ALERT REGARDING BANK INVESTMENT SECURITIES AND CUSTODIAL ACCOUNTS HELD AT SECURITIES BROKER-DEALERS
April 25, 2002
CHIEF EXECUTIVE OFFICER
Credit Risks Arising From Bank Investment Securities and Custodial Accounts Held at Securities Broker-Dealers
The Federal Deposit Insurance Corporation (FDIC) is alerting you to concerns it has identified regarding bank custodial relationships with failed broker-dealers. These concerns have arisen following the failure of a large regional securities broker-dealer and its liquidation by the Securities Investor Protection Corporation (SIPC). For this liquidation (which was the largest in SIPC history), the bankruptcy trustee has informed banks with securities held in safekeeping that they will incur a loss. This alert provides banks basic information regarding SIPC coverage and reminds banks of the credit risks associated with custodial relationships. Bank management is advised to review existing custodial relationships, evaluate the creditworthiness and reputation of custodians, and ensure that the bank maintains properly diversified custodial relationships.
The Securities Investor Protection Act of 1970 (SIPA) created SIPC to provide certain protections to customers against losses from the failure of a securities broker-dealer. Under SIPA, only customers of a SIPC-member firm qualify for SIPC protection and only "customer property" as defined in SIPA and determined to be in the member firm's custody are covered. Although SIPC coverage allows a bank, for its own account, to share in "customer property," banks cannot receive advances from SIPC. In the event that a bank demonstrates that it is acting as an agent for an investor, that investor is entitled to separate status as a "customer" and is eligible to receive advances from SIPC.
In general, during a liquidation proceeding, the trustee for the failed broker-dealer will (1) return to customers property that is registered in a specific customer's name, (2) pay those customers their pro rata share of "customer property," and (3) provide customers (other than banks and broker-dealers for their own accounts) SIPC advances up to the $500,000 limit. Customers not subject to SIPC protection, such as banks, will receive a pro rata distribution of "customer property." Banks should be aware of SIPC's coverage and claims procedures and be able to differentiate between bank-owned and bank customer-owned accounts and securities held at failed broker-dealers.
These events serve as an opportunity to remind banks of their obligation under existing supervisory policy to exercise due diligence when selecting broker-dealers and establishing a custodial relationship. Banks should establish and periodically review broker-dealer selection criteria that would include a review of the broker-dealer's financial statements and an assessment of the firm's ability to honor its commitments. An inquiry into the broker-dealer's reputation should be conducted. Such information can be obtained from state and federal securities regulators and industry self-regulatory organizations such as the National Association of Securities Dealers (NASD). The custodian's reputation and creditworthiness should be periodically reviewed. Banks should review their existing custodial relationships and underlying documentation and practices so that bank management can fully understand the nature and extent of potential credit risks that can arise from existing custodial relationships. Where needed, banks should consult with their attorneys and independently review their agreements and business practices with broker-dealers.
These events also instruct that even sound due diligence practices may not adequately minimize banks' exposure. In order to avoid unforeseen credit exposure in similar circumstances, banks should ensure that their custodial relationships are properly diversified. Maintaining relationships with different custodians can minimize the bank's exposure in this area.
Michael J. Zamorski
Distribution: FDIC-Supervised Banks (Commercial and Savings)
NOTE: Paper copies of FDIC financial institution letters may be obtained through the FDIC's Public Information Center, 801 17th Street, NW, Room 100, Washington, DC 20434 (800-276-6003 or (703) 562-2200).