DRAFT DRAFT Examination Guidelines as of June 10, 1993 INTERBANK LIABILITY Introduction The sources of the exposure of a bank to its correspondents tend to arise from two types of activity. First, banks may become exposed to their correspondents when obtaining banking services, such as check collection services, from their correspondents. Second, exposure may arise when banks engage in transactions with correspondents in the financial markets. Each type of exposure presents its own risks and characteristics. Correspondent banking services are the primary source of interbank exposure for the majority of banks, particularly small- and medium-sized banks. In connection with check collection services and other trade- or payment-related correspondent services, banks often maintain balances with their correspondents in order to settle transactions and to compensate the correspondents for the services provided. These balances give rise to exposure to the correspondents. Although correspondent services are in some cases provided on a fee basis, many correspondents may prefer compensating balance arrangements, as these balances provide the correspondents with a stable source of funding. Similarly, banks may prefer to pay for services with "soft charges" in the form of balances instead of "hard charges" in the form of fees. Exposure to a correspondent may be significant, particularly where a bank uses one correspondent for all of the bank's check collections and other payment services, sells excess reserve account balances ("fed funds") to the correspondent, and engages in [Page Break] DRAFT [Please note that there is no Page number 2.] Page 3 other banking transactions with the correspondent. [Footnote 1 - Although a bank's primary correspondent often will buy fed funds as principal directly from the bank, a correspondent may act as agent to place the funds with another institution. In such agency arrangements, a bank may provide its correspondent with a pre-approved list of institutions with which the correspondent may place the funds. Where a correspondent is acting as the bank's agent in placing fed funds, the bank's exposure would be to the ultimate purchaser of the funds, not to the correspondent placing the funds on its behalf. Fed funds sales generally are unsecured. A bank also may provide funds to a correspondent through transactions known as "reverse repurchase agreements," in which the bank provides funds to the correspondent by buying an asset, generally a government security. The correspondent agrees that it will repurchase the asset from the bank at the expiration of a set period, generally overnight, at a repurchase price calculated to compensate the bank for the use of its funds. Unlike fed funds sales, these transactions are essentially secured transactions. End of Footnote 1.] This exposure may increase when interest rates fall, as higher levels of compensating balances may be required to provide adequate compensation to the correspondent. Money center banks and large regional banks may have significant exposure to correspondents [Footnote 2 - Although the depository institutions that are parties to transactions in the interbank markets discussed above generally are referred to as "counterparties," the term "correspondent" generally will be used in this discussion to denote any depository institution to which an insured depository institution is exposed. End of Footnote 2.] through their activities in interbank markets, such as the securities, swap, and foreign exchange markets. Interbank transactions such as swaps, foreign exchange contracts, and over-the-counter options that call for performance in the future give rise to exposure to the depository institutions that act as counterparties in such transactions. In addition to credit risk, this exposure may include settlement risk, that is, the risk that a counterparty will fail to make a payment or delivery in a timely manner. Settlement risk may arise from transactions in the government securities, foreign [Page Break] DRAFT Page 4 exchange, or other markets, and may result from operational, liquidity, or credit problems. [National banks are subject to lending limits that prohibit national banks from lending amounts equal to more than 15 percent of the national bank's unimpaired capital and surplus to a single borrower on an unsecured basis, and an additional 10 percent on a secured basis. The national bank lending limits apply only to "loans and extensions of credit," and do not include most off-balance sheet transactions that may provide significant sources of exposure to correspondents. Additionally, the national bank lending limits do not apply to overnight Fed funds sales.] [State-chartered banks generally are subject to lending limits under state law. Almost all states impose lending limits on the banks they charter. Most of these limits are patterned on the national bank lending limits, although the specific percentages or transactions covered vary. [Footnote 3 - National banks are subject to lending limits that prohibit national banks from lending amounts equal to more than 15 percent of the national bank's unimpaired capital and surplus to a single borrower on an unsecured basis, and an additional 10 percent on a secured basis. The national bank lending limits apply only to "loans and extensions of credit," and do not include most of the off-balance sheet transactions that may provide significant sources of exposure to correspondents. Additionally, the national bank lending limits do not apply to overnight Fed funds sales, a significant source of short-term exposure to correspondents. State limits generally do not apply to a broader range of transactions than the national bank limits, although some states include Fed funds transactions within their limits. End of Footnote 3.] A number of states, however, exclude interbank transactions from their lending limits entirely.] [Federal savings associations generally are subject to the same limitations on loans to one borrower as national banks, with exceptions for loans under $500,000 and loans [Page Break] DRAFT Page 5 for residential real estate development. [Footnote 4 - National banks are subject to lending limits that prohibit national banks from lending amounts equal to more than 15 percent of the national bank's unimpaired capital and surplus to a single borrower on an unsecured basis, and an additional 10 percent on a secured basis. The national bank lending limits apply only to "loans and extensions of credit," and do not include most of the off-balance sheet transactions that may provide significant sources of exposure to correspondents. Additionally, the national bank lending limits do not apply to overnight Fed funds sales, a significant source of short-term exposure to correspondents. State limits generally do not apply to a broader range of transactions than the national bank limits, although some states include Fed funds transactions within their limits. End of Footnote 4.] 12 U.S.C. 1464(u). In some states, state- chartered savings associations are subject to the same limitations as state-chartered banks, but a significant number of states have no lending limits that apply to savings associations or place no limits on deposits by a savings association with an insured depository institution.] Regulation F Regulation F, Interbank Liabilities, implements section 308 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), which requires the Board of Governors of the Federal Reserve (Board) to prescribe standards to limit the risks posed by exposure of insured depository institutions to other depository institutions. The purpose of Regulation F is to limit the risks that the failure of a depository institution would pose to insured depository institutions. All depository institutions insured by the FDIC are subject to the Federal Reserve Board's Regulation F, Limits on Interbank Liabilities. [Page Break] DRAFT Page 6 Regulation F (See Appendix I), Interbank Liabilities, consists of two primary parts: 1. Prudential Standards (Section 206.3), and 2. Credit Exposure (Section 206.4). The "Prudential Standards" section requires depository institutions to develop and adopt internal policies and procedures to evaluate and control exposure to the depository institutions with which they do business, referred to as "correspondents." [Footnote 5 - Banks must have in place the internal policies and procedures required by the rule on June 19, 1993. End of Footnote 5.] The "Credit Exposure" section requires a bank's internal policies and procedures to limit "credit exposure" to a correspondent to 25 percent or less of the exposed bank's capital, unless the bank can demonstrate that the correspondent is at least "adequately capitalized," as defined in the rule. [Footnote 6 - The regulatory limit on credit exposure to correspondents that a bank cannot demonstrate are at least "adequately capitalized" will be phased in, with the limit set at 50 percent of the exposed bank's capital for a one-year period beginning on June 19, 1994, and reduced to 25 percent as of June 19, 1995. End of Footnote 6.] No limit is specified for "credit exposure" to correspondents that are at least "adequately capitalized," but prudential standards are required for all correspondents, regardless of capital level. Under this rule, "correspondent" includes both domestically chartered depository institutions that are FDIC insured and foreign banks. Prudential Standards. [Page Break] DRAFT Page 7 The rule requires depository institutions to adopt internal policies and procedures to address the risk arising from exposure to a correspondent, taking into account the financial condition of the correspondent and the size, form, and maturity of the exposure. Depository institutions are permitted to adopt flexible policies and procedures to meet this requirement in order to permit resources to be allocated in a manner that will result in real reductions in risk, while minimizing the burden of compliance with the rule. The rule requires written policies and procedures addressing exposure to correspondents. These policies and procedures must be reviewed annually by the bank's board of directors, but individual correspondent relationships need not be approved by the board. Examiners should determine that the policies and procedures adopted by the board provide for consideration of credit and liquidity risks in establishing and maintaining relationships with correspondents. [Footnote 7 - Both the term "liquidity risk" and "operational risk" are used in the definition of exposure. Liquidity risk is the risk that payment will be delayed for some period of time. For example, a bank is subject to the liquidity risk that a payment due from a failed correspondent will not be made on time; the bank's credit risk may be a lesser amount due to later distributions from the correspondent's receiver. Liquidity risk is included in the definition of exposure. Operational risk is the risk that operational problems, such as computer failure, at a correspondent on whom you rely for extensive data processing support may prevent it from making payments, thereby creating liquidity risks for other banks, and is also included in the definition of exposure. End of Footnote 7.] Additionally, if the bank has significant operating risk-such as relying on a correspondent for extensive data processing-that exposure could also lead to liquidity problems. This may not be an issue for many institutions who are not operationally dependent on any particular correspondent. Also, many institutions may address this exposure elsewhere in their operational procedures. [Page Break] DRAFT Page 8 A bank's policies and procedures should provide for periodic review of the financial condition of any correspondent to which the bank has significant exposure in relation to the size and maturity of the exposure and the condition of the correspondent. [Footnote 8 - Because exposure to a Federal Reserve Bank or Federal Home Loan Bank poses minimal risk to a respondent, Federal Reserve Banks and Federal Home Loan Banks are not included in the definition of correspondent. End of Footnote 8.] Examiners should determine that a depository institution has periodically reviewed the financial condition of any correspondent to which the depository institution has significant exposure. The frequency of these reviews will depend upon the size and maturity of the exposure and the condition of the correspondent. For example, the policies of many banks provide for an extensive review of a correspondent's financial condition on an annual basis, such policies may also provide for less extensive interim reviews under some circumstances such as where exposure to a correspondent is very high or where a correspondent has experienced financial difficulty. A depository institution need not require periodic review of the financial condition of all correspondents. For example, periodic reviews would not be necessary for a correspondent to which the depository institution has only insignificant levels of exposure, such as small balances maintained for clearing purposes. [Footnote 9 - Other forms of exposure that also generally would not be considered significant include: (1) a collecting bank's risk that a check will be returned, (2) an originating bank's risk that an ACH debit transfer will be returned or its settlement reversed, (3) a receiving bank's risk that settlement for an ACH credit transfer will be reversed, or (4) a credit card transaction. In these types of transactions, the amounts involved are generally small and the exposed bank usually has prompt recourse to other parties. End of Footnote 9.] Significant [Page Break] DRAFT Page 9 levels of exposure should reflect those amounts that a prudent depository institution believes deserve analysis for risk of loss. A depository institution may base its review of the financial condition of a correspondent on publicly available information, such as call reports, Thrift Financial Reports, Uniform Bank Performance Reports, annual reports, or on financial information obtained from a rating service. A depository institution generally is not required to obtain non-public information on which to base its analysis of the financial condition of a correspondent. [Footnote 10 - A bank is required to obtain non-public information to evaluate a correspondent's condition only for those foreign banks for which no public financial statements are available. In these limited circumstances, the bank would need to obtain financial information directly from the correspondent. End of Footnote 10.] For correspondents to which a depository institution has a significant relationship, a depository institution may have considerable non-public information, such as information on the quality of management, general portfolio composition, and similar information, but such information is not always available and is not required. Regardless of whether public or nonpublic sources of information are used, a depository institution may rely on another party, such as its bank holding company, a bank rating agency, or another correspondent, to provide financial analysis of a correspondent. Examiners should ascertain that the depository institution has reviewed the assessment criteria used by the source of the financial analysis. Additionally, where a depository institution relies on its bank holding company to select and monitor correspondents, or on a correspondent, such as a bankers' bank, to choose other [Page Break] DRAFT Page 10 correspondents with which to place the depository institution's federal funds or other deposits, examiners should ensure that the depository institution has reviewed and approved the selection criteria used. For a depository institution with exposure to a correspondent that has experienced a deterioration in its financial condition, examiners should ascertain that the depository institution has taken into account such deterioration in its correspondent's condition in evaluating the creditworthiness of the correspondent and the appropriate level of exposure to the correspondent. Factors that have a bearing on the financial condition of the correspondent include the capital level of the correspondent, level of nonaccrual and past due loans and leases, level of earnings, and other factors affecting the financial condition of the correspondent. Where the financial condition of the correspondent and the form or maturity of the exposure create a significant risk that payments will not be made as contemplated, examiners should ensure that the depository institution has established appropriate limits on the exposure. Examiners should determine that the limits are consistent with the risk undertaken given the maturity of the exposure and the condition of the correspondent. The rule does not require a particular structure or method of maintaining internal limits. Inflexible dollar limits are not necessary in all cases. Limits can be flexible, based on factors such as the level of monitoring of the exposure and the condition of the correspondent. For example, a bank may choose not to establish a specific limit on exposure to a correspondent where the bank is able to ascertain account balances with the correspondent on a daily basis, as such balances could be reduced [Page Break] DRAFT Page 11 rapidly if necessary. In appropriate circumstances a bank may establish limits for longer term exposure to a correspondent, while not setting limits for interday (overnight) or intraday (within the day) exposure. Generally, depository institutions do not need to set one overall limit on exposure to a correspondent. Many institutions prefer to set separate limits for different forms of exposure, products, or maturities. Although the total of all such facilities may be very high in relation to a depository institution's capital, evaluation of such facilities should take into account overall utilization levels and procedures for further limiting or monitoring overall exposure. Where internal limits for significant exposure have been established, examiners should ensure that a depository institution either has procedures to monitor its exposure to remain within established limits or structures transactions with the correspondent to ensure that the exposure ordinarily remains within the internal limits established by the bank. While some depository institutions may monitor actual overall exposure, others may establish individual lines for significant sources of exposure, such as federal funds sales. For such institutions, the examiner should ensure that the depository institution has established procedures to ensure that exposure generally remained within the established lines. In some instances, a depository institution may accomplish this by establishing limits on exposure that are monitored by a correspondent, such as for sales of federal funds through the correspondent as agent. Where monitoring is used, Regulation F indicates that the appropriate level of monitoring will depend on the type and volatility of the exposure, on the extent to which the exposure approaches the bank's internal limits, and on the condition of the [Page Break] DRAFT Page 12 correspondent. Generally monitoring may be done on a retrospective basis. Examples of such monitoring include checking close-of-business balances at a correspondent for the prior day or obtaining daily balance records from a correspondent at the end of each month. Thus, banks are not expected to monitor exposure to correspondents on a real- time basis. Although the purpose of requiring monitoring or structuring of transactions to which limits apply is to ensure that exposure generally remains within established limits, the rule recognizes that occasional excesses over limits may result from factors such as unusual market disturbances, unusual favorable market moves, or other unusual increases in activity or operational problems. Unusual late incoming wires or unusually large cash letters would be considered examples of the types of activities that could lead to excesses over internal limits that would not be considered impermissible under the rule. Examiners should verify that banks have established appropriate procedures to address excesses over internal limits. A bank's internal policies and procedures must address intraday exposure. As with other exposure of longer maturities (i.e., interday or longer), however, the rule does not necessarily require that limits be established on intraday exposure. Examiners should expect to see such limits or frequent monitoring of balances only if the size of the intraday exposure and the condition of the correspondent indicated that there is a significant risk that payments will not be made as contemplated. Examiners should keep in mind that intraday exposure may be difficult for a bank to actively monitor and limit. Consequently, like interday exposure, intraday exposure may be monitored [Page Break] DRAFT Page 13 retrospectively. In addition, smaller banks may limit their focus on intraday exposure to being aware of the range of peak intraday exposure to particular institutions and the effect that exposure may have on the bank. For example, a bank may receive reports on intraday balances from a correspondent on a monthly basis and would only need to take actions to limit or more actively monitor such exposure if the bank becomes concerned about the size of the intraday exposure relative to the condition of the correspondent. Credit Exposure. A bank's internal policies and procedures should limit overnight "credit exposure" to a correspondent to 25 percent of the exposed bank's capital, unless the bank can demonstrate that its correspondent is at least "adequately capitalized," as defined by the rule. [Footnote 11 - Total capital is the total of a bank's Tier 1 and Tier 2 capital under the risk-based capital guidelines provided by the bank's primary federal supervisor. For an insured branch of a foreign bank organized under the laws of a country that subscribes to the principles of the Basle Capital Accord, "total capital" means total Tier 1 and Tier 2 capital as calculated under the standards of that country. For an insured branch of a foreign bank organized under the laws of a country that does not subscribe to the principles of the Basle Capital Accord, "total capital" means total Tier 1 and Tier 2 capital as calculated under the provisions of the Accord. The limit on credit exposure of the insured branch of a foreign bank is based on the foreign bank's total capital, as defined in this section, not on the imputed capital of the branch. For Regulation F, an "adequately capitalized" correspondent is defined as one with a total risk-based capital ratio of 8.0 percent or greater, a Tier 1 risk-based capital ratio of 4.0 percent or greater, and a leverage ratio of 4.0 percent or greater. End of Footnote 11.] The "credit exposure" that is limited is based on the assets and off-balance sheet transactions involving exposure to a correspondent against which the bank must maintain capital under the risk-based capital guidelines, with some exclusions of lower- [Page Break] DRAFT Page 14 risk transactions permitted. [Footnote 12 - A bank is required to include with the bank's own credit exposure 100 percent of the credit exposure of any subsidiary that the bank is required to consolidate on its Report of Condition and Income or Thrift Financial Report. This provision generally captures the credit exposure of any majority-owned subsidiary of the bank. Therefore, none of a minority-owned subsidiary's exposure and all of a majority-owned subsidiary's exposure would be included in the parent bank's exposure calculation. End of Footnote 12.] "Credit exposure" therefore includes items such as deposit balances with a correspondent, federal funds sales, and credit equivalent amounts of interest rate and foreign exchange rate contracts and other off balance sheet transactions. "Credit exposure" does not include settlement exposure, transactions in which the bank acts as agent, and other forms of exposure that are not covered by the capital adequacy guidelines or that do not involve exposure to a correspondent. [Footnote 13 - For example, where assets of a bank, such as securities, are held in safe-keeping by a correspondent, there is no exposure to the correspondent, even though the securities themselves may be subject to a capital charge. End of Footnote 13.] Regulation F does not specify limits for "credit exposure" to adequately or well-capitalized correspondents. Existing exposure above the 25 percent limit for "credit exposure" to a less than adequately capitalized correspondent is not "grandfathered" under the rule if the correspondent slips below adequately capitalized. The existence of this limit should encourage banks to shorten the maturity of exposure to correspondents that are at risk of dropping below the capital levels required to be adequately capitalized. This emphasizes the importance of banks having adequate procedures for analyzing the creditworthiness of correspondents. This limit on "credit exposure" should be implemented as part of the bank's policies and procedures required under the "Prudential Standards" section. Quarterly [Page Break] DRAFT Page 15 monitoring of capital is only required for correspondents to which a bank's potential "credit exposure" is more than 25 percent of its own capital. [Footnote 14 - Because information on risk-based capital ratios is generally based on the call report, a bank would be justified in relying on the most recently available reports based on call report data. While there may be a significant lag in such data, where the information in such reports is followed by the bank on a continuing basis, the reports remain a useful monitor of trends in the condition of the correspondent. End of Footnote 14.] If the internal systems of a bank ordinarily limit "credit exposure" to a correspondent to less than 25 percent of the exposed bank's capital, no monitoring of the correspondent's capital would be necessary, although periodic reviews of the correspondent's financial condition may be required under the prudential standards section if exposure to the correspondent is significant. Every effort should be made to allow banks to use existing risk monitoring and control systems and practices where they effectively maintain "credit exposure" within the prescribed limits. For smaller institutions, it is relatively easy to determine how their measure of exposure compares to the definition of "credit exposure" in Regulation F due to their relatively simple types of exposure. Examiners, however, should keep in mind that the intent of this regulation is to place greater emphasis on appropriate levels of exposure based on analysis of the creditworthiness of correspondents as opposed to merely concentrating on staying within regulatory established limits. Accordingly, for those correspondents the bank has not demonstrated are at least "adequately capitalized," this limit should be viewed as a maximum level for "credit exposure" rather than as a safe harbor level of "credit exposure." Examiners should ensure that capital of domestic correspondents is monitored quarterly to pick up information based on the correspondent's most recent [Page Break] DRAFT Page 16 call report, financial statement, or bank rating report. Currently, it is difficult to obtain information on the risk-based capital levels of a correspondent. Under Regulation F, this task is somewhat simplified, as a bank will be required to demonstrate only that its correspondent's capital ratios qualify it as at least adequately capitalized. While the call report for correspondents that are not required to file a complete Schedule RC-R currently does not provide sufficient information to calculate a correspondent's precise capital ratios, it can be relied on to demonstrate that a correspondent is at least adequately capitalized. Banks with assets of $1 billion or less generally are required to complete only Part I of the Schedule, which provides a rough estimate of risk-based capital. A bank may assume that its correspondent is at least adequately capitalized if the correspondent has completed only Part I of Schedule RC-R. For correspondents that file a complete Schedule RC-R, the call report does include sufficient information to calculate a correspondent's risk-based capital. A bank is not limited to a single source of information for capital ratios. A bank may rely on capital information obtained from a correspondent, bank rating agency, or other reliable source of information. Further, examiners should anticipate that most banks will receive information on their correspondent's capital ratios either directly from the correspondents or from a bank rating agency. The standard used in the rule is based solely on capital ratios and does not require disclosure of CAMEL ratings. [Page Break] DRAFT Page 17 For foreign bank correspondents, monitoring frequency should be related to the frequency with which financial statements or other regular reports are available. [Footnote 15 - Regulation F permits a foreign correspondent to be considered "adequately capitalized" without regard to the level of the foreign bank's leverage ratio. This treatment of foreign banks is consistent with the findings of the Capital Equivalency Report submitted by the Federal Reserve Board and the Department of Treasury to Congress in 1992. End of Footnote 15. ] Although such information is available quarterly for some foreign banks, for many foreign banks financial statements generally will be available only on a semiannual basis. The Board recognizes that public sources of information on risk-based capital ratios may not be available for many foreign bank correspondents. As with domestic correspondents, however, examiners should anticipate that in most instances the correspondent will provide the information to the banks with which it does business. A bank's internal policies and procedures should limit overnight "credit exposure" to a correspondent to 25 percent of the exposed bank's capital, unless the bank can demonstrate that its correspondent is at least "adequately capitalized," as defined by the rule. Examiners, however, should not necessarily expect banks to have formal limits on "credit exposure" to a correspondent that the bank does not maintain quarterly capital information or that is a less than adequately capitalized correspondent where the banks' policies and procedures effectively limit "credit exposure" to an amount below the 25 percent limit. Such situations include where only small balances are maintained with the correspondent or where the correspondent has only been approved for a limited relationship. Although in many cases it will be necessary for a bank to establish formal [Page Break] DRAFT Page 18 internal limits to meet the regulatory limit, the provisions of section 206.3 (Prudential Standards) concerning excesses over internal limits also apply to limits established for the purpose of controlling "credit exposure" under section 206.4 of Regulation F. [Page Break] DRAFT [There is no page numbering on this page.] Appendix I Regulation F Pursuant to the Board's authority under section 23 of the Federal Reserve Act, 12 U.S.C. 371b-2, the Board is adding 12 CFR Part 206 to read as follows: PART 206 - LIMITATIONS ON INTERBANK LIABILITIES Sec. 206.1 Authority, purpose, and scope. 206.2 Definitions. 206.3 Prudential standards. 206.4 Credit exposure. 206.5 Capital levels of correspondents. 206.6 Waiver. 206.7 Transition provisions. AUTHORITY: Section 308 of Pub. L. 102-242, 105 Stat. 2236, 12 U.S.C. 371b-2. § 206.1 Authority, purpose, and scope. (a) Authority and purpose. This part (Regulation F, 12 CFR Part 206) is issued by the Board of Governors of the Federal Reserve System (Board) to implement section 308 of the Federal Deposit Insurance Corporation Improvements Act of 1991 (Act), 12 U.S.C. 371b-2. The purpose of this part is to limit the risks that the failure of a depository institution would pose to insured depository institutions. [Page Break] DRAFT Page 2 (b) Scope. This part applies to all depository institutions insured by the Federal Deposit Insurance Corporation. § 206.2 Definitions. As used in this part, unless the context requires otherwise: (a) Bank means an insured depository institution, as defined in section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813), and includes an insured national bank, state bank, District bank, or savings association, and an insured branch of a foreign bank. (b) Commonly-controlled correspondent means a correspondent that is commonly controlled with the bank and for which the bank is subject to liability under section 5(e) of the Federal Deposit Insurance Act. A correspondent is considered to be commonly controlled with the bank if: (1) 25 percent or more of any class of voting securities of the bank and the correspondent are owned, directly or indirectly, by the same depository institution or company; or (2) either the bank or the correspondent owns 25 percent or more of any class of voting securities of the other. (c) Correspondent means a U.S. depository institution or a foreign bank, as defined in this part, to which a bank has exposure, but does not include a commonly controlled correspondent. (d) Exposure means the potential that an obligation will not be paid in a timely manner or in full. "Exposure" includes credit and liquidity risks, including operational risks, related to intraday and interday transactions. [Page Break] DRAFT Page 3 (e) Foreign bank means an institution that: (1) is organized under the laws of a country other than the United States; (2) engages in the business of banking; (3) is recognized as a bank by the bank supervisory or monetary authorities of the country of the bank's organization; (4) receives deposits to a substantial extent in the regular course of business; and (5) has the power to accept demand deposits. (f) Primary federal supervisor has the same meaning as the term "appropriate Federal banking agency" in section 3(q) of the Federal Deposit Insurance Act (12 U.S.C. 1813(q)). (g) Total capital means the total of a bank's Tier 1 and Tier 2 capital under the risk-based capital guidelines provided by the bank's primary federal supervisor. For an insured branch of a foreign bank organized under the laws of a country that subscribes to the principles of the Basle Capital Accord, "total capital" means total Tier 1 and Tier 2 capital as calculated under the standards of that country. For an insured branch of a foreign bank organized under the laws of a country that does not subscribe to the principles of the Basle Capital Accord, "total capital" means total Tier 1 and Tier 2 capital as calculated under the provisions of the Accord. (h) U.S. depository institution means a bank, as defined in § 206.2(a) of this part, other than an insured branch of a foreign bank. § 206.3 Prudential standards. [Page Break] DRAFT Page 4 (a) General. A bank shall establish and maintain written policies and procedures to prevent excessive exposure to any individual correspondent in relation to the condition of the correspondent. (b) Standards for selecting correspondents. (1) A bank shall establish policies and procedures that take into account credit and liquidity risks, including operational risks, in selecting correspondents and terminating those relationships. (2) Where exposure to a correspondent is significant, the policies and procedures shall require periodic reviews of the financial condition of the correspondent and shall take into account any deterioration in the correspondent's financial condition. Factors bearing on the financial condition of the correspondent include the capital level of the correspondent, level of nonaccrual and past due loans and leases, level of earnings, and other factors affecting the financial condition of the correspondent. Where public information on the financial condition of the correspondent is available, a bank may base its review of the financial condition of a correspondent on such information, and is not required to obtain non-public information for its review. However, for those foreign banks for which there is no public source of financial information, a bank will be required to obtain non-public information for its review. (3) A bank may rely on another party, such as a bank rating agency or the bank's holding company, to assess the financial condition of or select a correspondent, provided that the bank's board of directors has reviewed and approved the general assessment or selection criteria used by that party. [Page Break] DRAFT Page 5 (c) Internal limits on exposure. (1) Where the financial condition of the correspondent and the form or maturity of the exposure create a significant risk that payments will not be made in full or in a timely manner, a bank's policies and procedures shall limit the bank's exposure to the correspondent, either by the establishment of internal limits or by other means. Limits shall be consistent with the risk undertaken, considering the financial condition and the form and maturity of exposure to the correspondent. Limits may be fixed as to amount or flexible, based on such factors as the monitoring of exposure and the financial condition of the correspondent. Different limits may be set for different forms of exposure, different products, and different maturities. (2) A bank shall structure transactions with a correspondent or monitor exposure to a correspondent, directly or through another party, to ensure that its exposure ordinarily does not exceed the bank's internal limits, including limits established for credit exposure, except for occasional excesses resulting from unusual market disturbances, market movements favorable to the bank, increases in activity, operational problems, or other unusual circumstances. Generally, monitoring may be done on a retrospective basis. The level of monitoring required depends on: (i) the extent to which exposure approaches the bank's internal limits; (ii) the volatility of the exposure; and (iii) the financial condition of the correspondent. [Page Break] DRAFT Page 6 (3) A bank shall establish appropriate procedures to address excesses over its internal limits. (d) Review by board of directors. The policies and procedures established under this section shall be reviewed and approved by the bank's board of directors at least annually. § 206.4 Credit exposure. (a) Limits on credit exposure. (1) The policies and procedures on exposure established by a bank under § 206.3(c) of this part shall limit a bank's interday credit exposure to an individual correspondent to not more than 25 percent of the bank's total capital, unless the bank can demonstrate that its correspondent is at least adequately capitalized, as defined in § 206.5(a) of this part. (2) Where a bank is no longer able to demonstrate that a correspondent is at least adequately capitalized for the purposes of § 206.4(a) of this part, including where the bank cannot obtain adequate information concerning the capital ratios of the correspondent, the bank shall reduce its credit exposure to comply with the requirements of § 206.4(a)(1) of this part within 120 days after the date when the current Report of Condition and Income or other relevant report normally would be available. (b) Calculation of credit exposure. Except as provided in §§ 206.4 (c) and (d) of this part, the credit exposure of a bank to a correspondent shall consist of the bank's assets and off-balance sheet items that are subject to capital requirements under the capital adequacy guidelines of the bank's primary federal supervisor, and that involve [Page Break] DRAFT Page 7 claims on the correspondent or capital instruments issued by the correspondent. For this purpose, off-balance sheet items shall be valued on the basis of current exposure. The term "credit exposure" does not include exposure related to the settlement of transactions, intraday exposure, transactions in an agency or similar capacity where losses will be passed back to the principal or other party, or other sources of exposure that are not covered by the capital adequacy guidelines. (c) Netting. Transactions covered by netting agreements that are valid and enforceable under all applicable laws may be netted in calculating credit exposure. (d) Exclusions. A bank may exclude the following from the calculation of credit exposure to a correspondent: (1) transactions, including reverse repurchase agreements, to the extent that the transactions are secured by government securities or readily marketable collateral, as defined in paragraph (f) of this section, based on the current market value of the collateral; (2) the proceeds of checks and other cash items deposited in an account at a correspondent that are not yet available for withdrawal; (3) quality assets, as defined in paragraph (f) of this section, on which the correspondent is secondarily liable, or obligations of the correspondent on which a creditworthy obligor in addition to the correspondent is available, including but not limited to: (i) loans to third parties secured by stock or debt obligations of the correspondent; [Page Break] DRAFT Page 8 (ii) loans to third parties purchased from the correspondent with recourse; (iii) loans or obligations of third parties backed by stand-by letters of credit issued by the correspondent; or (iv) obligations of the correspondent backed by stand-by letters of credit issued by a creditworthy third party; (4) exposure that results from the merger with or acquisition of another bank for one year after that merger or acquisition is consummated; and (5) the portion of the bank's exposure to the correspondent that is covered by federal deposit insurance. (e) Credit exposure of subsidiaries. In calculating credit exposure to a correspondent under this part, a bank shall include credit exposure to the correspondent of any entity that the bank is required to consolidate on its Report of Condition and Income or Thrift Financial Report. (f) Definitions. As used in this section: (1) Government securities means obligations of, or obligations fully guaranteed as to principal and interest by, the United States government or any department, agency, bureau, board, commission, or establishment of the United States, or any corporation wholly owned, directly or indirectly, by the United States. (2) Readily marketable collateral means financial instruments or bullion that may be sold in ordinary circumstances with reasonable promptness at a fair [Page Break] DRAFT Page 9 market value determined by quotations based on actual transactions on an auction or a similarly available daily bid- and ask-price market. (3)(i) Quality asset means an asset: (A) That is not in a nonaccrual status; (B) On which principal or interest is not more than thirty days past due; and (C) Whose terms have not been renegotiated or compromised due to the deteriorating financial condition of the additional obligor. (ii) an asset is not considered a "quality asset" if any other loans to the primary obligor on the asset have been classified as "substandard," "doubtful," or "loss," or treated as "other loans specially mentioned" in the most recent report of examination or inspection of the bank or an affiliate prepared by either a federal or a state supervisory agency. § 206.5 Capital levels of correspondents. (a) Adequately capitalized correspondents. [Footnote 1 - As used in this part, the term "adequately capitalized" is similar but not identical to the definition of that term as used for the purposes of the prompt corrective action standards. See, e.g., 12 CFR Part 208, Subpart B. End of Footnote 1.] For the purpose of this part, a correspondent is considered adequately capitalized if the correspondent has: (1) a total risk-based capital ratio, as defined in paragraph (e)(1) of this section, of 8.0 percent or greater; (2) a Tier 1 risk-based capital ratio, as defined in paragraph (e)(2) of this section, of 4.0 percent or greater; and [Page Break] DRAFT Page 10 (3) a leverage ratio, as defined in paragraph (e)(3) of this section, of 4.0 percent or greater. (b) Frequency of monitoring capital levels. A bank shall obtain information to demonstrate that a correspondent is at least adequately capitalized on a quarterly basis, either from the most recently available Report of Condition and Income, Thrift Financial Report, financial statement, or bank rating report for the correspondent. For a foreign bank correspondent for which quarterly financial statements or reports are not available, a bank shall obtain such information on as frequent a basis as such information is available. Information obtained directly from a correspondent for the purpose of this section should be based on the most recently available Report of Condition and Income, Thrift Financial Report, or financial statement of the correspondent. (c) Foreign banks. A correspondent that is a foreign bank may be considered adequately capitalized under this section without regard to the minimum leverage ratio required under paragraph (a)(3) of this section. (d) Reliance on information. A bank may rely on information as to the capital levels of a correspondent obtained from the correspondent, a bank rating agency, or other party that it reasonably believes to be accurate. (e) Definitions. For the purposes of this section: (1) Total risk-based capital ratio means the ratio of qualifying total capital to weighted risk assets. [Page Break] DRAFT Page 11 (2) Tier 1 risk-based capital ratio means the ratio of Tier 1 capital to weighted risk assets. (3) Leverage ratio means the ratio of Tier 1 capital to average total consolidated assets, as calculated in accordance with the capital adequacy guidelines of the correspondent's primary federal supervisor. (f) Calculation of capital ratios. (i) For a correspondent that is a U.S. depository institution, the ratios shall be calculated in accordance with the capital adequacy guidelines of the correspondent's primary Federal supervisor. (ii) For a correspondent that is a foreign bank organized in a country that has adopted the risk-based framework of the Basle Capital Accord, the ratios shall be calculated in accordance with the capital adequacy guidelines of the appropriate supervisory authority of the country in which the correspondent is chartered. (iii) For a correspondent that is a foreign bank organized in a country that has not adopted the risk-based framework of the Basle Capital Accord, the ratios shall be calculated in accordance with the provisions of the Basle Capital Accord. § 206.6 Waiver. The Board may waive the application of § 206.4(a) of this part to a bank if the primary federal supervisor of the bank advises the Board that the bank is not reasonably able to obtain necessary services, including payment-related services and placement of funds, without incurring exposure to a correspondent in excess of the otherwise applicable limit. [Page Break] DRAFT Page 12 § 206.7 Transition provisions. (a) Beginning on June 19, 1993, a bank shall comply with the prudential standards prescribed under § 206.3 of this part. (b) Beginning on June 19, 1994, a bank shall comply with the limit on credit exposure to an individual correspondent required under § 206.4(a) of this part, but for a period of one year after this date the limit shall be 50 percent of the bank's total capital. [Page Break] DRAFT [There is no page numbering on this page.] Examination Objectives 1. To determine if the policies, practices, procedures and internal controls regarding interbank liabilities adequately address the risks posed by exposure of the bank to other depository institutions. 2. To determine if bank officers and employees are operating in compliance with the policies and procedures established by the bank. 3. To determine if the financial condition of correspondents to which the bank has significant exposure in relation to the size and maturity of the exposure and the condition of the correspondent is reviewed periodically. 4. To determine if internal limits on exposure have been established where necessary and are consistent with the risk undertaken. 5. To determine if exposure ordinarily remains within the established internal limits and if appropriate procedures have been established to address excesses over internal limits. 6. To determine that "credit exposure" to less than adequately capitalized correspondents does not exceed 25 percent of the exposed bank's capital, keeping in mind that the intent of Regulation F is to place greater emphasis on appropriate levels of exposure based on analysis of the creditworthiness of correspondents as opposed to merely concentrating on staying within regulatory established limits. 7. To determine if capital levels of correspondents to which the bank has "credit exposure" exceeding 25 percent of capital are monitored quarterly to insure that the correspondents remain at least adequately capitalized. 8. To initiate corrective action when policies, procedures or internal controls are deficient, or when violations of laws or regulations have been noted. [Page Break] DRAFT [There is no page numbering on this page.] Examination Procedures Examiners should obtain or prepare the information necessary to perform the appropriate procedural steps. 1. If selected for implementation, complete or update the Interbank Liabilities section of the Internal Control Questionnaire. 2. Based on the evaluation of internal controls, determine the scope of the examination. 3. Test for compliance with policies, practices, procedures and internal controls in conjunction with performing the remaining examination procedures. 4. Request bank files relating to exposure to correspondents as defined in the "Prudential Standards" section, and a. Request documentation demonstrating that the bank has periodically reviewed the financial condition of any correspondent to which the depository institution has significant exposure. Factors that have a bearing on the financial condition of the correspondent that should be addressed by the bank include the capital level of the correspondent, level of nonaccrual and past due loans and leases, level of earnings, and other factors affecting the financial condition of the correspondent. b. Request information from the bank indicating the level of exposure to correspondents as measured by the bank's internal control systems (e.g., for smaller banks this information may include correspondent statements and a list of securities held in the investment portfolio). c. Determine if the frequency of the reviews of financial condition are adequate for those institutions to which the bank has very large or long maturities, or for correspondents in deteriorating condition. d. If a bank relies on another party (such as its bank holding company, a bank rating agency, or another correspondent) to provide financial analysis of a correspondent, determine if the bank's board of directors has reviewed and approved the assessment criteria used by the other party. e. Where the bank relies on its bank holding company to select and monitor correspondents, or on a correspondent, such as a bankers' bank, to choose other correspondents with which to place the depository institution's [Page Break] DRAFT Page 2 federal funds, ensure that the bank's board of directors has reviewed and approved the selection criteria used. f. If the bank is exposed to a correspondent that has experienced a deterioration in its financial condition, ascertain that the bank has taken into account such deterioration in evaluating the creditworthiness of the correspondent and the appropriate level of exposure to the correspondent. g. Where internal limits for significant exposure have been established by the bank, determine that the bank either monitors its exposure or structures transactions with the correspondent to ensure that exposure ordinarily remains within the internal limits established by the bank based on the risk undertaken. h. If the bank chooses to set separate limits for different forms of exposure, products, or maturities and does not set an overall internal limit on exposure to a correspondent, review information on actual interday exposure to determine if the aggregate exposure (especially for less than adequately capitalized correspondents or financially deteriorating correspondents) is consistent with the risk undertaken. i. Where monitoring is used, determine if the level of ex post monitoring of significant exposure (especially for less than adequately capitalized correspondents or financially deteriorating correspondents) is appropriate given the type and volatility of exposure, the extent to which the exposure approaches the bank's internal limits, and the condition of the correspondent. j. Determine if the bank had any occasional excesses over the internal limits, and verify that the bank utilized appropriate procedures to address these excesses. k. If the size of intraday exposure to a correspondent and the condition of the correspondent indicate that there is a significant risk that payments will not be made as contemplated, verify that the bank has established intraday limits consistent with the risk undertaken and monitored intraday exposure. 5. Request a list of all institutions to which the bank regularly has "credit exposure," as defined in the "Credit Exposure" section (section 206.4) of Regulation F, greater than 25 percent of capital during a specified time interval (every effort should be made to allow banks to use existing risk monitoring and control systems and practices where they effectively maintain "credit exposure" within the prescribed limits where appropriate) and review the bank's files to: [Page Break] DRAFT Page 3 a. verify that the capital levels of correspondent's are monitored quarterly, b. verify that these institutions are at least adequately capitalized as defined by Regulation F, and c. determine that "credit exposure" to those correspondents at risk of dropping below the capital levels required to be adequately capitalized could be reduced to 25 percent of capital or less in a timely manner. [Page Break] DRAFT [There is no page numbering on this page.] Internal Control Questionnaire Review the bank's internal controls, policies, practices and procedures for interbank liabilities. The bank's system should be documented in a complete and concise manner and should include, where appropriate, narrative descriptions, flowcharts, copies of forms used and other pertinent information. Prudential Standards 1. Has the bank developed written policies and procedures to evaluate and control exposure to all correspondents? 2. Have the written policies and procedures been reviewed and approved by the board of directors annually? 3. Do the written policies and procedures adequately address the banks exposure(s) to a correspondent including: credit risk, liquidity risk, and settlement risk? (See Discussion in Introduction p. 6) 4. Has the bank adequately evaluated its intraday exposure? Does the bank have significant exposure to its correspondent due to operational risks, such as extensive reliance on a correspondent for data processing? If so, has the bank addressed these operational risks (may be elsewhere in its operational procedures)? 5. Do the written policies and procedures establish criteria for selecting a correspondent or terminating that relationship? 6. Do the written policies and procedures require a periodic review of the financial condition of a correspondent whenever the size and maturity of exposure is considered significant in relation to the financial condition of the correspondent? (See Discussion in Introduction pp. 6-7) 7. Where exposure is considered significant, is the financial condition of the correspondent periodically reviewed? 8. Does the periodic review of the correspondent's financial condition include its level of: capital, nonaccrual and past due loans and leases, earnings, and [Page Break] DRAFT Page 2 other factors affecting the financial condition of the correspondent. 9. If a party other than bank management conducts the financial analysis of or selects a correspondent, has the bank's board of directors reviewed and approved the general assessment and/or selection criteria used by that party? 10. If the financial condition of the correspondent, or the form or maturity of exposure creates significant risk, do the written policies and procedures establish internal limits or other procedures such as monitoring to control exposure? 11. Are the internal limits or controls described in question 9 appropriate for the level of risk exposure? If no internal limits have been established, is this appropriate based on the financial condition of the correspondent and size, form and maturity of exposure? Why or Why not? 12. Where internal limits for significant exposure to a correspondent have been set, has the bank established procedures or structured transactions with the correspondent to ensure that the exposure ordinarily remains within the bank's established internal limits? 13. If not, is actual exposure to a correspondent monitored to ensure that the exposure ordinarily remains within the bank's established internal limits? 14. Is the level (frequency) of monitoring performed appropriate for: the type and volatility of the exposure, the extent to which the exposure approaches the bank's internal limits, and the financial condition of the correspondent? 15. Are transactions and/or monitoring reports on exposure reviewed for compliance with internal policies and procedures? If so, by whom and how often? 16. Do the written policies and procedures address deterioration in a correspondent's financial condition with respect to: • the periodic review of the correspondent's financial condition, appropriate limits on exposure, and monitoring the exposure or structuring transactions with the correspondent to ensure that the exposure remains within the internal limits established? Are these appropriate and realistic? 17. Do the written procedures establish guidelines to address excesses over the internal limits? (Such excesses could include unusual late incoming wires, unusually large cash letters, unusual market moves, or other unusual increases in activity or operational problems.) Are the procedures appropriate? [Page Break] DRAFT Page 3 Credit Exposure Limits 1. Do the bank's written policies and procedures effectively limit overnight "credit exposure" to 25 percent or less of bank's capital, if a correspondent is less than adequately capitalized? (See Discussion in Introduction pp. 11-12) 2. If "credit exposure" is not limited to 25 percent or less of the bank's capital, does the bank: a. Obtain quarterly information to determine its correspondent's capital levels (determine source)? b. Monitor its overnight "credit exposure" to its correspondents (determine frequency)? [The End]