Fund Management

Funds Management and LiquidityEffective date July 1997 Section 3200.1

Funds management is an essential element ofsound planning and financial management forany financial institution. A sound basis forevaluating funds management requires under-standing the branch, its customer mix, the natureof its assets and liabilities, and its economic andcompetitive environment. No single theory canbe applied universally to all branches. Thepurpose of funds management is to ensureadequate liquidity and effectively manage thespread between interest earned and interest paid.Therefore, funds management has two compo-nents: liquidity and interest rate risk manage-ment. This section primarily addresses liquidity.Interest rate risk management is addressed inSection 3210 of this manual, and should be readin conjunction with this section.

LIQUIDITY

Liquidity is defined as the ability to meet assetand liability obligations without delay, includingthe funding of loan commitments. In a soundliquidity management system, it is essential fora branch to provide for fluctuations in its bal-ance sheet and meet immediate or day-to-dayobligations as opposed to providing funds forlong-term growth.

A branch generally has both internal andexternal sources of liquidity. Internal sources ofliquidity include short-term, high-quality assetsthat are readily convertible to cash at a reason-able cost. External sources of liquidity includeborrowings from related offices of the foreignbanking organization (FBO), other financialinstitutions, and overnight or short-termdepositors.

The price of liquidity is a function of generalmarket conditions and the markets perceptionof the FBO. Generally, the higher the risk profileof the FBO, the higher the FBOs cost of fundsand the greater its need to meet liquidity demandsthrough the management of its liabilities. Gen-erally, the market perception of the branch canbe no better than the market perception of theFBO.

BRANCH/FBO RELATIONSHIP

Liquidity at a branch is closely integrated with

that of the FBO. While a branch, on a standalone basis, may be able to obtain sufficientfunding at a reasonable cost (by either increas-ing funding sources or converting assets tocash), from a market standpoint, there is nodistinction between the branch and the FBO.Even if all of the branchs assets consisted ofhigh-quality, liquid securities, liquidity wouldstill be influenced by the market perception ofthe FBO as a whole.

In evaluating funds management and liquid-ity, the examiner should begin with an under-standing of the FBOs current financial situationand be familiar with any potential liquidityconcerns that could affect the branch.1 Gener-ally, if the FBO is in sound financial conditionand has satisfactory market ratings, the evalua-tion of liquidity at the branch will be a lesserconcern. In such a case, the examiner shouldlimit the analysis of liquidity to (1) reviewinginformation supporting the adequacy of liquidityat the FBO, (2) developing a thorough under-standing of the branchs funds management andliquidity profile, and (3) reviewing how thebranchs funding and liquidity are guided andmonitored, either directly or indirectly, by thehead office and/or a U.S. regional office.

In contrast, if the FBOs current financialcondition or market perception raises concernsregarding funds management and liquidity, theexaminer should conduct a more in-depth evalu-ation of branch liquidity. The evaluation shouldconsider the branchs funds management profilewith close attention to: (1) funding sources;(2) liquidity and funding gaps; (3) funds man-agement policy guidance from the head office;(4) current economic and market conditions; and(5) the adequacy of the contingency fundingplan. The examiner should be prepared to makerecommendations to address any identified orpotential concerns at the branch and, if appro-priate, at other U.S. or U.S.-managed or con-trolled offshore operations.

FBOs with multiple U.S. operations may cen-tralize funds management and liquidity at aregional U.S. office. The examination of such aregional U.S. office, therefore, should include anevaluation of funds management and liquidity

1. This information is available to examiners as a part ofthe FBOs annual strength of support assessment. Examinersshould review this assessment as a part of the pre-examinationplanning process, and be prepared to consider this informationin evaluating the branchs funds management and liquidity.

Branch and Agency Examination Manual September 1997Page 1

for the branchs entire area of responsibility,including any U.S.-managed or controlled off-shore operations.

FUNDS MANAGEMENT ANDLIQUIDITY PROFILE

The examiner should understand and evaluatethe branchs funding and liquidity profile.Regardless of the condition of the FBO, thebranchs funding profile, or whether the branchmanages its own funding needs, this reviewshould begin with an understanding of the FBOsfunds management guidelines and practices forthe branch. Head office should provide branchmanagement with funds management and liquid-ity guidelines and some method of daily moni-toring compliance with these guidelines. Gener-ally, the greater the complexity of the branch orits responsibilities in funds management andliquidity, the more comprehensive the guide-lines and monitoring practices.

A major point to consider in evaluating branchliquidity is whether the FBO views the branch asa net user or provider of funds. The examinershould determine if the FBO has been a consis-tent supplier of funds, or whether the branch actsas a dollar funding vehicle for the FBO. Thisdetermination, which is particularly important ifthe FBO raises liquidity concerns, will be evi-dent from the trend in the net Due Fromposition with related parties. The examinershould review a period of branch quarterlyReports of Assets and Liabilities (FFIEC 002) todetermine the direction, volume, and frequencyof the flow of funds between the branch and itshead office or other related parties, includingU.S.-managed or controlled offshore operations.The examiner should take into considerationthat an analysis of quarter-end reports may notprovide a true picture of ongoing activities dueto certain types of balance sheet window dress-ing activities employed by the branch. Averagestatements of condition should be obtained inorder to get a true picture of branch liquidityover time. From a supervisory viewpoint, a netdue to position is regarded more favorably thana net due from position because it provides acushion for nonrelated depositors and creditors.However, any recommendations related to thebranchs funding role should be considered inrelation to the FBOs overall financial conditionand other factors discussed in this section. For

additional information on funding transactionswith related parties, refer to Section 3240, DueFrom/Due To Related Parties.

The evaluation of funds management andliquidity should also consider the branchs costand distribution of funds; economic and markettrends; levels of liquid assets; future earningscapacity; asset quality; concentrations; customermix; the nature and mix of its assets andliabilities, including maturity, currency andrepricing mismatches; and its anticipated fund-ing needs. Generally, these considerations aremore significant if the branch manages its ownfunding and liquidity needs.

The remaining discussion is applicable tobranches that are not simply net users of fundsand have some degree of control over theirfunds management.

POLICY GUIDANCE

Branch management is expected to maintainpolicies and procedures approved by head officethat facilitate the development of funding andliquidity strategies. Policies and proceduresshould provide an outline of goals regarding theFBOs asset and liability management, liquidity,off-balance-sheet exposure, degree of risk toler-ance, and other relevant factors. The individualor committee responsible for funds managementdecisions, including monitoring anticipated fund-ing needs, funding strategies, guidelines andlimitations, should be specified in the policiesand procedures. The depth of these policies andprocedures will depend upon the degree towhich branch management is responsible forfunds management. In some cases, the headoffice or U.S. regional management is largelyresponsible for funds management at the branch.In other cases, responsibility rests with localbranch management.

Policy statements should address limitationson funding sources to avoid a concentration toany one source or grouping. They also shouldidentify alternative funding sources, the degreeof support dictated by the FBO, and the natureof that support. Interest rate sensitivity match-ing, maturity matching, and the use of financialderivatives may be addressed under these poli-cies or in a separate interest rate risk policy.Written procedures should provide staff with areference document on the day-to-day proce-

3200.1 Funds Management and Liquidity

September 1997 Branch and Agency Examination ManualPage 2

dures in funding and provide for a system ofinternal control in critical areas, such as separa-tion of duties, proper completion of reports, andmonitoring of limits. Refer to Interest Rate RiskManagement, Section 3210 for additional infor-mation on policies and procedures.

MANAGEMENT INFORMATIONSYSTEMS

An effective Management Information System(MIS) is integral to making sound funds man-agement and liquidity decisions and is a factorin evaluating the branchs financial controls.Reports containing certain basic informationshould be prepared and reviewed regularly bymanagement. Report content and format willvary among branches; however, an effectiveMIS will contain reports detailing liquidity needsand the sources of funds available to meet thoseneeds. Typically MIS may include the follow-ing: the maturity distribution of assets andliabilities, and the related gaps, including maxi-mum and minimum liquidity needs; expectedfunding of commitments; asset yields; liabilitycosts; net interest margins and variances (bothfrom prior months and budget); funding vol-umes by liability, customer, market, andovernight/short-term funds; and exceptions topolicy guidelines and limits. Refer to Section3410, Management Information Systems, foradditional information.

FUNDING AND LIQUIDITYPRACTICES

A branch responsible for its own funding andliquidity needs may meet those needs bymanipulating its asset structure through the saleor planned runoff of short-term or readily mar-ketable assets. As an alternative, the branchcould transfer to the head office or other relatedoffices, a block of assets that would serve toreduce its asset base and increase liquidity. As amatter of general practice, however, a branchcan meet its liquidity needs by manipulating itsliability structure to access discretionary fund-ing sources or derive funds from its intercom-pany funding base. The ability of a branch toaccess discretionary funding sources is ulti-mately a function of the position and reputationof the FBO in the money markets. An FBO with

a good reputation affords its branches easieraccess to funds at market rates.

The ability to obtain additional fundingsources represents liquidity potential. The mar-ginal cost of liquidity or the cost of incrementalfunds acquired is of paramount importance inevaluating liability sources of liquidity. Consid-eration must be given to factors such as howfrequently the branch must regularly refinancematuring liabilities and an evaluation of thebranchs ongoing ability to obtain funds undernormal market conditions. The obvious diffi-culty in estimating the latter is that until thebranch goes to the market to borrow, it cannotdetermine with complete certainty that fundswill be available at a price that will maintain apositive yield spread. Changes in money marketconditions or the FBOs reputation and/or finan-cial strength may cause a rapid deterioration in abranchs capacity to borrow at a favorable rate.In this context, liquidity potential represents theability to attract funds in the market, whenneeded, at reasonable cost compared to assetyield.

Frequently, the base rate for funding costs onmoney market transactions is available only tothe largest and most financially sound institu-tions. Some branches may pay in excess of thebase rate for money market funds, with thedifferential denoting the markets perception ofthe FBO and home country conditions. The sizeof the premium compared to other FBOs can bea rough indication of the stability of fundingsources in this market. As indicated earlier, ifthe FBO carries a rating of AAA or AA by anindependent rating agency, it is unlikely thatfunding and liquidity will be an examinationissue. If the FBO carries a lower rating or has nomarket presence, the probability that there maybe funding and liquidity concerns grows propor-tionately and funds management and liquidityare more critical.

FUNDING AVAILABILITY

Management at the branch and head office mustbe constantly aware of the composition, charac-teristics, and diversification of its fundingsources. If possible, the branch should securefunding lines from multiple sources. In certaininstances, the branch may be using suballocatedlines from its head office. With multiple sourceadvised discretionary lines of credit, the branch

Funds Management and Liquidity 3200.1


is much better positioned to manage usage androtation in order to ensure availability of fundsat competitive pricing. The role of the FBO inthis circumstance would be to provide backupresources and to be the ultimate lender forcontingency purposes.

Nevertheless, many interbank credit agree-ments contain escape provisions, known as mate-rial adverse change clauses, that enable thelending bank to refuse to allow the borrowingbank to draw on advised credit lines. Bankingorganizations experiencing considerable prob-lems, particularly those relating to asset qualityand/or liquidity, have found that these facilitiesare no longer available. Such escape provisionsshould be considered in the assessment of fundsmanagement and liquidity.

CONTINGENCY FUNDING

Examiners should determine if management atthe branch has an effective contingency plan thatidentifies minimum and maximum liquidityneeds both in normal and adverse market con-ditions, and weighs alternative courses of actionto meet these needs. The branch may rely onback-up funding lines or support from the headoffice or other related offices to meet unforeseenliquidity demands. In this case, examiners shouldcomment on the FBOs ability to meet theseneeds.

HOME COUNTRY FUNDINGRESTRICTIONS

An FBOs home country may impose restric-tions on capital outflows. Such impediments

could defeat the attempts of the FBO to aid thebranch in the event of a liquidity crisis. For thisreason, the examiner should investigate homecountry funding restrictions.

TRANSFER RISKCONSIDERATIONS

The stability and availability of funding shouldbe related to the distribution of assets, takinginto consideration certain assets subject to trans-fer risk. Potential liquidity problems may existwhen a branch relies heavily on the U.S. moneymarket for funding, while its assets are concen-trated in a country with serious economic prob-lems. In such a case, the branch is typically in anet due from position with the FBO and prob-lems may arise if the FBO or borrowers do nothave ready access to U.S. dollars to meet theirobligations. Refer to Section 6020, TransferRisk, for additional information.

OFF-BALANCE-SHEETCONSIDERATIONS

The nature, volume and anticipated usage ofoff-balance- sheet activity must be factored intothe assessment of funds management and liquid-ity. The potential for funding contingent liabili-ties varies widely, but the most likely to requirefunding are loan commitments. Economic con-ditions and the business cycle may also influ-ence anticipated usage. The branch should havesufficient existing funding sources to provide foranticipated usage, in view of the nature andvolume of its contingent liabilities.

3200.1 Funds Management and Liquidity


Funds Management and LiquidityExamination ObjectivesEffective date July 1997 Section 3200.2

1. To assess the branchs ability to obtain stablefunding sources from related and unrelatedparties.

2. To determine if reasonable local policies,procedures, and parameters have been estab-lished and approved by the head office forthe branchs liquidity position and if thebranch is operating within those establishedguidelines.

3. To evaluate the management of assets, liabili-ties, and off-balance-sheet positions to deter-mine if management is planning adequately

for liquidity and if the branch can effectivelymeet anticipated and potential liquidity needs.

4. To determine if internal management reportsprovide the necessary information forinformed liquidity decisions and monitoringtheir results, and that reports are regularlyprovided and reviewed by head office.

5. To recommend corrective action when poli-cies, practices, procedures, or internal con-trols are deficient or when violations of lawor regulations have been noted.


Funds Management and LiquidityExamination ProceduresEffective date July 1997 Section 3200.3

1. Evaluate the funding relationship betweenthe branch and the FBO. Consider the rea-sons why the branch is in a net due from ordue to position with related offices and affili-ates of the FBO.

2. Review the Funds Management and Liquid-ity policies, practices, and procedures andtest for compliance. Ensure that there are:a. Lines of authority and responsibility for

liquidity management decisions.b. Formal mechanisms to coordinate funds

management and liability decisions.c. Methods to identify liquidity needs and

the means to meet those needs.d. Guidelines for the level of liquid assets

and funding sources in relation to antici-pated and potential needs.

e. Appropriate controls and supervision ofthe volume of loan commitments andother off-balance sheet exposure that mayimpact funding and liquidity.

3. Determine if management has planned prop-erly for liquidity and if the branch hasadequate sources of funds to meet anticipatedor potential needs by:a. Reviewing the internal management reports

detailing liquidity requirements and sourcesof liquidity.

b. Evaluating primary and secondary sourcesof funds.

c. Determining whether funding and liquid-ity requirements are factored into the bud-geting process and are based on growthprojections, changes in the branchs assetand liability mix, and other anticipatedchanges.

4. Evaluate the effectiveness of the internalmanagement reporting system in providingfor adequate liquidity management.

5. Discuss the following issues with manage-ment and summarize findings in the workpa-pers and, to the degree necessary, for theexamination report:a. The quality of the branchs planning and

the current ability of the branch to meetanticipated and potential liquidity needs.

b. The quality of administrative control andinternal management reporting systems.

6. Update the workpapers with any informationthat will facilitate future examinations. Dis-cuss with senior branch management thefindings of the examination regarding thebranchs funding and liquidity policies andpractices, and document the discussion in theworkpapers.


Funds Management and LiquidityInternal Control QuestionnaireEffective date July 1997 Section 3200.4

1. Is the FBO in less than satisfactory condi-tion and subject to liquidity concerns?

2. Is the FBO subject to market disciplinarypricing?

3. Does the FBOs home country imposerestrictions on capital outflows?

4. Has the branch and head office manage-ment, consistent with its duties and respon-sibilities, adopted funds management poli-cies, practices and procedures which include:a. Lines of authority, and responsibility

for funds management and liquiditydecisions?

b. A formal mechanism to coordinate fundsmanagement and liquidity decisions?

c. A method to identify funding and liquid-ity needs and the means to meet thoseneeds?

d. A contingency funding plan that pro-vides guidelines for the level of liquidassets and other sources of funds inrelationship to anticipated and potentialneeds?

e. An adequate system of internal controlsin critical areas, such as separation ofduties, proper MIS reporting and moni-toring of limits?

f. Transfer risk considerations?5. Does the FBO view the branch as net user

or provider of funds?If the branch is a net user of funds:a. Does the branch have a funding and

liquidity profile that identifies the branchas a non-risk taker?

b. Are funds management and liquiditydecisions centralized at an FBO locationwithin the U.S. that is subject to regula-tory supervision?

If the branch is a net provider of funds,answer the following questions; otherwiseproceed to question 12.

6. Have internal management reports beenprepared that provide an adequate basis for

making ongoing liquidity managementdecisions and for monitoring the results ofthose decisions?

7. Do management reports include the follow-ing:a. Maturity distribution of assets and

liabilities?b. Expected funding commitments?c. Asset yields and liability costs?d. Net interest margin and variance analysis

(e.g., previous month, quarter, year-to-date and budget reporting)?

e. Funding volumes by type of liability(e.g., overnight/short-term funds), cus-tomer and market?

f. Exceptions to policy guidelines andlimits?

8. Does the planning and budgeting functionconsider funding and liquidity requirements?

9. Does the branchs contingency funding planaddress:a. Minimum and maximum liquidity needs

and alternative courses of action to meetthose needs?

b. Alternative sources of funding?c. Orderly asset liquidation?

10. Have adequate discretionary (back-up) linesof credit been established?

11. Are advised discretionary lines of creditcontaining adverse change clauses consid-ered by branch management in its contin-gency funding plan?

12. Is the information covered by this ICQadequate for evaluating internal controls inthis area? If not, indicate any additionalexamination procedures deemed necessary.

13. Based on the information gathered, evaluatethe internal controls in this area (i.e., strong,satisfactory, fair, marginal, unsatisfactory).


Interest Rate Risk ManagementEffective date July 1997 Section 3210.1

Interest rate risk (IRR) is an aspect of normalbanking operations that became increasinglyimportant in the United States with the deregu-lation of interest rates in the early 1980s. Thephaseout of interest rate controls and increasedcompetitiveness, the latter of which was partlydue to the growing presence of foreign banks inU.S. markets, significantly increased the flexibil-ity of banks in adjusting their IRR profiles. Thisflexibility has been further enhanced by thedevelopment of new financial instruments usedto hedge against or profit from interest ratechanges.

In order to maintain profitability, safety, andsoundness, institutions should fully comprehendthe risks associated with changes in interestrates and should have adequate policies andsystems in place for controlling these risks. Inthis regard, the branch and its head officemanagement both have important responsibilities.

The head office is responsible for providingclear policy guidance to branch management oncontrolling and monitoring IRR. The policiesprovided to branch management by the headoffice should indicate acceptable levels of risk-taking, given the branchs role in the foreignbanking organization (FBO), and establish pro-cedures and controls to ensure that there is anadequate system for measuring IRR and moni-toring compliance with established limits. Inthis regard, there should also be a reportingprocess that demonstrates adherence with estab-lished limits and an adequate system of internalcontrols.

It is recognized that, as part of a larger entity,IRR management for certain branches may becentralized within the FBO. Whether or not thebranch is responsible for managing its IRR,there should be evidence at the branch, in theform of IRR policy guidelines, managementreports, etc., showing how this risk is beingeffectively identified, measured, and controlledfor the branch.The following discussion pro-vides an overview of IRR considerations, whichthe examiner should use in reviewing, to theextent applicable, this area of risk within thebranch.

INTEREST RATE RISK

IRR is defined as a branchs vulnerability tochanges in interest rates. IRR arises from differ-

ences in the maturities or repricing dates of assetand liability positions, and cash flows. However,risk may remain in a given branchs portfolio inwhich long and short positions of differentmaturities are well hedged against a uniformchange in all interest rates, but not against achange in the shape of the yield curve whereinterest rates of different maturities change byvarying amounts. This type of risk is calledyield-curve risk. Similarly, a branch may bewell hedged against yield curve risk but exposedto basis risk, in which the prices of particularassets and liabilities, as well as hedging instru-ments, are not perfectly correlated. For example,three-month interbank deposits priced at LIBOR,three-month Eurodollars and three-month Trea-sury bills all pay three-month interest rates.However, these three-month rates are not per-fectly correlated with each other and spreadsbetween their yields may vary over time. As aresult, three-month Treasury bills, for example,funded by three-month interbank deposits arenot a perfectly hedged position. Given a rise ordecline in interest rates, a branchs interest rateexposure can be viewed as the potential forchange in its reported earnings.

Focusing on the sensitivity of a branchsreported earnings to changes in interest ratesrepresents an accounting perspective of IRRassessment. In general, this approach involvesassessing the effect that changing rates mighthave on the revenues produced by interest-earning assets, the expense of interest-bearingliabilities, and the resulting net interest incomeof the branch. Risk to current earnings measuresthe timing of income effects, which can help riskmanagers determine what action to take regard-ing exposure.

RISK MEASUREMENTTECHNIQUES

Branches can use a variety of methods to mea-sure their IRR exposure. The three most com-mon generic methods are maturity gap analysis(used to measure the interest rate sensitivity ofearnings), duration analysis, and simulation mod-eling. While these methods highlight differentfacets of IRR, many branches use them incom-bination or use hybrid methods that combinefeatures of each.


Maturity Gap Analysis

Maturity gap analysis begins with constructing amaturity gap report. This report categorizesasset and liability accounts, including off-balance-sheet items, according to the timeremaining to their maturities in specific timeperiods, known as repricing buckets. Thesebuckets vary from branch to branch, but mostbranches include time bands of overnight, over-night to one month, one month to three months,three months to six months, six months to oneyear, and beyond one year. Categorizing assetsand liabilities lacking definitive repricing timeframes into specific time periods (or buckets)varies by institution. As a result, the assump-tions used by each institution should be reviewedby the examiner to ensure that they are reason-able. This approach reflects the accounting orcurrent earnings orientation of gap reports.

For each time period or bucket, rate-sensitiveliabilities (RSL) are subtracted from rate-sensitive assets (RSA) to yield the dollar matu-rity mismatch or gap . The gap measure is eithera positive or negative dollar amount and is theprimary tool used to assess the impact of changesin interest rates on the institutions net interestincome.

A negative gap (liability sensitive) indicatesthat more liabilities than assets will reprice in agiven time period. During periods of risinginterest rates, net interest income would beadversely affected because the interest expenseon liabilities during that period would show agreater increase relative to the increase in inter-est earnings on assets. If rates decline, a bankwith a negative gap would expect its earnings tobe enhanced because more liabilities than assetswould reprice at lower rates.

Conversely, a positive gap (asset sensitive)indicates that more assets than liabilities willreprice in a given time period. In this case,earnings tend to increase as interest rates increasebecause more assets than liabilities reprice athigher rates.

The maturity gap of an institution is the mostbasic measure of IRR. It is a static measure thatassumes the current balance sheet remains con-stant through time and a given change in interestrates is not reversed over time. For this reason,it may not accurately reflect a branchs true riskexposure. In addition, its emphasis on the risk toshort-term earnings inadequately addresses therate sensitivity of longer-term fixed rate instru-

ments, the value of which can change dramati-cally without affecting short-term interest income.

Some simple forms of maturity gap analysisidentify only the amount of assets and liabilitiesat risk and ignore basis risk. Basis risk refers tothe likelihood that changes in interest rates abranch pays on liabilities and earns on its assetsare not perfectly correlated. That risk is present,even when the assets and liabilities are matchedin terms of their maturity or repricing periods.Despite these shortcomings, most branches usematurity gap analysis or some variant, as onecomponent of IRR measurement. Many brancheselaborate on the simple gap framework in orderto gain insight into the more complex aspects ofIRR.

While the maturity gap of an institution is awidely used indicator of IRR, it is not a suffi-cient measure for gauging overall exposurewhen taken alone. A branchs condition andsize, complexity of the balance-sheet and off-balance-sheet activities (if any), degree of com-petition, and sophistication of the markets beingserved also must be considered. For example, asmall, retail-oriented branch may have moder-ately large negative gap positions but may notbe exposed to major risks. Factors that mayminimize such risks are the branchs strong coredeposit base within its target market.

Duration Analysis

Duration analysis is used to calculate theweighted average maturity of the cash flowsemanating from financial instruments. In con-trast to the simple average nominal cash flows,duration provides more meaningful, analyticalmeasures of a stream of cash flows. The durationmeasure can be used to calculate the percentagechange in the present value of a stream of cashflows that is generated by a one percentage pointchange in interest rates. Duration analysis canmeasure the exposure of a branchs currentincome to changes in interest rates.

Duration analysis can complement gap analy-sis. Using gap repricing data and selected ratedata, duration provides a more accurate measureof IRR. Duration analysis, unlike gap analysis,accounts for the time value of money by calcu-lating the present value of future cash flows. Inso doing, it properly aggregates the branchsrepricing mismatches or gaps. Thus, durationcan be used to analyze the risk standing of a

3210.1 Interest Rate Risk Management


branch with a complicated series of repricingmismatches. Like gap analysis, duration analy-sis generally assumes that the repricing structureof a branchs assets and liabilities remainsconstant. In addition, duration analysis requiresinformation on cash flows that may not alwaysbe available.

Used in conjunction with maturity gap analy-sis, duration analysis can add significant insightsinto the IRR exposure of an institution. How-ever, duration also has some limitations, inparticular:

The duration measure becomes less accurateas the amount of the interest rate changeincreases;

The duration of different instruments willchange at different rates as time passes, result-ing in a hedged position becoming unhedgedover time; and,

Duration alone does not address the dispersionof cash flows in a branchs portfolio.

Simulation Modeling

Simulation techniques attempt to overcome thelimitations of both the static gap and durationmeasures by computer-modeling the branchsinterest rate sensitivity. Such modeling involvesmaking assumptions about the future course ofinterest rates and changes in a branchs businessactivity and estimating their effect on thebranchs net interest income. Branches candevelop their own simulation packages or choosefrom a variety of commercially availablepackages.

A simulation model can provide branch man-agement with an important tool for understand-ing the measurement of, and assisting in themanagement of, IRR, and for evaluating thebranchs exposure under a variety of interestrate scenarios. Simulation techniques can alsoplay an integral planning role in evaluating theeffect of alternative business strategies on riskexposure. Unlike other methods, simulation cananticipate the effect of changes in customerbehavior induced by interest rate changes (suchas time deposit rollovers, in retail branches).

The usefulness of simulation techniquesdepends on the validity of the underlyingassumptions and the accuracy of the basic struc-ture upon which the model is run. If theseassumptions do not fairly reflect the branchs

internal and external environment, the resultsobtained will not be meaningful.

ASSESSMENT OF IRRMANAGEMENT

Examiners should focus on the presence of clearand comprehensive policies with correspondingappropriate internal controls when assessing themanagement of IRR. The policies should outlinethe following: the objectives of risk manage-ment, clear lines of authority and communica-tion, and limits on the vulnerability of netinterest income to changes in interest rates. Riskmanagement systems and procedures should beadequate and consistent with the stated policiesof risk management.

Strong internal management controls need tobe maintained given the potential impact ofinterest rate exposure on a branchs earnings.These controls include policies, risk measure-ment systems, and reporting mechanisms. Eachof these should be reviewed from twoperspectives:

Does management understand and effectivelyadminister IRR controls?

Do these controls establish reasonable param-eters considering the specific IRR profile ofthe branch?

In larger branches, IRR may be managed byan Asset/Liability Management Committee(ALCO), which is composed of senior branchmanagers who represent units that undertakeIRR. ALCO is responsible for formulating andadministering branch strategy with regard toIRR, which is based on managements view ofthe future interest rate environment, the branchsrelative ability to adjust to changing marketconditions, and the head offices risk-acceptancelevel. The activities of ALCO, including theimplementation of IRR policies, should bereviewed for approval by the head office.

Additionally, in the cases where IRR manage-ment is centralized at a particular branch of theFBO, the following question must be consid-ered: Is the process of transferring a givenbranchs IRR to the portfolio of the branchhousing the centralized IRR management func-tion adequately governed by appropriate poli-cies and accurate reporting mechanisms?

Interest Rate Risk Management 3210.1


POLICIES

The need for established and properly super-vised IRR policies has increased greatly inrecent years. An adequate policy facilitates thedevelopment of a prospective plan that consid-ers the branchs goals regarding its asset andliability mix, off-balance-sheet activities, liquid-ity, risk tolerance, and other relevant factors.The policy should establish responsibility forIRR management decisions and provide a mecha-nism for the necessary coordination among dif-ferent departments of the branch, or betweendifferent branches of the FBO, as appropriate.

In addition to establishing responsibility forplanning and day-to-day IRR decisions, thepolicy should set forth certain guidelines:

Interest rate exposure limits should be estab-lished relative to reasonable forecasts andassumptions;

Limits should be based on the potential impactof interest rate changes on the branchs netinterest income;

Individual limits should be set for units thatincur IRR;

Clear lines of authority and communicationshould be established for the implementationand execution of strategies; and,

For those branches that are not authorized toincur or manage IRR, the policy should clearlyoutline procedures for accurately and effec-tively transferring the IRR incurred by itsnormal business activities to a designatedbranch or other office of the FBO responsiblefor the centralized management of IRR.

In most cases branches accomplish the trans-fer of IRR incurred by a given transaction byentering into an offsetting, "mirror" transactionwith the office responsible for managing thebranchs IRR. As an example, if a branchentered into a five-year, fixed- rate loan, it couldbook a five-year, fixed-rate liability to the relatedoffice to fund the loan; the maturity and princi-pal amount should be matched.

RISK MANAGEMENT SYSTEMS

The effectiveness of assessing IRR through theuse of a risk management system depends to alarge degree on the branchs ability to measureits exposure. Risk management systems arebased on a quantitative assessment of exposure

(as previously discussed) and managementsadaptation and analysis of that assessment. Thesesystems should be:

Consistent with established limits; Comprehensive, covering the rate risk associ-

ated with all asset, liability, and off-balancesheet accounts;

Capable of identifying excessive exposure; Capable of measuring the impact of rate

changes on the branchs chosen targetaccount(s);

Flexible, so that the introduction of newinstruments and changes in strategy can beabsorbed and accounted for; and,

Able to suggest strategies for corrective action.

REPORTING MECHANISMS

Strong lines of communication and authority areessential to the timely execution and adjustmentof a branchs IRR strategy because earnings canbe rapidly eroded by unexpected rate changes.In particular, when risk management responsi-bilities are delegated to those most familiar withparticular products or markets, the need forcommunication becomes stronger, so that posi-tions in one market are not excessively magni-fied by positions elsewhere.

Coordination between the branch and headoffice management and business units that incurIRR is essential to the successful control of IRR.This is especially important when the businessunit incurring IRR is another branch of the FBO.Controls should focus on the following:

Branch and head office management should beregularly apprised of the nature and results ofrisk management decisions undertaken by thebranch;

Branch and head office management should beprovided with periodic status reports detailingrisk exposure;

Treasury management should have periodiccontact with branch line managers responsiblefor undertaking risk;

Risk-taking units should be aware of limitsestablished by head office and/or branch man-agement, with limit exceptions regularly moni-tored and communicated to senior manage-ment; and,

Units not allocated risk limits should providethe branch responsible for its IRR manage-

3210.1 Interest Rate Risk Management


ment with reports detailing not only the unitscurrent positions, but potential or plannedtransactions, as well.

PRICING

Conclusions drawn from the analysis of thebranchs interest rate sensitivity position restupon the assumption that the branch has anadequate asset-pricing mechanism. A pricingmechanism that is not attuned to the branchscost of funds, overhead costs, and credit riskwill not allow the branch to maintain an adequatenet interest margin on an ongoing basis. Thus,the examiner should bear in mind the interde-pendence of pricing methods and interest ratesensitivity when assessing the branchs ability tomaximize and maintain the spread betweeninterest earned and interest paid.

An important component of pricing is the costof funds. Bankers generally price from either theaverage cost of funds or the marginal cost offunds. The average cost of funds is a weightedaverage of all of the rates paid on interest-bearing liabilities. The marginal cost of funds isdefined as the cost of the additional fundsneeded to support asset growth and is consid-ered by many bankers to be the more econom-ically appropriate method. This view is takenbecause funds on the balance sheet alreadysupport assets held and the cost of those fundsshould not enter into the pricing decision fornew assets.

The marginal cost of funds is not, however,always the best method of pricing because thebranch may be replacing assets, instead ofgrowing. If the branch is only changing its assetmix to compensate the organization for its creditrisk, its average cost of funds, plus overhead andrepricing considerations, represent a moreappropriate pricing measure. Additionally, mar-ket forces, which include the demand for andavailability of funds, should be considered ascomplements to cost factors when making pric-ing decisions. The market in which the branchoperates often dictates the pricing mechanismused.

Branches most often obtain funds from thedomestic interbank money market; however,offshore sources, including related branches andthe head office, are frequently used. In many

cases, a FBO may have to pay an additionalspread over interbank rates for perceived coun-try risk, liquidity risk, or credit risk. For branchesrequired to pay such additional spreads, the sizeand volatility of these premiums should beconsidered in the institutions pricing mechanism.

HEDGING

The examiner should keep in mind that risk maybe reduced by hedging activities when determin-ing the extent of IRR exposure at the branch.These activities may be explicit and easilyquantifiable or they may be implicit and difficultto measure from the branchs managementinformation system.

Types of explicit hedging activities includeinstruments such as futures, interest rate swaps,forwards, options, and various hybrid products.Types of implicit hedging might include interestrate caps and floors on commercial loans; limitson the amount of rate adjustment allowed forproducts, such as adjustable rate mortgages; oreven investment policies that might set internalstop loss limits on various longer-term portfoliopositions. Explicit hedging strategies can eitherbe matched to a specific asset or liability(micro hedges) or be designed to reduce theoverall level of risk in a position (macro orportfolio hedging).

Institutions engaged in hedging activitiesshould have clearly defined policies that outlinespecific hedge strategies and explain how thosestrategies reduce risk. Individuals responsiblefor hedging activity should be designated andoverall position limits should be established.Internal controls should be established to includea system that measures the degree to which ahedge is meeting its stated objective of reducingrisk (hedge effectiveness). Finally, branch man-agement should regularly provide reports to thehead office that, at a minimum, show gains orlosses on hedge instruments and estimates ofhedge effectiveness.

Finally, some entities now use derivativeinstruments in managing IRR. The individualregulatory agencies have issued policy state-ments regarding derivative instruments. Theexaminer should consult with his/her respectiveagency for guidance.

Interest Rate Risk Management 3210.1


Interest Rate Risk ManagementExamination ObjectivesEffective date July 1997 Section 3210.2

1. To evaluate the policies regarding interestrate risk (IRR) formulated by branch andhead office management, including the limitsestablished for the branchs IRR profile.

2. To determine if the branchs IRR profile iswithin those limits.

3. To evaluate the management of the branchsIRR, including the adequacy of the methodsand assumptions used to measure IRR.

4. To determine if internal management report-ing systems provide the information neces-sary for informed interest rate managementdecisions.

5. To recommend corrective action when inter-est rate management policies, practices, pro-cedures, or internal controls are deficient incontrolling and monitoring IRR.


Interest Rate Risk ManagementExamination ProceduresEffective date July 1997 Section 3210.3

1. Determine if there were concerns in theprevious examination report regarding IRR,and if corrective action was required.

2. Determine if IRR is managed at the branchlevel or at another level within the FBO.a. If IRR is managed at the branch level,

proceed to procedure #3.b. If IRR is managed at a higher level

within the FBO: Determine if adequate procedures are

in place for any activities at the branchwhich are required by the managinglevel within the FBO (i.e. personnelauthorized and steps necessary for call-ing in funding requirements).

Provide a description of the activitiesconducted by the managing levelwithin the FBO.

Proceed to procedure #10.3. Review the branchs written policies and

procedures for reasonableness. At a mini-mum, policies should cover:a. Definition and measurement of accept-

able risks, including acceptable levels ofinterest rate exposure.

b. Net interest margin goals.c. Sources and uses of funds.d. Off-balance-sheet activities that affect

interest rate exposure.e. Responsibilities within the branch for

IRR management activities.f. Reporting mechanisms.

4. Evaluate the internal controls and/or theinternal audit function. Determine whetherinternal mechanisms are adequate to ensurecompliance with established limits on IRR.Prepare a brief description of the branchsinternal controls/audit for IRR managementand identify areas in need of improvement.

5. Evaluate management practices. The evalu-ation should include, but not be limited to,the following:a. Determine who is responsible for mak-

ing IRR management decisions (indi-vidual, committee or other), and whetherthis is appropriate, given the level ofexperience and sophistication of theindividuals and the nature of the branchsactivities.

b. Determine who is responsible for mak-ing principal assumptions and param-

eters used in the measurement system(s),and whether this individual or committeereviews the principal assumptions andparameters on a regular basis and updatesthem as needed.

c. Determine who is responsible for imple-menting strategic decisions. Ensure thatthe scope of that individuals authority isreasonable. Determine if any one indi-vidual exerts undue influence over theeconomic forecasts and managementdecisions.

d. Assess branch managements knowledgeof IRR in relation to the size and com-plexity of the branch. In particular, assessmanagements understanding of the meth-ods used by the branch to measure therisk.

e. Determine if new products or hedginginstruments are adequately analyzedbefore purchase.

6. Assess senior management (i.e. lead U.S.office for FBO or head office) oversight ofIRR management. The assessment shouldinclude the following:a. Determine how frequently the policy is

reviewed and approved by senior man-agement (at least annually).

b. Determine whether the results of themeasurement system provide clear andreliable information and whether theresults are communicated to senior man-agement at least quarterly. Reports tosenior management should identify thebranchs current position and relation-ship to policy limits.

c. Determine the extent to which excep-tions to policies and resulting correctivemeasures are reported to senior manage-ment, including the promptness of suchreporting.

7. Evaluate the risk measurement system(s)used by the branch, which should be con-sistent with the size and complexity of itson- and off-balance-sheet activities. Theevaluation should include the following:a. Evaluate whether the risk measurement

systems structure and capabilities areadequate to accurately assess the riskexposure of the branch, support theinstitutions risk management process,


and serve as a basis for internal limitsand authorizations.

b. Evaluate whether the risk measurementsystem is operated with sufficient disci-pline to accurately assess the risk expo-sure of the branch, support the institu-tions risk management process, andserve as a basis for internal limits andauthorizations.

c. Determine whether the assumptions arereasonable given current business condi-tions and the institutions strategic plan,and whether assumptions about futurebusiness are sensitive to changes in inter-est rates.

8. Evaluate the branchs exposure to IRR by:a. Reviewing reports regularly prepared by

management for controlling and moni-toring IRR.

b. Reviewing variance reports, i.e., reportsthat compare predicted and actual results.Comment on whether the risk measure-ment system has made reasonably accu-rate predictions in earlier periods.

c. Determining whether the level of risk iswithin the limits management has set.

d. Determining the stability of interest mar-gins under varying economic conditionsor simulations (causes of significant fluc-tuations should be identified).

e. Determining the branchs ability to adjustits interest rate exposure, or its ability toeffectively transfer its interest rate expo-sure to the designated unit of the FBOfor IRR management.

9. Contact the examiner responsible for ana-lyzing income and expense to determine the

adequacy of the net interest margin, basedon an analysis of the components of themargin (i.e., interest expense and interestincome). If the margin or any component isunusually high or low, determine:a. If goals have been established for net

interest earnings.b. Managements success in meeting estab-

lished goals.c. The effect of the branchs IRR position

on meeting established goals.d. The effect of the branchs pricing poli-

cies on meeting established goals.e. The effect of any premium charged the

branch on borrowed funds resulting fromany perceived liquidity risk, country risk,or credit risk on meeting establishedgoals.

f. The effect of the branchs credit riskappetite on the margin.

g. The effect of interoffice pricing policiesfor borrowed funds from related offices,and the reliance on these funds, on themargin.

10. Write in appropriate report format and dis-cuss with management:a. The quality of managements ability to

control and monitor IRR.b. The level of the branchs IRR exposure

and an assessment of the associateddegree of risk.

c. The quality of the related administrativecontrols and internal management report-ing systems.

d. The effect of IRR management decisionson earnings.

11. Update the workpapers with any informa-tion that will facilitate future examinations.

3210.3 Interest Rate Risk Management: Examination Procedures


Interest Rate Risk ManagementInternal Control QuestionnaireEffective date July 1997 Section 3210.4

Complete the following questions only if IRR ismanaged at the local level. If IRR is managed atanother level within the FBO, determine thatadequate procedures are in place for any activityrequired of the branch by the managing office.

1. Has branch and head office managementadopted an IRR management policy thatincludes:a. Risk management philosophy and objec-

tives regarding IRR?b. Clear lines of responsibility to either

manage IRR or transfer the branchs IRRpositions to the appropriate unit of theFBO assigned the IRR managementfunction?

c. Defining and setting of limits on IRRexposure?

d. Specific procedures for reporting andapprovals necessary for exceptions topolicies and limits?

e. Plans or procedures management willimplement if IRR falls outside estab-lished limits?

f. Specific IRR measurement system(s)?g. Acceptable activities used to manage or

adjust the institutions IRR exposure,including, when applicable, proceduresfor the transfer of IRR to the unit assignedthe IRR management function?

h. The individuals or committees who areresponsible for IRR managementdecisions?

i. A process for evaluating major new prod-ucts and their IRR characteristics?

2. Have internal management reports beenprepared that provide an adequate basis formaking interest rate management decisionsand for monitoring the results of thosedecisions? Specifically:a. Are reports prepared on the branchs

IRR exposure, using an appropriate mea-surement method?

b. Is historical information on asset yields,cost of funds, and net interest marginsreadily available?

c. Are interest margin variations, both fromthe prior reporting period and from thebudget, regularly monitored?

d. Is sufficient information available to per-mit an analysis of the cause of interestmargin variations?

3. Is the bank in compliance with its policies,and is it adhering to its written procedures?If not, are exceptions and deviations:a. Approved by appropriate authorities?b. Made infrequently?c. Nonetheless consistent with safe and

sound banking practices?4. Does senior management review and approve

the policy at least annually?5. Did senior management review positions,

and the relationship of these positions toestablished limits, at least quarterly?

6. Were exceptions to policies promptlyreported to the senior management?

7. Does one individual exert undue influenceover interest risk management activities?

8. Discuss with senior management the branchsinternal risk measurement model(s) regardto the following:a. Has (Have) internal model(s) been audited

(by internal or external auditors)?b. Does one individual control the model-

ing process, or otherwise exert undueinfluence over the risk measurementprocess?

c. Is the model reconciled to source data toassure data integrity?

d. Are principal assumptions and param-eters used in the model reviewed peri-odically by senior management?

e. Are the workings of, and the assump-tions used in, the internal modeladequately documented and available forexaminer review?

f. Is the model run on the same scenario(s)for which the institutions limits areestablished?

g. Does management compare the histori-cal results of the model to actual results?

CONCLUSION


10. Based on the information gathered, evaluateinternal controls in this area (i.e. strong,satisfactory, fair, marginal, unsatisfactory).


Borrowed FundsEffective date July 1997 Section 3220.1

Borrowed funds include all nondeposit liabili-ties, exclusive of long-term subordinated debt,such as capital notes and debentures. Commonforms of direct borrowing include Federal fundspurchased (overnight and term), bills payable tothe Federal Reserve, interbank deposits (domes-tic or foreign), due bills, short sales from tradingsecurities, and overdrafts on deposit accountsdue from other depository institutions. Indirectforms of borrowing include rediscounted cus-tomer paper, trade bills and bankers accep-tances, securities borrowed, and assets sold withthe endorsement or guarantee of the FBO orsubject to a repurchase agreement. If an FBOissues commercial paper in the U.S., the issu-ance is generally through a U.S. subsidiary andreflected on the books of the branch as a balancedue to related institutions.

When a branch manages its borrowed fundsposition independently from other FBO offices,a complete analysis of its borrowing activitiessince the previous examination should be done.The principal sources of borrowings, the rangeof amounts, frequency, length of time indebted,concentration of borrowings, and reasonsadvanced by management for such borrowingsshould be explored. Some of the more fre-quently used sources and instruments that pro-vide short-term, nondeposit funds are discussedbelow.

INTRACOMPANY/INTERCOMPANYBORROWING

A principal borrowing relationship frequentlyexists between a branch and its head office. Thebranch may also have borrowing relationshipswith other related branches or affiliated compa-nies. The head office frequently serves as aprimary funding source for the branch, but thelevel and nature of borrowing may be deter-mined by other factors, including the branchsrole in the overall funding strategy of the FBO.For example, an FBO will designate one U.S.branch (generally the branch located in theFBOs home state) to provide the funding to allother U.S. branches. To develop a completeunderstanding of the borrowing relationship ofthe branch with the head office and other relatedoffices, the examiner must gain an understand-ing of the funding strategy of the FBO in the

U.S., and should determine the purpose of theborrowing and the reason for the level and flowof funds to various offices.

For FBOs with a controlling interest in a U.S.commercial bank, a borrowing relationshipbetween the commercial bank and offices of theFBO must be explored fully to ensure there areno violations of Sections 23A and 23B of theFederal Reserve Act, inasmuch as the FBO isconsidered a foreign bank holding company.Additional information on intercompany borrow-ing and funding relationships is contained inSection 3240, Due From/Due To Related Offices.

FEDERAL FUNDS PURCHASED

The day-to-day use of Federal funds is common-place among U.S. banking organizations, includ-ing branches of FBOs. The most frequent typeof Federal funds transaction is unsecured, forone day, and repayable the following businessday. The rate is usually determined by overallmoney market rates and by the available supplyof and the demand for funds. Most transactionsare in units of $1 million, although the trading ofsmaller amounts is fairly common dependingupon individual situations. In some instances,where the selling and buying relationshipbetween two financial institutions is a more orless continuing one, a line of credit may beestablished on a funds-available basis. Althoughthe most common transaction is on an over-night unsecured basis, the selling of funds canalso be on a secured basis and for longer periodsof time such as term Federal funds. While termFederal funds are quite common, the selling offunds on a secured basis is quite rare. Securedborrowing is usually done in instances of severecredit risk and/or perceived default. However,according to the Federal Reserve Act, Section23A(c)(1), if an FBO owns a domestic, FDIC-insured subsidiary bank, any extensions of creditby the domestic bank to the FBO must be doneon a secured basis.

INTERBANK DEPOSITS ANDBORROWINGS

Interbank deposits are not defined as borrowingsfor regulatory purposes, and continue to be


reflected as deposits. Interbank deposit instru-ments include certificates of deposits (CDs),Eurodollar deposits or takings (Euro-CDs) anddeposits taken under separate borrowing agree-ments. These funds are generally obtainedthrough the branchs money market deposittaking activities. However, narrowly definingthese instruments as deposits instead of borrow-ings is not universally accepted and, in fact, thenegotiable money market CD and Euro-CD arewidely recognized as primary borrowing vehi-cles. Dependence on CDs and Euro-CDs assources of funds is discussed in Section 3230,Deposit Accounts.

Negotiable CDs and Euro-CDs are generallyused by wholesale branches. They consist ofdeposits over $100,000 and are not consideredcore funds. The major distinction between Euro-CDs and negotiable CDs is that Euro-CDs areprimarily funds from offshore sources. Withmore diverse products entering the market, float-ing rate CDs and floating rate Euro-CDs arebecoming more popular.

REPURCHASE AGREEMENTS

Instead of resorting to direct borrowing, a branchmay sell assets to another bank or some otherparty and simultaneously agree to repurchasethe assets at a specified time or after certainconditions have been met. Securities and loansare often sold under repurchase agreements togenerate temporary working funds. Agreementsof this nature are frequently used because thecost of this type of secured borrowing is gener-ally lower than that of unsecured borrowings,such as Federal funds purchased. Repurchaseagreements should not be confused with resaleagreements (also known as reverse repurchaseagreements). The usual terms for sale of secu-rities under a repurchase agreement require that,after a stated period of time, the seller repur-chases the same securities at a predeterminedprice or yield. U.S. government and agencysecurities are the most common type of instru-ments sold under repurchase agreements becausethey are exempt from reserve requirements.

Management should be aware of certain con-siderations and potential settlement risks asso-ciated with repurchase agreements entered intoin large volume with institutional investorsand/or brokers. If the value of the underlyingsecurities exceeds the price at which the repur-

chase agreement was sold, the branch could beexposed to the risk of loss in the event that thebuyer is unable to perform and return thesecurities. This possibility is more likely if thesecurities are physically transferred to the insti-tution or broker with which the branch hasentered into the repurchase agreement. For thisreason, branches should avoid, if possible, pledg-ing excessive collateral. However, most transac-tions today do not involve the physical transferof securities, rather they involve a book entrysystem which can reduce settlement risk. Thebranch should obtain sufficient financial infor-mation on and analyze the financial condition ofthose institutions and brokers with whom theyengage in repurchase transactions.

Branches engaging in repurchase agreementsshould include these transactions when calculat-ing their interest rate sensitivity positions. Inaddition, the degree to which a branch borrowsthrough repurchase agreements should be ana-lyzed with respect to its liquidity needs, andcontingency plans should provide for alternatesources of funds in the event of a run-off ofrepurchase agreement liabilities.

LINES OF CREDIT FROMCORRESPONDENT BANKS

Lines of credit with correspondent banks may beon an advised or unadvised basis. Advised (alsoknow as committed or fee paid) lines of creditprovide a reliable source of back-up funding tothe branch, in that the correspondent bank iscommitted to lend under the specified terms ofthe credit facility. Unadvised lines of credit arenot committed facilities and access to suchfunds can be denied by the correspondent bank.On occasion, branches negotiate loans fromtheir principal correspondent banks. The loansare usually for short periods and may or may notbe secured. Lines of credit to finance tradetransactions evidenced by letters of credit canresult in the correspondent bank financing thebranch for an additional period of time, after asight draft drawn under a letter of credit hasbeen presented at the correspondent bank.

SHORT-TERM DEBT

Short-term borrowings may be found in a branch,both on a direct and indirect basis. Borrowings

3220.1 Borrowed Funds


on a direct basis are usually evidenced bypromissory notes, or through accounts with thehead office or a correspondent bank. Indirectforms of borrowing include notes and trade billsrediscounted; notes, acceptances, import drafts,or trade bills sold with the branchs endorsementor guarantee; notes and other obligations soldsubject to repurchase agreements; and accep-tance pool participations.

LONG-TERM DEBT

On an infrequent basis, long-term debt borrow-ings may be found in a branch. The most

common form of long-term debt is direct termborrowings from correspondent banks. Branchesare usually more interested in attracting long-term funds through the U.S. capital markets fortheir head office than issuing long-term debt fortheir own utilization.

Borrowed Funds 3220.1


Borrowed FundsExamination ObjectivesEffective date July 1997 Section 3220.2

1. To determine if the policies, practices, pro-cedures, and internal controls regarding bor-rowed funds are adequate.

2. To determine if branch officers are operatingin conformity with the established guidelinesof the head office.

3. To determine the scope and adequacy of theinternal/external audit function as it relates toborrowed funds.

4. To determine compliance with laws and regu-lations as it relates to borrowed funds.

5. To determine if the existing level of bor-rowed funds is consistent with the branchsactivities.

6. To determine if the existing rates paid are inline with concurrent market rates.

7. To recommend corrective action when poli-cies, practices, procedures, or internal con-trols are deficient or when violations of lawor regulations have been noted.


Borrowed FundsExamination ProceduresEffective date July 1997 Section 3220.3

1. If selected for implementation, complete orupdate the Internal Control Questionnaire.

2. Determine if deficiencies noted at the previ-ous examination or by internal/external auditshave been addressed by management.

3. Determine the purpose of each type of bor-rowing and whether the branchs borrowingposture is justified in light of its role withinthe FBOs network and other relevantcircumstances.

4. Determine if the branch has adequate contin-gency plans for alternate sources of fundsand if these contingency funding lines areperiodically tested for availability.

5. Prepare, in appropriate report form, and dis-cuss with appropriate management:

a. The adequacy of written policies regard-ing borrowings.

b. The manner in which branch officers areoperating in conformance with establishedpolicy.

c. The existence of any unjustified borrow-ing practices.

d. Any violation of laws or regulations.e. Recommended corrective action when

policies, practices, or procedures are defi-cient; violations of laws or regulationsexist; or when unjustified borrowing prac-tices are being pursued.

6. Update the workpapers with any informationthat will facilitate future examinations.


Borrowed FundsInternal Control QuestionnaireEffective date July 1997 Section 3220.4

POLICY

1. Has the head office approved a written policywhich:a. Outlines the objectives of the branchs

borrowings?b. Describes the branchs borrowing philoso-

phy relative to risk considerations, i.e.,leverage/growth, liquidity/income?

c. Provides for risk diversification in termsof staggered maturities, rather than solelyon cost?

d. Limits borrowings by amount outstand-ing, specific type, or total interest expense?

e. Limits or restricts execution of borrow-ings by branch officers?

f. Provides a system of reporting require-ments to monitor borrowing activity?

g. Requires subsequent approval oftransactions?

h. Provides for review and revision of estab-lished policy at least annually?

RECORDS

2. Does the branch maintain subsidiary recordsfor each type of borrowing, including properidentification of the obligee and a writtenconfirmation?

3. Is the preparation, addition, and posting ofthe subsidiary borrowed funds records per-formed or adequately reviewed by personswho do not also:

a. Handle cash?b. Issue official checks and drafts?c. Prepare all supporting documents required

for payment of debt?4. Are subsidiary records for borrowed funds

reconciled with the general ledger accountsat an interval consistent with borrowingactivity, and are the reconciling items inves-tigated by persons who do not also:a. Handle cash?b. Prepare or post to the subsidiary records

for borrowed funds?5. Has it been determined that borrowings from

U.S. bank subsidiaries conform with applica-ble regulatory restrictions?

6. Are corporate resolutions properly preparedas required by creditors and are copies on filefor reviewing personnel?

7. Are monthly reports furnished to the headoffice management reflecting the activity ofborrowed funds, including amounts outstand-ing, interest rates, interest paid to date, andanticipated future activity?

CONCLUSION


9. Based on the information gathered, evaluatethe internal controls in this area (i.e. strong,satisfactory, fair, marginal, unsatisfactory).


Borrowed FundsAudit GuidelinesEffective date July 1997 Section 3220.5

1. Using an appropriate sampling technique,select items for review of supporting docu-mentation, including terms, balances, andother appropriate details, and request a posi-tive confirmation from the lender. Control allanswered confirmations and investigate anyreported differences. Include all confirma-tions in the workpapers and document thedisposition of all exceptions or no-replies.

2. To the extent appropriate, review collateral-ized transactions for the sufficiency of secu-rity to cover the lenders requirements andensure that the branchs assets pledged ascollateral are clearly identified.

3. Examine supporting documents for accuracyand trace applicable entries, including pro-ceeds, to detail records and to the generalledger.

4. Test interest computations for accuracy andtrace entries to appropriate accounts.

5. Examine transactions for adherence withterms of borrowing arrangements.

6. Review all borrowings requiring head officeapproval for appropriate documentation andauthorization.


Deposit AccountsEffective date July 1997 Section 3230.1

U.S. branches of foreign banking organizations(FBOs) may hold deposits, which representfunds that branch customers have advanced andthe branch is obligated to repay on demand,after a specific period of time, or after expirationof some required notice period. Definitions ofdeposit types (i.e., demand, savings, and NOWaccounts and their respective availabilities) areoutlined in the Federal Reserve Boards Regu-lation D and in the instructions to the Reportof Assets and Liabilities of U.S. Branches andAgencies of Foreign Banks (FFIEC 002). Thenature, type, and level of deposits that a branchmay accept is dependent on a variety of fac-tors, including the licensing agency, applicablestate restrictions, Federal Deposit InsuranceCorporation insurance status, and the limitationsimposed based on the type of office, i.e., depo-sitory or nondepository office. Managementshould have policies in place to ensure compli-ance with all applicable deposit-takingrestrictions.

The majority of U.S. branches of FBOs do notmaintain FDIC insurance and are therefore sub-ject to relevant notification requirementsdescribed in the Federal Deposit Insurance-Insured and Uninsured Branches section of thismanual. These wholesale branches generallymay accept deposits over $100,000 or from U.S.nonresidents. Branches, however, can acceptdeposits of less than $100,000 from residentsprovided the branchs total retail deposits do notexceed 1 of its total deposits. Refer to FDICRules and Regulations Part 346 for additionalinformation. Licensing agencies may apply addi-tional deposit-taking restrictions, which shouldbe incorporated into the reviews scope. Unin-sured branches (non-FDIC-insured) may facelegal limitations on deposits but generally havegreater flexibility in taking borrowed funds.Examiners should review the documentationsupporting deposit and borrowed funds transac-tions to determine that they are properly identi-fied and reported.

Guidelines applicable to offices with FDIC-insured deposits are also available in the sectionon Federal Deposit Insurance- Insured andUninsured Branches.

Some branches use private banking depart-ments to gather and retain large deposit bases.For more information on these depart-ments, see the Private Banking section in thismanual.

REGULATION K SUBPART BSECTION 211.21(B)CREDITBALANCES

As defined in Regulation K, Subpart B, Section211.21(b), Credit Balances, U.S. agencies, asopposed to branches, of FBOs arenotallowed toaccept deposits from U.S. citizens or residents.Agencies may, however, maintain credit bal-ances for U.S. citizens and residents, in additionto taking deposits from foreign residents. Obli-gations are not considered credit balances unlessthey meetall of the following conditions:

Arise out of, or are incidental to the exerciseof other lawful banking powers, such as thedisbursement of loan proceeds, receipt of wiretransfer activities, or arise out of letter ofcredit transactions;

Serve a specific purpose; Are not solicited from the general public; Are not used to pay routine operating expenses

in the United States, such as salaries, rent, ortaxes;

Are withdrawn, within a reasonable period oftime, after the specific purpose for which theywere placed has been accomplished; and

Are drawn upon in a manner reasonable inrelation to the size and nature of the account.

The agencys Report of Assets and Liabilitiesshould correctly show such credit balances.

The remaining discussion applies to thosebranches that rely heavily on retail deposits as afunding source.

DEPOSIT DEVELOPMENT ANDRETENTION PROGRAM

Branch management should adopt and imple-ment a development and retention program forall types of deposits because of competition forfunds, the need for most individuals and corpo-rations to minimize idle funds, and the effect ofdisintermediation (the movement of deposits toother higher- yielding markets) on a branchsdeposit base. The review of a branchs depositdevelopment and retention program and themethods used to determine the volatility andcomposition of the deposit structure are impor-tant elements of the examination process. The


deposit development and retention program isoften included in the funds management policyand should contain a marketing strategy, projec-tions of deposit structure and associated costs,and a formula for comparing results againstprojections.

Marketing Strategy

In determining its market strategy, managementmust first consider many factors, including:

The composition of the market area economicbase, especially the countries targeted by theprivate banking, corporate banking, or corre-spondent banking departments;

The ability to employ deposits profitably; The adequacy of current operations (staffing

and systems) and the location and size ofbanking quarters relative to its volume ofbusiness;

The degree of competition from banks andnonbank financial institutions and their pro-grams to attract deposit customers; and

The effects of the local and foreign economiesand the monetary and fiscal policies of thelocal and foreign government on the branchsmarket area.

After a deposit program is developed, man-agement must continue to monitor those factorsand correlate any findings to determine if adjust-ments are needed. The long term success of anydeposit program relates directly to the ability ofmanagement to detect the need for change at theearliest possible time.

Deposit Structure and AssociatedCosts

Management should not only look at depositgrowth but also at the characteristics of thedeposit structure. Management must be able todetermine what percentage of the overall depositstructure is centered in stable or core deposits, influctuating or seasonal deposits, and in volatiledeposits to properly invest such funds in view ofanticipated or potential withdrawals.

It is important that internal reports with infor-mation concerning the composition of the depositstructure be provided periodically to both branchand head office management. In analyzing thedeposit structure, information gathered by the

various examination procedures should be suf-ficient to allow the examiner to evaluate thecomposition of both volatile and core deposits.Managements lack of such knowledge couldlead to an asset/liability mismatch, which couldcause problems at a later date. Ultimately, theexaminer should be satisfied that managementhas properly planned for the branchs future.

Examiners must analyze the present andpotential effect deposit accounts have on thefinancial profile of the branch, particularly withregard to the quality and scope of managementsplanning. The examiners efforts should bedirected to the various types of deposit accountsthat the branch uses for its funding base. Theexaminers assigned to funds management and toanalytical review of the branchs income andexpenses should be informed of any significantchange in interest-bearing deposit accountactivity.

For branches with a significant deposit base,interest paid on deposits can represent the larg-est expense to the branch. Additional costsassociated with deposits include general operat-ing costs, promotional and advertising costs, andchanges in required reserves. As a result, interest-bearing deposit accounts employed in a margin-ally profitable manner could have significantand lasting effects on branch earnings. Refer tothe Income and Expense Section of this manualfor additional information.

Comparing Results to Projections

Management should have a formula in place forcomparing results against projections. Projec-tions should be periodically reviewed andupdated throughout the fiscal year. Actual resultsshould be periodically compared to projectionsand material variances should be identified andreviewed by management. Typically, the branchsannual budget will include projections for depos-its and associated costs. Refer to the Income andExpense section of this manual for additionalinformation on comparing actual results to thoseprojected.

SPECIAL DEPOSIT-RELATEDISSUES

The examiner should keep in mind the followingissues during an examination to ensure that thebranch is in compliance, where applicable.

3230.1 Deposit Accounts


Abandoned Property Law

State abandoned property laws are generallycalled escheat laws. Although escheat laws varyfrom state to state, they normally require abranch to remit the proceeds of any depositaccount to the state treasurer when:

The deposit account has been dormant for acertain number of years; and

The owner of the account cannot be located.

Service charges on dormant accounts shouldbear a direct relationship to the cost of servicingthe accounts to ensure that the charges are notexcessive. Management should have policiesand procedures in place to review and documentthe basis on which service charges on dormantaccounts are assessed. There have been occa-sions when, because of excessive charges, therewere no proceeds to remit at the time theaccount became subject to escheat requirementsand courts have required banks to reimburse thestate. (Refer to the discussion on dormantaccounts in the subsequent Potential ProblemAreas section.)

Bank Secrecy Act

Examiners should be aware of the Bank SecrecyAct when examining the deposit area and followup on any unusual activities or arrangementsnoted. The Act was implemented by the Trea-sury Departments Financial Recordkeeping andReporting of Currency and Foreign TransactionsRegulation. For further information, see theFederal Reserves Bank Secrecy Act Manual,Section 208.14 of the Federal Reserves Regu-lation H, and other supervisory material. TheFederal Reserves Bank Secrecy Act Manualalso includes information on Know Your Cus-tomer guidelines.

Banking Hours and Processing ofDemand Deposits

The Uniform Commercial Code (UCC) allows abank or branch to establish a banking day cut-offhour of 2:00 p.m. or later for the handling ofitems received for deposit or presented forpayment (UCC 4-108). A banking day is definedas the part of a day on which the bank or branchis open to the public for substantially all of its

banking functions (UCC 4-104(a)(3)). Forbranches with retail deposit-taking activities, abanking day generally includes, at a minimum,operation of a teller window and the bookkeep-ing and loan departments. Items received on anonbanking day or after the cut-off hour on abanking day may be processed as if received onthe following banking day.

A branch that violates the cut-off hour couldbe subject to civil liability for not performing itsduties under other provisions of the UCC (seeUCC 4-202, 4-213, 4-214, 4-301, and 4-302).

Foreign Currency Deposits

Branches are permitted to accept depositsdenominated in foreign currency. Branchesshould notify customers that such deposits aresubject to foreign exchange risk. The branchconverts such accounts to the U.S. dollar equiva-lents for reporting to the Federal Reserve.Examiners should verify that all reports are inorder and evaluate the branchs use of suchfunds and management of the accompanyingforeign exchange risk. Foreign currency denomi-nated accounts are not subject to the require-ments of Regulation CC, Availability of Fundsand Collection of Checks. For additional infor-mation, examiners may refer to the FederalReserves supervisory guidance letter, SR-90-3(IB), Foreign (Non-U.S.) Currency Denomi-nated Deposits Offered at Domestic DepositoryInstitutions.

International Banking Facilities

An International Banking Facility (IBF) is a setof asset and liability accounts segregated on thebooks of a branch. IBF activities are essentiallylimited to accepting deposits from and extend-ing credit to foreign residents (including banks),other IBFs, and the institutions establishing theIBF. IBFs are not required to maintain reservesagainst their time deposits or loans. Whenexamining an IBF, the examiner should followthe special examination procedures in the Inter-national Banking Facility section of this manual.

Reserve Requirements

Under the Monetary Control Act of 1980 andthe Federal Reserves Regulation D, Reserve

Deposit Accounts 3230.1


Requirements of Depository Institutions,branches are subject to reserve requirements inthe following instances:

It is an insured branch, and its parent foreignbank has total worldwide consolidated bankassets in excess of $1 billion; or

It is an insured branch, and is controlled by aforeign company or by a group of foreigncompanies that own or control foreign banksthat in the aggregate have total worldwideconsolidated bank assets in excess of $1 bil-lion; or

It is a branch that is eligible to apply tobecome an insured bank under section 5 of theFederal Deposit Insurance Act.

For reserve requirement purposes, there aretwo categories of deposits: transaction accountsand nontransaction accounts. Refer to the Fed-eral Reserves Regulation D and the FFIEC 002instructions for specific definitions of the vari-ous types of deposits. Branches may choose tomaintain reserves for discount window access.

POTENTIAL PROBLEM AREAS

The following paragraphs discuss the types ofdeposit accounts and related activities that haveabove-average risk and, therefore, require theexaminers special attention.

Branch-Controlled Deposit Accounts

Branch-controlled deposit accounts, such as sus-pense, official checks, cash collateral, dealerreserves, and undisbursed loan proceeds areused to perform many necessary banking func-tions. However, the absence of sound adminis-trative policies and adequate internal controlsregarding these accounts can cause significantloss to the branch. To ensure that such accountsare properly administered and controlled, branchand head office management must ensure thatoperating policies and procedures are in effectthat establish acceptable purpose and use;appropriate entries; controls over posting entries;and the length of time an item may remainunrecorded, unposted, or outstanding. Internalcontrols that limit employee access to branch-controlled accounts, determine the responsibil-ity for frequency of reconcilement, discourage

improper posting of items, and provide forperiodic internal supervisory review of accountactivity are essential to efficient depositadministration.

The deposit suspense account is used toprocess unidentified, unposted, or rejected items.Characteristically, items posted to such accountsclear in one business day. The length of time anitem remains in control accounts often reflectson the branchs operational efficiency. Thisdeposit type has a higher risk potential becausethe transactions are incomplete and requiremanual processing to be completed. Due to theneed for human interaction and the exceptionnature of these transactions, the possibility ofmisappropriation exists.

Official checks are a type of demand deposit,and include bank checks, cashiers checks,expense checks, interest checks, dividend pay-ment checks, certified checks, and money or-ders. Official checks reflect the branchs prom-ise to pay a specified sum upon presentation ofsuch checks. Because accounts are controlledand reconciled by branch personnel, it is impor-tant that appropriate internal controls are inplace to ensure that account reconcilement issegregated from check origination. Operationalinefficiencies, such as unrecorded checks thathave been issued, can result in a significantunderstatement of the branchs liabilities. Mis-use of official checks may result in substantiallosses through theft.

Cash collateral, undisbursed loan proceeds,and various loan escrow accounts are alsosources of potential loss. The risk lies in ineffi-ciency or misuse if the accounts become over-drawn or if funds are diverted for other purposes,such as the payment of principal or interest onbranch loans. Funds deposited to these accountsshould be used only for their stated purposes.

Brokered Deposits

Brokered deposits represent funds the branchobtains, directly or indirectly, by or through anydeposit broker for deposit into one or moredeposit accounts. Thus, brokered deposits includeboth those in which the entire beneficial interestin a given branch deposit account or instrumentis held by a single depositor and those in whichthe deposit broker pools funds from more thanone investor for deposit in a given branchdeposit account.

3230.1 Deposit Accounts


A small or medium-sized branchs depen-dence on the deposits of customers who resideoutside of or conduct their business outside ofthe branchs normal service area should beclosely monitored by branch and head officemanagement, and analyzed by the examiner.Such deposits may be the product of personalrelationships or good customer service; how-ever, large out-of-area deposits are sometimesattracted by

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