FDIC Federal Register Citations

[Federal Register: October 3, 1997 (Volume 62, Number 192)]

[Notices]

[Page 51862-51867]

From the Federal Register Online via GPO Access [wais.access.gpo.gov]

[DOCID:fr03oc97-81]

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FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL

Supervisory Policy Statement on Investment Securities and End-

User Derivatives Activities

AGENCY: Federal Financial Institutions Examination Council.

ACTION: Notice and request for comment.

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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), request

comment on a Supervisory Policy Statement on Investment Securities and

End-User Derivatives Activities (1997 Statement) to provide guidance on

sound practices for managing the risks of investment activities. The

agencies also are seeking comment on their intent to rescind the

Supervisory Policy Statement on Securities Activities published on

February 3, 1992 (1992 Statement). Many elements of that prior

statement are retained in the 1997 Statement, while other elements have

been revised or eliminated. Changes in generally accepted accounting

principles, various developments in both securities and derivatives

markets, and revisions to the regulators' approach to risk management

have contributed to the need to reassess the 1992 Statement. In

particular, the agencies are proposing to eliminate the specific

constraints on investing in ``high risk'' mortgage derivative products

that were stated in the 1992 Statement. The agencies believe that it is

a sound practice for institutions to understand the risks related to

their investment holdings. Accordingly, the 1997 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 1997 Statement does not supersede any other

requirements of the respective agencies' statutory rules, regulations,

policies, or supervisory guidance.

DATES: Comments must be received by November 17, 1997.

ADDRESSES: Comments should be sent to Joe M. Cleaver, Executive

Secretary, Federal Financial Institutions Examination Council, 2100

Pennsylvania Avenue, NW, Suite 200, Washington, D.C. 20037 or by

facsimile transmission to (202) 634-6556.

FOR FURTHER INFORMATION CONTACT: FRB: James Embersit, Manager,

Financial Analysis, (202) 452-5249, Division of Banking Supervision and

Regulation; Gregory Baer, Managing Senior Counsel, (202) 452-3236,

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, 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; Christine

Harrington, Counsel (Banking and Finance), (202) 906-7957, Regulations

and Legislation Division, Chief Counsel's Office, Office

[[Page 51863]]

of Thrift Supervision, 1700 G Street, NW, Washington, DC 20552.

NCUA: Daniel Gordon, Senior Investment Officer, (703) 518-6360,

Office of Investment Services; Lisa Henderson, 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. 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.

Therefore, most MDPs were not subject to legal investment limits. 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 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

a high risk MDP 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

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\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.

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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 applied to individual securities may have also

inhibited some institutions from applying 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 are

useful for the supervision of well-managed institutions. 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. Consequently, the

agencies are proposing to rescind the 1992 Policy Statement and

eliminate the high risk tests as binding constraints on MDP purchases.

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.

To advance such an initiative, the agencies are seeking industry

comment on the practices identified in the proposed policy statement.

The proposal to rescind 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 proposed policy

statement indicates 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.

The proposed text of the 1997 Statement 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. 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

individual circumstances, consistent with this Statement.

[[Page 51864]]

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.³ This Statement applies to all federally-insured

commercial banks, savings banks, savings associations, and federally

chartered credit unions.

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\3\ Federal credit unions are not permitted to purchase asset-

backed securities and may participate in derivative programs only if

authorized by the NCUA.

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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 on both a

long-range (strategic) and day-to-day (operational) basis. 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 policies should ensure an understanding of 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. Depending upon the complexity and

sophistication of the risk measurement systems, 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 into which it enters.

Reports to the board of directors and senior management should

summarize the risks related to the institution's

[[Page 51865]]

investment activities and should address compliance with the investment

policy's objectives, constraints, and 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.⁴

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\4\ Federal credit unions must comply with the investment

monitoring requirements of 12 CFR Sec. 703.90. See 62 FR 32989 (June

18, 1997).

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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

[[Page 51866]]

fully understand the assumptions and techniques used.

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. Otherwise, these 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. An

institution's policies should identify criteria for selecting these

organizations and should list all approved firms. 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, or a committee thereof, should set limits

on the amounts and types of transactions authorized for each securities

firm with whom the institution deals. At least annually, the board of

directors should review and reconfirm the list of authorized dealers,

investment bankers, and brokers.

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:

<bullet> Valuation. Procedures should ensure independent portfolio

pricing. For thinly traded or illiquid securities, completely

independent pricing may be difficult. In such cases, operational units

may need to use portfolio manager prices. 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.

<bullet> 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.

[[Page 51867]]

<bullet> Documentation. Institutions should clearly define

documentation requirements for securities transactions, saving and

safeguarding important documents, as well as maintaining 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: September 29, 1997.

Joe M. Cleaver,

Executive Secretary, Federal Financial Institutions Examination

Council.

[FR Doc. 97-26207 Filed 10-2-97; 8:45 am]

BILLING CODE 6210-01-P, 6720-01-P, 6714-01-P, 4810-01-P, 7535-01-P