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Financial Institution Letters

[Federal Register: April 23, 1998 (Volume 63, Number 78)]


[Page 20191-20197]

From the Federal Register Online via GPO Access []








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rescinded the Supervisory Policy Statement on Securities Activities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.



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



[[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.<SUP>1</SUP> 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




\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


\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


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


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



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.<SUP>3</SUP> 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.<SUP>4</SUP> 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


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


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


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. <SUP>5</SUP>



\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


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:

<bullet> 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.

<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


<bullet> Documentation. Institutions should clearly define

documentation requirements for securities transactions, saving and

safeguarding important documents, as well as maintaining


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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%

Last Updated 07/16/1999

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