Trading And Capital Market Activities Manual.pdf

Supplement 12—April 2007Nature of Changes Examination objectives, examination dures, and an internal control questionnairesections 2030.2, 2030.3, and 2030.4, respec-tively have been add

Trading and Capital-MarketsActivities Manual

Federal Reserve SystemSend comments to:

Director, Division of Banking Supervisionand Regulation

Board of Governors of the FederalReserve System

Washington, D.C 20551Copies of this manual may be obtained from:

Publications ServicesDivision of Support ServicesBoard of Governors of the FederalReserve System

Washington, D.C 20551Updates are available at an additional charge Forinformation about updates or to order by credit card,call 202-452-3244

Supplement 14—July 2011Nature of Changes

The ‘‘Liquidity Risk’’ section (3005.1) has beenrevised to incorporate, in part, provisions of theMarch 17, 2010, ‘‘Interagency Policy State-ment on Funding and Liquidity Risk Manage-ment.’’ The policy statement provides guid-ance on sound practices for managing thefunding and liquidity risks of depository institu-tions The guidance explains the process thatdepository institutions should follow inappropriately identifying, measuring, monitor-ing, and controlling their funding and liquidityrisks In particular, the guidance reemphasizesthe importance of cash flow projections; diversi-fied funding sources; stress testing; a cushion ofliquid assets; and a formal, well-developedcontingency funding plan as primary tools formeasuring and managing funding and liquidityrisks The interagency guidance also isconsistent with the principles of sound liquidity-risk management issued in September 2008 bythe Basel Committee on Banking Supervision

entitled, Principles for Sound Liquidity RiskManagement and Supervision.

The Federal Reserve expects all supervisedfinancial institutions to manage their liquidityrisk using processes and systems that are com-mensurate with their complexity, risk profile,and scope of operations See SR-10-6 and itsattachment

Small corrections were made to other ity Risk sections (3005.2, 3005.3, 3005.4, and3005.5) In addition, the following changes weremade to the Liquidity Risk appendixes section(3005.5): the Fourteen Principles for the Assess-ment of Liquidity Management in Banking Or-ganizations was removed as appendix 2; theJoint Agency Advisory on Brokered and Rate-Sensitive Deposits (SR-01-14) was removed asappendix 4; the Interagency Advisory on theUse of the Federal Reserve’s Primary CreditProgram in Effective Liquidity Management(SR-03-15) was removed as appendix 5; and theSummary of Major Legal and Regulatory Con-siderations was redesignated as appendix 2

Supplement 13—January 2009Nature of Changes

The ‘‘Investment Securities and Activities’’ section (3000.1) has been revised toconform the discussion of the Uniform Agree-ment on the Classification of Assets andAppraisal of Securities Held by Banks andThrifts (the uniform agreement) with the guid-

End-User-ance contained in the Commercial Bank nation Manual The Uniform Agreement was

Exami-jointly issued by the federal banking and thriftagencies on June 15, 2004 The agreement setsforth the definitions of the classification catego-ries and the specific examination procedures andinformation for classifying securities

Supplement 12—April 2007

Nature of Changes

Examination objectives, examination dures, and an internal control questionnaire(sections 2030.2, 2030.3, and 2030.4, respec-tively) have been added to the Market LiquidityRisk of Trading Activities section

proce-An internal control questionnaire (section3005.4) has been added to the Liquidity Risk

sections Small corrections were made to otherLiquidity Risk sections (3005.1, 3005.3, and3005.5) In addition, the Interagency Advisoryon the Use of the Federal Reserve’s PrimaryCredit Program in Effective Liquidity Manage-ment (SR-03-15) has been added as appendix 5to section 3005.5

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3005.5, pages 19–20pages 33–34

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sections of this manual and the CommercialBank Examination Manual, as well as in guid-

ance issued by the Office of the Comptroller of

the Currency, the Federal Deposit InsuranceCorporation, and the Basel Committee on Bank-ing Supervision The section also includes adiscussion of the analytical process for evaluat-ing and rating an institution’s inherent liquidity-risk exposure and the quality of its liquidity-riskmanagement Examination objectives andexamination procedures have been added (sec-tions 3005.2 and 3005.3, respectively) Anappendix section (3005.5) provides additionalbackground on special topics related to liquidity-risk management, including the various measure-ment tools, techniques, and considerations thatinstitutions generally consider when they evalu-ate their liquidity-risk management practices

The new section replaces the general risk discussion formerly found in section 2030.1,which has been renamed ‘‘Market LiquidityRisk of Trading Activities.’’

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Supplement 10—September 2003Nature of Changes

Capital-Markets Activities

Two SR-letters on accrued interest receivableshave been added to section 3020.1, ‘‘Securitiza-tion and Secondary-Market Credit Activities.’’Both letters include interagency guidance SR-02-12 (May 17, 2002) provides guidance on theregulatory capital treatment of accrued interest

receivables related to credit card securitizations.SR-02-22 (December 4, 2002) clarifies the ear-lier guidance to state that, when the institution’s(seller’s) right to an accrued interest receivableis subordinated as a result of a securitization, theseller generally should include the accrued inter-est receivable as a subordinated retained interestin accounting for the sale of credit card receiv-ables and in computing the gain or loss on sale

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Trading and Capital-Markets Activities Manual September 2003

Supplement 9—April 2003Nature of Changes

Trading Activities

Section 2030.1, ‘‘Liquidity Risk,’’ has beenrevised to include information on the FederalReserve’s new discount window programs: pri-mary credit and secondary credit Effective Janu-ary 9, 2003, these programs replaced the adjust-ment credit and extended credit programs Abanking organization’s funding-liquidity plansmay include accessing the Federal Reserve’sdiscount window The examination procedures,section 2030.3, have also been updated

In section 2100.1, ‘‘Financial Performance,’’several revisions were made to the discussion ofpricing models Institutions that use pricingmodels to value and hedge complex financialsecurities in illiquid markets should have asound model-validation process Such a processevaluates, among other things, a model’s sensi-tivity to material sources of model risk Aninstitution’s model-validation function shouldalso work closely with the new-product-approvalfunction to determine what effect a new producthas on the institution’s pricing model

The definitions of tier 1 and tier 2 capital insection 2110.1, ‘‘Capital Adequacy,’’ have beenupdated The section was further revised in themarket-risk subsection to state that, for purposesof the market-risk capital calculation, an insti-tution must meet an additional restriction: Thesum of its tier 2 capital and tier 3 capitalallocated for market risk may not exceed 250percent of tier 1 capital allocated for market risk.In section 2120.1, ‘‘Accounting,’’ referencesto Statement of Financial Accounting StandardsNo 133 (FAS 133), ‘‘Accounting for DerivativeInstruments and Hedging Activities,’’ wereupdated to state that FAS 133 was amended byStatement of Financial Accounting StandardsNos 137 and 138 (FAS 137 and FAS 138) Theexamination objectives, examination proce-dures, internal control questionnaire, and appen-dix on related financial-statement disclosures,sections 2120.2, 2120.3, 2120.4, and 2120.5respectively, were also updated for this change.Section 2130.5, the appendix to ‘‘RegulatoryReporting,’’ was updated to include a descrip-tion of Form FR Y-12, Consolidated BHCReport of Equity Investments in NonfinancialCompanies

Section 2140.1, ‘‘Regulatory Compliance,’’was updated to reflect that, under the Gramm-Leach-Bliley Act enacted in 1999, financialholding companies are permitted to establishbroker-dealer subsidiaries engaged in securitiesunderwriting, dealing, and market making, with-out the restrictions that were applicable to sec-tion 20 subsidiaries

Section 2150.1, ‘‘Ethics,’’ was revised toreinforce that an institution’s policies and pro-cedures should provide for at least an annualreview, revision, and approval of its ethicalstandards and code of conduct The standardsand code should be communicated throughoutthe organization and reinforced by periodictraining The discussion of legal and reputa-tional risks notes that, although banking organi-zations are not directly accountable for theactions of their customers, organizations shouldrecognize that, to the extent their name orproduct is associated with a customer’s miscon-duct, additional legal and reputational risks mayarise An organization’s policies and proceduresshould ensure that legal- and reputational-riskissues are vetted and resolved at an appropriatelevel of seniority The examination objectives,examination procedures, and internal controlquestionnaire, sections 2150.2, 2150.3, and2150.4 respectively, were also revised

Capital-Markets Activities

Section 3020.1, ‘‘Securitization and Market Activities,’’ has been updated to includeinformation on banking organizations’ provid-ing implicit recourse to a securitization Implicitrecourse is of supervisory concern because itdemonstrates that the securitizing institution isreassuming risk associated with the securitizedassets—risk that the institution initially trans-ferred to the marketplace (See SR-02-15.) Inaddition, the section was revised to include adiscussion on the inclusion of supervisory-linked covenants in securitization documents.This practice has significant implications for aninstitution’s liquidity and is considered an unsafeand unsound banking practice (See SR-02-14.)In section 3040.1, ‘‘Equity Investment andMerchant Banking Activities,’’ a reference toFAS 133 was updated to reflect its amendmentby FAS 137 and FAS 138 The examination

Secondary-Trading and Capital-Markets Activities Manual April 2003

objectives and procedures, sections 3040.2 and3040.3 respectively, have also been updated forthis change.

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April 2003 Trading and Capital-Markets Activities Manual

Supplement 8—September 2002Nature of Changes

Trading Activities

In section 2020.1, ‘‘Counterparty Credit Riskand Presettlement Risk,’’ a new subsection onoff-market or prefunded derivatives transactionshas been added to provide examples of deriva-tives transactions that are the functional equiva-lent of extensions of credit to counterparties andto describe the risks associated with them Thediscussion of assessment of counterparty creditrisk has been revised to specify that bankingorganizations should understand and confirmwith their counterparties the business purpose ofderivatives transactions

A more detailed discussion of contingencyfunding plans has been added to section 2030.1,‘‘Liquidity Risk.’’ The characteristics of effec-tive contingency funding plans, such as forminga crisis-management team and establishing actionplans for different levels of liquidity stress, aredescribed Specific information on contingencyliquidity for bank holding companies is alsoprovided

Section 2070.1, ‘‘Legal Risk,’’ has been ganized and updated A new subsection describes

reor-how a banking organization can mitigate the riskthat may arise if a counterparty claims that abank-recommended or -structured derivativestransaction was unsuitable for it Other changesdiscuss the new-product approval process inbanking organizations, including the role ofin-house or outside legal counsel in defining andapproving new products The examinationobjectives and examination procedures, sections2070.2 and 2070.3, respectively, have also beenupdated

Capital-Markets Activities

Section 3040.1, ‘‘Equity Investment and chant Banking Activities,’’ has been completelyrevised The accounting, valuation, and riskmanagement of equity investments in bankingorganizations are summarized In addition, thesection explains the legal and regulatory com-pliance requirements for these transactions—including the January 2002 rule establishingminimum regulatory capital requirements forequity investments in nonfinancial companies.Examination objectives and examination proce-dures, sections 3040.2 and 3040.3, respectively,have been added

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Trading and Capital-Markets Activities Manual September 2002

Supplement 7—April 2002Nature of Changes

Section 3000.1, ‘‘Investment Securities and User Activities,’’ has been revised to explainrecent interpretations of sections 23A and 23Bof the Federal Reserve Act The internal controlquestionnaire, section 3000.4, has also beenupdated

End-• A final rule, effective June 11, 2001, providesthree exemptions from the quantitative limitsand collateral requirements of section 23A.The exemptions apply to certain loans aninsured depository institution makes to thirdparties that use the proceeds to purchasesecurities or assets through an affiliate of thedepository institution

• A final rule, effective June 11, 2001, exemptsfrom section 23A an insured depository insti-tution’s purchase of a security from an affili-ated broker-dealer registered with the Securi-ties and Exchange Commission (SEC),provided several conditions are met Amongother conditions, the purchased security musthave a ready market, as defined by the SEC,and a publicly available market quotation.• An interim rule, effective January 1, 2002,

confirms that (1) derivative transactionsbetween an insured depository institution andits affiliates and (2) intraday extensions ofcredit by an insured depository institution to

its affiliates are subject to the market-termsrequirement of section 23B

In Section 3020.1, ‘‘Securitization andSecondary-Market Credit Activities,’’ the discus-sion of risk-based provisions affecting assetsecuritizations has been updated to include afinal rule on the capital treatment of recourseobligations, residual interests, and direct-creditsubstitutes resulting from asset securitizations.The new rule treats recourse obligations anddirect-credit substitutes more consistently thanthe current risk-based capital standards, addsnew standards for the treatment of residualinterests, and introduces a ratings-based approachto assigning risk weights within a securitization.There is a one-year transition period for apply-ing the new rules to existing transactions Alltransactions settled on or after January 1, 2002,are subject to the revised rules

Revisions to section 3040.1, ‘‘Equity ment and Merchant Banking Activities,’’ incor-porate a final rule establishing special minimumregulatory capital requirements for equity invest-ments in nonfinancial companies The newrequirements, effective April 1, 2002, impose aseries of marginal capital charges on coveredequity investments The charges increase withthe level of a banking organization’s overallexposure to equity investments relative to tier 1capital

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April 2002 Trading and Capital-Markets Activities Manual

Supplement 6—September 2001Nature of Changes

Sections 2120.1, ‘‘Accounting,’’ and 3020.1,‘‘Securitization and Secondary-Market CreditActivities,’’ have been corrected to remove ref-erences to Statement of Financial AccountingStandards No 125 (FAS 125), which has beenreplaced by Statement of Financial Accounting

Standards No 140 (FAS 140) Section 2120.1was further corrected to replace a reference toAccounting Principles Board (APB) OpinionNo.16 with Statement of Financial AccountingStandards No 141 (FAS 141), ‘‘Business Com-binations.’’ References to FAS 125 have alsobeen removed from the instrument profiles (sec-tions 4010.1 through 4255.1 and section 4353.1)

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Supplement 5—April 2001Nature of Changes

Trading Activities

Section 2120.1, ‘‘Accounting,’’ has been revisedto incorporate the following recent guidancefrom the Financial Accounting Standards Board:Statement of Financial Accounting Standards(SFAS) No 133, ‘‘Accounting for DerivativeInstruments and Hedging Activities,’’ and SFASNo 140, ‘‘Accounting for Transfers and Servic-ing of Financial Assets and Extinguishments ofLiabilities." (SFAS 140 supersedes SFAS 125,which had the same title) The accounting treat-ment for securitizations, repurchase agreements,derivative instruments, and foreign-currencyinstruments has been updated The discussionon accounting for derivatives includes informa-tion on fair-value, cash-flow, and foreign-currency hedges The examination objectives,examination procedures, internal control ques-tionnaire, and appendix on financial statementdisclosures, sections 2120.2, 2120.3, 2120.4,and 2120.5, respectively, have also been updated.In section 2130.1, ‘‘Regulatory Reporting,’’references to the obsolete Monthly ConsolidatedForeign Currency Report (FFIEC form 035)have been removed, and the guidance on insti-tutions that are required to file the FR Y-20report has been revised The examination objec-tives, examination procedures, internal controlquestionnaire, and appendix on reports for trad-ing instruments, sections 2130.2, 2130.3, 2130.4,and 2130.5, respectively, have also been updated.The Gramm-Leach-Bliley Act (GLB Act),enacted in 1999, removed some restrictions thatwere formerly applicable to section 20 subsidi-aries engaged in underwriting, dealing, andother related activities Under the GLB Act,banking regulators are also required to rely tothe greatest extent possible on the functional

regulator of securities firms Section 2140.1,‘‘Regulatory Compliance,’’ has been revised toincorporate these provisions of the GLB Act

Capital-Markets Activities

New information on the valuation of retainedinterests, including SR-99-37 and its relatedinteragency guidance, has been added to section3020.1, ‘‘Securitization and Secondary-MarketCredit Activities.’’ The subsection on internalcontrols has also been expanded to include theminimum requirements for management infor-mation systems reports on securitizationactivities

A new section 3040.1, ‘‘Equity Investmentand Merchant Banking Activities,’’ has beenadded The new section incorporates the super-visory letter on these activities (SR-00-9) thatwas formerly in section 4360.1 The section alsoprovides new guidance on merchant bankingactivities of financial holding companies, includ-ing investment limitations, cross-marketing limi-tations, and special rules for private equityfunds

Instrument Profiles

The ‘‘Accounting Treatment’’ subsections in theinstrument profiles have been revised to deletereferences to obsolete accounting standards andadd references to SFAS 133 and SFAS 140.Section 4350.1, ‘‘Credit Derivatives,’’ was fur-ther revised to expand the risk-based capitalweighting guidance In section 4353.1, ‘‘Collat-eralized Loan Obligations,’’ more detailed infor-mation was provided on the risk-based capitalweighting of three types of transactions forsynthetic collateralized loan obligations

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2000

2120.2 Accounting—Examination Objectives 1 12120.3 Accounting—Examination Procedures 1 12120.4 Accounting—Internal Control Questionnaire 1 12120.5 Accounting—Related Financial Statement

3020.1 Securitization and Secondary-Market Credit

Activities

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Supplement 4—September 2000Equity Investments and MerchantBanking

The Federal Reserve’s supervisory letterSR-00-9, issued June 22, 2000, has been addedas a new instrument profile, section 4360.1.The section provides guidance for managingthe risks of equity investments and merchantbanking activities, which have become impor-tant sources of earnings at some financial insti-tutions Furthermore, the recently enactedGramm-Leach-Bliley Act provides additional

merchant banking authority to financial holdingcompanies

The new section outlines sound practices forequity investments and merchant banking,appropriate disclosure practices for institutionsengaging in these activities, and additional risk-management issues for institutions engaging intransactions with portfolio companies A finalrule on the conduct of equity investment andmerchant banking activities is forthcoming andwill be included in a future update to thismanual

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Supplement 3—April 2000

Capital Adequacy

A subsection on the capital treatment of thetic collateralized loan obligations (CLOs) hasbeen added to section 2110.1, ‘‘CapitalAdequacy.’’ The use of credit derivatives tosynthetically replicate CLOs has raised ques-tions about how to calculate their leverage andrisk-based capital ratios The new material dis-cusses supervisory and examination consider-ations for three types of synthetic CLO transac-tions in banking organizations: (1) the entirenotional amount of the reference portfolio ishedged, (2) a high-quality senior risk position inthe reference portfolio is retained, and (3) afirst-loss position is retained

syn-Accounting

‘‘Accounting,’’ section 2120.1, was revised in the‘‘Netting or Offsetting Assets and Liabilities’’subsection to clarify the conditions necessaryfor a master netting arrangement to exist and toadd information from the Financial AccountingStandards Board’s Interpretation 41 A newsubsection also provides guidance on account-ing for derivative instruments under FASB State-ment of Financial Accounting Standard No 133(SFAS 133), which is effective for fiscal yearsbeginning after June 15, 2000 SFAS 133requires banking organizations to recognize allderivatives on their balance sheets as assets orliabilities, and to report them at their fair value

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Supplement 2—September 1999

Nature of Changes

This supplement reflects new or revised tory and regulatory provisions and new or revisedsupervisory instructions or guidance issued bythe Division of Banking Supervision and Regu-lation since the publication of the March 1999supplement

statu-Counterparty Credit Risk

Section 2020.1, ‘‘Counterparty Credit Risk andPresettlement Risk,’’ has been revised to add alist of conditions examiners should use whenevaluating credit-risk management in bankinginstitutions, as provided in SR-99-3 (February 1,1999) The guidance on collateral arrangementshas been expanded to incorporate recent recom-mendations from the central banks of the Groupof Ten countries on over-the-counter derivativessettlement procedures, as well as market-practicerecommendations from the 1999 collateralreview by the International Swaps and Deriva-tives Association The examination objectives,examination procedures, and internal controlquestionnaire (sections 2020.2, 2020.3, and2020.4, respectively) have also been updated

Capital Adequacy

A new subsection on assessing capital adequacyat large, complex banking organizations hasbeen added to section 2110.1, ‘‘CapitalAdequacy.’’ The new guidance outlines the fun-damental elements of a sound internal analysisof capital adequacy, describes the risks thatshould be addressed in this analysis, and dis-cusses the examiner’s review of an institution’scapital adequacy analysis Other revisions weremade to expand the guidance on market-riskmeasure, including the use of internal modelsand qualitative and quantitative requirements formarket-risk management

Accounting

In section 2120.1, ‘‘Accounting,’’ the descriptionof the Statement of Financial Accounting Stan-dard No 133, ‘‘Accounting for DerivativeInstruments and Hedging Activities,’’ has beenupdated The Financial Accounting StandardsBoard has delayed the statement’s effective dateto fiscal years beginning after June 15, 1999

A reference to an outdated Federal Reservepolicy statement on securities activities has beenremoved The appendix on financial-statementdisclosures, section 2120.5, has also beenupdated

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2020.4 Counterparty Credit Risk and Presettlement

Risk—Internal Control Questionnaire

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1–69–122120.5 Accounting—Appendix: Related

Supplement 1—March 1999This supplement reflects new or revised statu-tory and regulatory provisions and new or revisedsupervisory instructions or guidance issued by

the Division of Banking Supervision and lation since the publication of the manual inFebruary 1998

Regu-LIST OF CHANGESCounterparty Credit Risk

Section 2020.1, Counterparty Credit Risk andPresettlement Risk, has been revised to incorpo-rate the supervisory guidance on counterpartycredit risk management provided in SR-99-3(February 1, 1999) Specific guidance on thecalculation of potential future exposure, exposure-monitoring and limit systems, the importance ofstress testing and scenario analysis, and theinterrelationship between credit and market risk,is included Additional guidance on creditenhancements, including collateral, close-outprovisions, and margining requirements, is pro-vided The section discusses in detail the needfor robust counterparty credit risk managementpolicies and internal controls to ensure thatexisting practice conforms to stated policies.The unique risks posed by institutional investorsand hedge funds are detailed in a separatesubsection, which includes a discussion of theJanuary 1999 report of the Basle Committee onBanking Supervision on the risks posed byhedge funds to creditors and the accompanyingsound practices standards for interactions withhedge funds The examination objectives,examination procedures, and internal controlquestionnaire (sections 2020.2, 2020.3, and2020.4, respectively) have also been updated.In section 2021.1, Counterpary Credit Risk andSettlement Risk, a discussion of the Board’sJune 1998 Policy Statement on Privately Oper-ated Multilateral Settlement Systems providesguidance on the additional settlement risks posedby these systems

Legal Risk

Section 2070.1, Legal Risk, has been updated toinclude a discussion on the importance of prop-erly and accurately defining the trigger eventsthat provide for payments between counterpar-ties, in light of experiences during the market

disruptions of 1998 A subsection on erable forwards and the need for explicit docu-mentation of these contracts is also added Theexamination objectives and examination proce-dures (sections 2070.2 and 2070.3, respectively)have been updated

nondeliv-Capital Adequacy

Section 2110.1, Capital Adequacy, has beenupdated to reflect regulatory changes to thedefinition of tier 1 and tier 2 capital and toinclude a revised discussion of the regulatorytreatment of credit derivatives

Accounting

In section 2120.1, Accounting, a brief tion of the Statement of Financial AccountingStandards No 133 (SFAS 133) for derivativeshas been added SFAS 133 is effective for fiscalyears beginning after June 15, 1999, with aneffective date of January 1, 2000, for mostbanks The description of SFAS 133 will beexpanded in subsequent revisions to the manual

descrip-Securities

Section 3000.1, Investment Securities and User Activities, has been revised to reflect thePolicy Statement on Investment Securities andEnd-User Derivatives Activities, published bythe Federal Financial Institutions ExaminationCouncil, and the recission of the high-risk testfor mortgage-derivative products

End-Interest-Rate Risk

In section 3010.1, Interest-Rate Risk ment, a discussion of an examination scope fornoncomplex institutions has been revised to

delete specific criteria previously used to tify institutions in which only baseline exami-nation procedures were necessary The revisedfocus is on the overall risk profile of the indi-vidual institution in lieu of dependence on strictquantitative criteria.

iden-Collateralized Loan Obligations

A new product profile on collateralized loan

obligations (CLOs) has been added as section4353.1 CLOs are securitizations of portfolios ofcommercial and industrial loans through abankruptcy-remote special-purpose vehicle thatissues asset-backed securities in one or moreclasses (or tranches) Alternatively, CLOs maybe synthetically created through the use of creditderivatives

FILING INSTRUCTIONS

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2020.4 Counterparty Credit Risk and Presettlement

Risk—Internal Control Questionnaire

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3000.1 Investment Securities and End-User Activities 5–6

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5–6, 6.117–19

3020.1 Securitization and Secondary-Market Credit

USING THIS MANUAL

This manual seeks to provide the examiner withguidance for reviewing capital-markets and trad-ing activities at all types and sizes of financialinstitutions The manual will be updated peri-odically as products and activities evolve

The manual codifies current procedures usedin the review of capital-markets and tradingactivities It discusses the risks involved invarious activities, risk-management and-measurement techniques, appropriate internalcontrols, and the examination process from thefollowing perspectives:

• Global applicability The manual is not

di-rected at trading at any one type of institution(commercial bank, branch/agency, other) butis meant to apply to capital-markets andtrading activities at all financial institutions tobe examined

• Portfolio The manual attempts to broaden our

review of trading operations from a by-product approach to a portfolio andfunctional-activity approach This method bet-ter reflects the multiple uses of financialinstruments by institutions, their relationshipto other instruments and activities on or off thebalance sheet, and attendant correlations

product-• Types of risk The manual identifies the range

of risks—market, credit, liquidity, tional, legal, and other risks—relevant to thereview of capital-markets and trading activi-ties, and discusses their management on afunctional and legal-entity basis

opera-The manual is divided into four basic tions The first section consists of broad intro-ductory remarks regarding the examination ofmost capital-markets and trading activities,including important considerations in preparingfor the examination and review of capital-markets activities It also discusses the impor-tance of examiner review of the managementorganization of the activity to be examined

sec-The second section presents supervisory ance regarding trading and dealer operations atbanking organizations and specifically detailscertain aspects of the examination process forthese operations In general, the discussion ofeach topic has the following four subsections:• discussion of the general topic

guid-• examination objectives• examination procedures• internal control questionnaire

The focus of the examination objectives,examination procedures, and internal controlquestionnaires is to provide examiners with apractical guide to examining the core areas ofany trading operation Examination objectivesdescribe the goals that should be of primaryinterest to the examiner and determine the scopeof the examination for the specific area ofinterest The examination procedures includeprocedures to be performed during a compre-hensive examination In some instances, not allthe procedures may apply to all financial insti-tutions Thus, examiners have the flexibility,depending on the characteristics of the particularinstitution under examination, to determine theexamination scope and procedures The materi-ality and significance of a given area of opera-tions are an examiner’s primary considerationswhen deciding the scope of the examinationand the procedures to be performed Examinerflexibility results in examinations tailored tothe operations of the banking institution Afterdetermining the proper objectives and pro-cedures, the examiner will have an organizedapproach to examining the institution’s tradingprocesses Core topics include the following:• market risk

• credit risk• settlement risk• liquidity risk• operations and systems risk• legal risk

• financial performance• capital adequacy of trading activities• accounting

• regulatory reporting• regulatory compliance• ethics

The third section of this manual offers visory guidance regarding various bankingactivities and functions that are not trading-related but are directly linked with capital-markets and Treasury operations While tar-geted primarily at larger institutions, the generalprinciples identified in this section are applica-ble to activities at institutions of all sizes Thissection presents the latest Federal Reserve

supervisory guidance on issues such as rate risk management within the banking book,securitization and secondary-market creditactivities, securities and end-user derivativeactivities, and other topics In some cases, theguidance consists of Federal Reserve super-vision and regulation (SR) letters on specifictopics In others, formal examination-manualtreatments are presented that include exam pro-cedures and internal control questionnaires.

interest-The fourth section of this manual presentsprofiles of specific financial instruments com-monly encountered in capital-markets and trad-ing activities An examiner’s understanding ofthese instruments is crucial to successful imple-mentation of a capital-markets examination.While the write-ups are not intended to providein-depth and fully comprehensive coverage ofeach instrument, they do present basic instru-ment characteristics and examination consider-ations In general, each instrument profile con-tains discussions in the following areas:

• general description• characteristics and features• uses

• description of the instrument’s market• pricing conventions

• hedging issues• discussion of the risks involved• accounting treatment

• risk-based capital considerations• bank-eligibility requirements• references for further information

When assigned to review a particular product,the examiner should first review the appropriateinstrument profile to become familiar with thecharacteristics of and the marketplace for theproduct The examination objectives, examina-tion procedures, and internal control question-naires will often be applicable across any num-ber of instruments and products Therefore,coordination with examiners who are reviewingother products is essential

Presettlement Risk2021 Counterparty Credit Risk and

Settlement Risk2030 Market Liquidity Risk of Trading

Activities2040 Operations and Systems Risk

(Management Information Systems)2050 Operations and Systems

Risk (Front-Office Operations)2060 Operations and Systems Risk

(Back-Office Operations)2070 Legal Risk

2100 Financial Performance2110 Capital Adequacy2120 Accounting2130 Regulatory Reporting2140 Regulatory Compliance2150 Ethics

ACTIVITIES

3000 Investment Securities and

End-User Activities3005 Liquidity Risk3010 Interest-Rate Risk Management3020 Securitization and Secondary-Market

Credit Activities3030 Futures Brokerage Activities and

Futures Commission Merchants3040 Equity Investment and Merchant

Banking Activities

4000 Introduction

4005 Federal Funds4010 Commercial Paper4015 Repurchase Agreements4020 U.S Treasury Bills, Notes, and Bonds4025 U.S Treasury STRIPS

4030 Treasury Inflation-Indexed Securities4035 U.S Government Agency Securities4040 Structured Notes

4045 Corporate Notes and Bonds4050 Municipal Securities4055 Eurodollar Certificates of Deposit4105 Asset-Backed Securities and

Asset-Backed Commercial Paper4110 Residential Mortgage–Backed

Securities4205 Australian Commonwealth

Government Bonds4210 Canadian Government Bonds4215 French Government Bonds

and Notes4220 German Government Bonds

and Notes4225 Irish Government Bonds4230 Italian Government Bonds

and Notes4235 Japanese Government Bonds

and Notes4240 Spanish Government Bonds4245 Swiss Government Notes

and Bonds4250 United Kingdom Government

Bonds4255 Brady Bonds and Other

Emerging-Markets Bonds4305 Foreign Exchange

4310 Forwards4315 Forward Rate Agreements4320 Financial Futures4325 Interest-Rate Swaps4330 Options

4335 Currency Swaps4340 Swaptions4345 Equity Derivatives4350 Credit Derivatives4353 Collateralized Loan Obligations4355 Commodity-Linked Transactions

SUBJECT INDEX

Section 1000.1

The globalization of markets, increased tion volume and volatility, and the introductionof complex products and trading strategies haveled capital-markets and trading activities to takeon an increasingly important role at financialinstitutions over the last decade These activitiesinclude the use of a range of financial productsand strategies, from the most liquid fixed-income securities to complex derivative instru-ments The risk dimensions of these productsand strategies should be fully understood, moni-tored, and controlled by bank management.Accordingly, adequate risk-management sys-tems and controls at financial institutions areessential to prevent losses and protect capital.The role of regulators in supervising capital-markets and trading activities is to evaluatemanagement’s ability to identify, measure, moni-tor, and control the risks involved in theseactivities and to ensure that institutions havesufficient capital to support the risks they take.The level of risk an institution may reasonablyassume through capital-markets and tradingactivities should be determined by the board ofdirectors’ stated tolerance for risk, the ability ofsenior management to effectively govern theseoperations, and the capital position of theinstitution

transac-OVERVIEW OF RISK

For capital-markets and trading activities, risk isgenerally defined as the potential for loss on aninstrument, portfolio, or activity Thus, the risksreferred to in this manual will be discussed interms of the impact of some event on value(value-at-risk) and income (earnings-at-risk)from the instrument, activity, or portfolio beingaddressed

Risk management is the process by whichmanagers identify, assess, monitor, and controlall risks associated with a financial institution’sactivities The increasing complexity of thefinancial industry and the range of financialinstruments have made risk management moredifficult to accomplish and to evaluate In moresophisticated institutions, the role of risk man-agement is to identify the risks associated withparticular business activities and to aggregatesummary data into generic components, ulti-mately allowing exposures to be evaluated on acommon basis This methodology enables insti-

tutions to manage risks by portfolio and toconsider exposures in relationship to the insti-tution’s global strategy and risk tolerance

A financial institution’s risk-management cess should not only be assessed by businessline, but also in the context of the global,consolidated institution A review of the globalorganization may reveal risk concentrations notreadily identifiable from the limited view of abranch, agency, Edge Act institution, nonbanksubsidiary, or head office on a stand-alone basis.The consolidation of risk information also allowsthe institution to identify, measure, and controlits risks, while giving the necessary consider-ation to the breakdown of exposure by legalentity Sometimes, if applicable rules and lawsallow, identified risks at a branch or subsidiarymay be compensated for by offsetting exposuresat another related institution However, thismanagement of risks across separate entitiesmust be done in a way that is consistent with theauthorities granted to each entity Some finan-cial institutions and their subsidiaries may notbe permitted to hold, trade, deal, or underwritecertain types of financial instruments, includingsome of those instruments discussed in the 4000sections of this manual, unless they have spe-cifically received regulatory approval Further-more, conditions and commitments may beattached to regulatory approvals to engage incertain capital-markets activities Examinersshould ensure that financial institutions have theproper regulatory authority for the activitiesthey engage in and that activities are conductedconsistent with their specific regulatory approvals.Ideally, an institution should be able to iden-tify the relevant generic risks and should havemeasurement systems in place to conceptualize,quantify, and control these risks on an insti-tutional level using a common measurementframework However, it is recognized that notall institutions have an integrated risk-management system that aggregates all businessactivities In addition, risk-management meth-odologies in the marketplace and an institution’sscope of business are continually evolving, mak-ing risk management a dynamic process None-theless, an institution’s risk-management systemshould always be able to identify, aggregate, andcontrol all risks posed by capital-markets andtrading activities that could have a significantimpact on capital or equity

Examiners need to determine the ability of theinstitution’s risk-management system to mea-sure and control risks The assessment of risk-management systems and controls should beperformed by type of instrument and type ofrisk Some of the risks inherent in the tradingprocess are described below:

• Market (price) risk is the risk that the value of

a financial instrument or a portfolio of cial instruments will change as a result of achange in market conditions (for example,interest-rate movement)

finan-• Funding-liquidity risk refers to the ability to

meet investment and funding requirementsarising from cash-flow mismatches

• Market-liquidity risk refers to the risk of being

unable to close out open positions quicklyenough and in sufficient quantities at a reason-able price to avoid adverse financial impacts

• Counterparty credit risk is the risk that a

counterparty to a transaction will fail to form according to the terms and conditions ofthe contract, thus causing the holder of theclaim to suffer a loss in cash flow or marketvalue

per-• Clearing/settlement credit risk is (1) the risk

that a counterparty who has received a ment or delivery of assets defaults beforedelivery of the asset or payment or (2) the riskthat technical difficulties interrupt delivery orsettlement despite the counterparty’s ability orwillingness to perform

pay-• Operations and systems risk is the risk of

human error or fraud or the risk that systemswill fail to adequately record, monitor, andaccount for transactions or positions

• Legal risk is the risk that a transaction cannot

be consummated because of some legal rier, such as inadequate documentation, aregulatory prohibition on a specific counter-party, and nonenforceability of bilateral andmultilateral close-out netting and collateralarrangements in bankruptcy

bar-• Reputational risk is the risk arising from

negative public opinion regarding an tion’s products or activities

institu-The examiner must be prepared to identifyand evaluate exposures that arise out of any partof a capital-markets operation To that end, theexaminer must become familiar with the insti-tution’s overall reporting structure and segre-gation of duties, range of business activities,global risk-management framework, risk-

measurement models, and system of internalcontrols Furthermore, the examiner must assessthe qualitative and quantitative assumptionsimplicit in the overall risk-management sys-tem and the effectiveness of the institution’sapproach to controlling risks In addition, theexaminer must determine that the managementinformation system and other forms of commu-nication are adequate for the institution’s levelof business activity

Banking supervision is a dynamic process andthis is especially evident in the oversight ofcapital-markets and trading activities As capitalmarkets, financial instruments, and secondary-market activities continue to expand anddevelop, they have an increasingly significantimpact on the safety and soundness of financialinstitutions Consequently, it has become equallynecessary for bank supervisors to focus theirattention on the capital-markets and tradingactivities arena Policies and practices for evalu-ating the exposures, management tools, andcontrols employed by banking institutions havehad to be constructed and adapted to keep pacewith changes in the industry In this context,the manual encourages the examiner to ask thefollowing basic questions:

• Are the tools employed by management tomeasure and monitor risk exposure adequate?• Is the level of risk exposure appropriate giventhe financial institution’s size, sophistication,and financial condition?

• Are the risks in the institution’s portfolioof products and activities recognized, under-stood, measured, and managed?

• Are the activities conducted consistent withthe goals and risk tolerance of senior manage-ment and the board of directors?

To prepare for the on-site portion of theexamination of any capital-markets or tradingactivity, a preliminary overview of the range ofproducts and activities of the institution shouldbe developed This overview will help examin-ers formulate a scope and objective for theupcoming exam that is consistent with the typesand levels of risk exposure assumed by theinstitution

PREEXAMINATION REVIEW

The review of trading activities is generally

conducted on the basis of a financial tion’s organizational structure These structuresmay vary widely depending on the size andsophistication of the institution, the markets andgeographies in which it competes, and theobjectives and strategies of its management andboard of directors.

institu-Many banks and bank holding companieshave several subsidiaries that conduct businessindependent of affiliated entities, and somebranches and agencies may operate autono-mously The overlap of business lines, sharingof information and personnel, and transactionnetting agreements that exist among affiliatedlegal entities force examiners to go beyond thebasic business-unit review and focus on func-tional exposures within the global institution Itis also important for an examiner to ensure thatan institution respects divisions between legalentities, such as firewall and bank/nonbankseparations For example, while a bank holdingcompany must be aware of the level of itsconsolidated risk, it cannot ignore legal bound-aries completely in the management of that risk.Exposure in the bank is not automatically hedgedby offsetting positions in the bank holdingcompany and vice versa In some cases, trans-actions may be offset by a transaction betweenthese affiliates which may, however, be subjectto other regulatory requirements Bank holdingcompanies should manage and control riskexposures on a consolidated basis, while recog-nizing legal distinctions among subsidiaries.Examiners should always maintain a view ofthe ‘‘big picture’’ impact of capital-marketsand trading activities on consolidated riskexposure

The examiner team should meet before theexamination begins to summarize the institu-tion’s status and assign responsibilities for com-pleting preparatory work Generally, examina-tion assignments may be segregated based onproducts, activities, or functions For example,for trading operations, examiners may be givenadministrative responsibility for the followingareas of review:

• interest-rate products including fixed-incomesecurities, swaps, futures, forward-rate agree-ments (FRAs), options, caps, and floors• currency-related activities including customer-

driven and discretionary foreign-exchange(FX) trading, cross-currency transactions, andcurrency derivatives (for example, currencyoptions, forwards, futures, and swaps)

• equity-based products and activities includingequity options, warrants, and swaps

• commodity-based products and activitiesincluding commodity futures, options, andforwards

Other capital-markets activities, such as assetsecuritization or secondary-market creditactivities may be assessed by specific activity,function, or product

To prepare examiners for their assignments,the following initial procedures should be fol-lowed to achieve the required scope and cover-age of the institution’s activities

• Determine the extent of work performed ing the past year by auditors and regulatoryagencies (these would include, but not belimited to, the institution’s internal auditors,the various exchanges, the Securities andExchange Commission, the CommodityFutures Trading Commission, the NationalAssociation of Securities Dealers, the NationalFutures Association, and the Internal RevenueService)

dur-• Review deficiencies identified by audit reportsand reports of examination

• Obtain a listing of the names, qualifications,functions, and positions of key trading andfront- and back-office personnel, and a currentorganizational chart This material should beavailable in prior examination and inspectionreports

• Evaluate the volume of transactions and thedollar value of positions held in each tradingproduct and activity These data may be foundin various regulatory reports

• Using the audit findings on the effectivenessof controls over capital-markets and tradingactivities, evaluate the examination scope toassess organizational and reporting changes,identify perceived weaknesses, and highlightpatterns of error

BACKGROUND REVIEW

Specific items which should be reviewed duringthe preexamination process for capital-marketsand trading activities include the following:

• Regulatory reports During the planning stages

of an examination, the examiners may mate activity volumes and diversity of instru-

ments and activities from periodical tory reports This information will help in thedevelopment of an examination scope andobjective, as well as in the determination ofstaffing and resource requirements.

regula-• Prior report of examination The findings and

conclusions of the prior examination areinvaluable to the preparation of the scope andobjectives of the current examination Exami-nation reports provide insight into bank man-agement’s policies and practices in measuringand managing risk, the extent of risk exposurein a given product and/or activity, and theoverall adequacy of the trading-activity con-trol environment

• Audit reports Internal and external audits are

often focused on the activities of individualbusiness units and may not encompass aggre-gate exposures and controls Nevertheless,they are useful in identifying exceptions tointernal policies and specific violations suchas limit exceptions Management’s responsesto audit findings are also useful in identifyingcorrective actions and the direction of the unit

• Correspondence since the last examination.

An additional resource that should be viewed before an examination is the corre-spondence file This will contain importantinformation such as management’s responseto the prior examination findings, any appli-cations submitted to the Federal Reserve (foradditional powers, mergers, and acquisitions),and any supervisory action or agreement thatmay exist

re-• Outstanding applications The

examiner-in-charge should inquire about the status of anyoutstanding applications before the FederalReserve Board that may suggest expansion inthe capital-markets and trading activities ofthe banking institution

FIRST-DAY LETTER

In preparation for an on-site examination, iners will often need to customize the first-day-letter questionnaire to reflect the specific focusof the capital-markets review The focus willreflect the range of products and activities of theinstitution as well as management’s approach to

exam-risk control The following is a brief list of corerequests to be made in the first-day letter:• a copy of the organization charts (including

name and title of managers) for the markets or global-trading operations to beassessed, including functional and legal-entityorganization

capital-• a copy of the institution’s written management policies and procedures that out-line the instruments traded, their associatedrisks, and the monitoring of the risks• a copy of established limits for each principal

risk-type of risk as well as documentation ing periodic approval by the board of directors• general-ledger and subsidiary-ledger accountsidentifying the range and level of activity as ofthe examination date

indicat-• management information reports used in theglobal, functional, or legal-entity oversight ofmarket- and credit-risk management• detailed information on transactions that are

unique or uncommon• copies of management reports issued in con-

nection with the bank’s new financial productsthat were put in place since the last examina-tion indicating the office at which such activ-ity is conducted, the lines and limits estab-lished for each activity, and the perceivedrisks associated with each activity

• a description of the scope and frequency ofinternal and external audits of the institution’scapital-markets and trading activities and cop-ies of audits, including working papers, con-ducted of capital-markets operations since thelast examination

The first-day letter to an institution thatengages in capital-markets or trading activitiesand the use of derivatives usually will be muchmore precise and comprehensive than this list,depending on the institution’s range of productsand activities Significantly more detail shouldbe requested relative to the objectives of thetrading operations, the activities in which theinstitution engages, the products it uses, and therisk-management methods and reports it relieson The first-day letter should also includerequests for detailed information related to theareas highlighted in the market, credit, liquidity,and operational risk sections of this manual

Section 1010.1

Obtaining an overview of the organization, agement structure, product universe, and controlenvironment of a financial institution’s capital-markets and trading activities is a critical initialstep in the examination process This overviewcan be developed by applying the examinationprocedures listed in this manual, which enablethe examination team to understand the institu-tion’s legal-entity and managerial structures andthe scope and location of its activities, and toevaluate policies, procedures, and actual prac-tices An overview also helps the examiner toidentify broad internal control processes andgain insight into how effectively they covertrading activities Finally, the overview helpsidentify significant changes in operations andthe rationale for those changes

man-Evaluating the capital-markets, trading, andmarketing activities conducted by the financialinstitution can be a complicated task that may becompounded by the lack of a clear distinctionbetween bank and nonbank powers granted to aninstitution A number of institutions will shiftpositions among legal entities to facilitate riskmanagement along product or geographic-market lines Therefore, the overview or orga-nizational structure is central in evaluatingwhether the financial institution has separatedactivities as required by law and regulation

The examiner-in-charge is responsible forevaluating the organizational structure, activi-ties, overall risk-management system, and con-trols of the global-trading and capital-marketsoperations at the highest organizational level Ina U.S financial institution, this would generallybe the bank holding company level Examinersshould be aware that organization and struc-ture can differ significantly among financialinstitutions

OPERATIONAL AND LEGALSTRUCTURE OF THE FIRMAND ITS CAPITAL-MARKETSACTIVITIES

The ownership structure includes the geographiclocations and legal-entity divisions of an insti-tution’s relevant banking and nonbanking opera-tions, including holding companies, significantaffiliated entities, and separately capitalized unitssuch as section 20 or limited purpose ‘‘venture’’

entities Other organizational structures includebranches, agencies, subsidiaries, joint ventures,or portfolio investment partnerships Some ofthese entities may be registered with regulatoryagencies such as the Securities and ExchangeCommission (SEC), National Association ofSecurities Dealers (NASD), and CommodityFutures Trading Commission (CFTC) and mayhave affiliations with, or membership in, stockand commodities exchanges worldwide Theseorganizations may impose constraints on theactivities of an institution, and the examinationteam should be aware of the scope, conclusions,and timing of any examinations, inspections,and reviews conducted by other regulatorybodies

Depending on the powers granted to it by thecountry having jurisdiction, a diversified multi-national banking organization may use a varietyof functional management structures which crosslegal-entity boundaries to invest, trade, under-write, or deal in trading products Functionalmanagement lines may be introduced to facili-tate decision making An institution may clearits own trading products, provide clearingservices for customers, or maintain clearingand settlement relationships with correspondentfinancial institutions The examiner shouldreview these operations as well as the reasonsand results of significant reorganizations, par-ticularly if the entities have exceptional earningsprofiles

To manage and control activities on a globalbasis, a financial institution should have pro-grams established to identify where it conductsactivities both by business entity and by legalentity These programs should document howactivities are monitored on an ongoing basis andreported to senior management The examinershould review the adequacy of the managementinformation system from a reporting and auto-mation perspective The most recent internaland external audit reports covering the bankinginstitution’s capital-markets and trading activi-ties should be evaluated to identify any defi-ciencies related to organizational structure andseparation of duties For additional guidance,

examiners should refer to the Bank HoldingCompany Examination Manual, specifically sec-

tion 2185.0 on nonbank section 20 subsidiariesengaged in dealing and underwriting and the3000 sections on nonbank activities, including

securities brokerage, foreign-exchange advisory,futures commission merchant, primary dealer,and a wide range of other underwriting anddealing activities.

Risk-Management Organization

Risk management is the process of monitoring,controlling, and communicating to senior man-agement and the board of directors the natureand extent of risk from capital-markets andtrading activities The board of directors hasa regulatory mandate to set and periodicallyapprove an institution’s limit levels, given itstolerance for risk Senior management shouldregularly evaluate the risk-management proce-dures in place to ensure they are appropriate andsound Senior management should also fosterand participate in active discussions with theboard of directors, staff of risk-managementfunctions, and traders regarding procedures formeasuring and managing risk Management mustalso ensure that capital-markets and tradingactivities are allocated sufficient resources tomanage and control risks

Personnel responsible for the risk-managementfunction should be separate from trading-floorpersonnel In contrast to the measurement andassessment of risk exposures, the day-to-daymanagement of exposures by trading staff mayfollow a decentralized, product- or portfolio-specific approach Therefore, an independentsystem for reporting exposures to both senior-level management and the board of directorsis an important element in the overall risk-management process

A review of the structure of managerialreporting lines is helpful in determining thefinancial institution’s capacity to identify andmanage risk The reporting lines may be struc-tured by legal entity, by functional lines ofresponsibility, or along business or profit-centerlines The examiner should request the organi-zation chart to identify overlaps in the legal andoperational structures and should cite possibleviolations of section 20 firewall provisions orother regulations which require strict separationof activities Examiners should be aware ofspecial conditions appearing in authorizationsfor the board of directors Potential conflictsof interest of board members should also beevaluated

Risk management can be performed globally,concentrating on the institution’s generic cate-

gories of risk, locations, and activities, or byfunctional department, specific product, or port-folio Global risk-management reports shouldclearly describe the elements of risk; provide aquantifiable description of the amount of capitalallocated to capital-markets and trading activi-ties; and identify limits on market, credit, and

operational risks Examiners should be awarethat a global approach to risk analysis can failto identity specific risk levels in specific prod-ucts, functions, or activities Conversely, func-tional decentralized approaches can miss con-solidated risks Risk-analysis methods whichincorporate aspects of both approaches aremore effective.

Financial institutions should have highly fied personnel throughout their capital-marketsand trading teams, including those in functionsresponsible for risk management and internalcontrol The personnel of independent risk-management functions should have a completeunderstanding of the risk associated with allon- and off-balance-sheet instruments that aretransacted Accordingly, compensation policiesfor these individuals should be adequate toattract and retain qualified personnel As amatter of general policy, compensation policies,especially in the risk-management, control, andsenior-management functions, should be struc-tured to avoid potential incentives for excessiverisk taking that can occur if, for example,salaries are tied too closely to the profitability ofcapital-markets and trading activities

quali-BUSINESS LINES AND SERVICES

Financial institutions identify primary businesslines in a variety of ways In trading operations,the transaction activity of different instrumentsmay be subdivided into financial engineering,sales and distribution, underwriting, market mak-ing, proprietary trading and advisory services,and others The grouping of activities mayprovide insight into the market strategy or com-petitive advantage of an institution, its capitaland risk-limit allocation, and its concentrationof risk Transaction-activity groupings may helpto identify the managerial and operational syn-ergy between business and product lines andbetween affiliated entities

Institutions may specialize in trading specifictypes of instruments and offer services tailoredto their customers The degree of diversity in the

range of business lines and services is a measureof the banking organization’s capacity to estab-lish a presence in those markets Diversity ofbusiness lines can be an early indicator ofpotential imbalances in an institution’s resourceallocation, such as too broad a range of unsu-pervised activities or dependence on too narrowa range of activities.

Products and services that an institution hasbegun offering or discontinued since the previ-ous examination should be identified Businessstrategies which discuss any planned or recentchanges to the business should be reviewed Arestructuring in business lines and services mightbe used to camouflage problems such as recog-nizing illegal profits or incurring large losses orbreaches of internal limits, controls, regulations,or banking and securities laws The examinershould refer all exceptional or unusual findingsto the examiner-in-charge Initiation of newproducts or new business initiatives should beformally approved by the board of directorsafter thorough research into all relevant aspectsof the product

Banking regulations provide for limitationsand restrictions on permissible activities forbanking organizations and their nonbank subsid-iaries A review of specific products and ser-vices is an additional check for identifying thebanking organization’s adherence to applicablelegal or regulatory requirements To ensure theadequacy of internal accounting, clearing, andsettlement of transactions, banking institu-tions should document the methods used tocollect and monitor information on all tradedinstruments

MANAGEMENT ANDCOMPENSATION STRUCTURE

Capital-markets and trading management tures may be organized by legal entity, businessline, profit center, or a combination thereof.Regulatory conditions as well as safe-and-soundbanking practices often require the separation ofmanagerial duties Overlaps should be reviewedfor compliance with regulations, ethical stan-dards, and safety-and-soundness concerns

struc-Background reviews include the evaluation ofmanagement expertise and character Resumesshould be reviewed to determine whether keymanagers in trading, sales, operations, and com-pliance have been or are currently registered

with any nonbank securities regulators (forexample, provisions such as NASD Series 7 orCFTC commodity or exchange requirementssuch as ‘‘registered principal’’) The reviewsshould indicate whether management or tradingand sales personnel have been cited for viola-tions of securities laws, mentioned in criminalreferrals to state or federal officials and arecurrently or have been under statutory super-vision or periods of disqualification underNASD, New York Stock Exchange (NYSE), orother self-regulatory organization (SRO) rules

The review should indicate whether ment or trading and sales personnel are allowedto trade for their own accounts Policies directedat the personal-investment activities of staff, aswell as the areas responsible for monitoring andcontrolling them, should be identified The com-pensation structure of key principals, includingcurrent and deferred salary, bonus, commission,equity participation, or other remuneration,should be described Loans between the insti-tution and key management should also beidentified Compensation practices should bereviewed to determine that the independence ofthose involved in risk-management oversightis not compromised by direct benefit from theprofits of the risk-taking function Finally, theprofiles section should comment on the reasonsfor resignations or reassignments of key manag-ers, traders, and salespeople

manage-The growing level of sophistication of capitalmarkets requires experienced management withappropriate credentials to understand complextrading instruments and their associated risk-management techniques The level of experi-ence required to understand quantitative analy-sis and advanced risk-based sensitivity analysisshould be commensurate with the sophisticationof the firm’s activities

Any deficiencies in management’s capacity tounderstand and control the instruments or thetypes of risk associated with them are cause forregulatory concern However, the determinationof deficiencies must be based on a fair andimpartial assessment of the products traded andthe institution’s future business plans

GENERAL POLICIES ANDPROCEDURES

The adequacy of policies and procedures forcapital-markets and trading activities should be

evaluated against the complexity and volume offinancial transactions Policies and proceduresshould be written and include, at a minimum, amission statement, limits approved by the boardof directors, procedures for reviewing limits, alist of traders and their assignments, the organi-zation’s structure and responsibilities, permis-sible activities, an approved list of brokers,counterparties, dealing guidelines, and anexplicit dispute-resolution methodology Further-more, the institution should have a code ofethics for employees, a policy for personaltrading, investment guidelines, a detaileddescription of transaction processing, and rec-

onciliations and accounting procedures ing a chart of accounts

includ-Policies and procedures should require thatcapital-markets and trading activities are undersenior management review and subject to peri-odic audit An internal audit department shouldbe organizationally and functionally separatefrom trading-management oversight and shouldreport to the board of directors of the institution.In institutions that are more active in trading,other organizational units should provide anindependent assessment of the profitability andrisk inherent in these activities

Section 2000.1

Risk is an inevitable component of tion and trading activity Given the fundamentaltrade-off between risks and returns, the objec-tive of regulators is to determine when riskexposures either become excessive relative tothe financial institution’s capital position andfinancial condition or have not been identified tothe extent that the situation represents an unsafeand unsound banking practice

intermedia-Determination of whether the institution’srisk-management system can measure and con-trol its risks is of particular importance Theprimary components of a sound risk-managementprocess are a comprehensive risk-measurementapproach; a detailed structure of limits, guide-lines, and other parameters used to govern risktaking; and a strong management informationsystem for monitoring and reporting risks Thesecomponents are fundamental to both trading andnontrading activities Moreover, the underlyingrisks associated with these activities, such asmarket, credit, liquidity, operations, and legalrisks, are not new to banking, although theirmeasurement can be more complex for tradingactivities than for lending activities Accord-ingly, the process of risk management for capital-markets and trading activities should be inte-grated into the institution’s overall risk-management system to the fullest extent possibleusing a conceptual framework common to thefinancial institution’s other business activities.Such a common framework enables the institu-tion to consolidate risk exposure more effec-tively, especially since the various individualrisks involved in capital-markets and tradingactivities can be interconnected and may tran-scend specific markets

The examiner must apply a multitude ofanalyses to appropriately assess the risk-management system of an institution Theassessment of risk-management systems andcontrols may be performed in consideration ofthe type of risk, the type of instrument, or byfunction or activity The examiner must becomefamiliar with the institution’s range of businessactivities, global risk-management framework,risk-measurement models, and system of inter-nal controls Furthermore, the examiner mustassess the qualitative and quantitative assump-tions implicit in the risk-management systemas well as the effectiveness of the institution’sapproach to controlling risks The examiner

must determine that the computer system, agement information reports, and other forms ofcommunication are adequate and accurate forthe level of business activity of the institution

man-GLOBAL RISK-MANAGEMENTFRAMEWORK

The primary goal of risk management is toensure that a financial institution’s trading,position-taking, credit extension, and opera-tional activities do not expose it to losses thatcould threaten the viability of the firm Globalrisk management is ultimately the responsibilityof senior management and the board of direc-tors; it involves setting the strategic direction ofthe firm and determining the firm’s tolerance forrisk The examiner should verify that the riskmanagement of capital-markets and tradingactivities is embedded in a strong global (firm-wide) risk-management system, and that seniormanagement and the directors are actively in-volved in overseeing the risk management ofcapital-markets products

Role of Senior Managementand the Board of Directors

Senior management and the board of directorshave a responsibility to fully understand therisks involved in the institution’s activities,question line management about the nature andmanagement of those risks, set high standardsfor prompt and open discussion of internalcontrol problems and losses, and engage man-agement in discussions regarding the events ordevelopments that could expose the firm tosubstantial loss The commitment to risk man-agement in any organization should be clearlydelineated in practice and codified in writtenpolicies and procedures approved by the boardof directors These policies should be consistentwith the financial institution’s broader businessstrategies and overall willingness to take risk.Accordingly, the board of directors should beinformed regularly of the risk exposure of theinstitution and should regularly reevaluate theorganization’s exposure and its risk toleranceregarding these activities Middle and senior

management, including trading and control staff,should be well versed in the risk-measurementand risk-management methodology of the finan-cial institution.

Senior management is responsible for ing that adequate policies and procedures forconducting long-term and day-to-day activitiesare in place This responsibility includes ensur-ing clear delineations of responsibility for man-aging risk, adequate systems for measuring risk,appropriately structured limits on risk taking,effective internal controls, and a comprehensiverisk-reporting process

ensur-The risk-management mandate from seniormanagement and the board of directors shouldinclude—

• identifying and assessing risks• establishing policies, procedures, and risk

limits• monitoring and reporting compliance with

limits• delineating capital allocation and portfolio

management• developing guidelines for new products and

including new exposures within the currentframework

• applying new measurement methods to ing products

exist-The limit structure should reflect the measurement system in place, as well as thefinancial institution’s tolerance for risk, given itsrisk profile, activities, and management’s objec-tives The limit structure should also be consis-tent with management’s experience and theoverall financial strength of the institution

risk-In addition, senior management and the boardof directors are responsible for maintaining theinstitution’s activities with adequate financialsupport and staffing to manage and control therisks of its activities Highly qualified personnelmust staff not only front-office positions such astrading desks, relationship or account officers,and sales, but also all back-office functionsresponsible for risk management and internalcontrol

Comprehensiveness of theRisk-Management System

The examiner should verify that the global management system is comprehensive and

risk-adequately identifies the major risks to whichthe institution is exposed The global risk-management system should cover all areas ofthe institution, including ‘‘special portfolios’’such as exotic currency and interest-rate optionsor specially structured derivatives At a mini-mum, the global risk-management system shouldprovide for the separate institution-wide mea-surement and management of credit, market,liquidity, legal, and operational risk

The evaluation of the firm’s institution-widerisk relative to the firm’s capital, earningscapacity, market liquidity, and professional andtechnological resources is an essential responsi-bility of senior management The examinershould also verify that senior management over-sees each of the major risk categories (credit,market, liquidity, operational, and legal risk)

Examiners should ascertain whether the cial institution has an effective process to evalu-ate and review the risks involved in productsthat are (1) either new to the firm or new to themarketplace and (2) of potential interest to thefirm In general, a bank should not trade aproduct until senior management and all rele-vant personnel (including those in risk manage-ment, internal control, legal, accounting, andaudit) understand the product and are able tointegrate the product into the financial institu-tion’s risk-measurement and control systems.Examiners should determine whether the finan-cial institution has a formal process for review-ing new products and whether it introduces newproducts in a manner that adequately limitspotential losses

finan-Financial institutions active in the derivativesmarkets generate many new products that arevariants of existing instruments they offer Inevaluating whether these products should besubject to the new-product-evaluation process,examiners should consider whether the firm hasadequately identified and aggregated all signifi-cant risks In general, all significant structuralvariations in options products should receivesome form of new-product review, even whenthe firm is dealing in similar products

ORGANIZATIONAL STRUCTUREOF RISK MANAGEMENT

Examiners should evaluate the company’s nizational structure and job descriptions to makesure that there is a clear understanding of the