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Financial Institution Letters

Division of Supervision and Consumer Protection

MEMORANDUM SYSTEM

Classification Number: 6300
Date: 5/18/04
Issuing Office: DSC/Capital Markets
Contact: Keith Ligon (202) 898-3618
Notice Memorandum

TO: Regional Directors
FROM: Michael J. Zamorski
Director
SUBJECT: Structured Note Holdings Reported at FDIC-Supervised Banking Institutions

1. Purpose
The purpose of this memorandum is to discuss the implications of current bank investment patterns, specifically the level of bank holdings of certain types of structured notes. A review of Call Report data and discussions with examiners and bank investment officers indicates recent, significant increases in the level of structured note holdings reported by insured depository institutions supervised by the FDIC. These aggregate levels appear to be comprised primarily of agency-issued single step-up bonds. While the level of structured note holdings may trigger concern during the off-site monitoring of institutions, the nature of the risks associated with agency-issued step-up bonds does not, standing alone, indicate that a bank has a heightened or unusual risk profile.

2. Background
Structured notes are hybrid securities that combine straight fixed- or variable-rate instruments and derivative products that are issued by corporations and government-sponsored enterprises (GSEs). (See, Division of Supervision and Consumer Protection Capital Markets Handbook, Section III.3.)

Structured notes have been captured as a separate line item in the Call Reports (RC-B, memoranda item 4) since 1995. This memoranda item was added to highlight the potential risks associated with and to track the level of bank exposure to debt instruments that present complex cash flow characteristics due primarily to the presence of features such as caps, floors, leverage, or variable principal redemption. As presently defined, the Call Report memoranda item captures all structured notes included in the held-to-maturity and available-for-sale accounts and describes structured notes as debt securities whose cash flow characteristics (coupon rate, redemption amount, or stated maturity) depend upon one or more indices and/or have embedded forwards or options. Structured notes are considered to include securities that are floating rate (single index constant maturity treasury or cost of funds index), step-ups, index-amortizing notes, dual index notes, de-leveraged bonds, range bonds, and inverse floaters. Agency-issued step-up bonds are currently included in this definition.

The Call Report memoranda item combines the reported levels of all such debt securities into a single aggregate number.

3. Examiner Guidance
Given the potential risks associated with certain structured notes, off-site monitoring efforts understandably often consider the level of bank structured note holdings. However, this single indicator does not, in and of itself, create a requirement for additional examiner scrutiny, but may, when combined with other aspects of the bank's interest rate risk exposure, justify increasing the scope of work in this area.

Current information indicates that a significant portion of the "structured notes" being acquired by banks are relatively low risk agency-issued, single or multiple step-up bonds which do not, when managed and controlled in compliance with supervisory policy, present significantly more risk than a simple callable fixed rate bond.

Examiners should be aware that the single Call Report memoranda item regarding structured notes captures all forms of structured notes, with differing cash flows and associated risk profiles. Accordingly, examiners should review the bank's investment activities and risk management processes in light of the particular bank's risk profile given its investment activities as a whole, not strictly upon only an off-site indication of growth in the aggregate indicator labeled "structured notes". As a general rule the FDIC does not discourage banks' investment in agency-issued bonds assuming that bank management understands the risks associated with such assets and the investments are consistent with the bank's investment policies and procedures.

4. Investment Activities Policy Statement
The 1998 Supervisory Policy Statement on Investment Securities and End-User Derivatives Activities (Policy Statement) applies to bank purchases and holdings of all forms of structured notes. Regardless of the risk profile of the instrument purchased, bank management is required to conduct pre-acquisition and periodic analysis of the price sensitivity of all structured notes in a manner consistent with the Policy Statement.

The Policy Statement provides guidance and sound principles to bankers for managing investment securities and derivatives risks. It makes clear the primacy of board oversight and management supervision, and focuses on risk management. The Policy Statement covers all securities, including structured notes, used for investment purposes. It applies to all federally insured commercial banks, savings banks, and savings associations. Notably, the Policy Statement:

  • Underscores the importance of board oversight and management supervision - and provides that bank management and boards should have an adequate understanding of nature and level of risk arising from its investment activities.
  • Highlights the need for an effective risk management process that includes policies and procedures identifying the bank's investment objectives, the risk characteristics of permissible investments, and that establishes clear lines of responsibility, sets risk limits at the bank, portfolio, sub-portfolio or instrument level, and is reviewed at least annually.
  • Provides that banks must identify and measure risks prior to acquisition and periodically after purchase and that bank should conduct its 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.
  • Requires periodic independent review of the risk management program, with effective reporting and adequate internal controls, including internal and external audits as appropriate.
In general, the Policy Statement declares that banks should implement programs to manage the market, credit, liquidity, legal, operational, and other risks that result from investment activities and should maintain adequate risk management programs to identify, measure, monitor, and control these risks. The failure to understand and adequately manage investment activity risks is an unsafe and unsound practice.

Examiners should obtain adequate information to assess bank's compliance with the Policy Statement, based upon a complete understanding of the nature and complexity of the bank's structured note holdings.

5. Responsibility and Action
Distribute this memorandum to all safety and soundness examiners.

6. Effective Date:
This memorandum is effective immediately.

Transmittal No.: 2004-022



Last Updated 05/27/2004 communications@fdic.gov