensation Agreements                                                                3015.1

liabilities. Therefore, to comply with APB 12,        Example 1: Fully Eligible at
institutions should periodically review both their    Agreement Inception
estimates of the expected future benefits under
IRPs and the discount rates used to compute the
                                                      A company enters into a deferred compensation
present value of the expected benefit payments,
                                                      agreement with a 55-year-old employee who has
and revise those estimates and rates, when
                                                      worked five years for the company. The agree-
                                                      ment states that, in exchange for the employee’s
   Deferred compensation agreements, includ-          past and future services and for his or her
ing IRPs, may include noncompete provisions           service as a consultant for two years after
or provisions requiring employees to perform          retirement, the company will pay an annual
consulting services during post-retirement years.     benefit of $20,000 to the employee, commenc-
If the value of the noncompete provisions can-        ing on the first anniversary of the employee’s
not be reasonably and reliably estimated, no          retirement. The employee is fully eligible for the
value should be assigned to the noncompete            deferred compensation benefit payments at the
provisions in recognizing the deferred compen-        inception of the agreement, and the consulting
sation liability. Institutions should allocate a      services are not substantive.
portion of the future benefit payments to con-
sulting services to be performed in post-             Other key facts and assumptions used in deter-
retirement years only if the consulting services      mining the benefits payable under the agreement
are determined to be substantive. Factors to          and in determining the liability and expense the
consider in determining whether post-retirement       company should record in each period are sum-
consulting services are substantive include but       marized in the following table:
are not limited to (1) whether the services are
required to be performed, (2) whether there is an
economic benefit to the institution, and
(3) whether the employee forfeits the benefits         Expected retirement age                        60
under the agreement for failure to perform such       Number of years to expected
services.                                               retirement age                                5
                                                      Discount rate (%)                            6.75
                                                      Expected mortality age based on
                                                        present age                                  70
COMPENSATION AGREEMENTS                               At the employee’s expected retirement date, the
                                                      present value of a lifetime annuity of $20,000
The following are examples of the full-eligibility-   that begins on that date is $142,109 (computed
date accounting requirements for a basic deferred     as $20,000 times 7.10545, the factor for the
compensation agreement. The assumptions used          present value of 10 annual payments at 6.75
in these examples are for illustrative purposes       percent). At the inception date of the agreement,
only. An institution must consider the terms of       the present value of that annuity of $102,514
its specific agreements, the current interest-rate     (computed as $142,109 times 0.721375, the
environment, and current mortality tables in          factor for the present value of a single payment
determining appropriate assumptions to use in         in five years at 6.75 percent) is recognized as
measuring and recognizing the present value of        compensation expense because the employee is
the benefits payable under its deferred compen-        fully eligible for the deferred compensation
sation agreements.                                    benefit at that date.
   Institutions that enter into deferred compen-         The following table summarizes one system-
sation agreements with employees, particularly        atic and rational method of recognizing the
more-complex agreements (such as IRPs), should        expense and liability under the deferred com-
consult with their external auditors and their        pensation agreement:
respective Federal Reserve Bank to determine
the appropriate accounting for their specific

Commercial Bank Examination Manual                                                            May 2005
                                                                                                Page 3
3015.1                                                        Deferred Compensation Agreements

             A               B               C               D              E             F
                                                          (B + C)                    (E + D – A)

                                                               Beginning-                 End-
           Benefit         Service       Interest  Compensation    of-year                of-year
 Year    payment ($)   component ($) component ($) expense ($) liability ($)          liability ($)

 0            –          102,514              –           102,514           –          102,514
 1            –             –               6,920           6,920        102,514       109,434
 2            –             –               7,387           7,387        109,434       116,821
 3            –             –               7,885           7,885        116,821       124,706
 4            –             –               8,418           8,418        124,706       133,124
 5            –             –               8,985           8,985        133,124       142,109
 6          20,000          –               9,593           9,593        142,109       131,702
 7          20,000          –               8,890           8,890        131,702       120,592
 8          20,000          –               8,140           8,140        120,592       108,732
 9          20,000          –               7,339           7,339        108,732        96,071
10          20,000          –               6,485           6,485         96,071        82,556
11          20,000          –               5,572           5,572         82,556        68,128
12          20,000          –               4,599           4,599         68,128        52,727
13          20,000          –               3,559           3,559         52,727        36,286
14          20,000          –               2,449           2,449         36,286        18,735
15          20,000          –               1,265           1,265         18,735             0
Totals     200,000       102,514           97,486         200,000

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

                                                                       Debit           Credit
Compensation expense                                                  $102,514
   Deferred compensation liability                                                    $102,514

[To record the column B service component]

In each period after the inception date of the      tion of the agreement, and revise the assump-
agreement, the company would adjust the             tions and rate, as appropriate.
deferred compensation liability for the interest       Assuming that no changes were necessary to
component and any benefit payment. In addi-          the assumptions used to determine the expected
tion, the company would reassess the assump-        future benefits under the agreement or to the
tions used in determining the expected future       discount rate used to compute the present value
benefits under the agreement and the discount        of the expected benefits, the following entry
rate used to compute the present value of the       would be made in year 1 to record the interest
expected benefits in each period after the incep-    component of the compensation expense:

May 2005                                                        Commercial Bank Examination Manual
Page 4
Deferred Compensation Agreements                                                              3015.1

                                                                         Debit            Credit
Compensation expense                                                     $6,920
   Deferred compensation liability                                                        $6,920

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

Similar entries (but for different amounts) would
be made in year 2 through year 15 to record the
interest component of the compensation expense.
   The following entry would be made in year 6
to record the payment of the annual benefit:

                                                                         Debit            Credit
Deferred compensation liability                                         $20,000
    Cash                                                                                 $20,000

[To record the column A benefit payment]

Similar entries would be made in year 7 through
year 15 to record the payment of the annual

Example 2: Fully Eligible at                         5.72213, the factor for the future value of five
Retirement Date                                      annual payments at 6.75 percent).
                                                        Other key facts and assumptions used in
If the terms of the contract described in example    determining the benefits payable under the agree-
1 had stated that the employee is only entitled to   ment and in determining the liability and expense
receive the deferred compensation benefit if the      the company should record in each period are
sum of the employee’s age and years of service       summarized in the following table:
equals 70 or more at the date of retirement, the
employee would be fully eligible for the deferred
compensation benefit at age 60, after rendering
                                                     Expected retirement age                        60
five more years of service. At the employee’s         Number of years to expected
expected retirement date, the present value of a       retirement age                                 5
lifetime annuity of $20,000 that begins on the
                                                     Discount rate (%)                             6.75
first anniversary of that date is $142,109 (com-
puted as $20,000 times 7.10545, the factor for       Expected mortality age based on
the present value of 10 annual payments at 6.75        present age                                  70
percent). The company would accrue this amount
in a systematic and rational manner over the
five-year period from the date it entered into the    The following table summarizes one systematic
agreement to the date the employee is fully          and rational method of recognizing the expense
eligible for the deferred compensation benefit.       and liability under the deferred compensation
Under one systematic and rational method, the        agreement:
annual service component accrual would be
$24,835 (computed as $142,109 divided by

Commercial Bank Examination Manual                                                          May 2005
                                                                                              Page 5
3015.1                                                           Deferred Compensation Agreements

             A                B                 C               D              E              F
                                                             (B + C)                     (E + D – A)

                                                               Beginning-                    End-
           Benefit         Service       Interest  Compensation    of-year                   of-year
 Year    payment ($)   component ($) component ($) expense ($) liability ($)             liability ($)

 1            –             24,835              –            24,835            –            24,835
 2            –             24,835            1,676          26,511          24,835         51,346
 3            –             24,835            3,466          28,301          51,346         79,647
 4            –             24,835            5,376          30,211          79,647        109,858
 5            –             24,835            7,416          32,251         109,858        142,109
 6          20,000            –               9,593           9,593         142,109        131,702
 7          20,000            –               8,890           8,890         131,702        120,592
 8          20,000            –               8,140           8,140         120,592        108,732
 9          20,000            –               7,339           7,339         108,732         96,071
10          20,000            –               6,485           6,485          96,071         82,556
11          20,000            –               5,572           5,572          82,556         68,128
12          20,000            –               4,599           4,599          68,128         52,727
13          20,000            –               3,559           3,559          52,727         36,286
14          20,000            –               2,449           2,449          36,286         18,735
15          20,000            –               1,265           1,265          18,735              0
Totals     200,000         124,175           75,825         200,000

No entry would be made at the inception date of
the agreement. The following entry would be
made in year 1 to record the service component
of the compensation expense and related deferred
compensation agreement liability:

                                                                          Debit            Credit
Compensation expense                                                     $24,835
   Deferred compensation liability                                                        $24,835

[To record the column B service component]

Similar entries would be made in year 2 through       tion liability for the interest component and any
year 5 to record the service component of the         benefit payment. In addition, the company would
compensation expense.                                 reassess the assumptions used in determining
   In each subsequent period, until the date the      the expected future benefits under the agreement
employee is fully eligible for the deferred com-      and the discount rate used to compute the
pensation benefit, the company would adjust the        present value of the expected benefits in each
deferred compensation liability for the total         period after the inception of the agreement, and
expense (the service and interest components).        revise the assumptions and rate, as appropriate.
In each period after the full eligibility date, the      Assuming no changes were necessary to the
company would adjust the deferred compensa-           assumptions used to determine the expected

May 2005                                                          Commercial Bank Examination Manual
Page 6
Deferred Compensation Agreements                                                      3015.1

future benefits under the agreement or to the
discount rate used to compute the present value
of the expected benefits, the following entry
would be made in year 2 to record the interest
component of the compensation expense:

                                                                  Debit           Credit
Compensation expense                                              $1,676
   Deferred compensation liability                                               $1,676

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

Similar entries (but for different amounts) would
be made in year 3 through year 15 to record the
interest component of the compensation expense.
   The following entry would be made in year 6
to record the payment of the annual benefit:

                                                                  Debit           Credit
Deferred compensation liability                                  $20,000
    Cash                                                                         $20,000

[To record the column A benefit payment]

Similar entries would be made in year 7 through
year 15 to record the payment of the annual

Commercial Bank Examination Manual                                                  May 2005
                                                                                      Page 7
Assessment of Capital Adequacy
Effective date April 2011                                                             Section 3020.1

Although both bank directors and bank regula-         definition of capital and a framework for calcu-
tors must look carefully at the quality of bank       lating risk-weighted assets by assigning assets
assets and management and at the ability of the       and off-balance-sheet items to broad categories
bank to control costs, evaluate risks, and main-      of credit risk. A bank’s risk-based capital ratio is
tain proper liquidity, capital adequacy is the area   calculated by dividing its qualifying capital (the
that triggers the most regulatory action, espe-       numerator of the ratio) by its risk-weighted
cially in view of prompt corrective action. The       assets (the denominator). The definition of
primary function of capital is to support the         qualifying capital is outlined below, as are the
bank’s operations, act as a cushion to absorb         procedures for calculating risk-weighted assets.
unanticipated losses and declines in asset values        The major objectives of the risk-based capital
that could otherwise cause a bank to fail, and        guidelines are to make regulatory capital require-
provide protection to uninsured depositors and        ments more sensitive to differences in credit-risk
debt holders in the event of liquidation. A           profiles among banking organizations; to factor
bank’s solvency promotes public confidence in          off-balance-sheet exposures into the assessment
the bank and the banking system as a whole by         of capital adequacy; to minimize disincentives
providing continued assurance that the bank           to holding liquid, low-risk assets; and to achieve
will continue to honor its obligations and pro-       greater consistency in the evaluation of the
vide banking services. By exposing stockhold-         capital adequacy of major banking organizations
ers to a larger percentage of any potential loss,     worldwide.
higher capital levels also reduce the subsidy            The guidelines set forth minimum supervi-
provided to banks by the federal safety net.          sory capital standards that apply to all state
Capital regulation is particularly important          member banks on a consolidated basis. Most
because deposit insurance and other elements of       banks are expected to operate with capital levels
the federal safety net provide banks with an          above the minimum ratios. Banking organiza-
incentive to increase their leverage beyond           tions that are undertaking significant expansion
what the market—in the absence of depositor           or that are exposed to high or unusual levels of
protection—would permit. Additionally, higher         risk are expected to maintain capital well above
capital levels can reduce the need for regulatory     the minimum ratios; in such cases, the Federal
supervision, thereby lowering costs to the bank-      Reserve may specify a higher minimum require-
ing industry and the government.                      ment. In addition, the risk-based capital ratio is
   The Federal Reserve uses two ratios to help        used as a basis for categorizing institutions for
assess the capital adequacy of state members:         purposes of prompt corrective action.1
the risk-based capital ratio and the tier 1 lever-       For most institutions, the risk-based capital
age ratio. State member banks may also be             ratio focuses principally on broad categories of
subject to separate capital requirements imposed      credit risk, although the framework for assign-
by state banking supervisors.                         ing assets and off-balance-sheet items to risk
                                                      categories does incorporate elements of transfer
                                                      risk as well as limited instances of interest-rate
OVERVIEW OF THE RISK-BASED                            and market risk.2 The framework incorporates
CAPITAL MEASURE FOR STATE                             risks arising from traditional banking activities
MEMBER BANKS                                          as well as risks arising from nontraditional
                                                      activities. The ratio does not, however, incorpo-
The Federal Reserve’s risk-based capital guide-       rate other factors that can affect an institution’s
lines (the guidelines) focus principally on the       financial condition. These factors include over-
credit risk associated with the nature of banks’      all interest-rate exposure; liquidity, funding, and
on- and off-balance-sheet exposures and on the        market risks; the quality and level of earnings;
type and quality of banks’ capital. The risk-
based capital guidelines apply to all state mem-         1. See section 4133.1, ‘‘Prompt Corrective Action.’’
ber banks. The information provided in this              2. A small number of institutions are required to hold
section should be used in conjunction with the        capital to support their exposure to market risk. For more
                                                      information, see the ‘‘Market-Risk Measure’’ subsection below,
guidelines, which are found in Regulation H           SR-09-1, ‘‘Application of the Market Risk Rule in BHCs and
(12 CFR 208, appendix A).                             SMBs,’’ or the Federal Reserve’s Trading and Capital-
   The risk-based capital guidelines provide a        Markets Activities Manual, section 2110.1, ‘‘Capital Adequacy.’’

Commercial Bank Examination Manual                                                                      April 2011
                                                                                                           Page 1
3020.1                                                               Assessment of Capital Adequacy

investment, loan portfolio, and other concentra-      capital and may consist of the following items
tions of credit; certain risks arising from nontra-   that are defined as core capital elements:
ditional activities; the effectiveness of loan and
investment policies; and management’s overall         1. Common stockholders’ equity,
ability to monitor and control financial and           2. Qualifying noncumulative perpetual pre-
operating risks, including the risks presented by        ferred stock (including related surplus), and
concentrations of credit and nontraditional           2. Minority interest in the equity accounts of
activities. An overall assessment of capital             consolidated subsidiaries.
adequacy must take into account these other
factors, including, in particular, the level and      Tier 1 capital is generally defined as the sum of
severity of problem and classified assets as well      core capital elements less any amounts of good-
as a bank’s exposure to declines in the economic      will, other intangible assets, interest-only strips
value of its capital due to changes in interest       receivables and nonfinancial equity investments
rates. For this reason, the final supervisory          that are required to be deducted.
judgment on a bank’s capital adequacy may
differ significantly from conclusions that might       Common stockholders’ equity. For purposes of
be drawn solely from the level of its risk-based      calculating the risk-based capital ratio, common
capital ratio.                                        stockholders’ equity is limited to common stock;
                                                      related surplus; and retained earnings, including
                                                      capital reserves and adjustments for the cumu-
DEFINITION OF CAPITAL                                 lative effect of foreign currency translation, net
                                                      of any treasury stock; less net unrealized hold-
For the purpose of risk-based capital, a bank’s       ing losses on available-for-sale equity securities
total capital consists of two types of compo-         with readily determinable fair values. For this
nents: ‘‘core capital elements’’ (which are           purpose, net unrealized holding gains on such
included in tier 1 capital) and ‘‘supplementary       equity securities and net unrealized holding
capital elements’’ (which are included in tier 2      gains (losses) on available-for-sale debt securi-
capital). To qualify as an element of tier 1 or       ties are not included in common stockholders’
tier 2 capital, a capital instrument must be          equity.
unsecured and may not contain or be covered by
any covenants, terms, or restrictions that are        Perpetual preferred stock. Perpetual preferred
inconsistent with safe and sound banking              stock is defined as preferred stock that does not
practices.                                            have a maturity date, that cannot be redeemed at
   Tier 1 capital is generally defined as the sum      the option of the holder of the instrument, and
of core capital elements. Core capital elements       that has no other provisions that will require
consist of common stock; related surplus; and         future redemption of the issue. Consistent with
retained earnings, including capital reserves and     these provisions, any perpetual preferred stock
adjustments for the cumulative effect of foreign      with a feature permitting redemption at the
currency translation, net of any treasury stock;      option of the issuer may qualify as capital only
less net unrealized holding losses on available-      if the redemption is subject to prior approval of
for-sale equity securities with readily determin-     the Federal Reserve. In general, preferred stock
able fair values. For this purpose, net unrealized    will qualify for inclusion in capital only if it can
holding gains on such equity securities and net       absorb losses while the issuer operates as a
unrealized holding gains (losses) on available-       going concern (a fundamental characteristic of
for-sale debt securities are not included in com-     equity capital) and only if the issuer has the
mon stockholders’ equity.                             ability and legal right to defer or eliminate
                                                      preferred dividends.
                                                         The only form of perpetual preferred stock
                                                      that state member banks may consider as an
The Components of Qualifying                          element of tier 1 capital is noncumulative per-
Capital                                               petual preferred. While the guidelines allow for
                                                      the inclusion of noncumulative perpetual pre-
Core capital elements (tier 1 capital). The tier 1    ferred stock in tier 1, it is desirable from a
component of a bank’s qualifying capital must         supervisory standpoint that voting common
represent at least 50 percent of qualifying total     stockholders’ equity remain the dominant form

April 2011                                                         Commercial Bank Examination Manual
Page 2
Assessment of Capital Adequacy                                                                    3020.1

of tier 1 capital. Thus, state member banks            direct claims on (including securities, loans, and
should avoid overreliance on preferred stock or        leases), and the portions of claims that are
non-voting equity elements within tier 1. Tier 1       directly and unconditionally guaranteed by, the
capital elements represent the highest form of         central governments of the Organisation for
capital, namely, permanent equity.                     Economic Co-operation and Development
   Tier 2 capital consists of a limited amount of      (OECD) countries and U.S. government agen-
the allowance for loan and lease losses; per-          cies, as well as all direct local currency claims
petual preferred stock and related surplus that do     on, and the portions of local currency claims that
not qualify for inclusion in tier 1 capital; certain   are directly and unconditionally guaranteed by,
other hybrid capital instruments; mandatory con-       the central governments of non-OECD coun-
vertible securities; and limited amounts of term       tries, to the extent that the bank has liabilities
subordinated debt, intermediate-term preferred         booked in that currency. A claim is not consid-
stock, including related surplus, long-term pre-       ered to be unconditionally guaranteed by a
ferred stock with an original term of 20 years or      central government if the validity of the guar-
more, and unrealized holding gains on qualify-         antee depends on some affirmative action by the
ing equity securities.                                 holder or a third party. Generally, securities
   Capital investments in unconsolidated bank-         guaranteed by the U.S. government or its agen-
ing and finance subsidiaries, and reciprocal            cies that are actively traded in financial markets,
holdings of other banking organizations’ capital       such as Government National Mortgage Asso-
instruments, are deducted from a bank’s capital.       ciation (GNMA) securities, are considered to be
The sum of tier 1 and tier 2 capital less any          unconditionally guaranteed. This zero percent
deductions makes up total capital, which is the        category also includes claims collateralized
numerator of the total risk-based capital ratio.       (1) by cash on deposit in the bank or (2) by
The maximum amount of tier 2 capital that may          securities issued or guaranteed by OECD central
be included in a bank’s qualifying total capital is    governments or (3) by U.S. government agen-
limited to 100 percent of tier 1 capital (net of       cies for which a positive margin of collateral is
goodwill, other intangible assets, and interest-       maintained on a daily basis, fully taking into
only strips receivables and nonfinancial equity         account any change in the bank’s exposure to
investments that are required to be deducted).         the obligor or counterparty under a claim in
                                                       relation to the market value of the collateral held
                                                       in support of that claim.
Each asset and off-balance-sheet item is assigned
to one of four broad risk categories based on the      Category 2: 20 percent
perceived credit risk of the obligor or, if rel-
                                                       Category 2 includes cash items in the process of
evant, the guarantor or type of collateral. These
                                                       collection, both foreign and domestic; short-
risk categories are assigned weights of 0 per-
                                                       term claims on (including demand deposits),
cent, 20 percent, 50 percent, and 100 percent.
                                                       and the portions of short-term claims that are
The majority of items fall into the 100 percent
                                                       guaranteed by, U.S. depository institutions and
risk-weight category. A brief explanation of the
                                                       foreign banks; and long-term claims on, and the
components of each category follows. For more
                                                       portions of long-term claims that are guaranteed
detailed information, see the capital adequacy
                                                       by, U.S. depository institutions and OECD banks.
                                                       This category also includes the portions of
                                                       claims that are conditionally guaranteed by
Risk Categories                                        OECD central governments and U.S. govern-
                                                       ment agencies, as well as the portions of local
Category 1: Zero Percent                               currency claims that are conditionally guaran-
                                                       teed by non-OECD central governments, to the
Category 1 includes cash (domestic and foreign)        extent that the bank has liabilities booked in that
owned and held in all offices of the bank or in         currency. In addition, this category includes
transit, as well as gold bullion held in the bank’s    claims on, and the portions of claims that are
own vaults or in another bank’s vaults on an           guaranteed by, U.S. government–sponsored agen-
allocated basis to the extent it is offset by gold     cies and claims on, and the portions of claims
bullion liabilities. The category also includes all    guaranteed by, the International Bank for

Commercial Bank Examination Manual                                                             April 2011
                                                                                                  Page 3
3020.1                                                                                 Assessment of Capital Adequacy

Reconstruction and Development (the World                           parent company and the parent company has
Bank), the International Finance Corporation,                       such a rating. If ratings are available from more
the Inter-American Development Bank, the                            than one rating agency, the lowest rating will be
Asian Development Bank, the African Develop-                        used to determine whether the rating require-
ment Bank, the European Investment Bank, the                        ment has been met. This category also includes
European Bank for Reconstruction and Devel-                         a collateralized claim on a qualifying securities
opment, the Nordic Investment Bank, and other                       firm in such a country, without regard to satis-
multilateral lending institutions or regional                       faction of the rating standard, provided that the
development banks in which the U.S. govern-                         claim arises under a contract that (1) is a
ment is a shareholder or contributing member.                       reverse-repurchase/repurchase agreement or
General obligation claims on, or portions of                        securities-lending/borrowing transaction exe-
claims guaranteed by the full faith and credit of,                  cuted using standard industry documentation;
states or other political subdivisions of the                       (2) is collateralized by debt or equity securities
United States or other countries of the OECD-                       that are liquid and readily marketable; (3) is
based group are also assigned to this category.                     marked to market daily; (4) is subject to a daily
Category 2 also includes the portions of claims                     margin-maintenance requirement under the stan-
(including repurchase transactions) that are                        dard industry documentation; and (5) can be
(1) collateralized by cash on deposit in the bank                   liquidated, terminated, or accelerated immedi-
or by securities issued or guaranteed by OECD                       ately in bankruptcy or a similar proceeding, and
central governments or U.S. government agen-                        the security or collateral agreement will not be
cies that do not qualify for the zero percent                       stayed or avoided, under applicable law of the
risk-weight category; (2) collateralized by secu-                   relevant jurisdiction. 3c
rities issued or guaranteed by U.S. government–
sponsored agencies; or (3) collateralized by                        Category 3: 50 percent
securities issued by multilateral lending institu-
tions or regional development banks in which                        Category 3 includes loans fully secured by first
the U.S. government is a shareholder or contrib-                    liens on one- to four-family residential proper-
uting member.                                                       ties (either owner-occupied or rented), or on
   This risk category also includes claims on, 3a                   multifamily residential properties, that meet cer-
or guaranteed by, a qualifying securities firm                       tain criteria. To be included in category 3, loans
incorporated in the United States or other coun-                    must have been made in accordance with pru-
tries that are members of the OECD-based                            dent underwriting standards, be performing in
group of countries 3b provided that (1) the quali-                  accordance with their original terms, and not be
fying securities firm has a long-term issuer                         90 days or more past due or carried in nonac-
credit rating, or a rating on at least one issue of                 crual status. For the purposes of the 50 percent
long-term debt, in one of the three highest                         risk category, a loan modified on a permanent or
investment-grade rating categories from a                           trial basis solely pursuant to the U.S. Depart-
nationally recognized statistical rating organiza-                  ment of the Treasury’s Home Affordable Mort-
tion or (2) the claim is guaranteed by the firm’s                    gage Program will be considered to be perform-
                                                                    ing in accordance with its original terms. The
   3a. Claims on a qualifying securities firm that are instru-       following additional criteria must be applied to a
ments the firm, or its parent company, uses to satisfy its           loan secured by a multifamily residential prop-
applicable capital requirements are not eligible for this risk      erty that is included in this category: (1) all
   3b. With regard to securities firms incorporated in the           principal and interest payments on the loan must
United States, qualifying securities firms are those securities      have been made on time for at least the year
firms that are broker–dealers registered with the Securities and
Exchange Commission (SEC) and are in compliance with the
SEC’s net capital rule, 17 CFR 240.15c3-1. With regard to              3c. For example, a claim is exempt from the automatic stay
securities firms incorporated in any other country in the            in bankruptcy in the United States if it arises under a securities
OECD-based group of countries, qualifying securities firms           contract or a repurchase agreement subject to section 555 or
are those securities firms that a bank is able to demonstrate are    559 of the Bankruptcy Code, respectively (11 USC 555 or
subject to consolidated supervision and regulation (covering        559); a qualified financial contract under section 11(e)(8) of
their direct and indirect subsidiaries, but not necessarily their   the Federal Deposit Insurance Act (12 USC 1821(e)(8)); or a
parent organizations) comparable to that imposed on banks in        netting contract between financial institutions under sections
OECD countries. Such regulation must include risk-based             401–407 of the Federal Deposit Insurance Corporation
capital requirements comparable to those applied to banks           Improvement Act of 1991 (12 USC 4401–4407) or the
under the Basel Accord.                                             Board’s Regulation EE (12 CFR 231).

April 2011                                                                          Commercial Bank Examination Manual
Page 4
Assessment of Capital Adequacy                                                                   3020.1

preceding placement in this category, or, in the       included in the 50 percent category, unless they
case of an existing property owner who is              are backed by collateral or guarantees that allow
refinancing a loan on that property, all principal      them to be placed in a lower risk category.
and interest payments on the loan being refi-
nanced must have been made on time for at least
the year preceding placement in this category;         Category 4: 100 percent
(2) amortization of the principal and interest
must occur over a period of not more than 30           All assets not included in the categories above
years, and the minimum original maturity for           are assigned to category 4, which comprises
repayment of principal must not be less than           standard risk assets. The bulk of the assets
seven years; and (3) the annual net operating          typically found in a loan portfolio would be
income (before debt service) generated by the          assigned to the 100 percent category.
property during its most recent fiscal year must           Category 4 includes long-term claims on, and
not be less than 120 percent of the loan’s current     the portions of long-term claims that are guar-
annual debt service (115 percent if the loan is        anteed by, non-OECD banks, and all claims on
based on a floating interest rate) or, in the case of   non-OECD central governments that entail some
a cooperative or other not-for-profit housing           degree of transfer risk. This category includes
project, the property must generate sufficient          all claims on foreign and domestic private-
cash flow to provide comparable protection to           sector obligors not included in the categories
the institution. Also included in category 3 are       above (including loans to nondepository finan-
privately issued mortgage-backed securities, pro-      cial institutions and bank holding companies);
vided that (1) the structure of the security meets     claims on commercial firms owned by the public
the criteria described in section III.B.3. of the      sector; customer liabilities to the bank on accep-
risk-based measure of the capital guidelines (12       tances outstanding that involve standard risk
CFR 208, appendix A); (2) if the security is           claims; investments in fixed assets, premises,
backed by a pool of conventional mortgages on          and other real estate owned; common and pre-
one- to four-family residential or multifamily         ferred stock of corporations, including stock
residential properties, each underlying mortgage       acquired for debts previously contracted; all
meets the criteria described above for eligibility     stripped mortgage-backed securities and similar
for the 50 percent risk category at the time the       instruments; and commercial and consumer loans
pool is originated; (3) if the security is backed      (except those assigned to lower risk categories
by privately issued mortgage-backed securities,        due to recognized guarantees or collateral and
each underlying security qualifies for the 50 per-      loans secured by residential property that qualify
cent risk category; and (4) if the security is         for a lower risk weight). This category also
backed by a pool of multifamily residential            includes claims representing capital of a quali-
mortgages, principal and interest payments on          fying securities firm.
the security are not 30 days or more past due.            This category also includes industrial-
Privately issued mortgage-backed securities that       development bonds and similar obligations
do not meet these criteria or that do not qualify      issued under the auspices of states or political
for a lower risk weight are generally assigned to      subdivisions of the OECD-based group of coun-
the 100 percent risk category.                         tries for the benefit of a private party or enter-
   Also assigned to category 3 are revenue             prise when that party or enterprise, not the
(nongeneral obligation) bonds or similar obliga-       government entity, is obligated to pay the prin-
tions, including loans and leases, that are obli-      cipal and interest. All obligations of states or
gations of states or other political subdivisions      political subdivisions of countries that do not
of the United States (for example, municipal           belong to the OECD-based group are also
revenue bonds) or other countries of the OECD-         assigned to category 4. The following assets are
based group, but for which the government              assigned a risk weight of 100 percent if they
entity is committed to repay the debt with             have not been deducted from capital: invest-
revenues from the specific projects financed,            ments in unconsolidated companies, joint ven-
rather than from general tax funds. Credit-            tures, or associated companies; instruments that
equivalent amounts of derivative contracts             qualify as capital that are issued by other bank-
involving standard risk obligors (that is, obli-       ing organizations; and any intangibles, includ-
gors whose loans or debt securities would be           ing those that may have been grandfathered into
assigned to the 100 percent risk category) are         capital.

Commercial Bank Examination Manual                                                            April 2011
                                                                                                 Page 5
3020.1                                                                 Assessment of Capital Adequacy

Application of the Risk Weights                           bonds, warranties, standby letters of credit
                                                          related to particular transactions, and perfor-
The appropriate aggregate dollar value of the             mance standby letters of credit, as well as
amount in each risk category is multiplied by the         acquisitions of risk participations in perfor-
risk weight associated with that category. The            mance standby letters of credit. In addition,
resulting weighted values for each of the risk            this credit-conversion factor includes unused
categories are added together. The resulting sum          portions of commitments, including eligible
is the bank’s total risk-weighted assets and is the       ABCP liquidity facilities, with an original
denominator of the risk-based capital ratio.              maturity exceeding one year; revolving-
                                                          underwriting facilities; note-issuance facili-
                                                          ties; and other similar arrangements.
                                                        • Items with a 100 percent credit-conversion
Risk Weighting of Off-Balance-Sheet                       factor include, except as otherwise provided
Items                                                     within the risk-based capital guidelines, direct-
                                                          credit substitutes, recourse obligations, sale
Off-balance-sheet items are incorporated into             and repurchase agreements, ineligible ABCP
the risk-based capital ratio through a two-step           liquidity facilities, and forward agreements, as
process. First, an on-balance-sheet ‘‘credit-             well as securities lent where the securities
equivalent amount’’ is calculated, generally by           lender is at risk of loss.
multiplying the face amount of the item by a
credit-conversion factor (except for direct-credit      See the risk-based capital guidelines for more
subsitutes and recourse obligations). Most off-         information on the use, treatment, and applica-
balance-sheet items are assigned to one of the          tion of credit-conversions factors for off-balance-
five credit-conversion factors: 0 percent, 10 per-       sheet items and transactions.
cent, 20 percent, 50 percent, or 100 percent.              For derivative contracts, the credit-equivalent
These factors are intended to reflect the risk           amount for each contract is determined by
characteristics of the activity in terms of an          multiplying the notional principal amount of the
on-balance-sheet equivalent. Second, once the           underlying contract by a credit-conversion fac-
credit-equivalent amount of the off-balance-            tor and adding the resulting product (which is an
sheet item is calculated, the resultant credit-         estimate of potential future exposure) to the
equivalent amount is assigned to the appropriate        positive mark-to-market value of the contract
risk category according to the obligor or, if           (which is the current exposure). A contract with
relevant, the guarantor, the nature of any collat-      a negative mark-to-market value is treated as
eral, or external credit ratings. Briefly, the credit-   having a current exposure of zero. Where
conversion factors are as follows:                      appropriate, a bank may offset positive and
                                                        negative mark-to-market values of derivative
• Items with a zero percent credit-conversion           contracts entered into with a single counterparty
  factor include unused portions of commit-             subject to a qualifying, legally enforceable,
  ments (with the exception of asset-backed             bilateral netting arrangement.
  commercial paper (ABCP) liquidity facilities)            As a general rule, if the terms of a claim can
  with an original maturity of one year or less,        change, the claim should be assigned to the risk
  or which are unconditionally cancelable at any        category appropriate to the highest risk option
  time, provided a separate credit decision is          available under the terms of the claim. For
  made before each drawing under the facility.          example, in a collateralized loan where the
• Items with a 10 percent credit-conversion             borrower has the option to withdraw the collat-
  factor include unused portions of eligible            eral before the loan is due, the loan would be
  ABCP liquidity facilities with an original            treated as an uncollateralized claim for risk-
  maturity of one year or less.                         based capital purposes. Similarly, a commitment
• Items with a 20 percent credit-conversion             that can be drawn down in the form of a loan or
  factor include short-term, self-liquidating           a standby letter of credit would be treated as a
  trade-related contingencies that arise from the       commitment to make a standby letter of credit,
  movement of goods.                                    the higher risk option available under the terms
• Items with a 50 percent credit-conversion             of the commitment.
  factor include transaction-related contingen-            When an item may be assigned to more than
  cies, which include bid bonds, performance            one category, that item generally is assigned to

April 2011                                                           Commercial Bank Examination Manual
Page 6
Assessment of Capital Adequacy                                                                                           3020.1

the lowest eligible risk category. For example, a                     for which a positive margin (that is, greater than
mortgage originated by the bank for which a                           100 percent of the claim) of recognized collat-
100 percent Federal Housing Administration                            eral is maintained daily may qualify for a
guarantee has been obtained would be assigned                         zero percent risk weight. The full amount of a
the 20 percent risk weight that is appropriate to                     claim that is 100 percent secured by recognized
claims conditionally guaranteed by a U.S. gov-                        collateral may be assigned to the 20 percent risk
ernment agency, rather than the 100 percent risk                      category. For partially secured obligations, the
weight that is appropriate to high loan-to-value                      secured portion is assigned a 20 percent risk
single-family mortgages.                                              weight. Any unsecured portion is assigned the
   While the primary determinant of the risk                          risk weight appropriate for the obligor or guar-
category of a particular on-balance-sheet asset                       antor, if any. The extent to which an off-balance-
or off-balance-sheet credit-equivalent amount is                      sheet item is secured by collateral is determined
the obligor, collateral or guarantees may be used                     by the degree to which the collateral covers the
to a limited extent to assign an item to a lower                      face amount of the item before it is converted to
risk category than would be available to the                          a credit-equivalent amount and assigned to a
obligor. The only forms of collateral that are                        risk category. For derivative contracts, this
recognized for risk-based capital purposes are                        determination is made in relation to the credit-
cash on deposit in the lending bank;4 securities                      equivalent amount.
issued or guaranteed by the central governments                          The only guarantees that are recognized for
of the OECD-based group of countries,5 U.S.                           risk-based capital purposes are those provided
government agencies, or U.S. government–                              by central or state and local governments of the
sponsored agencies; and securities issued by                          OECD-based group of countries, U.S. govern-
multilateral lending institutions or regional                         ment agencies, U.S. government–sponsored
development banks in which the U.S. govern-                           agencies, multilateral lending institutions or
ment is a shareholder or contributing member.                         regional development banks in which the United
In order for a claim to be considered collateral-                     States is a shareholder or contributing member,
ized for risk-based capital purposes, the under-                      U.S. depository institutions, and foreign banks.
lying arrangements must provide that the claim                        If an obligation is partially guaranteed, the
will be secured by recognized collateral through-                     portion that is not fully covered is assigned the
out its term. A commitment may be considered                          risk weight appropriate to the obligor or to any
collateralized for risk-based capital purposes to                     collateral. An obligation that is covered by two
the extent that its terms provide that advances                       types of guarantees having different risk weights
made under the commitment will be secured                             is apportioned between the two risk categories
throughout their term.                                                appropriate to the guarantors.
   The extent to which qualifying securities are
recognized as collateral is determined by their
current market value. The full amount of a claim                      Minimum Risk-Based Capital Ratios
   4. There is a limited exception to the rule that cash must be      Banks are expected to meet a minimum ratio of
on deposit in the lending bank to be recognized as collateral.
A bank participating in a syndicated credit secured by cash on        capital to risk-weighted assets of 8 percent, with
deposit in the lead bank may treat its pro rata share of the          at least 4 percent taking the form of tier 1
credit as collateralized, provided that it has a perfected interest   capital. Banks that do not meet the minimum
in its pro rata share of the collateral.                              risk-based capital ratios, or that are considered
   5. The OECD-based group of countries comprises all full
members of the Organization for Economic Cooperation and              to lack sufficient capital to support their activi-
Development (OECD), as well as countries that have con-               ties, are expected to develop and implement
cluded special lending arrangements with the International            capital plans acceptable to the Federal Reserve
Monetary Fund (IMF) associated with the Fund’s General                for achieving adequate levels of capital.6 Such
Arrangements to Borrow. The OECD’s thirty member coun-
tries include Australia, Austria, Belgium, Canada, Czech              plans should satisfy the provisions of the guide-
Republic, Denmark, Finland, France, Germany, Greece, Hun-             lines or established arrangements that the Fed-
gary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg,              eral Reserve has agreed on with designated
Mexico, Netherlands, New Zealand, Norway, Poland, Portu-
gal, Slovak Republic, Spain, Sweden, Switzerland, Turkey,
United Kingdom, and United States. Any country that has                 6. Under the prompt-corrective-action framework, banks
rescheduled its external sovereign debt within the previous           that do not meet the minimum risk-based capital ratio are
five years is not considered to be part of the OECD-based              considered undercapitalized and must file capital-restoration
group of countries for risk-based capital purposes.                   plans that meet certain requirements.

Commercial Bank Examination Manual                                                                                   April 2011
                                                                                                                        Page 7
3020.1                                                               Assessment of Capital Adequacy

banks. In addition, such banks should avoid           also exclude an institution that meets the criteria
any actions, including increased risk taking or       if such exclusion is deemed to be consistent with
unwarranted expansion, that would lower or            safe and sound banking practices.
further erode their capital positions. In these          The market-risk rule supplements the risk-
cases, examiners are to review and comment on         based capital rules for credit risk; an institution
banks’ capital plans and their progress in meet-      applying the market-risk rule remains subject to
ing, and continuing to maintain, the minimum          the requirements of the credit-risk rules but must
risk-based capital requirements.                      adjust its risk-based capital ratio to reflect mar-
   The bank’s board of directors and senior           ket risk. In January 2009, the Board issued
management should be encouraged to establish          SR-09-1, ‘‘Application of the Market Risk Rule
capital levels and ratios that are consistent with    in Bank Holding Companies and State Member
the bank’s overall financial profile. When assess-      Banks,’’ which reiterated some of the market-
ing the bank’s capital adequacy, it is appropriate    risk rule’s core requirements, provided guidance
to include comments on risk-based capital in the      on certain technical aspects of the rule, and
open section of the examination report. Exam-         clarified several issues. SR-09-1 discusses (1) the
iner comments should address the adequacy of          core requirements of the market-risk rule, (2) the
the bank’s plans and progress toward meeting          market-risk rule capital computational require-
the relevant target ratios.                           ments, and (3) the communication and Federal
                                                      Reserve requirements in order for a bank to use
                                                      its VaR models. A bank that is applying the
Market-Risk Rule                                      market-risk rule must hold capital to support its
                                                      exposure to two types of risk: (1) general market
Institutions are responsible for identifying their    risk arising from broad fluctuations in interest
trading and other market risks and for imple-         rates, equity prices, foreign exchange rates, and
menting a sound risk-management program com-          commodity prices, including risk associated with
mensurate with those risks. Such programs             all derivative positions, and (2) specific risk
should include appropriate quantitative metrics       arising from changes in the market value of debt
as well as ongoing qualitative analysis per-          and equity positions in the trading account due
formed by competent, independent risk-                to factors other than broad market movements,
management staff. At a minimum, institutions          including the credit risk of an instrument’s
should reassess annually and adjust their market-     issuer. A bank’s covered positions include all
risk management programs, taking into account         trading-account positions as well as all foreign-
changing firm strategies, market developments,         exchange and commodity positions, whether or
organizational incentive structures, and evolv-       not they are in the trading account. Banks that
ing risk-management techniques.                       are subject to the market-risk capital rules are
   In August 1996, the Federal Reserve amended        precluded from applying those rules to positions
its risk-based capital framework to incorporate a     held in the bank’s trading book that act, in form
measure for market risk for state member banks.       or in substance, as liquidity facilities supporting
The market-risk rule is found in Regulation H         asset-backed commercial paper (ABCP). (See
(12 CFR 208), appendix E. Under the market-           the definition of covered positions in appendix
risk rule, certain institutions with significant       E, section 2(a).) Any facility held in the trading
exposure to market risk must measure that risk        book whose primary function, in form or in
using their internal value-at-risk (VaR) measure-     substance, is to provide liquidity to ABCP—
ment model and, subject to parameters in the          even if the facility does not qualify as an eligible
market-risk rule, hold sufficient levels of capital    ABCP liquidity facility under the rule—will be
to cover the exposure. The market-risk rule           subject to the banking-book risk-based capital
applies to any insured state member bank whose        requirements. Specifically, organizations will be
trading activity (the gross sum of its trading        required to convert the notional amount of all
assets and liabilities) equals (1) 10 percent or      trading-book positions that provide liquidity to
more of its total assets or (2) $1 billion or more.   ABCP to credit-equivalent amounts by applying
On a case-by-case basis, the Federal Reserve          the appropriate banking-book credit-conversion
may require an institution that does not meet         factors. For example, the full notional amount of
these criteria to comply with the market-risk         all eligible ABCP liquidity facilities with an
rule if deemed necessary for safety-and-              original maturity of one year or less will be
soundness reasons. The Federal Reserve may            subject to a 10 percent conversion factor, as

April 2011                                                         Commercial Bank Examination Manual
Page 8
Assessment of Capital Adequacy                                                                                              3020.1

described previously, regardless of whether the                     AMA Interagency Guidance for
facility is carried in the trading account or the                   Operational Risk
banking book.
                                                                    On June 3, 2011, the federal banking agencies
                                                                    (the agencies) issued Interagency Guidance on
Market Risk Rule Provisions for                                     the Advanced Measurement Approaches for
Securities Lending                                                  Operational Risk to address and clarify imple-
                                                                    mentation issues related to the AMA in applying
On February 6, 2006, the Board approved a                           the agencies’ advanced capital adequacy frame-
revision to Regulation H for its market-risk                        work. This guidance focuses on the combination
measure of the capital adequacy guidelines. (See                    and use of the required AMA data elements—
12 CFR 208, appendix E.) The amendment                              (1) internal operational loss event data; (2) exter-
lessened and aligned the capital requirement of                     nal operational loss event data; (3) business
state member banks (those that have adopted the                     environment and internal control factors; and
market-risk rule) to the risk involved with cer-                    (4) scenario analysis, which is discussed in
tain cash collateral that is posted in connection                   greater detail. Governance and validation are
with securities-borrowing transactions. 6a It also                  also discussed since they ensure the integrity of
broadened the scope of counterparties for which                     a bank’s AMA framework. (See SR-11-8 and its
favorable capital treatment would be applied.                       attachment.)
(See 71 Fed. Reg. 8932, February 22, 2006.) For
a detailed description of the market-risk mea-
sure, see the Federal Reserve’s Trading and                         Establishment of a Risk-Based Capital
Capital-Markets Activities Manual, section                          Floor
                                                                    Section 171(b)(2) of the Dodd-Frank Wall Street
                                                                    Reform and Consumer Protection Act (Dodd-
                                                                    Frank Act) requires the agencies to establish
Advanced Approaches Rule                                            minimum leverage and risk-based capital require-
                                                                    ments on a consolidated basis for insured deposi-
The Board adopted an advanced capital adequacy                      tory institutions, depository institution holding
framework, effective April 1, 2008, that imple-                     companies, 6c and nonbank financial companies
ments, in the United States, the revised interna-                   supervised by the Board. These capital require-
tional capital framework (Basel II) developed by                    ments cannot be less than the generally applica-
the Committee on Banking Supervision (See 12                        ble capital requirements that apply to insured
CFR 208, appendix F or 72 Fed. Reg. 69287).                         depository institutions. 6d
The rule provides a risk-based capital frame-                          On June 28, 2011, the agencies published a
work that permits state member banks (SMBs)                         final rule (effective July 28, 2011) that amended
to use an internal ratings-based approach to                        the advanced approaches rules with a permanent
calculate credit-risk capital requirements and                      floor equal to the minimum risk-based capital
advanced measurement approaches (AMA) in                            requirements under the general risk-based capi-
order to calculate regulatory operational-risk
capital requirements. See also the revisions
effective March 29, 2010, at 75 Fed. Reg.                              6c. Section 171 of the Dodd-Frank Act (Pub. L. 111-203,
4636. 6b                                                            section 171, 124 Stat. 1376, 1435-38 (2010)) defines ‘‘deposi-
                                                                    tory institution holding company’’ to mean a bank holding
                                                                    company or a savings and loan holding company (as those
                                                                    terms are defined in section 3 of the Federal Deposit Insurance
   6a. See the Board staff’s August 21, 2007, legal interpre-       Act) that is organized in the United States, including any bank
tation as to the appropriate risk-based capital risk weight to be   or savings and loan holding company that is owned or
applied to certain collateralized loans of cash.                    controlled by a foreign organization, but does not include the
   6b. The revisions address the Financial Accounting Stan-         foreign organization. (See section 171 of the Dodd-Frank Act,
dards Board’s adoption of Statements of Financial Accounting        12 USC 5371.)
Standards Nos. 166 (ASC topic 860, ‘‘Transfers and Servic-             6d. The ‘‘generally applicable’’ capital requirements are
ing’’) and 167 (ASC subtopic 810-10, ‘‘Consolidation—               those established by the federal banking agencies to apply to
Overall’’). These accounting standards make substantive             insured depository institutions, regardless of total asset size or
changes to how banking organizations account for many               foreign exposure, under the prompt corrective action provi-
items, including securitized assets, that had been previously       sions of the Federal Deposit Insurance Act. See 12 USC
excluded from these organizations’ balance sheets.                  5371(a).

Commercial Bank Examination Manual                                                                                   October 2011
                                                                                                                           Page 9
3020.1                                                                    Assessment of Capital Adequacy

tal rules. (See the Board’s press release and 76       sis of these requirements and factors may have
Fed. Reg. 37620, June 28, 2011.) Banking               a material impact on the amount of capital banks
organizations subject to the advanced approaches       must hold to appropriately support certain
rules are required to, each quarter, calculate and     activities for on- and off-balance-sheet items,
compare their minimum tier 1 and total risk-           and this analysis must be used in assessing
based capital ratios as calculated under the           compliance with the guidelines. The require-
general risk-based capital rules with the same         ments and factors to be considered relate to
ratios as calculated under the advanced                certain capital elements, capital adjustments,
approaches risk-based capital rules. They are to       balance-sheet activities, off-balance-sheet activi-
compare the lower of the two tier 1 risk-based         ties, and the overall assessment of capital
capital ratios and the lower of the two total          adequacy.
capital ratios to the minimum tier 1 ratio require-
ment and total capital ratio requirement of the
advanced approaches rules to determine whether         Federal Reserve Review of a Capital
the minimum capital requirements are met. 6e           Instrument
The amendment prevents the minimum capital
requirements for a banking organization that has       If the terms and conditions of a particular
adopted the advanced approaches rule from              instrument cause uncertainty as to how the
declining below the minimum capital require-           instrument should be treated for capital pur-
ments that apply to insured depository institutions.   poses, it may be necessary to consult with
                                                       Federal Reserve staff for a final determination.
                                                       The Federal Reserve will, on a case-by-case
Documentation                                          basis, determine whether a capital instrument
                                                       has characteristics that warrant its inclusion in
Banks are expected to have adequate systems            tier 1 or tier 2 capital, as well as determine any
in place to compute their risk-based capital           quantitative limit on the amount of an instru-
ratios. Such systems should be sufficient to            ment that will be counted as an element of tier 1
document the composition of the ratios to be used      or tier 2 capital. In making this determination,
for regulatory reporting and other supervisory         the Federal Reserve will consider the similarity
purposes. Generally, supporting documentation          of the instrument to instruments explicitly treated
will be expected to establish how banks track and      in the guidelines, the ability of the instrument to
report their capital components and on- and            absorb losses while the bank operates as a going
off-balance-sheet items that are assigned prefer-      concern, the maturity and redemption features
ential risk weights, that is, risk weights less than   of the instrument, and other relevant terms and
100 percent. Where a bank has inadequate               factors.
documentation to support its assignment of a
preferential risk weight to a given item, it may be
necessary for examiners to assign an appropriate       Redemptions of Capital
higher weight to that item. Examiners are
expected to verify that banks are correctly            Redemptions of permanent equity or other capi-
reporting the information requested on the             tal instruments before their stated maturity could
Reports of Condition and Income, which are used        have a significant impact on a bank’s overall
in computing banks’ risk-based capital ratios.         capital structure. Consequently, a bank consid-
                                                       ering such a step should consult with the Federal
                                                       Reserve before redeeming any equity or debt
SUPERVISORY CONSIDERATIONS                             capital instrument (before maturity) if its
FOR CALCULATING AND                                    redemption could have a material effect on the
EVALUATING RISK-BASED                                  level or composition of the institution’s capital
CAPITAL                                                base.7

Certain requirements and factors should be con-
sidered in assessing the risk-based capital ratios        7. Consultation would not ordinarily be necessary if an
and the overall capital adequacy of banks. Analy-      instrument was redeemed with the proceeds of, or replaced by,
                                                       a like amount of a similar or higher-quality capital instrument
                                                       and if the organization’s capital position is considered fully
  6e. 12 CFR 208, appendix F, section 3.               adequate by the Federal Reserve.

October 2011                                                           Commercial Bank Examination Manual
Page 10
Assessment of Capital Adequacy                                                                    3020.1

Capital Elements                                       Perpetual Preferred Stock

This subsection discusses the characteristics of       The risk-based capital guidelines define per-
                                                       petual preferred stock as preferred stock that has
the principal types of capital elements. It also
                                                       no maturity date, cannot be redeemed at the
covers terms and conditions that may disqualify
                                                       option of the holder, and has no other provisions
an instrument from inclusion in a particular
                                                       that will require future redemption of the issue.
element of capital.
                                                       Perpetual preferred stock qualifies for inclusion
                                                       in capital only if it can absorb losses while the
Common Stockholders’ Equity                            issuer operates as a going concern and only if
                                                       the issuer has the ability and legal right to defer
Common stockholders’ equity includes common            or eliminate preferred dividends.
stock; related surplus; and retained earnings,            Perpetual preferred stock with a feature per-
including capital reserves and adjustments for         mitting redemption at the option of the issuer
the cumulative effect of foreign-currency trans-       may qualify for tier 1 or unlimited tier 2 capital
lation, net of any treasury stock. A capital           only if the redemption is subject to prior approval
instrument that is not permanent or that has           of the Federal Reserve. An issue that is convert-
preference with regard to liquidation or the           ible at the option of the issuer into another issue
payment of dividends is not deemed to be               of perpetual preferred stock or a lower form of
common stock, regardless of whether it is called       capital, such as subordinated debt, is considered
common stock. Other preferences may also call          to be redeemable at the option of the issuer.
into question whether the capital instrument is        Accordingly, such a conversion must be subject
common stock. Close scrutiny should be paid to         to prior Federal Reserve approval.
the terms of common-stock issues of banks that            Banks may include perpetual preferred stock
have issued more than one class of common              in tier 1 capital only if the stock is noncumula-
stock. If preference features are found in one of      tive. A noncumulative issue may not permit the
the classes, that class generally should not be        accruing or payment of unpaid dividends in any
treated as common stock.                               form, including the form of dividends payable in
                                                       common stock. Perpetual preferred stock that
   From a supervisory standpoint, it is desirable      calls for the accumulation and future payment of
that voting common stockholders’ equity remain         unpaid dividends is deemed to be cumulative,
the dominant form of tier 1 capital. Accordingly,      regardless of whether it is called noncumulative,
the risk-based capital guidelines state that banks     and it is generally includable in tier 2 capital.
should avoid overreliance on nonvoting equity             Perpetual preferred stock (including auction-
elements in tier 1 capital. Nonvoting equity           rate preferred) in which the dividend rate is reset
elements can arise in connection with common           periodically based, in whole or in part, on the
stockholders’ equity when a bank has two classes       bank’s financial condition or credit standing is
of common stock, one voting and the other              excluded from tier 1 capital but may generally
nonvoting. Alternatively, one class may have           be included in tier 2 capital. The obligation
so-called super-voting rights entitling the holder     under such instruments to pay out higher divi-
to substantially more votes per share than the         dends when a bank’s condition deteriorates is
other class. In this case, the super-voting shares     inconsistent with the essential precept that capi-
may have so many votes per share that the              tal should provide both strength and loss-
voting power of the other shares is effectively        absorption capacity to a bank during periods of
overwhelmed.                                           adversity.
   Banks that have nonvoting, or effectively              Ordinarily, fixed-rate preferred stock and tra-
nonvoting, common equity and tier 1 perpetual          ditional floating- or adjustable-rate preferred
preferred stock in excess of their voting com-         stock—in which the dividend rate adjusts in
mon stock are clearly overrelying on nonvoting         relation to an independent index based solely on
equity elements in tier 1 capital. In such cases, it   general market interest rates and is in no way
may be appropriate to reallocate some of the           tied to the issuer’s financial condition—do not
nonvoting equity elements from tier 1 capital to       raise significant supervisory concerns, espe-
tier 2 capital.                                        cially when the adjustable-rate instrument is
                                                       accompanied by reasonable spreads and cap
                                                       rates. Such instruments may generally be

Commercial Bank Examination Manual                                                          October 2011
                                                                                               Page 10.1
3020.1                                                               Assessment of Capital Adequacy

included in tier 1 capital, provided they are         clearly overrelying on perpetual preferred stock
noncumulative.                                        in tier 1 capital. In such cases, it may be
   Some preferred-stock issues incorporate cer-       appropriate to reallocate the excess amount of
tain features that raise serious questions about      perpetual preferred stock from tier 1 capital to
whether these issues will truly serve as a            tier 2 capital.
permanent, or even long-term, source of capital.
Such features include so-called exploding-rate
mechanisms, or similar mechanisms, in which,          Forward Equity Transactions
after a specified period, the dividend rate auto-
matically increases to a level that could create      Banking organizations have engaged in various
an incentive for the issuer to redeem the instru-     types of forward transactions involving the repur-
ment. Perpetual preferred stock with this type of     chase of their common stock. In these transac-
feature could cause the issuing bank to be faced      tions, the banking organization enters into an
with higher dividend requirements at a future         arrangement with a counterparty, usually an
date when the bank may be experiencing finan-          investment bank or another commercial bank,
cial difficulties; it is generally not includable in   under which the counterparty purchases com-
tier 1 capital.                                       mon shares of the banking organization, either
   Traditional convertible perpetual preferred        in the open market or directly from the institu-
stock, which the holder can convert into a fixed       tion. The banking organization agrees that it will
number of common shares at a preset price,            repurchase those shares at an agreed-on forward
ordinarily does not raise supervisory concerns        price at a later date (typically three years or less
and generally qualifies as tier 1 capital, provided    from the execution date of the agreement).
the stock is noncumulative. However, forms of         These transactions are used to ‘‘lock in’’ stock
preferred stock that the holder must or can           repurchases at price levels that are perceived to
convert into common stock at the market price         be advantageous, and they are a means of
prevailing at the time of conversion do raise         managing regulatory capital ratios.
supervisory concerns. Such preferred stock may           Some banking organizations have treated
be converted into an increasing number of             shares under forward equity arrangements as tier
common shares as the bank’s condition deterio-        1 capital. However, because these transactions
rates and as the market price of the common           can impair the permanence of the shares and
stock falls. The potential conversion of such         typically have certain features that are undesir-
preferred stock into common stock could pose a        able from a supervisory point of view, shares
threat of dilution to the existing common share-      covered by these arrangements have qualities
holders. The threat of dilution could make the        that are inconsistent with tier 1 capital status.
issuer reluctant to sell new common stock, or it      Accordingly, any common stock covered by
could place the issuer under strong market            forward equity transactions entered into after the
pressure to redeem or repurchase the convertible      issuance of SR-01-27 (November 9, 2001), other
preferred stock. Such convertible preferred stock     than those specified for deferred compensation
should generally be excluded from tier 1 capital.     or other employee benefit plans, will be excluded
   Perpetual preferred stock issues may include       from the tier 1 capital of a state member bank,
other provisions or pricing mechanisms that           even if executed under a currently existing
would provide significant incentives or pres-          master agreement. The amount to be excluded is
sures for the issuer to redeem the stock for cash,    equal to the common stock, surplus, and retained
especially at a time when the issuer is in a          earnings associated with the shares. This guid-
weakened financial condition. As a general mat-        ance does not apply to shares covered under
ter, an issue that contains such features would be    traditional stock buyback programs that do not
ineligible for tier 1 treatment.                      involve forward agreements.
   While no formal limit is placed on the amount
of noncumulative perpetual preferred stock that
may be included in tier 1 capital, the guidelines     Minority Interest in Equity Accounts of
state that banks should avoid overreliance on         Consolidated Subsidiaries
preferred stock and other nonvoting equity ele-
ments in tier 1 capital. A bank that includes in      Minority interest in equity accounts of consoli-
tier 1 capital perpetual preferred stock in an        dated subsidiaries is included in tier 1 capital
amount in excess of its voting common stock is        because, as a general rule, this interest repre-

October 2011                                                       Commercial Bank Examination Manual
Page 10.2
Assessment of Capital Adequacy                                                                     3020.1

sents equity that is freely available to absorb        the stock is unsecured. Even if the bank’s
losses in operating subsidiaries whose assets are      accountants have permitted the bank to account
included in a bank’s risk-weighted asset base.         for perpetual preferred stock issued through an
While not subject to an explicit sublimit within       SPE as stock of the bank, rather than as minority
tier 1, banks are expected to avoid using minor-       interest in the equity accounts of a consolidated
ity interest as an avenue for introducing into         subsidiary, the stock may not be included in
their capital structures elements that might not       tier 1 capital and most likely is not includable in
otherwise qualify as tier 1 capital (such as           tier 2 capital.
cumulative or auction-rate perpetual preferred            Banks may also use operating or nonoperat-
stock) or that would, in effect, result in an          ing subsidiaries to issue subordinated debt. As
excessive reliance on preferred stock within           with perpetual preferred stock issued through
tier 1 capital. If a bank uses minority interest in    such subsidiaries, a possibility exists that such
these ways, supervisory concerns may warrant           debt is in effect secured and therefore not
reallocating some of the bank’s minority interest      includable in capital.
in equity accounts of consolidated subsidiaries
from tier 1 to tier 2 capital.
   Whenever a bank has included perpetual              Minority Interests in Small Business
preferred stock of an operating subsidiary             Investment Companies
in minority interest, a possibility exists that such
capital has been issued in excess of the subsid-       Minority interests in small business investment
iary’s needs, for the purpose of raising cheaper       companies (SBICs), in investment funds that
capital for the bank. Stock issued under these         hold nonfinancial equity investments, and in
circumstances may, in substance if not in legal        subsidiaries engaged in nonfinancial activities
form, be secured by the subsidiary’s assets.           are not included in a bank’s tier 1 or total capital
If the subsidiary fails, the outside preferred         base if the bank’s interest in the company or
investors would have a claim on the subsidiary’s       fund is held under the legal authorities listed in
assets that is senior to the claim that the bank,      section II.B.5.b. of the capital guidelines (12
as a common shareholder, has on those assets.          CFR 208, appendix A).
Therefore, as a general matter, issuances in
excess of a subsidiary’s needs do not qualify for
inclusion in capital. The possibility that a           Allowance for Loan and Lease Losses
secured arrangement exists should be consid-
ered if the subsidiary on-lends significant             The allowance for loan and lease losses is a
amounts of funds to the parent bank, is unusu-         reserve that has been established through a
ally well capitalized, has cash flow in excess          charge against earnings to absorb anticipated,
of its operating needs, holds a significant             but not yet identified, losses on loans or lease-
amount of assets with minimal credit risk              financing receivables. The allowance excludes
(for example, U.S. Treasury securities) that are       allocated transfer-risk reserves and reserves cre-
not consistent with its operations, or has issued      ated against identified losses. Neither of these
preferred stock at a significantly lower rate than      two types of reserves is includable in capital.
the parent could obtain for a direct issue.            The amount of the allowance for loan and lease
   Some banks may use a nonoperating subsid-           losses that is includable in tier 2 capital is
iary or special-purpose entity (SPE) to issue          limited to 1.25 percent of risk-weighted assets.
perpetual preferred stock to outside investors.
Such a subsidiary may be set up offshore so a
bank can receive favorable tax treatment for the       Net Unrealized Holding Gains (Losses)
dividends paid on the stock. In such arrange-          on Securities Available for Sale
ments, a strong presumption exists that the stock
is, in effect, secured by the assets of the subsid-    The Financial Accounting Standards Board’s
iary. It has been agreed internationally that a        Statement No. 115 (FAS 115), ‘‘Accounting for
bank may not include in its tier 1 capital             Certain Investments in Debt and Equity Securi-
minority interest in the perpetual preferred stock     ties,’’ created a new common stockholders’
of nonoperating subsidiaries. Furthermore, such        equity account known as ‘‘net unrealized hold-
minority interest may not be included in tier 2        ing gains (losses) on securities available for
capital unless a bank can conclusively prove that      sale.’’ Although this equity account is consid-

Commercial Bank Examination Manual                                                           October 2011
                                                                                                Page 10.3
3020.1                                                             Assessment of Capital Adequacy

ered to be part of a bank’s GAAP equity capital,
this account should not be included in a bank’s
regulatory capital calculations. There are excep-
tions, however, to this rule. A bank that legally
holds equity securities in its available-for-sale
portfolio8 may include up to 45 percent of the

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

October 2011                                                     Commercial Bank Examination Manual
Page 10.4
Assessment of Capital Adequacy                                                                                3020.1

pretax net unrealized holding gains on those                        tions should be included in capital as subordi-
securities in tier 2 capital. These equity securi-                  nated debt, subject to amortization in the last
ties must be valued in accordance with generally                    five years of its life and limited, together with
accepted accounting principles and have readily                     other subordinated debt and intermediate-term
determinable fair values. Unrealized holding                        preferred stock, to 50 percent of tier 1 capital.
gains may not be included in tier 2 capital if the                  For example, a bank has an outstanding equity
Federal Reserve determines that the equity                          contract note for $1 million and issues $300,000
securities were not prudently valued. Moreover,                     of common stock, dedicating the proceeds to the
if a bank experiences unrealized holding losses                     retirement of the note. The bank would include
in its available-for-sale equity portfolio, these                   the $300,000 of common stock in its tier 1
losses must be deducted from tier 1 capital.                        capital. The $700,000 of the equity contract note
                                                                    not covered by the dedication would be treated
                                                                    as an unlimited element of the bank’s tier 2
Mandatory Convertible Debt Securities                               capital. The $300,000 of the note covered by the
                                                                    dedication would be treated as subordinated
Mandatory convertible debt securities are essen-                    debt.
tially subordinated-debt securities that receive                       In some cases, the indenture of a mandatory
special capital treatment because a bank has                        convertible debt issue may require the bank to
committed to repay the principal from proceeds                      set up segregated trust funds to hold the pro-
obtained through the issuance of equity. Banks                      ceeds from the sale of equity securities dedi-
may include such securities (net of any stock                       cated to pay off the principal of the manda-
issued that has been dedicated to their retire-                     tory convertibles at maturity. The portion of
ment) in the form of equity contract notes or                       mandatory convertible securities covered by
equity commitment notes9 issued before May                          the amount of such segregated trust funds is
15, 1985, as unlimited elements of tier 2 capital,                  considered secured and may therefore not be
provided that the criteria set forth in 12 CFR                      included in capital. The maintenance of such
225, appendix B, are met. Consistent with these                     a separate segregated fund for the redemption
criteria, mandatory convertible notes are subject                   of mandatory convertibles exceeds the require-
to a maximum maturity of 12 years, and a bank                       ments of 12 CFR 225, appendix B. Accord-
must receive Federal Reserve approval before                        ingly, if a bank, with the agreement of the
redeeming (or repurchasing) such securities                         debtholders, seeks regulatory approval to elimi-
before maturity. The terms of the securities                        nate the fund, the approval normally should be
should note that such approval is required.                         given unless supervisory concerns warrant
   If a bank has issued common or perpetual                         otherwise.
preferred stock and dedicated the proceeds to
the retirement or redemption of mandatory con-
vertibles,10 the portion of mandatory convert-                      Subordinated Debt and Intermediate-Term
ibles covered by the dedication no longer carries                   Preferred Stock
a commitment to issue equity and is effectively
rendered into ordinary subordinated debt.                           To qualify as supplementary capital, subordi-
Accordingly, the amount of the stock dedicated                      nated debt and intermediate-term preferred
is netted from the amount of mandatory convert-                     stock must have an original average maturity of
ibles includable as unlimited tier 2 capital. The                   at least five years. The average maturity of an
portion of such securities covered by dedica-                       obligation whose principal is repayable in
                                                                    scheduled periodic payments (for example, a
   9. Equity contract notes are debt securities that obligate the   so-called ‘‘serial-redemption issue’’) is the
holder to take common or perpetual preferred stock for              weighted average of the maturities of all such
repayment of principal. Equity commitment notes are redeem-         scheduled repayments. If the holder has the
able only with the proceeds from the sale of common or
perpetual preferred stock.
                                                                    option to require the issuer to redeem, repay, or
   10. Such a dedication generally must be made in the              repurchase the instrument before the original
quarter in which the new common or perpetual preferred stock        stated maturity, maturity is defined as the earli-
is issued. There are no restrictions on the actual use of the       est possible date on which the holder can put the
proceeds of dedicated stock. For example, stock issued under
dividend-reinvestment plans or issued to finance acquisitions
                                                                    instrument back to the issuing bank. This date
may be dedicated to the retirement of mandatory convertible         may be much earlier than the instrument’s stated
debt securities.                                                    maturity date. In the last five years before the

Commercial Bank Examination Manual                                                                         May 2002
                                                                                                            Page 11
3020.1                                                                   Assessment of Capital Adequacy

maturity of a limited-life instrument, the out-       the bank. Other events of default, such as
standing amount includable in tier 2 capital          change of control of the bank or disposal of a
must be discounted by 20 percent a year. The          bank subsidiary, may limit the flexibility of
aggregate amount of subordinated debt and             management or banking supervisors to work out
intermediate-term preferred stock that may be         the problems of a troubled bank. Still other
included in tier 2 capital is limited to 50 percent   events of default, such as failure to maintain
of tier 1 capital.                                    certain capital ratios or rates of return or to limit
   Consistent with longstanding Federal Reserve       the amount of nonperforming assets or charge-
policy, a bank may not repay, redeem, or repur-       offs to a certain level, may be intended to allow
chase a subordinated debt issue without the prior     the debtholder to be made whole before a
written approval of the Federal Reserve. The          deteriorating institution becomes truly troubled.
terms of the debt indenture should note that          Debt issues that include any of these types of
such approval is required. The Federal Reserve        events of default are not truly subordinated and
requires this approval to prevent a deteriorating     should not be included in capital. Likewise,
institution from redeeming capital at a time          banks should not include debt issues in capital
when it needs to conserve its resources and to        that otherwise contain terms or covenants that
ensure that subordinated debtholders in a failing     could adversely affect the liquidity of the issuer;
bank are not paid before depositors.                  unduly restrict management’s flexibility to run
   Close scrutiny should be given to terms that       the organization, particularly in times of finan-
permit the holder to accelerate payment of            cial difficulty; or limit the regulator’s ability to
principal upon the occurrence of certain events.      resolve problem-bank situations.
The only acceleration clauses acceptable in a            Debt issues, including mandatory convertible
subordinated-debt issue included in tier 2 capital    securities, in which interest payments are tied to
are those that are triggered by the issuer’s          the financial condition of the borrower should
insolvency, that is, the appointment of a receiver.   generally not be included in capital. The interest
Terms that permit the holder to accelerate            payments may be linked to the financial condi-
payment of principal upon the occurrence of           tion of an institution through various ways, such
other events jeopardize the subordination of the      as (1) an auction-rate mechanism; (2) a preset
debt since such terms could permit debtholders        schedule mandating interest-rate increases, either
in a troubled institution to be paid out before       as the credit rating of the bank declines or over
the depositors. In addition, debt whose terms         the passage of time;11 or (3) a term that raises
permit holders to accelerate payment of princi-       the interest rate if payment is not made in a
pal upon the occurrence of events other than          timely fashion. These debt issues raise concerns
insolvency does not meet the minimum five-             because as the financial condition of a bank
year maturity requirement for debt capital            declines, it faces ever-increasing payments on
instruments. Holders of such debt have the right      its credit-sensitive subordinated debt at a time
to put the debt back to the issuer upon the           when it most needs to conserve its resources.
occurrence of the named events, which could           Thus, credit-sensitive debt does not provide
happen on a date well in advance of the debt’s        the support expected of a capital instrument to
stated maturity.                                      an institution whose financial condition is
   Close scrutiny should also be given to the         deteriorating; rather, the credit-sensitive feature
terms of those debt issues in which an event of       can accelerate depletion of the institution’s
default is defined more broadly than insolvency        resources and increase the likelihood of default
or a failure to pay interest or principal when due.
There is a strong possibility that such terms are        11. Although payment on debt whose interest rate increases
inconsistent with safe and sound banking prac-        over time may not on the surface appear to be directly linked
tice, so the debt issue should not be included        to the financial condition of the issuing bank, such debt
in capital. Concern is heightened where an            (sometimes referred to as expanding- or exploding-rate debt)
                                                      has a strong potential to be credit-sensitive in substance.
event of default gives the holder the right to        Banks whose financial condition has strengthened are more
accelerate payment of principal or where other        likely to be able to refinance the debt at a lower rate than that
borrowings exist that contain cross-default           mandated by the preset increase, whereas banks whose con-
clauses. Some events of default, such as issuing      dition has deteriorated are less likely to do so. Moreover, just
                                                      when these latter institutions would be in the most need of
jumbo certificates of deposit or making addi-          conserving capital, they would be under strong pressure to
tional borrowings in excess of a certain amount,      redeem the debt as an alternative to paying higher rates and
may unduly restrict the day-to-day operations of      would therefore accelerate the depletion of their resources.

May 2002                                                              Commercial Bank Examination Manual
Page 12
Assessment of Capital Adequacy                                                                                   3020.1

on the debt. While such terms may be acceptable                       retained) that may be included in capital cannot
in perpetual preferred stock qualifying for tier 2                    exceed 25 percent of tier 1 capital. Amounts of
capital, they are not acceptable in a capital debt                    MSAs, NMSAs, PCCRs, and credit-enhancing
issue because a bank in a deteriorating financial                      I/Os (both retained and purchased) in excess of
condition does not have the option available in                       these limitations, as well as all other identifiable
equity issues of eliminating the higher payments                      intangible assets, including core deposit intan-
without going into default.                                           gibles and favorable leaseholds, are to be
   When a bank has included subordinated debt                         deducted from a bank’s core capital elements in
issued by an operating or nonoperating subsid-                        determining tier 1 capital. However, identifiable
iary in its capital, a possibility exists that the                    intangible assets (other than MSAs and PCCRs)
debt is in effect secured, and thus not includable                    acquired on or before February 19, 1992, gen-
in capital. Further details on arrangements                           erally will not be deducted from capital for
regarding a bank’s issuance of capital instru-                        supervisory purposes, although they will con-
ments through subsidiaries are discussed in an                        tinue to be deducted for applications purposes.
earlier subsection, ‘‘Minority Interest in Equity                        For purposes of calculating the limitations on
Accounts of Consolidated Subsidiaries.’’                              MSAs, NMSAs, PCCRs, and credit-enhancing
                                                                      I/Os, tier 1 capital is defined as the sum of core
                                                                      capital elements, net of goodwill and net of all
Capital Adjustments                                                   identifiable intangible assets other than MSAs,
                                                                      NMSAs, and PCCRs. This calculation of tier 1 is
Intangible Assets                                                     before the deduction of any disallowed
                                                                      MSAs, any disallowed NMSAs, any disallowed
Goodwill and other intangible assets. Certain                         PCCRs, any disallowed credit-enhancing I/Os
intangible assets are deducted from a bank’s                          (both purchased and retained), any disallowed
capital for the purpose of calculating the risk-                      deferred tax assets, and any nonfinancial equity
based capital ratio.12 Those assets include good-                     investments.
will and certain other identifiable assets. These                         Banks may elect to deduct disallowed mort-
assets are deducted from the sum of the core                          gage servicing assets, disallowed non-mortgage
capital components (tier 1 capital).                                  servicing assets, and disallowed credit-enhancing
   The only identifiable intangible assets that are                    I/Os (both purchased and retained) on a basis that
eligible to be included in—that is, not deducted                      is net of any associated deferred tax liability.
from—a bank’s capital are marketable mortgage-                        Deferred tax liabilities netted in this manner
servicing assets (MSAs), nonmortgage-servicing                        cannot also be netted against deferred tax assets
assets (NMSAs), and purchased credit-card                             when determining the amount of deferred tax
relationships (PCCRs).13 The total amount of                          assets that are dependent on future taxable
MSAs and PCCRs that may be included in a                              income.
bank’s capital, in the aggregate, cannot exceed                          Banks must review the book value of goodwill
100 percent of tier 1 capital. The total amount of                    and other intangible assets at least quarterly and
NMSAs and PCCRs is subject to a separate                              make adjustments to these values as necessary.
aggregate sublimit of 25 percent of tier 1 capital.                   The fair value of MSAs, NMSAs, and PCCRs
In addition, the total amount of credit-enhancing                     must also be determined at least quarterly. This
interest-only strips (I/Os) (both purchased and                       determination of fair value should include
                                                                      adjustments for any significant changes in
                                                                      original valuation assumptions, including changes
   12. Negative goodwill is a liability and is therefore not
taken into account in the risk-based capital framework.
                                                                      in prepayment estimates or account-attrition
Accordingly, a bank may not offset goodwill to reduce the             rates. Examiners will review both the book value
amount of goodwill it must deduct from tier 1 capital.                and fair value assigned to these assets, as well as
   13. Purchased mortgage-servicing rights (PMSRs) no lon-            supporting documentation during the examina-
ger exist under the most recent accounting rules that apply to
servicing of assets. Under these rules (Financial Accounting
                                                                      tion process. The Federal Reserve may require,
Standards Board statements No. 122, ‘‘Accounting for Mort-            on a case-by-case basis, an independent valua-
gage Servicing Rights,’’ and No. 140, ‘‘Accounting for Trans-         tion of a bank’s intangible assets or credit-
fers and Servicing of Financial Assets and Extinguishments of         enhancing I/Os.
Liabilities’’), organizations are required to recognize separate
servicing assets (or liabilities) for the contractual obligation to
service financial assets that entities have either sold or             Value limitation. The amount of eligible servic-
securitized with servicing retained.                                  ing assets and PCCRs that a bank may include in

Commercial Bank Examination Manual                                                                            April 2011
                                                                                                                Page 13
3020.1                                                               Assessment of Capital Adequacy

capital is further limited to the lesser of 90 per-   credit enhancement, the Federal Reserve will
cent of their fair value, or 100 percent of their     look to the economic substance of the
book value, as adjusted for capital purposes in       transaction.
accordance with the instructions in the commer-
cial bank Consolidated Report of Condition and
Income (call report). The amount of I/Os that a       Disallowed Deferred Tax Assets
bank may include in capital shall be its fair
                                                      In response to the Financial Accounting Stan-
value. If both the application of the limits on
                                                      dards Board’s Statement No. 109 (FAS 109),
MSAs, NMSAs, and PCCRs and the adjustment
of the balance-sheet amount for these assets          ‘‘Accounting for Income Taxes,’’ the Federal
would result in an amount being deducted from         Reserve adopted a limit on the amount of certain
capital, the bank would deduct only the greater       deferred tax assets that may be included in (that
of the two amounts from its core capital ele-         is, not deducted from) tier 1 capital for risk-
ments in determining tier 1 capital.                  based and leverage capital purposes. Under the
   Consistent with longstanding Federal Reserve       rule, certain deferred tax assets can only be
policy, banks experiencing substantial growth,        realized if an institution earns taxable income in
whether internally or by acquisition, are expected    the future. Those deferred tax assets are limited,
to maintain strong capital positions substantially    for regulatory capital purposes, to the amount
above minimum supervisory levels, without             that the institution expects to realize within one
significant reliance on intangible assets or           year of the quarter-end report date (based on its
credit-enhancing I/Os.                                projections of future taxable income for that
   An arrangement whereby a bank enters into a        year) or to 10 percent of tier 1 capital, whichever
licensing or leasing agreement or similar trans-      is less.
action to avoid booking an intangible asset              The reported amount of deferred tax assets,
should be subject to particularly close scrutiny.     net of any valuation allowance for deferred tax
Normally, such arrangements will be dealt with        assets, in excess of the lesser of these two
by adjusting the bank’s capital calculation           amounts is to be deducted from a bank’s core
appropriately. In making an overall assessment        capital elements in determining tier 1 capital.
of a bank’s capital adequacy for applications         For purposes of calculating the 10 percent limi-
purposes, the institution’s quality and composi-      tation, tier 1 capital is defined as the sum of core
tion of capital are considered together with its      capital elements, net of goodwill and net of all
holdings of tangible and intangible assets.           identifiable intangible assets other than MSAs,
                                                      NMSAs, and PCCRs, but before the deduction
Credit-enhancing interest-only strips receiv-         of any disallowed MSAs, any disallowed
ables (I/Os). Credit-enhancing I/Os are on-           NMSAs, any disallowed PCCRs, any disal-
balance-sheet assets that, in form or substance,      lowed credit-enhancing I/Os, any disallowed
represent the contractual right to receive some       deferred tax assets, and any nonfinancial equity
or all of the interest due on transferred assets.     investments.
I/Os expose the bank to credit risk directly or          To determine the amount of expected deferred
indirectly associated with transferred assets that    tax assets realizable in the next 12 months, a
exceeds a pro rata share of the bank’s claim on       bank should assume that all existing temporary
the assets, whether through subordination pro-        differences fully reverse as of the report date.
visions or other credit-enhancement techniques.       Projected future taxable income should not
Such I/Os, whether purchased or retained and          include net operating-loss carry-forwards to be
including other similar ‘‘spread’’ assets, may be     used during that year or the amount of existing
included in, that is, not deducted from, a bank’s     temporary differences a bank expects to reverse
capital subject to the fair value and tier 1          within the year. Such projections should include
limitations. (See sections II.B.1.d. and e. of the    the estimated effect of tax-planning strategies
capital guidelines (12 CFR 208, appendix A).)         that the organization expects to implement to
   Both purchased and retained credit-                realize net operating losses or tax-credit carry-
enhancing I/Os, on a non-tax-adjusted-basis, are      forwards that would otherwise expire during the
included in the total amount that is used for pur-    year. A new 12-month projection does not have
poses of determining whether a bank exceeds           to be prepared each quarter. Rather, on interim
the tier 1 limitation. In determining whether an      report dates, the future-taxable-income projec-
I/O or other types of spread assets serve as a        tions may be used for their current fiscal year,

April 2011                                                         Commercial Bank Examination Manual
Page 14
Assessment of Capital Adequacy                                                                                  3020.1

adjusted for any significant changes that have               financial activities under section 4(k) of the
occurred or are expected to occur.                          Bank Holding Company Act (12 USC 1843(k)).
   Deferred tax assets that can be realized from            The rule does not apply to investments made in
taxes paid in prior carry-back years or from                companies that engage solely in banking and
future reversals of temporary differences are               financial activities, nor does it apply to invest-
generally not limited. For banks that have a                ments made by a state bank under the authority
parent, however, this amount may not exceed                 in section 24(f) of the Federal Deposit Insurance
the amount the bank could reasonably expect its             Act (FDI Act). The higher capital charges also
parent to refund. The disallowed deferred tax               do not apply to equity securities acquired and
assets are subtracted from tier 1 capital and also          held by a bank as a bona fide hedge of an equity
from risk-weighted assets.                                  derivatives transaction it entered into lawfully,
                                                            or to equity securities that are acquired in
Nonfinancial Equity Investments                              satisfaction of a debt previously contracted and
                                                            that are held and divested in accordance with
In general, a bank must deduct from its core                applicable law. The adjusted carrying value of
capital elements the sum of the appropriate                 these investments is not included in determining
percentages (as determined below) of the                    the total amount of nonfinancial equity invest-
adjusted carrying value of all nonfinancial equity           ments held by the bank. (See SR-02-4 for a
investments held by it or its direct or indirect            general discussion of the risk-based and lever-
subsidiaries. An equity investment includes the             age capital rule changes.)
purchase, acquisition, or retention of any equity              The bank must deduct from its core capital
instrument (including common stock, preferred               elements the sum of the appropriate percentages,
stock, partnership interests, interests in limited-         as stated in table 1, of the adjusted carrying
liability companies, trust certificates, and war-            value of all nonfinancial equity investments held
rants and call options that give the holder the             by the bank or its direct or indirect subsidiaries.
right to purchase an equity instrument), any                The amount of the percentage deduction increases
equity feature of a debt instrument (such as a              as the aggregate amount of nonfinancial equity
warrant or call option), and any debt instrument            investments held by the bank increases as a
that is convertible into equity.14 The Federal              percentage of its tier 1 capital.
Reserve may treat any other instrument (includ-                The ‘‘adjusted carrying value’’ of investments
ing subordinated debt) as an equity investment              is the aggregate value at which the investments
if, in its judgment, the instrument is the func-            are carried on the balance sheet of the bank,
tional equivalent of equity or exposes the state            reduced by (1) any unrealized gains on those
member bank to essentially the same risks as an             investments that are reflected in such carrying
equity instrument.                                          value but excluded from the bank’s tier 1 capital
   A nonfinancial equity investment, subject to              and (2) associated deferred tax liabilities. For
the risk-based capital rule (the rule), is an equity        example, for investments held as available-for-
investment in a nonfinancial company made                    sale (AFS), the adjusted carrying value of the
under the following authorities:                            investments would be the aggregate carrying
                                                            value of the investments (as reflected on the
• the authority to invest in SBICs under section            consolidated balance sheet of the bank) less any
  302(b) of the Small Business Investment Act               unrealized gains on those investments that are
  of 1958 (15 USC 682(b))                                   included in other comprehensive income and not
• the portfolio investment provisions of Regu-              reflected in tier 1 capital, and associated deferred
  lation K (12 CFR 211.8(c)(3)), including the              tax liabilities.15 The total adjusted carrying value
  authority to make portfolio investments through           of any nonfinancial equity investment that is
  Edge and agreement corporations                           subject to deduction is excluded from the bank’s
                                                            risk-weighted assets and for purposes of com-
A nonfinancial company is an entity that engages             puting the denominator of the bank’s risk-based
in any activity that has not been determined to
be permissible for the bank to conduct directly,
or to be financial in nature or incidental to                  15. Unrealized gains on AFS equity investments may be
                                                            included in supplementary capital to the extent permitted by
 14. This requirement generally does not apply to invest-   the capital guidelines. In addition, the unrealized losses on
ments in nonconvertible senior or subordinated debt.        AFS equity investments are deducted from tier 1 capital.

Commercial Bank Examination Manual                                                                          April 2011
                                                                                                              Page 15
3020.1                                                                              Assessment of Capital Adequacy

Table 1—Deduction for Nonfinancial Equity Investments

Aggregate adjusted carrying value of
all nonfinancial equity investments
held directly or indirectly by the                               Deduction from core capital elements (as
bank (as a percentage                                            a percentage of the adjusted carrying
of the tier 1 capital of the bank)1                              value of the investment)

Less than 15 percent                                                                   8 percent
15 percent to 24.99 percent                                                           12 percent
25 percent and above                                                                  25 percent
   1. For purposes of calculating the adjusted carrying value     the deduction for any disallowed MSAs, any disallowed
of nonfinancial equity investments as a percentage of tier 1       NMSAs, any disallowed PCCRs, any disallowed credit
capital, tier 1 capital is defined as the sum of core capital      enhancing I/Os (both purchased and retained), any disallowed
elements net of goodwill and net of all identifiable intangible    deferred tax assets, and any nonfinancial equity investments.
assets other than MSAs, NMSAs, and PCCRs, but before

capital ratio.16 The total adjusted carrying                         With respect to consolidated SBICs, some
value is also deducted from average total con-                    equity investments may be in companies that are
solidated assets when computing the leverage                      consolidated for accounting purposes. For invest-
ratio.                                                            ments in a nonfinancial company that is consoli-
   The deductions are applied on a marginal                       dated for accounting purposes under GAAP, the
basis to the portions of the adjusted carrying                    bank’s adjusted carrying value of the investment
value of nonfinancial equity investments that                      is determined under the equity method of
fall within the specified ranges of the parent                     accounting (net of any intangibles associated
bank’s tier 1 capital. The rule sets forth a                      with the investment that are deducted from the
‘‘stair-step’’ approach under which each tier of                  bank’s core). Even though the assets of the
capital charges applies, on a marginal basis, to                  nonfinancial company are consolidated for
the adjusted carrying value of the bank’s aggre-                  accounting purposes, these assets (as well as the
gate nonfinancial equity investment portfolio                      credit-equivalent amounts of the company’s off-
that falls within the specified ratios of the                      balance-sheet items) should be excluded from
organization’s tier 1 capital. The stair-step                     the bank’s risk-weighted assets for regulatory
approach reflects the fact that the financial risks                 capital purposes.
to a bank from equity investment activities                          The capital adequacy guidelines for state
increase as the level of these activities accounts                member banks establish minimum risk-based
for a larger portion of the bank’s capital, earn-                 capital ratios. Banks are at all times expected to
ings, and activities. For example, if the adjusted                maintain capital commensurate with the level
carrying value of all nonfinancial equity invest-                  and nature of the risks to which they are
ments held by a bank equals 20 percent of its tier                exposed. The risk to a bank from nonfinancial
1 capital, then the amount of the deduction                       equity investments increases with its concentra-
would be 8 percent of the adjusted carrying                       tion in such investments, and strong capital
value of all investments up to 15 percent of the                  levels above the minimum requirements are
bank’s tier 1 capital, and 12 percent of the                      particularly important when a bank has a high
adjusted carrying value of all investments in                     degree of concentration in nonfinancial equity
excess of 15 percent of the bank’s tier 1                         investments (for example, in excess of 50 per-
capital.                                                          cent of tier 1 capital).
                                                                     The Federal Reserve will monitor banks and
                                                                  apply heightened supervision, as appropriate, to
  16. For example, if 8 percent of the adjusted carrying value    equity investment activities, including where the
of a nonfinancial equity investment is deducted from tier 1        bank has a high degree of concentration in
capital, the entire adjusted carrying value of the investment     nonfinancial equity investments, to ensure that
will be excluded from risk-weighted assets when calculating
the denominator for the risk-based capital ratio, and from
                                                                  each bank maintains capital levels that are
average total consolidated assets when computing the lever-       appropriate in light of its equity investment
age ratio.                                                        activities. In addition, the Federal Reserve may

April 2011                                                                       Commercial Bank Examination Manual
Page 16
Assessment of Capital Adequacy                                                                                          3020.1

impose capital levels established by the capital                  which no deduction is required) must be included
adequacy rules, in light of the nature or perfor-                 in determining, for purposes of table 1, the total
mance of a particular organization’s equity                       amount of nonfinancial equity investments held
investments or the sufficiency of the organiza-                    by the bank in relation to its tier 1 capital.
tion’s policies, procedures, and systems to moni-
tor and control the risks associated with its                     Grandfather provisions. No deduction is required
equity investments.                                               to be made for the adjusted carrying value of
                                                                  any nonfinancial equity investment (or portion
SBIC investments. Investments may be made by                      of such an investment) that the bank made
banks in or through SBICs under section 4(c)(5)                   before March 13, 2000, or that the bank made on
of the BHC Act and section 302(b) of the Small                    or after this date pursuant to a binding written
Business Investment Act. No deduction is                          commitment18 entered into before March 13,
required for nonfinancial equity investments that                  2000, provided that in either case the bank has
are held by a bank (1) through one or more                        continuously held the investment since the rel-
SBICs that are consolidated with the bank or                      evant investment date.19 A nonfinancial equity
(2) in one or more SBICs that are not consoli-                    investment made before March 13, 2000,
dated with the bank, to the extent that all such                  includes any shares or other interests the bank
investments, in the aggregate, do not exceed                      received through a stock split or stock dividend
15 percent of the bank’s tier 1 capital. Any                      on an investment made before March 13, 2000,
nonfinancial equity investment that is held                        provided the bank provides no consideration for
through or in an SBIC and that is not required to                 the shares or interests received and the transac-
be deducted from tier 1 capital will be assigned                  tion does not materially increase the bank’s
a 100 percent risk weight and included in the                     proportional interest in the company. The exer-
bank’s consolidated risk-weighted assets.17                       cise on or after March 13, 2000, of options or
   To the extent the adjusted carrying value of                   warrants acquired before March 13, 2000, is not
all nonfinancial equity investments that a bank                    considered to be an investment made before
holds through one or more SBICs that are                          March 13, 2000, if the bank provides any
consolidated with the bank, or in one or more                     consideration for the shares or interests received
SBICs that are not consolidated with the bank,                    upon exercise of the options or warrants. Any
exceeds, in the aggregate, 15 percent of the                      nonfinancial equity investment (or portion
bank’s tier 1 capital, the appropriate percentage                 thereof) that is not required to be deducted from
of such amounts (as set forth in table 1) must be                 tier 1 capital must be included in determining
deducted from the bank’s core capital elements.                   the total amount of nonfinancial equity invest-
In addition, the aggregate adjusted carrying                      ments held by the bank in relation to its tier 1
value of all nonfinancial equity investments held
through a consolidated SBIC and in a noncon-                         18. A ‘‘binding written commitment’’ means a legally
                                                                  binding written agreement that requires the bank to acquire
solidated SBIC (including any investments for                     shares or other equity of the company, or make a capital
                                                                  contribution to the company, under terms and conditions set
   17. If a bank has an investment in an SBIC that is             forth in the agreement. Options, warrants, and other agree-
consolidated for accounting purposes but that is not wholly       ments that give a bank the right to acquire equity or make an
owned by the bank, the adjusted carrying value of the bank’s      investment, but do not require the bank to take such actions,
nonfinancial equity investments through the SBIC is equal to       are not considered a binding written commitment for purposes
the bank’s proportionate share of the adjusted carrying value     of this provision.
of the SBIC’s equity investments in nonfinancial companies.           19. For example, if a bank made an equity investment in
The remainder of the SBIC’s adjusted carrying value (that is,     100 shares of a nonfinancial company before March 13, 2000,
the minority interest holders’ proportionate share) is excluded   the adjusted carrying value of that investment would not be
from the risk-weighted assets of the bank. If a bank has an       subject to a deduction. However, if the bank made any
investment in an SBIC that is not consolidated for accounting     additional equity investment in the company after March 13,
purposes, and the bank has current information that identifies     2000, such as by purchasing additional shares of the company
the percentage of the SBIC’s assets that are equity invest-       (including through the exercise of options or warrants acquired
ments in nonfinancial companies, the bank may reduce the           before or after March 13, 2000) or by making a capital
adjusted carrying value of its investment in the SBIC propor-     contribution to the company, and such investment was not
tionately to reflect the percentage of the adjusted carrying       made pursuant to a binding written commitment entered into
value of the SBIC’s assets that are not equity investments in     before March 13, 2000, the adjusted carrying value of the
nonfinancial companies. If a bank reduces the adjusted carry-      additional investment would be subject to a deduction. In
ing value of its investment in a nonconsolidated SBIC to          addition, if the bank sold and repurchased, after March 13,
reflect financial investments of the SBIC, the amount of the        2000, 40 shares of the company, the adjusted carrying value of
adjustment will be risk-weighted at 100 percent and included      those 40 shares would be subject to a deduction under this
in the bank’s risk-weighted assets.                               provision.

Commercial Bank Examination Manual                                                                                  April 2011
                                                                                                                      Page 17
3020.1                                                                               Assessment of Capital Adequacy

capital for purposes of table 1. In addition, any                 portion (50 percent) of the investment allocated
nonfinancial equity investment (or portion                         to it, the remainder (up to 100 percent) is to be
thereof) that is not required to be deducted from                 deducted from tier 1 capital.
tier 1 capital will be assigned a 100 percent risk                   Advances to banking and finance subsidiaries
weight and included in the bank’s consolidated                    (that is, loans, extensions of credit, guarantees,
risk-weighted assets. The following example                       commitments, or any other credit exposures) not
illustrates these calculations.                                   considered as capital are included in risk-
   A bank has $1 million in tier 1 capital and has                weighted assets at the 100 percent risk weight
nonfinancial equity investments with an aggre-                     (unless recognized collateral or guarantees dic-
gate adjusted carrying value of $375,000. Of                      tate weighting at a lower percentage). However,
this amount, $100,000 represents the adjusted                     such advances may be deducted from the parent
carrying value of investments made before                         bank’s consolidated capital where examiners
March 13, 2000, and an additional $175,000                        find that the risks associated with the advances
represents the adjusted carrying value of invest-                 are similar to the risks associated with capital
ments made through the bank’s wholly owned                        investments, or if such advances possess risk
SBIC. The $100,000 in investments made before                     factors that warrant an adjustment to capital for
March 13, 2000, and $150,000 of the bank’s                        supervisory purposes. These risk factors could
SBIC investments would not be subject to the                      include the absence of collateral support or the
rule’s marginal capital charges. These amounts                    clear intention of banks to allow the advances to
are considered for purposes of determining the                    serve as capital to subsidiaries regardless of
marginal charge that applies to the bank’s cov-                   form.
ered investments (including the $25,000 of non-                      Although the Federal Reserve does not auto-
exempt SBIC investments). In this case, the total                 matically deduct investments in other unconsoli-
amount of the bank’s tier 1 capital deduction                     dated subsidiaries or investments in joint ven-
would be $31,250. This figure is 25 percent of                     tures and associated companies,22 the level and
$125,000, which is the amount of the bank’s                       nature of such investments should be closely
total nonfinancial equity portfolio subject to the                 monitored. Resources invested in these entities
rule’s marginal capital charges. The average tier                 support assets that are not consolidated with the
1 capital charge on the bank’s entire nonfinan-                    rest of the bank and therefore may not be
cial equity portfolio would be 8.33 percent.                      generally available to support additional lever-
                                                                  age or absorb losses of affiliated institutions.
                                                                  Close monitoring is also necessary because
Investments in Unconsolidated Banking                             experience has shown that banks often stand
and Finance Subsidiaries and Other                                behind the losses of affiliated institutions to
Subsidiaries                                                      protect the reputation of the organization as a
                                                                  whole. In some cases, this support has led to
Generally, debt and equity capital investments                    losses that have exceeded the investments in
and any other instruments deemed to be capital                    such entities.
in unconsolidated banking and finance subsidi-                        Accordingly, for risk-based capital purposes,
aries20 are to be deducted from the consolidated                  a bank may be required, on a case-by-case basis,
capital of the parent bank, regardless of whether                 to (1) deduct such investments from total capi-
the investment is made by the parent bank or its                  tal; (2) apply an appropriate risk-weighted charge
direct or indirect subsidiaries.21 Fifty percent of               against the bank’s pro rata share of the assets
the investment is to be deducted from tier 1                      of the affiliated entity; (3) consolidate the entity
capital and 50 percent from tier 2 capital. When                  on a line-by-line basis; or (4) operate with a
tier 2 capital is not sufficient to absorb the                     risk-based capital ratio above the minimum.
                                                                  In determining the appropriate capital treatment
                                                                  for such actions, the Federal Reserve will
  20. A banking and finance subsidiary is generally defined
as any company engaged in banking or finance in which the
                                                                  generally take into account whether (1) the bank
parent organization holds directly or indirectly more than        has significant influence over the financial or
50 percent of the outstanding voting stock, or any such
company which is otherwise controlled or capable of being
controlled by the parent organization.                               22. Such entities are defined in the instructions to the call
  21. An exception to this deduction is to be made for shares     report. Associated companies and joint ventures are generally
acquired in the regular course of securing or collecting a debt   defined as companies in which the bank owns 20 to 50 percent
previously contracted in good faith.                              of the voting stock.

April 2011                                                                        Commercial Bank Examination Manual
Page 18
Assessment of Capital Adequacy                                                                        3020.1

managerial policies or operations of the affili-        ment or a U.S. government agency are also
ated entity, (2) the bank is the largest investor in   assigned to the zero percent risk category. Claims
the entity, or (3) other circumstances prevail         that are directly but conditionally guaranteed are
(such as the existence of significant guaran-           assigned to the 20 percent risk category. A claim
tees from the bank) that appear to closely tie         is considered to be conditionally guaranteed by
the activities of the affiliated company to the         a central government if the validity of the
bank.                                                  guarantee depends on some affirmative action
                                                       by the holder or a third party. Generally, secu-
                                                       rities guaranteed by the U.S. government or its
Reciprocal Holdings of Banking                         agencies that are actively traded in financial
Organizations’ Capital Instruments                     markets are considered to be unconditionally
Reciprocal holdings are intentional cross-             guaranteed. These include Government National
holdings resulting from formal or informal             Mortgage Association (GNMA or Ginnie Mae)
arrangements between banking organizations to          and Small Business Administration (SBA)
swap or exchange each other’s capital instru-          securities.
ments. Such holdings of other banking organi-             A limited number of U.S. government agency–
zations’ capital instruments are to be deducted        guaranteed loans are deemed to be uncondition-
from the total capital of an organization for the      ally guaranteed and can be assigned to the zero
purpose of determining the total risk-based            percent risk category. These include most loans
capital ratio. Holdings of other banking organi-       guaranteed by the Export-Import Bank (Exim-
zations’ capital instruments taken in satisfac-        bank),23 loans guaranteed by the U.S. Agency
tion of debts previously contracted or that            for International Development (AID) under its
constitute stake-out investments that comply           Housing Guaranty Loan Program, SBA loans
with the Federal Reserve’s policy statement on         subject to a secondary participation guaranty in
nonvoting equity investments (12 CFR 225.143)          accordance with SBA form 1086, and Farmers
are not deemed to be intentional cross-holdings        Home Administration (FmHA) loans subject to
and are therefore not deducted from a bank’s           an assignment guaranty agreement in accor-
capital.                                               dance with FmHA form 449-36.
                                                          Apart from the exceptions noted in the pre-
                                                       ceding paragraph, loans guaranteed by the U.S.
                                                       government or its agencies are considered to be
On-Balance-Sheet Activities                            conditionally guaranteed. The guaranteed por-
                                                       tion of such loans is assigned to the 20 percent
Claims on, and Guaranteed by, OECD                     risk category. These include, but are not limited
Central Governments                                    to, loans guaranteed by the Commodity Credit
                                                       Corporation (CCC), the Federal Housing
The risk-based capital guidelines assign a zero        Administration (FHA), the Overseas Private
percent risk weight to all direct claims (including    Investment Corporation (OPIC), the Department
securities, loans, and leases) on the central          of Veterans Affairs (VA), and, except as indi-
governments of the OECD-based group of                 cated above, the FmHA and SBA. Loan guaran-
countries and U.S. government agencies. Gen-           tees offered by OPIC often guarantee against
erally, the only direct claims banks have on the       political risk. However, only that portion of a
U.S. government and its agencies take the form         loan guaranteed by OPIC against commercial or
of Treasury securities. Zero-coupon, that is,          credit risk may receive a preferential 20 percent
single-payment, Treasury securities trading un-        risk weight. The portion of government trust
der the U.S. Treasury’s Separately Traded              certificates issued to provide funds for the refi-
Registered Interest and Principal (STRIP) pro-         nancing of foreign military sales loans made by
gram are assigned to the zero percent risk             the Federal Financing Bank or the Defense
category. A security that has been stripped by a       Security Assistance Agency that are indirectly
private-sector entity, such as a brokerage firm, is     guaranteed by the U.S. government also qualify
considered an obligation of that entity and is         for the 20 percent risk weight.
accordingly assigned to the 100 percent risk
                                                         23. Loans guaranteed under Eximbank’s Working Capital
   Claims that are directly and unconditionally        Guarantee Program, however, receive a 20 percent risk
guaranteed by an OECD-based central govern-            weight.

Commercial Bank Examination Manual                                                                April 2011
                                                                                                    Page 19
3020.1                                                                   Assessment of Capital Adequacy

   Most guaranteed student loans are guaranteed       guidelines. Also eligible for the 50 percent risk
by a state agency or nonprofit organization that       weight are loans to builders with substantial
does not have the full faith and credit backing       project equity for the construction of one- to
of the state. The loans are then indirectly guar-     four-family residences that have been presold
anteed or reinsured by the U.S. government’s          under firm contracts to purchasers who have
Guaranteed Student Loan Program. Under the            obtained firm commitments for permanent quali-
program, a minimum percentage of the loan is          fying mortgage loans and have made substantial
reinsured, but a higher percentage could be           earnest-money deposits.
guaranteed if the bank has experienced an over-          In addition, qualifying multifamily residential
all low default rate on guaranteed student loans.     loans that meet certain criteria may be assigned
Only the portion of the loan covered by the           to the 50 percent risk category. These criteria are
minimum guarantee under the program may be            as follows: All principal and interest payments
assigned to the 20 percent risk category; the         must have been made on time for at least one
remainder should be assigned a 100 percent risk       year preceding placement in the 50 percent risk
weight.                                               category, amortization of the principal and
                                                      interest must occur within 30 years, the mini-
                                                      mum original maturity for repayment of princi-
Claims on, or Guaranteed by, a U.S.                   pal cannot be less than seven years, and annual
Government–Sponsored Agency                           net operating income (before debt service) gen-
                                                      erated by the property during the most recent
U.S. government–sponsored agencies are agen-          fiscal year must not be less than 120 percent of
cies originally established or chartered by the       the loan’s current annual debt service (115 per-
federal government to serve public purposes           cent if the loan is based on a floating interest
specified by the U.S. Congress. Such agencies          rate). In the case of cooperative or other not-for-
generally carry out functions performed directly      profit housing projects, the property must gen-
by the central government in other countries.         erate sufficient cash flow to provide comparable
The obligations of government-sponsored agen-         protection to the bank.
cies generally are not explicitly guaranteed by          To ensure that only qualifying residential
the full faith and credit of the U.S. government.     mortgage loans are assigned to this preferential
Claims (including securities, loans, and leases)      risk weight, examiners are to review the one-
on, or guaranteed by, such agencies are assigned      to four-family and multifamily residential real
to the 20 percent risk category. U.S. government–     estate loans that are included in the 50 percent
sponsored agencies include, but are not limited       risk category. Such loans are not eligible for
to, the College Construction Loan Insurance           preferential treatment unless they meet the fol-
Association, Farm Credit Administration, Fed-         lowing criteria: The loans are made subject to
eral Agricultural Mortgage Corporation, Federal       prudent underwriting standards, the loans are
Home Loan Bank System, Federal Home Loan              performing in accordance with their original
Mortgage Corporation (FHLMC or Freddie                terms and are not delinquent for 90 days or more
Mac), Federal National Mortgage Association           or carried on nonaccrual status, and the loan-to-
(FNMA or Fannie Mae), Financing Corporation           value ratios are conservative.24 For the purpose
(FICO), Postal Service, Resolution Funding Cor-       of this last criterion, the loan-to-value ratio
poration (REFCORP), Student Loan Marketing            should be based on the value of the property
Association (SLMA or Sallie Mae), Smithso-            determined by the most current appraisal or, if
nian Institution, and Tennessee Valley Authority      appropriate, the most current evaluation. Nor-
(TVA).                                                mally, this would be the appraisal or evaluation
                                                      performed at the time the loan was originated.25
                                                         If a bank has assigned a 50 percent risk
Loans Secured by First Liens on One- to               weight to residential mortgage loans made for
Four-Family Residential Properties and
Multifamily Residential Properties                       24. A conservative loan-to-value ratio for loans secured by
                                                      multifamily residential property must not exceed 80 percent
Qualifying loans on one- to four-family residen-      (or 75 percent if the loan is based on a floating interest rate).
                                                         25. When both first and junior liens are held by the bank
tial properties, either owner-occupied or rented      and no intervening liens exist, these transactions are treated as
(as defined in the instructions to the call report),   single loans secured by a first lien for the purpose of
are accorded a 50 percent risk weight under the       determining the loan-to-value ratio.

April 2011                                                            Commercial Bank Examination Manual
Page 20
Assessment of Capital Adequacy                                                                    3020.1

the purpose of speculative real estate develop-       Transfers and Servicing of Financial Assets and
ment or whose eligibility for such preferential       Extinguishments of Liabilities.’’ These criteria
treatment is otherwise questionable, and the          are summarized in the definition of ‘‘transfers of
amounts of nonqualifying loans are readily iden-      financial assets’’ in the glossary to the commer-
tifiable, such loans should be reassigned to the       cial bank Call Report instructions. If a transfer
100 percent risk-weight category. If material         of assets does not meet these criteria, the assets
evidence exists that a bank has assigned a            must remain on the bank’s balance sheet and are
preferential risk weight to residential mortgage      subject to the standard risk-based capital charge.
loans of questionable eligibility, but the amount        If a transfer of assets qualifies as a sale under
of the inappropriately weighted amount cannot         GAAP but the bank retains any risk of loss or
be readily identified, the overall evaluation of       obligation for payment of principal or interest,
the bank’s capital adequacy should reflect a           then the transfer is considered to be a sale with
higher capital requirement than would otherwise       recourse. A more detailed definition of an asset
be the case.                                          sale with recourse may be found in the definition
                                                      of ‘‘sales of assets for risk-based capital pur-
                                                      poses’’ in the glossary to the commercial bank
Accrued Interest                                      Call Report instructions. Although the assets are
                                                      removed from a bank’s balance sheet in an asset
Banks normally report accrued interest on loans       sale with recourse, the credit-equivalent amount
and securities in ‘‘Other Assets’’ on the Call        is assigned to the risk category appropriate to
Report. The majority of banks will risk-weight        the obligor in the underlying transaction, after
the entire amount of accrued interest at 100 per-     considering any associated guaranties or collat-
cent. However, for risk-based capital purposes,       eral. This assignment also applies when the
a bank is permitted to allocate accrued interest      contractual terms of the recourse agreement
among the risk categories associated with the         limit the seller’s risk to a percentage of the value
underlying claims, provided the bank has sys-         of the assets sold or to a specific dollar amount.
tems in place to carry out such an allocation            If, however, the risk retained by the seller is
accurately.                                           limited to some fixed percentage of any losses
                                                      that might be incurred and there are no other
                                                      provisions resulting in the direct or indirect
Off-Balance-Sheet Activities                          retention of risk by the seller, the maximum
                                                      amount of possible loss for which the selling
Off-balance-sheet transactions include recourse       bank is at risk (the stated percentage times the
obligations, direct-credit substitutes, residual      amount of assets to which the percentage applies)
interests, and asset- and mortgage-backed secu-       is subject to risk-based capital requirements.
rities. The treatments for direct-credit substi-      The remaining amount of assets transferred
tutes, assets transferred with recourse, and secu-    would be treated as a sale that is not subject to
rities issued in connection with asset                the risk-based capital requirements. For exam-
securitizations and structured financings are          ple, a seller would treat a sale of $1 million in
described later in this section. The terms asset      assets with a recourse provision that the seller
securitizations or securitizations, as used in this   and buyer proportionately share in losses incurred
subsection, include structured financings, as well     on a 10 percent and 90 percent basis, respec-
as asset-securitization transactions.                 tively, and with no other retention of risk
                                                      by the seller, as a $100,000 asset sale with
                                                      recourse and a $900,000 sale not subject to
Assets Sold with Recourse                             risk-based capital requirements.
                                                         There are several exceptions to the general
For risk-based capital adequacy purposes, a           reporting rule for recourse transactions. The first
bank must hold capital against assets sold with       exception applies to recourse transactions for
recourse if the bank retains any risk of loss. To     which the amount of recourse the institution is
qualify as an asset sale with recourse, a transfer    contractually liable for is less than the capital
of assets must first qualify as a sale according to    requirement for the assets transferred under the
the GAAP criteria set forth in paragraph 14 of        recourse agreement. For such transactions, a
the Financial Accounting Standards Board’s            bank must hold capital equal to its maximum
Statement No. 140 (FAS 140), ‘‘Accounting for         contractual recourse obligation. For example,

Commercial Bank Examination Manual                                                        November 2004
                                                                                                Page 21
3020.1                                                                Assessment of Capital Adequacy

assume an institution transfers a $100 pool of         servicing rights, it customarily makes represen-
commercial loans and retains a recourse obliga-        tations and warranties concerning those assets.
tion of 2 percent. Ordinarily, the bank would be       When a bank purchases loan-servicing rights,
subject to an 8 percent capital charge, or $8.         it may also assume representations and warran-
Because the recourse obligation is only 2 per-         ties made by the seller or a prior servicer. These
cent, however, the bank would be required to           representations and warranties give certain rights
hold capital of $2 against the recourse exposure.      to other parties and impose obligations on the
This capital charge may be reduced further by          seller or servicer of the assets. To the extent a
the balance of any associated noncapital GAAP          bank’s representations and warranties function
recourse liability account.                            as credit enhancements to protect asset purchas-
   A second exception to the general rule applies      ers or investors from credit risk, they are con-
to the transfer of small-business loans and to the     sidered as recourse or direct-credit substitutes.
transfer of leases on personal property with              The Federal Reserve’s risk-based capital
recourse. A bank that is considered to be well         adequacy rule is consistent with the agencies’
capitalized according to the Federal Reserve’s         long-standing recourse treatment of representa-
prompt-corrective-action framework should              tions and warranties that effectively guarantee
include in risk-weighted assets only the amount        the performance or credit quality of transferred
of retained recourse—instead of the entire             loans. However, banks typically make a number
amount of assets transferred—in connection with        of factual warranties that are unrelated to the
a transfer of small-business loans or a transfer of    ongoing performance or credit quality of trans-
leases on personal property with recourse, pro-        ferred assets. These warranties entail opera-
vided two conditions are met. First, the transac-      tional risk, as opposed to the open-ended credit
tion must be treated as a sale under GAAP;             risk inherent in a financial guaranty, and are
second, the bank must establish a noncapital           not considered recourse or a direct-credit sub-
reserve that is sufficient to cover the bank’s          stitute. Warranties that create operational risk
estimated liability under the recourse arrange-        include warranties that assets have been under-
ment. With the Board’s approval, this exception        written or collateral appraised in conformity
may also apply to a bank that is considered to be      with identified standards, as well as warranties
adequately capitalized under the prompt-               that provide for the return of assets in instances
corrective-action framework. The total outstand-       of incomplete documentation, fraud, or
ing amount of recourse retained under such             misrepresentation.
transactions may not exceed 15 percent of a               Warranties can impose varying degrees of
bank’s total risk-based capital without Board          operational risk. For example, a warranty that
approval.                                              asset collateral has not suffered damage from
                                                       potential hazards entails a risk that is offset to
                                                       some extent by prudent underwriting practices
Definitions                                             requiring the borrower to provide hazard insur-
                                                       ance to the bank. A warranty that asset collateral
The capital adequacy guidelines provide special        is free of environmental hazards may present
treatment for recourse obligations, direct-credit      acceptable operational risk for certain types
substitutes, residual interests, and asset- and        of properties that have been subject to environ-
mortgage-backed securities involved in asset-          mental assessment, depending on the circum-
securitization activities. A brief discussion of       stances. The appropriate limits for these opera-
some of the primary definitions follows.                tional risks are monitored through supervision
                                                       of a bank’s loan-underwriting, -sale, and
Credit derivatives. Credit derivative means a          -servicing practices. Also, a bank that pro-
contract that allows one party (the protection         vides warranties to loan purchasers and inves-
purchaser) to transfer the credit risk of an asset     tors must include associated operational risks in
or off-balance-sheet credit exposure to another        its risk management of exposures arising from
party (the protection provider). The value of a        loan-sale or securitization-related activities.
credit derivative is dependent, at least in part, on   Banks should be prepared to demonstrate to
the credit performance of a ‘‘reference asset.’’       examiners that operational risks are effectively
Credit-enhancing representations and warran-              Recourse or direct-credit-substitute treatment
ties. When a bank transfers assets, including          is required for warranties providing assurances

November 2004                                                      Commercial Bank Examination Manual
Page 22
Assessment of Capital Adequacy                                                                     3020.1

about the actual value of asset collateral, includ-   expired, the early-default clause will no longer
ing that the market value corresponds to its          trigger recourse treatment, provided there are no
appraised value or that the appraised value will      other provisions that constitute recourse.
be realized in the event of foreclosure and sale.
Warranties such as these, which make represen-        Direct-credit substitutes. The term direct-credit
tations about the future value of a loan or related   substitute refers to an arrangement in which a
collateral, constitute an enhancement of the          bank assumes, in form or in substance, credit
loan transferred, and thus are recourse arrange-      risk associated with an on- or off-balance-sheet
ments or direct-credit substitutes. When a seller     asset or exposure that was not previously owned
represents that it ‘‘has no knowledge’’ of cir-       by the bank (third-party asset), and the risk
cumstances that could cause a loan to be other        assumed by the bank exceeds the pro rata share
than investment quality, the representation is not    of its interest in the third-party asset. If the bank
recourse. Banks may limit recourse exposure           has no claim on the third-party asset, then the
with warranties that directly address the condi-      bank’s assumption of any credit risk on the
tion of the asset at the time of transfer (that       third-party asset is a direct-credit substitute.
is, creation of an operational warranty) and             The term direct-credit substitute explicitly
by monitoring compliance with stated underwrit-       includes items such as purchased subordinated
ing standards. Alternatively, banks might create      interests, agreements to cover credit losses that
warranties with exposure caps that would permit       arise from purchased loan-servicing rights, credit
it to take advantage of the low-level-recourse        derivatives, and lines of credit that provide
rule.                                                 credit enhancement. Some purchased subordi-
   The definition of credit-enhancing represen-        nated interests, such as credit-enhancing I/O
tations and warranties excludes warranties—           strips, are also residual interests for regulatory
such as early-default clauses and similar war-        capital purposes.
ranties that permit the return of, or premium-           Direct-credit substitutes include, but are not
refund clauses covering, one- to four-family          limited to—
residential first mortgage loans that qualify for a
50 percent risk weight for a maximum period of        • financial standby letters of credit that support
120 days from the date of transfer. These war-          financial claims on a third party that exceed a
ranties may cover only those loans that were            bank’s pro rata share of losses in the financial
originated within one year of the date of transfer.     claim;
   A premium-refund clause is a warranty that         • guarantees, surety arrangements, credit deriva-
obligates a seller who has sold a loan at a price       tives, and similar instruments backing finan-
in excess of par, that is, at a premium, to refund      cial claims that exceed a bank’s pro rata share
the premium, either in whole or in part, if the         in the financial claim;
loan defaults or is prepaid within a certain          • purchased subordinated interests or securities
period of time. Premium-refund clauses that             that absorb more than their pro rata share of
cover assets guaranteed, in whole or in part, by        losses from the underlying assets;
the U.S. government, a U.S. government agency,        • credit derivative contracts under which the
or a government-sponsored enterprise are not            bank assumes more than its pro rata share of
included in the definition of credit-enhancing           credit risk on a third-party exposure;
representations and warranties, provided the          • loans or lines of credit that provide credit
premium-refund clauses are for a period not to          enhancement for the financial obligations of
exceed 120 days from the date of transfer. The          an account party;
definition also does not include warranties that       • purchased loan-servicing assets if the servicer
permit the return of assets in instances of             is responsible for credit losses or if the ser-
misrepresentation, fraud, or incomplete                 vicer makes or assumes credit-enhancing rep-
documentation.                                          resentations and warranties with respect to the
                                                        loans serviced (mortgage-servicer cash
Early-default clauses. Early-default clauses typi-      advances that meet the conditions of section
cally give the purchaser of a loan the right to         III.B.3.a.x. of the guidelines (12 CFR 208,
return the loan to the seller if the loan becomes       appendix A) are not direct-credit substitutes);
30 or more days delinquent within a stated            • clean-up calls on third-party assets (clean-up
period after the transfer, for example, four            calls that are 10 percent or less of the original
months after transfer. Once the stated period has       pool balance that are exercisable at the option

Commercial Bank Examination Manual                                                        November 2004
                                                                                                Page 23
3020.1                                                               Assessment of Capital Adequacy

  of the bank are not direct-credit substitutes);     remaining loans in a pool when the balance of
  and                                                 those loans is equal to or less than 10 percent of
• liquidity facilities that provide liquidity sup-    the original pool balance. This treatment will
  port to ABCP (other than eligible ABCP              also apply to clean-up calls written with refer-
  liquidity facilities).                              ence to less than 10 percent of the outstanding
                                                      principal amount of securities. If, however, an
Clean-up calls. A clean-up call is an option that     agreement permits the remaining loans to be
permits a servicer or its affiliate (which may be      repurchased when their balance is greater than
the originator) to take investors out of their        10 percent of the original pool balance, the
positions in a securitization before all of the       agreement is considered to be a recourse obli-
transferred loans have been repaid. The servicer      gation or a direct-credit substitute. The exemp-
accomplishes this by repurchasing the remain-         tion from recourse or direct-credit-substitute
ing loans in the pool once the pool balance has       treatment for a clean-up call of 10 percent or
fallen below some specified level. This option in      less recognizes the real market need to be able to
a securitization raises long-standing agency con-     call a transaction when the costs of keeping it
cerns that a bank may implicitly assume a             outstanding are burdensome. However, to mini-
credit-enhancing position by exercising the           mize the potential for using such a feature as a
option when the credit quality of the securitized     means of providing support for a troubled port-
loans is deteriorating. An excessively large          folio, a bank that exercises a clean-up call
clean-up call facilitates a securitization servic-    should not repurchase any loans in the pool that
er’s ability to take investors out of a pool to       are 30 days or more past due. Alternatively, the
protect them from absorbing credit losses, and        bank should repurchase the loans at the lower of
thus may indicate that the servicer has retained      their estimated fair value or their par value plus
or assumed the credit risk on the underlying          accrued interest.
pool of loans.                                           Banks that repurchase assets pursuant to a
   Generally, clean-up calls (whether or not they     clean-up call may do so based on an aggregate
are exercised) are treated as recourse and direct-    fair value for all repurchased assets. Banks do
credit substitutes. The purpose of treating large     not have to evaluate each individual loan remain-
clean-up calls as recourse or direct-credit sub-      ing in the pool at the time a clean-up call is
stitutes is to ensure that a bank is not able to      exercised to determine fair value. Rather, the
provide credit support to the trust investors by      overall repurchase price should reflect the aggre-
repaying its investment when the credit quality       gate fair value of the assets being repurchased so
of the pool is deteriorating without holding          that the bank is not overpaying for the assets
capital against the exposure. The focus should        and, in so doing, providing credit support to the
be on the arrangement itself and not the exercise     trust investors. Examiners will review the terms
of the call. Thus, the existence, not the exercise,   and conditions relating to the repurchase arrange-
of a clean-up call that does not meet the require-    ments in clean-up calls to ensure that transac-
ments of the risk-based capital rule will trigger     tions are done at the lower of fair value or par
treatment as a recourse obligation or a direct-       value plus accrued interest. Banks should be
credit substitute. A clean-up call can function as    able to support their fair-value estimates. If the
a credit enhancement because its existence pro-       Federal Reserve concludes that a bank has
vides the opportunity for a bank (as servicer or      repurchased assets at a price that exceeds the
an affiliate of a servicer) to provide credit          lower of these two amounts, the clean-up call
support to investors by taking an action that is      provisions in its future securitizations may be
within the contractual terms of the securitization    treated as recourse obligations or direct-credit
documents.                                            substitutes. Regardless of the size of the clean-up
   Because clean-up calls can also serve an           call, the Federal Reserve will closely scrutinize
administrative function in the operation of a         and take appropriate supervisory action for any
securitization, a limited exemption exists for        transaction in which the bank repurchases dete-
these options. When an agreement permits a            riorating assets for an amount greater than a
bank that is a servicer or an affiliate of the         reasonable estimate of their fair value.
servicer to elect to purchase loans in a pool, the
agreement is not considered a recourse obliga-        Eligible ABCP liquidity facility. An eligible
tion or a direct-credit substitute if the agreement   ABCP liquidity facility is a liquidity facility that
permits the banking organization to purchase the      supports ABCP, in form or in substance, and is

November 2004                                                      Commercial Bank Examination Manual
Page 24
Assessment of Capital Adequacy                                                                    3020.1

subject to an asset-quality test at the time of      derived from assets an organization has sold into
draw that precludes funding against assets that      a securitization. In those cases, the spread
are 90 days or more past due or in default. In       account is considered to be a ‘‘credit-enhancing
addition, if the assets that an eligible ABCP        interest-only strip’’ and is subject to the concen-
liquidity facility is required to fund against are   tration limit. (See SR-02-16.) However, any
externally rated assets or exposures at the incep-   portion of a spread account that represents an
tion of the facility, the facility can be used to    interest in cash that has already been collected
fund only those assets or exposures that are         and is held by the trustee is a ‘‘residual interest’’
externally rated investment grade at the time of     subject to dollar-for-dollar capital, but is not a
funding. Notwithstanding the eligibility require-    credit-enhancing interest-only strip subject to
ments set forth in the two preceding sentences, a    the concentration limit. For example, assume
liquidity facility will be considered an eligible    that a bank books a single spread-account asset
ABCP liquidity facility if the assets that are       that is derived from two separate cash-flow
funded under the liquidity facility and which do     streams:
not meet the eligibility requirements are guar-
anteed, either conditionally or unconditionally,     • A receivable from the securitization trust that
by the U.S. government or its agencies or by the       represents cash that has already accumulated
central government of an OECD country.                 in the spread account. In accordance with the
                                                       securitization documents, the cash will be
Externally rated. Externally rated is a term           returned to the bank at some date in the future
which means that an instrument or obligation           after having been reduced by amounts used to
has received a credit rating from a nationally         reimburse investors for credit losses. Based on
recognized statistical rating organization.            the date when the cash is expected to be paid
                                                       out to the bank, the present value of this asset
Face amount. The face amount is the notional           is currently estimated to be $3.
principal, or face value, amount of an off-          • A projection of future cash flows that are
balance-sheet item; the amortized cost of an           expected to accumulate in the spread account.
asset not held for trading purposes; and the fair      In accordance with the securitization docu-
value of a trading asset.                              ments, the cash, to the extent collected, will
                                                       also be returned to the bank at some date in
Financial asset. A financial asset is cash or other     the future after having been reduced by
monetary instrument, evidence of debt, evidence        amounts used to reimburse investors for credit
of an ownership interest in an entity, or a            losses. Based on the date when the cash is
contract that conveys a right to receive or            expected to be paid out to the bank, the
exchange cash or another financial instrument           present value of this asset is currently esti-
from another party.                                    mated to be $2.

Financial standby letters of credit. A finan-            Both components of the above spread account
cial standby letter of credit means a letter         are considered to be residual interests under the
of credit or similar arrangement that represents     current capital standards because both represent
an irrevocable obligation to a third-party           on-balance-sheet assets subject to more than
beneficiary—                                          their pro rata share of losses on the underlying
                                                     portfolio of sold assets. However, the $2 asset
• to repay money borrowed by, advanced to, or        that represents the bank’s retained interest in
  for the account of a second party (the account     future cash flows exposes the organization to a
  party), or                                         greater degree of risk because the $2 asset
• to make payment on behalf of the account           presents additional uncertainty as to whether it
  party, in the event that the account party fails   will ever be collected. This additional uncer-
  to fulfill its obligation to the beneficiary.        tainty associated with the recognition of future
                                                     subordinated excess cash flows results in the $2
Spread accounts that function as credit-             asset being treated as a credit-enhancing interest-
enhancing interest-only strips. A spread account     only strip, a subset of residual interests.
is an on-balance-sheet asset that functions as a        The face amount of all of the bank’s credit-
credit enhancement and that can represent an         enhancing interest-only strips is first subject to a
interest in expected interest and fee cash flows      25 percent of tier 1 capital concentration limit.

Commercial Bank Examination Manual                                                        November 2004
                                                                                                Page 25
3020.1                                                                       Assessment of Capital Adequacy

Any portion of this face amount that exceeds                  spread-related assets as credit-enhancing I/O
25 percent of tier 1 capital is deducted from tier            strips on a case-by-case basis. For example,
1 capital. This limit will affect both a bank’s               including some principal payments with interest
risk-based and leverage capital ratios. The                   and fee cash flows will not otherwise negate the
remaining face amount of the bank’s credit-                   regulatory capital treatment of that asset as a
enhancing interest-only strips, as well as the                credit-enhancing I/O strip. Credit-enhancing I/O
face amount of the spread-account receivable                  strips include both purchased and retained
for cash already held in the trust, is subject to the         interest-only strips that serve in a credit-
dollar-for-dollar capital requirement established             enhancing capacity, even though purchased I/O
for residual interests, which affects only the                strips generally do not result in the creation of
risk-based capital ratios.                                    capital on the purchaser’s balance sheet.

Credit-enhancing interest-only strips. A credit-              Loan-servicing arrangements. The definitions
enhancing interest-only (I/O) strip is an                     of recourse and direct-credit substitute cover
on-balance-sheet asset that, in form or substance,            loan-servicing arrangements if the bank, as ser-
(1) represents the contractual right to receive               vicer, is responsible for credit losses associated
some or all of the interest due on transferred                with the serviced loans. However, cash advances
assets and (2) exposes the bank to credit risk that           made by residential mortgage servicers to ensure
exceeds its pro rata claim on the underlying                  an uninterrupted flow of payments to investors
assets, whether through subordination provi-                  or the timely collection of the mortgage loans
sions or other credit-enhancing techniques. Thus,             are specifically excluded from the definitions of
credit-enhancing I/O strips include any balance-              recourse and direct-credit substitute, provided
sheet asset that represents the contractual right             the residential mortgage servicer is entitled to
to receive some or all of the remaining interest              reimbursement for any significant advances and
cash flow generated from assets that have been                 this reimbursement is not subordinate to other
transferred into a trust (or other special-purpose            claims. To be excluded from recourse and direct-
entity), after taking into account trustee and                credit-substitute treatment, the bank, as servicer,
other administrative expenses, interest payments              should make an independent credit assessment
to investors, servicing fees, reimbursements to               of the likelihood of repayment of the servicer
investors for losses attributable to the beneficial            advance before advancing funds, and should
interests they hold, and reinvestment income                  only make such an advance if prudent lending
and ancillary revenues26 on the transferred assets.           standards are met. Risk-based capital is assessed
Credit-enhancing I/O strips are generally carried             only against the amount of the cash advance,
on the balance sheet at the present value of the              and the advance is assigned to the risk-weight
expected net cash flow that the banking organi-                category appropriate to the party obligated to
zation reasonably expects to receive in future                reimburse the servicer.
periods on the assets it has securitized, adjusted               If a residential mortgage servicer is not entitled
for some level of prepayments if relevant to that             to full reimbursement, then the maximum pos-
asset class, and discounted at an appropriate                 sible amount of any nonreimbursed advances on
market interest rate. Typically, when assets are              any one loan must be contractually limited to an
transferred in a securitization transaction that is           insignificant amount of the outstanding principal
accounted for as a sale under GAAP, the account-              on that loan. Otherwise, the servicer’s obligation
ing recognition given to the credit-enhancing                 to make cash advances will not be excluded
I/O strip on the seller’s balance sheet results in            from the definitions of recourse and direct-credit
the recording of a gain on the portion of the                 substitute. Banks that act as servicers should
transferred assets that has been sold. This gain is           establish policies on servicer advances and use
recognized as income, thus increasing the bank’s              discretion in determining what constitutes an
capital position. The economic substance of a                 ‘‘insignificant’’ servicer advance. The Federal
transaction will be used to determine whether a               Reserve will exercise its supervisory authority
particular interest cash flow functions as a credit-           to apply recourse or direct-credit-substitute treat-
enhancing I/O strip, and the Federal Reserve                  ment to servicer cash advances that expose a
reserves the right to identify other cash flows or             bank, acting as servicer, to excessive levels of
                                                              credit risk.
  26. According to FAS 140, ancillary revenues include such
revenues as late charges on the transferred assets.           Liquidity facility. A liquidity facility refers to a

November 2004                                                              Commercial Bank Examination Manual
Page 26
Assessment of Capital Adequacy                                                                    3020.1

legally binding commitment to provide liquidity       ing the third-party enhancement. Second mort-
support to ABCP by lending to, or purchasing          gages or home equity loans generally will not be
assets from, any structure, program, or conduit       considered recourse arrangements unless they
in the event that funds are required to repay         actually function as credit enhancements.
maturing ABCP.                                           Third-party enhancements (for example,
                                                      insurance protection) purchased by the origina-
Mortgage-servicer cash advance. A mortgage-           tor of a securitization for the benefit of investors
servicer cash advance represents funds that a         also do not generally constitute recourse. The
residential mortgage loan servicer advances to        purchase of enhancements for a securitization,
ensure an uninterrupted flow of payments,              when the bank is completely removed from any
including advances made to cover foreclosure          credit risk, will not, in most instances, constitute
costs or other expenses to facilitate the timely      recourse. However, if the purchase or premium
collection of the loan.                               price is paid over time and the size of the
   A mortgage-servicer cash advance is not a          payment is a function of the third-party’s loss
recourse obligation or a direct-credit substitute     experience on the portfolio, such an arrange-
if—                                                   ment indicates an assumption of credit risk and
                                                      would be considered recourse.
• the servicer is entitled to full reimbursement         Recourse may also exist implicitly if a bank
  and this right is not subordinated to other         provides credit enhancement beyond any con-
  claims on the cash flows from the underlying         tractual obligation to support assets it has sold.
  asset pool; or                                      The following are examples of recourse arrange-
• for any one loan, the servicer’s obligation to      ments:
  make nonreimbursable advances is contractu-
  ally limited to an insignificant amount of the       • credit-enhancing representations and warran-
  outstanding principal balance of that loan.           ties made on the transferred assets
                                                      • loan-servicing assets retained pursuant to an
Nationally recognized statistical rating organi-        agreement under which the bank will be
zation (NRSRO). An NRSRO is an entity that is           responsible for credit losses associated with
recognized by the Division of Market Regula-            the loans being serviced (mortgage-servicer
tion of the Securities and Exchange Commission          cash advances that meet the conditions of
(or any successor division) (the commission) as         section III.B.3.a.x. of the guidelines (12 CFR
a nationally recognized statistical rating organi-      208, appendix A) are not recourse
zation for various purposes, including the com-         arrangements)
mission’s uniform net capital requirements for        • retained subordinated interests that absorb
brokers and dealers.                                    more than their pro rata share of losses from
                                                        the underlying assets
Recourse. Recourse means the retention by a           • assets sold under an agreement to repurchase,
bank, in form or in substance, of any credit risk       if the assets are not already included on the
directly or indirectly associated with an asset it      balance sheet
has transferred that exceeds a pro rata share of      • loan strips sold without contractual recourse,
the bank’s claim on the asset. If a bank has no         when the maturity of the transferred loan is
claim on a transferred asset, then the retention of     shorter than the maturity of the commitment
any risk of credit loss is recourse. A recourse         under which the loan is drawn
obligation typically arises when a bank transfers     • credit derivatives issued that absorb more than
assets and retains an explicit obligation to repur-     the bank’s pro rata share of losses from the
chase the assets or absorb losses due to a default      transferred assets
on the payment of principal or interest or any        • clean-up calls at inception that are greater than
other deficiency in the performance of the under-        10 percent of the balance of the original pool
lying obligor or some other party. The definition        of transferred loans (clean-up calls that are
of recourse is consistent with the banking agen-        10 percent or less of the original pool balance
cies’ long-standing use of this term, and incor-        that are exercisable at the option of the bank
porates existing agency practices regarding reten-      are not recourse arrangements)
tion of risk in asset sales.                          • liquidity facilities that provide liquidity sup-
   Second-lien positions do not, in most circum-        port to ABCP (other than eligible ABCP
stances, constitute recourse for the bank receiv-       liquidity facilities)

Commercial Bank Examination Manual                                                        November 2004
                                                                                                Page 27
3020.1                                                                Assessment of Capital Adequacy

Residual interests. Residual interests are defined      future credit losses within the loan pools that
as any on-balance-sheet asset (1) that represents      they support, and thus are subject to valuation
an interest (including a beneficial interest)           inaccuracies. Spread accounts and overcollater-
created by a transfer that qualifies as a sale (in      alizations that do not meet the definition of
accordance with GAAP) of financial assets,              credit-enhancing I/O strips generally do not
whether through a securitization or otherwise,         expose a bank to the same level of risk as
and (2) that exposes a bank to credit risk directly    credit-enhancing I/O strips, and thus are excluded
or indirectly associated with the transferred          from the concentration limit.
assets that exceeds a pro rata share of                   The capital treatment for a residual interest
the bank’s claim on the asset, whether through         applies when a bank effectively retains the risk
subordination provisions or other credit-              associated with that residual interest, even if the
enhancement techniques. Residual interests gen-        residual is sold. The economic substance of the
erally do not include interests purchased from a       transaction will be used to determine whether
third party, except for credit-enhancing I/O strips.   the bank has transferred the risk associated with
Examples of residual interests (assets) include        the residual-interest exposure. Banks that trans-
credit-enhancing I/Os; spread accounts; cash-          fer the risk on residual interests, either directly
collateral accounts; retained subordinated inter-      through a sale or indirectly through guarantees
ests; accrued but uncollected interest on trans-       or other credit-risk-mitigation techniques, and
ferred assets that, when collected, will be            then reassume this risk in any form will be
available to serve in a credit-enhancing capac-        required to hold risk-based capital as though the
ity; and similar on-balance-sheet assets that          residual interest remained on the bank’s books.
function as a credit enhancement. The functional-      For example, if a bank sells an asset that is an
based definition reflects the fact that securitiza-      on-balance-sheet credit enhancement to a third
tion structures vary in the way they use certain       party and then writes a credit derivative to cover
assets as credit enhancements. Residual interests      the credit risk associated with that asset, the
therefore include any retained on-balance-sheet        selling bank must continue to risk-weight, and
asset that functions as a credit enhancement in a      hold capital against, that asset as a residual
securitization, regardless of how a bank refers to     interest as if the asset had not been sold.
the asset in financial or regulatory reports.
   In general, the definition of residual interests     Risk participation. Risk participation means a
includes only an on-balance-sheet asset that           participation in which the originating party
represents an interest created by a transfer of        remains liable to the beneficiary for the full
financial assets treated as a sale under GAAP, in       amount of an obligation (for example, a direct-
accordance with FAS 140. Interests retained in a       credit substitute) notwithstanding that another
securitization or transfer of assets accounted for     party has acquired a participation in that
as a financing under GAAP are generally                 obligation.
excluded from the definition of residual interest.
In the case of GAAP financings, the transferred         Securitization. Securitization is the pooling and
assets remain on the transferring bank’s balance       repackaging by a special-purpose entity of assets
sheet and are, therefore, directly included in         or other credit exposures into securities that can
both the leverage and risk-based capital calcu-        be sold to investors. Securitization includes
lations. Further, when a transaction is treated as     transactions that create stratified credit-risk posi-
a financing, no gain is recognized from an              tions whose performance is dependent on an
accounting standpoint.                                 underlying pool of credit exposures, including
   Sellers’ interests generally do not function as     loans and commitments.
a credit enhancement. Thus, if a seller’s interest
shares losses on a pro rata basis with investors,      Sponsor. A sponsor refers to a bank that estab-
such an interest would not be considered a             lishes an ABCP program; approves the sellers
residual interest. However, banks should recog-        permitted to participate in the program; approves
nize that sellers’ interests that are structured to    the asset pools to be purchased by the program;
absorb a disproportionate share of losses will be      or administers the program by monitoring the
considered residual interests.                         assets, arranging for debt placement, compiling
   The definition of residual interest also includes    monthly reports, or ensuring compliance with
overcollateralization and spread accounts because      the program documents and with the program’s
these accounts are susceptible to the potential        credit and investment policy.

November 2004                                                       Commercial Bank Examination Manual
Page 28
Assessment of Capital Adequacy                                                                                         3020.1

Structured finance program. A structured finance                    Risk-Weight Factor for Off-Balance-Sheet
program refers to a program where receivable                      Recourse Obligations and Direct-Credit
interests and asset-backed securities issued by                   Substitutes
multiple participants are purchased by a special-
purpose entity that repackages those exposures                    To determine the bank’s risk-weight factor for
into securities that can be sold to investors.                    off-balance-sheet recourse obligations and direct-
Generally, structured finance programs allocate                    credit substitutes, the credit-equivalent amount
credit risks between the participants and the                     is assigned to the risk category appropriate to
credit enhancement provided to the program.                       the obligor in the underlying transaction, after
                                                                  considering any associated guarantees or collat-
                                                                  eral. For a direct-credit substitute that is an
                                                                  on-balance-sheet asset (for example, a pur-
Recourse Obligations, Direct-Credit                               chased subordinated security), a bank must cal-
Substitutes, Residual Interests, and                              culate risk-weighted assets using the amount of
Asset- and Mortgage-Backed                                        the direct-credit substitute and the full amount
Securities                                                        of the assets it supports, that is, all the more
                                                                  senior positions in the structure. Direct-credit
                                                                  substitutes that have been syndicated or in
The risk-based capital treatment for recourse
                                                                  which risk participations have been conveyed or
obligations, direct-credit substitutes, and asset-
                                                                  acquired are considered off-balance-sheet items
and mortgage-backed securities in connection
                                                                  that are converted at a 100 percent conversion
with asset securitizations and structured financ-
                                                                  factor. (See section III.D.1. of the guidelines (12
ings is described below. The capital treatment
                                                                  CFR 208, appendix A) for more capital-treatment
described in this subsection applies to the bank’s
own positions.27
   For banks that comply with the market-risk
rules, except for liquidity facilities supporting                 Ratings-Based Approach—Externally
ABCP (in form or in substance), positions in the                  Rated Positions
trading book that arise from asset securitiza-
tions, including recourse obligations, residual                   Each loss position in an asset-securitization
interests, and direct-credit substitutes, should be               structure functions as a credit enhancement for
treated according to the market-risk rules. How-                  the more senior loss positions in the structure. A
ever, these banks remain subject to the 25 per-                   multilevel ratings-based approach is used to
cent concentration limit for credit-enhancing I/O                 assess capital requirements on recourse obliga-
strips.                                                           tions, residual interests (except credit-enhancing
                                                                  I/O strips), direct-credit substitutes, and senior
                                                                  and subordinated securities in asset securitiza-
Credit-Equivalent Amount                                          tions. The approach uses credit ratings from the
                                                                  rating agencies to measure relative exposure to
The credit-equivalent amount for a recourse                       credit risk and determine the associated risk-
obligation or a direct-credit substitute is the full              based capital requirement. Using these credit
amount of the credit-enhanced assets for which                    ratings provides a way to use determinations of
the bank directly or indirectly retains or assumes                credit quality that are relied on by investors and
credit risk, multiplied by a 100 percent conver-                  other market participants to differentiate the
sion factor. This treatment, however, does not                    regulatory capital treatment for loss positions
apply to externally rated positions, senior posi-                 representing different gradations of risk.
tions not externally rated, residual interests,                      Under the ratings-based approach, the capital
certain internally rated positions, and certain                   requirement for a position is computed by mul-
small-business loans and leases on personal                       tiplying the face amount of the position by the
property transferred with recourse.                               appropriate risk weight, determined in accor-
                                                                  dance with the following tables.28 Table 2 maps

                                                                     28. The rating designations (for example, AAA, BBB, A-1,
   27. The treatment also applies to banks that hold positions    and P-1) used in the tables are illustrative only and do not
in their trading book but that are not otherwise subject to the   indicate any preference for, or endorsement of, any particular
market-risk rules.                                                rating-agency designation system.

Commercial Bank Examination Manual                                                                           November 2004
                                                                                                                   Page 29
3020.1                                                                Assessment of Capital Adequacy

Table 2—Risk-Weight Assignments for Externally Rated Long-Term Positions
                 Long-term rating category                             examples      Risk weight
 Highest or second-highest investment grade                       AAA, AA                  20   percent
 Third-highest investment grade                                   A                        50   percent
 Lowest investment grade                                          BBB                     100   percent
 One category below investment grade                              BB                      200   percent

Table 3—Risk-Weight Assignments for Externally Rated Short-Term Positions
                 Short-term rating category                            examples      Risk weight
 Highest investment grade                                         A-1, P-1                 20 percent
 Second-highest investment grade                                  A-2, P-2                 50 percent
 Lowest investment grade                                          A-3, P-3                100 percent

long-term ratings to the appropriate risk weights.     enhancing I/O strips) retained, assumed, or issued
Table 3 maps short-term ratings for asset-backed       in connection with a securitization or structured
commercial paper to the appropriate risk weights.      finance program qualify for the ratings-based
The Federal Reserve has the authority, however,        approach.
to override the use of certain ratings or the             Corporate debt instruments, municipal bonds,
ratings on certain instruments, either on a case-      and other securities that are not related to a
by-case basis or through broader supervisory           securitization or structured finance program do
policy, if necessary or appropriate to address the     not meet these definitions, and thus do not
risk that an instrument poses to a bank.               qualify for the ratings-based approach.
   The ratings-based approach can be used for
certain designated asset-backed securities
(including asset-backed commercial paper),
recourse obligations, direct-credit substitutes,       Traded Positions
and residual interests (other than credit-
enhancing I/O strips). Credit-enhancing I/O strips     A traded position is only required to be rated by
have been excluded from the ratings-based              one rating agency. A traded position is defined
approach because of their high risk profile.            as a position that is externally rated and is
While the ratings-based approach is available          retained, assumed, or issued in connection with
for both traded and untraded positions, the            an asset securitization, where there is a reason-
approach applies different requirements to each        able expectation that, in the near future, the
type of position.                                      rating will be relied on by unaffiliated investors
                                                       to purchase the position or will be relied on by
                                                       an unaffiliated third party to enter into a trans-
                                                       action involving the position, such as a pur-
Ratings-Based Qualification for                         chase, loan, or repurchase agreement.
Corporate Bonds or Other Securities                       For a traded position that has received an
                                                       external rating on a long-term position that is
Corporate bonds or other securities not related        one grade below investment grade or better, or
in any way to a securitization or structured           that has received a short-term rating that is
finance program do not qualify for the ratings-         investment grade, the bank multiplies the face
based approach. Only mortgage- and asset-backed        amount of the position by the appropriate risk
securities, recourse obligations, direct-credit sub-   weight, determined in accordance with tables 2
stitutes, and residual interests (except credit-       and 3. Stripped mortgage-backed securities and

November 2004                                                      Commercial Bank Examination Manual
Page 30
Assessment of Capital Adequacy                                                                                       3020.1

other similar instruments, such as interest-only             lower. Similarly, if a portion of an instrument is
or principal-only strips that are not credit                 unrated, the entire position will be treated as if it
enhancements, must be assigned to the 100 per-               was unrated. In addition to this regulatory capi-
cent risk category. If a traded position has                 tal treatment, the Federal Reserve may also, as
received more than one external rating, the                  appropriate, adversely classify and require write-
lowest single rating will apply. Moreover, if a              downs for an other-than-temporary impairment
rating changes, the bank must use the new                    on unrated and below-investment-grade securi-
rating.                                                      ties, including split or partially rated securities.
   Table 3, for short-term ratings, is not identical         (See SR-02-16.)
to table 2, for long-term ratings, because the
rating agencies do not assign short-term ratings
using the same methodology as they use for                   Senior Positions Not Externally Rated
long-term ratings. Each short-term rating cate-
gory covers a range of longer-term rating cate-              A position that is not externally rated (an
gories.29 For example, a P-1 rating could map to             unrated position), but that is senior or preferred
a long-term rating that is as high as Aaa or as              in all respects (including collateralization and
low as A3.                                                   maturity) to a rated position that is traded, is
                                                             treated as if it had the rating assigned to the
                                                             rated position. The bank must satisfy the Federal
Externally Rated, Nontraded Positions                        Reserve that such treatment is appropriate. Senior
                                                             unrated positions qualify for the risk weighting
For a rated, but untraded, position to be eligible           of the subordinated rated positions in the same
for the ratings-based approach, it must meet                 securitization transaction as long as the subor-
certain conditions. To qualify, the position                 dinated rated position (1) is traded and (2) remains
(1) must be rated by more than one rating                    outstanding for the entire life of the unrated
agency; (2) must have received an external                   position, thus providing full credit support until
rating on a long-term position that is one grade             the unrated position matures.
below investment grade or better or, for                        Recourse obligations and direct-credit substi-
a short-term position, a rating that is investment           tutes (other than residual interests) that do not
grade or better by all rating agencies providing a           qualify for the ratings-based approach (or for the
rating; (3) must have ratings that are publicly              internal-ratings, program-ratings, or computer-
available; and (4) must have ratings that are                program-ratings approaches outlined below)
based on the same criteria used to rate traded               receive ‘‘gross-up’’ treatment, that is, the bank
securities. If the ratings are different, the lowest         holding the position must hold capital against
single rating will determine the risk-                       the amount of the position, plus all more senior
weight category to which the position will be                positions, subject to the low-level-exposure
assigned. This treatment does not apply to a                 requirement.30 This grossed-up amount is placed
credit-enhancing I/O strip.                                  into a risk-weight category according to the
                                                             obligor or, if relevant, according to the guarantor
                                                             or nature of the collateral. The grossed-up
Split or Partially Rated Instruments                         amount multiplied by both the risk weight and
                                                             8 percent is never greater than the full capital
For instruments that have been assigned sepa-                charge that would otherwise be imposed on the
rate ratings for principal and interest (split or
partially rated instruments), the Federal Reserve               30. Gross-up treatment means that a position is combined
will apply to the entire instrument the risk                 with all more senior positions in the transaction. The result is
weight that corresponds to the lowest compo-                 then risk-weighted based on the obligor or, if relevant, the
nent rating. For example, a purchased subordi-               guarantor or the nature of the collateral. For example, if a bank
                                                             retains a first-loss position (other than a residual interest) in a
nated security whose principal component is                  pool of mortgage loans that qualify for a 50 percent risk
rated BBB, but whose interest component is                   weight, the bank would include the full amount of the assets
rated B, is subject to the gross-up treatment                in the pool, risk-weighted at 50 percent, in its risk-weighted
accorded to direct-credit substitutes rated B or             assets for purposes of determining its risk-based capital ratio.
                                                             The low-level-exposure rule provides that the dollar amount
                                                             of risk-based capital required for assets transferred with
  29. See, for example, Moody’s Global Ratings Guide, June   recourse should not exceed the maximum dollar amount for
2001, p.3.                                                   which a bank is contractually liable.

Commercial Bank Examination Manual                                                                         November 2004
                                                                                                                 Page 31
3020.1                                                                                  Assessment of Capital Adequacy

assets if they were on the banking organization’s                    Transactions that, in substance, result in the
balance sheet.31                                                     retention of credit risk associated with a trans-
                                                                     ferred residual interest will be treated as if the
                                                                     residual interest was retained by the bank and
Residual Interests                                                   not transferred.
                                                                        When the aggregate capital requirement for
Credit-Enhancing I/O Strips                                          residual interests and other recourse obligations
                                                                     in connection with the same transfer of assets
After applying the concentration limit to credit-                    exceeds the full risk-based capital requirement
enhancing I/O strips (both purchased and                             for those assets, a bank must maintain risk-based
retained), a bank must maintain risk-based capi-                     capital equal to the greater of the risk-based
tal for a credit-enhancing I/O strip (both pur-                      capital requirement for the residual interest or
chased and retained), regardless of the external                     the full risk-based capital requirement for the
rating on that position, equal to the remaining                      assets transferred.
amount of the credit-enhancing I/O strip (net of
any existing associated deferred tax liability),
even if the amount of risk-based capital required
to be maintained exceeds the full risk-based                         Accrued Interest Receivables Held on
capital requirement for the assets transferred.                      Credit Card Securitizations
Transactions that, in substance, result in the
retention of credit risk associated with a trans-                    In a typical credit card securitization, an insti-
ferred credit-enhancing I/O strip will be treated                    tution transfers a pool of credit card receivables
as if the credit-enhancing I/O strip was retained                    to a trust, as well as the rights to receive future
by the bank and not transferred.                                     payments of principal, interest, and fee income
                                                                     from those receivables. If a securitization trans-
                                                                     action qualifies as a sale under FAS 140, the
Other Residual Interests                                             selling institution removes the receivables that
                                                                     were sold from its reported assets and continues
Residual interests that are not eligible for the                     to carry any retained interests in the transferred
ratings-based approach receive dollar-for-dollar                     receivables on its balance sheet; the right to
treatment. Dollar-for-dollar treatment means,                        these future cash flows should be reported as an
effectively, that one dollar in total risk-based                     accrued interest receivable (AIR) asset.33 ,34 Any
capital must be held against every dollar of a                       accrued amounts (cash flows) the institution
residual interest retained on the balance sheet                      collects (for example, accrued fees and finance
(net of any existing associated deferred tax                         charges) generally must be transferred to the
liability), even if the amount of risk-based                         trust and will be used first by the trustee for the
capital required to be maintained exceeds the                        benefit of third-party investors to satisfy more
full risk-based capital requirement for the assets                   senior obligations and for the payment of trust
transferred. This capital treatment applies to all                   expenses (such as servicing fees, investor-
residual interests, except for credit-enhancing                      certificate interest, and investor-principal charge-
I/O strips that have already been deducted from                      offs). Any remaining excess fee and finance
tier 1 capital under the concentration limit.32                      charges will flow back to the seller.
                                                                        Because the AIR asset constitutes a subordi-
   31. For assets that are assigned to the 100 percent risk-         nated residual (retained) interest in the trans-
weight category, the minimum capital charge is 8 percent of
the amount of assets transferred, and banking organizations
are required to hold 8 cents of capital for every dollar of assets
transferred with recourse. For assets that are assigned to the          33. The AIR represents fees and finance charges that have
50 percent risk-weight category, the minimum capital charge          been accrued on receivables that the institution has securitized
is 4 cents of capital for every dollar of assets transferred with    and sold to other investors. For example, in credit card
recourse.                                                            securitizations, this accrued interest receivable asset may
   32. Residual interests that are retained or purchased credit-     include both finance charges billed but not yet collected and
enhancing I/O strips are first subject to a capital concentration     finance charges accrued but not yet billed on the securitized
limit of 25 percent of tier 1 capital. For risk-based capital        receivables.
purposes (but not for leverage capital purposes), once this             34. Some institutions may categorize part or all of this
concentration limit is applied, a banking organization must          receivable as a loan, a ‘‘due from trust’’ account, a retained
then hold dollar-for-dollar capital against the face amount of       interest in the trust, or as part of an interest-only strip
credit-enhancing I/O strips remaining.                               receivable.

November 2004                                                                        Commercial Bank Examination Manual
Page 32
Assessment of Capital Adequacy                                                                                3020.1

ferred securitized assets, it meets the definition                  these approaches, the bank must satisfy the
of recourse exposure for risk-based capital pur-                   Federal Reserve that the use of the approach is
poses. Recourse exposures (such as the AIR                         appropriate for the particular bank and for the
asset) require risk-based capital against the full,                exposure being evaluated. The risk weight that
risk-weighted amount of the assets transferred                     may be applied to an exposure under these
with recourse, subject to the low-level-recourse                   alternative approaches is limited to a minimum
rule.35 The AIR asset serves as a credit                           of 100 percent.
enhancement to protect third-party investors in
the securitization from credit losses, and it meets
the definition of a residual interest under the                     Internal Risk-Rating Systems for
risk-based capital adequacy rules for the treat-                   Asset-Backed Commercial Paper
ment of recourse arrangements. Under those                         Programs
rules, an institution must hold dollar-for-dollar
capital against residual interests, even if that                   A bank that has a qualifying internal risk-rating
amount exceeds the full equivalent risk-based                      system can use that system to apply the ratings-
capital charge on the transferred assets.36 The                    based approach to its unrated direct-credit sub-
institution is expected to hold risk-based capital                 stitutes in asset-backed commercial paper pro-
in an amount consistent with the subordinated                      grams. Internal risk ratings could be used to
nature of the AIR asset.                                           qualify such a credit enhancement for a risk
   In accounting for the sale, the AIR asset is                    weight of 100 percent or 200 percent under the
treated as a subordinated retained interest of                     ratings-based approach, but not for a risk weight
credit card receivables when computing the gain                    of less than 100 percent.
or loss on sale. Consistent with GAAP, this                           Most sophisticated banking organizations that
means that the value of the AIR, at the date of                    participate extensively in the asset-securitization
transfer, must be adjusted based on its relative                   business assign internal risk ratings to their
fair (market) value. This adjustment will typi-                    credit exposures, regardless of the form of the
cally result in the carrying amount of the AIR                     exposure. Usually, internal risk ratings more
being lower than its book (face) value prior to                    finely differentiate the credit quality of a bank-
securitization. The AIR should be reported in                      ing organization’s exposures than the categories
regulatory reports as ‘‘Other Assets’’ and not as                  the banking agencies use to evaluate credit risk
a loan receivable. (See SR-02-12 and SR-02-22).                    during bank examinations (pass, substandard,
                                                                   doubtful, or loss). An individual bank’s internal
                                                                   risk ratings may be associated with a certain
Other Unrated Positions                                            probability of default, loss in the event of
                                                                   default, and loss volatility.
A position (but not a residual interest) main-                        The credit enhancements that sponsors obtain
tained in connection with a securitization and                     for their commercial paper conduits are rarely
that is not rated by a rating agency may be                        rated or traded. If an internal risk-ratings
risk-weighted based on the bank’s internal                         approach were not available for these unrated
determination of the credit rating of the position,                credit enhancements, the provider of the
as specified in table 4, multiplied by the face                     enhancement would have to obtain two ratings
amount of the position. The bank may use three                     solely to avoid the gross-up treatment that would
approaches to determine the capital require-                       otherwise apply to nontraded positions in asset
ments for certain unrated direct-credit substi-                    securitizations for risk-based capital purposes.
tutes and recourse obligations. Under each of                      However, before a provider of an enhancement
                                                                   decides whether to provide a credit enhance-
                                                                   ment for a particular transaction (and at what
   35. The low-level-recourse rule limits the maximum risk-        price), the provider will generally perform its
based capital requirement to the lesser of a banking organi-
zation’s maximum contractual exposure or the full capital
                                                                   own analysis of the transaction to evaluate the
charge against the outstanding amount of assets transferred        amount of risk associated with the enhancement.
with recourse.                                                     An internal risk-ratings approach, therefore, is
   36. For a complete description of the appropriate capital       potentially less costly than a ratings-based
treatment for recourse, residual interests, and credit-enhancing
interest-only strips, see ‘‘Recourse, Direct Credit Substitutes,
                                                                   approach that relies exclusively on ratings by
and Residual Interests in Asset Securitizations,’’ 66 Fed. Reg.    the rating agencies for the risk weighting of
59614 (November 29, 2001).                                         these positions.

Commercial Bank Examination Manual                                                                    November 2004
                                                                                                            Page 33
3020.1                                                                   Assessment of Capital Adequacy

Table 4—Risk-Weight Assignments for Unrated Positions Using the
Alternative Approaches1
                           Rating category                               examples      Risk weight
 Highest or second-highest investment grade                         AAA, AA                      100    percent
 Third-highest investment grade                                     A                            100    percent
 Lowest investment grade                                            BBB                          100    percent
 One category below investment grade                                BB                           200    percent
  1. such as the internal ratings approach

   Internal risk ratings that correspond to the            ers, as well as the risk associated with the
rating categories of the rating agencies can be            specific positions in a securitization transaction.
mapped to risk weights under the Federal               •   The ratings identify gradations of risk among
Reserve’s capital standards. This mapping can              ‘‘pass’’ assets, and not just among assets that
be done in a way that would make it possible to            have deteriorated to the point that they fall
differentiate the riskiness of various unrated             into ‘‘watch’’ grades. Although it is not nec-
direct-credit substitutes in asset-backed commer-          essary for a bank to use the same categories as
cial paper programs based on credit risk. The              the rating agencies, its internal ratings must
use of internal risk ratings, however, may raise           correspond to the ratings of the rating agen-
concerns about the accuracy and consistency of             cies so that the Federal Reserve can determine
the ratings, especially because the mapping of             which internal risk rating corresponds to each
ratings to risk-weight categories will give banks          rating category of the rating agencies. A bank
an incentive to rate their risk exposures in a way         would be responsible for demonstrating, to the
that minimizes the effective capital requirement.          satisfaction of the Federal Reserve, how these
A bank engaged in asset-backed commercial                  ratings correspond with the rating-agency stan-
paper securitization activities that wishes to use         dards that are used as the framework for the
the internal risk-ratings approach must therefore          asset-securitization portion of the risk-based
be able to demonstrate to the satisfaction of the          capital rule. This correlation is necessary so
Federal Reserve, before relying on its internal            that the mapping of credit ratings to risk-
ratings, that the bank’s internal credit-risk rating       weight categories in the ratings-based approach
system is adequate. Adequate internal risk-                can be applied to internal ratings.
rating systems usually have the following              •   The ratings classify assets into each risk grade
characteristics:                                           using clear, explicit criteria, even for subjec-
                                                           tive factors.
• The internal risk ratings are an integral part of    •   Independent credit-risk-management or loan-
  an effective risk-management system that                 review personnel assign or review the credit-
  explicitly incorporates the full range of risks          risk ratings. These personnel should have
  arising from the bank’s participation in secu-           adequate training and experience to ensure
  ritization activities. The system must also              that they are fully qualified to perform this
  fully take into account the effect of such               function.
  activities on the bank’s risk profile and capital     •   An internal audit procedure periodically veri-
  adequacy.                                                fies that internal risk ratings are assigned
• The ratings link to measurable outcomes, such            in accordance with the bank’s established
  as the probability that a position will experi-          criteria.37
  ence any losses, the expected losses on that
  position in the event of default, and the degree        37. The audit may be performed by any group within the
  of variance in losses given default on that          organization that is qualified to audit the system and is
  position.                                            independent of both the group that makes the decision to
                                                       extend credit to the asset-backed commercial paper program
• The ratings separately consider the risk asso-       and the groups that develop and maintain the internal credit-
  ciated with the underlying loans and borrow-         risk rating system. (See SR-02-16.)

November 2004                                                         Commercial Bank Examination Manual
Page 34
Assessment of Capital Adequacy                                                                       3020.1

• The performance of internal ratings is tracked       rating obtained by the sponsor of the program.
  over time to evaluate how well risk grades are          Banks with limited involvement in securitiza-
  being assigned, make adjustments to the rat-         tion activities may find the above alternative to
  ing system when the performance of the rated         be useful. In addition, some banks extensively
  positions diverges from assigned ratings, and        involved in securitization activities already rely
  adjust individual ratings accordingly.               on ratings of the credit-risk positions under their
• Credit-risk rating assumptions are consistent        securitization programs as part of their risk-
  with, or more conservative than, the credit-         management practices. Such banks can rely on
  risk rating assumptions and methodologies of         these ratings for regulatory capital purposes if
  the rating agencies.                                 the ratings are part of a sound overall risk-
                                                       management process and the ratings reflect the
   If it determines that a bank’s rating system is     risk of nontraded positions to the banks.
not adequate, the Federal Reserve may preclude
                                                          This approach in a structured financing pro-
the bank from applying the internal risk-ratings
                                                       gram can be used to qualify a direct-credit
approach to new transactions for risk-based
                                                       substitute or recourse obligation (but not a
capital purposes until the deficiencies have been
                                                       residual interest) for a risk weight of 100 percent
remedied. Additionally, depending on the sever-
                                                       or 200 percent of the face value of the position
ity of the problems identified, the Federal
                                                       under the ratings-based approach, but not for a
Reserve may decline to rely on the internal risk
                                                       risk weight of less than 100 percent.
ratings that the bank had applied to previous
transactions for purposes of determining its
regulatory capital requirements.                       Credit-Assessment Computer Programs
                                                       A bank (particularly a bank with limited involve-
Ratings of Specific Unrated Positions in                ment in securitization activities) may use an
Structured Financing Programs                          internal ratings-based approach if it is using an
                                                       acceptable credit-assessment computer pro-
A bank may also use a rating obtained from a           gram, developed by a rating agency, to deter-
rating agency for an unrated direct-credit sub-        mine the rating of a direct-credit substitute or a
stitute or recourse obligation (other than a           recourse obligation (but not a residual interest)
residual interest) that is assumed or retained in      issued in connection with a structured finance
connection with a structured finance program, if        program. To be used by a bank for risk-based
a rating agency has reviewed the terms of the          capital purposes, a computer program must have
program (according to the specifications set by         been developed by a rating agency. Further, the
the rating agency) and stated a rating for posi-       bank must demonstrate to the satisfaction of the
tions associated with the program. If the pro-         Federal Reserve that the computer program’s
gram has options for different combinations of         credit assessments correspond credibly and reli-
assets, standards, internal credit enhancements,       ably to the rating standards of the rating agen-
and other relevant factors, and if the rating          cies for traded positions in securitizations and
agency specifies ranges of rating categories to         with the rating of traded positions in the finan-
them, the bank may apply the rating category           cial markets. The latter would generally be
that corresponds to the bank’s position. To rely       shown if investors and other market participants
on a program rating, the bank must demonstrate         significantly used the computer program for
to the Federal Reserve’s satisfaction that the         risk-assessment purposes. In addition, the bank
credit-risk rating assigned to the program meets       must demonstrate to the Federal Reserve’s sat-
the same standards generally used by rating            isfaction that the program was designed to apply
agencies for rating traded positions.                  to its particular direct-credit substitute or recourse
   The bank must also demonstrate to the Fed-          exposure and that it has properly implemented
eral Reserve’s satisfaction that the criteria under-   the computer program. In general, sophisticated
lying the rating agency’s assignment of ratings        banks with extensive securitization activities
for the structured financing program are satisfied       should use this approach only if the computer
for the particular position. If a bank participates    program is an integral part of their risk-
in a securitization sponsored by another party,        management systems and if the bank’s systems
the Federal Reserve may authorize the bank to          fully capture the risks from its securitization
use this approach based on a programmatic              activities. This computer-program approach can

Commercial Bank Examination Manual                                                               April 2011
                                                                                                   Page 35
3020.1                                                                   Assessment of Capital Adequacy

be used to qualify a direct-credit substitute or      similar arrangements with embedded recourse
recourse obligation (but not a residual interest)     obligations or direct-credit substitutes, both the
for a risk weight of 100 percent or 200 percent       on-balance-sheet assets and the related recourse
of the face value of the position under the           obligations and direct-credit substitutes must be
ratings-based approach, but not for a risk weight     separately risk-weighted and incorporated into
of less than 100 percent.                             the risk-based capital calculation.

                                                      Asset-Backed Commercial Paper Program
Limitations on Risk-Based Capital                     Assets and Related Minority Interests
                                                      An asset-backed commercial paper (ABCP) pro-
                                                      gram typically is a program through which a
Low-Level Exposure                                    bank provides funding to its corporate custom-
                                                      ers by sponsoring and administering a
If a bank’s maximum contractual exposure to
                                                      bankruptcy-remote special-purpose entity that
loss retained or assumed in connection with a
                                                      purchases asset pools from, or extends loans to,
recourse obligation or a direct-credit substitute,
                                                      those customers.38 The asset pools in an ABCP
except for a residual interest, is less than the
                                                      program might include, for example, trade
effective risk-based capital requirement for the
                                                      receivables, consumer loans, or asset-backed
enhanced assets, the risk-based capital require-
                                                      securities. The ABCP program raises cash to
ment is limited to the maximum contractual
                                                      provide funding to the bank’s customers, pri-
exposure, less any recourse liability account
                                                      marily (that is, more than 50 percent of the
established in accordance with GAAP. This
                                                      ABCP’s issued liabilities) through the issuance
limitation does not apply when a bank provides
                                                      of externally rated commercial paper into the
credit enhancement beyond any contractual obli-
                                                      market. Typically, the sponsoring bank provides
gation to support assets it has sold.
                                                      liquidity and credit enhancements to the ABCP
                                                      program. These enhancements aid the program
Mortgage-Related Securities or                        in obtaining high credit ratings that facilitate the
Participation Certificates Retained in a               issuance of the commercial paper.39
Mortgage Loan Swap                                       Under the Board’s risk-based capital rule, a
                                                      bank that qualifies as a primary beneficiary and
If a bank holds a mortgage-related security or a      must consolidate an ABCP program that is
participation certificate as a result of a mortgage    defined as a variable interest entity under GAAP
loan swap with recourse, capital is required to       may not exclude the consolidated ABCP pro-
support the recourse obligation plus the percent-     gram’s assets from risk-weighted assets when it
age of the mortgage-related security or partici-      consolidates ABCP program assets. The bank
pation certificate that is not covered by the          must assess the appropriate risk-based capital
recourse obligation. The total amount of capital      charge against any exposures of the bank arising
required for the on-balance-sheet asset and the       in connection with such ABCP programs, includ-
recourse obligation, however, is limited to the       ing direct-credit substitutes, recourse obliga-
capital requirement for the underlying loans,         tions, residual interests, liquidity facilities, and
calculated as if the bank continued to hold the       loans, in accordance with sections III.B.5., III.C.,
loans as on-balance-sheet assets.                     and III.D. of the risk-based capital rule (12 CFR

                                                         38. The definition of ABCP program generally includes
Related On-Balance-Sheet Assets                       structured investment vehicles (entities that earn a spread by
                                                      issuing commercial paper and medium-term notes and using
If a recourse obligation or a direct-credit substi-   the proceeds to purchase highly rated debt securities) and
                                                      securities arbitrage programs.
tute also appears as a balance-sheet asset, the          39. A bank is considered the sponsor of an ABCP program
balance-sheet asset is not included in a bank’s       if it establishes the program; approves the sellers permitted to
risk-weighted assets to the extent the value of       participate in the program; approves the asset pools to be
the balance-sheet asset is already included in the    purchased by the program; or administers the program by
                                                      monitoring the assets, arranging for debt placement, compil-
off-balance-sheet credit-equivalent amount for        ing monthly reports, or ensuring compliance with the program
the recourse obligation or direct-credit substi-      documents and with the program’s credit and investment
tute. In the case of loan-servicing assets and        policy.

April 2011                                                            Commercial Bank Examination Manual
Page 36
Assessment of Capital Adequacy                                                                              3020.1

208, appendix A). A bank sponsoring a program         recourse obligations or direct-credit substitutes
issuing ABCP that does not meet the rule’s            for the purposes of the Board’s risk-based capi-
definition of an ABCP program must include the         tal guidelines.
program’s assets in the institution’s risk-              The resulting credit-equivalent amount would
weighted asset base.                                  then be risk-weighted according to the under-
                                                      lying assets or the obligor, after considering any
Liquidity facilities supporting ABCP. Liquidity       collateral or guarantees, or external credit rat-
facilities supporting ABCP often take the form        ings, if applicable. For example, if an eligible
of commitments to lend to, or purchase assets         short-term liquidity facility providing liquidity
from, the ABCP programs in the event that             support to ABCP covered an asset-backed secu-
funds are needed to repay maturing commercial         rity (ABS) externally rated AAA, then the
paper. Typically, this need for liquidity is due to   notional amount of the liquidity facility would
a timing mismatch between cash collections on         be converted at 10 percent to an on-balance-
the underlying assets in the program and sched-       sheet credit-equivalent amount and assigned to
uled repayments of the commercial paper issued        the 20 percent risk-weight category appropriate
by the program.                                       for AAA-rated ABS.40
   A bank that provides liquidity facilities to
ABCP is exposed to credit risk regardless of          Overlapping exposures to an ABCP program. A
the term of the liquidity facilities. For example,    bank may have multiple overlapping exposures
an ABCP program may require a liquidity fa-           to a single ABCP program (for example, both a
cility to purchase assets from the program at         program-wide credit enhancement and multiple
the first sign of deterioration in the credit qual-    pool-specific liquidity facilities to an ABCP
ity of an asset pool, thereby removing such           program that is not consolidated for risk-based
assets from the program. In such an event, a          capital purposes). A bank must hold risk-based
draw on the liquidity facility exposes the bank       capital only once against the assets covered by
to credit risk.                                       the overlapping exposures. Where the overlap-
   Short-term commitments with an original            ping exposures are subject to different risk-
maturity of one year or less expose banks to a        based capital requirements, the bank must apply
lower degree of credit risk than longer-term          the risk-based capital treatment that results in
commitments. This difference in the degree of         the highest capital charge to the overlapping
credit risk is reflected in the risk-based capital     portion of the exposures.
requirement for the different types of exposure.         For example, assume a bank provides a
The Board’s capital guidelines impose a 10 per-       program-wide credit enhancement that would
cent credit-conversion factor on eligible short-      absorb 10 percent of the losses in all of the
term liquidity facilities supporting ABCP. A          underlying asset pools in an ABCP program and
50 percent credit-conversion factor applies to        pool-specific liquidity facilities that cover
eligible long-term ABCP liquidity facilities.         100 percent of each of the underlying asset
These credit-conversion factors apply regardless      pools. The bank would be required to hold
of whether the structure issuing the ABCP meets       capital against 10 percent of the underlying asset
the rule’s definition of an ABCP program. For          pools because it is providing the program-wide
example, a capital charge would apply to an           credit enhancement. The bank would also be
eligible short-term liquidity facility that pro-      required to hold capital against 90 percent of
vides liquidity support to ABCP where the             the liquidity facilities it is providing to each of
ABCP constitutes less than 50 percent of the          the underlying asset pools.
securities issued by the program, thus causing           If different banks have overlapping exposures
the issuing structure not to meet the rule’s          to an ABCP program, however, each organiza-
definition of an ABCP program. However, if a           tion must hold capital against the entire maxi-
bank (1) does not meet this definition and must        mum amount of its exposure. As a result, while
include the program’s assets in its risk-weighted     duplication of capital charges will not occur for
asset base or (2) otherwise chooses to include        individual banks, some systemic duplication
the program’s assets in risk-weighted assets,         may occur where multiple banking organiza-
then no risk-based capital requirement will be
assessed against any liquidity facilities provided       40. See section 4030.1 and also the Board staff’s October
by the bank that support the program’s ABCP.          12, 2007, legal interpretation regarding the risk-based capital
Ineligible liquidity facilities will be treated as    treatment of ABCP liquidity facilities.

Commercial Bank Examination Manual                                                                      April 2011
                                                                                                          Page 37
3020.1                                                                 Assessment of Capital Adequacy

tions have overlapping exposures to the same            recourse obligation or a direct-credit substitute
ABCP program.                                           and generally will be converted at 100 percent.

Asset-quality test. For a liquidity facility, either
short- or long-term, that supports ABCP not
to be considered a recourse obligation or a
                                                        Risk-Based Capital Treatment of
direct-credit substitute, it must meet the rule’s       Certain Off-Balance-Sheet Items and
definition of an eligible ABCP liquidity facil-          Certain Other Types of Transactions
ity. An eligible ABCP liquidity facility must
meet a reasonable asset-quality test that, among
other things, precludes funding assets that are
                                                        Distinction Between Financial and
90 days or more past due or in default. When
                                                        Performance Standby Letters of Credit
assets are 90 days or more past due, they typi-
                                                        For risk-based capital purposes, the vast major-
cally have deteriorated to the point where there
                                                        ity of standby letters of credit a bank issues are
is an extremely high probability of default.
                                                        considered financial in nature. On the one hand,
Assets that are 90 days past due, for example,
often must be placed on nonaccrual status in ac-        in issuing a financial standby letter of credit, a
cordance with the agencies’ Uniform Retail              bank guarantees that the account party will
Credit Classification and Account Management             fulfill a contractual financial obligation that
Policy.41 Further, they generally must also be          involves payment of money. On the other hand,
classified substandard under that policy.                in issuing a performance standby letter of credit,
   The rule’s asset-quality test specifically            a bank guarantees that the account party will
allows a bank to reflect certain guarantees              fulfill a contractual nonfinancial obligation, that
providing credit protection to the bank provid-         is, an obligation that does not entail the payment
ing the liquidity facility. In particular, the          of money. For example, a standby letter of credit
‘‘days-past- due limitation’’ is not applied with       that guarantees that an insurance company will
respect to assets that are either conditionally or      pay as required under the terms of a policy is
unconditionally guaranteed by the U.S. govern-          deemed to be financial and is converted at
ment or its agencies or by another OECD                 100 percent, while a letter of credit that guaran-
central government. To qualify as an eligible           tees a contractor will pave a street according to
ABCP liquidity facility, if the assets covered by       certain specifications is deemed to be perfor-
the liquidity facility are initially externally rated   mance related and is converted at 50 percent.
(at the time the facility is provided), the facil-      Financial standby letters of credit have a higher
ity can be used to fund only those assets that are      conversion factor in large part because, unlike
externally rated investment grade at the time of        performance standby letters of credit, they tend
funding.                                                to be drawn down only when the account party’s
   The practice of purchasing assets that are           financial condition has deteriorated.
externally rated below investment grade out of
an ABCP program is considered the equivalent
of providing credit protection to the commercial        Participations of Off-Balance-Sheet
paper investors. Thus, liquidity facilities permit-     Transactions
ting purchases of below-investment-grade secu-
rities will be considered either recourse obliga-       If a standby letter of credit or commitment has
tions or direct-credit substitutes. However, the        been participated to other institutions in the
‘‘investment-grade’’ limitation is not applied in       form of a syndication, as defined in the instruc-
the asset-quality test with respect to assets that      tions to the Call Report, that is, if each bank is
are conditionally or unconditionally guaranteed
by the U.S. government or its agencies or by
another OECD central government. If the asset-
quality tests are not met (that is, if a bank
actually funds through the liquidity facility assets
that do not satisfy the facility’s asset-quality
tests), the liquidity facility will be considered a

  41. See 65 Fed. Reg. 36904 (June 12, 2000).

April 2011                                                          Commercial Bank Examination Manual
Page 38
Assessment of Capital Adequacy                                                                      3020.1

responsible only for its pro rata share of loss and     other form of consideration. Commitments are
there is no recourse to the originating bank, each      included in weighted-risk assets regardless of
bank includes only its pro rata share of the            whether they contain ‘‘material adverse change’’
standby or commitment in its risk-based capital         clauses or other provisions that are intended to
calculation.                                            relieve the issuer of its funding obligation under
   The treatment differs, however, if the partici-      certain conditions. In the case of commitments
pation takes the form of a conveyance of a risk         structured as syndications, where the bank is
participation. In such a participation, the origi-      obligated solely for its pro rata share, only the
nating bank remains liable to the beneficiary for        bank’s proportional share of the syndicated
the full amount of the standby or commitment if         commitment is taken into account in calculating
the institution that has acquired the participation     the risk-based capital ratio.
fails to pay when the instrument is drawn. Under
this arrangement, the originating bank is exposed       Commitments to make off-balance-sheet trans-
to the credit risk of the institution that has          actions. As specified in the instructions to the
acquired the conveyance rather than that of the         Call Report, a commitment to make a standby
account party. Accordingly, for risk-based capi-        letter of credit is considered to be a standby
tal purposes, the originating bank should con-          letter of credit. Accordingly, such a commitment
vert the full amount of the standby or commit-          should be converted to an on-balance-sheet
ment to an on-balance-sheet credit-equivalent           credit-equivalent amount at 100 percent if it is
amount. The credit-equivalent amount of the             a commitment to make a financial standby let-
portion of the credit that has not been conveyed        ter of credit or at 50 percent if it is a commit-
is assigned to the risk category appropriate to         ment to make a performance standby letter of
the obligor, after giving effect to any collateral      credit.
or guarantees. The portion that has been con-              A commitment to make a commitment is
veyed is assigned either to the same risk cate-         treated as a single commitment whose maturity
gory as the obligor or to the risk category             is the combined maturity of the two commit-
appropriate to the institution acquiring the par-       ments. For example, a 6-month commitment to
ticipation, whichever category carries the lower        make a 1-year commitment is considered to be a
risk weight. Any remainder is assigned to the           single 18-month commitment. Since the matu-
risk category appropriate to the obligor, guaran-       rity is over one year, such a commitment would
tor, or collateral. For example, the pro rata share     receive the 50 percent conversion factor appro-
of the full amount of the assets supported, in          priate to long-term commitments, rather than the
whole or in part, by a direct-credit substitute         zero percent conversion factor that would be
conveyed as a risk participation to a U.S. domes-       accorded to separate unrelated short-term com-
tic depository institution or foreign bank is           mitments of six months and one year.
assigned to the 20 percent risk category. Risk             A commitment to make a commercial letter of
participations with a remaining maturity of over        credit may be treated either as a commitment or
one year that are conveyed to non-OECD banks            as a commercial letter of credit, whichever
are to be assigned to the 100 percent risk              results in the lower conversion factor. Normally,
category, unless a lower risk category is appro-        this would mean that a commitment under one
priate to the obligor, guarantor, or collateral.        year to make a commercial letter of credit would
                                                        be treated as a commitment and converted at
                                                        zero percent, while a similar commitment of
Commitments                                             over one year would be treated as a commercial
                                                        letter of credit and converted at 20 percent.
Commitments are defined as any legally binding              If a commitment facility is structured so that
arrangements that obligate a bank to extend             it can be drawn down in several forms, such as
credit in the form of loans or leases; to purchase      a standby letter of credit, a loan, or a commer-
loans, securities, or other assets; or to participate   cial letter of credit, the entire facility should be
in loans and leases. Commitments also include           treated as a commitment to extend credit in the
overdraft facilities, revolving credit, home equity     form that incurs the highest capital charge.
and mortgage lines of credit, eligible ABCP             Thus, if a facility could be drawn down in any of
liquidity facilities, and similar transactions. Nor-    the three forms just cited, the entire facility
mally, commitments involve a written contract           would be treated as a commitment to issue a
or agreement and a commitment fee, or some              standby letter of credit and would be converted

Commercial Bank Examination Manual                                                          November 2004
                                                                                                  Page 39
3020.1                                                                           Assessment of Capital Adequacy

at 100 percent, rather than treated as a commit-                  advance notice of cancellation to the obligor or
ment to make a loan or commercial letter of                       which permit the commitment to roll over auto-
credit, which would have a lower conversion                       matically (that is, on the same terms and without
factor.                                                           a thorough credit review) unless the bank gives
                                                                  notice otherwise, are not unconditionally can-
Unused commitments. Except for eligible ABCP                      celable. Thus, any such commitment whose
liquidity facilities,42 unused portions of commit-                term from date of issuance could exceed one
ments, including underwriting commitments, and                    year is subject to the 50 percent conversion
commercial and consumer credit commitments                        factor.
that have an original maturity of one year or less                   A bank may issue a commitment that expires
are converted at zero percent.                                    within one year, with the understanding that the
   Unused commitments that have an original                       commitment will be renewed upon expiration
maturity of over one year are converted at                        subject to a thorough credit review of the
50 percent. For this purpose, original maturity is                obligor. Such a commitment may be converted
defined as the length of time between the date                     at zero percent only if (1) the renegotiation
the commitment is issued and the earliest date                    process is carried out in good faith, involves a
on which (1) the bank has the permanent ability                   full credit assessment of the obligor, and allows
to, at its option, unconditionally cancel43 (with-                the bank flexibility to alter the terms and con-
out cause) the commitment44 and (2) the bank is                   ditions of the new commitment; (2) the bank has
scheduled to (and as a normal practice actually                   absolute discretion to decline renewal or exten-
does) review the facility to determine whether                    sion of the commitment; and (3) the renegoti-
the unused commitment should be extended. (It                     ated commitment expires within 12 months
should be noted that the term of any loan                         from the time it is made. Some commitments
advances that can be made under a commitment                      contain unusual renegotiation arrangements that
is not taken into account in determining the                      would give the borrower a considerable amount
commitment’s maturity.) Under this definition                      of advance notice that a commitment would not
of original maturity, commitments with a nomi-                    be renewed. Provisions of this kind can have the
nal original maturity of more than one year can                   effect of creating a rolling commitment arrange-
be treated as having a maturity of one year or                    ment that should be treated for risk-based capital
less for risk-based capital purposes only if the                  purposes as a long-term commitment and should
issuing bank (1) has full and unconditional                       therefore be converted to a credit-equivalent
discretion to cancel the commitment without                       amount at 50 percent. Normally, the renegotia-
cause and without notice on each and every day                    tion process should take no more than six to
after the first year and (2) conducts at least                     eight weeks, and in many cases it should take a
annually a formal credit review of the commit-                    shorter period of time. The renegotiation period
ment, including an assessment of the credit                       should immediately precede the expiration date
quality of the obligor.                                           of the commitment and should be reasonably
   It should be noted that a bank is not deemed                   short and appropriate to the complexity of the
able to unconditionally cancel a commitment                       transaction. The reasons for provisions in a
if it is required to give, or is presumed to be                   commitment arrangement that would appear to
required to give, any advance notice of cancel-                   allow for a protracted renegotiation period should
lation. Accordingly, so-called evergreen com-                     be thoroughly documented by the bank and
mitments, which require the bank to give                          reviewed by the examiner.
                                                                     As mentioned above, a commitment to make
  42. Unused portions of eligible ABCP liquidity facilities
                                                                  a commitment is treated as a single commitment
with an original maturity of one year of less are converted at    whose maturity is the combined maturity of the
10 percent.                                                       two commitments. Although such commitments
  43. A bank’s option to cancel a commitment under a              whose combined maturity is in excess of one
material adverse change clause is not considered to be an
option to unconditionally cancel a commitment.
                                                                  year are generally considered long-term, if the
  44. In the case of consumer home equity or mortgage lines       customer has a bona fide business reason for
of credit secured by liens on one- to four-family residential     requesting a new commitment to supersede the
properties, the bank is deemed able to unconditionally cancel     unexpired one, such as an unanticipated increase
the commitment for the purpose of this criterion if, at its
option, it can prohibit additional extensions of credit, reduce
                                                                  in the volume of business or a change in the
the credit lines, and terminate the commitment to the full        customer’s cash flow and credit needs, then the
extent permitted by relevant federal law.                         commitment would not automatically be consid-

November 2004                                                                 Commercial Bank Examination Manual
Page 40
Assessment of Capital Adequacy                                                                      3020.1

ered long-term. However, if the bank exhibits a        following off-balance-sheet contracts:
pattern and practice of extending short-term
commitments before their expiration—either for         • interest-rate contracts
one customer or more broadly within the bank—             — single-currency interest-rate swaps
then such extended commitments would be                   — basis swaps
viewed as long-term. This treatment generally             — forward rate agreements
would apply to all commitments, including tra-            — interest-rate options purchased (includ-
ditional commercial paper liquidity lines.                     ing caps, collars, and floors purchased)
   Other criteria for determining whether a               — any other instrument linked to interest
facility is short- or long-term include the actual             rates that gives rise to similar credit risks
level of risk associated with the transaction and              (including when-issued securities and for-
whether that level of risk is more characteristic              ward deposits accepted)
of a long-term (as opposed to a short-term)            • exchange-rate contracts
commitment. Liquidity facilities issued in con-           — cross-currency interest-rate swaps
nection with asset-backed commercial paper                — forward foreign-exchange-rate contracts
programs, when judged by these criteria, seem             — currency options purchased
to possess risk characteristics that are less than        — any other instrument linked to exchange
those associated with typical short-term com-                  rates that gives rise to similar credit risks
mercial loan commitments. One of these char-           • equity derivative contracts
acteristics is the short-term nature of the secu-         — equity-linked swaps
ritized receivables. The receivables that are             — equity-linked options purchased
securitized in asset-backed commercial paper              — forward equity-linked contracts
programs tend to be of very short average                 — any other instrument linked to equities
maturity—often in the range of 30 to 60 days.                  that gives rise to similar credit risks
Advances under asset-backed commercial paper           • commodity (including precious metal) deriva-
liquidity facilities generally are very rare, and        tive contracts
when such advances are made, it is against pools          — commodity-linked swaps
of very high-quality performing receivables that          — commodity-linked options purchased
would generally liquidate very quickly. These             — forward commodity-linked contracts
facilities are further protected against credit risk      — any other instrument linked to commodi-
by significant amounts of overcollateralization,                ties that gives rise to similar credit risks
as well as other credit enhancements.                  • credit derivatives
   A series of short-term commitments would               — credit-default swaps
generally be treated as a single commitment               — total-rate-of-return swaps
whose original maturity is the combined matu-             — other types of credit derivatives
rities of the individual commitments in the
series. Also, a commitment may be structured to        Exceptions. Exchange-rate contracts with an
be drawn down in a number of tranches, some            original maturity of 14 or fewer calendar days
exercisable in one year or less and others exer-       and derivative contracts traded on exchanges
cisable in over one year. The full amount of such      that require daily receipt and payment of cash-
a commitment is deemed to be over one year             variation margin may be excluded from the
and converted at 50 percent. Some long-term            risk-based ratio calculation. Gold contracts are
commitments may permit the customer to draw            accorded the same treatment as exchange-rate
down varying amounts at different times to             contracts, except that gold contracts with an
accommodate, for example, seasonal borrowing           original maturity of 14 or fewer calendar days
needs. The 50 percent conversion factor should         are included in the risk-based ratio calculation.
be applied to the maximum amount that could            Over-the-counter options purchased are included
be drawn down under such commitments.                  and treated in the same way as other derivative

Credit-Equivalent Computations for                     Calculation of credit-equivalent amounts. The
Derivative Contracts                                   credit-equivalent amount of a derivative con-
                                                       tract (excluding credit derivatives) that is not
Applicable derivative contracts. Credit-               subject to a qualifying bilateral netting contract
equivalent amounts are computed for each of the        is equal to the sum of—

Commercial Bank Examination Manual                                                          November 2004
                                                                                                  Page 41
3020.1                                                                Assessment of Capital Adequacy

Table 5—Conversion-Factor Matrix
                                               Foreign-                       Precious      commodity
                                              exchange-                        metals       (excluding
                                Interest-        rate                        (excluding      precious
Remaining maturity                rate         and gold         Equity          gold)         metals)

One year or less                   0.0           1.0              6.0            7.0            10.0
Over one to five years              0.5           5.0             8.0             7.0            12.0
Over five years                     1.5           7.5             10.0            8.0            15.0

• the current exposure (sometimes referred to as       tract. A derivative contract not included in the
  the replacement cost) of the contract, and           definitions of interest-rate, exchange-rate, equity,
• an estimate of the potential future credit           or commodity contracts is included in the risk-
  exposure of the contract.                            based capital calculation and is subject to the
                                                       same conversion factors as a commodity, exclud-
   The current exposure is determined by the           ing precious metals.
mark-to-market value of the contract. If the              No potential future credit exposure is calcu-
mark-to-market value is positive, then the cur-        lated for a single-currency interest-rate swap in
rent exposure is equal to that mark-to-market          which payments are made based on two floating-
value. If the mark-to-market value is zero or          rate indexes, so-called floating/floating or basis
negative, then the current exposure is zero.           swaps. The credit exposure on these contracts is
Mark-to-market values are measured in dollars,         evaluated solely on the basis of their mark-to-
regardless of the currency or currencies speci-        market values.
fied in the contract, and should reflect changes in
the underlying rates, prices, and indexes, as well     Avoidance of double-counting. In certain cases,
as in counterparty credit quality.                     credit exposures arising from derivative con-
   The potential future credit exposure of a           tracts may be reflected, in part, on the balance
contract, including a contract with a negative         sheet. To avoid double counting these exposures
mark-to-market value, is estimated by multiply-        in the assessment of capital adequacy and,
ing the notional principal amount of the contract      perhaps, assigning inappropriate risk weights,
by a credit-conversion factor. Banks should use,       examiners may need to exclude counterparty
subject to examiner review, the effective rather       credit exposures arising from the derivative
than the apparent or stated notional amount in         instruments covered by the guidelines from
this calculation. The conversion factors (in per-      balance-sheet assets when calculating a bank’s
cent) are in table 5. The Board has noted that         risk-based capital ratios. This exclusion will
these conversion factors, which are based on           eliminate the possibility that an organization
observed volatilities of the particular types of       could be required to hold capital against both an
instruments, are subject to review and modifi-          off-balance-sheet and on-balance-sheet amount
cation in light of changing volatilities or market     for the same item. This treatment is not accorded
conditions.                                            to margin accounts and accrued receivables
   For a contract that is structured such that         related to interest-rate and exchange-rate
on specified dates any outstanding exposure is          contracts.
settled and the terms are reset so that the mar-          The aggregate on-balance-sheet amount
ket value of the contract is zero, the remaining       excluded from the risk-based capital calculation
maturity is equal to the time until the next reset     is equal to the lower of—
date. Such resetting interest-rate contracts must
have a minimum conversion factor of                    • each contract’s positive on-balance-sheet
0.5 percent.                                             amount, or
   For a contract with multiple exchanges of           • its positive market value included in
principal, the conversion factor is multiplied by        the off-balance-sheet risk-based capital
the number of remaining payments in the con-             calculation.

November 2004                                                       Commercial Bank Examination Manual
Page 42
Assessment of Capital Adequacy                                                                   3020.1

For example, a forward contract that is marked                lent location in the case of noncorporate
to market will have the same market value on                  entities, and if a branch of the counter-
the balance sheet as is used in calculating the               party is involved, then also under the law
credit-equivalent amount for off-balance-sheet                of the jurisdiction in which the branch is
exposures under the guidelines. Therefore, the                located;
on-balance-sheet amount is not included in the           — the law that governs the individual con-
risk-based capital calculation. When either the               tracts covered by the netting contract;
contract’s on-balance-sheet amount or its mar-                and
ket value is negative or zero, no deduction from         — the law that governs the netting contract;
on-balance-sheet items is necessary for that          • the bank establishes and maintains procedures
contract.                                               to ensure that the legal characteristics of
   If the positive on-balance-sheet asset amount        netting contracts are kept under review in light
exceeds the contract’s market value, the excess         of possible changes in relevant law; and
(up to the amount of the on-balance-sheet asset)      • the bank maintains documentation in its files
should be included in the appropriate risk-             that is adequate to support the netting of rate
weight category. For example, a purchased               contracts, including a copy of the bilateral
option will often have an on-balance-sheet              netting contract and necessary legal opinions.
amount equal to the fee paid until the option
expires. If that amount exceeds market value,         A contract containing a walkaway clause is not
the excess of carrying value over market value        eligible for netting for purposes of calculating
would be included in the appropriate risk-weight      the credit-equivalent amount.
category for purposes of the on-balance-sheet            By netting individual contracts for the pur-
portion of the calculation.                           pose of calculating credit-equivalent amounts of
                                                      derivative contracts, a bank represents that it has
Netting of swaps and similar contracts. Netting       met the requirements of the risk-based measure
refers to the offsetting of positive and negative     of the capital adequacy guidelines for bank
mark-to-market values in the determination of a       holding companies and that all the appropriate
current exposure to be used in the calculation of     documents are in the organization’s files and
a credit-equivalent amount. Any legally enforce-      available for inspection by the Federal Reserve.
able form of bilateral netting (that is, netting      The Federal Reserve may determine that a
with a single counterparty) of derivative con-        bank’s files are inadequate or that a netting
tracts is recognized for purposes of calculating      contract, or any of its underlying individual
the credit-equivalent amount provided that—           contracts, may not be legally enforceable. If
                                                      such a determination is made, the netting con-
• the netting is accomplished under a written         tract may be disqualified from recognition for
  netting contract that creates a single legal        risk-based capital purposes, or underlying indi-
  obligation, covering all included individual        vidual contracts may be treated as though they
  contracts, with the effect that the organization    are not subject to the netting contract.
  would have a claim to receive, or an obliga-           The credit-equivalent amount of contracts
  tion to receive or pay, only the net amount of      that are subject to a qualifying bilateral netting
  the sum of the positive and negative mark-to-       contract is calculated by adding—
  market values on included individual con-
  tracts if a counterparty, or a counterparty to      • the current exposure of the netting contract
  whom the contract has been validly assigned,          (net current exposure), and
  fails to perform due to default, insolvency,        • the sum of the estimates of the potential future
  liquidation, or similar circumstances;                credit exposures on all individual contracts
• the bank obtains written and reasoned legal           subject to the netting contract (gross potential
  opinions that in the event of a legal challenge—      future exposure), adjusted to reflect the effects
  including one resulting from default, insol-          of the netting contract.
  vency, liquidation, or similar circumstances—
  the relevant court and administrative authorities      The net current exposure of the netting con-
  would find the bank’s exposure to be such a          tract is determined by summing all positive and
  net amount under—                                   negative mark-to-market values of the indi-
   — the law of the jurisdiction in which the         vidual contracts included in the netting contract.
        counterparty is chartered or the equiva-      If the net sum of the mark-to-market values is

Commercial Bank Examination Manual                                                       November 2004
                                                                                               Page 43
3020.1                                                                    Assessment of Capital Adequacy

positive, then the current exposure of the netting     ing bilateral netting contract to determine the
contract is equal to that sum. If the net sum of       adjusted add-on for that netting contract.
the mark-to-market values is zero or negative,            In the event a netting contract covers con-
then the current exposure of the netting contract      tracts that are normally excluded from the risk-
is zero. The Federal Reserve may determine that        based ratio calculation—for example, exchange-
a netting contract qualifies for risk-based capital     rate contracts with an original maturity of 14 or
netting treatment even though certain individual       fewer calendar days or instruments traded on
contracts may not qualify. In these instances, the     exchanges that require daily payment and receipt
nonqualifying contracts should be treated as           of cash-variation margin—an institution may
individual contracts that are not subject to the       elect to either include or exclude all mark-to-
netting contract.                                      market values of such contracts when determin-
   Gross potential future exposure (Agross) is         ing net current exposure, provided the method
calculated by summing the estimates of poten-          chosen is applied consistently.
tial future exposure for each individual contract         Examiners should review the netting of off-
subject to the qualifying bilateral netting con-       balance-sheet derivative contracts used by banks
tract. The effects of the bilateral netting contract   when calculating or verifying risk-based capital
on the gross potential future exposure are rec-        ratios to ensure that the positions of such con-
ognized through the application of a formula           tracts are reported gross, unless the net positions
that results in an adjusted add-on amount (Anet).      of those contracts reflect netting arrangements
The formula, which employs the ratio of net            that comply with the netting requirements listed
current exposure to gross current exposure             previously.
(NGR), is expressed as—

  Anet = (0.4 × Agross) + 0.6(NGR × Agross)            Credit Derivatives

The NGR may be calculated in accordance with           Credit derivatives are off-balance-sheet arrange-
either the counterparty-by-counterparty approach       ments that allow one party (the beneficiary) to
or the aggregate approach. Under the                   transfer credit risk of a reference asset—which
counterparty-by-counterparty approach, the NGR         the beneficiary may or may not own—to another
is the ratio of the net current exposure for a         party (the guarantor).45 Many banks increas-
netting contract to the gross current exposure of      ingly use these instruments to manage their
the netting contract. The gross current exposure       overall credit-risk exposure. In general, credit
is the sum of the current exposures of all             derivatives have three distinguishing features:
individual contracts subject to the netting con-
tract. Net negative mark-to-market values for          • the transfer of the credit risk associated with a
individual netting contracts with the same coun-         reference asset through contingent payments
terparty may not be used to offset net positive          based on events of default and, usually, the
mark-to-market values for other netting con-             prices of instruments before, at, and shortly
tracts with the same counterparty.                       after default (reference assets most often take
   Under the aggregate approach, the NGR is the          the form of traded sovereign and corporate
ratio of the sum of all the net current exposures        debt instruments or syndicated bank loans)
for qualifying bilateral netting contracts to the      • the periodic exchange of payments or the
sum of all the gross current exposures for those         payment of a premium rather than the pay-
netting contracts (each gross current exposure is        ment of fees customary with other off-balance-
calculated in the same manner as in the                  sheet credit products, such as letters of credit
counterparty-by-counterparty approach). Net            • the use of an International Swap Derivatives
negative mark-to-market values for individual            Association (ISDA) master agreement and the
counterparties may not be used to offset                 legal format of a derivatives contract
net positive current exposures for other
   A bank must consistently use either the               45. Credit derivatives generally fall into three basic trans-
counterparty-by-counterparty approach or the           action types: total-rate-of-return swaps, credit-default swaps,
                                                       and credit-default or credit-linked notes. For a more in-depth
aggregate approach to calculate the NGR.               description of these types of credit derivatives, see the Federal
Regardless of the approach used, the NGR               Reserve’s Trading and Capital-Markets Activities Manual,
should be applied individually to each qualify-        section 4350.1, ‘‘Credit Derivatives,’’ as well as SR-96-17.

November 2004                                                          Commercial Bank Examination Manual
Page 44
Assessment of Capital Adequacy                                                                               3020.1

   For risk-based capital purposes, total-rate-of-                    A bank providing a guarantee through a credit
return swaps and credit-default swaps generally                    derivative may mitigate the credit risk associ-
should be treated as off-balance-sheet direct-                     ated with the transaction by entering into an
credit substitutes.46 The notional amount of a                     offsetting credit derivative with another
contract should be converted at 100 percent to                     counterparty—a so-called back-to-back posi-
determine the credit-equivalent amount to be                       tion. A bank that has entered into such a position
included in the risk-weighted assets of a guar-                    may treat the first credit derivative as being
antor.47 A bank that provides a guarantee through                  guaranteed by the offsetting transaction for risk-
a credit derivative transaction should assign its                  based capital purposes. Accordingly, the notional
credit exposure to the risk category appropriate                   amount of the first credit derivative may be
to the obligor of the reference asset or any                       assigned to the risk category appropriate to the
collateral. On the other hand, a bank that owns                    counterparty providing credit protection through
the underlying asset upon which effective credit                   the offsetting credit derivative arrangement (for
protection has been acquired through a credit                      example, the 20 percent risk category if the
derivative may, under certain circumstances,                       counterparty is an OECD bank).
assign the unamortized portion of the underlying                      In some instances, the reference asset in the
asset to the risk category appropriate to the                      credit derivative transaction may not be identi-
guarantor (for example, the 20 percent risk                        cal to the underlying asset for which the bene-
category if the guarantor is an OECD bank).                        ficiary has acquired credit protection. For exam-
   Whether the credit derivative is considered an                  ple, a credit derivative used to offset the credit
eligible guarantee for purposes of risk-based                      exposure of a loan to a corporate customer may
capital depends on the actual degree of credit                     use as the reference asset a publicly traded
protection. The amount of credit protection                        corporate bond of that customer, with the credit
actually provided by a credit derivative may be                    quality of the bond serving as a proxy for the
limited depending on the terms of the arrange-                     on-balance-sheet loan. In such a case, the under-
ment. In this regard, for example, a relatively                    lying asset would still generally be considered
restrictive definition of a default event or a                      guaranteed for capital purposes, as long as both
materiality threshold that requires a comparably                   the underlying asset and the reference asset are
high percentage of loss to occur before the                        obligations of the same legal entity and have the
guarantor is obliged to pay could effectively                      same level of seniority in bankruptcy. In addi-
limit the amount of credit risk actually trans-                    tion, a bank offsetting credit exposure in this
ferred in the transaction. If the terms of the                     manner would be obligated to demonstrate to
credit derivative arrangement significantly limit                   examiners that (1) there is a high degree of
the degree of risk transference, then the benefi-                   correlation between the two instruments; (2) the
ciary bank cannot reduce the risk weight of the                    reference instrument is a reasonable and suffi-
‘‘protected’’ asset to that of the guarantor bank.                 ciently liquid proxy for the underlying asset so
On the other hand, even if the transfer of credit                  that the instruments can be reasonably expected
risk is limited, a bank providing limited credit                   to behave in a similar manner in the event of
protection through a credit derivative should                      default; and (3) at a minimum, the reference
hold appropriate capital against the underlying                    asset and underlying asset are subject to mutual
exposure while it is exposed to the credit risk of                 cross-default provisions. A bank that uses a
the reference asset.                                               credit derivative that is based on a reference
                                                                   asset that differs from the protected underlying
                                                                   asset must document the credit derivative being
                                                                   used to offset credit risk, and must link it
   46. Unlike total-rate-of-return swaps and credit-default        directly to the asset or assets whose credit risk
swaps, credit-linked notes are on-balance-sheet assets or          the transaction is designed to offset. The docu-
liabilities. A guarantor bank should assign the on-balance-        mentation and the effectiveness of the credit
sheet amount of the credit-linked note to the risk category
appropriate to either the issuer or the reference asset, which-
                                                                   derivative transaction are subject to examiner
ever is higher. For a beneficiary bank, cash consideration          review. A bank providing credit protection
received in the sale of the note may be considered as collateral   through such an arrangement must hold capital
for risk-based capital purposes.                                   against the risk exposures that are assumed.
   47. A guarantor bank that has made cash payments repre-
senting depreciation on reference assets may deduct such
                                                                      Some credit derivative transactions provide
payments from the notional amount when computing credit-           credit protection for a group or basket of refer-
equivalent amounts for capital purposes.                           ence assets and call for the guarantor to absorb

Commercial Bank Examination Manual                                                                   November 2004
                                                                                                           Page 45
3020.1                                                                          Assessment of Capital Adequacy

losses on only the first asset in the group that             facilities, letters of credit, banker’s acceptances,
defaults. Once the first asset in the group defaults,        or other asset-backed securities. In a typical
the credit protection for the remaining assets              CLO transaction, the sponsoring banking orga-
covered by the credit derivative ceases. If                 nization (SBO) transfers the loans and other
examiners determine that the credit risk for the            assets to a bankruptcy-remote special-purpose
basket of assets has effectively been transferred           vehicle (SPV), which then issues asset-backed
to the guarantor and the beneficiary banking                 securities consisting of one or more classes of
organization owns all of the reference assets               debt. This type of transaction represents a
included in the basket, then the beneficiary may             so-called cash-flow CLO. It enables the spon-
assign the asset with the smallest dollar amount            soring institution (SI) to reduce its leverage and
in the group—if less than or equal to the                   risk-based capital requirements, improve its
notional amount of the credit derivative—to the             liquidity, and manage credit concentrations.
risk category appropriate to the guarantor. Con-               The first synthetic CLO (issued in 1997) used
versely, a bank extending credit protection                 credit-linked notes (CLNs).49 Rather than trans-
through a credit derivative on a basket of assets           ferring assets to the SPV, the sponsoring bank
must assign the contract’s notional amount of               issued CLNs to the SPV, individually referenc-
credit exposure to the highest risk category                ing the payment obligation of a particular com-
appropriate to the assets in the basket.                    pany, or ‘‘reference obligor.’’ The notional
   In addition to holding capital against credit            amount of the CLNs issued equaled the dollar
risk, a bank that is subject to the market-risk rule        amount of the reference assets the sponsor was
(see ‘‘Market-Risk Measure’’ earlier in this                hedging on its balance sheet. Other structures
section) must hold capital against market risk              have evolved that use credit-default swaps to
for credit derivatives held in its trading account.         transfer credit risk and create different levels of
(For a description of market-risk capital require-          risk exposure, but that hedge only a portion of
ments for credit derivatives, see SR-97-18.)                the notional amount of the overall reference
                                                               Traditional CLO structures usually transfer
Using Credit Derivatives                                    assets into the SPV. In synthetic securitizations,
to Synthetically Replicate Collateralized                   the underlying exposures that make up the
Loan Obligations                                            reference portfolio remain in the institution’s
                                                            banking book.51 The credit risk is transferred
Credit derivatives can be used to synthetically             into the SPV through credit-default swaps or
replicate collateralized loan obligations (CLOs).           CLNs. The institution is thus able to maintain
Banking organizations (BOs) can use CLOs and                client confidentiality and avoid sensitive
their synthetic variants to manage their balance            client-relationship issues that arise from loan-
sheets and, in some instances, transfer credit risk         transfer-notification requirements, loan-
to the capital markets. Such transactions allow             assignment provisions, and loan-participation
economic capital to be more efficiently allo-                restrictions.
cated, resulting in, among other things, improved              Corporate credits are assigned to the 100 per-
shareholders’ returns.                                      cent risk-weighted asset category. In the case of
   The issue for BOs is how synthetic CLOs                  high-quality investment-grade corporate expo-
should be treated under the risk-based and                  sures, the associated 8 percent capital require-
leverage capital guidelines.48 Supervisors and              ment may exceed the economic capital that the
examiners need to fully understand these com-               sponsoring bank sets aside to cover the credit
plex structures and identify the relative degree
of transference and retention of the securitized               49. CLNs are obligations whose principal repayment is
portfolio’s credit risk. They must determine                conditioned upon the performance of a referenced asset or
whether the institution’s regulatory capital is             portfolio. The assets’ performance may be based on a variety
                                                            of measures, such as movements in price or credit spread, or
adequate given the retained credit exposures.               the occurrence of default.
   A CLO is an asset-backed security that is                   50. A credit-default swap is similar to a financial standby
usually supported by a variety of assets, includ-           letter of credit in that the institution writing the swap provides,
ing whole commercial loans, revolving-credit                for a fee, credit protection against credit losses associated with
                                                            a default on a specified reference asset or pool of assets.
                                                               51. ‘‘Banking book’’ refers to nontrading accounts. See the
  48. See SR-99-32 and its November 15, 1999, attachment,   definition of ‘‘trading accounts’’ in the glossary for the
an FRB-OCC capital interpretation on synthetic CLOs.        instructions to the bank Call Report.

November 2004                                                                Commercial Bank Examination Manual
Page 46
Assessment of Capital Adequacy                                                                                   3020.1

Figure 1—Transaction 1

        Bank                                          SPV                         $1.5 billion
                        $1.5 billion cash                                        cash proceeds
     $1.5 billion          proceeds              Holds portfolio
    credit portfolio                              of CLNs
                         $1.5 billion
                          of CLNs
                          issued by

                                                   $1.5 billion
                                                    of notes

                                        X-year                     Y-year
                                        notes                       notes

risk of the transaction. Therefore, one of the              In the example shown in figure 1, this amount is
apparent motivations behind CLOs and other                  $1.5 billion.
securitizations is to more closely align the SI’s              If any obligor linked to a CLN in the SPV
regulatory capital requirements with the eco-               defaults, the SI will call the individual CLN and
nomic capital required by the market.                       redeem it based on the repayment terms speci-
   Synthetic CLOs can raise questions about                 fied in the note agreement. The term of each
their capital treatment when calculating the                CLN is set so that the credit exposure (to which
risk-based and leverage capital ratios. Capital             it is linked) matures before the maturity of the
treatments for three synthetic CLO transactions             CLN, which ensures that the CLN will be in
follow. They are discussed from the perspective             place for the full term of the exposure to which
of the investors and the SBOs.                              it is linked.
                                                               An investor in the notes issued by the SPV is
Transaction 1—Entire notional amount of the                 exposed to the risk of default of the underlying
reference portfolio is hedged. In the first type of          reference assets, as well as to the risk that the SI
synthetic securitization, the SBO, through a                will not repay principal at the maturity of the
synthetic CLO, hedges the entire notional amount            notes. Because of the linkage between the credit
of a reference-asset portfolio. An SPV acquires             quality of the SI and the issued notes, a down-
the credit risk on a reference portfolio by pur-            grade of the sponsor’s credit rating most likely
chasing CLNs issued by the SBO. The SPV                     will result in the notes also being downgraded.
funds the purchase of the CLNs by issuing a                 Thus, a BO investing in this type of synthetic
series of notes in several tranches to third-party          CLO should assign the notes to the higher of the
investors. The investor notes are in effect col-            risk categories appropriate to the underlying
lateralized by the CLNs. Each CLN represents                reference assets or the issuing entity.
one obligor and the bank’s credit-risk exposure                For purposes of risk-based capital, the SBOs
to that obligor, which could take the form of               may treat the cash proceeds from the sale of
bonds, commitments, loans, and counterparty                 CLNs that provide protection against underlying
exposures. Since the noteholders are exposed to             reference assets as cash collateralizing these
the full amount of credit risk associated with the          assets.52 This treatment would permit the refer-
individual reference obligors, all of the credit
risk of the reference portfolio is shifted from the
                                                               52. The CLNs should not contain terms that would signifi-
sponsoring bank to the capital markets. The                 cantly limit the credit protection provided against the under-
dollar amount of notes issued to investors equals           lying reference assets, for example, a materiality threshold
the notional amount of the reference portfolio.             that requires a relatively high percentage of loss to occur

Commercial Bank Examination Manual                                                                     November 2004
                                                                                                             Page 47
3020.1                                                                               Assessment of Capital Adequacy

ence assets, if carried on the SI’s books, to be                     In the structure illustrated in figure 2, the
assigned to the zero percent risk category to the                 SBO purchases default protection from an SPV
extent that their notional amount is fully collat-                for a specifically identified portfolio of banking-
eralized by cash. This treatment may be applied                   book credit exposures, which may include let-
even if the cash collateral is transferred directly               ters of credit and loan commitments. The credit
into the general operating funds of the institu-                  risk on the identified reference portfolio (which
tion and is not deposited in a segregated account.                continues to remain in the sponsor’s banking
The synthetic CLO would not confer any bene-                      book) is transferred to the SPV through the use
fits to the SBO for purposes of calculating its                    of credit-default swaps. In exchange
tier 1 leverage ratio because the reference assets                for the credit protection, the SI pays the SPV
remain on the organization’s balance sheet.                       an annual fee. The default swaps on each of the
                                                                  obligors in the reference portfolio are struc-
Transaction 2—High-quality, senior risk posi-                     tured to pay the average default losses on all
tion in the reference portfolio is retained. In the               senior unsecured obligations of defaulted
second type of synthetic CLO transaction, the                     borrowers.
SBO hedges a portion of the reference portfolio                      To support its guarantee, the SPV sells CLNs
and retains a high-quality, senior risk position                  to investors and uses the cash proceeds to
that absorbs only those credit losses in excess of                purchase U.S. government Treasury notes. The
the junior-loss positions. In some recent syn-                    SPV then pledges the Treasuries to the SBO to
thetic CLOs, the SBO has used a combination of                    cover any default losses.53 The CLNs are often
credit-default swaps and CLNs to essentially                      issued in multiple tranches of differing seniority
transfer to the capital markets the credit risk of                and in an aggregate amount that is significantly
a designated portfolio of the organization’s credit               less than the notional amount of the reference
exposures. Such a transaction allows the SI to                    portfolio. The amount of notes issued typically
allocate economic capital more efficiently and to                  is set at a level sufficient to cover some multiple
significantly reduce its regulatory capital                        of expected losses, but well below the notional
requirements.                                                     amount of the reference portfolio being hedged.

before CLN payments are adversely affected, or a structuring        53. The names of corporate obligors included in the refer-
of CLN post-default payments that does not adequately pass        ence portfolio may be disclosed to investors in the CLNs.
through credit-related losses on the reference assets to inves-
tors in the CLNs.

Figure 2—Transaction 2

                                       Default payment and
                                       pledge of Treasuries
         Bank                                                                              SPV

      $5 billion                                                                    Holds $400 million
    credit portfolio             $5 billion of credit-default swaps                of pledged Treasuries
                                          and annual fee

                                                                      $400 million            $400 million
                                                                        of CLNs                 of cash



November 2004                                                                    Commercial Bank Examination Manual
Page 48
Assessment of Capital Adequacy                                                                                  3020.1

   There may be several levels of loss in this                      tion of its retained senior position in the refer-
type of synthetic securitization. The first-loss                     ence portfolio to the 20 percent risk weight.
position may consist of a small cash reserve,                       However, to the extent that the reference port-
sufficient to cover expected losses. The cash                        folio includes loans and other on-balance-sheet
reserve accumulates over a period of years and                      assets, an SBO involved in such a synthetic
is funded from the excess of the SPV’s income                       securitization would not realize any benefits in
(that is, the yield on the Treasury securities plus                 the determination of its leverage ratio.
the credit-default-swap fee) over the interest                         In addition to the three stringent minimum
paid to investors on the notes. The investors in                    conditions, the Federal Reserve may impose
the SPV assume a second-loss position through                       other requirements as it deems necessary to
their investment in the SPV’s senior and junior                     ensure that the SI has virtually eliminated all of
notes, which tend to be rated AAA and BB,                           its credit exposure. Furthermore, the Federal
respectively. Finally, the SBO retains a high-                      Reserve retains the discretion to increase the
quality, senior risk position that would absorb                     risk-based capital requirement assessed against
any credit losses in the reference portfolio that                   the retained senior exposure in these structures,
exceed the first- and second-loss positions.                         if the underlying asset pool deteriorates
   Typically, no default payments are made until                    significantly.
the maturity of the overall transaction, regard-                       Federal Reserve staff will make a case-by-
less of when a reference obligor defaults. While                    case determination, based on a qualitative review,
operationally important to the SBO, this feature                    as to whether the senior retained portion of an
has the effect of ignoring the time value of                        SBO’s synthetic securitization qualifies for the
money. Thus, the Federal Reserve expects that                       20 percent risk weight. The SI must be able to
when the reference obligor defaults under the                       demonstrate that virtually all the credit risk of
terms of the credit derivative and when the                         the reference portfolio has been transferred from
reference asset falls significantly in value, the                    the banking book to the capital markets. As they
SBO should, in accordance with GAAP, make                           do when BOs are engaging in more traditional
appropriate adjustments in its regulatory reports                   securitization activities, examiners must care-
to reflect the estimated loss that takes into                        fully evaluate whether the institution is fully
account the time value of money.                                    capable of assessing the credit risk it retains in
   For risk-based capital purposes, BOs invest-                     its banking book and whether it is adequately
ing in the notes must assign them to the risk                       capitalized given its residual risk exposure. The
weight appropriate to the underlying reference                      Federal Reserve will require the SBO to main-
assets.54 The SBO for such transactions must                        tain higher levels of capital if it is not deemed to
include in its risk-weighted assets its retained                    be adequately capitalized given the retained
senior exposure in the reference portfolio, to the                  residual risks. In addition, an SI involved in
extent these underlying assets are held in its                      synthetic securitizations must adequately dis-
banking book. The portion of the reference                          close to the marketplace the effect of the trans-
portfolio that is collateralized by the pledged                     action on its risk profile and capital adequacy.
Treasury securities may be assigned a zero                             The Federal Reserve may consider an SBO’s
percent risk weight. Unless the SBO meets the                       failure to require the investors in the CLNs to
stringent minimum conditions for transaction 2                      absorb the credit losses that they contractually
that are outlined in the minimum conditions                         agreed to assume to be an unsafe and unsound
explanation below, the remainder of the port-                       banking practice. In addition, such a failure
folio should be risk-weighted according to the                      generally would constitute ‘‘implicit recourse’’
obligor of the exposures.                                           or support to the transaction, which would result
   When the SI has virtually eliminated its                         in the SBO’s losing preferential capital treat-
credit-risk exposure to the reference portfolio                     ment on its retained senior position.
through the issuance of CLNs, and when the                             If an SBO of a synthetic securitization does
other stringent minimum conditions are met, the                     not meet the stringent minimum conditions, it
institution may assign the uncollateralized por-                    may still reduce the risk-based capital require-
                                                                    ment on the senior risk position retained in the
   54. Under this type of transaction, if a structure exposes       banking book by transferring the remaining
investing BOs to the creditworthiness of a substantive issuer,
for example, the SI, then the investing institutions should
                                                                    credit risk to a third-party OECD bank through
assign the notes to the higher of the risk categories appropriate   the use of a credit derivative. Provided the credit
to the underlying reference assets or the SI.                       derivative transaction qualifies as a guarantee

Commercial Bank Examination Manual                                                                      November 2004
                                                                                                              Page 49
3020.1                                                                           Assessment of Capital Adequacy

under the risk-based capital guidelines, the risk                       other credit enhancements—which effec-
weight on the senior position may be reduced                            tively must be deducted from capital—is
from 100 percent to 20 percent. Institutions may                        no greater than a reasonable estimate of
not enter into nonsubstantive transactions that                         expected losses on the reference portfolio;
transfer banking-book items into the trading                            and
account to obtain lower regulatory capital                          — ensure that the SI does not reassume any
requirements.55                                                         credit risk beyond the first-loss position
                                                                        through another credit derivative or any
   Minimum conditions. The following stringent                          other means.
minimum conditions are those that SIs must                        • Condition 2—Demonstration of ability to
meet to use the synthetic securitization capital                    evaluate remaining banking-book risk expo-
treatment for transaction 2. The Federal Reserve                    sures and provide adequate capital support.
may impose additional requirements or condi-                        To ensure that the SI has adequate capital for
tions as deemed necessary to ascertain that the                     the credit risk of its unhedged exposures, an
SBO has sufficiently isolated itself from the                        institution is expected to have adequate sys-
credit-risk exposure of the hedged reference                        tems that fully account for the effect of those
portfolio.                                                          transactions on its risk profiles and capital
                                                                    adequacy. In particular, its systems should be
• Condition 1—Demonstration of transfer of                          capable of fully differentiating the nature and
  virtually all of the risk to third parties. Not all               quality of the risk exposures an institution
  transactions structured as synthetic securitiza-                  transfers from the nature and quality of the
  tions transfer the level of credit risk needed to                 risk exposures it retains. Specifically, to gain
  receive the 20 percent risk weight on the                         capital relief institutions are expected to—
  retained senior position. To demonstrate that a                   — have a credible internal process for grad-
  transfer of virtually all of the risk has been                        ing credit-risk exposures, including
  achieved, institutions must—                                          (1) adequate differentiation of risk among
  — produce credible analyses indicating a                              risk grades, (2) adequate controls to
      transfer of virtually all of the credit risk to                   ensure the objectivity and consistency of
      substantive third parties;                                        the rating process, and (3) analysis or
  — ensure the absence of any early-                                    evidence supporting the accuracy or
      amortization or other credit performance–                         appropriateness of the risk-grading system;
      contingent clauses;56                                         — have a credible internal economic capital-
  — subject the transaction to market discipline                        assessment process that defines the insti-
      through the issuance of a substantive                             tution to be adequately capitalized at an
      amount of notes or securities to the capital                      appropriate insolvency probability and that
      markets;                                                          readjusts, as necessary, its internal eco-
  — have notes or securities rated by a nation-                         nomic capital requirements to take into
      ally recognized credit rating agency;                             account the effect of the synthetic-
  — structure a senior class of notes that                              securitization transaction. In addition, the
      receives the highest possible investment-                         process should employ a sufficiently long
      grade rating, for example, AAA, from a                            time horizon to allow necessary adjust-
      nationally recognized credit rating agency;                       ments in the event of significant losses.
  — ensure that any first-loss position retained                         The results of an exercise demonstrating
      by the SI in the form of fees, reserves, or                       that the organization is adequately capital-
                                                                        ized after the securitization transaction
   55. For instance, a lower risk weight would not be applied           must be presented for examiner review;
to a nonsubstantive transaction in which the SI (1) enters into     — evaluate the effect of the transaction on the
a credit derivative transaction to pass the credit risk of the          nature and distribution of the nontrans-
senior retained portion held in its banking book to an OECD
bank and then (2) enters into a second credit derivative
                                                                        ferred banking-book exposures. This analy-
transaction with the same OECD bank, in which it reassumes              sis should include a comparison of the
into its trading account the credit risk initially transferred.         banking book’s risk profile and economic
   56. Early-amortization clauses may generally be defined as            capital requirements before and after the
features that are designed to force a wind-down of a securi-
tization program and rapid repayment of principal to asset-
                                                                        transaction, including the mix of expo-
backed securities investors if the credit quality of the under-         sures by risk grade and business or eco-
lying asset pool deteriorates significantly.                             nomic sector. The analysis should also

November 2004                                                                 Commercial Bank Examination Manual
Page 50
Assessment of Capital Adequacy                                                                                  3020.1

      identify any concentrations of credit risk                  10-K and annual reports, SIs must adequately
      and maturity mismatches. Additionally,                      disclose to the marketplace the accounting,
      the bank must adequately manage and                         economic, and regulatory consequences of
      control the forward credit exposure that                    synthetic CLO transactions. In particular,
      arises from any maturity mismatch. The                      institutions are expected to disclose—
      Federal Reserve retains the flexibility to                   — the notional amount of loans and commit-
      require additional regulatory capital if the                    ments involved in the transaction;
      maturity mismatches are substantive                         — the amount of economic capital shed
      enough to raise a supervisory concern.                          through the transaction;
      Moreover, as stated above, the SBO must                     — the amount of reduction in risk-weighted
      demonstrate that it meets its internal eco-                     assets and regulatory capital resulting from
      nomic capital requirement subsequent to                         the transaction, both in dollar terms and in
      the completion of the synthetic securitiza-                     terms of the effect in basis points on the
      tion; and                                                       risk-based capital ratios; and
  — perform rigorous and robust forward-                          — the effect of the transaction on the distri-
      looking stress testing on nontransferred                        bution and concentration of risk in the
      exposures (remaining banking-book loans                         retained portfolio by risk grade and sector.
      and commitments), transferred exposures,
      and exposures retained to facilitate trans-           Transaction 3—Retention of a first-loss position.
      fers (credit enhancements). The stress tests          In the third type of synthetic transaction, the
      must demonstrate that the level of credit             SBO may retain a subordinated position that
      enhancement is sufficient to protect the               absorbs first losses in a reference portfolio. The
      sponsoring bank from losses under                     SBO retains the credit risk associated with a
      scenarios appropriate to the specific                  first-loss position and, through the use of credit-
      transaction.                                          default swaps, passes the second- and senior-
• Condition 3—Provide adequate public disclo-               loss positions to a third-party entity, most often
  sures of synthetic CLO transactions regarding             an OECD bank. The third-party entity, acting as
  their risk profile and capital adequacy. In their          an intermediary, enters into offsetting credit-

Figure 3—Transaction 3

                                      fee (basis points per year)
            OECD Bank                                                                Holds $400 million
                                           Default payment and                      of pledged Treasuries
                                           pledge of Treasuries

                       Default payment
                                                                         $400 million            $400 million
                        and pledge of
                                                                           of CLNs                 of cash
                       Treasuries equal
                      to $400 million to
  swap fee
                      cover losses above
                          1% of the                                                     Senior
                        reference assets                                                notes

          $5 billion credit                                                                         notes

Commercial Bank Examination Manual                                                                    November 2004
                                                                                                            Page 51
3020.1                                                                                 Assessment of Capital Adequacy

default swaps with an SPV, thus transferring its                       It is possible that the second approach may
credit risk associated with the second-loss posi-                   result in a higher risk-based capital requirement
tion to the SPV.57 The SPV then issues CLNs to                      than the dollar-for-dollar capital charge imposed
the capital markets for a portion of the reference                  by the first approach. This depends on whether
portfolio and purchases Treasury collateral to                      the reference portfolio consists primarily of
cover some multiple of expected losses on the                       loans to private obligors or of undrawn long-
underlying exposures. (See figure 3.)                                term commitments, which generally have an
   Two alternative approaches could be used to                      effective risk-based capital requirement that is
determine how the SBO should treat the overall                      one-half of the requirement for loans, since such
transaction for risk-based capital purposes. The                    commitments are converted to an on-balance-
first approach employs an analogy to the low-                        sheet credit-equivalent amount using the 50 per-
level capital rule for assets sold with recourse.                   cent conversion factor. If the reference pool
Under this rule, a transfer of assets with recourse                 consists primarily of drawn loans to private
that contractually is limited to an amount less                     obligors, then the capital requirement on the
than the effective risk-based capital require-                      senior loss position would be significantly higher
ments for the transferred assets is assessed a                      than if the reference portfolio contained only
total capital charge equal to the maximum                           undrawn long-term commitments. As a result,
amount of loss possible under the recourse                          the capital charge for the overall transaction
obligation. If this rule was applied to an SBO                      could be greater than the dollar-for-dollar capi-
retaining a 1 percent first-loss position on a                       tal requirement set forth in the first approach.
synthetically securitized portfolio that would                         SIs will be required to hold capital against a
otherwise be assessed 8 percent capital, the SBO                    retained first-loss position in a synthetic securi-
would be required to hold dollar-for-dollar capi-                   tization equal to the higher of the two capital
tal against the 1 percent first-loss risk position.                  charges resulting from application of the first
The SI would not be assessed a capital charge                       and second approaches, as discussed above.
against the second and senior risk positions.58                     Further, although the SBO retains only the credit
   The second approach employs a literal read-                      risk associated with the first-loss position, it still
ing of the capital guidelines to determine the                      should continue to monitor all the underlying
SBO’s risk-based capital charge. In this instance,                  credit exposures of the reference portfolio to
the one percent first-loss position retained by the                  detect any changes in the credit-risk profile of
SI would be treated as a guarantee, that is, a                      the counterparties. This is important to ensure
direct-credit substitute, which would be assessed                   that the institution has adequate capital to pro-
an 8 percent capital charge against its face value                  tect against unexpected losses. Examiners should
of one percent. The second-loss position, which                     determine whether the sponsoring bank has the
is collateralized by Treasury securities, would                     capability to assess and manage the retained risk
be viewed as fully collateralized and subject to a                  in its credit portfolio after the synthetic securi-
zero percent capital charge. The senior-loss                        tization is completed. For risk-based capital
position guaranteed by the intermediary bank                        purposes, BOs investing in the notes must assign
would be assigned to the 20 percent risk cate-                      them to the risk weight appropriate to the
gory appropriate to claims guaranteed by OECD                       underlying reference assets.60

   57. Because the credit risk of the senior position is not
                                                                    Reservation of Authority
transferred to the capital markets but remains with the
intermediary bank, the SBO should ensure that its counter-          The Federal Reserve reserves its authority to
party is of high credit quality, for example, at least investment   determine, on a case-by-case basis, the appro-
grade.                                                              priate risk weight for assets and credit-equivalent
   58. A BO that sponsors this type of synthetic securitization
would not realize any benefits with respect to the determina-
tion of its leverage ratio since the reference assets remain on
the SI’s balance sheet.                                             would be subject to the standardized specific-risk capital
   59. If the intermediary is a BO, then it could place both sets   charge.
of credit-default swaps in its trading account and, if subject to      60. Under this type of transaction, if a structure exposes
the Federal Reserve’s market-risk capital rules, use its general-   investing BOs to the creditworthiness of a substantive issuer,
market-risk model and, if approved, specific-risk model to           for example, the SI, then the investing institutions should
calculate the appropriate risk-based capital requirement. If the    assign the notes to the higher of the risk categories appropriate
specific-risk model has not been approved, then the SBO              to the underlying reference assets or the SI.

November 2004                                                                       Commercial Bank Examination Manual
Page 52
Assessment of Capital Adequacy                                                                   3020.1

amounts and the appropriate credit-conversion        Certain agency securities-lending arrangements
factor for off-balance-sheet items. The Federal      (May 2003 exception for ‘‘cash-collateral trans-
Reserve’s exercise of this authority may result      actions’’). In response to a bank’s inquiry, the
in a higher or lower risk weight for an asset        Board issued a May 14, 2003, interpretation for
or credit-equivalent amount, or in a higher or       the risk-based capital treatment of certain Euro-
lower credit-conversion factor for an off-           pean agency securities’ lending arrangements in
balance-sheet item. This reservation of authority    which the bank, acting as agent, lends securities
explicitly recognizes that the Federal Reserve       of a client and receives cash collateral from the
retains sufficient discretion to ensure that banks,   borrower. The transaction is marked-to-market
as they develop novel financial assets, will          daily and a positive margin of cash collateral
be treated appropriately under the regulatory        relative to the market value of the securities lent
capital standards. Under this authority, the Fed-    is maintained at all times. If the borrowing
eral Reserve reserves its right to assign risk       counterparty defaults on the securities loaned
positions in securitizations to appropriate risk     through, for example, failure to post margin
categories on a case-by-case basis, if the credit    when required, the transaction is immediately
rating of the risk position is determined to be      terminated and the cash collateral is used by the
inappropriate.                                       bank to repurchase in the market the securities
                                                     lent in order to restore them to the client. The
                                                     bank indemnifies its client against the risk that,
                                                     in the event of counterparty default, the amount
Board Approved Exceptions to Risk-Based              of cash collateral may be insufficient to repur-
Capital Guidelines (Reservation of                   chase the amount of securities lent. Thus, the
Authority) Involving Securities Lending              indemnification is limited to the difference
                                                     between the value of the cash collateral and the
Securities lent by a bank are treated in one of      repurchase price of the replacement securities.
two ways, depending upon whether the lender          In addition, the bank, again acting as agent,
is at risk of loss. If a bank, as agent for a cus-   reinvests, on the client’s behalf, the cash collat-
tomer, lends the customer’s securities and does      eral received from the borrower. The reinvest-
not indemnify the customer against loss, then        ment transaction takes the form of a cash loan to
the transaction is excluded from the risk-based      a counterparty that is fully collateralized by
capital calculation. Alternatively, if a bank        government or corporate securities (through, for
lends its own securities or, acting as agent for a   example, a reverse repurchase agreement). Like
customer, lends the customer’s securities and        the first transaction, the reinvestment transaction
indemnifies the customer against loss, the            is subject to daily marking-to-market and remar-
transaction is converted at 100 percent and          gining and is immediately terminable in the
assigned to the risk-weight category appropri-       event of counterparty default. The bank issues
ate to the obligor, or, if applicable, to any col-   an indemnification to the client against the
lateral delivered to the lending bank or the         reinvestment risk, which is similar to the indem-
independent custodian acting on the lending          nification the bank gives on the original
bank’s behalf. When a bank is acting as agent        securities-lending transaction.
for a customer in a transaction involving the           The Federal Reserve Board’s current risk-
lending or sale of securities that is collateral-    based capital guidelines treat indemnifications
ized by cash delivered to the bank, the transac-     issued in connection with agency securities-
tion is deemed to be collateralized by cash on       lending activities as off-balance-sheet guaran-
deposit for purposes of determining the appro-       tees that are subject to capital charges. Under the
priate risk-weight category, provided that           guidelines, the bank’s first indemnification would
(1) any indemnification is limited to no more         receive the risk weight of the securities-
than the difference between the market value of      borrowing counterparty because of the bank’s
the securities and the cash collateral received      indemnification of the client’s reinvestment risk
and (2) any reinvestment risk associated with        on the cash collateral. (See 12 CFR 208, appen-
that cash collateral is borne by the customer.       dix A, section III.D.1.c.) The bank’s second
See the ‘‘Risk-Weighting Process’’ discussion        indemnification would receive the lower of the
in this section and also the discussion in sec-      risk weight of the reverse repurchase counter-
tion 2030.1 on bank dealer securities-lending or     party or the collateral, unless it was fully collat-
-borrowing transactions.                             eralized with margin by OECD government

Commercial Bank Examination Manual                                                       November 2006
                                                                                               Page 53
3020.1                                                               Assessment of Capital Adequacy

securities, which would qualify for a zero per-       unsecured loan equivalent amount will be
cent risk weight. (See 12 CFR 208, appendix A,        assigned the risk weight appropriate to the
sections III.D.1.a. and b.)                           counterparty.
   The bank inquired about the possibility of            To determine the unsecured loan equivalent
assigning a zero percent risk weight for both         amount, the bank must add together its current
indemnifications, given the low risk they pose to      exposure to the counterparty and a measure for
the bank. The Board approved an exception to          potential future exposure (PFE) to the counter-
its risk-based capital guidelines for the bank’s      party. The current exposure is the sum of the
agency securities-lending transactions. The Board     market value of all securities and cash lent to the
approved this exception under the reservation of      counterparty under the bank’s indemnified
authority provision contained in the guidelines.      arrangements, less the sum of all securities and
This provision permits the Board, on a case-by-       cash received from the counterparty as collateral
case basis, to determine the appropriate risk         under the indemnified arrangements. The PFE
weight for any asset or off-balance-sheet item        calculation is to be based on the market volatili-
that imposes risks on a bank that are incommen-       ties of the securities lent and the securities
surate with the risk weight otherwise specified        received, as well as any foreign exchange rate
in the guidelines. (See 12 CFR 208, appendix A,       volatilities associated with any cash or securities
section III.A.)                                       lent or received.
   This exception applies to the bank’s agency           The Board considered two methods for incor-
securities-lending transactions collateralized by     porating market volatilities into the PFE calcu-
cash where the bank indemnifies its client             lation: (1) the bank’s own estimates of those
against (1) the risk that, in the event of default    volatilities based on a year’s historical observa-
by the securities borrower, the amount of cash        tion of market prices with no recognition of
collateral may be insufficient to repurchase the       correlation effects or (2) a value-at-risk (VaR)
amount of securities lent and (2) the reinvest-       type model. The bank was calculating daily,
ment risk associated with lending the cash            counterparty VAR estimates for its agency lend-
collateral in a transaction fully collateralized by   ing transactions and it had a VaR model that had
securities (for example, in a reverse repur-          been approved for purposes of the Board’s
chase transaction).                                   market risk rule. The Board determined that the
   The capital treatment the Board approved for       bankt could use a VaR model to calculate the
these transactions relies upon an economic mea-       PFE for each of its counterparties.
surement of the amount of risk exposure the              The bank must calculate the VaR using a
bank has to each of its counterparties. Under this    five-day holding period and a 99th percentile
approved approach, the bank does not use the          one-tailed confidence interval based on market
notional amount of underlying transactions that       price data over a one-year historical observa-
are subject to client indemnifications as the          tion period. The data set used should be updated
exposure amount for risk-based capital pur-           no less frequently than once every three months
poses. Rather, the bank must use an economic          and should be reassessed whenever market
exposure amount that takes into account the           prices are subject to material changes. For each
market value of collateral and the market price       counterparty, the bank is required to calculate
volatilities of (1) the instruments delivered by      daily an unsecured loan equivalent amount,
the bank to the counterparty and (2) the instru-      including the VaR PFE component. These
ments received by the bank from the counter-          calculations will be subject to supervisory
party. This approach builds on best practices of      review to ensure they are in line with the
banks for measuring their credit exposure             quarter-end calculations used to determine
amounts for purposes of managing internal             regulatory capital requirements.
single-borrower exposure limits, as well as upon         To qualify for the capital treatment outlined
existing concepts incorporated in the Basel           above, the securities-lending and cash loan trans-
Accord and the Board’s risk-based capital and         actions covered by the bank’s indemnification
market risk rules. The bank, under this excep-        must meet the following conditions:
tion, is required to determine an unsecured loan
equivalent amount for each of the counterparties      • the transactions are fully collateralized
to which, as agent, the bank lends securities         • any securities lent or taken as collateral are
collateralized by cash or lends cash collateral-        eligible for inclusion in the trading book and
ized by securities. As described below, the             are liquid and readily marketable

November 2006                                                      Commercial Bank Examination Manual
Page 54
Assessment of Capital Adequacy                                                                             3020.1

• any securities lent or taken as collateral are      request and receive Board approval for such
  marked-to-market daily                              treatment.
• the transactions are subject to a daily margin
  maintenance requirement                             Certain agency securities-lending arrangements
                                                      (August 2006 exception for ‘‘securities-collateral
   Further, the transactions must be executed         transactions’’). In response to an inquiry made
under a bilateral netting agreement or an equiva-     by a bank, a Board interpretation was issued on
lent arrangement. These arrangements must             August 15, 2006, which discussed the regulatory
(1) provide the non-defaulting party the right to     capital treatment of certain securities-lending
promptly terminate and close out all transactions     transactions. In these transactions, the bank,
under the agreement upon an event of default,         acting as agent for its clients, lends its clients’
including insolvency or bankruptcy of the coun-       securities and receives liquid securities collat-
terparty; (2) provide for the netting of gains and    eral in return (the securities-collateral transac-
losses on transactions (including the value of        tions).61 Each securities loan is marked-to-
any collateral) terminated and closed out under       market daily, and the bank calls for additional
the agreement so that a single net amount is          margin as needed to maintain a positive margin
owed by one party to the other; (3) allow for the     of collateral relative to the market value of the
prompt liquidation or setoff of collateral upon       securities lent at all times. The bank also agrees
the occurrence of an event of default; (4) be         to indemnify its clients against the risk that, in
conducted, together with the rights arising from      the event of borrower default, the market value
the conditions required in provisions 1 and 3         of the securities collateral is insufficient to
above, under documentation that is legally bind-      repurchase the amount of securities lent.
ing on all parties and legally enforceable in each       If the borrower were to default, the bank
relevant jurisdiction upon the occurrence of an       would be in a position to terminate a securities-
event of default and regardless of the counter-       collateral transaction and sell the collateral in
party’s insolvency or bankruptcy; and (5) be          order to purchase securities to replace the secu-
conducted under documentation for which the           rities that were originally lent. The bank’s expo-
bank has completed sufficient legal review to          sure under a securities-collateral transaction
verify it meets provision 4 above and for which       would be limited to the difference between the
the bank has a well-founded legal basis for           purchase price of the replacement securities and
reaching this conclusion.                             the market value of the securities collateral.
   With regard to the counterparty VaR model             The bank requested that the Federal Reserve
that the bank uses, the bank is required to           Board approve another exception to the capital
conduct regular and rigorous backtesting proce-       guidelines that would permit the bank to mea-
dures, subject to supervisory review, to ensure       sure its exposure amounts for risk-based capital
the validity of the correlation factors used by the   purposes with respect to the securities-collateral
bank and the stability of these factors over time.    transactions under the methodology of the bank’s
The bank was not subject to a formal backtest-        prior May 14, 2003, approval (the prior approval).
ing procedure requirement at the time the letter      The Board, again, determined that, under its
was issued. However, if supervisory review            current risk-based capital guidelines, the capital
determines that the bank’s counterparty VaR           charges for these securities-lending arrange-
model or its backtesting procedures have mate-        ments would exceed the amount of economic
rial deficiencies and the bank does not take           risk posed to the bank, which would result in
appropriate and expeditious steps to rectify those    capital charges that would be significantly out of
deficiencies, supervisors may take action to           proportion to the risk posed. The Board there-
adjust the bank’s capital calculations. Such action   fore approved an August 15, 2006, exception to
could range from imposing a multiplier on the         its risk-based capital guidelines according to the
VaR estimates of PFE calculated by the bank to        prior approval, allowing the bank to compute its
disallowing the use of its counterparty VaR           regulatory capital for these transactions using a
model and requiring use of the own estimates          loan-equivalent methodology. In so doing, the
approach to determine the PFE component of            bank would assign the risk weight of the coun-
the unsecured loan equivalent amounts.                terparty to the exposure amount of all such
   The capital treatment that the Board ap-
proved in the letter has been and will be made           61. The liquid securities collateral includes government
                                                      agency, government-sponsored entity, corporate debt or equity,
available to similarly situated institutions that     or asset-backed or mortgage-backed securities.

Commercial Bank Examination Manual                                                               November 2006
                                                                                                       Page 55
3020.1                                                                   Assessment of Capital Adequacy

transactions with the counterparty. Specifically,       ment, funding sources, capital formation, man-
the Board granted the bank its request to use an       agement, marketing, operations, and informa-
unsecured loan equivalent amount (calculated as        tion systems to achieve success. Strategic
current exposure plus a VaR-modeled PFE) for           planning helps the organization more effectively
the securities-collateral transactions for risk-       anticipate and adapt to change. Management
based capital purposes. The Board approved the         must also ensure that planning information as
exception under the reservation authority provi-       well as corporate goals and objectives are effec-
sion contained in its capital guidelines.              tively communicated throughout the organiza-
                                                       tion. Effective strategic planning allows the
                                                       institution to be more proactive than reactive in
                                                       shaping its own future. The strategic plan should
Overall Assessment of Capital                          clearly outline the bank’s capital base, antici-
Adequacy                                               pated capital expenditures, desirable capital level,
                                                       and external capital sources. Each of these areas
The following factors should be taken into             should be evaluated in consideration of the
account in assessing the overall capital ade-          degree and type of risk that management and the
quacy of a bank.                                       board of directors are willing to accept.

Capital Ratios                                         Growth. Capital is necessary to support a bank’s
                                                       growth; however, it is the imposition of required
Capital ratios should be compared with regula-         capital ratios that controls growth. Because a
tory minimums and with peer-group averages.            bank has to maintain a minimum ratio of capital
Banks are expected to have a minimum total             to assets, it will only be able to grow so fast. For
risk-based capital ratio of 8 percent. However,        example, a rapid growth in a bank’s loan port-
because risk-based capital does not take explicit      folio may be a cause of concern, for it could
account of the quality of individual asset port-       indicate that a bank is altering its risk profile by
folios or the range of other types of risks to         reducing its underwriting standards.
which banks may be exposed, such as interest-
rate, liquidity, market, or operational risks, banks   Dividends. Examiners should review historical
are generally expected to operate with capital         and planned cash-dividend payout ratios to deter-
positions above the minimum ratios. Institutions       mine whether dividend payments are impairing
with high or inordinate levels of risk are also        capital adequacy.62 Excessive dividend payouts
expected to maintain capital well above the            may result from several sources:
minimum levels.
   The minimum tier 1 leverage ratio is 3 per-         • If the bank is owned by a holding company,
cent. However, an institution operating at or            the holding company may be requiring exces-
near these levels is expected to have well-              sive dividend payments from the bank to fund
diversified risk, including no undue interest-rate        the holding company’s debt-repayment pro-
risk exposure, excellent asset quality, high             gram, expansion goals, or other cash needs.
liquidity, and good earnings, and to generally be      • The bank’s board of directors may be under
considered a strong banking organization, rated          pressure from individual shareholders to pro-
composite 1 under the CAMELS rating system               vide funds to repay bank stock debt or to use
of banks. For all but the most highly rated banks        for other purposes.
meeting the above conditions, the minimum              • Dividends may be paid or promised to support
tier 1 leverage ratio is 3 percent plus an addi-         a proposed equity offering.
tional cushion of at least 100 to 200 basis points.
                                                       Access to additional capital. Banks that do not
                                                       generate sufficient capital internally may require
Impact of Management                                   external sources of capital. Large, independent
                                                       institutions may solicit additional funding from
Strategic planning. One of management’s most           the capital markets. Smaller institutions may
important functions is to lead the organization        rely on a bank holding company or a principal
by designing, implementing, and supporting an          shareholder or control group to provide addi-
effective strategic plan. Strategic planning is a
long-term approach to integrating asset deploy-          62. See also ‘‘Dividends,’’ section 4070.1.

November 2006                                                         Commercial Bank Examination Manual
Page 56
Assessment of Capital Adequacy                                                                  3020.1

tional funds, or on the issuance of new capital       a bank generating losses is incapable of replen-
instruments to existing or new investors. Cur-        ishing its capital accounts internally.
rent shareholders may resist efforts to obtain
additional capital by issuing new capital instru-     Funds management. A bank with undue levels
ments because of the diluting effect of the new       of interest-rate risk should be required to
capital. In deciding whether to approve obtain-       strengthen its capital positions, even though it
ing additional capital in this manner, sharehold-     may meet the minimum risk-based capital stan-
ers must weigh the dilution against the possibil-     dards. Assessments of capital adequacy should
ity that, without the additional funds, the           reflect banks’ appropriate use of hedging instru-
institution may fail.                                 ments. Other things being equal, banks that have
   Under Federal Reserve policy, a bank holding       appropriately hedged their interest-rate exposure
company is expected to serve as a source of           will be permitted to operate with lower levels of
strength to its subsidiary banks. A bank holding      capital than those banks that are vulnerable to
company can fulfill this obligation by having          interest-rate changes. While the Federal Reserve
enough liquidity to inject funds into the bank or     does not want to discourage the use of legitimate
by having access to the same sources of addi-         hedging vehicles, some instruments, in particu-
tional capital, that is, current or existing share-   lar interest-only strips (IOs) and principal-only
holders, as outlined above.                           strips (POs), raise concerns. IOs and POs have
                                                      highly volatile price characteristics as interest
                                                      rates change, and they are generally not consid-
Financial Considerations                              ered appropriate investments for most banks.
                                                      However, some sophisticated banks may have
Capital levels and ratios should be evaluated in      the expertise and systems to appropriately use
view of the bank’s overall financial condition,        IOs and POs as hedging vehicles.
including the following areas.
                                                      Off-balance-sheet items and activities. Once
Asset quality. The final supervisory judgment on       funded, off-balance-sheet items become subject
a bank’s capital adequacy may differ signifi-          to the same capital requirements as on-balance-
cantly from conclusions that may be drawn             sheet items. A bank’s capital levels should be
solely from the level of a bank’s risk-based          sufficient to support the quality and quantity of
capital ratio. Generally, the main reason for this    assets that would result from a significant por-
difference is the evaluation of asset quality.        tion of these items being funded within a short
Final supervisory judgment of a bank’s capital        time.
adequacy should take into account examination
findings, particularly those on the severity of
problem and classified assets and investment or        Adequacy of and Compliance with
loan portfolio concentrations, as well as on the      Capital-Improvement Plans
adequacy of the bank’s allowance for loan and
lease losses.                                         Capital-improvement plans are required for
                                                      banks operating with capital ratios below regu-
Balance-sheet composition. A bank whose earn-         latory minimums as required by the prompt-
ing assets are not diversified or whose credit         corrective-action part of the Federal Deposit
culture is more risk-tolerant is generally expected   Insurance Act, as well as for some banks oper-
to operate with higher capital levels than a          ating under supervisory actions. Examiners
similar-sized institution with well-diversified,       should review any such plans and determine
less-risky investments.                               their adequacy and reasonableness, keeping in
                                                      mind that banks may meet required capital-to-
Earnings. An adequately capitalized, growing          asset ratios in three ways:
bank should have a consistent pattern of capital
augmentation by earnings retention. Poor earn-        • They may issue more capital. In doing so,
ings can have a negative effect on capital              banks must weigh the need for additional
adequacy in two ways. First, any losses absorbed        capital against the dilution of market value
by capital reduce the ability of the remaining          that will result.
capital to fulfill that function. Second, the impact   • They may retain earnings rather than paying
of losses on capital is magnified by the fact that       them out as dividends.

Commercial Bank Examination Manual                                                           May 2007
                                                                                              Page 57
3020.1                                                              Assessment of Capital Adequacy

• They may sell assets. By reducing the amount       included in tier 2 capital is limited to 50 percent
  of total assets, a bank reduces the amount of      of tier 1 capital. Amounts issued or outstanding
  capital necessary to meet the required ratios.     in excess of this limit are not included in the
                                                     risk-based capital calculation but should be
                                                     taken into consideration when assessing the
                                                     bank’s funding and financial condition.
Inadequate Allowance for Loan and
Lease Losses
                                                     Unrealized Asset Values
An inadequate allowance for loan and lease
losses (ALLL) will require an additional charge      Banks often have assets on their books that are
to current income. Any charge to current income      carried at significant discounts below current
will reduce the amount of earnings available to      market values. The excess of the market value
supplement tier 1 capital. Because the amount of     over the book value (historical cost or acquisi-
the ALLL that can be included in tier 2 capital is   tion value) of assets such as investment securi-
limited to 1.25 percent of gross risk-weighted       ties or banking premises may represent capital
assets, an additional provision may increase the     to the bank. These unrealized asset values are
ALLL level above this limit, thereby resulting in    not included in the risk-based capital calculation
the excess portion being excluded from tier 2        but should be taken into consideration when
capital.                                             assessing capital adequacy. Particular attention
                                                     should be given to the nature of the asset, the
                                                     reasonableness of its valuation, its marketability,
Ineligible Collateral and Guarantees                 and the likelihood of its sale.

The risk-based capital guidelines recognize only
limited types of collateral and guarantees. Other    Accounting for Defined Benefit Pension
types of collateral and guarantees may support       and Other Postretirement Plans
the asset mix of the bank, particularly within its
loan portfolio. Such collateral or guarantees        In September 2006, the Financial Accounting
may serve to substantially improve the overall       Standards Board adopted the Statement of Finan-
quality of a loan portfolio and other credit         cial Accounting Standard No. 158, ‘‘Employers
exposures, and should be considered in the           Accounting for Defined Benefit Pension and
overall assessment of capital adequacy.              Other Postretirement Plans’’ (FAS 158). The
                                                     standard requires, as early as December 31,
                                                     2006, that a bank, bank holding company, or
                                                     other banking or thrift organization that spon-
Market Value of Bank Stock
                                                     sors a single-employer defined benefit postre-
Examiners should review trends in the market         tirement plan—such as a pension plan or health
price of the bank’s stock and whether stock is       care plan—to recognize the overfunded or under-
trading at a reasonable multiple of earnings or a    funded status of each such plan as an asset or
reasonable percentage (or multiple) of book          liability on its balance sheet with corresponding
value. A bank’s low stock price may merely be        adjustments recognized in accumulated other
an indication that it is undervalued, or it may be   comprehensive income (AOCI), a component of
indicative of regional or industry-wide prob-        equity capital. After a banking organization
lems. However, a low-valued stock may also           initially applies FAS 158, changes in the benefit
indicate that investors lack confidence in the        plan asset or liability reported on the organiza-
institution; such lack of support could impair the   tion’s balance sheet will be recognized in the
bank’s ability to raise additional capital in the    year in which the changes occur and will result
capital markets.                                     in an increase or decrease in AOCI. Postretire-
                                                     ment plan amounts carried in AOCI are adjusted
                                                     as they are subsequently recognized in earnings
Subordinated Debt in Excess of Limits                as components of the plans’ net periodic benefit
The total of term subordinated debt and                 The Federal Reserve Board, along with other
intermediate-term preferred stock that may be        federal bank and thrift regulatory agencies (the

May 2007                                                          Commercial Bank Examination Manual
Page 58
Assessment of Capital Adequacy                                                                        3020.1

Agencies63), issued a joint press release on              will; amounts of mortgage-servicing assets,
December 14, 2006, in which they announced                nonmortgage-servicing assets, and purchased
that FAS 158 will not affect a banking organi-            credit-card relationships that, in the aggregate,
zations’ regulatory capital. The agencies decided,        are in excess of 100 percent of tier 1 capital;
until they can determine otherwise through a              amounts of nonmortgage-servicing assets and
rulemaking, that banks should exclude from                purchased credit-card relationships that, in the
regulatory capital any amounts recorded in AOCI           aggregate, are in excess of 25 percent of tier 1
resulting from the adoption and application of            capital; amounts of credit-enhancing interest-
FAS 158. The purpose of this exclusion is to              only strips that are in excess of 25 percent of tier
neutralize the effect of the application of FAS           1 capital; all other identifiable intangible assets;
158 on regulatory capital, including the report-          any investments in subsidiaries or associated
ing of the risk-based and leverage capital                companies that the Federal Reserve determines
measures.                                                 should be deducted from tier 1 capital; deferred
                                                          tax assets that are dependent on future taxable
                                                          income, net of their valuation allowance, in
TIER 1 LEVERAGE RATIO FOR                                 excess of the limitations set forth in section II.B.
                                                          of appendix A of Regulation H; and the amount
STATE MEMBER BANKS                                        of the total adjusted carrying value of nonfinan-
The Federal Reserve has adopted a minimum                 cial equity investments that is subject to a
ratio of tier 1 capital to average total assets to        deduction from tier 1 capital.
assist in the assessment of the capital adequacy             Under the tier 1 leverage ratio guidelines, the
of state member banks. The principal objective            minimum level of tier 1 capital to total assets for
of this measure (which is intended to be used as          strong state member banks is 4 percent, unless
a supplement to the risk-based capital measure)           they are rated composite 1 under the UFIRS
is to place a constraint on the maximum degree            (CAMELS) rating system of banks. Institutions
to which a state member bank can leverage its             not meeting these characteristics, as well as
equity capital base.                                      institutions with supervisory, financial, or opera-
   The guidelines implementing the tier 1 lever-          tional weaknesses, are expected to operate well
age ratio are found in Regulation H (12 CFR               above minimum capital standards. Institutions
208), appendix B, and apply to all state member           experiencing or anticipating significant growth
banks on a consolidated basis. The ratio is to be         are also expected to maintain capital ratios,
used in the examination and supervisory pro-              including tangible capital positions, well above
cess, as well as in the analysis of applications          the minimum levels. Moreover, higher capital
acted on by the Federal Reserve.                          ratios may be required for any banking institu-
   A bank’s tier 1 leverage ratio is calculated by        tion if warranted by its particular circumstances
dividing its tier 1 capital (the numerator of the         or risk profile. In all cases, institutions should
ratio) by its average total consolidated assets           hold capital commensurate with the level and
(the denominator of the ratio). For purposes of           nature of the risks, including the volume and
calculating this ratio during an examination,             severity of problem loans, to which they are
examiners may use the bank’s average total                exposed.
assets as of the last Call Report date. The ratio            A bank that does not have a 4 percent
will be calculated using period-end assets when-          leverage ratio (3 percent if it is rated a compos-
ever necessary, on a case-by-case basis. For the          ite CAMELS 1) is considered undercapitalized
purpose of this leverage ratio, the definition of          under the prompt-corrective-action framework
tier 1 capital as set forth in the risk-based capital     and must file a capital-restoration plan that
guidelines in appendix A of the Federal Reserve’s         meets certain requirements.
Regulation H is used. Average total consolidated
assets are defined as the quarterly average total
assets (defined net of the allowance for loan and
lease losses) reported on the bank’s Reports of
                                                          De Novo Banks
Condition and Income (Call Reports), less good-
                                                          Initial capital in a de novo state member bank
  63. The Office of the Comptroller of the Currency, the
                                                          should be reasonable in relation to the bank’s
Federal Deposit Insurance Corporation, and the Office of   location, business plan, competitive environ-
Thrift Supervision.                                       ment, and state law. At a minimum, however, a

Commercial Bank Examination Manual                                                                  May 2007
                                                                                                     Page 59
3020.1                                                            Assessment of Capital Adequacy

de novo bank must maintain a tangible tier 1        reliance on additional capital injections. Even
leverage ratio (core capital elements minus all     though a 9 percent tangible leverage ratio is not
intangible assets divided by average total assets   required after the third year, de novo banks are
minus all intangible assets) of 9 percent for the   expected to maintain capital ratios that are
first three years of operations. The applicant       commensurate with ongoing safety-and-
must provide projections of asset growth and        soundness concerns and that are generally well
earnings performance that reasonably support        in excess of regulatory minimums. (See SR-
the bank’s ability to maintain this ratio without   91-17.)

May 2007                                                        Commercial Bank Examination Manual
Page 60
Assessment of Capital Adequacy
Examination Objectives
Effective date May 2000                                                      Section 3020.2

1. To determine the adequacy of capital.              leverage capital guidelines, as well as exist-
2. To determine compliance with the risk-             ing conditions and future plans.
   based and tier 1 leverage capital adequacy      6. To initiate corrective action when policies,
   guidelines.                                        procedures, or capital are deficient.
3. To determine if the policies, practices, and    7. To evaluate whether—
   procedures with regard to the capital ade-         a. the institution is fully capable of assessing
   quacy guidelines are adequate.                        the credit risk associated with the collat-
4. To determine if the bank’s officers and                eralized loan obligations (CLOs) it retains
   employees are operating in conformity with            in its banking book (nontrading accounts);
   the Board’s established capital adequacy              and
   guidelines.                                        b. the institution is adequately capitalized
5. To evaluate the propriety and consistency of          given its residual risk exposure involving
   the bank’s present and planned level of               CLOs.
   capitalization in light of the risk-based and

Commercial Bank Examination Manual                                                          May 2000
                                                                                              Page 1
Assessment of Capital Adequacy
Examination Procedures
Effective date November 2004                                                Section 3020.3

VERIFICATION OF THE                                         — any issuer-redemption feature must
RISK-BASED CAPITAL RATIO                                         be subject to prior Federal Reserve
Examiners should verify that the bank has                   — noncumulative
adequate systems in place to compute and docu-              — fixed rate or traditional floating or
ment its risk-based capital ratios. Small banks                  adjustable rate
with capital ratios well in excess of established           — must not contain features that would
minimums may not have a system explicitly                        require or create an incentive for
designed to capture risk-based capital informa-                  the issuer to redeem or repurchase
tion. In addition, depending on a bank’s current                 the instrument, such as an ‘‘explod-
capital structure and ratios, all procedures may                 ing rate,’’ an auction-rate pricing
not apply.                                                       mechanism, or a feature that allows
                                                                 the stock to be converted into
 1. Verify that the bank is correctly reporting                  increasing numbers of common
    the risk-based capital information requested                 shares
    on the Reports of Condition and Income.               • Perpetual preferred stock, includable
                                                            within tier 2 capital without a sublimit,
   For the qualifying components of capital (the            must have the characteristics listed
ratio’s numerator):                                         above for tier 1 perpetual preferred
                                                            stock, but perpetual preferred stock
 2. Determine if management is adhering to the              does not otherwise qualify for inclu-
    underlying terms of any currently outstand-             sion in tier 1 capital. For example,
    ing stock issues.                                       cumulative or auction-rate perpetual
 3. Review common stock to ensure that the                  preferred stock, which does not qualify
    bank is in compliance with the terms of any             for tier 1 capital, may be includable in
    underlying agreements and to determine if               tier 2 capital.
    more than one class exists. When more than      5. Verify that minority interest in equity
    one class exists, review the terms for any         accounts of consolidated subsidiaries
    preference or nonvoting features. If the           included in tier 1 capital consists only of
    terms include such features, determine             qualifying tier 1 capital elements. Deter-
    whether the class of common stock qualifies         mine whether any perpetual preferred stock
    for inclusion in tier 1 capital.                   of a subsidiary that is included in minority
 4. Review any perpetual and long-term pre-            interest is secured by the subsidiary’s assets;
    ferred stock for the following:                    if so, that stock may not be included in
    a. Compliance with terms of the underlying         capital.
       agreements carefully noting—                 6. Review the intermediate-term preferred
       • adherence to the cumulative or non-           stock and subordinated debt instruments
          cumulative nature of the stock and           included in capital for the following:
       • adherence to any conversion rights.           a. Compliance with terms of the underlying
    b. Proper categorization as tier 1 or tier 2          agreements, noting that subordinated debt
       for capital adequacy purposes, noting the          containing the following terms may not
       following requirements:                            be included in capital:
       • Tier 1 perpetual preferred stock must            • interest payments tied to the bank’s
          have the following characteristics:               financial condition
          — no maturity date                              • acceleration clauses or broad condi-
          — cannot be redeemed at the option                tions of events of default that are
             of the holder                                  inconsistent with safe and sound bank-
          — unsecured                                       ing practices
          — ability to absorb losses                   b. Compliance with restrictions on the
          — ability and legal right for issuer to         inclusion of such instruments in capital
             defer or eliminate dividends                 by verifying that the aggregate amount

Commercial Bank Examination Manual                                                    November 2004
                                                                                             Page 1
3020.3                                   Assessment of Capital Adequacy: Examination Procedures

       of both types of instruments does not          9. Verify that the amount of the allowance for
       exceed 50 percent of tier 1 capital (net of       loan and lease losses included in tier 2
       goodwill) and that the portions includ-           capital has been properly calculated and
       able in tier 2 capital possess the follow-        disclosed, and verify that the supporting
       ing characteristics:                              computations of that amount have been
       • unsecured                                       adequately documented.
       • minimum five-year original weighted
          average maturity                              For the calculation of risk-weighted assets
       • in the case of subordinated debt, con-      (the ratio’s denominator):
          tains terms stating that the debt (1) is
          not a deposit, (2) is not insured by       10. Determine whether the bank consolidates,
          a federal agency, (3) cannot be                in accordance with the Financial Account-
          redeemed without prior approval from           ing Standards Board’s FIN 46-R, the assets
          the Federal Reserve, and (4) is sub-           of any asset-backed commercial paper
          ordinated to depositors and general            (ABCP) program that it sponsors.
          creditors                                      a. Determine whether the bank’s ABCP
    c. Appropriate amortization, if the instru-             program meets the definition of a spon-
       ments have a remaining maturity of less              sored ABCP program under the Federal
       than five years.                                      Reserve’s risk-based capital guidelines.
 7. Determine, through review of minutes of                 If the bank does consolidate the assets of
    board of directors meetings, if a stock                 an ABCP program, review the documen-
    offering or subordinated debt issue is being            tation of its risk-based capital ratio cal-
    considered. If so, determine that manage-               culations, and determine whether the
    ment is aware of the risk-based capital                 associated ABCP program’s assets and
    requirements for inclusion in capital.                  minority interests were excluded from
 8. Review any mandatory convertible debt                   the bank’s risk-weighted asset base (and
    securities for the following:                           also if they were excluded from tier 1
    a. Compliance of the terms with the criteria            capital—the ratio’s numerator). See sec-
       set forth in 12 CFR 225 (Regulation Y),              tion III.B.6. of the risk-based capital
       appendix B.                                          guidelines (12 CFR 208, appendix A).
    b. Notification in the terms of agreement             b. Determine whether any of the bank’s
       that the redemption or repurchase of                 liquidity facilities meet the definition and
       such securities before maturity is subject           requirements of an eligible ABCP liquid-
       to prior approval from the Federal                   ity facility under the Federal Reserve’s
       Reserve.                                             risk-based capital guidelines. See section
    c. The treatment of the portions of such                III.B.3.a.iv. of the risk-based capital
       securities covered by the issuance of                guidelines (12 CFR 208, appendix A).
       common or perpetual preferred stock               c. Determine from the bank’s supporting
       dedicated to the repayment of the secu-              documentation of its risk-based capital
       rities, bearing in mind the following:               ratios whether the bank held risk-based
       • The amount of the security covered by              capital against its eligible ABCP liquid-
          dedicated stock should be treated as              ity facilities.
          subordinated debt and is subject,              d. Determine whether the bank applied the
          together with other subordinated debt             correct conversion factors to the eligible
          and intermediate-term preferred stock,            ABCP liquidity facilities when it deter-
          to a sublimit within tier 2 capital of            mined the amount of risk-weighted assets
          50 percent of tier 1 capital, as well as          for its risk-based capital ratios. See sec-
          to amortization in the last five years of          tion III.D. of the risk-based capital guide-
          life.                                             lines (12 CFR 208, appendix A).
       • The portion of a mandatory convert-                • For those eligible ABCP liquidity
          ible security that is not covered by                 facilities having an original maturity of
          dedication qualifies for inclusion in                 one year or less, determine if a 10 per-
          tier 2 capital without any sublimit and              cent credit-conversion factor was used.
          without being subject to amortization             • For those eligible ABCP liquidity
          in the last five years of life.                       facilities having an original maturity

November 2004                                                     Commercial Bank Examination Manual
Page 2
Assessment of Capital Adequacy: Examination Procedures                                           3020.3

           exceeding one year, determine if a              or that are otherwise considered to lack
           50 percent credit-conversion factor             sufficient capital to support their activities,
           should have been used.                          examine the bank’s capital plans for achiev-
    e. Determine if ineligible ABCP liquidity              ing adequate levels of capital. In conjunc-
        facilities were treated as direct-credit           tion with management of the appropriate
        substitutes or as recourse obligations, as         Reserve Bank, determine whether the plans
        required by the risk-based capital guide-          are acceptable to the Federal Reserve.
        lines.                                             Review and comment on these plans and
11. Verify that each on- and off-balance-sheet             any progress achieved in meeting the
    item has been assigned to the appropriate              requirements.
    risk category in accordance with the risk-          2. The review processes discussed in ‘‘Overall
    based capital guidelines. Close attention              Conclusions Regarding Condition of the
    should be paid to the underlying obligor,              Bank,’’ section 5020.1, require an evalua-
    collateral, and guarantees, and to assign-             tion of the propriety and consistency of the
    ment to a risk category based on the terms             bank’s present and planned level of capitali-
    of a claim. The claim should be assigned to            zation in light of existing conditions and
    the risk category appropriate to the highest           future plans. In this regard, the examiner
    risk option available under the terms of the           assigned to assessing capital adequacy
    transaction. Verify that the bank’s documen-           should do the following:
    tation supports the assignment of preferen-            a. Using the latest Uniform Bank Perfor-
    tial risk weights. If necessary, recalculate              mance Report (UBPR), analyze applica-
    the value of risk-weighted assets.                        ble ratios involving capital funds, com-
12. Verify that all off-balance-sheet items have              paring these ratios with those of the
    been converted properly to credit-equivalent              bank’s peer group and investigating
    amounts based on the risk-based capital                   trends or significant variations from peer-
    guidelines. Close attention should be paid to             group averages.
    the proper reporting of assets sold with               b. Determine, with regard to the bank’s
    recourse, financial and performance standby                overall financial condition, that the bank’s
    letters of credit, participations of off-balance-         capital is sufficient to compensate for
    sheet transactions, and commitments.                      any instabilities or deficiencies in the
                                                              asset and liability mix and in quality, as
                                                              described in the ‘‘Funds Management’’
                                                              paragraph (‘‘Financial Considerations’’
VERIFICATION OF THE TIER 1                                    subsection of section 3020.1).
LEVERAGE RATIO                                             c. Determine if the bank’s earnings perfor-
                                                              mance enables it to fund its expansion
 1. Verify that the bank has correctly calculated
                                                              adequately, to remain competitive in the
    tier 1 capital in accordance with the defini-
                                                              market, and to replenish or increase its
    tion of tier 1 capital, as set forth in the
                                                              capital funds as needed.
    risk-based capital guidelines.
                                                           d. Analyze trends in the bank’s deposit and
 2. Verify that the bank has properly calculated
                                                              borrowed funds structure to determine
    average total consolidated assets, which are
                                                              whether capital is maintained at a level
    defined as the quarterly average total assets
                                                              sufficient to sustain depositor and lender
    as reported on the Call Report, less good-
    will and any other intangible assets and any
                                                           e. If the allowance for loan and lease losses
    investments in subsidiaries that the Federal
                                                              is determined to be inadequate, analyze
    Reserve determines should be deducted from
                                                              the impact of current and potential losses
    tier 1 capital.
                                                              on the bank’s capital structure. See ‘‘Ana-
                                                              lytical Review and Income and Expense,’’
                                                              section 4010.1.
OVERALL ASSESSMENT OF                                      f. Consider the impact of any management
CAPITAL ADEQUACY                                              deficiencies on present and projected
 1. For banks that do not meet the minimum                 g. Determine if there are any assets or
    risk-based tier 1 leverage capital standards              contingent accounts whose quality rep-

Commercial Bank Examination Manual                                                       November 2004
                                                                                                Page 3
3020.3                                   Assessment of Capital Adequacy: Examination Procedures

      resents an actual or potential serious                  minimum conditions have been met for
      weakening of capital.                                   that treatment.
   h. Consider the potential impact of any           3.   Review capital adjustments such as good-
      proposed changes in controlling owner-              will and intangible assets by performing the
      ship (if approved) on the projected capi-           following procedures:
      tal position.                                       a. Verify the existence of adequate docu-
   i. Analyze assets that are considered                      mentation concerning book and fair
      undervalued on the balance sheet and                    values and the amortization method.
      carried at below-market values. The                 b. Verify that intangibles are being reduced
      excess of fair value over cost may rep-                 in accordance with the amortization
      resent an additional cushion to the bank.               method. If the book carrying amount
   j. Consider the cushion for absorbing losses               exceeds the fair value, the intangible
      that may be provided by any subordi-                    should be written down or off.
      nated debt or intermediate-term pre-                c. Determine if the bank is performing a
      ferred stock not included in tier 2 capital             quarterly review of the book and fair
      because of the 50 percent of tier 2 capital             values and the quality of all intangibles.
      limitation, or that is not included in              d. Verify that goodwill and other nonquali-
      capital for tier 1 leverage ratio purposes.             fying identifiable intangibles are deducted
   k. Analyze any collateral and guarantees                   from tier 1 capital.
      supporting assets that may not be taken             e. Determine the proper inclusion of other
      into account for risk-based or tier 1                   identifiable intangibles included in tier 1
      leverage capital purposes, and consider                 capital by verifying that the criteria and
      these collateral and guarantees in the                  limitations outlined in the risk-based capi-
      overall assessment of capital adequacy.                 tal guidelines are met.
   l. Evaluate the bank’s overall asset quality,     4.   In light of the analysis conducted in step 2
      and determine whether the bank needs to             (under ‘‘Overall Assessment of Capital
      strengthen its capital position based on            Adequacy’’), and in accordance with the
      the following:                                      Federal Reserve’s capital adequacy guide-
      • the severity of problem and classified             lines, determine any appropriate supervi-
         assets                                           sory action with regard to the bank’s capital
      • investment or loan- portfolio con-                adequacy.
         centrations                                 5.   Review the following items with the
      • the adequacy of loan-loss reserves                examiner-in-charge in preparation for dis-
   m. Analyze the bank’s interest-rate risk and           cussion with appropriate management:
      use of hedging instruments. Determine if            a. all deficiencies noted with respect to the
      the bank should strengthen its capital                  capital accounts
      position because of undue levels of risk.           b. the adequacy of present and projected
      Review hedging instruments for the use                  capital
      of interest-only strips (IOs) and principal-   6.   Ascertain through minutes, reports, etc., or
      only strips (POs) (which raise concerns),           through discussions with management, how
      and review management’s expertise in                the future plans of the bank (for example,
      using hedging instruments.                          growth through commercial lending, retail
   n. Determine whether the sponsoring bank               operations, etc.) will affect the bank’s asset
      is able to assess and manage the retained           quality, capital position, and other areas of
      risk in its credit portfolio after the issu-        its balance sheet.
      ance of synthetic collateralized loan          7.   Prepare comments for the examination report
      obligations (CLOs).                                 on the bank’s capital position, including any
   o. If the bank has used the special risk-              deficiencies noted.
      based regulatory capital treatment for         8.   Update the workpapers with any informa-
      synthetic CLOs, verify that the stringent           tion that will facilitate future examinations.

November 2004                                                     Commercial Bank Examination Manual
Page 4
Assessment of Capital Adequacy
Internal Control Questionnaire
Effective date November 1993                                               Section 3020.4

Review the bank’s internal controls, policies,       *4. Are capital transactions verified by more
practices, and procedures concerning capital.            than one person before stock certificates
The bank’s system should be documented in a              are issued?
complete and concise manner and should include,      *5. Are stock certificates and debentures han-
where appropriate, narrative descriptions, flow-          dled by persons who do not also record
charts, copies of forms used, and other pertinent        those transactions?
information. Items marked with an asterisk           *6. Does the bank maintain a stock certificate
require substantiation by observation or testing.        book with certificates serially numbered
                                                         by the printer?
                                                     *7. Is the stock certificate book maintained
GENERAL                                                  under dual control?
                                                     *8. Does the bank’s policy prohibit the sign-
  1. Has the bank established procedures to              ing of blank stock certificates?
     ensure that—                                    *9. Does the bank maintain a shareholders’
     a. all components of capital are accurately         ledger that shows the total number of
        categorized and reported for purposes            shares owned by each stockholder?
        of the risk-based and leverage capital      *10. Does the bank maintain a stock transfer
        measures?                                        journal disclosing names, dates, and
     b. all on-and off-balance-sheet items are           amounts of transactions?
        accurately risk-weighted and reported       *11. Does the bank cancel surrendered stock
        for purposes of the risk-based capital           certificates?
        measures?                                   *12. Are inventories of unissued notes or
     c. categorization of on- and off-balance-           debentures—
        sheet items and capital for purposes of          a. maintained under dual control?
        the risk-based capital measures is ade-          b. counted periodically by someone other
        quately documented?                                 than the person responsible for their
     d. the bank is in compliance with the                  custody?
        terms of any contractual agreements         *13. When transfers are made—
        underlying capital instruments?                  a. are notes or debentures surrendered and
     e. management and the board of directors               promptly cancelled?
        consider the requirements of the risk-           b. are surrendered notes or debentures
        based capital guidelines for inclusion              inspected to determine that proper
        in capital of stock or debt prior to                assignment has been made and that new
        issuance?                                           notes or debentures agree in amount?
  2. Does the bank prepare a periodic analysis
     of its risk-based and leverage capital posi-
     tions to assess capital adequacy for both      CONCLUSION
     current and anticipated needs?
 *3. Has the board of directors authorized spe-      14. Indicate additional procedures used in
     cific bank officers to—                               arriving at conclusions.
     a. sign stock certificates?                      15. Are internal controls of capital adequate
     b. maintain custody of unissued stock               based on a composite evaluation, as
        certificates?                                     evidenced by answers to the foregoing
     c. maintain stock journals and records?             questions?

Commercial Bank Examination Manual                                                      March 1994
                                                                                            Page 1
Assessing Risk-Based Capital—Direct-Credit Substitutes
Extended to ABCP Programs
Effective date October 2007                 Section 3030.1

The Federal Reserve Board and the other federal                      internal-ratings approach to their unrated direct-
banking agencies (the agencies)1 amended their                       credit substitutes extended to ABCP programs4
risk-based capital standards on November 29,                         that they sponsor by mapping internal risk
2001, to adopt a new capital framework for                           ratings to external rating equivalents. These
banking organizations (includes bank holding                         external credit rating equivalents are organized
companies) engaged in securitization activities                      into three ratings categories: investment-grade
(the securitization capital rule).2 In March 2005,                   (BBB and above) credit risk, high non-
the agencies issued interagency guidance that                        investment-grade (BB+ through BB-) credit risk,
clarifies how banking organizations are to use                        and low non-investment-grade (below BB-)
internal ratings that they assign to asset pools                     credit risk. These rating categories can then be
purchased by their asset-backed commercial                           used to determine whether a direct-credit sub-
paper (ABCP) programs in order to appropri-                          stitute provided to an ABCP program should be
ately risk-weight any direct-credit substitutes                      (1) assigned to a risk weight of 100 percent or
(for example, guarantees) extended to such pro-                      200 percent or (2) subject to the ‘‘gross-up’’
grams. For state member bank examination                             treatment, as summarized in the table on the
purposes, the interagency guidance has been                          next page.5 (See appendix A for a more detailed
reformatted for examiner use as examination                          description of ABCP programs.)
objectives, examination procedures, and an inter-                       As the table indicates, the minimum risk
nal control questionnaire. The guidance uses the                     weight available under the internal risk-ratings
term ‘‘banking organization.’’ In this section, the                  approach is 100 percent, regardless of the inter-
guidance should be interpreted to mean the                           nal rating.6 Conversely, positions rated below
application of the risk-based capital guidelines                     BB- receive the gross-up treatment. That is, the
to all state member banks on a consolidated                          banking organization holding the position must
basis.                                                               maintain capital against the amount of the posi-
   The guidance sets forth an analytical frame-                      tion plus all more senior positions.7 Application
work for assessing the broad risk characteristics                    of gross-up treatment, in many cases, will result
of direct-credit substitutes3 that a banking orga-                   in a full dollar-for-dollar capital charge (the
nization provides to an ABCP program it spon-                        equivalent of a 1,250 percent risk weight) on
sors. The guidance provides specific informa-                         direct-credit substitutes that fall into the low
tion on evaluating direct-credit substitutes issued                  non-investment-grade category. In addition, the
in the form of program-wide credit enhance-                          risk-based capital requirement applied to a direct-
ments, as well as an approach to determine the                       credit substitute is subject to the low-level-
risk-based capital charge for these enhance-                         exposure rule. Under the rule, the amount of
ments. (See SR-05-6 and its attachment. Also,                        required risk-based capital would be limited to
see sections 3020.1, ‘‘Assessment of Capital                         the lower of a full dollar-for-dollar capital charge
Adequacy,’’ and 4030.1, ‘‘Asset Securitization.’’)                   against the direct-credit substitute or the effec-
   The securitization capital rule permits bank-                     tive risk-based capital charge (for example,
ing organizations with qualifying internal risk-                     8 percent) for the entire amount of assets in the
rating systems to use those systems to apply the
                                                                        4. ABCP programs include multiseller ABCP conduits,
   1. The Office of the Comptroller of the Currency, the              credit arbitrage ABCP conduits, and structured investment
Federal Deposit Insurance Corporation, and the Office of              vehicles.
Thrift Supervision.                                                     5. The rating designations (for example, ‘‘BBB-’’ and
   2. See 66 Fed. Reg. 59614 (November 29, 2001). See also           ‘‘BB+’’) used in the table are illustrative only and do not
12 C.F.R. 208, appendix A, section III.B.3.                          indicate any preference for, or endorsement of, any particular
   3. Direct-credit substitute means an arrangement in which         rating designation system.
a banking organization assumes, in form or in substance,                6. Exposures externally rated by a nationally recognized
credit risk associated with an on- or off-balance-sheet credit       statistical rating organization (NRSRO) above BBB+ are
exposure that it did not previously own (that is, a third-party      eligible for lower risk weights (that is, 20 percent for AAA
asset) and the risk it assumes exceeds the pro rata share of its     and AA, 50 percent for A).
interest in the third-party asset. If the banking organization has      7. Gross-up treatment means that a position is combined
no claim on the third-party asset, then the organization’s           with all more senior positions in the transaction. The resulting
assumption of any credit risk with respect to the third-party        amount is then risk-weighted based on the obligor or, if
asset is a direct-credit substitute.                                 relevant, the guarantor or the nature of the collateral.

Commercial Bank Examination Manual                                                                                  October 2007
                                                                                                                          Page 1
3030.1                       Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs

         Internal risk-rating
              equivalent                               Ratings category                      Risk weighting
            BBB- or better                           Investment grade                             100%
             BB+ to BB-                             High non-investment                           200%
              Below BB-                             Low non-investment                     Gross-up treatment

ABCP program.8                                                         A process is provided that is designed to aid
   The use of internal risk rattings under the                      in determining the regulatory capital treatment
securitization capital rule is limited to determin-                 for program-wide credit enhancements, pro-
ing the risk-based capital charge for unrated                       vided to an ABCP program. The key underlying
direct-credit substitutes that banking organiza-                    principles are as follows:
tions provide to ABCP programs. Thus, banking
organizations may not use the internal-ratings                      1. The determination of the credit quality of the
approach to derive the risk-based capital require-                     program-wide credit enhancement shall be
ment for unrated direct-credit substitutes ex-                         based on the risk of draw and subsequent
tended to other transactions. Approved use of                          loss, which depends directly on the quality of
the internal rating-based approach for ABCP                            the credit-enhanced assets funded through
programs under the securitization capital rule                         the ABCP program.
will have no bearing on the overall appropriate-                    2. An estimate of the risk of draw for the
ness of a banking organization’s internal risk-                        program-wide credit enhancement is derived
rating system for other purposes.                                      from the quality (rating) of the riskiest cred-
   Most rated commercial paper issued out of an                        it(s) within the ABCP program, which is
ABCP program is supported by program-wide                              often indicated by the internal rating a bank-
credit enhancement, which is a direct-credit                           ing organization assigns to a transaction’s
substitute. Often the sponsoring banking orga-                         pool-specific liquidity facility. Other credit
nization provides, in whole or in part, program-                       risks (for example, seller/servicer risk) to the
wide credit enhancement to the ABCP program.                           program-wide credit enhancement may also
Program-wide credit enhancement may take a                             be considered.
number of different forms, including an irrevo-                     3. The weakest-link approach assigns risk-
cable loan facility, a standby letter of credit, a                     based capital against the program-wide credit
financial guarantee, or a subordinated debt.                            enhancement in rank order of the internal
   The interagency guidance also discusses the                         ratings starting with the lowest-rated posi-
weakest-link approach. This approach is used                           tions supported by the program-wide credit
for calculating the risk-based capital require-                        enhancement. Therefore, if all of the posi-
ment and assumes that the risk of the program-                         tions supported by the program-wide credit
wide credit enhancement is directly dependent                          enhancement are internally rated investment
on the quality (that is, internal rating) of the                       grade, the banking organization would risk-
riskiest transaction(s) within the ABCP                                weight the notional amount of the program-
program. (See step 9 of the examination                                wide credit enhancement at 100 percent and
procedures, section 3030.3.) More specifically,                         there would be no need to proceed further.
the weakest-link concept presupposes the prob-                         However, for positions supported by the
ability that the program-wide credit enhance-                          program-wide credit enhancement that are
ment that will be drawn is equal to the prob-                          non-investment grade, banking organizations
ability of default of the transaction(s) with the                      can use the formula-driven weakest-link
weakest transaction risk rating.                                       approach illustrated in step 9 of the exami-
                                                                       nation procedures to generate the appropriate
                                                                       amount of risk-based capital to be assessed
   8. The low-level-exposure rule provides that the dollar             against an unrated position.
amount of risk-based capital required for a recourse obligation
or direct-credit substitute should not exceed the maximum
dollar amount for which a banking organization is contractu-
ally liable. (See 12 C.F.R 208, appendix A, section III.B.3.g.i.)

October 2007                                                                     Commercial Bank Examination Manual
Page 2
Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs                              3030.1

                                                  Asset Pools
   Pool-Specific Credit                                                           Pool-Specific
     Enhancement                                                                 Liquidity Facility

                                                 ABCP Conduit

   Program Manager/                                                               Program-Wide
        Sponsor                                                                  Liquidity Facility

                Commercial                        Program-Wide
               Paper Investors                 Credit Enhancement

ASSESSMENT OF INTERNAL                                   APPENDIX A—OVERVIEW OF
RATING SYSTEMS                                           ABCP PROGRAMS
The guidance is organized in the form of a               ABCP programs provide a means for corpora-
decision tree that (1) provides an outline of the        tions to obtain relatively low-cost funding by
key decisions that examiners and sponsoring              selling or securitizing pools of homogenous
banking organizations should consider when               assets (for example, trade receivables) to
reviewing internal risk-rating systems for ABCP          special-purpose         entities     (SPEs/ABCP
programs and (2) provides supervisors with               programs). The ABCP program raises funds for
more-specific information on how to assess the            purchase of these assets by issuing commercial
adequacy of these systems. Many of the quali-            paper into the marketplace. The commercial
tative and quantitative factors used to evaluate         paper investors are protected by structural
risk in this guidance are comparable with rating         enhancements provided by the seller (for
agency criteria (for example, criteria from S&P,         example, overcollateralization, spread ac-
Moody’s, and Fitch) because the ABCP pro-                counts, early-amortization triggers, etc.) and by
gram sponsors generally use the rating method-           credit enhancements (for example, subordinated
ologies of nationally recognized statistical rating      loans or guarantees) provided by banking
organizations (NRSROs) when assessing the                organization sponsors of the ABCP program
credit quality of their risk exposures to ABCP           and by other third parties. In addition, liquid-
programs. The guidance has two primary goals:
                                                         ity facilities are also present to ensure the rapid
                                                         and orderly repayment of commercial paper
• provide information to banking organizations
                                                         should cash-flow difficulties emerge. ABCP
  to ensure the accuracy and consistency of the
                                                         programs are nominally capitalized SPEs that
  ratings assigned to transactions in an ABCP
  program                                                issue commercial paper. A sponsoring banking
• assist supervisors in assessing the adequacy of        organization establishes the ABCP program but
  a banking organization’s internal risk-rating          usually does not own the conduit’s equity,
  system based on the nine key criteria set forth        which is often held by unaffiliated third-party
  in the securitization capital rule9                    management companies that specialize in own-
                                                         ing such entities, and are structured to be
                                                         bankruptcy remote.
  9. 12 C.F.R. 208, appendix A, III.B.3.f.i.

Commercial Bank Examination Manual                                                            October 2007
                                                                                                    Page 3
3030.1                Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs

Typical Structure                                   or higher. SIVs operate on a market-value basis
                                                    similar to market value CDOs in that they must
ABCP programs are funding vehicles that bank-       maintain a dynamic overcollateralization ratio
ing organizations and other intermediaries estab-   determined by analysis of the potential price
lish to provide an alternative source of funding    volatility on securities held in the portfolio.
to themselves or their customers. In contrast to    SIVs are monitored daily and must meet strict
term securitizations, which tend to be amortiz-     liquidity, capitalization, leverage, and concentra-
ing, ABCP programs are ongoing entities that        tion guidelines established by the rating agencies.
usually issue new commercial paper to repay
maturing commercial paper. The majority of
ABCP programs in the capital markets are            Key Parties and Roles
established and managed by major international
commercial banking organizations. As with tra-      Key parties for an ABCP program include the
ditional commercial paper, which has a maxi-        following:
mum maturity of 270 days, ABCP is short-term
debt that may either pay interest or be issued at   •   program management/administrators
a discount.                                         •   credit-enhancement providers
                                                    •   liquidity-facility providers
                                                    •   seller/servicers
Types of ABCP Programs                              •   commercial paper investors

Multiseller programs generally provide working      Program Management
capital financing by purchasing or advancing
against receivables generated by multiple cor-      The sponsor of an ABCP program initiates the
porate clients of the sponsoring banking organi-    creation of the program but typically does not
zations. These programs are generally well diver-   own the equity of the ABCP program, which is
sified across both sellers and asset types.          provided by unaffiliated third-party investors.
                                                    Despite not owning the equity of the ABCP
Single-seller programs are generally established    program, sponsors usually retain a financial
to fund one or more types of assets originated by   stake in the program by providing credit
a single seller. The lack of diversification is      enhancement, liquidity support, or both, and
generally compensated for by increased program-     they play an active role in managing the pro-
wide credit enhancement.                            gram. Sponsors typically earn fees—such as
                                                    credit-enhancement, liquidity-facility, and
Loan-backed programs fund direct loans to           program-management fees—for services pro-
corporate customers of the ABCP program’s           vided to their ABCP programs.
sponsoring banking organization. These loans           Typically, an ABCP program makes arrange-
are generally closely managed by the banking        ments with various agents/servicers to conduct
organization and have a variety of covenants        the administration and daily operation of the
designed to reduce credit risk.                     ABCP program. This includes such activities as
                                                    purchasing and selling assets, maintaining oper-
Securities-arbitrage programs invest in securi-     ating accounts, and monitoring the ongoing
ties that generally are rated AA- or higher. They   performance of each transaction. The sponsor is
generally have no additional credit enhancement     also actively engaged in the management of the
at the seller/transaction level because the secu-   ABCP program, including underwriting the
rities are highly rated. These programs are         assets purchased by the ABCP program and the
typically well diversified across security types.    type/level of credit enhancements provided to
The arbitrage is mainly due to the difference       the ABCP program.
between the yield on the securities and the
funding cost of the commercial paper.
                                                    Credit-Enhancement Providers
Structured investment vehicles (SIVs) are a form
of a securities-arbitrage program. These ABCP       The sponsoring banking organization typically
programs invest in securities typically rated AA-   provides pool-specific and program-wide backup

October 2007                                                     Commercial Bank Examination Manual
Page 4
Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs                             3030.1

liquidity facilities, and program-wide credit          can purchase the ABCP from the conduit if the
enhancements, all of which are usually unrated         commercial paper cannot be issued. Pool-
(pool-specific credit enhancement, such as over-        specific and program-wide credit enhance-
collateralization, is provided by the seller of the    ments also protect commercial paper investors
assets). These enhancements are fundamental            from deterioration of the underlying asset pools.
for obtaining high investment-grade ratings on
the commercial paper issued to the market by
the ABCP program. Seller-provided credit               The Loss Waterfall
enhancement may exist in various forms and is
generally sized based on the type and credit           The loss waterfall diagram (on the next page)
quality of the underlying assets as well as the        for the exposures of a typical ABCP program
quality and financial strength of seller/servicers.     generally has four legally distinct layers.
Higher-quality assets may only need partial            However, most legal documents do not specify
support to achieve a satisfactory rating for the       which form of credit or liquidity enhancement is
commercial paper. Lower-quality assets may             in a priority position after pool-specific credit
need full support.                                     enhancement is exhausted due to defaults. For
                                                       example, after becoming aware of weakness in
                                                       the seller/servicer or in asset performance, an
Liquidity-Facility Providers                           ABCP program sponsor may purchase assets
                                                       out of the conduit using pool-specific liquidity.
The sponsoring banking organization and in             Liquidity agreements must be subject to a valid
some cases, unaffiliated third parties, provide         asset-quality test that prevents the purchase of
pool-specific or program-wide liquidity facili-         defaulted or highly delinquent assets. Liquidity
ties. These backup liquidity facilities ensure the     facilities that are not limited by such an asset-
timely repayment of commercial paper under             quality test are to be viewed as credit enhance-
certain conditions, such as financial market            ment and are subject to the risk-based capital
disruptions or if cash-flow timing mismatches           requirements applicable to direct-credit
occur, but generally not under conditions associ-      substitutes.
ated with the credit deterioration of the underly-
ing assets or the seller/servicer to the extent that
such deterioration is beyond what is permitted         Pool-Specific Credit Enhancement
under the related asset-quality test.
                                                       The form and size of credit enhancement for
                                                       each particular asset pool is dependent upon the
Commercial Paper Investors                             nature and quality of the asset pool and the
                                                       seller/servicer’s risk profile. In determining the
Commercial paper investors are typically               level of credit enhancement, consideration is
institutional investors, such as pension funds,        given to the seller/servicer’s financial strength,
money market mutual funds, bank trust depart-          quality as a servicer, obligor concentrations, and
ments, foreign banks, and investment                   obligor credit quality, as well as the historic
companies. Commercial paper maturities range           performance of the asset pool. Credit enhance-
from 1 day to 270 days, but most frequently are        ment is generally sized to cover a multiple level
issued for 30 days or less. There is a limited         of historical losses and dilution for the particular
secondary market for commercial paper since            asset pool. Pool-specific credit enhancement can
issuers can closely match the maturity of the          take several forms, including overcollateraliza-
paper to the investors’ needs. Commercial paper        tion, cash reserves, seller/servicer guarantees
investors are generally repaid from the reissu-        (for only highly rated seller/servicers), and sub-
ance of new commercial paper or from cash              ordination. Credit enhancement can either be
flows stemming from the underlying asset pools          dynamic (that is, increases as the asset pool’s
purchased by the program. In addition, to ensure       performance deteriorates) or static (that is, fixed
timely repayment in the event that new com-            percentage). Pool-specific credit enhancement is
mercial paper cannot be issued or if anticipated       generally provided by the seller/servicer (or
cash flows from the underlying assets do not oc-        carved out of the asset pool in the case of
cur, ABCP programs utilize backup liquidity            overcollateralization) but may be provided by
facilities. In addition, the banking organization      other third parties.

Commercial Bank Examination Manual                                                           October 2007
                                                                                                   Page 5
3030.1                Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs

                       The Loss Waterfall

                                                                                   Last Loss



                      Program-Wide Credit

                        Pool-Specific Credit
                                                                                   First Loss

   The ABCP program sponsor or administrator         specific credit enhancement and other structur-
will generally set strict eligibility requirements   ing protections.
for the receivables to be included in the pur-
chased asset pool. For example, receivable eli-
gibility requirements will establish minimum         Program-Wide Credit Enhancement
credit ratings or credit scores for the obligors
and the maximum number of days the receivable        The second level of contractual credit protection
can be past due.                                     is the program-wide credit enhancement, which
   Usually the purchased asset pools are struc-      may take the form of an irrevocable loan facility,
tured (credit-enhanced) to achieve a credit-         a standby letter of credit, a surety bond from a
quality equivalent of investment grade (that is,     monoline insurer, or an issuance of subordinated
BBB or higher). The sponsoring banking orga-         debt. Program-wide credit enhancement protects
nization will typically utilize established rating   commercial paper investors if one or more of the
agency criteria and structuring methodologies to     underlying transactions exhaust the pool-specific
achieve the desired internal rating level. In        credit enhancement and other structural protec-
certain instances, such as when ABCP programs        tions. The sponsoring banking organization or
purchase ABS, the pool-specific credit enhance-       third-party guarantors are providers of this type
ment is already built into the purchased ABS         of credit protection. The program-wide credit
and is reflected in the security’s credit rating.     enhancement is generally sized by the rating
The internal rating on the pool-specific liquidity    agencies to cover the potential of multiple
facility provided to support the purchased asset     defaults in the underlying portfolio of transac-
pool will reflect the inclusion of the pool-          tions within ABCP conduits and takes into

October 2007                                                     Commercial Bank Examination Manual
Page 6
Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs                                              3030.1

account concentration risk among seller/servicers             defaults that would require a draw against the
and industry sectors.                                         program-wide credit enhancement.11 While the
                                                              liquidity banking organization is exposed to the
                                                              credit risk of the underlying asset pool, the risk
Pool-Specific Liquidity                                        is mitigated by the seller-provided credit en-
                                                              hancement and the asset-quality test.12 At the
Pool-specific liquidity facilities are an important            time that the asset pool is put to the liquidity
structural feature in ABCP programs because                   banking organization, the facility is usually fully
they ensure investors of timely payments on the               drawn because the entire amount of the pool that
issued commercial paper by smoothing timing                   qualifies under the asset-quality test is pur-
differences in the payment of interest and prin-              chased by the banking organization. However,
cipal on the pooled assets and ensuring pay-                  with respect to revolving transactions (such as
ments in the event of market disruptions. The                 credit card securitizations) it is possible to
types of liquidity facilities may differ among                average less than 100 percent of the commitment.
various ABCP programs and may even differ
among asset pools purchased by a single ABCP
program. For instance, liquidity facilities may               Program-Wide Liquidity
be structured either in the form of (1) an
asset-purchase agreement, which provides liquid-              The senior-most position in the waterfall,
ity to the ABCP program by purchasing nonde-                  program-wide liquidity, is provided in an amount
faulted assets from a specific asset pool, or (2) a            sufficient to support that portion of the face
loan to the ABCP program, which is repaid                     amount of all the commercial paper that is
solely by the cash flows from the underlying                   issued by the ABCP program that is necessary to
assets.10 Some older ABCP programs may have                   achieve the desired external rating on the issued
both pool-specific liquidity and program-wide                  paper. Progam-wide liquidity also provides
liquidity coverage, while more-recent ABCP                    liquidity in the event of a short-term disruption
programs tend to utilize only pool-specific facili-            in the commercial paper market. In some cases,
ties. Typically, the seller-provided credit enhance-          a liquidity banking organization that extends a
ment continues to provide credit protection on                direct liquidity loan to an ABCP program may
an asset pool that is purchased by a liquidity                be able to access the program-wide credit
banking organization so that the institution is               enhancement to cover losses while funding the
protected against credit losses that may arise due            underlying asset pool.
to subsequent deterioration of the pool.
   Pool-specific liquidity, when drawn prior to
the ABCP program’s credit enhancements, is                    APPENDIX B—CREDIT-
subject to the credit risk of the underlying asset
pool. However, the liquidity facility does not
                                                              APPROVAL MEMORANDUM
provide direct-credit enhancement to the com-                 The credit-approval memorandum typically
mercial paper holders. Thus, the pool-specific                 should include a description of the following:
liquidity facility generally is in an economic
second-loss position after the seller-provided                1. Transaction structure. In the beginning of the
credit enhancements and prior to the program-                    credit-approval memorandum, the sponsor-
wide credit enhancement even when the legal                      ing banking organization will outline the
documents state that the program-wide credit                     structure of the transaction, which includes a
enhancement would absorb losses prior to the
pool-specific liquidity facilities. This is because               11. In fact, according to the contractual provisions of some
the sponsor of the ABCP program would most                    conduits, a certain level of draws on the program-wide credit
likely manage the asset pools in such a way that              enhancement is a condition for unwinding the conduit pro-
                                                              gram, which means that this enhancement is never meant to be
deteriorating portfolios or assets would be put to            used.
the liquidity banking organizations prior to any                 12. An asset-quality test or liquidity-funding formula deter-
                                                              mines how much funding the liquidity banking organization
   10. Direct-liquidity loans to an ABCP program may be       will extend to the conduit based on the quality of the
termed a commissioning agreement (most likely in a foreign    underlying asset pool at the time of the draw. Typically,
bank program) and may share in the security interest in the   liquidity banking organizations will fund against the conduit’s
underlying assets when commercial paper ceases to be issued   purchase price of the asset pool less the amount of defaulted
due to deterioration of the asset pool.                       assets in the pool.

Commercial Bank Examination Manual                                                                           October 2007
                                                                                                                   Page 7
3030.1                 Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs

   discussion of the asset type that would be            tion summary. For certain types of assets,
   purchased by the ABCP program and the                 such as auto loans, the sponsoring banking
   liquidity facilities (and possibly credit             organization should consider the seller’s use
   enhancements) that the sponsoring banking             of credit scoring and the minimum accept-
   organization is providing to the transaction.         able loan score that may be included in the
   Generally, the sponsoring banking organiza-           asset pool. In addition, the credit-approval
   tion indicates the type and dollar volume of          memorandum may include an indication of
   the liquidity facility that the institution is        whether the underwriting standards have
   seeking to extend to the transaction, such as         remained relatively constant over time or
   a $250 million short-term pool-specific liquid-        whether there has been a recent tightening or
   ity facility, as well as the type of first-loss        loosening.
   credit enhancement that is provided by the         4. Asset-eligibility criteria. In order to reduce
   seller, such as overcollateralization. The asset      the ABCP program’s exposure to higher-
   purchase by the ABCP conduit from the                 risk assets, an ABCP program generally
   seller may be described as a two-step sale            specifies minimum asset-eligibility criteria.
   that first involves the sale of the assets (for        This is particularly true for revolving
   example, trade receivables) to an SPV on a            transactions since the seller’s underwriting
   true-sale basis and then involves the sale of         standards may change so that the credit qual-
   the assets by the SPV to the ABCP program.            ity of the assets purchased by the ABCP
   Other features of the structure should be             program can be adversely affected. While
   described, such as if the transaction is a            eligibility criteria may be designed for
   revolving transaction with a one-year revolv-         specific transactions, there is a common set
   ing period.                                           of criteria that are generally applicable,
      In addition, the sponsoring banking orga-          including those that exclude the purchase of
   nization typically obtains true-sale and non-         defaulted assets or assets past due more than
   consolidation opinions from the seller’s              a specified number of days appropriate for
   external legal counsel. The opinions should           the specific transaction; limiting excess
   identify the various participants in the              concentration to an individual obligor;
   transaction—including the seller, servicer,           excluding the purchase of assets of obligors
   and trustee—as appropriate. For instance, the         that are affiliates of the seller; or limiting the
   seller of the assets is identified as the party        tenor of the assets to be purchased. Other
   that would act as the servicer of the assets and      criteria also may require that the obligor be a
   who is responsible for all the representa-            resident of a certain country and that the
   tions and warranties associated with the sold         asset is payable in a particular currency. All
   assets.                                               of these criteria are intended to reduce the
2. Asset seller’s risk profile. The assessment of         credit risk inherent in the asset pool to be
   the asset seller’s risk profile should consider        purchased by the ABCP program. A strong
   its past and expected future financial perfor-         set of eligibility criteria may reduce the
   mance, its current market position and                necessary credit enhancement provided by
   expected competitiveness going forward, as            the selling organization.
   well as its current debt ratings. For example,     5. Collection process. Often, if the seller/
   the sponsor may review the seller’s leverage,         servicer has a senior unsecured debt rating of
   generation of cash flow, and interest cover-           at least BBB-, cash collections may be com-
   age ratios, and whether the seller is at least        mingled with the seller/servicer’s cash until
   investment grade. Also, the sponsoring bank-          such time as periodic payments are required
   ing organization may attempt to anticipate            to be made to the ABCP program. Documen-
   the seller’s ability to continue to perform           tation should provide an ABCP program with
   under more-adverse economic conditions. In            the ability to take steps to control the cash
   addition, some sponsors may take other infor-         flows when necessary and include covenants
   mation into account, such as KMV ratings, to          to redirect cash flows or cause the segrega-
   confirm their internal view of the seller’s            tion of funds into a bankruptcy-remote SPE
   financial strength.                                    upon the occurrence of certain triggers. A
3. Underwriting standards. A discussion of the           description of how checks, cash, and debit
   seller’s current and historical underwriting          payments are to be handled may be dis-
   standards should be included in the transac-          cussed. For instance, documentation may

October 2007                                                       Commercial Bank Examination Manual
Page 8
Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs                                    3030.1

   state that payments by check must be pro-            ABCP program.
   cessed on the same day they are received by       8. Historical performance. As a prelude to siz-
   the lockbox and that after the checks clear,         ing the pool-specific credit enhancement pro-
   the cash is deposited in a segregated collec-        vided by the seller, the sponsoring banking
   tion account at the sponsoring banking orga-         organization will review the historical per-
   nization. Also, the documents may describe           formance of the seller’s portfolio, including
   the types of eligible investments in which the       consideration of losses (that is, loss rate and
   cash may be invested, which are usually              loss severity), delinquencies, dilutions, and
   highly rated, liquid investments such as gov-        the turnover rate.13 An indication of the
   ernment securities and A1/P1+ commercial             direction of losses and delinquencies, and the
   paper.                                               reasons behind any increase or decrease are
6. Assets’ characteristics. Usually, a transaction      often articulated. For instance, an increase in
   summary will provide a description of the            losses may reflect losses due to specific
   assets that will be sold into the program and        industry-related problems and general eco-
   outline relevant pool statistics. For instance,      nomic downturns. Typically, the rating agen-
   there likely will be a discussion of the             cies prefer at least three years’ worth of
   weighted average loan balance, weighted              historical information on the performance of
   average credit score (if appropriate), weighted      the seller’s asset pools, although the rating
   average original term, and weighted average          agencies periodically permit transactions to
   coupon, as well as the ranges of each char-          have less information. As a result, a sponsor-
   acteristic. In addition, the portfolio may be        ing banking organization likely will require
   segmented by the sponsoring banking orga-            the same degree of information as a rating
   nization’s internal-rating grades to give an         agency whether this is a full three-year his-
   indication of each segment’s average credit          tory or a lesser amount, as appropriate, when
   quality (as evidenced by an average credit           assessing the credit quality of its liquidity
   score) and share of the portfolio’s balances.        and credit-enhancement exposures.
   Many times, the sponsor will identify con-        9. Termination events. ABCP programs usually
   centrations to individual obligors or geo-           incorporate commercial paper stop-issuance
   graphic areas, such as states.                       or wind-down triggers to mitigate losses that
7. Dilution. Certain asset types (for example,          may result from a deteriorating asset pool or
   trade receivables) purchased by ABCP pro-            some event that may hinder the ABCP pro-
   grams may be subject to dilution, which is           grams’ ability to repay maturing commercial
   the evaporation of the asset due to customer         paper. Such triggers may be established at
   returns of sold goods, warranty claims, dis-         either the pool level or program-wide level,
   putes between the seller and its customers, as       and may, if hit, require the ABCP program to
   well as other factors. For instance, the seller      immediately stop issuing commercial paper
   of the assets to the ABCP program may                to fund (1) new purchases from a particular
   permit its customers to return goods, at             seller or (2) any new purchases regardless of
   which point the receivables cease to exist.          the seller. In addition, such triggers may
   The likelihood of this risk varies by asset          require the ABCP program to begin liquidat-
   type and is typically addressed in the trans-        ing specific asset pools or its entire portfolio.
   action summary. For instance, in sales of               The rating agencies consider these struc-
   credit card receivables to an ABCP program,          tural safeguards, which are designed to pro-
   the risk of dilution is small due to the             tect the ABCP program from credit deterio-
   underlying diversity of the obligors and mer-        ration over time, in determining the rating on
   chants. While the pool-specific liquidity             an ABCP program’s commercial paper. In
   facilities often absorb dilution initially, the      many ABCP programs, there may be a pro-
   seller generally is required to establish a          vision that requires the program to wind
   reserve to cover a multiple of expected dilu-        down if a certain percentage of the program-
   tion, which is based on historical informa-          wide credit enhancement has been used to
   tion. The adequacy of the dilution reserve is
   reviewed at the inception of the transaction         13. The turnover rate of a receivables portfolio is a
                                                     measure of how fast the outstanding assets are paid off. For
   and may or may not be incorporated in the         example, if a seller had sales of $4,000 in the prior year and
   seller-provided credit enhancement that is        an average portfolio balance of $1,000, then the turnover rate
   provided on the pool of assets sold to the        of the portfolio is four.

Commercial Bank Examination Manual                                                                 October 2007
                                                                                                         Page 9
3030.1                Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs

   cover losses (for example, 25 percent).          above predetermined levels. Program-wide
      Examples of pool-specific triggers include     triggers may include (1) the ABCP pro-
   the insolvency or bankruptcy of the seller/      gram’s failure to repay maturing commercial
   servicer; downgrade of the seller’s credit       paper or (2) when draws reduce the program-
   rating below a specific rating grade; or dete-    wide credit enhancement below a stated
   rioration of the asset pool to the point where   threshold.
   charge-offs, delinquencies, or dilution rises

October 2007                                                Commercial Bank Examination Manual
Page 10
Assessing Risk-Based Capital (RBC)—Direct-Credit
Substitutes Extended to ABCP Programs
Examination Objectives
Effective date October 2007                                                    Section 3030.2

Unless otherwise specified, examiners should             by the ABCP programs is rated by one or
weigh the importance and significance of the             more nationally recognized statistical rating
objectives being assessed when he or she deter-         organizations (NRSROs).
mines a final conclusion.                             2. To verify that NRSROs are monitoring the
                                                        ABCP programs in order to ensure the main-
                                                        tenance of minimum standards for the respec-
INTERNAL RISK-RATING                                    tive ABCP program’s rating.
1. To determine if the banking organization has      UNDERWRITING STANDARDS
   a robust internal risk-rating system.             AND MANAGEMENT OVERSIGHT
2. To determine if the banking organization
   generally has sound risk-management prac-         1. To assess the quality and robustness of the
   tices and principles.                                underwriting process.

SYSTEM FOR ABCP                                      INTERNAL-RATING
                                                     RATINGS ISSUED BY THE
1. To determine the extent to which the banking      RATING AGENCIES
   organization integrates its ABCP internal
   risk-rating process with its credit-risk man-     1. To confirm that whenever ABCP program
   agement framework.                                   transactions are externally rated, internal rat-
2. To qualitatively assess the suitability of the       ings are consistent with, or more conserva-
   banking organization’s risk-rating process           tive than, those issued by NRSROs.
   relative to the transactions and type of assets
3. To assess the adequacy of the credit-approval     FIRST-LOSS POSITION FOR
   process.                                          PROGRAM-WIDE CREDIT
INTERNALLY RATED                                     1. To assertain the rank order, if possible, of the
EXPOSURES                                               risk assumed by the various direct-credit
                                                        substitutes and liquidity facilities in the ABCP
1. To determine whether the banking organiza-           program—determining the order in which
   tion applies its internal risk-rating system to      various exposures would absorb losses.
   liquidity facilities and credit enhancements      2. To determine if third-party investors provide
   extended to ABCP programs.                           program-wide credit enhancement to the
2. To determine whether the assigned internal           ABCP conduit.
   ratings incorporate all of the risks associated   3. To determine if the spread that third-party
   with rated exposures extended to ABCP                investors or the banking organization charges
   programs.                                            for taking program-wide credit-enhancement
                                                        risk is generally within the market’s
                                                        investment-grade pricing range.
1. To confirm that the commercial paper issued

Commercial Bank Examination Manual                                                        October 2007
                                                                                                Page 1
3030.2 RBC—Direct-Credit Substitutions Extended to ABCP Programs: Examination Objectives

CONCENTRATIONS OF                                      mine the banking organization’s assessment
NON-INVESTMENT GRADE                                   of the credit quality of the risk exposure.
SELLER/SERVICERS                                    2. To rank-order the underlying transactions in
                                                       the ABCP program on the basis of internal
1. To determine if the sponsoring banking orga-        risk ratings in order to determine the notional
   nization is exposed to an inordinate amount         amount of transactions falling in each of the
   of seller/servicer risk.                            three ratings categories: investment grade
                                                       (BBB- or better), high non-investment grade
                                                       (BB+ to BB-), and low non-investment grade
UNDERLYING ASSETS OF THE                               (below BB-).
ABCP PROGRAM STRUCTURED                             3. To determine a risk-based capital require-
TO INVESTMENT-GRADE RISK                               ment for the program-wide credit
1. To obtain the internal rating for the program-
   wide credit enhancement in order to deter-

October 2007                                                    Commercial Bank Examination Manual
Page 2
Assessing Risk-Based Capital (RBC)—Direct-Credit
Substitutes Extended to ABCP Programs
Examination Procedures
Effective date October 2007                                                     Section 3030.3

DECISION TREE                                        the internal-ratings approach for exposures to
                                                     ABCP programs is inappropriate for purposes of
The decision tree is intended to assist examiners    the respective provisions of the risk-based capi-
in determining the adequacy of the internal          tal rule.
rating systems used for rating direct-credit sub-       While this guidance has been designed to
stitutes extended to asset-backed commercial         address common industry underwriting and risk-
paper (ABCP) programs. If examiners consider         management practices, it may not sufficiently
a banking organization’s internal rating system      address all circumstances. For unique cases not
adequate, then the institution may use the inter-    adequately addressed by the guidance, examin-
nal ratings assigned to calculate the risk-based     ers should review the specific facts and circum-
capital charge for unrated direct-credit substi-     stances with the responsible Reserve Bank man-
tutes, including program-wide credit enhance-        agement in conjunction with the Board’s Banking
ments. The determination process can essen-          Supervision and Regulation staff before render-
tially be broken down into individual steps that     ing a final conclusion.
start by answering broad fundamental risk ques-
tions and end with examining more-detailed
ABCP program-specific characteristics.                Organizing the Examination Process
   The first six steps (1–6) of the process focus
                                                     When organizing the examination, examiners
on evaluating the banking organization’s risk-
                                                     should note if the banking organization operates
rating system, while the final three steps (7–9)
                                                     multiple ABCP conduits. In some cases, a bank-
are used to determine the amount of risk-based
                                                     ing organization may manage individual ABCP
capital to be assessed against program-wide
                                                     conduits out of different legal entities or lines of
credit enhancements.
                                                     business, and each conduit may focus on differ-
                                                     ent business strategies.

PERFORMING THE                                       1. Before initiating the examination process,
EXAMINATION PROCEDURES                                  determine—
                                                        a. the number of ABCP conduits sponsored
Examiners should be mindful that evaluating the            by the banking organization,
adequacy of internal risk-rating systems gener-         b. which ABCP conduits have direct-credit
ally depends on both subjective judgments and              substitutes provided by the banking orga-
objective information generated in each step of            nization, and
the process. When performing the examination            c. from what areas within the organization
procedures, the examiner may determine that                these activities are conducted.
certain observed weaknesses in meeting specific       2. When multiple ABCP conduits exist, assess
supervisory expectations may not necessarily be         whether the banking organization applies the
severe enough to conclude that the internal             internal risk-rating system consistently to
risk-rating system is inadequate. In some cases,        each program with identical policies, proce-
compensating strengths in components of the             dures, and controls.
risk-rating system may offset observed weak-         3. If the banking organization operates ABCP
nesses. However, examiners should take such             program activities out of different legal enti-
weaknesses into consideration in formulating            ties or lines of business, or if the application
their overall conclusion and consider them when         of an internal rating system varies from
developing recommendations to improve the               program to program, evaluate the adequacy
internal risk-rating process. Failure to meet the       of each unique application.
regulatory requirements and follow the supervi-      4. Consider limiting any Federal Reserve
sory guidance typically is an indication of unsafe      approval of the use of internal ratings to
and unsound banking practices in the risk man-          those programs that have been examined and
agement of ABCP programs. Where failures are            determined to meet the requirements outlined
observed, examiners should conclude that use of         in this guidance.

Commercial Bank Examination Manual                                                         October 2007
                                                                                                 Page 1
3030.3      RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures

               Assessment of Internal Risk-Rating System         Assessment of Program-wide Credit Enhancement


      Step 1                                                     Step 7
                                                                          Exposure Is
               Acceptable          No                                                    Yes           Credit
                                                                          in the First
               Risk-Rating                                                                          May Require
                                               Use of Internal                Loss
                System?                                                                               Gross-Up
                                                Risk-Rating                Position?
                                               System Should
                                              Not be Approved

                       Yes                                                       No

      Step 2                                                     Step 8

            Established                                                    Is Seller/
           Rating System                 No                                               Yes
             for ABCP                                                     Risk High?

                       Yes                                                       No

      Step 3                                                     Step 9
                                                                            Are All                   Risk-weight
                Relevant                                                  Underlying      Yes        Program-wide
               Exposures                 No                               Exposures                      Credit
                Internally                                                Investment                 Enhancement
                 Rated?                                                     Grade?                     at 100%

                       Yes                                                       No

      Step 4
             Exposures                                             Risk-Based Capital
            Monitored by                 No                        Requirement Using
               Rating                                                 Weakest-Link
             Agencies?                                                  Formula


      Step 5
               Underwriting              No
               Standards &


      Step 6
              Internal &
               External                  No
             Ratings are


         Use of Internal Risk-
          Rating System is

October 2007                                                                     Commercial Bank Examination Manual
Page 2
RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures                    3030.3

      Banking organizations may have estab-                 enhancement to maintain an internal risk
   lished ABCP lines of business from which                 rating.
   they coordinate client relationships,               6.   The transactional due-diligence, approval,
   transaction-origination activities, funding              or execution documentation is poorly
   activities, and ABCP conduit management.                 prepared.
   An inspection of such ‘‘front-office’’ opera-        7.   A significant number of problem transac-
   tions can provide important insight into the             tions are taken out of the ABCP program
   unique characteristics of the banking organi-            through liquidity draws.
   zation’s ABCP program. Examiners should             8.   There is no independent review or oversight
   focus the examination’s review on the areas              of the internal rating system or the assigned
   of the organization where credit decisions               transaction ratings. A review conducted by
   and credit-risk management are housed and                internal parties within the sponsoring/
   where oversight of the internal risk-rating              administrating banking organization may
   system is maintained.                                    still be considered independent so long as
5. Consider the factors listed below while con-             the business unit conducting the review
   ducting the banking organization’s examina-              does not report to the unit that is responsible
   tion. When any of these factors are observed,            for the ABCP program’s transactions.
   perform a more thorough review of its inter-        9.   The transaction-underwriting and risk-
   nal controls, risk management, and potential             management functions of an ABCP pro-
   weaknesses before approving the banking                  gram sponsor/administrator, other than rou-
   organization’s internal risk-rating system.              tine outside audit reviews, are delegated to
      Although observation of a single factor               unaffiliated third parties.
   may not be compelling enough for withhold-         10.   The ABCP conduit commercial paper is not
   ing approval, the examiner’s observation of              rated lower than A-2/P2 on an ongoing
   one or more of these factors should result in            basis by the rating agencies.
   the adoption of a more conservative bias as
   the examination procedures are performed.                If examiners observe either of the following
                                                            two factors, the banking organization should
   If a combination of the risk factors identified           not receive Federal Reserve approval to use
   below is observed during the examination                 the internal-ratings approach. (See the
   process, the examiner may determine that the             examination procedures for more detail.)
   internal risk-rating system should not be
   relied upon for assessing the risk-based capi-     11. The banking organization does not have, in
   tal treatment for direct-credit substitutes pro-       the examiner’s view, an established or
   vided to ABCP programs.                                acceptable internal risk-rating system to
                                                          assess the credit quality of its exposures to
   The following factors should be considered:            its ABCP programs.
                                                      12. Relevant direct-credit substitutes or liquid-
 1. The sponsoring banking organization has a             ity facilities are not internally risk rated.
    short track record and is inexperienced in
    the management of an ABCP program.
 2. The transaction-specific credit enhancement
    is solely in the form of excess spread.           Step 1—Acceptable Internal
 3. Significantly higher ABCP program costs            Risk-Rating Systems
    exist for program-wide credit enhancement
    as compared with the internal and external        1. Determine if the banking organization is able
    benchmarks for investment-grade risk.                to satisfactorily demonstrate how its internal
 4. The sponsoring banking organization fails            risk-rating system corresponds to the rating
    to maintain historical ratings-migration data        agencies’ standards used as the framework
    or the migration data of required credit-            for complying with the securitization require-
    enhancement levels.                                  ments in the risk-based capital rule. Ascer-
 5. There is an excessive number of transaction-         tain whether the credit ratings map to the
    rating migrations (both internal and exter-          risk-weight categories in the ratings-based
    nal), or excessive collateral calls are neces-       approach so they can be applied to internal
    sary to enhance transaction-level credit             ratings.

Commercial Bank Examination Manual                                                           October 2007
                                                                                                   Page 3
3030.3    RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures

2. If a separate supervisory team has conducted             credit-risk management or loan-review
   a detailed evaluation of the robustness and              personnel assigning or reviewing the
   effectiveness of the banking organization’s              credit-risk ratings.
   overall internal ratings system, use the inspec-      g. The banking organization has an internal
   tion work to assess the application of internal          audit procedure that periodically verifies
   ratings specific to the banking organization’s            that internal risk ratings are assigned in
   ABCP programs. Consider reducing the pro-                accordance with the organization’s estab-
   cedures to a quick review of the previous                lished criteria.
   examination’s findings.                                h. The banking organization (1) monitors the
3. If there was no previous evaluation of the               performance of the internal credit-risk
   banking organization’s risk-rating system or             ratings assigned to nonrated, nontraded
   if documentation of the evaluation findings is            direct-credit substitutes over time to deter-
   unavailable, perform a full review of the                mine the appropriateness of the initial
   organization’s risk-rating system.                       credit-risk rating assignment and (2) adjusts
4. Ascertain whether the banking organiza-                  individual credit-risk ratings, or the over-
   tion’s overall risk-rating process is generally          all internal credit-risk ratings system, as
   consistent with the fundamental elements of              needed.
   sound risk management and with the rating             i. The internal credit-risk system makes
   assumptions and methodologies of the rating              credit-risk rating assumptions that are con-
   agencies.                                                sistent with, or more conservative than,
   a. Determine if the internal ratings are incor-          the credit-risk rating assumptions and
       porated into the credit-approval process             methodologies of the nationally recog-
       and are considered in the pricing of credit.         nized statistical rating organizations
   b. Find out if the internal lending and expo-            (NRSROs).
       sure limits are linked to internal ratings.
5. Verify that the internal risk-rating system for        If all of the above supervisory guidance is
   ABCP programs contains the following nine              not adhered to, the use of internal ratings
   criteria:                                              under the risk-based capital rule should not
   a. The internal credit-risk system is an inte-         be approved.
       gral part of the banking organization’s
       risk-management system, which explicitly
       incorporates the full range of risks arising   Step 2—Use of an Established
       from its participation in securitization       Internal Risk-Rating System Tailored
       activities.                                    to ABCP Securitization Exposures
   b. Internal credit ratings are linked to mea-
       surable outcomes, such as the probability      1. Determine if an internal rating system exists
       that the position will experience any loss,       that assesses exposures (for example, liquid-
       the position’s expected loss given default,       ity facilities) provided to ABCP programs.
       and the degree of variance in losses given     2. Ascertain whether there is evidence that the
       default on that position.                         ABCP internal risk-rating process is an inte-
   c. The banking organization’s internal credit-        grated component of the enterprise-wide
       risk system separately considers (1) the          credit-risk management process. This
       risk associated with the underlying loans         includes—
       or borrowers and (2) the risk associated          a. risk ratings that are a fundamental portfo-
       with the structure of a particular securiti-         lio management tool and
       zation transaction.                               b. internal ratings that are considered in
   d. The banking organization’s internal credit-            credit and pricing decisions.
       risk system identifies gradations of risk       3. Evaluate whether the management team and
       among ‘‘pass’’ assets and other risk              staff are experienced with the types of assets
       positions.                                        and facilities internally rated for the ABCP
   e. The banking organization has clear, explicit       program.
       criteria, including subjective factors, that   4. Determine if there is meaningful differentia-
       are used to classify assets into each inter-      tion of risk. Verify that—
       nal risk grade.                                   a. separate ratings are applied to borrowers
   f. The banking organization has independent              and facilities that separately consider the

October 2007                                                      Commercial Bank Examination Manual
Page 4
RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures                           3030.3

      risk associated with the underlying loans                    the ABCP program has been rated in the
      and borrowers, as well as the risk associ-                   second-highest short-term rating category
      ated with the specific positions in a secu-                   (A2, P2, or F2) or higher.
      ritization transaction, and                               2. Confirm that there is evidence that rating
   b. a distinct set of rating criteria exists for                 agencies are actively monitoring the structur-
      each grade. The banking organization                         ing methodologies and credit quality of the
      should have classified its assets into each                   transactions purchased by the ABCP conduit.
      risk grade using clear, explicit criteria,                   a. Prescreened programs. Confirm that
      even for subjective factors.                                    NRSROs are prescreening each new trans-
5. Verify that the risk-ratings criteria for ABCP                     action placed in the ABCP program.
   transactions are documented with specific                        b. Post-review programs. Find out if ABCP
   methodologies detailed for different asset                         program transactions are monitored by the
   types.                                                             NRSROs via monthly or quarterly reports.
6. Find out if the banking organization includes                      Determine if the banking organization is
   a transaction summary1 as part of its credit-                      promptly forwarding information on new
   approval process. The transaction summary                          transactions and transactions experiencing
   should include a description of the following:                     deterioration to the NRSROs (for example,
   transaction structure, seller/servicer’s risk pro-                 through monthly reports).
   file,2 relevant underwriting criteria, asset-
   eligibility criteria, collection process, asset
   characteristics, dilution and historical loss
   rates, and trigger and termination events.                   Step 5—Sufficient Underwriting
   (See appendix B of section 3030.1 for a more                 Standards and Management Oversight
   detailed description of the above transaction-
   summary categories.)                                          1. Determine if the banking organization has
7. Before reaching a final assessment, consult                       internal policies addressing underwriting
   with the other examiners who have con-                           standards that are applicable to ABCP
   ducted reviews of the banking organization’s                     programs.
   other risk-rating systems, including the cor-                 2. For each ABCP transaction, ascertain
   porate risk-rating system.                                       whether the institution applies the following
                                                                    factors in its underwriting process:

Step 3—Relevant Internally Rated                                    a. General Portfolio Characteristics:
                                                                        • an understanding of the operations of
1. Verify that the banking organization inter-                            the businesses that originates the
   nally rates all relevant exposures to ABCP                             assets being securitized
   programs, such as pool-specific liquidity                             • a review of the general terms offered
   facilities.                                                            to the customer
2. Ascertain if the banking organization maps                           • a determination of the quality of assets
   its internal ratings to the full scale of external                     and from which legal entity assets are
   ratings provided by the NRSROs.                                        originated
                                                                        • a determination of customer, indus-
                                                                          try, and geographic concentrations
Step 4—ABCP Program Monitored
                                                                        • an understanding of the recent trends
by Rating Agencies                                                        in the business that may affect any
                                                                          historical information about the assets
1. Verify that the commercial paper issued by

   1. The transaction summary may not be specifically iden-          b. Legal Structure of the
tified, but its elements would be part of the credit-approval           Transaction:
   2. The seller/servicer’s risk profile may be developed by a
group within the banking organization other than the ABCP
                                                                        • A general structuring of transactions
program group and incorporated into the transaction summary               as ‘‘bankruptcy-remote’’ via a legal
by reference.                                                             ‘‘true sale’’ of assets rather than as

Commercial Bank Examination Manual                                                                  October 2007
                                                                                                          Page 5
3030.3    RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures

           secured loans. (This reduces the like-         Reserves may take a number of differ-
           lihood that a creditor of the seller can       ent forms, including recourse to the
           successfully challenge the security            seller (if the seller is of high credit
           interest in the asset pool in the event        quality), funded cash reserves, and over-
           of seller insolvency.) Determine if the        collateralization.
           banking organization maintains cop-            (1) Determine if the credit-approval
           ies of true-sale opinions in the facility           chain carefully scrutinizes transac-
           file or as a part of the facility’s legal            tions in which reserves are in the
           documents.                                          form of recourse to a seller with
         • An appropriate management level in                  weak credit quality.
           the credit-approval hierarchy that is          (2) Ascertain if the banking organiza-
           responsible for reviewing transac-                  tion’s criteria for structuring the
           tions that do not have a bankruptcy-                appropriate reserve levels are gen-
           remote ‘‘true-sale’’ structure.                     erally consistent with rating agency
         • Uniform commercial code (UCC) fil-                   criteria for a particular asset class.
           ings and searches on securitized               (3) Review and consider the relevant
           assets. (UCC filings are often needed                rating agency methodology when
           to ensure that asset transfers resist               evaluating reserves for any particu-
           third-party attack [that is, are ‘‘per-             lar transaction.
           fected’’]). UCC searches often ensure
           that asset transfers are not subject to a
           higher-priority security interest (that
                                                       d. Eligibility Criteria
           is, that the banking organization’s            Eligibility criteria are structured into
           interests are ‘‘first priority’’). If such      securitization transactions to restrict (or
           filings and searches have not been              limit) the inclusion of certain categories
           performed, examiners should make               of receivables as appropriate to the
           further inquiry. There may be a satis-         particular transaction. Examples of such
           factory reason for not using the UCC           restricted categories may include:
           filing system.
                                                          • delinquent receivables (based on a
         • Transactions that include a contrac-             stated aging policy, such as 30 days
           tual representation or a legal opinion           past due)
           ensuring that there are no provisions,         • receivables of bankrupt obligors
           such as negative pledges or limita-            • foreign receivables
           tions on the sale of assets, that would
                                                          • affiliate receivables
           prohibit the securitization transaction.
                                                          • receivables of obligors with delin-
                                                            quent balances above a certain amount
    c. Transaction-Specific Credit                         • bill and hold receivables
       Enhancements                                       • unearned receivables
                                                          • non-U.S.-dollar-denominated receiv-
         Transaction-specific credit enhance-                ables
         ment takes a variety of forms depend-            • receivables subject to offset
         ing upon the asset type. For instance,           • disputed receivables
         credit enhancement relating to trade             • receivables with a payment date
         receivables may consist of the follow-             beyond a specified time horizon
         ing types of reserves:                           • post-petition receivables
         • loss reserve—reserves related to obli-
           gor default risk                               The above list is illustrative and should
         • dilution reserve—reserves related to           not be considered comprehensive.
           non-cash reductions of balances
         • servicing reserve—reserves related to          (1) Conduct further analysis when there
           fees for servicing and trustees                    is a lack of any specific eligibility
                                                              criteria (for example, those listed
         The loss and dilution reserves typically             above) that warrants a further deter-
         account for most of the reserves.                    mination as to whether the banking

October 2007                                                  Commercial Bank Examination Manual
Page 6
RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures            3030.3

            organization has taken appropriate        g. Due-Diligence Reviews
            measures to alleviate any particular
            risk arising from the lack of a              (1) Ascertain if the banking organiza-
            specific feature.                                 tion conducts due-diligence reviews
                                                             prior to closing its ABCP transac-
                                                             tions. Determine if such reviews
    e. Concentrations                                        were tailored to the asset type being
                                                             securitized and the availability of
        (1) Analyze obligor, industry, and geo-              audit information. A frequent pub-
            graphic concentrations.                          lic asset-backed securities (ABS)
        (2) Ascertain if the appropriate concen-             issuer that accesses conduit funding
            tration limits have been established             or a seller that has strong credit
            within transaction documents, often              quality may be eligible for a post-
            within the eligibility criteria.                 closing review, provided recent
                                                             audit results are obtained. If not, it
                                                             should be subject to pre-closing
    f. Trigger Events and Termination                        review. For example, a review tai-
       Events                                                lored to trade receivables should
                                                             focus on most of the following:
        The inclusion of trigger and termination             • Confirming the receivable infor-
        events plays a critical role in securiti-               mation (balances, sales, dilution,
        zation structures. It is standard practice              write-offs, etc.) previously pro-
        to have trigger or termination events                   vided by the seller, with the sell-
        related to the performance of the assets                er’s books and records over at
        and, depending upon the asset type, to                  least two reporting periods. Such
        the seller/servicer. Trigger events are                 a review might be performed by a
        comparable to performance covenants                     third-party auditor.
        in corporate debt and provide a lender               • Sampling invoices against the
        with the ability to accelerate a transac-               seller’s aged trial balance to test
        tion, when appropriate. In addition, such               the accuracy of agings.
        triggers create incentives that allow the            • Sampling past invoices to deter-
        seller and the banking organization to                  mine ultimate resolution (paid,
        negotiate higher levels of credit enhance-              credited, written-off, etc.)
        ment or add further restrictions to eli-             • Sampling credits against their
        gibility criteria when the receivables’                 respective invoices to test the
        performance metrics indicate deteriora-                 dilution horizon.
        tion beyond an established trigger level.            • Sampling write-offs to determine
        In a similar way, termination events are                timing and reasons for write-offs.
        established to begin the early termina-              • Reviewing significant customer
        tion of the transaction when the receiv-                concentrations, including delin-
        able performance deteriorates. Typical                  quent balances.
        trigger events are based on one or more              • Determining systems capability
        of the following performance metrics:                   with respect to transaction report-
        • asset coverage ratio                                  ing and compliance.
                                                             • Reviewing credit files for com-
        • delinquencies                                         pleteness and conformity with
        • losses                                                credit policies.
        • dilution                                           • Reviewing collection systems and
                                                                determining the portion of cash
        Termination events may include these                    going into segregated lockboxes
        same metrics but may also include the                   or bank accounts.
        bankruptcy, insolvency, change of con-               • Reviewing internal and external
        trol of the seller/servicer, or the failure             auditor reports to the extent that
        of the servicer to perform its responsi-                such documents are available for
        bilities in full.                                       review.

Commercial Bank Examination Manual                                                   October 2007
                                                                                           Page 7
3030.3    RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures

             • Noting any unusual items that            should be required in the monthly report.
               may complicate the receivable
               transaction.                             (1) Determine if quarterly, or more fre-
         (2) Determine if ABCP transactions are             quent, reports for a trade receivable
             reviewed at least annually.                    transaction include the following:
             • Confirm that the banking organi-              • beginning balances
               zation verifies the accuracy of the           • sales
               monthly servicer’s transaction               • cash collections
               reports, including compliance                • dilution or credits
               with sale and servicing require-             • write-offs
               ments.                                       • ending balances
             • Determine if an increased review             • delinquencies by aging bucket
               frequency is needed for any issues           • ineligible assets
               raised in prior reviews, transac-            • total eligible receivables
               tions with higher-risk sellers, and          • excess concentrations
               transactions serviced out of mul-            • net receivable balance
               tiple locations.                             • conduit investment
                                                            • conduit’s purchased interest
                                                            • calculation of receivable perfor-
    h. Cash Management                                         mance termination events
                                                            • top 10 obligor concentrations
         (1) Assess a seller’s cash-management
                                                        (2) Ascertain if the banking organiza-
             practices. Commingling of cash col-
                                                            tion has established other special
             lections can cause a loss in the
                                                            reporting requirements based on the
             perfected security interest of cash
                                                            particular pool of receivables being
             flows, particularly in the event of
             seller insolvency.
             • Determine if, preferably, the bank-
               ing organization requires that all    j. Receivable Systems
               payment collections flow into a
               single, segregated lockbox               (1) Because of the significant reporting
               account to minimize cash-                    requirements in a securitization
               commingling risk.                            transaction, verify that the banking
             • For trade receivables, find out if            organization assesses—
               the banking organization requires            • the seller’s receivable systems to
               that the cash collections be rein-              determine if they will be suffi-
               vested in new receivables to                    cient to provide the required
               eliminate cash-commingling risk.                information and
         (2) For higher-risk sellers, determine if          • the seller’s data backup and disas-
             the banking organization—                         ter recovery systems.
             • establishes an account in the name
               of the trust or special-purpose
               vehicle (SPV) into which collec-      k. Quality of Seller/Servicer
               tions could be swept on a daily
                                                        (1) Verify that the banking organiza-
               basis or
                                                            tion performs an assessment of the
             • requires that settlement be done
                                                            creditworthiness of the seller that is
               weekly, or daily, ensuring that
                                                            conducted from the relationship
               there are always sufficient receiv-
               ables to cover investments and
                                                        (2) Determine if the banking organiza-
                                                            tion conducts a more focused as-
                                                            sessment on the seller/servicer’s
    i. Reporting                                            management team that is involved
                                                            in the day-to-day receivables opera-
         When underwriting a portfolio, it is               tion (that is, credit, accounting,
         important to decide what information               sales, servicing, etc.).

October 2007                                               Commercial Bank Examination Manual
Page 8
RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures                3030.3

    l. Performance Monitoring                                (2) Evaluate the robustness of the
                                                                 underwriting process and deter-
        (1) Find out whether the banking orga-                   mine if it is comparable to stated
            nization has developed and uses a                    rating agency criteria. If weak-
            performance-monitoring plan that                     nesses in the underwriting process
            periodically monitors the portfolio.                 are found, determine if there are
            • Determine if there is appropriate                  any existing compensating strengths
              monitoring that allows the desig-                  and any other relevant factors to be
              nated administrator to review rel-                 considered when determining its
              evant pool performance to evalu-                   overall assessment.
              ate the level of available funding             (3) If the examiner determines that the
              under the asset-quality tests in                   supervisory expectations generally
              the related liquidity facility.                    are not met, he or she should not
            • Determine if the banking organi-                   recommend to the appropriate
              zation tests these conditions when                 Reserve Bank supervisory official
              the seller reports performance                     that the use of internal ratings,
              data relating to an underlying                     under the securitization capital rule,
              transaction (usually monthly or                    be approved.

       Typically, a liquidity facility has a fund-   Step 6—Consistency of Internal
     ing condition based on asset quality            Ratings of ABCP Program’s
     whereby the liquidity provider will not
     advance against any receivable that is
                                                     Exposures with Ratings Issued
     considered defaulted. A performance-            by the Rating Agencies
     monitoring plan may entail monitoring the
     run rate of defaulted assets so that the        1. Find out if any underlying transactions funded
     potential losses do not exceed the loss            through ABCP programs are externally rated
     protection.                                        by one or more rating agencies.
                                                     2. Confirm if the mapping of the internal ratings
                                                        assigned to these transactions is consistent
    m. Post-Closing Monitoring                          with, or more conservative than, those issued
                                                        by NRSROs.
        (1) Determine if the banking organiza-       3. When the underlying transactions are split-
            tion’s underwriting team assists the        rated by two or more rating agencies, deter-
            portfolio management team in                mine if the internal ratings are consistent
            developing all of the items that            with the most conservative (lowest) external
            should be tracked on the transac-           rating.
            tion, including the development of       4. Ascertain that the above exceptions do not
            a spreadsheet that ensures the cap-         represent more than a small fraction of the
            ture and calculation of the appro-          total number of transactions that are exter-
            priate information.                         nally rated. If such exceptions exist, deter-
                                                        mine if there are generally an equal or larger
    n. Underwriting Exceptions                          percentage of externally rated transactions
                                                        where internal ratings are more conservative
        (1) If a banking organization approves          than the external rating.
            a transaction after it has agreed to
            an exception from standard under-           If supervisory expectations are not met, then
            writing procedures, find out if the          the internal risk-rating system may not be
            banking organization closely moni-          appropriately mapped to the external ratings
            tors and periodically evaluates the         of an NRSRO. In such cases, further review
            policy exception.                           of the adequacy of the banking organiza-
                                                        tion’s risk-rating system must be undertaken
Banking organizations may utilize variations of         before the use of internal ratings under the
the above-listed underwriting standards.                securitization capital rule can be approved.

Commercial Bank Examination Manual                                                       October 2007
                                                                                               Page 9
3030.3    RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures

Determine Adequacy of Internal Ratings                      ranges of non-investment-grade and
Systems                                                     investment-grade exposures of the spon-
                                                            soring banking organization, the loan syn-
If, through the examination process, the internal           dication market, and the bond market.
risk-rating system utilized for ABCP exposures              This may be a gauge as to whether a third
is found to be inadequate, then the banking                 party considers the risk as investment
organization may not apply the internal risk-               grade or non-investment grade.
ratings approach to ABCP exposures for risk-             b. Reference such sources for reviewing mar-
based capital purposes until the organization has           ket pricing as Loan Pricing Corporation’s
remedied the deficiencies. Banking organiza-                 Gold Sheets and Bloomberg (for bond
tions that have adequate risk-rating systems that           spreads). A range or average pricing for
are well integrated into risk-management pro-               both investment-grade and non-investment-
cesses applied to ABCP programs may be                      grade syndicated loans can be found in the
approved for use of the internal risk-ratings               Gold Sheets.
approach.                                                c. Similarly, review also the price the sponsor/
   Once a banking organization’s internal rating            banking organization is charging for its
system is deemed adequate, the organization                 respective portion of the program-wide
may use its internal ratings to slot ABCP expo-             credit enhancement.
sures, including pool-specific liquidity facilities,
into the appropriate rating category (investment
grade, high non-investment grade, and low non-
investment grade), and apply the corresponding
                                                      Step 8—Risk Levels
risk weights. However, due to the unique nature       Posed by Concentrations of
of program-wide credit enhancements, further          Non-Investment-Grade
guidance is provided in steps 7 through 9 to help     Seller/Servicers
establish the appropriate capital requirement.
                                                      1. Confirm that the banking organization’s inter-
                                                         nal risk-rating systems properly account for
                                                         the existence of seller/servicer risk.
Step 7—Determination of Whether                             An asset originator (that is, the entity
Program-Wide Credit Enhancements                         selling the assets to the ABCP program)
Are in the First-Loss Position                           typically is the servicer and essentially acts
                                                         as the portfolio manager for the ABCP pro-
1. Determine if the ABCP program documenta-              gram’s investment. The servicer identifies
   tion confirms that the program-wide credit             receivables eligible for the ABCP program
   enhancement is not the first-loss credit               and manages to preserve the investment on
   enhancement for any transaction in the ABCP           behalf of the banking organization sponsor-
   program and is, at worst, in the second-              ing the ABCP program. As previously dis-
   economic-loss position, usually after                 cussed, servicer risk can be partially miti-
   transaction-specific credit enhancements.              gated through seller allocation and structuring
2. Verify if the spread charged for the program-         payments to protect against commingling of
   wide credit enhancement is the spread range           cash.
   of investment-grade exposures of a term            2. Determine if the banking organization has
   securitization. Consider other factors that           specific transaction structures, such as a
   may influence pricing, such as availability of         backup servicer, in place to mitigate servicer
   the credit enhancement.                               risk.
3. Find out if the financial guarantee providers,      3. Ascertain if exposure to an excessive number
   such as AMBAC, FSA, and FGIC, partici-                of non-investment-grade servicers adversely
   pate in a program-wide credit-enhancement             affects the overall credit quality of the ABCP
   tranche either on a senior position or on a           program, exposing the conduit to the higher
   pari-passu position with other providers. The         bankruptcy risk that inherently exists with
   risk taken by these institutions is usually           non-investment-grade obligors.
   investment grade.                                  4. Use the benchmarks below to assess the
   a. Compare the price of the guarantee                 banking organization’s potential exposures
      charged by these institutions to the pricing       to non-investment-grade seller/servicer con-

October 2007                                                      Commercial Bank Examination Manual
Page 10
RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures        3030.3

   centrations in its ABCP program. Depending       tions are internally rated below invest-
   on the circumstances, concentrations exceed-     ment grade, then consider using the fol-
   ing these benchmarks may be considered as        lowing weakest-link approach to calculate
   unsafe and unsound banking practices.            an appropriate risk-based capital charge
   a. Determine, based on the grid below, the       for the program-wide credit enhancement.
      percentage of securitized assets from non-       The approach takes into account the
      investment-grade servicers to the total       internal ratings assigned to each underly-
      outstandings of an ABCP program that          ing transaction in an ABCP program.
      has a lower weighted average rating of all    These transaction-level ratings are typi-
      the transactions in the program. For          cally based on the internal assessment of a
      example, if the ABCP program transac-         transaction’s pool-specific liquidity facil-
      tions have a weighted average rating          ity and the likelihood of its being drawn.
      equivalent to ‘‘BBB,’’ no more than 30 per-   The transactions are rank-ordered by their
      cent of the total outstandings of the ABCP    internal rating and then bucketed into the
      program should be represented by non-         three ratings categories: investment grade,
      investment-grade seller/servicers. How-       high non-investment grade, and low non-
      ever, an ABCP program that has transac-       investment grade. The program-wide credit
      tions structured to a higher weighted         enhancement is then assigned an appropri-
      average rating, such as a single ‘‘A’’        ate risk weight based upon the notional
      equivalent, could have up to 60 percent of    amount of transactions in each ratings
      the outstandings originated by non-           bucket.
      investment-grade seller/servicers without        Under the weakest-link approach, the
      causing undue concerns.                       risk of loss corresponds first to the weak-
                                                    est transactions to which the program-
        Weighted               Servicer             wide credit enhancement is exposed. Bank-
    average rating            percentage            ing organizations should begin with the
                                                    lowest bucket (low non-investment grade)
       equivalent                below              and then move to the next-highest rating
    of transactions        investment grade         bucket until the entire amount of the
         AA                       90%               program-wide credit enhancement has
        AA–                       80%               been assigned. The assigned risk weights
         A+                       70%               and their associated capital charges are
          A                       60%               then aggregated. However, if the risk-
          A–                      50%               based capital charge for the non-
        BBB+                      40%               investment-grade asset pools equals or
        BBB                       30%               exceeds the 8 percent charge against the
        BBB–                      20%               entire amount of assets in the ABCP
         BB+                      10%               program, then the risk-based capital charge
                                                    is limited to the 8 percent against the
                                                    program’s assets.
                                                       Banking organizations that sponsor
Step 9—The Portion of Underlying                    ABCP programs may have other method-
Assets of the ABCP Program                          ologies to quantify risk across multiple
Structured to Investment-Grade Risk                 exposures. For example, collateralized debt
                                                    obligation (CDO) ratings methodology
1. Determine the appropriate amount of risk-        takes into account both the probability of
   based capital that should be assessed against    loss on each underlying transaction and
   the program-wide credit enhancement based        correlations between the underlying trans-
   on the internal risk ratings of the underlying   actions. This and other methods may gen-
   transactions in the ABCP program.                erate capital requirements equal to or
   a. If all underlying transactions are rated      more conservative than those arrived at
      investment grade, risk-weight the notional    via the weakest-link method. Regardless
      amount of the program-wide credit             of the approach used, well-managed insti-
      enhancement at 100 percent.                   tutions should be able to support their
   b. If one or more of the underlying transac-     risk-based capital calculations.

Commercial Bank Examination Manual                                                October 2007
                                                                                       Page 11
3030.3    RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures

 Weakest-Link Formula
               IF [(0.16 * NI1) + NI2**] ≥ (0.08 * PROG), THEN RBC = (0.08 x PROG)
                    Capital = [0.08 * (PWC Ø (NI1 + NI2))] + 0.16 * NI1] + [NI2**]

   **Although the term NI2 should reflect a gross-up charge under the securitization capital rule
   (that is, an effective 1,250 percent risk weight), for the sake of simplicity a dollar-for-dollar
   charge is used here. The reason for using dollar-for-dollar is based on the assumption that the
   NI2 portion of an ABCP pool is typically smaller than the gross-up charge would be on the
   entire pool. Thus, instead of grossing-up the NI2 portion and then applying the low-level-
   exposure rule (which, if NI2 is less than the gross-up charge, will yield a dollar-for-dollar
   capital charge), the term just assumes the dollar-for-dollar amount.

   In any event, the risk-based capital charge on the program-wide credit enhancement will
   never exceed the maximum contractual amount of that program-wide credit enhancement
   (that is, the low-level-exposure rule).

   RBC = Risk-based capital
   PROG = Notional amount of all underlying exposures in the program
   PWC = Notional amount of program-wide credit enhancement
   IG = Notional amount of exposures rated BBB- or better
   NI1 = Notional amount of exposures rated between BB+ and BB-
   NI2 = Notional amount of exposures rated below BB-

Example 1                                            Example 2
ABCP program size (PROG) = $1,000 MM                 ABCP program size (PROG) = $1,000 MM
Program-wide credit enhancement (PWC) =              Program-wide credit enhancement (PWC) =
  $100 MM                                              $150 MM
Total amount of investment grade (IG) =              Total amount of investment grade (IG) =
  $995 MM                                              $940 MM
Total amount of high non-investment grade            Total amount of high non-investment grade
  (NI1) = $4 MM                                        (NI1) = $50 MM
Total amount of low non-investment grade             Total amount of low non-investment grade
  (NI2) = $1 MM                                        (NI2) = $10 MM

Weakest Link                                         Weakest Link
RBC = IF [(0.16 * 4) + 1] ≥ (0.08 * 1,000), then     RBC = IF [(0.16 * 50) + 10] ≥ (0.08 * 1,000),
RBC = (0.08 * 1,000)                                  then RBC = (0.08 * 1,000) = $18 MM
    = $1.64 MM < $80 MM                                < $80 MM

  Else                                                 Else

RBC = [(0.08 * (100 Ø (4 + 1))] + (0.16 * 4) +       RBC = [(0.08 * (150 Ø (50+10))] + (0.16 * 50)
 (1)                                                  + (10)
RBC = (7.60) + (0.64) + (1)                          RBC = (7.20) + (8.00) + (10)
     = $ 9.24 MM                                         = $25.2MM

October 2007                                                      Commercial Bank Examination Manual
Page 12
RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures             3030.3

Example 3                                         too much risk-based capital being assessed. If
                                                  this situation arises, banking organizations
ABCP program size (PROG) = $1,000 MM              should first apply the gross-up treatment to the
Program-wide credit enhancement (PWC) =           NI2 asset pools and then assess 16 percent
  $150 MM                                         risk-based capital against an amount of the NI1
Total amount of investment grade (IG) =           asset pools that, when added with the NI2 asset
  $0 MM                                           pools, would equal the amount of the program-
Total amount of high non-investment grade         wide credit enhancement. For example, if the
  (NI1) = $500 MM                                 program-wide credit enhancement is $100 on
Total amount of low non-investment grade          underlying transactions totaling $1,000, and the
  (NI2) = $500 MM                                 underlying exposures are $10 low non-
                                                  investment grade, $100 high non-investment
                                                  grade, and $890 investment grade, then risk
Weakest Link                                      weighting will be based on the gross-up approach
                                                  for $10 and assigning the remaining $90 to the
RBC = IF [(0.16 * 500) + 500] ≥ (0.08 * 1,000),   200 percent risk-weight category, as shown
THEN RBC = (0.08 * 1,000) = $580 MM >             below:
$80 MM
  Therefore,                                        $10 * 1,250% * 8% = $10.00
                                                    $90 * 200% * 8% = $14.40
RBC = (0.08 * 1,000) = $80 MM
                                                    Total                     $24.40
Because $580 MM is greater than the $80 MM
capital charge that would apply if all of the        Finally, the aggregate capital charge, $24.40
assets supported by the PWC were on-balance-      in this case, is then compared to the capital
sheet, the maximum risk-based capital charge is   charge imposed on the underlying transactions if
$80 MM.                                           all the program assets were on the banking
  When the sum of all non-investment-grade        organization’s balance sheet (that is, 0.08 *
asset pools (that is, NI1 + NI2) exceeds the      $1,000 = $80); the lower amount prevails. This
amount of the program-wide credit enhance-        establishes the capital charge for the program-
ment, the weakest-link formula would result in    wide credit enhancement.

Commercial Bank Examination Manual                                                     October 2007
                                                                                            Page 13
Assessing Risk-Based Capital—Direct-Credit Substitutes
Extended to ABCP Programs
Internal Control Questionnaire
Effective date October 2007                                                Section 3030.4

1. Does the banking organization have an               sures consistent with ratings issued by the
   acceptable risk-rating system?                      rating agencies?
2. Does the banking organization use an estab-      7. Is program-wide credit enhancement in the
   lished internal risk-rating system tailored to      first-loss position?
   ABCP securitization exposures?
3. Are the relevant exposures internally rated?     8. Do concentrations of non-investment-grade
4. Are the ABCP programs monitored by rating           seller/services pose an excessive level of
   agencies?                                           risk?
5. Are there sufficient underwriting standards       9. What portion of the underlying assets of the
   and management oversight?                           ABCP programs is structured to investment-
6. Are internal ratings of ABCP program expo-          grade risk?

Commercial Bank Examination Manual                                                    October 2007
                                                                                            Page 1

Shared By: