OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551
SUPERVISION AND REGULATION
May 14, 1998
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OF THE FEDERAL RESERVE SYSTEM WASHINGTON, D. C. 20551 |
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| DIVISION OF BANKING SUPERVISION AND REGULATION |
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| SR 98-12 (SUP) May 14, 1998 |
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TO THE OFFICER IN CHARGE OF SUPERVISION AND APPROPRIATE SUPERVISORY AND EXAMINATION STAFF AT EACH FEDERAL RESERVE BANK AND TO EACH DOMESTIC AND FOREIGN BANKING ORGANIZATION SUPERVISED BY THE FEDERAL RESERVE
On April 23, 1998, the Federal Financial Institutions Examination Council issued the attached Supervisory Policy Statement on Investment Securities and End-User Derivatives Activities (1998 Policy Statement).1 The 1998 Policy Statement, which has been adopted by the Board, provides guidance on sound practices for managing the risks involved in investment and end-user activities. In essence, this new FFIEC policy statement conforms interagency guidance with that issued by the Federal Reserve in 1995 under SR 95-17. The 1998 Policy Statement also rescinds the constraints on investments in "high risk" mortgage derivatives products contained in the 1992 FFIEC Supervisory Policy Statement on Securities Activities published on February 3, 1992 (SR 92-1) (1992 Policy Statement).
Just as with SR 95-17, the guidance advanced in the 1998 Policy Statement applies to the risk management practices of state member banks and Edge corporations. The basic principles also apply to bank holding companies, which should manage and control aggregate risk exposures on a consolidated basis, while recognizing legal distinctions and possible obstacles to cash movements among subsidiaries.2 More generally, the principles advanced set forth fundamental risk management practices that are relevant to most portfolio management endeavors. Institutions should review the applicability of these principles in providing fiduciary and investment management services.
The guidance in the 1998 Policy Statement reflects the agencies' move to a more risk-focused approach to supervision, which considers the appropriateness of an instrument held for investment or end-user purposes in light of a variety of factors, including management's ability to measure and manage the risks of the institution's holdings and the impact of those holdings on aggregate portfolio risk. The 1998 Policy Statement reflects a supervisory focus on evaluating and controlling risks on an investment portfolio or institution-wide basis.
The 1998 Policy Statement advances sound practices for managing the market, credit, liquidity, operational, and legal risks of investment and end-user activities. In managing the interest rate risk component of market risk, institutions are advised of the merits of internally developed policies that specify the type of pre-acquisition analyses to be conducted for particular types of instruments including those that are new to the institution or have complex or potentially volatile risk profiles. On an on-going basis, institutions should monitor periodically the price sensitivity of their portfolios to ensure that they meet board-established limits. In assessing credit risk, institutions should fully assess the creditworthiness of their counterparties, including brokers and issuers. Institutions should also ensure that they take proper account of the liquidity of the instruments they hold.
Last, we note that in adopting the 1998 Policy Statement, the 1992 FFIEC Policy Statement is rescinded, including constraints on banks' investments in "high-risk" mortgage derivative products. The agencies believe that it is a sound practice for institutions to understand the risks involved in all of their investment and end-user holdings, including but not limited to, mortgage derivative products. Accordingly, as of the 1998 Policy Statement's effective date of May 25, 1998, banks will no longer be required to conduct the "FFIEC high-risk test" for mortgage derivative products. Rather, banks are expected to implement the sound practices advanced in the 1998 Policy Statement, including the application of internally developed limits and pre-acquisition stress testing consistent with the scope, sophistication, and complexity of their investment securities and end-user derivative holdings.
Because the new FFIEC guidance conforms to existing Federal Reserve policy, current Federal Reserve guidance as reflected in the recently revised Trading and Capital Markets Activities Manual remains appropriate and applicable.
Please distribute this SR Letter to all appropriate supervisory staff at your Reserve Bank and forward it to all institutions supervised by the Federal Reserve in your District. Attached is a draft transmittal letter that may be used for that purpose. Questions regarding the 1998 FFIEC Policy Statement should be directed to Jim Embersit, Manager, Capital Markets (202-452-5249).
Director
Footnotes 1. 63 Fed. Reg. 20,191 (April 23, 1998). Return to text 2. The basic principles set forth in this guidance should also be incorporated into the policies of U.S. branches and agencies of foreign banks with appropriate adaptations to reflect the fact that: 1) those offices are an integral part of a foreign bank that should be managing its risks on a consolidated basis and recognizing possible obstacles to cash movements among branches, and 2) the foreign bank is subject to overall supervision by its home country supervisory authority. Return to text
Suggested Transmittal Letter
State member banks and Edge corporations are expected to apply the sound practices advanced in the new policy statement, which reflect a risk-focused approach and the evaluation and control of risk on an investment portfolio or institution-wide basis. The basic principles also apply to bank holding companies, which should manage and control aggregate risk exposures on a consolidated basis, while recognizing legal distinctions and possible obstacles to cash movements among subsidiaries. The guidance also should be incorporated into the policies of U.S. branches and agencies of foreign banks, with appropriate adaptations to reflect the fact that (1) those offices are an integral part of a foreign bank which should be managing its risks on a consolidated basis and recognizing possible obstacles to cash movements among its branches, and (2) the foreign bank is subject to overall supervision by home country supervisory authority. The attached SR Letter provides an overview of the new FFIEC policy statement, a copy of which is also provided for your reference. Please contact ____________________ of this Reserve Bank if you have any questions.
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SR letters | 1998
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