[Federal Register Volume 63, Number 78 (Thursday, April 23, 1998)]
[Notices]
[Pages 20191-20197]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-10744]
=======================================================================
-----------------------------------------------------------------------
FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL
Supervisory Policy Statement on Investment Securities and End-
User Derivatives Activities
AGENCY: Federal Financial Institutions Examination Council.
ACTION: Statement of policy.
-----------------------------------------------------------------------
SUMMARY: The Board of Governors of the Federal Reserve System (FRB),
the Federal Deposit Insurance Corporation (FDIC), the Office of the
Comptroller of the Currency (OCC), the Office of Thrift Supervision
(OTS), and the National Credit Union Administration (NCUA)
(collectively referred to as the agencies), under the auspices of the
Federal Financial Institutions Examination Council (FFIEC), have
approved the Supervisory Policy Statement on Investment Securities and
End-User Derivatives Activities (1998 Statement) which provides
guidance on sound practices for managing the risks of investment
activities. By this issuance of the 1998 Statement, the agencies have
rescinded the Supervisory Policy Statement on Securities Activities
published on February 3, 1992 (1992 Statement). Many elements of that
prior statement are retained in the 1998 Statement, while other
elements have been revised or eliminated. In adopting the 1998
Statement, the agencies are removing the specific constraints in the
1992 Statement concerning investments by insured depository
institutions in ``high risk'' mortgage derivative products. The
agencies believe that it is a sound practice for institutions to
understand the risks related to all their investment holdings.
Accordingly, the 1998 Statement substitutes broader guidance than the
specific pass/fail requirements contained in the 1992 Statement. Other
than for the supervisory guidance contained in the 1992 Statement, the
1998 Statement does not supersede any other requirements of the
respective agencies' statutory rules, regulations, policies, or
supervisory guidance. Because the 1998 Statement does not retain the
elements of the 1992 Statement addressing the reporting of securities
activities (Section II of the 1992 Statement), the agencies intend to
separately issue supervisory guidance on the reporting of investment
securities and end-user derivatives activities. Each agency may issue
additional guidance to assist institutions in the implementation of
this statement.
EFFECTIVE DATE: May 26, 1998.
FOR FURTHER INFORMATION CONTACT:
FRB: James Embersit, Manager, Capital Markets, (202) 452-5249,
Charles Holm, Manager, Accounting Policy and Disclosure (202) 452-3502,
Division of Banking Supervision and Regulation, Board of Governors of
the Federal Reserve System. For the hearing impaired only,
Telecommunication Device for the Deaf (TDD), Dorothea Thompson, (202)
452-3544, Board of Governors of the Federal Reserve System, 20th and C
Streets, NW, Washington, DC 20551.
FDIC: William A. Stark, Assistant Director, (202) 898-6972, Miguel
D. Browne, Manager, (202) 898-6789, John J. Feid, Chief, Risk
Management, (202) 898-8649, Lisa D. Arquette, Senior Capital Markets
Specialist, (202) 898-8633, Division of Supervision; Michael B.
Phillips, Counsel, (202) 898-3581, Legal Division, Federal Deposit
Insurance Corporation, 550 17th Street, NW, Washington, DC 20429.
OCC: Kurt Wilhelm, National Bank Examiner, (202) 874-5670, J. Ray
Diggs, National Bank Examiner, (202) 874-5670, Treasury and Market
Risk; Mark J. Tenhundfeld, Assistant Director, (202) 874-5090,
Legislative and Regulatory Activities Division, Office of the
Comptroller of the Currency, 250 E Street, SW, Washington, DC 20219.
OTS: Robert A. Kazdin, Senior Project Manager, (202) 906-5759,
Anthony G. Cornyn, Director, (202) 906-5727, Risk Management; Vern
McKinley, Senior Attorney, (202) 906-6241, Regulations and Legislation
Division, Chief Counsel's Office, Office of Thrift Supervision, 1700 G
Street, NW, Washington, DC 20552.
NCUA: Daniel Gordon, Senior Investment Officer, (703) 518-6360,
Office of Investment Services; Michael McKenna, Attorney, (703) 518-
6540, National Credit Union Administration, 1775 Duke Street,
Alexandria, VA 22314-3428.
SUPPLEMENTARY INFORMATION: In 1992, the agencies implemented the
FFIEC's Supervisory Policy Statement on Securities Activities (57 FR
4028, February 3, 1992). The 1992 Statement addressed: (1) selection of
securities dealers, (2) portfolio policy and strategies (including
unsuitable investment practices), and (3) residential mortgage
derivative products (MDPs).
The final section of the 1992 Statement directed institutions to
subject MDPs to supervisory tests to determine the degree of risk and
the investment portfolio eligibility of these instruments. At that
time, the agencies believed that many institutions had demonstrated an
insufficient understanding of the risks associated with investments in
MDPs. This occurred, in part, because most MDPs were issued or backed
by collateral guaranteed by government sponsored enterprises. The
agencies were concerned that the absence of significant credit risk on
most MDPs had allowed institutions to overlook the significant interest
rate risk present in certain structures of these instruments. In an
effort to enhance the investment decision making process at financial
institutions, and to emphasize the interest rate risk of highly price
sensitive instruments, the agencies implemented supervisory tests
designed
[[Page 20192]]
to identify those MDPs with price and average life risks greater than a
newly issued residential mortgage pass-through security.
These supervisory tests provided a discipline that helped
institutions to better understand the risks of MDPs prior to purchase.
The 1992 Statement generally provided that institutions should not hold
high risk MDPs in their investment portfolios.1 A high risk
MDP was defined as a mortgage derivative security that failed any of
three supervisory tests. The three tests included: an average life
test, an average life sensitivity test, and a price sensitivity
test.2
---------------------------------------------------------------------------
\1\ The only exceptions granted were for those high risk
securities that either reduced interest rate risk or were placed in
a trading account. Federal credit unions were not permitted these
exceptions.
\2\ Average Life: Weighted average life of no more than 10
years; Average Life Sensitivity: (a) weighted average life extends
by not more than 4 years (300 basis point parallel shift in rates),
(b) weighted average life shortens by no more than 6 years (300
basis point parallel shift in rates); Price Sensitivity: price does
not change by more than 17 percent (increase or decrease) for a 300
basis point parallel shift in rates.
---------------------------------------------------------------------------
These supervisory tests, commonly referred to as the ``high risk
tests,'' successfully protected institutions from significant losses in
MDPs. By requiring a pre-purchase price sensitivity analysis that
helped institutions to better understand the interest rate risk of
MDPs, the high risk tests effectively precluded institutions from
investing in many types of MDPs that resulted in large losses for other
investors. However, the high risk tests may have created unintended
distortions of the investment decision making process. Many
institutions eliminated all MDPs from their investment choices,
regardless of the risk versus return merits of such instruments. These
reactions were due, in part, to concerns about regulatory burden, such
as higher than normal examiner review of MDPs. By focusing only on
MDPs, the test and its accompanying burden indirectly provided
incentives for institutions to acquire other types of securities with
complex cash flows, often with price sensitivities similar to high risk
MDPs. The emergence of the structured note market is just one example.
The test may have also created the impression that supervisors were
more concerned with the type of instrument involved (i.e., residential
mortgage products), rather than the risk characteristics of the
instrument, since only MDPs were subject to the high risk test. The
specification of tests on individual securities may have removed the
incentive for some institutions to apply more comprehensive analytical
techniques at the portfolio and institutional level.
As a result, the agencies no longer believe that the pass/fail
criteria of the high risk tests as applied to specific instruments
constitutes effective supervision of investment activities. The
agencies believe that an effective risk management program, through
which an institution identifies, measures, monitors, and controls the
risks of investment activities, provides a better framework. Hence, the
agencies are eliminating the high risk tests as binding constraints on
MDP purchases in the 1998 Statement.
Effective risk management addresses risks across all types of
instruments on an investment portfolio basis and ideally, across the
entire institution. The complexity of many financial products, both on
and off the balance sheet, has increased the need for a more
comprehensive approach to the risk management of investment activities.
The rescission of the high risk tests as a constraint on an
institution's investment activities does not signal that MDPs with high
levels of price risk are either appropriate or inappropriate
investments for an institution. Whether a security, MDP or otherwise,
is an appropriate investment depends upon a variety of factors,
including the institution's capital level, the security's impact on the
aggregate risk of the portfolio, and management's ability to measure
and manage risk. The agencies continue to believe that the stress
testing of MDP investments, as well as other investments, has
significant value for risk management purposes. Institutions should
employ valuation methodologies that take into account all of the risk
elements necessary to price these investments. The 1998 Statement
states that the agencies believe, as a matter of sound practice,
institutions should know the value and price sensitivity of their
investments prior to purchase and on an ongoing basis.
Summary of Comments
The 1998 Statement was published for comment in the Federal
Register of October 3, 1997 (62 FR 51862). The FFIEC received twenty-
one comment letters from a variety of insured depository institutions,
trade associations, Federal Reserve Banks, and financial services
organizations. Overall, the comments were supportive of the 1998
Statement. The comments generally approved of: (i) the rescission of
the high risk test as a constraint on investment choices in the 1992
Statement; (ii) the establishment by institutions of programs to manage
market, credit, liquidity, legal, operational, and other risks of
investment securities and end-user derivatives activities; (iii) the
implementation of sound risk management programs that would include
certain board and senior management oversight and a comprehensive risk
management process that effectively identifies, measures, monitors, and
controls risks; and (iv) the evaluation of investment decisions at the
portfolio or institution level, instead of the focus of the 1992
Statement on limiting an institution's investment decisions concerning
specific securities instruments.
The following discussion provides a summary of significant concerns
or requests for clarifications that were presented in the
aforementioned comments.
1. Scope
The guidance covers a broad range of instruments including all
securities in held-to-maturity and available-for-sale accounts as
defined in the Statement of Financial Accounting Standards No.115 (FAS
115), certificates of deposit held for investment purposes, and end-
user derivative contracts not held in trading accounts.
Some comments focused on the 1998 Statement's coverage of ``end-
user derivative contracts not held in trading accounts.'' According to
these comments, the 1998 Statement appears to cover derivative
contracts not traditionally viewed as investments including: (i) Swap
contracts entered into when the depository institution makes a fixed
rate loan but intends to change the income stream from a fixed to
floating rate, (ii) swap contracts that convert the interest rates on
certificates of deposit from fixed to floating rates of interest, and
(iii) swap contracts used for other asset-liability management
purposes. Those commenters objected to the necessity of additional
guidance for end-user derivatives contracts given current regulatory
guidance issued by the agencies with respect to derivative contracts.
The guidance contained in the 1998 Statement is consistent with
existing agency guidance. The agencies believe that institutions should
have programs to manage the market, credit, liquidity, legal,
operational, and other risks of both investment securities and end-user
derivative activities. Given the similarity of the risks in those
activities and the similarity of the programs needed to manage those
risks, especially when end-user derivatives are used as investment
vehicles, the agencies believe that covering both activities
[[Page 20193]]
within the scope of the 1998 Statement is appropriate.
2. Board Oversight
Some commenters stated that the 1998 Statement places excessive
obligations on the board of directors. Specifically, comments indicated
that it is unnecessary for an institution's board of directors to: (i)
Set limits on the amounts and types of transactions authorized for each
securities firm with whom the institution deals, or (ii) review and
reconfirm the institution's list of authorized dealers, investment
bankers, and brokers at least annually. These commenters suggested that
it may be unnecessary for the board--particularly for larger
institutions--to review and specifically authorize each dealer. They
indicated that it should be sufficient for senior management to ensure
that the selection of securities firms is consistent with board
approved policies, and that establishment of limits for each dealer is
a credit decision that should be issued pursuant to credit policies.
The agencies believe that the board of directors is responsible for
supervision and oversight of investment portfolio and end-user
derivatives activities, including the approval and periodic review of
policies that govern relationships with securities dealers. Especially
with respect to the management of the credit risk of securities
settlements, the agencies encourage the board of directors or a
subcommittee chaired by a director to actively participate in the
credit decision process. The agencies understand that institutions will
have various approaches to the credit decision process, and therefore
that the board of directors may delegate the authority for selecting
dealers and establishing dealer limits to senior management. The text
of the 1998 Statement has been amended to clarify the obligation of the
board of directors.
3. Pre-Purchase Analysis
The majority of the commenters were in full support of eliminating
the specific constraints on investing in ``high risk'' MDPs. Some
commenters expressed opposition with respect to the 1998 Statement's
guidance concerning pre-purchase analysis by institutions of their
investment securities. Those commenters felt that neither pre-
acquisition stress testing nor any specific stress testing methodology
should be required for individual investment decisions. Some commenters
involved in the use of securities for collateral purposes emphasized
the benefits of pre-and post-purchase stress testing of individual
securities.
The agencies wish to stress that institutions should have policies
designed to meet the business needs of the institution. These policies
should specify the types of market risk analyses that should be
conducted for various types of instruments, including that conducted
prior to their acquisition and on an ongoing basis. In addition,
policies should specify any required documentation needed to verify the
analysis. Such analyses will vary with the type of investment
instrument.
As stated in Section V of the 1998 Statement, not all investment
instruments need to be subjected to a pre-purchase analysis. Relatively
simple or standardized instruments, the risks of which are well known
to the institution, would likely require no or significantly less
analysis than would more volatile, complex instruments. For relatively
more complex instruments, less familiar instruments, and potentially
volatile instruments, institutions should fully address pre-purchase
analysis in their policies. In valuing such investments, institutions
should ensure that the pricing methodologies used appropriately
consider all risks (for example, caps and floors in adjustable-rate
instruments). Moreover, the agencies do not believe that an institution
should be prohibited from making an investment based solely on whether
that instrument has a high price sensitivity.
4. Identification, Measurement, and Reporting of Risks
Some commenters questioned whether proposed changes by the agencies
concerning Schedule RC-B of the Consolidated Reports of Condition and
Income (``Call Reports'') conflicted with the 1998 Statement's
elimination of the high risk test for mortgage derivative products. The
proposed changes to the Call Reports would require the disclosure of
mortgage-backed and other securities whose price volatility in response
to specific interest rate changes exceeds a specified threshold level.
(See 62 FR 51715, October 2, 1997.)
The banking agencies have addressed the concerns presented in these
comments within the normal process for changing the Call Reports. For
the 1998 Call report cycle, there will be no changes to the high risk
test reporting requirement in the Call Reports.
5. Market Risk
One commenter suggested that the agencies enhance the 1998
Statement by discussing and endorsing the concept of total return. The
agencies agree that the concept of total return can be a useful way to
analyze the risk and return tradeoffs for an investment. This is
because the analysis does not focus exclusively on the stated yield to
maturity. Total return analysis, which includes income and price
changes over a specified investment horizon, is similar to stress test
analysis since both examine a security under various interest rate
scenarios. The agencies' supervisory emphasis on stress testing
securities has, in fact, implicitly considered total return. Therefore,
the agencies endorse the use of total return analysis as a useful
supplement to price sensitivity analysis for evaluating the returns for
an individual security, the investment portfolio, or the entire
institution.
6. Measurement System
One respondent stated that the complexity and sophistication of the
risk measurement system should not be a factor in determining whether
pre- and post-acquisition measurement of interest rate risk should be
performed at the individual investment level or on an institutional or
portfolio basis. The agencies agree that this statement may be
confusing and are amending the Market Risk section.
The text of the statement of policy follows.
Supervisory Policy Statement on Investment Securities and End-User
Derivatives Activities
I. Purpose
This policy statement (Statement) provides guidance to financial
institutions (institutions) on sound practices for managing the risks
of investment securities and end-user derivatives
activities.3 The FFIEC agencies--the Board of Governors of
the Federal Reserve System, the Federal Deposit Insurance Corporation,
the Office of the Comptroller of the Currency, the Office of Thrift
Supervision, and the National Credit Union Administration--believe that
effective management of the risks associated with securities and
derivative instruments represents an essential component of safe and
sound practices. This guidance describes the practices that a prudent
manager normally would follow and is not intended to be a checklist.
Management should establish practices and maintain documentation
appropriate to the institution's
[[Page 20194]]
individual circumstances, consistent with this Statement.
---------------------------------------------------------------------------
\3\ The 1998 Statement does not supersede any other requirements
of the respective agencies' statutory rules, regulations, policies,
or supervisory guidance.
---------------------------------------------------------------------------
II. Scope
This guidance applies to all securities in held-to-maturity and
available-for-sale accounts as defined in the Statement of Financial
Accounting Standards No.115 (FAS 115), certificates of deposit held for
investment purposes, and end-user derivative contracts not held in
trading accounts. This guidance covers all securities used for
investment purposes, including: money market instruments, fixed-rate
and floating-rate notes and bonds, structured notes, mortgage pass-
through and other asset-backed securities, and mortgage-derivative
products. Similarly, this guidance covers all end-user derivative
instruments used for nontrading purposes, such as swaps, futures, and
options.4 This Statement applies to all federally-insured
commercial banks, savings banks, savings associations, and federally
chartered credit unions.
---------------------------------------------------------------------------
\4\ Natural person federal credit unions are not permitted to
purchase non-residential mortgage asset-backed securities and may
participate in derivative programs only if authorized by the NCUA.
---------------------------------------------------------------------------
As a matter of sound practice, institutions should have programs to
manage the market, credit, liquidity, legal, operational and other
risks of investment securities and end-user derivatives activities
(investment activities). While risk management programs will differ
among institutions, there are certain elements that are fundamental to
all sound risk management programs. These elements include board and
senior management oversight and a comprehensive risk management process
that effectively identifies, measures, monitors, and controls risk.
This Statement describes sound principles and practices for managing
and controlling the risks associated with investment activities.
Institutions should fully understand and effectively manage the
risks inherent in their investment activities. Failure to understand
and adequately manage the risks in these areas constitutes an unsafe
and unsound practice.
III. Board and Senior Management Oversight
Board of director and senior management oversight is an integral
part of an effective risk management program. The board of directors is
responsible for approving major policies for conducting investment
activities, including the establishment of risk limits. The board
should ensure that management has the requisite skills to manage the
risks associated with such activities. To properly discharge its
oversight responsibilities, the board should review portfolio activity
and risk levels, and require management to demonstrate compliance with
approved risk limits. Boards should have an adequate understanding of
investment activities. Boards that do not, should obtain professional
advice to enhance its understanding of investment activity oversight,
so as to enable it to meet its responsibilities under this Statement.
Senior management is responsible for the daily management of an
institution's investments. Management should establish and enforce
policies and procedures for conducting investment activities. Senior
management should have an understanding of the nature and level of
various risks involved in the institution's investments and how such
risks fit within the institution's overall business strategies.
Management should ensure that the risk management process is
commensurate with the size, scope, and complexity of the institution's
holdings. Management should also ensure that the responsibilities for
managing investment activities are properly segregated to maintain
operational integrity. Institutions with significant investment
activities should ensure that back-office, settlement, and transaction
reconciliation responsibilities are conducted and managed by personnel
who are independent of those initiating risk taking positions.
IV. Risk Management Process
An effective risk management process for investment activities
includes: (1) policies, procedures, and limits; (2) the identification,
measurement, and reporting of risk exposures; and (3) a system of
internal controls.
Policies, Procedures, and Limits
Investment policies, procedures, and limits provide the structure
to effectively manage investment activities. Policies should be
consistent with the organization's broader business strategies, capital
adequacy, technical expertise, and risk tolerance. Policies should
identify relevant investment objectives, constraints, and guidelines
for the acquisition and ongoing management of securities and derivative
instruments. Potential investment objectives include: generating
earnings, providing liquidity, hedging risk exposures, taking risk
positions, modifying and managing risk profiles, managing tax
liabilities, and meeting pledging requirements, if applicable. Policies
should also identify the risk characteristics of permissible
investments and should delineate clear lines of responsibility and
authority for investment activities.
An institution's management should understand the risks and
cashflow characteristics of its investments. This is particularly
important for products that have unusual, leveraged, or highly variable
cashflows. An institution should not acquire a material position in an
instrument until senior management and all relevant personnel
understand and can manage the risks associated with the product.
An institution's investment activities should be fully integrated
into any institution-wide risk limits. In so doing, some institutions
rely only on the institution-wide limits, while others may apply limits
at the investment portfolio, sub-portfolio, or individual instrument
level.
The board and senior management should review, at least annually,
the appropriateness of its investment strategies, policies, procedures,
and limits.
Risk Identification, Measurement and Reporting
Institutions should ensure that they identify and measure the risks
associated with individual transactions prior to acquisition and
periodically after purchase. This can be done at the institutional,
portfolio, or individual instrument level. Prudent management of
investment activities entails examination of the risk profile of a
particular investment in light of its impact on the risk profile of the
institution. To the extent practicable, institutions should measure
exposures to each type of risk and these measurements should be
aggregated and integrated with similar exposures arising from other
business activities to obtain the institution's overall risk profile.
In measuring risks, institutions should conduct their own in-house
pre-acquisition analyses, or to the extent possible, make use of
specific third party analyses that are independent of the seller or
counterparty. Irrespective of any responsibility, legal or otherwise,
assumed by a dealer, counterparty, or financial advisor regarding a
transaction, the acquiring institution is ultimately responsible for
the appropriate personnel understanding and managing the risks of the
transaction.
Reports to the board of directors and senior management should
summarize the risks related to the institution's investment activities
and should address compliance with the investment policy's objectives,
constraints, and
[[Page 20195]]
legal requirements, including any exceptions to established policies,
procedures, and limits. Reports to management should generally reflect
more detail than reports to the board of the institution. Reporting
should be frequent enough to provide timely and adequate information to
judge the changing nature of the institution's risk profile and to
evaluate compliance with stated policy objectives and constraints.
Internal Controls
An institution's internal control structure is critical to the safe
and sound functioning of the organization generally and the management
of investment activities in particular. A system of internal controls
promotes efficient operations, reliable financial and regulatory
reporting, and compliance with relevant laws, regulations, and
institutional policies. An effective system of internal controls
includes enforcing official lines of authority, maintaining appropriate
separation of duties, and conducting independent reviews of investment
activities.
For institutions with significant investment activities, internal
and external audits are integral to the implementation of a risk
management process to control risks in investment activities. An
institution should conduct periodic independent reviews of its risk
management program to ensure its integrity, accuracy, and
reasonableness. Items that should be reviewed include:
(1) Compliance with and the appropriateness of investment policies,
procedures, and limits;
(2) The appropriateness of the institution's risk measurement
system given the nature, scope, and complexity of its activities;
(3) The timeliness, integrity, and usefulness of reports to the
board of directors and senior management.
The review should note exceptions to policies, procedures, and
limits and suggest corrective actions. The findings of such reviews
should be reported to the board and corrective actions taken on a
timely basis.
The accounting systems and procedures used for public and
regulatory reporting purposes are critically important to the
evaluation of an organization's risk profile and the assessment of its
financial condition and capital adequacy. Accordingly, an institution's
policies should provide clear guidelines regarding the reporting
treatment for all securities and derivatives holdings. This treatment
should be consistent with the organization's business objectives,
generally accepted accounting principles (GAAP), and regulatory
reporting standards.
V. The Risks of Investment Activities
The following discussion identifies particular sound practices for
managing the specific risks involved in investment activities. In
addition to these sound practices, institutions should follow any
specific guidance or requirements from their primary supervisor related
to these activities.
Market Risk
Market risk is the risk to an institution's financial condition
resulting from adverse changes in the value of its holdings arising
from movements in interest rates, foreign exchange rates, equity
prices, or commodity prices. An institution's exposure to market risk
can be measured by assessing the effect of changing rates and prices on
either the earnings or economic value of an individual instrument, a
portfolio, or the entire institution. For most institutions, the most
significant market risk of investment activities is interest rate risk.
Investment activities may represent a significant component of an
institution's overall interest rate risk profile. It is a sound
practice for institutions to manage interest rate risk on an
institution-wide basis. This sound practice includes monitoring the
price sensitivity of the institution's investment portfolio (changes in
the investment portfolio's value over different interest rate/yield
curve scenarios). Consistent with agency guidance, institutions should
specify institution-wide interest rate risk limits that appropriately
account for these activities and the strength of the institution's
capital position. These limits are generally established for economic
value or earnings exposures. Institutions may find it useful to
establish price sensitivity limits on their investment portfolio or on
individual securities. These sub-institution limits, if established,
should also be consistent with agency guidance.
It is a sound practice for an institution's management to fully
understand the market risks associated with investment securities and
derivative instruments prior to acquisition and on an ongoing basis.
Accordingly, institutions should have appropriate policies to ensure
such understanding. In particular, institutions should have policies
that specify the types of market risk analyses that should be conducted
for various types or classes of instruments, including that conducted
prior to their acquisition (pre-purchase analysis) and on an ongoing
basis. Policies should also specify any required documentation needed
to verify the analysis.
It is expected that the substance and form of such analyses will
vary with the type of instrument. Not all investment instruments may
need to be subjected to a pre-purchase analysis. Relatively simple or
standardized instruments, the risks of which are well known to the
institution, would likely require no or significantly less analysis
than would more volatile, complex instruments. 5
---------------------------------------------------------------------------
\5\ Federal credit unions must comply with the investment
monitoring requirements of 12 C.F.R. Sec. 703.90. See 62 FR 32989
(June 18, 1997).
---------------------------------------------------------------------------
Sec. 703.90. Sec 62 FR 32989 (June 18, 1997).
For relatively more complex instruments, less familiar instruments,
and potentially volatile instruments, institutions should fully address
pre-purchase analyses in their policies. Price sensitivity analysis is
an effective way to perform the pre-purchase analysis of individual
instruments. For example, a pre-purchase analysis should show the
impact of an immediate parallel shift in the yield curve of plus and
minus 100, 200, and 300 basis points. Where appropriate, such analysis
should encompass a wider range of scenarios, including non-parallel
changes in the yield curve. A comprehensive analysis may also take into
account other relevant factors, such as changes in interest rate
volatility and changes in credit spreads.
When the incremental effect of an investment position is likely to
have a significant effect on the risk profile of the institution, it is
a sound practice to analyze the effect of such a position on the
overall financial condition of the institution.
Accurately measuring an institution's market risk requires timely
information about the current carrying and market values of its
investments. Accordingly, institutions should have market risk
measurement systems commensurate with the size and nature of these
investments. Institutions with significant holdings of highly complex
instruments should ensure that they have the means to value their
positions. Institutions employing internal models should have adequate
procedures to validate the models and to periodically review all
elements of the modeling process, including its assumptions and risk
measurement techniques. Managements relying on third parties for market
risk measurement systems and analyses should ensure that they fully
understand the assumptions and techniques used.
[[Page 20196]]
Institutions should provide reports to their boards on the market
risk exposures of their investments on a regular basis. To do so, the
institution may report the market risk exposure of the whole
institution. Alternatively, reports should contain evaluations that
assess trends in aggregate market risk exposure and the performance of
portfolios in terms of established objectives and risk constraints.
They also should identify compliance with board approved limits and
identify any exceptions to established standards. Institutions should
have mechanisms to detect and adequately address exceptions to limits
and guidelines. Management reports on market risk should appropriately
address potential exposures to yield curve changes and other factors
pertinent to the institution's holdings.
Credit Risk
Broadly defined, credit risk is the risk that an issuer or
counterparty will fail to perform on an obligation to the institution.
For many financial institutions, credit risk in the investment
portfolio may be low relative to other areas, such as lending. However,
this risk, as with any other risk, should be effectively identified,
measured, monitored, and controlled.
An institution should not acquire investments or enter into
derivative contracts without assessing the creditworthiness of the
issuer or counterparty. The credit risk arising from these positions
should be incorporated into the overall credit risk profile of the
institution as comprehensively as practicable. Institutions are legally
required to meet certain quality standards (i.e., investment grade) for
security purchases. Many institutions maintain and update ratings
reports from one of the major rating services. For non-rated
securities, institutions should establish guidelines to ensure that the
securities meet legal requirements and that the institution fully
understands the risk involved. Institutions should establish limits on
individual counterparty exposures. Policies should also provide credit
risk and concentration limits. Such limits may define concentrations
relating to a single or related issuer or counterparty, a geographical
area, or obligations with similar characteristics.
In managing credit risk, institutions should consider settlement
and pre-settlement credit risk. These risks are the possibility that a
counterparty will fail to honor its obligation at or before the time of
settlement. The selection of dealers, investment bankers, and brokers
is particularly important in effectively managing these risks. The
approval process should include a review of each firm's financial
statements and an evaluation of its ability to honor its commitments.
An inquiry into the general reputation of the dealer is also
appropriate. This includes review of information from state or federal
securities regulators and industry self-regulatory organizations such
as the National Association of Securities Dealers concerning any formal
enforcement actions against the dealer, its affiliates, or associated
personnel.
The board of directors is responsible for supervision and oversight
of investment portfolio and end-user derivatives activities, including
the approval and periodic review of policies that govern relationships
with securities dealers.
Sound credit risk management requires that credit limits be
developed by personnel who are as independent as practicable of the
acquisition function. In authorizing issuer and counterparty credit
lines, these personnel should use standards that are consistent with
those used for other activities conducted within the institution and
with the organization's over-all policies and consolidated exposures.
Liquidity Risk
Liquidity risk is the risk that an institution cannot easily sell,
unwind, or offset a particular position at a fair price because of
inadequate market depth. In specifying permissible instruments for
accomplishing established objectives, institutions should ensure that
they take into account the liquidity of the market for those
instruments and the effect that such characteristics have on achieving
their objectives. The liquidity of certain types of instruments may
make them inappropriate for certain objectives. Institutions should
ensure that they consider the effects that market risk can have on the
liquidity of different types of instruments under various scenarios.
Accordingly, institutions should articulate clearly the liquidity
characteristics of instruments to be used in accomplishing
institutional objectives.
Complex and illiquid instruments can often involve greater risk
than actively traded, more liquid securities. Oftentimes, this higher
potential risk arising from illiquidity is not captured by standardized
financial modeling techniques. Such risk is particularly acute for
instruments that are highly leveraged or that are designed to benefit
from specific, narrowly defined market shifts. If market prices or
rates do not move as expected, the demand for such instruments can
evaporate, decreasing the market value of the instrument below the
modeled value.
Operational (Transaction) Risk
Operational (transaction) risk is the risk that deficiencies in
information systems or internal controls will result in unexpected
loss. Sources of operating risk include inadequate procedures, human
error, system failure, or fraud. Inaccurately assessing or controlling
operating risks is one of the more likely sources of problems facing
institutions involved in investment activities.
Effective internal controls are the first line of defense in
controlling the operating risks involved in an institution's investment
activities. Of particular importance are internal controls that ensure
the separation of duties and supervision of persons executing
transactions from those responsible for processing contracts,
confirming transactions, controlling various clearing accounts,
preparing or posting the accounting entries, approving the accounting
methodology or entries, and performing revaluations.
Consistent with the operational support of other activities within
the financial institution, securities operations should be as
independent as practicable from business units. Adequate resources
should be devoted, such that systems and capacity are commensurate with
the size and complexity of the institution's investment activities.
Effective risk management should also include, at least, the following:
Valuation. Procedures should ensure independent portfolio
pricing. For thinly traded or illiquid securities, completely
independent pricing may be difficult to obtain. In such cases,
operational units may need to use prices provided by the portfolio
manager. For unique instruments where the pricing is being provided by
a single source (e.g., the dealer providing the instrument), the
institution should review and understand the assumptions used to price
the instrument.
Personnel. The increasingly complex nature of securities
available in the marketplace makes it important that operational
personnel have strong technical skills. This will enable them to better
understand the complex financial structures of some investment
instruments.
Documentation. Institutions should clearly define
documentation requirements for securities transactions, saving and
safeguarding important documents, as well as maintaining
[[Page 20197]]
possession and control of instruments purchased.
An institution's policies should also provide guidelines for
conflicts of interest for employees who are directly involved in
purchasing and selling securities for the institution from securities
dealers. These guidelines should ensure that all directors, officers,
and employees act in the best interest of the institution. The board
may wish to adopt policies prohibiting these employees from engaging in
personal securities transactions with these same securities firms
without specific prior board approval. The board may also wish to adopt
a policy applicable to directors, officers, and employees restricting
or prohibiting the receipt of gifts, gratuities, or travel expenses
from approved securities dealer firms and their representatives.
Legal Risk
Legal risk is the risk that contracts are not legally enforceable
or documented correctly. Institutions should adequately evaluate the
enforceability of its agreements before individual transactions are
consummated. Institutions should also ensure that the counterparty has
authority to enter into the transaction and that the terms of the
agreement are legally enforceable. Institutions should further
ascertain that netting agreements are adequately documented, executed
properly, and are enforceable in all relevant jurisdictions.
Institutions should have knowledge of relevant tax laws and
interpretations governing the use of these instruments.
Dated: April 17, 1998.
Keith J. Todd,
Assistant Executive Secretary, Federal Financial Institutions
Examination Council.
[FR Doc. 98-10744 Filed 4-22-98; 8:45 am]
BILLING CODES FRB: 6210-01-P 20%, OTS: 6720-01-P 20%, FDIC: 6714-01-P
20%, OCC: 4810-33-P 20%, NCUA: 7535-01-P 20%
