Section 4(c)(8) of the BHC Act (Mortgage Banking—Derivative Commitments to Originate ...€¦ ·...

Section 4(c)(8) of the BHC Act (Mortgage Banking—DerivativeCommitments to Originate and Sell Mortgage Loans) Section 3071.0

3071.0.1 INTERAGENCY ADVISORYON ACCOUNTING AND REPORTINGFOR COMMITMENTS TO ORIGINATEAND SELL MORTGAGE LOANS

On May 3, 2005, the Federal Reserve and theother federal financial institution regulatoryagen-cies1 (the agencies) issued an InteragencyAdvisory on Accounting and Reporting for Com-mitments to Originate and Sell MortgageLoans.2 (See SR-05-10.)

The advisory provides guidance on the appro-priate accounting and reporting for commit-ments to—

• originate mortgage loans that will beheld forresale, and

• sell mortgage loans under mandatory-deliveryand best-efforts contracts.

Commitments to originate mortgage loansthat will be held for resale are derivatives andmust be accounted for at fair value on the bal-ance sheet by the issuer. All loan-sales agree-ments, including both mandatory-delivery andbest-efforts contracts, must be evaluated to deter-mine whether the agreements meet the defini-tion of a derivative under Statement of FinancialAccounting Standards No. 133, ‘‘Accounting forDerivative Instruments and Hedging Activities,’’as amended by Statement of Financial Account-ing Standards No. 149, ‘‘Amendment of State-ment 133 on Derivative Instruments and Hedg-ing Activities’’ (collectively, FAS 133). Afinancial institution should also account for loan-sales agreements that meet the definition of aderivative at fair value on the balance sheet.

The advisory discusses the characteristics thatshould be considered in determining whethermandatory-delivery and best-efforts contractsare derivatives and the accounting and regula-tory reporting treatment for both commitmentsto originate mortgage loans that will be held forresale and those loan-sales agreements that meetthe definition of a derivative. The advisory alsoaddresses the guidance that should be consid-ered in determining the fair value of derivatives.

The advisory provides additional guidance on

the application of FAS 133. Financial institu-tions, including those that arenot required to filereports with the Securities and Exchange Com-mission (SEC), are expected to follow the guid-ance in SEC Staff Accounting Bulletin No. 105,‘‘Application of Accounting Principles to LoanCommitments’’ (SAB 105).3

A financial institution is expected to accountfor and report derivative loan commitments andforward loan-sales commitments as derivativesin accordance with generally accepted account-ing principles (GAAP), which include the use ofvaluation techniques that are reasonable andsupportable in the determination of fair value.An institution’s failure to account for and reportderivative loan commitments and forward loan-sales commitments in regulatory reports inaccordance with GAAP may be an unsafe andunsound practice.

3071.0.1.1 Accounting and Reporting

3071.0.1.1.1 Accounting Policies

Well-managed financial institutions have writ-ten and consistently applied accounting policiesfor commitments to originate mortgage loansthat will be held for resale and to sell mortgageloans under mandatory-delivery and best-effortscontracts, including approved valuation method-ologies and procedures to formally approvechanges to those methodologies. The method-ologies should be reasonable, objectively sup-ported, and fully documented. Procedural disci-pline and consistency are key concepts in anyvaluation-measurement technique. Institutionsshould ensure that internal controls, includingeffective independent review or audit, are inplace to provide integrity to the valuation pro-cess. Institutions’ practices should, therefore,reflect these concepts to ensure the reliability oftheir valuations of derivative loan commitmentsand forward loan-sales commitments.

3071.0.1.1.2 Derivative LoanCommitments

A financial institution should account for deriva-1. The agencies are the Board of Governors of the Federal

Reserve System, the Federal Deposit Insurance Corporation,the National Credit Union Administration, the Office of theComptroller of the Currency, and the Office of Thrift Supervi-sion.

2. The guidance in the interagency advisory is also in-tended to apply to financial-statement reporting by bank hold-ing companies.

3. Staff accounting bulletins (SABs) summarize the viewsof the SEC’s staff regarding the application of generallyaccepted accounting principles.

BHC Supervision Manual January 2006Page 1

tive loan commitments at fair value on the bal-ance sheet, regardless of the manner in whichthe intended sale of the mortgage loans will beexecuted (e.g., under a best-efforts contract, amandatory-delivery contract, or the institution’sown securitization). An institution should reporteach fixed, adjustable, and floating derivativeloan commitment as an ‘‘ other asset’’ or an‘‘ other liability’’ in their regulatory reports basedupon whether the individual commitment has apositive (asset) or negative (liability) fair value.4

With respect to floating derivative loan com-mitments, because the interest rate on such acommitment ‘‘fl oats’’ on a daily basis with mar-ket interest rates, the fair value of a floatingderivative loan commitment approximates zeroas long as the creditworthiness of the borrowerhas not changed. However, as with other deriva-tive loan commitments, an institution must reportthe entire gross notional amount of floatingderivative loan commitments in its regulatoryreports.

Commitments to originate mortgage loansthat will be held for investment purposes andcommitments to originate other types of loansare not within the scope of FAS 133 and, there-fore, are not accounted for as derivatives.5 Aninstitution should report the unused portion ofthese types of commitments, which are not con-sidered derivatives, as ‘‘ unused commitments’’in its regulatory reports.

3071.0.1.1.3 Forward Loan-SalesCommitments

A financial institution should account for for-ward loan-sales commitments for mortgage loansas derivatives at fair value on the balance sheet.Each forward loan-sales commitment should bereported as an ‘‘ other asset’’ or an ‘‘ other liabil-ity’’ based upon whether the individual commit-ment has a positive (asset) or negative (liability)fair value.6

3071.0.1.1.4 Netting of Contracts

For balance-sheet-presentation purposes, FAS133 does not provide specific guidance onfinancial-statement presentation.7 A financialinstitution may not offset derivatives with nega-tive fair values (liabilities) against those withpositive fair values (assets), unless the criteriafor ‘‘ netting’’ under GAAP have been satis-fied.8 In addition, an institution may not offsetthe fair value of forward loan-sales commit-ments against the fair value of derivative loancommitments (the pipeline) or mortgage loansheld for sale (warehouse loans). Rather, forwardloan-sales commitments must be accounted forseparately at fair value, and warehouse loansmust be accounted for at the lower of cost or fairvalue (commonly referred to as ‘‘ LOCOM’’ )9

with certain adjustments to the cost basis of theloans if hedge accounting is applied.

3071.0.1.1.5 Hedge Accounting

A financial institution should follow the guid-ance in FAS 133 when applying hedge account-ing to its mortgage banking activities. If theFAS 133 qualifying criteria are met, an institu-tion may apply—

• fair-value hedge accounting in a hedgingrelationship between forward loan-sales com-mitments (the hedging instrument) and fixed-rate warehouse loans (the hedged item), or

• cash-flow hedge accounting in a hedgingrelationship between forward loan-sales com-

4. When preparing Reports of Condition and Income (CallReports) and the Consolidated Financial Statements for BankHolding Companies (BHC reports), fixed, adjustable, andfloating derivative loan commitments should not be reportedas unused commitments in Schedule RC-L, Derivatives andOff-Balance Sheet Items (Schedule HC-1 for bank holdingcompanies), because such commitments are to be reported asderivatives in this schedule.

5. See FAS 133, paragraph 10(i).6. Regardless of whether the underlying mortgage loans

will be held for investment or for resale, commitments topurchase mortgage loans from third parties under either

mandatory-delivery contracts or best-efforts contracts arederivatives if, upon evaluation, the contracts meet the defini-tion of a derivative under FAS 133. An institution shouldreport its loan-purchase commitments that meet the definitionof a derivative at fair value on the balance sheet.

7. That is, FAS 133 does not provide specific guidancewhere, in the financial statements, the fair value of derivativesor the changes in the fair value of derivatives should beclassified and presented on the financial statement.

8. When an institution has two (or more) derivatives withthe same counterparty, contracts with positive fair values andnegative fair values may be netted if the conditions set forth inFASB Interpretation No. 39, ‘‘ Offsetting of Amounts Relatedto Certain Contracts’’ (FIN 39), are met. Those conditions areas follows: (1) each of the parties owes the other determinableamounts; (2) the reporting party has the right to set off theamount owed with the amount owed by the other party;(3) the reporting party intends to set off; and (4) the right ofsetoff is enforceable at law. In addition, without regard to thethird condition, fair-value amounts recognized for derivativecontracts executed with the same counterparty under a masternetting arrangement may be offset.

9. See Statement of Financial Accounting Standards No.65, ‘‘Accounting for Certain Mortgage Banking Activities’’(FAS 65), paragraph 4.

Mortgage Banking—Derivative Commitments to Originate and Sell Mortgage Loans 3071.0


mitments (the hedging instrument) and theforecasted sale of the warehouse loans and/orthe loans to be originated under derivativeloan commitments (the forecastedtransaction).10

If a financial institution does not apply hedgeaccounting, either because the FAS 133 hedgecriteria are not met or the institution chooses notto apply hedge accounting, forward loan-salescommitments should be treated as nonhedgingderivatives. If hedge accounting is not applied,an institution will account for its warehouseloans at the lower of cost or fair value. Becausenonhedging forward loan-sales commitmentsare accounted for at fair value through earnings,such an approach causes volatility in reportedearnings if the fair value of the warehouse loansincreases above their cost basis. In this situa-tion, the volatility is a result of recognizing thefull amount of any decline in the fair value ofthe forward loan-sales commitments in earningswhile not adjusting the carrying amount of thewarehouse loans above their cost basis.

3071.0.1.1.6 Income-Statement Effect

Unless cash-flow hedge accounting is applied, afinancial institution should include the periodicchanges in the fair value of derivative loancommitments and forward loan-sales commit-ments in current-period earnings. An institutionshould report these changes in fair value ineither ‘‘ other non-interest income’’ or ‘‘ othernon-interest expense,’’ but not as trading rev-enue, in their regulatory reports. However, aninstitution’s decision as to whether to report thechanges in fair value in its regulatory reports inan income or expense line item should be con-sistent with its presentation of these changes inits general-purpose external financial statements(including audited financial statements)11 andshould be consistent from period to period.

3071.0.1.2 Valuation

3071.0.1.2.1 Fair Value

FAS 133 indicates that the guidance in State-ment of Financial Accounting Standards No.107, ‘‘ Disclosures About Fair Value of Finan-cial Instruments’’ (FAS 107), should be fol-

lowed in determining the fair value of deriva-tives.12 That guidance provides that quoted marketprices are the best evidence of the fair value offinancial instruments. However, when quotedmarket prices are not available, which is typi-cally the case for derivative loan commitmentsand forward loan-sales commitments, estimatesof fair value should be based on the best infor-mation available in the circumstances (e.g., valu-ation techniques based on estimated expectedfuture cash flows). When expected future cashflows are used, they should be the institution’sbest estimate based on reasonable and support-able assumptions and projections.

Estimates of fair value should consider pricesfor similar assets or similar liabilities and theresults of valuation techniques to the extentavailable in the circumstances. In the absence of(1) quoted market prices in an active market,(2) observable prices of other current markettransactions, or (3) other observable data sup-porting a valuation technique, the transactionprice represents the best information availablewith which to estimate fair value at the incep-tion of an arrangement.

A financial institution should not recognizean unrealized gain or loss at inception of aderivative instrument unless the fair value ofthat instrument is obtained from a quoted mar-ket price in an active market or is otherwiseevidenced by comparison to other observablecurrent market transactions or based on a valua-tion technique incorporating observable marketdata.13 Based on this guidance, derivative loancommitments generally would have a zero fairvalue at inception.14 However, subsequentchanges in the fair value of a derivative loancommitment must be recognized in financialstatements and regulatory reports (e.g., changesin fair value attributable to changes in marketinterest rates).

When estimating the fair value of derivativeloan commitments and those best-efforts con-tracts that meet the definition of a derivative, a

10. See FAS 133, paragraphs 20–21, and related FAS 133guidance for hedging instruments, hedged items, and fore-casted transactions that qualify for fair-value and cash-flowhedge accounting.

11. See footnote 7.

12. See FAS 133, paragraph 17.13. See footnote 3 in Emerging Issues Task Force Issue

No. 02-3 (EITF 02-3), ‘‘ Issues Involved in Accounting forDerivative Contracts Held for Trading Purposes and ContractsInvolved in Energy Trading and Risk Management Activi-ties.’’

14. If a potential borrower pays the lender a fee uponentering into a derivative loan commitment (e.g., a rate-lockfee), there is a transaction price, and the lender should recog-nize the derivative loan commitment as a liability at inceptionusing an amount equal to the fee charged to the potentialborrower.



financial institution should consider predicted‘‘ pull-through’’ (or, conversely, ‘‘ fallout’’ ) rates.A pull-through rate is the probability that aderivative loan commitment will ultimately resultin an originated loan. Some factors that may beconsidered in arriving at appropriate pull-through rates include (but are not limited to) theorigination channel (which may be either inter-nal [retail] or external [wholesale or correspon-dent, to the extent the institution rather than thecorrespondent closes the loan]),15 current mort-gage interest rates in the market versus theinterest rate incorporated in the derivative loancommitment, the purpose of the mortgage (pur-chase versus refinancing), the stage of comple-tion of the underlying application and under-writing process, and the time remaining until theexpiration of the derivative loan commitment.Estimates of pull-through rates should be basedon historical information for each type of loanproduct adjusted for potential changes in marketinterest rates that may affect the percentage ofloans that will close. An institution should notconsider the pull-through rate when reportingthe notional amount of derivative loan commit-ments in regulatory reports but, rather, mustreport the entire gross notional amount.

3071.0.1.2.2 SAB 105

In March 2004, the SEC issued SAB 105 toprovide guidance on the proper accounting anddisclosures for derivative loan commitments.SAB 105 is effective for derivative loan com-mitments entered into after March 31, 2004.SAB 105 indicates that the expected future cashflows related to the associated servicing of loansshould not be considered in recognizing deriva-tive loan commitments. Incorporating expectedfuture cash flows related to the associated ser-vicing of the loan essentially results in theimmediate recognition of a servicing asset. Ser-vicing assets should only be recognized whenthe servicing asset has been contractually sepa-rated from the underlying loan by sale or securi-tization of the loan with servicing retained.16

Further, no other internally developed intangibleassets (such as customer-relationship intangibleassets) should be recognized as part of deriva-tive loan commitments. Recognition of suchassets would only be appropriate in a third-partytransaction (for example, the purchase of aderivative loan commitment either individually,in a portfolio, or in a business combination).

3071.0.1.3 Standard-Setter Activities

Financial institutions should be aware that theSEC or the Financial Accounting StandardsBoard (FASB) may issue additional fair-value,measurement, or recognition guidance in thefuture (e.g., a fair-value measurement state-ment). To the extent that additional guidance isissued, institutions must also consider the guid-ance in developing fair-value-estimate method-ologies for derivative loan commitments andforward loan-sales commitments as well as mea-suring and recognizing such derivatives.

3071.0.1.4 Changes in Accounting forDerivative Loan Commitments andLoan-Sales Agreements

Financial institutions should follow AccountingPrinciples Board Opinion No. 20 (APB 20),‘‘Accounting Changes,’’ 17 if a change in theiraccounting for derivative loan commitments,best-efforts contracts, or mandatory-delivery con-tracts is necessary. APB 20 defines various typesof accounting changes and addresses the report-ing of corrections of errors in previously issuedfinancial statements. APB 20 states, ‘‘ Errors infinancial statements result from mathematicalmistakes, mistakes in the application of account-ing principles, or oversight or misuse of factsthat existed at the time the financial statementswere prepared.’’

For regulatory reporting purposes, a financialinstitution must determine whether the reasonfor a change in its accounting meets the APB 20definition of an accounting error. If the reasonfor the change meets this definition, the errorshould be reported as a prior-period adjustmentif the amount is material. Otherwise, the effectof the correction of the error should be reportedin current earnings.

If the effect of the correction of the error is

15. If an institution commits to purchase a loan that will beclosed by a correspondent in the correspondent’s name, theinstitution would have a loan-purchase commitment ratherthan a derivative loan commitment. See footnote 6.

16. See Statement of Financial Accounting Standards No.140 (FAS 140), ‘‘Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities,’’ para-graph 61.

17. Effective December 15, 2005, APB 20 will be replacedby FASB Statement No. 154, ‘‘Accounting Changes and ErrorCorrections—A Replacement of APB Opinion No. 20 andFASB Statement No. 3.’’



material, a financial institution should also con-sult with its primary federal regulatory agencyto determine whether any of its prior regulatoryreports should be amended. If amended regula-tory reports are not required, the institutionshould report the effect of the correction of theerror on prior years’ earnings, net of applicabletaxes, as an adjustment to the previously reportedbeginning balance of equity capital. For the CallReport, the institution should report the amountof the adjustment in Schedule RI-A, item 2,‘‘ Restatements due to corrections of materialaccounting errors and changes in accountingprinciples,’’ with an explanation in ScheduleRI-E, item 4.

The effect of the correction of the error onincome and expenses since the beginning of theyear in which the error is corrected should bereflected in each affected income and expenseaccount on a year-to-date basis beginning in thenext quarterly income statement (Call Report) tobe filed and not as a direct adjustment to retainedearnings.

3071.0.1.5 Definitions of Terms Used inthe Advisory

3071.0.1.5.1 Derivative LoanCommitment

The term derivative loan commitment refers to alender’s commitment to originate a mortgageloan that will be held for resale. Notwithstand-ing the characteristics of a derivative set forth inFAS 133, these commitments to originate mort-gage loans must be accounted for as derivativesby the issuer under FAS 133 and include, butare not limited to, those commonly referred toas interest-rate-lock commitments.

In a derivative loan commitment, the lenderagrees to extend credit to a borrower undercertain specified terms and conditions in whichthe interest rate and the maximum amount of theloan18 are set prior to or at funding. Under theagreement, the lender commits to lend funds toa potential borrower (subject to the lender’sapproval of the loan) on a fixed- or adjustable-rate basis, regardless of whether interest rateschange in the market, or on a floating-rate basis.In a typical derivative loan commitment, theborrower can choose to—

• ‘‘ lock in’’ the current market rate for a fixed-rate loan (i.e., a fixed derivative loancommitment),

• ‘‘ lock in’’ the current market rate for anadjustable-rate loan that has a specified for-mula for determining when and how the inter-est rate will adjust (i.e., an adjustable deriva-tive loan commitment), or

• wait until a future date to set the interest rateand allow the interest rate to ‘‘fl oat’’ withmarket interest rates until the rate is set (i.e., afloating derivative loan commitment).

Derivative loan commitments vary in term andexpire after a specified time period (e.g., 60days after the commitment date). Additionally,derivative loan commitments generally do notbind the potential borrower to obtain the loan,nor do they guarantee that the lender will approvethe loan once the creditworthiness of the poten-tial borrower has been determined.

3071.0.1.5.2 Forward Loan-SalesCommitment

The term forward loan-sales commitment refersto either (1) a mandatory-delivery contract or(2) a best-efforts contract that, upon evaluationunder FAS 133, meets the definition of aderivative.

3071.0.1.5.3 Mandatory-DeliveryContract

A mandatory-delivery contract is a loan-salesagreement in which a financial institution com-mits to deliver a certain principal amount ofmortgage loans to an investor at a specifiedprice on or before a specified date. If the institu-tion fails to deliver the amount of mortgagesnecessary to fulfill the commitment by the speci-fied date, it is obligated to pay a ‘‘ pair-off’’ fee,based on then-current market prices, to theinvestor to compensate the investor for the short-fall. Variance from the originally committedprincipal amount is usually permitted, but typi-cally may not exceed 10 percent of the commit-ted amount.

All loan-sales agreements must be evaluatedto determine whether they meet the definition ofa derivative under FAS 133.19 A mandatory-

18. In accordance with the ‘‘ Background Information andBasis for Conclusions’’ in Statement of Financial AccountingStandards No. 149 (FAS 149), the notional amount of aderivative loan commitment is the maximum amount of theborrowing. See FAS 149, paragraph A27.

19. See FAS 133, paragraph 6, for the characteristics of afinancial instrument or other contract that meets the definitionof a derivative.



delivery contract has a specified underlying (thecontractually specified price for the loans) andnotional amount (the committed loan-principalamount), and requires little or no initial netinvestment. Additionally, a mandatory-deliverycontract requires or permits net settlement or theequivalent thereof as the institution is obligatedunder the contract to either deliver mortgageloans or pay a pair-off fee (based on the then-current market prices) on any shortfall on thedelivery of the committed loan-principal amount.Since the option to pay a pair-off fee accom-plishes net settlement, it is irrelevant as towhether the mortgage loans to be delivered areconsidered readily convertible to cash.20 Basedon these characteristics, a mandatory-deliverycontract meets the definition of a derivative atthe time an institution enters into the commitment.

3071.0.1.5.4 Best-Efforts Contract

The term best-efforts contract refers to a loan-sales agreement in which a financial institutioncommits to deliver an individual mortgage loanof a specified principal amount and quality to aninvestor if the loan to the underlying borrowercloses. Generally, the price the investor will paythe seller for an individual loan is specified priorto the loan being funded (e.g., on the same daythe lender commits to lend funds to a potentialborrower). A best-efforts contract that has all ofthe following characteristics would meet thedefinition of a derivative:

• an underlying (e.g., the price the investor willpay the seller for an individual loan is speci-fied in the contract)

• a notional amount (e.g., the contract specifiesthe principal amount of the loan as an exactdollar amount or as a principal range with adeterminable maximum amount)21

• requires little or no initial net investment (e.g.,no fees are exchanged between the seller andinvestor upon entering into the agreement, ora fee that is similar to a premium on otheroption-type contracts is exchanged)

• requires or permits net settlement or the equiva-

lent thereof (for example, the seller is contrac-tually obligated to either (1) deliver the loanto the investor if the loan closes or (2) pay apair-off fee, based on then-current marketprices, to the investor to compensate the in-vestor if the loan closes and is not delivered.Since the option to pay a pair-off fee accom-plishes net settlement, it is irrelevant as towhether the loan to be delivered is consideredreadily convertible to cash.).

3071.0.1.5.5 Master Agreement

A financial institution may enter into one ofseveral types of arrangements with an investorto govern the relationship between the institu-tion and the investor and set the parametersunder which the institution will deliver indi-vidual mortgage loans through separate best-efforts contracts. Such an arrangement mightinclude, for example, a master agreement or anumbrella contract. These arrangements mayspecify an overall maximum principal amountof mortgage loans that the institution may deliverto the investor during a specified time period,but generally they do not specify the price theinvestor will pay for individual loans. Further,while these arrangements may include pair-off-fee provisions for loans to be sold under indi-vidual best-efforts contracts covered by thearrangements, the seller is neither contractuallyobligated to deliver the amount of mortgagesnecessary to fulfill the maximum principal amountspecified in the arrangement nor required to paya pair-off fee on any shortfall. Because thesearrangements generally either do not have aspecified underlying or determinable notionalamount or do not require or permit net settle-ment or the equivalent thereof, the arrangementstypically do not meet the definition of a deriva-tive. As discussed above, an individual best-efforts contract governed by one of thesearrangements may, however, meet the definitionof a derivative.

As the terms of individual best-efforts con-tracts and master agreements or umbrella con-tracts vary, a financial institution must carefullyevaluate such contracts to determine whetherthe contracts meet the definition of a derivativein FAS 133.

20. See FAS 133, paragraph 57(c)(1), for a description ofcontracts that have terms that implicitly or explicitly requireor permit net settlement.

21. The use of a maximum amount as the notional amountof a best-efforts contract is consistent with the loan-commitment discussion in the ‘‘ Background Information andBasis for Conclusions’’ in FAS 149. See FAS 149, paragraphA27.



3071.0.1.6 Example of the Accountingfor Commitments to Originate and SellMortgage Loans22

3071.0.1.6.1 ABC Mortgage FinancialInstitution (Best-Efforts Contracts and NoApplication of Fair-Value HedgeAccounting)

The following simplified example was devel-oped to provide a financial institution that has alimited number of derivative loan commitmentsgeneral guidance on one approach that may beused to value such commitments.23 This exam-ple also illustrates the regulatory reportingrequirements for derivative loan commitmentsand forward loan-sales commitments.

The guidance in this example is for illustra-tive purposes only, as there are several ways thata financial institution might estimate the fairvalue of its derivative loan commitments. Asecond approach to valuing derivative loan com-mitments is described in Derivative Loan Com-mitments Task Force Illustrative Disclosures onDerivative Loan Commitments, a practice aiddeveloped by staff of the American Institute ofCertified Public Accountants (AICPA) and atask force comprising representatives from thefinancial services, mortgage banking, and publicaccounting communities.24 As indicated in thebody of the interagency advisory, a financialinstitution must consider the guidance in FAS133, FAS 107, EITF 02-3, and SAB 105 inmeasuring and recognizing derivative loan com-mitments and forward loan-sales commitments.In addition, an institution should be aware thatthe SEC or FASB may issue additional guidancein the future that may alter certain aspects ofthis example.

3071.0.1.6.1.1 Background

ABC Mortgage Financial Institution (ABC) en-ters into fixed, adjustable, and floating deriva-

tive loan commitments to originate mortgageloans that it intends to sell. The institutionaccounts for the commitments as derivativefinancial instruments as required under FAS133.

ABC enters into best-efforts contracts with amortgage investor under which it commits todeliver certain loans that it expects to originateunder derivative loan commitments (i.e., thepipeline) and loans that it has already originatedand currently holds for sale (i.e., warehouseloans). ABC and the mortgage investor agree onthe price that the investor will pay ABC for anindividual loan with a specified principal amountprior to the loan being funded. Once the pricethat the mortgage investor will pay ABC for anindividual loan and the notional amount of theloan are specified, and ABC is obligated todeliver the loan to the investor if the loan closes,the contract represents a forward loan-sales com-mitment. Under FAS 133, ABC accounts forthese forward loan-sales commitments asderivative financial instruments.

On December 31 of a given year, the notionalamounts of ABC’s mortgage banking derivativeloan commitments and forward loan-sales com-mitments are as follows:

Table 1—Notional Amounts of DerivativeLoan Commitments and ForwardLoan-Sales Commitments

Notionalamount

Derivative loancommitments

Fixed-ratecommitments

$ 8,500,000

Adjustable-ratecommitments 1,500,000

Floating-ratecommitments

2,000,000

Total derivative loancommitments $12,000,000 [A]2522. This example uses the definitions and concepts pre-

sented in the body of the Interagency Advisory on Accountingand Reporting for Commitments to Originate and Sell Mort-gage Loans (the interagency advisory). Refer to the inter-agency advisory for clarification of the terms and conceptsused in this example.

23. Estimating fair values when quoted market prices areunavailable requires considerable judgment. Valuation tech-niques using simplified assumptions may sometimes be used(with appropriate disclosure in the financial statements) toprovide a reliable estimate of fair value at a reasonable cost.See FAS 107, paragraphs 60–61.

24. The practice aid is available at www.aicpa.org/download/members/div/acctstd/Illustrative_Disclosure_on_Derivative_Loan_Commitments.pdf.

25. Alpha references in table 1 and the text of this examplerefer to the ‘‘ Reference’’ column in table 3.



Table 1—continued

Notionalamount

Forward loan-salescommitments

Pipeline loancommitments

$12,000,000

Warehouse loancommitments 8,000,000

Total forward loan-sales commitments $20,000,000 [B]

Market interest rates have changed through-out the time period that ABC’s derivative loancommitments and forward loan-sales commit-ments have been outstanding. Some of the fixed-rate commitments are at rates above currentmarket rates while others are at rates at or belowcurrent market rates. All of ABC’s adjustable-rate commitments are at rates below currentmarket rates.

Based on its past experience, ABC estimatesa pull-through rate of 70 percent on its fixed-rate commitments for which the locked-in rateis above current market rates (i.e., 70 percent ofthe commitments will actually result in loanoriginations) and a pull-through rate of 85 per-cent for its fixed-rate commitments for whichthe locked-in rate is at or below current marketrates. ABC also estimates a pull-through rate of85 percent for all of its adjustable-rate commit-ments that are below market rates.

The pull-through-rate assumptions in thisexample have been simplified for illustrativepurposes. In determining appropriate pull-through rates, a financial institution must con-sider all factors that affect the probability thatderivative loan commitments will ultimatelyresult in originated loans. Therefore, an institu-tion is expected to have more granularity (i.e.,stratification) in its application of pull-through-rate assumptions to its derivative loancommitments.

3071.0.1.6.1.2 Discussion of ABC’s Approachto Valuing Derivative Loan Commitments andForward Loan-Sales Commitments

ABC estimates the fair value of its derivativeloan commitments using the best information

available in the circumstances because quotedmarket prices are not available. In this case,ABC uses valuation techniques that take intoaccount current secondary-market loan pricinginformation.26 ABC had noted the appropriatereference price for the underlying loans on theday that each derivative loan commitment wasgiven to a borrower, and assigned an initial fairvalue of zero to each loan commitment consis-tent with the guidance in SAB 105 and EITF02-3. At the end of the month, ABC comparesthe current reference price of each underlyingloan with its initial reference price and calcu-lates the price difference. ABC then calculatesthe fair value of these derivatives by multiply-ing the price difference by the estimated pull-through rate. This approach is illustrated intable 2.

As illustrated in table 2, ABC excludes timevalue from its fair-value-estimate methodologydue to the short-term nature of the derivativeloan commitments. As the exclusion of timevalue is not appropriate for all fair-value esti-mates, an institution must consider the terms ofits specific agreements in determining an appro-priate estimation methodology.

In the example in table 2, ABC estimated theinitial reference price of the underlying loan tobe originated under the commitment, excludingthe value of the associated servicing rights, to be$100,000. That is, at the date it entered into thefixed derivative loan commitment with the bor-rower, ABC estimated it would receive $100,000,excluding the value of the associated servicingrights, if the underlying loan was funded andsold in the secondary market on that day. Becausethis amount is equal to the notional amount ofthe loan, ABC would not experience a gain orloss on the sale of the underlying loan (beforeconsidering the effect of the loan-originationfees and costs associated with the loan). Assuch, the fair value of this derivative loan com-mitment would be zero, and there would not beany unrealized gain or loss at the inception ofthe derivative loan commitment. This may notbe true for all derivative loan commitments.

ABC defers all unrealized gains and losses atthe inception of its derivative loan commitmentsuntil the underlying loans are sold. ABC’s pol-icy is based on the short-term nature of its

26. In general, source data for secondary-market loan-pricing information may include, for example, quotationsfrom rate sheets; brokers; or electronic systems such as thoseprovided by third-party vendors, market makers, or mortgageloan investors. When secondary-market loan-pricing informa-tion that includes the value of servicing rights is used, the fairvalue of the derivative loan commitments ultimately mustexclude any value attributable to servicing rights.



Table 2—ABC’s Calculation of the Fair Value of Derivative Loan Commitments: AnExample of a Fixed Derivative Loan Commitment for Which the Locked-In Rate IsAbove the Current Market Rate*

Notionalamount

ofloan

Initial referenceprice of loan

to beoriginated undercommitment—

excludingservicing

rights

Current referenceprice of loan

to beoriginated undercommitment—

excludingservicing

rightsPrice

difference

Pull-through

rate

Fair value ofderivative

loancommitment

(1) (2) (3) [(3) - (2)] (4) [(3) - (2)] × (4)

$100,000 $100,000 $100,500 $500 70% $350

* The example in this table presents the fair-value calculation for one derivative loan commitment. The fair value of thisderivative, which is positive, would be added to all the other derivative loan commitments with positive fair values. Nettingderivatives with positive fair values (assets) against derivatives with negative fair values (liabilities) is not permitted unless theconditions stipulated in FIN 39 are met. Refer to footnote 8.

derivative loan commitments and was adoptedin order to not accelerate the timing of gainrecognition. As this practice may not be appro-priate for all derivative loan commitments orother derivatives initially accounted for underEITF 02-3, and due to the lack of authoritativeguidance in this area, an institution should con-sult with its accounting advisers concerning theappropriateaccounting for its specificagreements.

After applying the methodology describedabove to individual derivative loan commit-ments, ABC aggregates the fair values of thederivative loan commitments by type (i.e., fixed,adjustable, and floating) and by whether thecommitments have above-, at-, or below-marketrates. The fair values of the fixed derivative loancommitments with above-market rates, adjustedfor the appropriate pull-through rate, total $21,000[C], which represents an asset. The aggregatefair value of the fixed derivative loan commit-ments thathaveat-orbelow-market rates, adjustedfor the appropriate pull-through rate, sums to($31,000) [D], which represents a liability. Forthe adjustable derivative loan commitments, theaggregate fair value, adjusted for the pull-through rate, is approximately ($2,000) [E],which is also a liability. The fair value of thefloating derivative loan commitmentsapproximates zero.

ABC also estimates the fair value of its for-ward loan-sales commitments outstanding at theend of the month using a similar methodologyas that described above. Based upon this infor-mation, ABC determines that the estimated fairvalue of the forward loan-sales commitmentsrelated to its derivative loan commitments and

warehouse loans with above-market rates isapproximately ($45,000) [F], which represents aliability, because current market interest ratesfor comparable mortgage loans are lower thanthe rates in effect when the derivative loan com-mitments were initiated. (Consequently, currentoffered delivery prices for similar commitmentsare greater than the delivery prices of ABC’sexisting forward loan-sales commitments. There-fore, the change in the fair value of ABC’sforward loan-sales commitments since they wereentered into represents a loss.) The fair value ofABC’s forward loan-sales commitments relatedto its derivative loan commitments and ware-house loans with at- or below-market rates isestimated to be $50,000, which is an asset.27

3071.0.1.6.1.3 Regulatory Reporting

The following table illustrates the regulatoryreporting requirements for the derivative-relateddollar amounts cited in the example.

As illustrated in table 3, depending upon par-ticular market circumstances, individual deriva-tive loan commitments and forward loan-sales

27. The absolute value of the fair value of the forwardloan-sales commitments is greater than the absolute value ofthe fair value of the related derivative loan commitmentsbecause the forward loan-sales commitments also apply to,and act as an economic hedge of, ABC’s warehouse loans.ABC accounts for its warehouse loans at the lower of cost orfair value in accordance with FAS 65. In this example, ABCdoes not apply hedge accounting to its warehouse loans.



Table 3—Regulatory Reporting Implications for Derivative Loan Commitments andForward Loan-Sales Commitments

Amount Reference

Derivative loan commitmentsNotional amount of ‘‘ over-the-counter written options’’ 28 $12,000,000 [A]Derivatives with a positive fair value held for purposes

other than trading (asset) $21,000 [C]Derivatives with a negative fair value held for purposes

other than trading (liability) $33,000 [D + E]

Forward loan-sales commitmentsNotional amount of ‘‘ forward contracts’’ $20,000,000 [B]Derivatives with a positive fair value held for purposes

other than trading (asset) $50,000 [G]Derivatives with a negative fair value held for purposes

other than trading (liability) $45,000 [F]

Derivative loan commitments and forward loan-salescommitments

Total notional amount of derivative contracts held forpurposes other than trading $32,000,000 [A + B]

commitments may have either positive or nega-tive fair values, which ABC properly reportsgross as assets or liabilities on its balance sheet.In addition, for regulatory reporting purposes,ABC consistently reports the periodic changesin the fair value of its derivative contracts in‘‘ other non-interest expense’’ in its income state-ment. Alternatively, ABC could have chosen toconsistently report these fair-value changes in‘‘ other non-interest income’’ in its regulatoryreports.

3071.0.2 INSPECTION OBJECTIVE

1. To find out if the bank holding companyaccounted for and reported the followingtransactions at their fair value: (1) its com-mitments to originate mortgage loans thatwere held for resale (derivatives) and (2) itsloan-sales agreements that are derivatives. Ifso, ascertain if these transactions were

accounted for and reported—a. in accordance with the instructions for the

BHC reports (for example, the FR Y-9C);GAAP; and SR-05-10 and its attachedMay 3, 2005, Interagency Advisory onAccounting and Reporting for Commit-ments to Originate and Sell MortgageLoans and

b. based on reasonable and supportable valu-ation techniques as prescribed by the May3, 2005, interagency advisory.

3071.0.3 INSPECTION PROCEDURES

1. Determine whether the bank holding com-pany has written and consistently appliedaccounting policies to its commitments to(1) originate mortgage loans that were heldfor resale and (2) sell mortgage loans undermandatory-delivery and best-efforts contracts.

2. Find out if the bank holding company hasdeveloped and uses approved valuation meth-odologies and procedures to obtain formalapproval for changes to those methodologies.a. Ascertain whether the valuation method-

ologies are reasonable, objectively sup-ported, and fully documented.

28. Because derivative loan commitments are in certainrespects similar to options, they are reported with ‘‘ over-the-counter written options’’ for regulatory reporting purposes.



b. Determine if the bank holding companyhas internal controls, including an effec-tive independent review or audit, in placethat give integrity to the valuation process.

3. If the bank holding company issues fixed-,adjustable-, and floating-rate derivative loancommitments or forward loan-sales commit-ments, review an adequate sample that evi-dences the full coverage of these types oftransactions.a. Ascertain if these transactions were prop-

erly reported on the balance sheet as an‘‘ other asset’’ or an ‘‘ other liability,’’ basedon whether the individual commitmenthas a positive (asset) or negative (liabil-ity) fair value in accordance with theinstructions for the BHC reports.

b. Determine if the floating-rate derivativeloan commitments and other derivativeloan commitments were reported at theirentire gross notional amount in the BHC’sreports (such as the FR Y-9C).

c. Find out if the balance sheet correctlypresents accounts for all such transac-tions, including the netting of contracts,the application of hedge accounting tomortgage banking activities, the valuationof derivatives, and any material or otheraccounting changes for derivative loancommitments and loan-sales agreements.Also determine if the bank holding com-pany complies with the May 3, 2005,Interagency Advisory on Accounting and

Reporting for Commitments to Originateand Sell Mortgage Loans and with GAAP.

d. Ascertain if periodic changes in the fairvalue of derivative loan commitments andforward loan-sales commitments arereported in current-period earnings as either‘‘ other non-interest income or ‘‘ non-interest expense, as appropriate.

4. Report to the central point of contact orexaminer-in-charge any failure by the bankholding company’s management to follow(1) the bank holding company’s accountingand valuation policies for its commitments tooriginate mortgage loans that are held forresale and its commitments to sell mortgageloans, (2) the instructions for the Consoli-dated Financial Statement for Bank HoldingCompanies, (3) the May 3, 2005, interagencyadvisory, or (4) GAAP.

5. When additional inspection scrutiny isneeded—based on the examination’s find-ings; the supervisory concerns discussed insection 3071.0; the February 23, 2003, Inter-agency Advisory on Mortgage Banking (seeSR-03-4 and its attachment); and the May 3,2005, Interagency Advisory on Accountingand Reporting for Commitments to Originateand Sell Mortgage Loans (see SR-05-10 andits attachment)—consider using the compre-hensive mortgage banking examination pro-cedures in the appendix section A.2040.3 ofthe Commercial Bank Examination Manual.



Section 4(c)(8) of the BHC Act (Activities Related to ExtendingCredit) Section 3072.0

In 1997, the Board amended Regulation Y toinclude ‘‘activities related to extending credit’’in section 225.28(b)(2), which includes the fol-lowing permissible nonbanking activities:

Section No.1. real estate and personal property

appraising 3270.02. arranging commercial real estate

equity financing 3220.03. check-guaranty services 3320.04. collection agency services 3330.05. credit bureau services 3340.06. asset-management, servicing, and

collection activities 3084.07. acquiring debt in default 3104.08. real estate settlement services1 3072.8

1. Real estate settlement services do not include providingtitle insurance as principal, agent, or broker.

BHC Supervision Manual July 2006Page 1

Section 4(c)(8) of the BHC Act Real Estate Settlement ServicesSection 3072.8

In 1997, the Board incorporated real estate ser-vicing into section 225.28(b)(2) as one of theactivities related to extending credit. (See 12C.F.R. 225.28(b)(2)(viii).) Real estate settle-ment services do not include providing titleinsurance as principal, agent, or broker. Previ-ously, the Board had approved the activity byBoard order. In the order, the Board found thatreal estate settlement services consist of—

1. reviewing the status of the title in the titlecommitment, resolving any exceptions to thetitle, and reviewing the purchase agreementto identify any requirements that need to becomplied with;

2. verifying payoffs on existing loans securedby the real estate and verifying the amount ofand then calculating the prorating of specialassessments and taxes on the property;

3. obtaining an updated title insurance commit-ment to the date of closing; preparing therequired checks, deeds, and affidavits; andobtaining any authorization letters needed;

4. establishing a time and place for the closing,conducting the closing, and ensuring that allparties properly execute all appropriate docu-ments and meet all commitments;

5. collecting and disbursing funds for the par-ties, holding funds in escrow pending satis-faction of certain commitments, and prepar-ing the HUD settlement statement, the deedof trust, mortgage notes, the Truth-in-Lending statement, and purchaser’s affida-vits; and

6. recording all of the documents required underlaw. (See 1990 FRB 1058.)

3072.8.1 REAL PROPERTYEXCHANGE TRANSACTIONS UNDERSECTION 1031 OF THE INTERNALREVENUE CODE

A request submitted to the Board on behalf of abank holding company (BHC) requested anadvisory opinion pursuant to section 225.27 ofRegulation Y (12 C.F.R. 225.27). The BHC wasproposing the acquisition of a subsidiary (the1031 exchange subsidiary) that provided ser-vices to customers seeking to make exchangesof real property pursuant to section 1031 of theInternal Revenue Code (1031 exchangetransactions).

Section 1031 of the Internal Revenue Codeprovides a U.S. taxpayer with deferral of gainwhen the taxpayer exchanges his or her property

for another property of a ‘‘like kind.’’ In a‘‘forward’’ 1031 exchange transaction, the tax-payer first sells his or her existing property andlater purchases a replacement property.1 In orderto complete a forward 1031 exchange transac-tion successfully, a taxpayer must satisfy certainconditions in section 1031 of the Internal Rev-enue Code and the U.S. Treasury regulationsthat implement section 1031. For example, in aforward 1031 exchange transaction, at the clos-ing of the sale of the initial property, the pro-ceeds of the sale must be held by an individualor entity otherwise unrelated to the transaction(the qualified intermediary). In addition, the tax-payer engaging in the forward 1031 exchangetransaction may not receive the sale proceedsduring the period in which a replacement prop-erty is identified (up to 45 days) and acquired(up to 180 days). In this request, the BHC wasproposing to acquire a subsidiary that would actas a qualified intermediary in forward 1031exchange transactions involving real property.

The 1031 exchange subsidiary would engagein several activities in order to facilitate forward1031 exchange transactions. First, the subsidi-ary would provide its customer with documentsrelated to theexchange toensure that theexchangequalified as a valid forward 1031 exchangetransaction. Specifically, the subsidiary wouldprovide an exchange agreement, an assignmentagreement, and a notice. The exchange agree-ment is a contract between the customer and thesubsidiary that, among other features, notes therequirements for the successful completion ofthe transaction. The assignment agreement trans-fers from the customer to the subsidiary certainresponsibilities for the sale of the initial prop-erty and the receipt of sales proceeds in order toensure that the customer does not ‘‘construc-tively receive’’ the proceeds of the initial prop-erty sale for tax purposes. These responsibilitiesmay include taking the transitory title to theinitial property and replacement property as theyare transferred from seller to buyer. The noticeinforms the purchaser of the initial property thatthe transaction is part of a forward 1031 exchangetransaction; it helps establish that the mecha-

1. In a ‘‘reverse’’ 1031 exchange transaction, the taxpayerfirst purchases a replacement property and later sells his or herproperty. The proposal did not include the provision of ser-vices to customers seeking to make reverse 1031 exchangetransactions.


nism for the forward 1031 exchange transactionis in place at the time of the sale.

Second, the 1031 exchange subsidiary wouldinvest the proceeds of the sale of the initialproperty on behalf of the customer until thecustomer acquired the replacement property.The proceeds would be invested at the discre-tion of the subsidiary but would typically bedeposited into deposit accounts at the BHC’ssubsidiary state-chartered commercial bank.2 Thesubsidiary would also transfer the necessaryfunds to the appropriate party to effect the cus-tomer’s purchase of the replacement property. Ifthe customer does not identify a replacementproperty or purchase the replacement propertywithin the required time periods set forth insection 1031 of the Internal Revenue Code orU.S. Treasury regulations implementing section1031, the proceeds of the sale of the initialproperty would be transferred to the customer. Itwas represented that the subsidiary would act ina fiduciary capacity in holding, investing, anddisbursing the customer’s funds and that a state-chartered nondepository trust company wouldbe allowed to engage in the activities of thesubsidiary.

The 1031 exchange subsidiary (1) would notparticipate in negotiating the terms of the real

property sale and purchase transactions that con-stitute the forward 1031 exchange transactionand (2) would not assist the customer in locatinga buyer of the initial property or a seller of thereplacement property. The requestor also assertedthat the proposed services are permissible non-banking activities for BHCs under section225.28(b) of Regulation Y (12 C.F.R. 225.28(b)).

In view of all the facts of the record, Boardstaff opined that the proposed activities of the1031 exchange subsidiary would be permissiblereal estate settlement services under section225.28(b)(2)(viii) of Regulation Y (12 C.F.R.225.28(b)(2)(viii)); would be trust company func-tions under section 225.28(b)(5) of RegulationY (12 C.F.R. 225.28(b)(5)); and would be finan-cial advisory services, including tax-planningand tax-preparation services, under section225.28(b)(6) of Regulation Y (12 C.F.R.225.28(b)(6)).3

The opinion is limited to the activities relat-ing to the 1031 exchange transaction describedin the opinion and in the correspondenceexchanged between the requestor and Boardstaff. See the Board staff’s February 9, 2006,legal interpretation.

2. The BHC’s commercial bank subsidiary also may be alender with respect to real properties involved in the 1031exchange transaction. Any lending relationship between thebank and the customer would depend on the ability of thecustomer and the loan transaction to meet the bank’s standardunderwriting terms and conditions.

3. The Office of the Comptroller of the Currency (OCC)authorized national banks to provide a wide range of servicesto facilitate their customers’ 1031 exchange transactions. SeeOCC Interpretive Letter No. 880 (December 16, 1999) andOCC Corporate Decision No. 2001–30 (October 10, 2001).

Section 4(c)(8) of the BHC Act Real Estate Settlement Services 3072.8


Section 4(c)(8) of the BHC Act(Education-Financing Activities) Section 3073.0

3073.0.1 EXPANDED STUDENT-LOAN-SERVICING ACTIVITIES

A bank holding company applied for the Board’sapproval under section 4(c)(8) of the Bank Hold-ing Company Act (BHC Act) and section 225.23of Regulation Y to expand the student-loan-servicing activities of its nonbank subsidiary.The activities would consist of—

1. providing student-loan authorities (the author-ity) with regular reports that include informa-tion in the aggregate and by individual lend-ers concerning the volume of loans beingserviced for the authority and the volume ofloans outstanding;

2. preparing projections for approval by theauthority of student loans to be purchasedand commitments to be issued in the future,based on the volume of loans being servicedandcommitmentsoutstanding,consistentwiththe amount of funds available to the author-ity as the result of its sale of bonds;

3. advising eligible lenders, borrowers, and otherinterested parties of the authority’s student-loan-purchase program, including the criteriaused by the authority in purchasing studentloans and the extent to which the authoritywill be purchasing loans in the future basedon the availability of funds; and

4. meeting regularly with the authority to adviseit of the nonbank subsidiary’s efforts in con-nection with the student-loan activities.

Under no circumstances would the nonbanksubsidiary be authorized to bind the authority orits bank trustee to commit to purchase or actu-

ally to purchase student loans from eligiblelenders.

The proposed activities were regarded as beingequivalent to the activities of a mortgage bank-ing subsidiary of a bank holding company,authorized under section 225.28(b)(1) of Regu-lation Y, with respect to acquiring and servicingmortgage loans for institutional investors or inconnection with the secondary-mortgage mar-ket. The activities proposed and currently con-ducted by the applicant, to the extent that theywere different from the services performed byany institution that services loans for others,were perceived as being different only in thatthey related to servicing student loans for agovernmental authority. Banks and their non-bank subsidiaries generally provide comprehen-sive loan-acquisition and -servicing ‘‘packages’’for investors in mortgage and other loans. Thebank holding company’s nonbank subsidiarywas the nation’s largest servicer of studentloans, and was thus particularly well equippedto perform the proposed expanded services.

In addition to determining that the proposedactivities were closely related to banking toapprove the application, the Board had to con-clude that the proposed activities would producebenefits to the public that would outweigh anypossible adverse effects, such as unsound bank-ing practices, unfair competition, conflicts ofinterests, or undue concentration of resources.The Board made that conclusion in addition todetermining that the balance of public interestfactors that it is required to consider under sec-tion 4(c)(8) of the BHC Act was favorable.Accordingly, the application was approved onJuly 1, 1985 (1985 FRB 725).

BHC Supervision Manual December 1998Page 1

Section 4(c)(8) of the BHC Act(Servicing Loans) Section 3080.0

A bank holding company or its subsidiary mayengage in the activity of servicing loans or otherextensions of credit for either affiliated compa-nies or for persons or institutions not affiliatedwith the holding company. The service willoften be carried on as an additional activity of acredit-extending subsidiary, such as a mortgagecompany, where the loan serviced was origi-nated by the subsidiary and subsequently sold toan investor. A servicing company provides thecollection vehicle through receipt and disburse-ment of funds for investors who may not pos-sess the resources to accomplish the activity.The purpose of servicing is to keep a sound loanin good standing for a passive investor. Theservicing company’s remuneration is usuallybased upon a percentage of the outstanding bal-ance of the loan.The traditional servicing arrangement arises

from the normal business of a mortgage com-pany. The company grants extensions of creditto qualified borrowers and subsequently pack-ages and sells these loans, normally withoutrecourse, to individuals or institutional investorswho contract the collection of the credit to themortgage company. The company may also pur-chase mortgages or other extensions of credit inthe open market with the intention of resellingthe credit and retaining the servicing or cansimply purchase servicing portfolios (12 C.F.R.225.132). The collection itself is basically abookkeeping function.Servicing loans for others is relatively risk-

free to the company when the credits are soldwithout recourse to investors. A credit whichhas been soldwith recourse represents an unusualcircumstance and should, therefore, be reviewedin detail. The serviced loans will generally behigh quality mortgages which are in turn pur-chased from the company by passive investorsdesiring a fixed rate of return on their funds.The risk to a servicing company lies in itsportfolio of unsold loans, or its ‘‘warehouse.’’The risk is two-fold: (1) the loan may not be ofhigh enough quality to attract an investor so thatthe servicing company will have to continue tocarry the credit for its own account, and (2) theloan was made at an interest rate which is belowcurrent market rates. In the latter case, the ser-vicing company must either sell the loan at adiscount or continue to hold the credit for itsown account. In either case, the loan is treatedas an asset of the company and involves creditrisk.The inspection of a servicing company, or a

servicing department of a credit-extending sub-

sidiary, should focus on adequacy of documen-tation and controls, and on the quality and mar-ketability of thewarehoused loans. The examinershould obtain a past due report for the portfolioand note in the inspection report significantcredits which are past due together with theperiod of delinquency, the type of loan, and theasset classification, if any. The nature of theservicing business is such that the number ofpast dues should be small because loans areonly warehoused for a short period of time untilthey can be sold to an investor. As a rule, a pastdue loan or a current loan which has been ware-housed for more than several months is indica-tive of some problem with the credit. Each loanshould be evaluated to determine the reason ithas not been sold.During periods of rising long-term interest

rates, the warehouse portfolio becomes subjectto the risk that a loan may not be marketable,except at a discount, because of its relativelylow yield. This affects both the servicer’s incomeand liquidity.In the case of the parent company acting as a

servicer, the inspection should also determinewhether the activity is being carried on underthe proper exemption. A bank holding companymay act as a servicer under section 4(c)(8) ofthe Act or under the provisions of sections4(a)(2) and/or 4(c)(1) of the Act. If carried onunder Section 4(a)(2) of the BHC Act, the hold-ing company is limited to servicing loans onlyfor its own account or its banking and nonbank-ing subsidiaries. If carried under Section4(c)(1)(C) of the BHC Act, the bank holdingcompany is limited to servicing loans only forits own account or its banking subsidiaries.Finally, the income of the company should be

subject to scrutiny. A servicing company shouldbe a profitable business. The servicer receives afee based upon a percentage of the outstandingbalance of the loan. In the early years of thepayback period, the fee should significantlyexceed the cost of the service, and becausemuch of the portfolio will be refinanced eitherprior to its maturity or prepaid, the fee incomeshould be sufficient to cover the servicer’s costplus profit. The reason for poor earnings in thisactivity is generally either inefficiency in thecollection area, failure to attain the breakevenpoint of servicing volume, or the inability toturnover the warehouse portfolio often enoughto maintain new fee generation. In the event that


the servicer is unprofitable, the examiner shoulddetermine the reasons and clearly set them forthin the inspection report.The servicing arrangement is of a fiduciary

nature and as such it gives rise to certain contin-gent liabilities. In the situation where the ser-vicer is not fully and properly discharging itsservicing responsibilities in accordance with theservicing agreement, the holder of the servicednotes might bring legal claims against the ser-vicer. The inspection process should directattention to this area including a review of theservicing agreement and verification that theservicer is fulfilling its obligations. Manage-ment should be reminded of the significant lossexposure which can result from improper atten-tion to its fiduciary responsibilities.

3080.0.1 INSPECTION OBJECTIVES

1. To determine that internal controls areadequate to administer effectively the servicingof the loan portfolio.

2. To determine the level of exposure tocredit risk of loans held for the firm’s ownaccount.3. To determine if the firm’s earnings are

sufficient so as not to be a burden on the parentor subsidiary bank.


1. Review the balance sheet to determine thevolume of credits held for the firm’s own accountand evaluate their asset quality.2. Review internal controls and evaluate their

adequacy.3. Review earnings and appraise the impact

on the parent and bank subsidiaries.4. Review servicing agreements and evaluate

the potential or contingent risks to which thefirm is exposed in the event of failure by aborrower to service its loan properly.5. Determine whether mortgage servicing

rights are recorded as an asset and whether theyare being amortized over the average life of theloans being serviced.

Section 4(c)(8) of the BHC Act (Servicing Loans) 3080.0


Section 4(c)(8) of the BHC Act (Asset-Management,Asset-Servicing, and Collection Activities) Section 3084.0

A bank holding company may engage undercontract with a third party in the management,servicing, and collection1 of the types of assetsthat an insured depository institution may origi-nate and own. The company cannot engage inreal property management or real estate broker-age services as part of these services. See Regu-lationY,section225.28(b)(2)(vi).Providedbeloware some initial historical examples of Boardorders that involve asset-management servicesrelated to this nonbanking activity. The commit-ments and conditions provided for within theBoard orders should not be considered to becurrently applicable.

3084.0.1 ASSET-MANAGEMENTSERVICES TO CERTAINGOVERNMENTAL AGENCIES ANDUNAFFILIATED FINANCIALINSTITUTIONS WITH TROUBLEDASSETS

Three bank holding companies (the applicants)applied for the Board’s approval under section4(c)(8) of the BHC Act to engage de novo inprovidingasset-managementservices to theReso-lution Trust Corporation and the Federal DepositInsurance Corporation, and generally to unaffili-ated financial institutions with troubled assets.The applicants committed to conduct theseactivities under the same terms and conditionsas set out in 1988 FRB 771.

The commitments and conditions of this orderrequired that (1) the asset-management activi-ties would be provided to the banks and savingsassociations, (2) the applicant would obtain theBoard’s approval before providing asset-management services for pools of assets thatwere not originated or held by financial institu-tions and their affiliates, (3) the applicant wouldcause its asset-management subsidiary to estab-lish procedures to preserve the confidentiality ofinformation obtained in the course of providingasset-management services, and (4) neither theapplicant nor its management subsidiary wouldtake title to the assets managed by the asset-management subsidiary.

The applications of these holding companieswere approved by a Board order on Decem-ber 24, 1990 (1991 FRB 124). Two additional

orders about providing asset-management ser-vices were approved on March 25, 1991 (1991FRB 331 and 334).

3084.0.2 ASSET-MANAGEMENTSERVICES FOR ASSETSORIGINATED BY NONFINANCIALINSTITUTIONS

Two bank holding companies (the applicants)applied jointly for the Board’s approval undersection 4(c)(8) of the BHC Act to engage denovo in collection-agency activities pursuant toRegulation Y through a joint venture. The Boardconcluded that the collection activities werepermissible.

The bank holding companies also applied forthe Board’s approval to engage in asset-management, asset-servicing, and collectionactivities through a nonbank of the joint venturelocated in New Jersey. The subsidiary wouldprovide asset-management services to the Reso-lution Trust Corporation (RTC) and the FederalDeposit Insurance Corporation (FDIC). It wouldalso provide these services to unaffiliated third-party investors that purchase pools of assetsassembled by the RTC or the FDIC. Under theproposal, neither the applicants nor this non-bank subsidiary would acquire an ownershipinterest in the assets that they manage or in theinstitutions for which they provide the asset-management services. The applicants furthercommitted that they would not provide realproperty management or real estate brokerageservices as part of the proposed activities.

The Board previously determined that, withincertain parameters, providing asset-managementservices for assets originated by financial institu-tions (banks, savings associations, and creditunions) and their bank holding company affili-ates is an activity closely related to banking (see1991 FRB 331, 334 and section 3600.15.3). Theapplicants proposed to conduct all asset-management activities subject to the same con-ditions as in the Board orders previously cited.

The applicants proposed to engage in asset-management activities for assets originated bynonfinancial institutions as well as by financialinstitutions. These assets include real estate,consumer, and other loans; equipment leases;and extensions of credit. Assets of nonfinancialinstitutions include pension funds, leasing com-

1. Asset-management services include acting as agent inthe liquidation or sale of loans and collateral for loans, includ-ing real estate and other assets acquired through foreclosureor in satisfaction of debts previously contracted.

BHC Supervision Manual June 1999Page 1

panies, finance companies, and investment com-panies formed to engage in asset-managementactivities. The managed assets would be limitedto the types of assets that financial institutionshave the authority to originate. The Board con-cluded that the applicants would have the exper-tise to engage in managing these types of assets,

regardless of the originating entity. The Boardalso determined that the proposal was consistentwith the asset-management proposals approvedin its prior orders. The Board concluded that theapplicants’ proposed activities are closely relatedto banking and approved the order on December21, 1992. (1993 FRB 131)

Section 4(c)(8)—(Asset-Management, Asset-Servicing, and Collection Activities) 3084.0


Section 4(c)(8) of the BHC Act(Receivables) Section 3090.0

Two nonbanking activities authorized undersection 4(c)(8) of the BHC Act, per RegulationY in section 225.28(b)(1), are the discount pur-chasing of a client’s accounts receivables (fac-toring) and the establishment of a revolving

credit facility secured by an assignment ofaccounts receivable (accounts receivable financ-ing). These activities date back to Board ordersissued in 1951. See sections 3090.1 and 3090.2.


Section 4(c)(8) of the BHC Act(Factoring) Section 3090.1

3090.1.1 INTRODUCTION

Factoring is the discount purchasing of the cli-ent’s accounts receivable invoices for goods thathave been manufactured and shipped. Factoringdiffers from accounts receivable financing inthat the factor assumes the credit risk of collect-ing payment from the recipient of the goods.The principal advantage of factoring is that theclient is assured of the collection of the pro-ceeds of its sales, regardless of whether thefactor is paid.

A factor generally offers four basic services:(1) credit investigation and approval; (2) buyingthe client’s accounts receivable at a discount(generally between .75 and 1.5 percent) aftershipment of the goods to which there is nosubsequent claim, just a claim against theinvoices; (3) bookkeeping in the form of postingaccounts; and (4) advancing funds in the formof an ‘‘open account’’ when there could be30 days between shipment and payment. Thelater allows the client to replenish inventoryloans for working capital or expansion.

Maturity factoring and advance factoring arethe basic techniques of the industry. In maturityfactoring, an average maturity due date is com-puted for the receivables purchased during aperiod and the client receives payment on thatdate. Advance factoring uses the same computa-tions, however, the client has the option of tak-ing advance payments equal to a percentage ofthe balance due at any timeprior to the com-puted average maturity due date. The unad-vanced balance, sometimes called the ‘‘client’sequity,’’ is payable on demand at the due date.

The factor’s balance sheet reflects the pur-chases as ‘‘factored receivables’’ and the liabili-ties as ‘‘due to clients.’’ Usually the due toclients balance will be significantly less than thefactored receivables balance because of pay-ments and advances to the clients. The incomestatement will show factoring commissions,which represent the discount on the receivablespurchased. Interest income for advances on thedue to client balances may or may not be aseparate line item.

The factor is a pivoting point between thebuyer and the seller. The buyer must pay or allparties lose. Also the seller must have a reputa-tion for delivering quality merchandise. The fac-tor must know the business well enough toaccount for sudden increases in returns for out-of-specification merchandise or for merchandiseof low quality. If the seller does not performadequately, payment for the goods may not be

forthcoming, and if bankruptcy threatens theseller, buyers may hold back their futurepurchases.

3090.1.2 FUNDING

Since factors traditionally provide financing toindustries with seasonal borrowing require-ments, such as textiles, shoes, clothing, andother consumer goods, their own funding pro-grams will usually reflect this volatility. It maybe expected that factors generally will havegreater access to short-term unsecured creditfacilities than would be expected for other non-bank activities. This would hold true for factorsfunded solely from internal sources as well asexternal sources.

Because of a factor’s inherent funding volatil-ity, a major portion of a factor’s liabilities willbe short-term debt. For the internally fundedcompany, this source will be predominantlycommercial paper proceeds from the parentcompany, with perhaps some bank line proceedsintermixed. The externally funded company willprobably rely on bank lines for its short-termneeds, usually with the parent company’s guar-anty of the debt.

Longer term funding may be provided throughbank term loans and subordinated debt, althoughthe volume of this type of debt appears to below relative to other financing industries. Theterms and covenants of long-term debt appear toallow for relatively more flexibility in opera-tions and more highly leveraged positions thansimilar debt for other financing industries inrecognition of the volatility of factoring opera-tions and the liquidity of factoring assets.

The principal suppliers of senior and subordi-nated funds to factors and accounts receivablefinancers appear to be limited to a few insurancecompanies that specialize in this field, althougha few banks also provide senior term funding.These lenders have incorporated their percep-tions of acceptable balance sheet ratios andearnings performance into their debt agreementsas restrictive covenants. Since comparativeindustry data is limited, these restrictive cove-nants may be the examiner’s primary means ofevaluating leverage, loss reserves, and capitaladequacy. The ‘‘due to clients’’ account is anothersignificant measure of a factor’s liabilities. Asnoted before, the account represents the


accumulation of the amounts payable to theclients upon the maturity of their factoredreceivables. This liability is, to a large extent,self-liquidating through the collection of thosereceivables.

An analysis of the changes in the relativeproportions of the ‘‘due to clients’’ accountshould provide valuable input into the analysisof a factor’s earnings. Since factoring is a highlycompetitive industry, price cutting has reducedfactoring commissions to a point where theyprovide minimal support to earnings; therefore,the interest margins on factoring advances havea significant impact on net income. The implica-tion of the analysis of proportional changes isthat as more clients take advances (reducing‘‘due to clients’’), profit margins should widen,and conversely, as the ‘‘due to clients’’ propor-tion of total liabilities rises, profit margins maybe expected to narrow.


1. To determine whether the company is op-erating within the scope of its approved activi-ties and within the provisions of the Act andRegulation Y.

2. To determine whether transactions withaffiliates, including banks, are in accordancewith applicable statutes and regulations.

3. To determine the quality of the asset port-folios, and whether lending, monitoring and col-lection policies are adequate to maintain soundasset conditions.

4. To determine the adequacy of the reservefor loan losses and whether the asset charge-offpolicy is appropriate.

5. To determine the viability of the companyas a going-concern, and whether its affiliatestatus represents a potential or actual adverseinfluence upon the condition of the consolidatedcorporation.


The inspection procedures for a factor havebeen divided into two phases, preliminary andon-site, when considered necessary.

The preliminary phase entails the gatheringand analysis of information at the parent com-pany in order to determine the scope of the fieldwork to be performed on-site. The on-site seg-ment of the procedures expresses some of the

typical practices and considerations in this formof financing.

During the preliminary phase, the followinginformation should be reviewed:

1. System approvals for offices and activities,including stipulated public benefits;

2. Financial statements, both interim and fis-cal, for a sufficient period to determine trendsand operating patterns;

3. All management reports which shouldindicate problem loans, loan volume, newaccounts and other reports regarding loan port-folio and company status;

4. External debt instruments to determinematerial restrictive covenants;

5. Internal audit reports and workpapers;6. Minutes of the board of directors, execu-

tive committee and loan committee, if availableat the parent company;

7. Theresultsofaparentcompany loanreview,if any.

8. To be requested:a. Schedules of past due loans, intercom-

pany participations, and large loans;b. Schedules of problem accounts, liqui-

dating accounts, and repossessed assets;c. General ledger trial balance;d. Loan trial balance, including over-

advances;e. Statements of company lending, accrual,

and other policies;f. Reconcilement of the loan loss reserve

for the period between inspections;g. Listing of common borrowers between

affiliates.

3090.1.4.1 On-Site Procedures

After reviewing the material available at theparent company, including the audit review, adecision whether to go on-site is in order. Someof the determinants of this decision are relativesize, current earnings performance, overall con-tribution to the corporation’s condition, assetquality as indicated by internal loan reviewreports and problem loan reports, and the condi-tion of the company when last inspected. Fromthe information provided, it might be deter-mined that the company is operating properlyand is in apparently sound condition. In such acase, an on-site inspection may not be war-ranted. Conversely, a deteriorating conditionmight be detected which would require a visit,even though a satisfactory condition had beendetermined during the previous inspection. Sub-sidiaries in unsatisfactory condition should be

Section 4(c)(8) of the BHC Act (Factoring) 3090.1


inspected each time the parent company isinspected.

The following comments provide a generaloutline of the factor’s basic operation. This out-line will provide a background for the com-ments in the inspection procedures.

While the typical factoring agreement stipu-lates that all accounts receivable of a client areassigned to the factor, not all are purchasedwithout recourse. The agreement between thefactor and the client will usually state thatreceivables subject to shipping disputes anderrors, returns, and adjustments are chargeableto the client because they do not represent bonafide sales. In addition, sales made without thefactor’s approval are consideredclient riskreceivables, with full recourse to the client if thecustomer fails to pay.

The usual approval process requires the clientto contact the factor’s credit department beforefilling a sales order on credit terms. The creditdepartment will research its files, determine thecredit worthiness of the customer, and approveor reject the sale. As stated before, if the creditdepartment rejects the sale, the client may com-plete the sale, but at its own risk. The mostcommon reasons for rejection are sales to affili-ates, sales to known bad risks, sales to custom-ers whose credit cannot be verified, and sales tocustomers whose outstanding payables exceedthe factor’s credit line.

Once a sale has been made and the receivableassigned to the factor, approved or not, theclient’s account will be credited for the netinvoice amount of the sale. That is, any trade orvolume discounts, early payment terms, andother adjustments are deducted from the invoiceamount. The receivable then becomes part ofthe client’s ‘‘availability’’ to be paid in advanceor at the computed due date, depending upon thebasis of the factoring arrangement.

Each month the client will receive an ‘‘ac-counts current’’ statement from the factor whichdetails the transactions on a daily basis. Thisstatement will reflect the daily assignments ofreceivables, remittances made, deductions forterm loans, and interest charges and factoringcommissions. Credit memos, client risk, chargebacks, and other adjustments will also be shown.Client risk charge backs are the amounts deductedfrom the balance due to the client upon thefailure of customers to pay receivables factoredat client risk.

The accounts current statement and the avail-ability sheets will be necessary for the assetanalysis process. Considering the volume oftransactions, the accounting system that devel-ops this data will probably be automated, which

may allow the factor to obtain comparison andmonitoring data on the client. If a monitoringsystem is in place, the data provided will bevaluable in the asset analysis process.

The evaluation of a factor includes a reviewof its systems and controls as well as an analysisof the quality of its assets, both of which may beaccomplished by a two segment analyticalapproach. A major portion of a factor’s assetswill be factored receivables, for which the creditdepartment has the responsibility for credit qual-ity and collection. The other major portion ofthe assets will be the client loans and creditaccommodations, for which the account officersare responsible. The procedures for each areawill be dealt with separately.

3090.1.4.2 Credit Department

Because of its integral function in the credit andcollection process, the credit department is theheart of a factor. The department maintainscredit files, which are continually updated aspurchases are made and paid for by the custom-ers. These files will include financial statements,credit bureau reports, and details of purchasingvolume and paying habits. Usually, each cus-tomer will have an assigned credit line, which isthe credit department’s estimate of the custom-er’s credit capacity.

The evaluation of this department should takethe form of a review of a sample of the customerfiles. The sample may be drawn from lists oflarge volume customers and closely monitoredcustomers, or it may be a random sample. Theexaminer should have either a copy of depart-mental policies and procedures or a verbalunderstanding of them prior to the review. Itshould be kept in mind that the objective of thereview is to critique the credit and collectionprocess and to verify departmental effective-ness, and not to obtain classifications.

3090.1.4.3 Asset Evaluation

Prior to the review of asset quality, the examinershould receive the lists of problem clients, clientover-advances, term loans, and credit accommo-dations; as well as the aging schedule of fac-tored receivables including client risk receiv-ables. These will be used as the basis for selectingthe clients to be reviewed. It is recommendedthat the selection be made from the list of clientswith term loans, largest first, in addition to the



acknowledged problems. Clients with high dilu-tion rates and those with client risk receivablesequal to 20 percent or more of factored volumemay also be included.

It should be noted that a factor usually col-lects principal and interest payments directlyfrom the client’s availability, which means thatthe expected delinquency rate is minimal. Pastdue factored volume is not an effective measureof client quality.

A maturity client’s availability is the sum ofall factored receivables, less trade and otherdiscounts, factoring commissions, credit memos,and client risk charge-backs. There may also beother deductions for letters of credit and othercredit accommodations. An advance client’savailability would be further reduced by ad-vances on the factored receivables, interestcharges, and the reciprocal of the contractuallyagreed upon ‘‘advance’’ percentage. This recip-rocal, 20 percent in the case of an 80 percentadvance client, is sometimes referred to as theclient’s ‘‘equity’’ in the factored receivables.Availability may be increased by liens on addi-tional collateral such as inventory, machineryand equipment, real estate, and other marketableassets.

The review and analysis of asset quality willbe procedurally similar to that used in accountsreceivable financing. However, certain aspectsof the financial statements may need elabora-tion. The client’s balance sheet will have a ‘‘duefrom factor’’ account instead of accounts receiv-able. The account balance may be somewhatlower than a normal receivables balance, whichwould affect turnover ratios and other short-term ratios. The difference relates to the client’sability to convert sales to cash faster with afactor than if the receivables were to be col-lected normally. In addition, the analysis of thestatements should incorporate an assessment ofthe client’s ability to absorb normal dilution andthe potential losses associated with client riskreceivables, particularly when these factors arehigher than usual for the portfolio.

As a factor’s systems and controls for clientloans are somewhat similar to those for accountsreceivable financing, the evaluation of assetquality must consider these factors before theclassification of a client is made. While thetypical client may have less than satisfactoryfinancial statements, the factor’s working knowl-edge of the client’s operations and industrytends to mitigate the risk factors present.

For classification purposes, ‘‘client risk

receivables’’ is the only portion of factored vol-ume that is appropriate for use in the amountclassified. Because of the recourse aspect thebalance is considered as an indirect obligationrather than a direct obligation.

As a further step in the evaluation of thelending area and its controls, the evaluation ofthe steps taken and the results of at least onerecent client liquidation should be made. Byreviewing the chronology of events along withthe loan and collateral balances, the effective-ness of systems and controls under extendedcircumstances may be assessed. The type ofliquidation will have a bearing on the lossestaken. Losses tend to be higher when clientfraud is involved.

In the process of evaluating a factor’s condi-tion, the adequacy of systems and controls andthe capability of management are consideredsignificant measures. Asset quality, as measuredby classifications, may be influenced by sea-sonal aspects and should be carefully analyzedto allow for such influences. Because of a lackof regular and consistent comparative data forthe industry, earnings and capital adequacyare evaluated in terms of the company’s ownperformance.

The review of the company’s internal systemsand controls should be continuous during theinspection. Considering the large volume ofdaily transactions that flows through a factor,any internal control that can be easily negatedrepresents a potential problem and should bebrought to management’s attention. In the broadcontext, this review would include the creditcontrols for both clients and customers. Sincecredit problems can develop rapidly in factor-ing, credit controls and systems must be respon-sive to the identification of these problems.Deficiencies noted should be discussed withmanagement and, if significant, cited in thereport. The company’s earnings trends may beevaluated by using a comparative yield on assetsapproach. By analyzing yields on asset cate-gories from period to period the examiner willbe able to make a judgment as to the efficiencyof the systems. Factors are subject to the sameprice competition in the commercial financemarket as accounts receivable financers. Declin-ing portfolio yields may reflect the inroads madeby competition and may indicate a decline infuture profitability.

The subject of capital adequacy is influencedby the aforementioned seasonal characteristics.Over the period of a year, the comparisons ofequity to assets and equity to liabilities will varysignificantly. It is suggested that an averagebalance sheet be used to stabilize the variations.



In addition to balance-sheet ratio analysis, theeffects of dividends and fees paid to the parentcompany on the capital accounts may be ana-lyzed to determine the rate of internal capitalgeneration. If the company is in a growth pro-file, or attempting to gain market share, the

comparisons between fiscal periods may reflecta declining trend. Such a trend should be dis-cussed with parent company management.

The report comments should summarize theseconsiderations in a clear, concise presentation.

3090.1.5 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws1 Regulations2 Interpretations3 Orders

Loans to affiliates 23A FRA371c

Purchase of affiliate’s notes froma third party

23A FRA371c

3–1131 1951 FRB 960

Activities not closely relatedto banking

4(c)(8) BHC Act1843(c)(8)

225.126 4–184

Acquisition of assets 4(c)(8) BHC Act1843(c)(8)

225.132 4–175.1 1974 FRB 7251984 FRB 370

Real estate mortgages as eligiblecollateral under section 23A

23A FRA371c

1933 FRB 566

Indebtedness of affiliate on assetsacquired from member bank

23A FRA371c

3–1125 1936 FRB 324

Marketability of collateral undersection 23A

23A FRA371c

3–1121 1935 FRB 395

Activities closely relatedto banking

4(c)(8) BHC Act1843(c)(8)

225.123225.28(b)(1)

4–176 1971 FRB 5141975 FRB 2451984 FRB 501984 FRB 3701984 FRB 3761984 FRB 4521984 FRB 7361986 FRB 1431988 FRB 1771988 FRB 3301989 FRB 791992 FRB 74

Community developmentactivities

4(c)(8) BHC Act1843(c)(8)

225.127225.28(b)(12)

4–178 1972 FRB 572

1. 12 U.S.C., unless specifically stated otherwise.2. 12 C.F.R., unless specifically stated otherwise.

3. Federal Reserve Regulatory Service reference.



Section 4(c)(8) of the BHC Act(Accounts Receivable Financing) Section 3090.2


Accounts receivable financing is a revolvingcredit facility secured by an assignment ofaccounts receivable. As a financing technique, itallows the client (the financed company) toobtain working capital without waiting for cus-tomer payments. This form of financing is fre-quently used by companies with working-capitalshortages, companies in seasonal industries, andcompanies with weak financial conditions. Typi-cally, the funding requirements of these compa-nies are in excess of any amounts that would beavailable through unsecured bank financing.

The financing process begins with a bona fidecredit sale by the client and the assignment ofthe resulting receivable to the financer. Uponassignment, the financer advances a specific per-centage of the receivable to the client. The loanis repaid by customers’ direct payments or, inthe case of a lockbox, by the remittance of thecustomer’s payment to the financer, who returnsthe amount in excess of the loan to the client.While a simple concept for a single transac-tion, the operations of an accounts receivablefinancer become a complex process when manyclients and perhaps thousands of receivables areinvolved.

Companies engaged in accounts receivablefinancing usually incorporate the full range ofcommercial financing activities into their opera-tion. These activities would include inventoryfinancing, loans secured by machinery and equip-ment, some forms of real estate loans, and loanssecured by other assets. As a general statement,these companies will provide working-capitalfinancing using almost any form of viable collat-eral to secure the loans. These additional activi-ties are facilitated by the financer’s in-depthknowledge of the borrowers’ financial condi-tions and cash flows. This knowledge comesfrom the controls placed on the borrowers, suchas periodic field audits, the flow of the borrow-er’s cash through the company, and an internalstaff that specializes in the financed industries.

3090.2.2 FUNDING

Accounts receivable financing companies, likefactors, traditionally provide working-capitalfinancing to seasonal industries. Consequently,the funding programs of these financing com-panies will reflect these variations in theirincreased use of short-term funds relative toother nonbanking activities.

Since many accounts receivable clients have

seasonal businesses, a large portion of thefinancer’s liabilities will be short-term debt. Forinternally funded financers, this debt will bepredominantly commercial paper proceeds fromthe parent company, with perhaps some banklines intermixed. The externally funded com-pany will probably rely on bank lines for itsshort-term needs, usually with the parent com-pany’s guaranty of the debt.

Longer term funding may be provided throughbank term loans and subordinated debt, althoughthe volume of this type of debt appears to below relative to other financing industries, anotherparallel to factoring. The terms and covenants oflong-term debt appear to allow for more flexibil-ity in operations and somewhat more highlyleveraged positions than similar debt for otherfinancing industries. This practice is apparentlyin recognition of the volatility of this form offinancing and the liquidity of the assets support-ing the financer’s loans.

The principal suppliers of senior and subordi-nated funds to collateral lenders (factors andaccounts receivable financers) appear to be lim-ited to a few insurance companies that special-ize in this field, although a few banks alsoprovide senior term funding. These lenders haveincorporated their perceptions of acceptablebalance-sheet ratios and earnings performanceinto their debt agreements as restrictive cov-enants. Since comparative industry data arelimited, these restrictive covenants may be theexaminer’s primary means of evaluating lever-age, loss reserves, and capital adequacy.


1. To determine whether the company is op-erating within the scope of its approved activi-ties and within the provisions of the act andRegulation Y.


3. To determine the quality of the asset port-folios and whether lending, monitoring, and col-lection policies are adequate to maintain soundasset conditions.

4. To determine the adequacy of the reservefor loan losses and whether the asset charge-offpolicy is appropriate.

5. To determine the viability of the companyas a going concern, and whether its affiliate


status represents a potential or actual adverseinfluence upon the condition of the consolidatedcorporation.


The inspection procedures for an accountsreceivable company have been divided into twophases, preliminary and on-site.

The preliminary phase entails the gatheringand analysis of information at the parent com-pany in order to determine the scope of the fieldwork to be performed on-site, if required. Theon-site segment of the procedures expressessome of the typical practices and considerationsin this form of financing.

During the preliminary phase, the followinginformation should be reviewed:

1. system approvals for offices and activities,including stipulated public benefits

2. financial statements, both interim and fis-cal, for a sufficient period to determine trendsand operating patterns

3. all management reports which shouldindicate problem loans, loan volume, newaccounts and other reports regarding loan port-folio and company status

4. externaldebt instruments todeterminemate-rial restrictive covenants

5. internal audit reports and workpapers—a. internal control exception report to

determine weaknesses and corrective actions,b. flow charts in the workpapers which

will enable the examiner to become familiarwith company systems, and

c. additional internal reports may be iden-tified which may assist the inspection on-site

6. minutes of the board of directors, execu-tive committee and loan committee, if availableat the parent company

7. the results of a parent company loan review,if completed

8. To be requested:a. schedules of past-due loans, inter-

company participations, and large loansb. schedules of problem accounts, liquidat-

ing accounts, and repossessed assetsc. general ledger trial balanced. loan trial balancee. statements of company lending, accrual,

and other policiesf. reconcilement of the loan-loss reserve

for the period between inspectionsg. listing of common borrowers between

affiliates

3090.2.4.1 On-Site Procedures

After reviewing the material available at theparent company level, including the audit review,a decision whether to go on-site is in order.Some of the determinants of this decision wouldinclude relative size, current earnings perfor-mance, overall contribution to the corporation’scondition, asset quality as indicated by internalloan review reports and problem loan reports,and the condition of the company when lastinspected. From the information provided, itmight be determined that the company is operat-ing properly and is in apparently sound condi-tion. In such a case, an on-site inspection maynot be warranted. Conversely, a deterioratingcondition might be detected which would re-quire a visit, even though a satisfactory condi-tion had been determined during the previousinspection. Subsidiaries in unsatisfactory condi-tion should be inspected each time the parentcompany is inspected.

The on-site inspection procedure will be simi-lar to that used in a commercial department of abank. Selection and evaluation of the assets,review of internal controls, identification oflending policies, and credit review proceduresare all familiar areas to the examiner and do notneed further explanation. However, the account-ing and reporting systems are somewhat differ-ent and will require the examiner to becomefamiliar with systems and policies before pro-ceeding with the asset evaluation process.

3090.2.4.2 Accounting and Controls

There are two basic systems within the account-ing and control environment of an accountsreceivable company. The first system providesaccounting and control for client loans and col-lateral balances and is frequently automated tohandle the large flows of data generated in theoperation. It is also common to find lockboxarrangements with banks that tie into the clientsystem for the receipt of customer remittances.Such lockbox arrangements provide a greaterdegree of control over remittances.

The mechanics of the client system will bedetailed in the internal audit file, which shouldalso indicate the adequacy and efficiency of thesystem’s controls. The audit file may also indi-cate the accounting techniques used and theclient-monitoring reports that are generated bythe system, such as dilution rates and trends,and year-to-year volume and operating compari-sons. The client system provides the basic datafor the company’s accounting and control sys-

Section 4(c)(8) of the BHC Act (Accounts Receivable Financing) 3090.2


tem. While the basic accounting considerationsare outlined in the AICPAIndustry Audit Guide:Audits of Finance Companies, there are certainaccounting aspects which deserve additionaltreatment. In some cases where a group ofrelated companies are clients, the financingarrangements may include cross-guarantees andcross-collateralizationagreements. In thesecases,the financer might utilize excess availability forsome of the related entities to offset the over-advance of another entity. Another treatmentthat may be applied is the use of a ‘‘reserve forliquidating accounts,’’ which in some instancesis a specific reserve for a problem account thatreverses at least current period earnings for theaccount. This reserve is in addition to the allow-ance for bad debts and may not be an explicitbalance sheet account, but an offset to grossloans outstanding.

3090.2.4.3 Definitions

While many of the following comments definecertain routine accounting and control consider-ations for accounts receivable financing, certainof the concepts are necessary for proper evalua-tion of client quality (i.e., availability, dilution,over-advances, and advances on other collat-eral). These definitions are general in nature asis the terminology, however, the processes willbe similar in almost every company.

Loans to the client are based upon a contrac-tual percentage of the client’s eligible receiv-ables against which the financer has agreed toadvance funds. Eligible receivables include allassigned receivables, less trade discounts, earlypayment discounts, contra-accounts (reciprocalsales between the client and customers), receiv-ables past due beyond the eligibility periodspecified in the contract, and other adjustments.The advance percentage is determined by anumber of factors which include the expectedaverage dilution rate (disputed invoices, mis-shipped goods, returns and allowances, etc.) andthe client’s expected gross profit margin. As ageneral rule, lenders in this field try to financeonly the cost of sales and not the client’s profits.

Because this form of financing involves rap-idly changing collateral balances, a high volumeof customer payments, and frequent loan re-quests, the financer has to determine the client’s‘‘availability’’ (loanable funds) before advanc-ing the loan. Availability is the total of eligiblereceivables times the advance percentage lesscredit memos and the current loan balance.Credit memos are adjustments to the customer’saccount for errors in the client’s shipments (i.e.,

the quantity shipped was less than that ordered).It is the client’s responsibility to provide thisinformation to the financer on a daily basis. Ifthere is sufficient availability, the requestedamount is usually advanced. On occasion, theavailability computation will show the client tobe ‘‘over-advanced,’’ that is the loan balanceexceeds the agreed percentage advance againstcollateral. This situation may have occurred be-cause some receivables have become past due,or the financer may have authorized additionalfunds to meet some valid client requirement. Asa rule, over- advance positions are usually sub-ject to a quick paydown to reduce the loanbalance to the original contractual terms.

At times, the availability computation willreflect additional collateral value in the form ofinventories, machinery and equipment, and otherassets, shown net of an advance percentage.These categories usually indicate term loans,secured by liens against the respective assets,which expand the collateral base and provideadditional support to the client’s working capitalrequirements. These term loans should not beconfused with loans for the acquisition of suchassets which might appear only in the client’smonthly statement.

The accounts receivable financer charges in-terest on the daily cash borrowings of the clientand accumulates these charges on the client’smonthly statement. The total interest charge foradvances on receivables and other loans isdeducted directly from remittances received bythe financer. Accordingly, the expected delin-quency rate for an accounts receivable operationis low except for the rare loan which is paiddirectly by the client and other assets whichformerly belonged to a defunct client.

3090.2.4.4 Over-Advances and OtherLoans

It was indicated earlier that an over-advancerepresented funds advanced in excess of avail-able loanable funds and that there are two basiccauses for over-advances. Some over-advancesoccur because a portion of eligible receivablesbecomes past due and ineligible for advances.This condition is usually corrected by theassignment of additional receivables or receiptof customer payments, and therefore may existonly for a few days.

The other basic over-advance occurs when aclient requires additional funds for valid busi-



ness purposes, such as an inventory buildup atthe beginning of a season. In such cases, theover-advance is set up as a very short-term loanand paid down rapidly out of the client’s avail-ability. While the policy for over-advances variesbetween financers, when they are permitted theyare usually carefully analyzed by the internalcredit committee and closely monitored untilpaid off.

If a client is involved only in receivablesfinancing and has made an over-advance request,the financer generally will prefer to take a lienagainst inventory rather than make an unsecuredover-advance. Regardless of the purpose of theinventory loan, the financer will advance only asmall percentage of the inventory value (40 to50 percent) to allow for shrinkage, spoilage andobsolescence of the collateral. While inventoryliens are in effect, the field audit staff will par-tially verify the inventory during each audit.

While machinery and equipment may bepledged as additional collateral to support work-ing capital loans during the business period,most client companies will also finance equip-ment purchases on a secured basis. In eithercase, the financer usually advances a percentageof the quick sale or auction value of the equip-ment as determined by an appraisal. Duringfield audits, the presence of the equipment andappropriate lien tagging are verified by the fieldauditors.

On occasion, a lien on real estate is part of thepledged collateral. The real estate may be oper-ating premises, land, or the property of theprincipal of the client. Such liens may occurwhen the client is acquiring new, or expand-ing old, operating facilities and is using thefinancing relationship to fund the project. How-ever, in many cases the lien was taken to pro-vide additional collateral for working capitalloans. In either case, appropriate documentationand appraisals should be on file.

It should be noted that loans on real estatecollateral are limited to those providing supportto the primary business of the client. Loans tofinance speculative real estate acquisitions, andunrelated commercial property are not consid-ered to be the usual practice of this industry, andwould be considered as not complying with thegeneral activities of a commercial finance com-pany, unless specifically approved.

3090.2.4.5 Asset Evaluation

In selecting the loans to be reviewed, the first

group to be considered is the acknowledgedproblem accounts. The next sample should bedrawn from accounts with high dilution rates,those with frequent or large over-advances, andthose which constantly take down all of theiravailability. Participations, purchased or sold,between affiliates should also be included in theexaminer’s sample. While this approach mayexclude some of the larger accounts, it is intendedto include those accounts which are potentialproblems in the primary review group. Shouldthe company have a monitoring system forpotential problem accounts, the system shouldbe used for drawing the review sample.

The principal tools for the review processshould include: the credit file, the field audit file,the monthly statement for the inspection date,the availability sheet for the inspection date, andupdated information for the interim period end-ing with the on-site inspection date. Within thecredit file, the copies of the financing agree-ments will indicate the specific terms of theborrowing relationship: the pledged collateral;advance percentage; interest rate; guarantees;appraisals; and the required communications,such as monthly receivables agings, inventoryand machinery and equipment certification,etc. The usual file information will also in-clude management’s analysis of the client’soperations.

The field audit file will contain the auditreports originated by the financer’s field auditstaff. These reports are usually quite comprehen-sive, with a primary focus upon critical financialareas. As a minimum, the auditors will analyzetrade payables, State and federal taxes, cashflows, inventories, and receivables. Particularattention is paid to the client’s sales and ship-ping procedures in order to ascertain that validinvoices are being assigned to the financer. Theclient’s accounting procedures are also analyzedto determine their effectiveness and accuracy.These reports represent a primary source ofinformation regarding the general financial con-dition of the client.

The client’s monthly statement and availabil-ity sheets represent spot information on the cli-ent’s activity. Many clients operate in seasonalindustries such as clothing and textiles. In suchindustries, a client will tend to use all of itsavailability, as well as seasonal over-advances,during its inventory buildup period, and will payoff the over-advances and may have excessavailability during the sales and collection period.The examiner will have to analyze the client’scurrent position with regard to its particularoperating cycle. Over-advances granted to a cli-ent for valid reasons do not necessarily repre-



sent undue exposure or a substandard asset forthe financer.

The financial statements of a client quite fre-quently reflect a ‘‘relatively unsatisfactory orweak’’ financial condition, with minimal work-ing capital, high leverage, and uncertain earn-ings as prime ingredients. There have been caseswhere both deficit working capital and deficitnet worth were in evidence, however, the financ-ing relationship has continued to function prop-erly. The financer can continue these relation-ships if the short-term factors (sales volume,receivables and inventory turnover, and currentliabilities) are appropriate and the character ofthe principals warrants the exposure. Analysisof a financed client should emphasize the short-term analytical factors and the related trends inthe evaluation of asset quality.

Such factors as the success of the sellingseason, availability of materials, and fad mer-chandising will have direct impact on the cli-ent’s financial condition. While the loan may beadequately protected by pledged collateral, theability of the client to continue operations maybe affected by these short-term factors.

For classification purposes, the financer’s con-trols will have to be considered in addition toweighing the degree and quality of collateralprotection, short-term factors, and the client’sability to withstand any financial reverses thatare evident. Clients with deficit net worth, past-due tradeobligations,anddelinquent taxesshouldbe considered to be problems and appropriatelyclassified. The ability of the financer to controlthe risk exposure in the portfolio will be animportant consideration in determining whetherto classify a specific loan.

3090.2.4.6 DPC Assets

In some companies, assets acquired from de-funct clients remain in the loan account insteadof being reclassified to another balance-sheetcategory. Usually, these assets are uncollectedaccounts receivable, inventory, and machineryand equipment which have not been liquidated.However, these assets may include securities, aswell as business and personal real estate, whichhad been pledged as collateral. By retainingthese assets in the loan category, effective liqui-dation of the respective assets may be delayedbecause they usually represent small dollaramounts. Apart from this consideration, classifi-cation as loans may disguise the fact that certainof the assets may be subject to provisions ofRegulation Y and the act, such as control andretention considerations. Separate control ofthese assets is recommended.

It is common practice in the accounts receiv-able and factoring industry for the lender torequire a pledge of client company stock by theprincipals, particularly in overextended situa-tions. Additional pledges of securities owned bythe principals may also provide added collateral.While such pledges are not precluded by Regu-lation Y and the act, once they become com-pany assets they should be reviewed for controland retention purposes.

3090.2.4.7 Financial Condition

Secured lending relies upon the four C’s ofcredit: the traditional Capital, Character, Capac-ity, and Collateral. Pragmatically, these lenderspractice a fifth C, Control. In this context, con-trol implies the continuous monitoring of theclient’s financial condition, continued evalua-tion of the collateral, constant contact with theclient, and the adjusting of the credit accommo-dation to conform to the client’s current situa-tion. This control is the reason that the securedlender can maintain a proper and mutually prof-itable financing arrangement with the client.

It is to be expected that the typical portfoliomay include clients with less than satisfactoryfinancial conditions. Considering the controlsimposed upon the borrowing relationships, thesecured lender has compensated for some of theadditional risk in the loans. The combination offield audits, collateral controls, and accountofficer contact can be expected to reduce theexposure to unsatisfactory clients to a mini-mum. However, clients do fail and losses maybe taken in liquidating the account. The inci-dence rate of liquidations and the extent oflosses taken may be an indicator of the effective-ness of company controls.

The earnings of an accounts receivable com-pany are based upon loans carrying interest ratesabove prime, which means that loan volume is amajor determinant of revenues. Because thisindustry is very competitive, loan pricing isfrequently used to obtain new clients from otherlenders in order to promote growth in loan vol-ume. Increases in loan volume combined withdeclining interest margins may be an indicatorof price competition that is yielding negativeresults. Analysis of client turnover may verifythis possibility.

In summary, management’s ability to controlrisk and achieve profitability is essential to thesoundness of an accounts receivable operation.



The effectiveness of company policies, theexpertise of the lending staff and field auditstaff, and the adequacy of systems and controlsare the expressions of this ability to control risk.Company profitability is a measure of man-

agement’s ability to obtain satisfactory clientquality and terms in a price-competitive envi-ronment. The examiner will have to balancethese factors in assessing the condition of thecompany.



Loans to affiliates 23A FR Act371c

Purchase of affiliate’s notesfrom a third party 3–1131 1951 FRB 960

Acquisition of assets 225.132 4–175.1 1974 FRB 7251984 FRB 370

Activities closely relatedto banking

225.123 4–176 1971 FRB 5141975 FRB 245

Investments in communitywelfare projects

225.127 4–178 1972 FRB 572





Section 4(c)(8) of the BHC Act(Consumer Finance) Section 3100.0


The basic activity of a consumer finance com-pany is making installment loans to individualsand ispermissiblepursuant tosection225.28(b)(1)of Regulation Y and section 4(c)(8) of the BHCAct (the act). In most areas, a company maymake these loans under one or more of thefollowing licenses: consumer discount, smallloan, sales finance, or second mortgage. Most ofa company’s activity will probably be directcash lending, in which the borrower and thelender come into direct contact with one anotherin the credit-extension process. However, a sig-nificant volume of lending is done through third-party contact. This is sales finance lending inwhich the company purchases, or discounts, theloans originated by a durable goods dealer indaily retail sales activity. Second mortgage lend-ing may be originated from either direct contactor through home-improvement contractors.

Most consumer finance companies offer credit-related insurance as part of their services, andmay have a captive insurance subsidiary if theyare large enough. Inspection considerations andprocedures for reviewing credit-related insur-ance activities are covered in section 3170.0.

3100.0.2 FUNDING

In some holding companies, management haselected to use a conventional industry fundingpattern to support its consumer finance com-pany operations. This pattern makes use of long-term subordinated debt in a specific proportionto equity capital. The further addition of seniorlong-term and short-term debt is then limited byrestrictive covenants incorporated into the sub-ordinated debt agreements. These covenants alsoprovide operating limits for management in suchareas as the proportions of specific classes ofassets, minimum levels of net worth to be main-tained, and the maximum dividend payoutallowable. Since the wording and limits ofthese covenants are negotiated between the bor-rower and the subordinated debt holder, gener-alizations regarding the usual terms are notpracticable.

It appears that certain life insurance compa-nies supply most of this subordinated debt to theconsumer finance industry. Along with theirgeneral knowledge of the industry, these insur-ance companies police their loans by requiringperiodic reports from the borrower and by send-ing teams of their people to review the borrow-

er’s operations. In a sense, this approach tofunding represents regulation and control bymarket forces rather than by governmentalintervention.

In other holding companies, management haselected to support these operations using hold-ing company funding sources such as commer-cial paper and lines of credit. In using thisapproach, operating management is generallyfree from market restrictions on operations.

It is likely that most affiliated consumer financecompanies will have a funding plan that fallssomewhere between these two extremes. Sincecommercial paper generally carries a lower totalcost than bank lines of credit, the examiner mayfind that the senior short-term debt componentis almost completely supplied by the parentcompany. On the other hand, long-term debtmay have been obtained directly, or with theparent company’s guaranty, or it may have beenborrowed from the parent company’s sources—that is, the parent borrows from a third party andre-lends the proceeds to the subsidiary.

Since a large volume of consumer installmentpaper carries maturities of three years or more,the use of commercial paper proceeds withmaximum maturities of 270 days warrants somecomment. Securities Act Release No. 401 spe-cifically recognizes this use of commercial paperas appropriate. Further information may be foundin the Code of Federal Regulations, 17 C.F.R.231.4412. Also see sections 2080.1 and 5010.16for information on commercial paper.


1. Todeterminewhether thecompany isoperatingwithin the scope of its approved activitiesand within the provisions of the act andRegulation Y.


3. To determine the quality of the asset port-folio, and whether lending, monitoring, andcollection policies are adequate to maintainsound asset conditions.

4. To determine the adequacy of the reserve forloan losses and whether the asset charge-offpolicy is appropriate.

5. To determine the viability of the company asa going concern, and whether its affiliate


status represents a potential or actual adverseinfluence on the condition of the consoli-dated corporation or the subsidiary bank(s).


After reviewing the material available at theparent company level, including the audit review,a decision whether or not to go on-site is inorder. Some of the determinants of this decisionwould include relative size, current earningsperformance, overall contribution to the corpo-ration’s condition, asset quality as indicated bydelinquency reports and industry comparisons(detailed later in this section), and the conditionof the company when last inspected. From theinformation provided, it might be determinedthat the company is operating properly and is inapparently sound condition. In such a case, anon-site inspection may not be warranted, provid-ing that a fairly recent on-site inspection hadbeen conducted. Conversely, a deteriorating con-dition might be detected which would require avisit, even though a satisfactory condition hadbeen determined during the previous inspection.Subsidiaries in unsatisfactory condition shouldbe inspected each time the parent company isinspected.

The inspection procedures for a consumerfinance company have been divided into twophases: preliminary and on-site. The prelimi-nary phase entails the gathering and analysis ofinformation at the parent company to determinethe scope of the field work to be performedon-site. The on-site phase establishes a mini-mum scope of the inspection at the main office,and includes considerations to be incorporatedinto a visit to field offices if the inspection scopeis expanded to that degree.

During the preliminary phase, the followinginformation should be reviewed:1. system approvals for offices and activities,

including stipulated public benefits2. financial statements, both interim and fiscal,

for a sufficient period to determine trendsand operating patterns

3. all management reports which should indicateproblem loans, loan volume, delinquencies,and other reports regarding loan portfolioand company status including the RobertMorrisAssociates’DirectCashLendingQues-tionnaireand similar reports

4. external debt instruments to determine mate-rial restrictive covenants

5. internal audit reports and workpapers:a. internal control exception reports to

determine weaknesses and correctiveactions

b. flow charts in the workpapers to becomefamiliar with company systems

c. additional internal reports may be identi-fied which may assist the inspection on-site

6. examination reports of any state regulatoryagencies having jurisdiction over the compa-ny’s offices

7. minutes of the board of directors, executivecommittee, and any other such committee, ifavailable at the parent company

8. the results of a parent company loan reviewor operations review, if conducted andavailable

9. the following items to be requested frommanagement:a. detailed past-due schedules and inter-

company participationsb. schedule of problem accounts, liquidating

accounts, and repossessed assetsc. general-ledger trial balanced. loan trial balancee. policy statements on lending, accrual, and

charge-offsf. reconcilement of the loan-loss reserve for

the period between inspectionsg. organization charth. listing of company offices with addresses

and operating licenses

3100.0.4.1 On-Site Phase

The procedures of the on-site inspection areintended to evaluate management and its super-visory efforts, to determine the soundness andcompliance with the company’s operating poli-cies, and to analyze the impact of these policieson the company’s financial condition using ratioanalysis. A thorough understanding of the poli-cies and systems of the company is necessaryfor the examiner to accurately determine thecompany’s condition.

During the initial period on-site, the examinermay obtain an overview of the company’s sys-tems by interviewing the key staff officers. Theseindividuals can provide the examiner with thedetailed reports, policy manuals, and other infor-mation necessary for the inspection.

Section 4(c)(8) of the BHC Act (Consumer Finance) 3100.0


3100.0.4.2 Policy Evaluation

Because of its large volume of transactions andthe number of offices involved, the typical con-sumer company will maintain an extensive setof policy and procedure manuals which areintended to guide company personnel in theirdaily activities. During the review of these manu-als, the examiner should bear in mind that lib-eral policies and procedures may allow the com-pany to mask portfolio problems and reflectother than an accurate condition in its financialstatements.

The principal policies to be considered coversuch areas as:1. extensions of credit;2. treatment of delinquent accounts and partial

payments;3. loan renewals;4. loan charge-offs;5. provisions for loan losses;6. bulk purchases of loans, for both credit and

account purposes; and7. treatment of deferred income.After assessing the soundness of company poli-cies, the next step is to test their implementationthrough a review of the company’s supervisorystructure.

3100.0.4.3 Evaluation of the SupervisoryStructure

The effectiveness of the supervisory structure isa key element in the condition of a consumerfinance operation. This system serves two func-tions: it communicates the policies to the fieldpersonnel, and it enforces those policies. Assum-ing that management’s policies are valid, theeffectiveness of this system will be partiallyreflected in the ratio analysis of the company.However, it may take close analysis to deter-mine whether any poor ratios are due to inad-equate policies or ineffective enforcement.

In order to evaluate the supervisory effort, theexaminer may review a sample of the varioussupervisor’s reports which are prepared aftervisits to the loan offices. The sample shouldrepresent a cross-section of the offices and super-visors in order to obtain a balanced view of thecompany.

A further evaluative step may be undertakenif there are sufficient resources available to theexaminer. The on-site visits to selected loanoffices may provide considerable input to theexaminer in assessing supervisory effort. Inselecting the offices to be visited, well-performing as well as poor-performing offices

should be selected. Concentration on poor officeswill result in a biased assessment of the supervi-sory effort and may result in an invalid evalua-tion of company policies. The selection of theoffices may be made by using the number ofpolicy exceptions cited, poor performancerecords, or local economic conditions as criteria.

3100.0.4.4 Detailed Procedures for anOffice Visit

The following steps outline a general procedurefor determining field compliance with companypolicies and assessing the effectiveness of thesupervisory effort. The examiner may modify,eliminate, or expand any of these steps or maydevise any procedure deemed appropriate underthe circumstances present.

The review of loans on-site should be ori-ented toward confirming the implementation ofcompany policies for delinquency, balancerenewals, charge-offs, extensions, partial pay-ments,collection,and loanapprovals.This reviewis intended to be a test of compliance and nota review of specific assets for classificationpurposes.1. Review the detailed delinquency report for

the selected office for a short period beforethe inspection date, generally two or threemonths. Trace the well overdue loans throughto resolution, pay-off, charge-off, or rein-statement. Check these loans against the loanregister to determine whether new loans havebeen granted to these customers and if so,determine if they are in accordance withcompany policy.

2. Review the controls for charging off loansand determine the effectiveness of the collec-tion and recovery effort.

3. Review the loans to present borrowers. Whilerenewals are usually granted to the bettercustomers, the examiner will find a volumeof renewals (‘‘under 10 percent new moneyadvanced’’ loans). In some companies, these‘‘under 10 percent new money’’ loans repre-sent efforts to rehabilitate borrowers withpoor payment records due to ill health, unem-ployment, etc. However, the examiner mayfind that management is using this approachto adjust and control delinquency and lossrates. There should be sufficient internal con-trols present to prevent the continuous renewalof such loans to poor borrowers.



The examiner may find that some officepersonnel are circumventing these controls,for example, by advancing 11 percent newmoney to the borrower. If found, such cir-cumvention raises serious questions regard-ing portfolio quality, the adequacy of internalcontrols, and the effectiveness of the supervi-sory effort. A high volume of ‘‘under 10 per-cent’’ loans or evidence of circumvention ofcontrols may warrant separate treatment inthe report.

4. Review partial-payment, interest-only, andextension accounts. Significant numbers ofthese accounts may indicate potential prob-lems for the loan portfolio and the office.

5. Review credit-extension and loan documen-tation procedures, especially if the office’sportfolio has a high level of losses or fre-quent litigation. Proper credit controls anddocumentation are essential for sound opera-tions. If the office extends second mortgagefinancing, appraisals and lien searches shouldbe included with the documentation.

6. Test the office’s delinquency reporting. Thereare two methods for computing delinquen-cies, a contractual basis and the recencybasis. On a contractual basis, principal reduc-tions are applied to the most overdue pay-ment under the contract and the loan is con-sidered past due from the date of the oldestunsatisfied payment. On a recency basis,delinquency is computed from the date oflast payment regardless of contract terms.

As an example, assume a loan was grantedwith payments beginning the first of March.The borrower makes the first payment ontime and the second payment on the first ofJune. On the first of April, the loan is a30-day recency account and current contrac-tually. On the first of May, the loan is a60-day recency account and a 30-day con-tractual account. Upon receipt of payment inJune, the loan is current on a recency basisand a 60-day (two-payment) contractualaccount. Notice the difference in computa-tions between the banking industry and theconsumer finance industry.

The consumer finance industry has begunto institute contractual delinquency reportingstandards. As these standards are developedand refined, changes in the computation ofdelinquent accounts may be expected.

7. Review the collection effort. The past-dueaccounts will be under the control of thecollection manager, whose objective is to

return these accounts to current status. Themanager’s collection efforts must begin earlyin the delinquency pattern if the loans are tobe salvaged from charge-off. Consistent, per-sistent, frequent effort is expected.

The foregoing steps should provide the examineropportunity to evaluate the company’s policies,procedures, and supervisory systems.

3100.0.4.5 Additional Procedures

While field visits are a desirable aspect of theinspection procedure, the examiner may have torely on other procedures to be satisfied withcertain aspects of company operations, particu-larly when the company reports past-due receiv-ables on a recency rather than a contractualbasis. The additional procedures may be neces-sary when the examiner has other reasons toquestion portfolio quality or the adequacy ofinternal controls.

Theexaminermayperformanextensive reviewof the most recent audit of the company, includ-ing the workpapers and programs of the internaland independent auditors, when available. Inthis review, the examiner should be able todetermine whether internal controls are adequate,andportfoliocharacteristicsareproperly reported.

3100.0.4.6 Compliance

Certain aspects of the company are subject toreview for compliance with the requirements ofthe act and Regulation Y. These include publicbenefits, office activities and locations, and bulkpurchases of assets.1. Public benefits stipulated in approval orders

frequently require continuing reduced inter-est rates or insurance charges as part of theapproval to operate. It is expected that theserelative public benefits continue in effectdespite changes in state-mandated rates.

2. Office locations and activities are subject toapproval by the Board before opening forbusiness. The operating licenses and activi-ties of the offices should also be reviewed forcompliance with the respective approvals.

3. On occasion, a consumer finance companymay make a bulk purchase of loans or otherassets of another finance company. Undercertain circumstances, these purchases requirethe prior approval of the Board (12 C.F.R.225.132). These bulk purchases should notbe confused with the bulk purchase of salesfinance contracts from a retailer recentlysigned to a dealer agreement.



4. While most consumer finance activity relatesto consumer installment loans, some compa-nies also extend credit under the ‘‘large loan’’provisions of the consumer lending statutesof certain states. While the limitations varyfrom state to state, these provisions allowloans of many times the size of normal con-sumer loans. A review of these large loansmay indicate that there are extensions ofcredit to local businesses which may consti-tute commercial installment lending. Unlessspecifically approved by the System, thisactivity may not be permissible for the com-pany being inspected. Review for compli-ance with various consumer regulations isthe responsibility of the Federal Trade Com-mission.

3100.0.4.7 Asset Classification Policy

As previously discussed, companies use one oftwo different methods of delinquency computa-tion. In general, classifications should be basedon the contractual reporting basis wheneverpossible. Since much of the industry utilizesrecencyreporting, which tends to reduce classi-fications comparatively, the classificationapproach enumerated above may unduly penal-ize an affiliated company using the contractualbasis. This is particularly true when such impor-tant measures of portfolio quality as the liquida-tion ratios are in line with industry averages.Therefore, formula classification may result inmore severe classifications for companies usingthe contractual method than those reporting on arecency basis. Examiners should indicate thereporting method used when calculatingclassifications.

Classification information is used to evaluatethe adequacy of the loss reserve. In assessingthe adequacy of the loss reserves, the examinershould take into consideration the charge-offfrequency, the period of delinquency whichwould require charge-off under company policy,and the controls regarding renewal of severelypast-due accounts. A shorter charge-off cycleprevents the accumulation of poor-quality assets;in this respect, monthly charge-offs are prefer-able to annual charge-offs. An unlimited ‘‘whendeemed uncollectible’’ charge-off policy is con-sidered lax and inadequate. The delinquencyperiod to required charge-offs refers to the periodof time a loan is past due before it is charged tothe reserve; a six-month period is understand-ably preferred to a nine-month or one-yearperiod. Management should have sufficient con-trols in place to prevent the continued

renewal of loans to avoid charge-off. Adequatecontrols might include special coding of suchloans, with supervisory review of the renewals.Inadequate controls over these assets representpoor management practices deserving specialcomment.

Most subordinated debt agreements providefor an adjustment (reduction) to net worth whencalculating compliance with leverage limits forany loans past due 60 days on a recency basisthat exceed loss reserves. As there are someseasonal characteristics to the loan portfolio, itmay be of benefit to compare the delinquencystatistics on inspection date to the company’sseasonal pattern as revealed in both the subordi-nated debt calculations and monthly past-duereports. It is possible that a currently adverseportfolio condition may be due to local eco-nomic conditions which correct themselves overa period of time. Such conditions may relate to atourist economy, an agricultural community, ora strike at a major local employer’s plant. Con-sumer finance companies are very sensitive tothese local factors; therefore, these factors maytemper the examiner’s evaluation of the lossreserves.

3100.0.4.8 Ratio Analysis

In order to assess the condition of a companyusing ratio analysis, the examiner will have tobe familiar with the company’s accounting poli-cies and systems. It will become obvious fromthe data used in the ratios that, under certainaccounting treatments, the data can be misinter-preted. The following analysis has been struc-tured around theDirect Cash Lending Question-naire, published by the Robert Morris Associ-ates and endorsed by the National ConsumerFinance Association, in an effort to provide botha format for developing the information and ameans of minimizing the possibility of misinter-pretation. While some consumer companies donot prepare the questionnaire, much of the infor-mation is required for management purposesand should be available from company systems.

The analytical factors presented have beenderived from two principal sources:A Lender’sApproach to a Realistic Analysis of ConsumerFinance Companiesby Richard E. Edwards(Philadelphia: The Philadelphia National Bank,1970) and theIndustry Audit Guide: Audits ofFinanceCompaniesby theCommitteeonFinanceCompanies (New York: American Institute of



Certified Public Accountants, 1988). Thesesources provide basic information on certainaccounting and management policies and arerecommended as references for the examiner.While the Federal Reserve System stipulates nospecific accounting policies, the examiner maychoose to criticize those policies which result ina misleading presentation of the company’sfinancial condition.

Each year theAnnual Statement Studies,pub-lished by Robert Morris Associates, includessets of consumer finance company operatingratios. This information will provide a back-ground against which the performance of thecompany under inspection can be measured.Such compiled ratios should be used only asbackground as they represent the ‘‘average com-pany’’ in the respective sample. Attention shouldbe directed toward the company’s trends as theycompare to the industry’s trends and the changesin the company that are indicated by thosetrends.

3100.0.4.9 Delinquency

As shown in theAnnual Statement Studies,thedelinquency rates are on a recency-of-paymentbasis.While past-due statistics based on con-tractual payments are preferred,companies con-tinue to report on a recency basis. It is importantto have full knowledge of the company’s report-ing, lending, and renewal policies in order tofully understand the implications of this data.The trends for ‘‘interest-only’’ accounts and‘‘partial-payment’’ accounts will provide somemeasure of the adherence of the operating per-sonnel to company policy regarding these loancategories.

3100.0.4.10 Liquidation

Liquidation ratios provide two types of informa-tion. First, they indicate the amount of principalcash flowing back to the company for liquiditypurposes. Secondly, they indicate the amountrequired to pay senior debt and the period oftime required to do so. Several ratios follow:1. Average monthly cash principal collection to

average net monthly outstanding.The higher this percentage, the more liq-

uid the portfolio. A company following con-servative policies such as requiring full pay-ments and a contractual aging of receivables

will tend to show a higher principal collec-tion percentage and, accordingly, a higherliquidity. This ratio can be used to estimatenear term collections as compared to currentoutstandings.

Monthlycashcollectionsshouldnot includeloan renewals or rebates during the period.On an industry-wide basis, there appears tobe a pattern of increased loan renewals dur-ing November and December, which wouldbe reflected in a seasonal decrease in princi-pal cash collections. Lower than expectedcollections may be indications of changes inlocal economic patterns or of increased mar-ket effort by a competitor which has resultedin loan payoff. In any event, adverse changein the collection pattern should be reviewedfor the underlying causes.

2. The ratio of unsubordinated liabilities lesscash and near cash to estimated monthlyprincipal collections results in the number ofmonths it would take to pay senior debt.

3. The ratio of senior debt to gross receivablesreflects the proportion of gross receivableswhich would have to be liquidated to repaysenior debt. The higher the percentage, themore senior lenders are relying on the assetsfor protection.

3100.0.4.11 Loss Reserves

Analysis of the loss reserve for a specific entityhas to include company policy regarding loancharge-offs,delinquencies,payments,andcharge-off frequency. In addition, if charge-offs aremade gross of deferred income, the reserveaccount may be slightly larger than if charge-offs were net of deferred income. Ratios used toevaluate loss reserves include—1. Reserve for loan losses to total receivables,

net of deferred income,2. Loans charged off less recoveries to average

outstandings (net or gross of deferred income,depending on policy).

Unless the company’s charge-off anddelinquency policies are realistic, this ratiowill not depict true losses over the periods,and

3. Recoveries to loans charged off tends to behigher incompanieswithconservativecharge-off policies than those with liberal policies.This ratio is indicative of the effectiveness ofa company’s collection and follow-up policy.

3100.0.4.12 Volume

Analyzing aspects of a company’s loan volume



can provide the examiner with some informa-tion regarding the company’s renewal and creditpolicies.

Lengthening of loan maturities during thecurrent period will be reflected in the futureaverage monthly principal collections and in thecompany’s liquidity. While loans of longermaturity are not necessarily indicative of anadverse trend, the reasons behind a longer matu-rity portfolio should be analyzed. Ratios used toevaluate loan volume include:1. New money advanced to present borrowers

to total loan volume.This ratio issomewhat indicativeofwhether

the company’s renewal policy is conserva-tive or liberal. A high percentage may indi-cate that a volume of new money is beingadvanced along with the renewal of the pre-vious balance.

2. Loans to present borrowers with less than 10percent new money advanced to loan volume.

A high ratio can indicate the possibility ofdisguised delinquencies and potential charge-offs. The examiner may take a random sampleof loans in the new money advanced topresent borrowers category and review themto determine whether or not the company’s‘‘balance renewal’’ policy is being followed.The preceding ratios were presented because

they represent a means of measuring the effectof certain company policies. The analysis ofcompany operations may be expanded to includeother ratios such as return on equity, return onassets, interest margins, and other conventionalmeasurements. The particular format utilizedwill, of course, vary to some degree betweencompanies, however, the analysis should bebroad enough in scope to determine the compa-ny’s trends and the causes of those trends.

3100.0.4.13 Evaluation of the Company’sCondition

Ratio analysis of a consumer finance companyis a feasible technique for evaluating its condi-tion because of the ‘‘portfolio effect’’ of itsassets. However, the examiner must look beyondthe ratios and analyze the effects of companypolicies on the elements of the ratios. As anexample, if a company only charges off loansonce a year, the losses determined by a formulaclassification would be less just after the charge-off date than just before.

In comparing classifications from one inspec-tion to another, there might be a difference inthe loss classifications which may be interpretedas an apparent improvement or decline in assetquality should the inspections bracket the charge-off date. Similar misinterpretations can occurfrom a change in charge-off frequency, a changeto an automatic charge-off policy, or a shorten-ing in the past-due period required for charge-off.

Certain accounting and reporting techniquesmay also be misleading in ratio analysis. Forexample, an artificial improvement in earningswould be reported when a company changesfrom a collection basis to an accrual basis ofincome recognition, if the collection andfollow-up policy had been poor or deteriorating.Only a thorough review of the accounting poli-cies and an understanding of their interplay withoperating policies will prevent this type of mis-interpretation. In some cases, the company’saccounting system may yield results that inad-vertently distort the ratios. A company recogniz-ing income on a straight-line basis would, dur-ingaperiodof low loanvolume, reflect improvinggross interest income as a percentage of loansoutstanding. While the importance of realisticaccounting policies cannot be overstated, nei-ther can the proper interpretation of reportedresults be overstressed.

One of the key elements in the evaluation ofthe company’s performance is reflected in theratios, but not quantified by the analysis. Thecompany’s internal controls and managementinformation systems are the primary means ofcontrolling asset quality and communicatingmanagement’s policies. The supervisory effortis not only reflected by the ratios, but also insuch areas as personnel turnover, citations instate supervisory reports, audit exceptions, andlitigation. The systems relied on by manage-ment should be responsive not only to the chang-ing needs of the company, but also to the chang-ing climate of consumer regulations.

In the inspection report commentary, theexaminer should maintain an objective view ofthe company under inspection. Management’scorrective actions for exceptions and plans toreverse adverse trends are a necessary ingredi-ent in the commentary. Report comments shouldgive the reader an accurate picture of the condi-tion of the company and its relationship with,and impact on, the financial condition of theconsolidated corporation and the subsidiarybank(s).





Activities not closelyrelated to banking

225.126 4–184

Marketability of collateralunder section 23A

3–1121 1935 FRB 395

Activities closely related tobanking

225.123 4–176 1971 FRB 5141975 FRB 245

Expansion of activitiesof a trust company, oracquisition of a de novobank, to include consumerlending

225.28(b)(1) 1984 FRB 3711985 FRB 511985 FRB 551985 FRB 611985 FRB 253





Section 4 (c)(8) of the BHC Act(Acquiring Debt in Default) Section 3104.0

The Board amended Regulation Y, effectiveApril 21, 1997, to include the acquiring of debtin default as an authorized nonbanking activityfor bank holding companies (see Regulation Y,section 225.28(b)(2)(vii)). A bank holding mayacquire debt that is in default at the time ofacquisition if the company—

1. divests shares or assets securing debt indefault that are not permissible investmentsfor bank holding companies, within the timeperiod required for divestiture of propertyacquired in satisfaction of a debt previouslycontracted under section 225.12(b) of Regu-lation Y;

2. stands only in the position of a creditor anddoes not purchase equity of obligors of debtin default (other than equity that may becollateral for such debt); and

3. does not acquire debt in default secured byshares of a bank or bank holding company.

The Board held that these restrictions werenecessary to define the scope of the activity andto ensure that the activity remains the acquisi-tion of debt instead of an impermissible non-banking activity involving the acquisition ofsecurities or other assets. As for calculating thetime period for disposing of the underlyingshares or assets, the time period is the same asthat applied under the BHC Act to disposing ofshares or assets acquired in satisfaction of a debtpreviously contracted. During this period, abank holding company can divest the propertyor, in the case of any debt that has been previ-ously contracted, restructure the debt.

The initial Board order that was issued topermit the acquisition of defaulted debt is sum-marized here as a historical example of thenonbanking activity. Provisions or commitmentsmade in the Board order should not be reliedupon. The current requirements are found insection 225.28(b)(2)(vii) of Regulation Y.

3104.0.1 ACQUISITION OFDEFAULTED DEBT—BOARD ORDER

A bank holding company (the applicant) withinthe meaning of the BHC Act gave notice undersection 4(c)(8) of the BHC Act (12 U.S.C.1843(c)(8)) and the Board’s Regulation Y that itproposed to acquire a company (the company)and engage nationwide in asset-based commer-cial lending and management of assets.

The applicant proposed to engage through the

company in managing certain assets as the cor-porate general partner in two limited partner-ships (the partnerships).1 The applicant commit-ted to conduct the activities, which the Boardpreviously determined to be permissible, throughthe partnerships, subject to the limitations previ-ously established by the Board.2

One nonbanking activity proposed by thepartnerships, acquisition of defaulted debt, wasan activity that the Board had not previouslyapproved. The partnerships are engaged prima-rily in making, servicing, and investing in dis-counted bank loans and other debt securities.3

The partnerships acquire debt that has been or isin the process of being restructured, includingsecured and unsecured debt in the form of bankloans, privately placed and publicly traded debtinstruments, bonds, notes, debentures, and dis-counted receivables.4 The applicant stated thatthe partnerships will take an active role in therestructuring of the defaulted debt they acquire,including participating on creditors’ commit-tees. The applicant indicates that such dis-counted debt would be acquired for the purposeof restructuring the debt to achieve a higheryield and greater collateral protection.

Some of the debt the partnerships wouldacquire may be in default at the time of acquisi-tion and may be secured by voting shares or

1. The first partnership group (in which the companyowned more than a 50 percent interest) was to terminate byDecember 31, 1995. The company owned less than 50 percentof the second partnership group, which would terminate byDecember 31, 1999.

2. See 1994 FRB 736. The partnerships, together with theapplicant and its affiliates, would hold not more than 5 percentof any class of voting securities of any issuer and not morethan 25 percent of the total equity, including subordinateddebt, of any issuer. In addition, the applicant committed thatno directors, officers, or employees of the applicant or itsaffiliates will serve as directors, officers, or employees of anyissuer of which the applicant and its affiliates hold more than10 percent of the total equity. The applicant also committedthat future limited partnerships would be structured in thesame manner as the current partnerships.

3. The partnerships are not leveraged, and the applicantstated that the partnerships will not be leveraged. The appli-cant has committed that neither the applicant nor any ofits subsidiaries would be permitted to make loans to thepartnerships.

4. The debt investments may include investments in com-panies that may be contemplating, be involved in, or recentlyhave completed a negotiated restructuring of their outstandingdebt or a reorganization under chapter 11 of the FederalBankruptcy Code.


other assets that would be impermissible for abank holding company to hold without Boardapproval.5 Because the partnerships would havethe right in some cases to take title immediatelyto shares or assets securing defaulted debt thatthey acquire, the applicant committed that thepartnerships would treat this collateral, as wellas any other assets acquired in renegotiating thisdebt, as assets acquired in satisfaction of a debtpreviously contracted (DPC). Under the BHCAct, a bank holding company must divest anyshares or assets acquired as DPC within twoyears from the date the asset is acquired. Forthis purpose, the applicant has committed that itwill consider shares or assets acquired in satis-faction of defaulted debt to have been acquiredon the date the defaulted debt is acquired.6

The Board stated that the acquisition ofdefaulted debt under the circumstances and con-ditions proposed by the applicant is an activitythat is closely related to banking. The applicantstated that it will only purchase debt, not equity,and will stand in the position of a creditor.

Based on all the facts of record, the Boardconcluded that the proposed activities are closelyrelated to banking. The Board approved thenotice on October 17, 1995 (see 1995 FRB1128). Approval was specifically conditionedon the applicant’s compliance with the commit-ments made in connection with the notice.

5. The applicant has committed that the partnerships willnot acquire debt in default that is secured by shares of banksor bank holding companies.

6. The applicant could apply for up to a three-year exten-sion. See 12 C.F.R. 225.22(d)(1). The Board notes that thedivestiture requirement would be satisfied if, during the dives-titure period, the partnerships renegotiate the debt into aperforming obligation and release the collateral to the bor-rower as part of the renegotiation. To the extent that defaulteddebt acquired by the partnerships is secured by assets orshares that would be permissible investments for a bankholding company, this divestiture commitment would notapply.

Section 4 (c)(8) of the BHC Act (Acquiring Debt in Default) 3104.0


Section 4(c)(8) of the BHC Act (Credit Card Authorizationand Lost/Stolen Credit Card Reporting Services)Section 3105.0

A bank holding company applied for the Board’sapproval, pursuant to section 4(c)(8) of the BHCAct, to engage de novo, through its existingnonbank subsidiary, in credit card authorizationservices and lost/stolen credit card reportingservices. The credit card authorization activitywould consist of providing, for a fee, a serviceto issuers of credit cards that would enablemerchants to determine the validity and creditlimits of cards tendered to them. In addition, theapplicant was to provide, for a fee, a reportingservice to credit card holders, that would enablethem to report the loss or theft of any of theircredit cards via a single toll-free telephone callto the nonbank subsidiary.

A number of banks indirectly offer the ser-vice of reporting lost cards that are issued byother institutions by arranging with independentcompanies to provide the service under a tradename associated with the bank. With respect to

credit card authorization services, banks have afinancial interest in the security of the creditcards and the availability of credit. Based on theforegoing, the Board believed that banks gener-ally have, in fact, provided the services pro-posed by the applicant and are particularly wellsuited to provide the proposed services. On thatbasis, the Board concluded that the proposedservices were closely related to banking.

Since the proposed credit card reporting ser-vice would create more competition and providegreater conveniences by allowing an individualwho loses more than one card to report all lostcards at once to one source rather than having tomake separate notifications to each card issuer,and there was no evidence of adverse effects asa result of the proposal, the application wasapproved by the Board on January 5, 1985(1985 FRB 648). See Regulation Y, sec-tion 225.28(b)(2).


Section 4(c)(8) of the BHC Act(Stand-Alone Inventory-Inspection Services) Section 3107.0

A domestic bank holding company (the appli-cant) applied for the Board’s permission undersection 4(c)(8) of the BHC Act and section225.23(a)(3) of the Board’s Regulation Y toengage de novo, through a wholly owned sub-sidiary, in the following services to customerswho make loans secured by inventory:

1. identifying inventory and deciding its gen-eral condition, level of protection, and amountof use, as appropriate

2. identifying inventory subject to a purchase-money security interest under the UniformCommercial Code

3. identifying missing inventory and any creditexposure that could result

4. supporting the proper allocation of loan pay-ments that are related to the aging or sale ofinventory1

The applicant would provide the aboveinventory-inspection services only in connec-tion with an extension of credit either by the

BHC (applicant) or a third pary. The servicewould be provided throughout the United States,but only in connection with inventory pledgedas collateral for a loan.

Bank holding companies currently inspectand survey collateral for loans made or servicesprovided by them. Banks inspect collateral forloans originated in direct lending activities. Theapplicant suggested that its proposed collateral-inspection services to third-party lenders areidentical to the collateral-inspection servicesperformed for its own extensions of credit.

In accordance with section 225.28(b)(1) ofRegulation Y, the Board authorized bank hold-ing companies to make, acquire, and serviceloans for the company’s own account or for theaccount of others. The Board believes that theseactivities include collateral-inspection servicesprovided to third parties in connection withthird-party extensions of credit. The Board alsobelieves that bank holding companies have thenecessary expertise to provide this service forother lenders (on a stand-alone basis).

The Board found that public benefits wouldresult from a potential increase in the availabil-ity of inventory financing. It noted that therewas no evidence suggesting that the proposalwould result in significant adverse effects. Thefinancial and managerial resources of the appli-cant were believed to be consistent with previ-ous approvals. The Board, based on the facts ofrecord, and the commitments and conditionsmade by the applicant, approved the request onSeptember 13, 1993 (1993 FRB 1053).

1. For example, a loan may be secured by a pool ofinventory collateral, but there may be an agreement to applyloan proceeds to specific items of collateral in a specifiedorder. Equipment used beyond a stated number of hours mightbe of limited value, and the lender might agree to release itssecurity interest in such items. The inspection of inventorycollateral would verify the equipment’s proceeds to pay offthe oldest (or the youngest) items of collateral first (or last),rather than applying the proceeds pro rata to all items.


Section 4(c)(8) of the BHC Act(Industrial Banking) Section 3110.0

WHAT’S NEW IN THIS REVISEDSECTION

Effective January 2015, this section was revisedto amend the beginning discussion and to includestatutory and regulatory citations and a currentBoard order reference within section 3110.0.4.

A bank holding company may acquire or retainan industrial bank to the extent authorized bystate law, under section 225.28(b)(4) of Regula-tion Y only if the industrial bank acquired bythe holding company is not a ‘‘bank’’ within themeaning of the Bank Holding Company Act.Industrial loan companies, industrial banks, andMorris Plan banks are state-chartered financialinstitutions that engage primarily in the businessof furnishing consumer loans and small- busi-ness loans. The distinction between these insti-tution and consumer finance companies lies inthe ability of the industrial loan company togenerate funds through the acceptance of depos-its or issuance of certificates of indebtedness(thrift notes). Although some of these institu-tions have the same charters as banks (in somestates), they traditionally have not been consid-ered to be banks for purposes of the Bank Hold-ing Company Act as they cannot both makecommercial loans and accept demand deposits,although in some states they have been empow-ered to offer NOW accounts. Under a decisionof the Supreme Court, NOW accounts are notdemand deposits for the purposes of definingwhat a bank is. Thus, industrial loan companiesand similar institutions may offer NOW accountsand make commercial loans without being treatedas banks for purposes of the Bank HoldingCompany Act. These institutions may be in-sured by the Federal Deposit Insurance Corpora-tion and are eligible for membership in theFederal Reserve System.

3110.0.1 NONBANKINGACQUISITIONS NOT REQUIRINGPRIOR BOARD APPROVAL

In accordance with 12 C.F.R. 225.22(d)(8) ofRegulation Y, the Board’s prior approval is notrequired for certain asset acquisitions by a lend-ing company or industrial bank. This refers tothe assets of an office(s) of a company of whichall, or substantially all, the assets relate to mak-ing, acquiring, or servicing loans for personal,family, or household purposes, if—

• the acquiring company has previously receivedBoard approval to engage in lending or indus-trial banking activities under Regulation Y;

• the assets acquired during any 12-month perioddo not represent more than 50 percent of therisk-weighted assets (on a consolidated basis)of the acquiring lending company or indus-trial bank, or more than $100 million, which-ever amount is less;

• the assets acquired do not represent more than50 percent of the selling company’s consoli-datedassets that aredevoted to lendingactivitiesor industrial banking business;

• the acquiring company notifies the ReserveBank of the acquisition within 30 days afterthe acquisition; and

• the acquiring company, after giving effect tothe transaction, meets the Board’s capitaladequacy guidelines and the Board has notpreviously notified the acquiring companythat it may not acquire the assets under theexemption.


1. To determine the quality of the loan portfolioand the overall condition of the company.

2. To determine what exposure the subsidiarypresents to the holding company and subsidi-ary bank(s).

3. To determine compliance with applicablelaws and regulations.


1. Contact theapplicable state regulatoryagencyto determine the legal parameters withinwhich the company operates and to assessthe degree to which the company is super-vised. Each of the institutional structuresunder this exemption is state chartered, andthe laws and regulations vary widely fromstate to state. The company may be directlysupervised by its state department of bank-ing or may be subject to virtually no super-vision or regulation. If the company isinsured by the Federal Deposit InsuranceCorporation or is a member of the FederalReserve System, the company is primarilysubject to the primary supervision and regu-lation of that agency. In cases in which the


company is supervised by a banking agency,that agency’s report of examination willgenerally suffice. However, when the com-pany is not supervised or examined, orwhen the Reserve Bank finds the supervis-ing agency’s report inadequate, an on-siteinspection is necessary.

2. Focus on an evaluation of the loan portfolioand securities account, a determination ofthe volatility of the deposits, an appraisal ofthe adequacy of the audit program, and areview of the company’s internal policies.

3. Review the receivables representing lend-ing activities. The company should providea schedule of the aging of the consumerreceivables. It is preferable that the agingbe done on a contractual method. Classifi-cation of the consumer paper may be doneon a formula basis. The larger credits mustbe given a complete evaluation.

4. Review the adequacy of the allowance forloan and lease losses in conjunction withthe asset evaluation.

5. Price the securities portfolio, with particularemphasis placed upon determining itsliquidity. Since the deposits of these institu-tions are not always insured, they are moresusceptible to a deposit run off; therefore,the requirement of adequate liquidity is ofparamount importance.

The deposits may be insured by a guar-anty corporation up to a certain limit in

some states. These guaranty corporationshave provided some stability to the indus-try. The guaranty corporations are indepen-dent of any government agency or munici-pality and therefore are limited in the amountof protection which can be offered depositors.

6. Review back-up lines of credit available toensure secondary liquidity to the company.

7. Review the deposit accounts of the com-pany. The deposits are evidenced by certifi-cates of indebtedness, or thrift notes. Infor-mation regarding the number of deposits,the size of accounts, and maturity distribu-tion should be obtained to assess the stabil-ity of the funding base.

8. Determine that the institution makes properdisclosure to the public as to the type ofinstrument the certificate represents. Somestates require that a disclosure statement, ora prospectus, be filed with the public yearly,which sets forth the uses to which the fundsare being put and states that the funds arenot insured. This prospectus should bereviewed for proper disclosure of the requiredinformation to ensure against possible suits.

9. Check the company’s policy concerningwithdrawals, giving recognition to state lawrequirements, to ascertain whether funds aregenerally not allowed to be withdrawn with-out prior notice.

10. Review the scope of the internal or externalaudits.

Section 4(c)(8) of the BHC Act (Industrial Banking) 3110.0



Subject Laws 1 Regulations 2 Interpretations 3 Orders

Reference for authorizednonbanking activity—activity closely related tobanking

4(c)(8)4j(2)(A)

225.28(b)(4) 1982 FRB 2531983 FRB 9211984 FRB 2311984 FRB 2341984 FRB 3711984 FRB 4691984 FRB 7411985 FRB 476

BHC indirect acquisitionof an industrial bank

4(c)(8)4j(2)(A)

225.24225.28(b)(1)and (3)

2014 FRB 59, Q2

Nonbanking acquisition notrequiring Board approval(conditions specified)

225.22 (d)(8)



Section 4(c)(8) of the BHC Act (Industrial Banking) 3110.0


Section 4(c)(8) of the BHC Act(Acquisition of Savings Associations) Section 3111.0


Effective January 2016, this section was revisedto include in subsection 3111.03 additional Boardorders that have authorized the acquisition ofsavings and loan holding companies.

3111.0.1 ACQUISITION OF ASAVINGS ASSOCIATION

Prior to 1989, the Board had determined thatthe operation of a savings association was closelyrelated to banking but concluded, as a generalrule, that the operation of a savings and loanassociation was not a proper incident to bankingbecause the potential adverse effects, of allow-ing the affiliations of banks and thrift institu-tions outweighed the potential public benefits(1977 FRB 280). Upon consideration of someindividual cases, the Board found that the adverseeffects of the affiliation would be outweighed bythe public benefits of preserving the failing thriftinstitution as a competitor in its market and ofensuring public confidence. (See 1985 FRB462.) The 1982 Garn–St Germain Act recog-nized the Board’s authority under section 4(c)(8)of the BHC Act to approve such acquisitionsby authorizing the Board to dispense with thenecessary notice and hearing requirements ofthis section under appropriate emergencycircumstances.

The Financial Institutions Reform, Recovery,and Enforcement Act of 1989 (FIRREA)amended section 4 of the Bank Holding Com-pany Act (BHC Act) to authorize, effectiveAugust 9, 1989, bank holding companies (BHCs)to acquire any savings association. The legisla-tion lifted the previously existing ‘‘tandemoperations’’ restrictions as they applied to sav-ings associations owned by BHCs. (See 1989FRB 716, appendix I.) These restrictions (1) pro-vided that savings associations acquired by aBHC could not be operated in tandem with anyother subsidiary of the BHC and (2) requiredapproval by the appropriate Federal ReserveBank before the savings association engaged inany transactions with the BHC or its other sub-sidiaries. The Board may not impose these re-strictions on such transactions in the future,except for those restrictions required by sections23A and 23B of the Federal Reserve Act.

With respect to previous Board approvals ofthe acquisition of problem thrifts by BHCs,FIRREA required the Board to modify those

approvals by limiting any restrictions on trans-actions between the savings association andits holding company affiliates to those requiredunder sections 23A and 23B of the FederalReserve Act. In 1989, the Board removed thetandem restrictions imposed on the operationsof savings association subsidiaries of a BHC.(See 1989 FRB 71b.)

The Board amended Regulation Y pursuantto FIRREA, effective October 10, 1989 (12C.F.R. 225.28(b)(4)(ii)). The regulation allowsBHCs to acquire healthy and failed or failingsavings and loan associations in accordancewith FIRREA. The regulation permits BHCs toacquire savings and loan associations in anystate, regardless of whether the holding com-pany may operate a bank in that state. It doesnot impose any operational or branching condi-tions on the operation of savings and loan asso-ciations. The regulation authorizes, as a permis-sible activity under section 4(c)(8) of the BHCAct, the owning, controlling, or operating of asavings association if the savings associationengages only in deposit taking, lending, andother activities that are permissible for BHCs.1

The Board has permitted a short divestitureperiod for impermissible investments and otheractivities. (See 1992 FRB 707.)

The Board requires that when a BHC acquiresa savings association, the BHC must conformthe acquired institution’s direct and indirect ac-tivities to those permissible for BHCs undersection 4 of the BHC Act.

In 2002, a foreign banking organization sub-ject to the provisions of the BHC Act, and itswholly owned subsidiary, requested the Board’sapproval under section 4(c)(8) and section 4(j)of the BHC Act to acquire a savings associationand thereby engage in operating a savings asso-ciation, and to conduct certain nonbanking ac-tivities as a result of that acquisition. The for-eign banking organization committed that itwould conform all the activities of the acquiredsavings association to those permissible under

1. Section 225.2(m) of Regulation Y defines a savingsassociation as (1) any federal savings association or federalsavings bank; (2) any building and loan association, savingsand loan association, homestead association, or cooperativebank if such association or cooperative bank is a member ofthe Savings Association Insurance Fund; and (3) any savingsbank or cooperative deemed by the director of the Office ofThrift Supervision to be a savings association under section10(l) of the Home Owners’ Loan Act.


section 4(c)(8) of the BHC Act and RegulationY. (See section 225.28(b)(4)(ii). See also 2002FRB 385, 2002 FRB 485, 2003 FRB 439, 2004FRB 503, and 2005 FRB 91.) The foreign bank-ing organization was also treated as a financialholding company. Any other activities of theacquired savings association were, therefore, re-quired to conform to those permissible for afinancial holding company under section 4(k) ofthe BHC Act.

3111.0.2 APPROVAL TO BECOME ABHC BY ACQUIRING ANOTHER BHC

A savings and loan holding company (SLHC)requested the Board’s approval, under section 3of the BHC Act, to become a bank holdingcompany (BHC), by merging with HN Corpo-ration (a bank holding company) and therebyacquire HNB, a national bank. The SLHC re-quested the Board’s approval to continue to op-erate SB, a subsidiary federal savings bank, un-til its conversion to a national bank. After themerger, SLHC would convert SB to a nationalbank and merge its subsidiary commercial bank(SCB) and HNB into SB, the survivor beingSB.

SLHC also requested the Board’s approvalunder section 3 of the BHC Act to acquire HN’sminority interest in another BHC, BBI and itssubsidiary bank, B Bank.

3111.0.2.1 Financial, Managerial, andOther Supervisory Considerations

Sections 3 and 4 of the BHC Act require theBoard to consider the financial and managerialresources and future prospects of the compa-nies, banks, and savings associations involvedin a proposal and certain other supervisory fac-tors.2 These factors include supervisory andexamination information received from the rel-evant federal and state supervisors of the organi-zations involved in the proposal, and other avail-able financial information, including informationprovided by the SLHC. The Board is required toconsider the managerial resources of the organi-zations involved and the proposed combinedorganization.3

3111.0.2.2 Nonbanking Activities

The SLHC filed a notice pursuant to sections4(c)(8) and 4(j) of the BHC Act to (1) retain itsownership interest in SB and thereby operate asavings association and (2) engage in activitiesthat are permissible for BHCs through its non-banking subsidiaries, including lending, loansservicing and related activities, leasing, and sell-ing credit-related insurance. The Board previ-ously has determined by regulation that theoperating of a savings association by a BHC andthe other nonbanking activities for which SLHChas requested approval, are closely related tobanking for the purposes of section 4(c)(8) ofthe BHC Act.4

With respect to the public interest factorsunder section 4(j) of the act, the Board mustdetermine whether the operation of SB as asavings association by a BHC can reasonably beexpected to produce benefits to the public, suchas greater convenience, increased competition,or gains in efficiency, that outweigh possibleadverseeffects, suchasconcentrationof resources,decreased or unfair competition, conflicts of in-terests, or unsound banking practices. The re-cord indicated that consummation of the pro-posal would create a stronger and more diversifiedfinancial services organization and would pro-vide current and future customers of HNB withexpanded financial products and services.

2. 12 U.S.C. 1842(c)(2) and (3).3. A comment received from the public expressed concern

that SLHC acquired control over HN before obtaining the

Board’s approval of the application as the result of an exten-sion of credit the SLHC made to HN. The extension of creditwas made after the SLHC had filed its application with theBoard to acquire HN. The SLHC loaned HN $50 million,secured by the shares of HNB. HN invested the loan proceedsin HNB to increase the bank’s capital.

The Board noted its concern about a banking organizationseeking to acquire another banking organization and making aloan to the acquiree in advance of the Board’s approval of theacquisition. Such types of loans raise concern that the transac-tions would be, in substance, the acquisition of a controllinginterest or would provide the acquirer with the ability toexercise a controlling influence over the management andpolicies of the BHC before receiving approval. The Boardcarefully reviewed the loan transaction, its supporting docu-mentation, and the relationships of the organizations after theloan transaction. Based on all the facts of record, the Boardconcluded that the loan did not result in SLHC acquiringvoting securities of, or a controlling equity interest in, HN, orin SLHC exercising, or having the ability to exercise, acontrolling influence over HN. The Board noted that it contin-ues to believe that when a loan is made by an acquirer to atarget organization before it receives agency approval of itsacquisition proposal, it raises important issues, and that it willreview these arrangements critically and carefully.

4. See 12 C.F.R. 225.28(b)(1), (2), (3), (4), (8), and (11).

Section 4(c)(8) of the BHC Act (Acquisition of Savings Associations) 3111.0


3111.0.2.3 Noncontrolling Investment

The SLHC proposed to acquire 17.5 percent ofBBI’s voting shares that HN currently ownedand to increase up to 19.9 percent its totalownership of BBI’s voting shares. The Boardpreviously had approved HN’s investment inBBI as a passive investment, and HN compliedwith certain commitments that were previouslyrelied on by the Board in determining that aninvesting BHC would not exercise a controllinginfluence over another BHC or bank for thepurposes of the BHC Act (‘‘Passivity Commit-ments’’).5 The SLHC indicated that it did notpropose to control or exercise a controllinginfluence over BBI and that its indirect invest-ment in B Bank also would be a passive invest-ment. The SLHC provided the passivity com-mitments to the Board (see appendix A). Basedon those commitments, the Board concludedthat the SLHC would not acquire control of, orhave the ability to exercise a controlling influ-ence over, BBI or B Bank through the proposedacquisition of BBI’s voting shares.

3111.0.2.4 Appendix APassivity Commitments

The SLHC will not, without the prior approvalof the Federal Reserve Board or its staff, di-rectly or indirectly:

1. Exercise or attempt to exercise a controllinginfluence over the management or policiesof BBI or any of its subsidiaries;

2. Have or seek to have a representative ofSLHC serve on the board of directors ofBBI or any of its subsidiaries;

3. Have or seek to have any employee orrepresentative of SLHC serve as an officer,agent, or employee of BBI or any of itssubsidiaries;

4. Take any action that would cause BBI orany of its subsidiaries to become a subsidi-ary of SLHC;

5. Acquire or retain shares that would causethe combined interests of SLHC and itsofficers, directors, and affiliates to equal orexceed 19.9 percent of the outstanding vot-ing shares of BBI or any of its subsidiaries;

6. Propose a director or slate of directors inopposition to a nominee or slate of nomi-nees proposed by the management or boardof directors of BBI or any of its subsidiaries;

7. Solicit or participate in soliciting proxieswith respect to any matter presented to theshareholders of BBI or any of its subsidiaries;

8. Attempt to influence the dividend policies;loan, credit, or investment decisions or poli-cies; pricing of services; personnel deci-sions; operations activities, including thelocation of any offices or branches or theirhours of operation, etc.; or any similar ac-tivities or decisions of BBI or any of itssubsidiaries;

9. Dispose or threaten to dispose (explicitly orimplicitly) of shares of BBI in any manneras a condition or inducement of specificaction or non-action by BBI or any of itssubsidiaries;

10. Enter into any other banking or nonbankingtransactions with BBI or any of its subsidi-aries, except that SLHC may establish andmaintain deposit accounts with BBI, pro-vided that the aggregate balance of all suchdeposit accounts does not exceed $500,000and that the accounts are maintained onsubstantially the same terms as those pre-vailing for comparable accounts of personsunaffiliated with BBI.

11. Acquire or seek to acquire any nonpublicfinancial information of BBI or any of itssubsidiaries, beyond the information alreadyavailable to it as a shareholder of BBI.SLHC also confirms that there are no legal,contractual, or statutoryprovisions thatwouldallow it or its subsidiaries to have anyaccess to financial information of BBI or itssubsidiaries beyond the information avail-able to shareholders.

3111.0.2.5 Interstate Acquisition

Under the Dodd-Frank Act, the Board of Gover-nors of the Federal Reserve System may notapprove the acquisition of an insured depositoryinstitution (including a savings association) ifthe home state of the insured depository institu-tion is a state other than the home state of the

5. The Board previously determined that the acquisition ofless than a controlling interest in a bank or BHC is not anormal acquisition for a BHC. The requirement in section3(a)(3) of the BHC Act that the Board’s approval be obtainedbefore a BHC acquires more than 5 percent of the votingshares of a bank seems to suggest, however, that Congresscontemplated the acquisition by BHCs of between 5 and25 percent of the voting shares of banks. See 12 U.S.C.1843(a)(3). On this basis, the Board has previously approvedthe acquisition of a BHC of less than a controlling interest in abank or BHC. See 2006 FRB C37 (acquisition of up to24.89 percent of the voting shares of a BHC); 2005 FRB 74(acquisition of 24.9 percent of the shares of a BHC); and 2000FRB 52 (acquisition of up to 9.9 percent of the voting sharesof a BHC).



bank holding company and the applicant con-trols, upon consummation, more than 10 percentof the total amount of insured deposits in the

United States. (For the Dodd-Frank cite, see 12USC 1843(c)(8). Pub. L. 111-203 124 stat 1547,1634)

3111.0.3 LAWS, REGULATIONS, INTERPRETATIONS, ORDERS


Activity approval 1843(4)(i) 225.28(b)(4)(ii) 1997 FRB 275

Determination that theoperation of a thriftinstitution is closely relatedto banking and a properincident thereto

225.28(b)(1),(2), (3), (4), (8),and (11)

2010 FRB B71989 FRB 861986 FRB 7241986 FRB 3421985 FRB 3401983 FRB 8121982 FRB 6601982 FRB 3161977 FRB 2801974 FRB 868

Bank holding companiesacquiring savings associationsmust conform their direct andindirect nonbank activities tothose permissible for bankholding companies

225.28(b)(4)(ii) 2014 FRB 13, Q3(FRB OrderNo. 2014-16)

2010 FRB B72005 FRB 912004 FRB 5032003 FRB 4392002 FRB 4852002 FRB 385

Acquisition of stock savingsand loan associations

1985 FRB 462

Removal of tandem restric-tions

1989 FRB 716

Establishing branches on aninterstate basis afteracquisition

1993 FRB 890

BHC’s joint acquisition of asavings association, mergedsubsequently into a subsidiarybank

225.28(b)(4)(ii) 2014 FRB 23, Q4(FRB OrderNo. 2014-22)

Minority investment (interest)in a savings bank

1995 FRB 509

Acquisition of a BHC of lessthan a controlling interest in abank or BHC

2006 FRB C372005 FRB 742000 FRB 52




Acquisition of a savings andloan holding company

1843(c)(8)and (j)

225.28(b)(4)(ii) 2015 FRB 61(Board OrderNo. 2015-27

2015 FRB 37(Board OrderNo. 2015-34

1. 12 U.S.C., unless specifically stated otherwise.2. 12 C.F.R., unless specifically stated otherwise.3. Federal Reserve Regulatory Service reference.



Section 4(c)(8) of the BHC Act(Trust Services) Section 3120.0

The performance of trust services by a trustcompany subsidiary that is neither a ‘‘bank’’ nora nonbank bank encompasses virtually any kindof fiduciary, agency, or custodial service com-monly performed by a trust company so long asthe subsidiary does not accept demand depositsor make loans, except as expressly permitted bysection 225.28(b)(5) of Regulation Y. Generally,under Regulation Y, a trust company may onlyaccept deposits arising out of trust funds notcurrently invested; perform escrow services,such as receiving, holding, and disbursing down-payments and other funds deposited by purchas-ers in real estate transactions; and act as anagent for an issuer of, or broker or dealer in,securities in a capacity of a paying agent,dividend-disbursing agent, or securities clearingagent, so long as the funds are not used by thecustomer as a general-purpose checking accountand do not bear interest. The subsidiary’s lend-ing activities are restricted to making call loansto securities dealers and to purchasing moneymarket instruments; however, such loans maynot be used to provide funding for nonbanksubsidiaries of the holding company.

Trust companies may be either state charteredor nationally chartered. Some nationally char-tered trust companies have national bank char-ters but have agreed through limitations in theirbylaws to engage only in those activities permit-ted for trust departments of national banks. Toprevent the use of a trust company as a vehiclefor evasion of section 3(d) of the Bank HoldingCompany Act, the Board has conditioned itsapproval of certain interstate acquisitions byrequiring that (1) the trust company’s demanddeposit–taking activities not be operated in tan-dem with any other subsidiary, (2) demanddeposit and commercial lending services ofaffiliates will not be linked in any way, and(3) the trust company will not engage in anytransactions with affiliates, other than the pay-ment of dividends or the infusion of capital,without the Board’s approval (for example, seeU.S. Trust Corporation, 1984 FRB 371). Thescope of these conditions may be reviewed bythe Board in connection with nonbank bankapplications.

As part of normal administration of its trustaccounts, a trust company will from time to timeengage in an activity, such as property manage-ment or land development, that has beendetermined to benot closely related to bankingby the Board. Any such service may only beperformed incidentally to fiduciary-account

administration and may not be offered or mar-keted as a separate service.

The board of directors and senior manage-ment of financial holding companies (FHCs)and bank holding companies (BHCs) areresponsible for overseeing the operations oftheir fiduciary activities in a safe and soundmanner. Such oversight (particularly for thoseBHCs and FHCs engaged in a broad range offinancial activities) at the consolidated level isimportant because the risks associated with finan-cial activities as well as fiduciary activities cancut across legal entities and business lines. Fed-eral Reserve examiners review and assess theinternal policies, reports, and procedures andeffectiveness of the BHC/FHC consolidated risk-management process.

The appropriate regulator of trust activities(including activities of a fiduciary, agency, orcustodial nature) has the primary responsibilityfor evaluating risks, hedging, and risk manage-ment at the legal-entity level for any subsidiaryor subsidiaries that the regulator supervises.Federal Reserve examiners should seek to usethe examination findings of the appropriate regu-lators. (See SR-00-13.)

To determine the complete scope of fiduciaryassets within an FHC/BHC, examiners shouldreference the Uniform Bank Performance Report(UBPR), which reflects the information gath-ered on Schedule RC-T. To further understandthe scope of fiduciary assets within an FHC/BHC, an examiner should also look at informa-tion reported on Schedules Y-11 and Y-9C withrespect to income derived from trust, fiduciary,and asset-management activities. (See also page4 of the Bank Holding Company PerformanceReport (BHCPR) for the amount and percent-ages of income from fiduciary activities toadjusted operating income (tax-equivalent),including the BHC’s corresponding peer-groupratios.)

Peer analysis is also available at the banklevel. Examiners should refer to pages Trust 1and Trust 1A of the UBPR. General comparisoninformation is also available on a lagged basisin the FFIEC’s electronic report ‘‘Trust Assetsof Financial Institutions’’ (www2.fdic.gov/structur/trust/index.asp).Aggregatedataare listedby year back to 1996.


3120.0.1 ON-SITE INSPECTIONS

Trust companies are normally engaged in activi-ties such as management of funds for individu-als. These activities are significant to the integ-rity of the banking system and involve significantpotential liability to the bank holding companyif not properly conducted. Therefore, periodicon-site inspections should be performed. If thetrust company is examined by a state bankingdepartment, then alternate-year examination pro-cedures may apply. If nationally chartered, areview of the periodic on-site examinations ofthe Comptroller of the Currency will generallysuffice. If the trust company is not subject to a

regular examination by another federal bankingagency (i.e., if it is an uninsured, state-charterednonmember trust company), the Reserve Bankshould perform regular on-site inspections toinclude, at a minimum, full-scope reviews of thetrust activity. The inspections would use proce-dures such as those used in the examinations oftrust activities of state member banks. This por-tion of the inspection should be performed byexaminers specially trained in trust examina-tions. Holding company inspectors should spe-cifically review trust activities for compliancewith any conditions imposed by the Board inconnection with the approval of an application.

Section 4(c)(8) of the BHC Act (Trust Services) 3120.0


Section 4(c)(8) of the BHC Act(General Financial and Investment Advisory Activities) Section 3130.0

The main sections that follow (sections 3130.1through 3130.9) address all financial and invest-ment advisory activities under section 4(c)(8) ofthe BHC Act and section 225.28(b)(6) of Regu-lation Y that have been authorized by the Board.This section provides general inspection objec-tives and procedures that relate to such financialand investment advisory activities. These objec-tives and procedures can be applied to the BHCinspection of every advisory activity when advi-sory activities are not listed separately in any ofthis manual’s individual advisory sections.

Any commitments that were made by thebank holding company or its nonbank subsidi-aries to the Federal Reserve System pertainingto its financial and investment advisory non-banking activities should be reviewed by theexaminer for compliance and applicability, inaccordance with the current statutory and regu-latory provisions. Any existing commitments orconditions that relate to the financial resourcesof a bank holding company or its subsidiaries orto commitments or conditions that relate to therisk-management policies of the organizationshould remain intact and should be reviewedby an examiner for compliance during eachinspection.

The Board’s Regulation Y, effective April1997, resulted in a structural reorganization offinancial and investment advisory nonbankingactivities. The provision of discretionary invest-ment advice is no longer limited to institutionalcustomers. Bank holding companies and theirsubsidiaries may engage in financial and invest-ment advisory activities without restriction. Bankholding companies can manage retail customeraccounts outside of the trust department of anaffiliated bank (to the extent permitted by law).Further, bank holding companies may engage inany combination of permissible nonbankingactivities listed in Regulation Y. Accordingly,bank holding companies may provide financialand investment advice jointly with permissibleagency transactional service, investment or trad-ing transactions as principal, or any other listednonbanking activity.

The rules in Regulation Y provide examplesof financial and investment advisory activitiesthat are illustrative rather than exclusive. Withregard to the examples, a bank holding companymay act as an investment or financial adviserwithout restriction to any person, including

1. serving as an investment adviser (as definedin section 2(a)(20) of the Investment Com-pany Act of 1940) to an investment company

registered under that act, including sponsor-ing, organizing, and managing a closed-endinvestment company;

2. furnishing general economic information andadvice, general economical statistical fore-casting services, and industry studies;

3. providing advice in connection with mergers,acquisitions, divestitures, investments, jointventures, leveraged buyouts, recapitaliza-tions, capital structurings, financing transac-tions and similar instruments, and conduct-ing financial-feasibility studies;

4. providing information, statistical forecasting,and advice with respect to any transaction inforeign exchange, swaps, and similar transac-tions, commodities, and any forward con-tract, option, future, option on a future, andsimilar instrument;

5. providing educational courses and instruc-tional materials to consumers on individualfinancial-management matters; and

6. providing tax-planning and tax-preparationservices to any person.

Sections 3130.1 through 3130.9 include manyhistorical examples of various financial andinvestment advisory activities that have beenapproved by the Board. These examples are tobe viewed as historical references. They shouldbe considered as to their applicability to currentstatutory and regulatory provisions. Someexamples include, but are not limited to, provid-ing financial advice in rendering fairness opin-ions and providing valuation services in connec-tion with mergers, acquisitions, divestitures,investments, joint ventures, leveraged buyouts,recapitalizations, and capital structurings. Otherexamples include providing advice on financingand similar transactions with respect to privateand public financings and loan syndications;conducting financial-feasibility studies; and pro-viding financial advice to state and local govern-ments with respect to the issuance of theirsecurities.


1. To review the adviser’s organizational struc-ture and the qualifications of its managementto conduct business, and to determine whetherthey are satisfactory.


2. To determine the status of the adviser’sfinancial condition and the adequacy ofinternal controls, general accounting poli-cies, and reporting procedures, and to deter-mine if they reflect the guidelines estab-lished by management.

3. To determine whether fee income is accu-rately computed and reported on a consis-tent basis.

4. To determine what financial effect the activ-ity has on the parent holding company andthe bank subsidiaries.

5. To review and evaluate investment prac-tices considering the adviser’s investmentresponsibilities for the selection and alloca-tion of investments for various types ofaccounts to determine whether they areappropriate.

6. To evaluate funding sources, includingindebtedness, and their management withrespect to maturities and interest rates.

7. To determine the adequacy of internal andexternal audits.

8. To determine whether the adviser companyhas adequate policies and procedures to pre-vent self-dealing and similar improperconflicts.

9. To determine whether operating practicesprovide for adequate legal documents andagreements such that the account activities,in general, are consistent with the contrac-tual responsibilities and authorities.

10. To determine if any litigation is pendingagainst the company and the possible impactof an unfavorable court decision.

11. To evaluate compliance with applicable bankholding company laws, regulations, andinterpretations, including compliance withthe standards of care and conduct applica-ble to fiduciaries as required by Regula-tion Y.


1. Review System approval and activities forconformance with any limitations. Deter-mine if the activity is conducted through aseparately incorporated subsidiary of thebank holding company that—a. refrains from taking positions for its own

account;b. observes the standards of care and con-

duct applicable to fiduciaries with respectto its advisory and transactional services;and

c. avoids executing customer transactionswhen acting in an advisory capacity.

2. Prepare financial statements for the last twofiscal years, plus interim if appropriate.Analyze for adverse trends and evaluate fornegative effects on affiliates.

3. Evaluateassetqualitywhenwarranted,docu-menting the scope and detailing asset review.Compile classification data, write up classi-fications if appropriate, and evaluate reserveadequacy.

4. Obtain documentation for all indebtedness.Evaluate funding sources for maturity mis-match, dependence on affiliates’ concentra-tions, and dependability. Review borrow-ings from affiliate banks for compliancewith section 23A of the Federal ReserveAct.

5. Review income and expense accounts andtransactions with affiliates for compliancewith section 23B of the Federal ReserveAct.

6. Review the company’s revenue sources todetermine that it has not taken positions anddoes not, itself, execute transactions whenacting in an advisory capacity.

7. Evaluate contracts and service agreementswith affiliates. Identify whether the com-pany receives or provides services or prod-ucts. Determine that the services or prod-ucts are needed and received or provided,and that the contract or agreement termsrepresent market rates.

8. Review the company’s fee schedule for pro-viding advice and the fees charged by affili-ated banks to conduct transactions for thecompany’s customers. Determine whetherthe bank is being adequately compensatedfor executing trades, or whether these prof-its are accruing largely to the benefit of thecompany.

9. Review checking-account statements for allaccounts at affiliate banks for overdraftssince the previous inspection.

10. Evaluate whether the nonbank activities arebeing performed by affiliate bank personnelor are using bank assets. If so, is the bankadequately compensated?

11. Identify off-balance-sheet activities and con-tingent liabilities, and assess the risk to thecompany and any affiliate.

12. Obtain a listing of litigation against thecompany or any individuals who representthe company from the company’s legal coun-sel, and evaluate potential effects on thefinancial condition.

13. Obtain and review internal and externalaudit reports and workpapers.

Section 4(c)(8) of the BHC Act (General Financial and Investment Advisory Activities) 3130.0


14. Obtain and review internal and externalasset-review reports.

15. Obtain and review copies of the board ofdirectors’ and senior management’s poli-cies and procedures.

16. Review a sample of recommendations todetermine that a reasonable basis exists forthe company’s recommendations.

17. Review the advisory contracts to determineif there are any conflicts of interests involv-ing the parent company or affiliates, as wellas the officers, directors, or principal share-holders and their related interests of theholding company and its affiliates.

18. Evaluate insurance for adequacy.19. Obtain or verify that workpapers contain

the following permanent documentation:a. System approval lettersb. date of incorporation or date acquiredc. date activity commencedd. articles of incorporation and by-lawse. commitmentsf. supervisory actionsg. other pertinent correspondence

20. Obtain and review a listing of shareholdersfor each class of stock outstanding, and aschedule of officers, directors, and their re-lated interests.

Section 4(c)(8) of the BHC Act (General Financial and Investment Advisory Activities) 3130.0


Section 4(c)(8) of the BHC Act(Investment or Financial Advisers) Section 3130.1


This section is revised to amend section 3130.1.6,Laws, Regulations, Interpretations, and Orders.The table references a 2015 Board order thatauthorizes the merger of two bank holding com-panies and the acquisition of a bank, whichwere immediately followed by the acquisition ofnonbank subsidiaries authorized to be engagedin financial and investment advisory activitiesunder section 225.28(b)(6) of Regulation Y.

A bank holding company or its nonbank subsid-iary that engages in investment or financialadviser activities is subject to section 225.28(b)(6)of Regulation Y. The purpose of an inspectionof a company providing investment or financialadvice is to determine that it is operating accord-ing to applicable laws, regulations, and interpre-tations, and to determine that the company issubject to an adequate audit program. Regula-tion Y allows a bank holding company to serveas an investment adviser as defined in section2(a)(20) of the Investment Company Act of1940 (15 U.S.C. 80a-2(a)(20)), which defines an‘‘investment adviser’’ of an investment com-pany as ‘‘...any person who pursuant to contractwith such company regularly furnishes adviceto such company with respect to the desirabilityof investing in, purchasing or selling securitiesor other property, or is empowered to determinewhat securities or other property shall be pur-chased or sold by such company...’’

The Board has issued an interpretive ruleregarding the investment adviser activities ofbank holding companies under Regulation Y(12 C.F.R. 225.125). The following is a list ofsome of its provisions:

1. Bank holding companies, including theirbank and nonbank subsidiaries, may act asinvestmentadvisers tovarious typesof invest-ment companies such as mutual funds andclosed-end investment companies. Mutualfunds and closed-end investment compa-nies are described in the interpretation.

2. Bank holding company investment adviseractivities are limited by the Glass-SteagallAct (Banking Act of 1933 (12 U.S.C. 24,78, 377, 378)). This act generally prohibitsmember banks from engaging in the pur-chase or sale of equity securities other thanin an agency capacity.

3. A bank holding company may not sponsor,organize, or control a mutual fund. This

does not apply to closed-end investmentcompanies so long as they are not primarilyor frequently engaged in the issuance, sale,or distribution of securities.

4. A bank holding company should not act asinvestment adviser to an investment com-pany which has a name similar to the bankholding company or any of its subsidiarybanks, unless the prospectus of the invest-ment company contains certain requireddisclosures. In no case should a bank hold-ing company act as investment adviser to aninvestment company that has either thesame name as the name of the bankholding company or any of its subsidiarybanks, or that has a name that contains theword ‘‘bank.’’

5. Since investment adviser activities may cre-ate potential conflicts of interest, the Boarddetermined that a bank holding companyand its subsidiaries should not purchase intheir sole discretion, in a fiduciary capacity(including as managing agent), securities ofany investment company for which the bankholding company acts as investment adviser,unless the purchase is specifically autho-rized by (1) the terms of the instrumentcreating the fiduciary relationship, (2) courtorder, or (3) the law of the jurisdictionunder which the trust is administered.

6. A bank holding company may not engage,directly or indirectly, in the underwriting,public sale, or distribution of securities ofany investment company for which it or anynonbank subsidiary acts as investmentadviser, except in compliance with section20 of the Glass-Steagall Act. The Board hasdetermined, however, that the conduct ofsecurities brokerage activities by a bankholding company or its nonbank subsidi-aries, when conducted individually or incombination with investment advisoryactivities, is not deemed to be the under-writing, public sale, or distribution of secu-rities prohibited by the Glass-Steagall Act.

7. A bank holding company or any of its non-bank subsidiaries that have been authorizedby the Board under the Bank Holding Com-pany Act to conduct securities brokerageactivities (either separately or in combina-tion with investment advisory activities)may act as agent, upon the order and for theaccount of customers of the holding com-


pany or its nonbank subsidiary, to purchaseor sell shares of an investment company forwhich the bank holding company or itssubsidiaries act as an investment adviser.

8. A bank holding company or any of its non-bank subsidiaries that have been authorizedby the Board under the Bank Holding Com-pany Act to provide investment advice tothird parties generally (either separately orin combination with securities brokerageservices) may provide investment advice tocustomers with respect to the purchase orsale of shares of an investment company forwhich the holding company or any of itssubsidiaries acts as an investment adviser.

9. A bank holding company or its subsidiarybank, at the time a service is provided, mustcaution customers to read the prospectus ofthe investment company before investing.Customers must be advised in writing thatthe investment company’s shares are notinsured by the Federal Deposit InsuranceCorporation and are not deposits, obliga-tions, or endorsed or guaranteed in any wayby any bank (unless that is the case). Therole of the company or affiliate as adviser tothe investment company must be disclosedin writing. Such disclosures may be doneorally, but the cusotomer must be givensuch disclosures in writing immediatelythereafter.

10. Because of potential conflicts of interest, abank holding company which acts both ascustodian and investment adviser for aninvestment company should exercise careto maintain at a minimum level demanddeposit accounts of the investment com-pany which are placed with a bank affiliate,and should not invest cash funds of theinvestment company in time deposit accounts(including certificates of deposit) of anybank affiliate.

3130.1.1 REAL ESTATEDEVELOPMENT ADVISERS FORSTATE AND LOCAL GOVERNMENTS

Advising state and local governments aboutmethods available to finance real estate develop-ment projects, and evaluating projected incometo determine if debt resulting from proposeddevelopment projects can be adequately ser-viced is permissible if the activities are autho-

rized under section 225.28(b)(6) of Regula-tion Y.

Before this activity was incorporated intoRegulation Y, in 1980, the Board had receivedcertain comments noting that certain aspects ofthese advisory services may be within the scopeof the activity of ‘‘management consulting.’’The Board had found that it was not permissiblefor bank holding companies to offer manage-ment consulting services to nonaffiliated compa-nies.Certainmanagementconsultingadvicecouldbe provided to unaffiliated depository institu-tions, however. In view of the relationship thathad traditionally existed between banks andstate and local governments, and the net publicbenefits that would result from provision ofadvice to such governments by bank holdingcompanies, the Board indicated that it would bemore flexible in determining what particularservices constitute ‘‘providing financial advice’’rather than ‘‘management consulting’’ when theservices are solely for state and local govern-ments rather than other nonbank organizations.With the Board’s April 1997 revision of Regula-tion Y, investment and financial advisory activi-ties were grouped together and a bank holdingcompany could act as an investment or financialadviser without restriction.

The Board also allowed the provision ofmanagement consulting services regarding anyfinancial, economic, accounting, or audit matterto any company. These financial activities aredirectly related to the activities and expertise ofbank holding companies. Management consult-ing services are subject to a revenue limitation,however. They may be provided to any cus-tomer on any matter, provided that the totalannual revenue derived from the managementconsulting services does not exceed 30 percentof the company’s total annual revenue derivedfrom management consulting activities. Thus,any services provided to state and local govern-ments that are deemed management consultingservices are subject to this revenue limitation.


1. To review the adviser’s organizational struc-ture and the qualifications of managementtoconductbusiness, and todeterminewhetherthey are satisfactory.

2. To determine the status of the adviser’sfinancial condition and the adequacy ofinternal controls, general accounting poli-cies, and reporting procedures, and to deter-mine if they reflect the guidelines estab-lished by management.

Section 4(c)(8) of the BHC Act (Investment or Financial Advisers) 3130.1


3. To determine whether fee income is accu-rately computed and reported on a consis-tent basis.

4. To determine what financial effect the activ-ity has on the parent holding company andthe bank subsidiaries.

5. To review and evaluate investment prac-tices considering the adviser’s investmentresponsibilities for the selection and alloca-tion of investments for various types ofaccounts, and to determine whether they areappropriate.


BHC Supervision Manual January 2016Page 2.1

6. To evaluate funding sources, includingindebtedness, and their management basedon maturities and interest rates.

7. To determine the adequacy of internal andexternal audits.

8. To determine whether the adviser companyhas adequate policies and procedures to pre-vent self-dealing and similar improper con-flicts.

9. To determine whether operating practicesprovide for adequate legal documents andagreements such that the account activities,in general, are consistent with the contrac-tual responsibilities and authorities.

10. To determine if any litigation is pendingagainst the company and the possible impactof an unfavorable court decision.

11. To evaluate compliance with applicable bankholding company laws, regulations, andinterpretations, including compliance withthe standards of care and conduct applica-ble to fiduciaries as required by Regula-tion Y.


1. Obtain the company’s policy and proceduremanuals, and distribute relevant portions tothe examiners for review and complianceevaluation.

2. Review the minutes of meetings of theboard of directors, audit committees, andany officer-level committees. Ensure thatexaminers performing other portions of theinspection review relevant minutes or sum-maries thereof.

3. Obtain, review, and evaluate the adequacyof internal and external audit procedures,reports, and workpapers.

4. Prepare financial statements for the last twofiscal years, plus the interim period, ifappropriate. Analyze and evaluate the infor-mation for adverse trends and for negativeeffects on affiliates.

5. Obtain, review, and evaluate internal andexternal asset-review reports.

6. Evaluateassetqualitywherewarranted,docu-menting the scope and detailing asset review.Compile classification data, write up classi-fications if appropriate, and evaluate theadequacy of contra asset allowances.

7. Obtain documentation for all indebtedness.Evaluate funding sources for maturity mis-match, dependence on affiliates, concentra-tions, and dependability. Review borrow-ings from affiliate banks for compliance

with section 23A of the Federal ReserveAct.

8. Review checking-account statements for allaccounts at affiliate banks, checking foroverdrafts since the previous inspection.

9. Complete the inspection checklist (see thesections beginning at 3130.1.3.2) based onthe guidance provided in section 3130.1.3.1.

10. Identify off-balance-sheet activities and con-tingent liabilities, and assess the risk to thecompany and any affiliate.

11. Obtain a listing of litigation against thecompany or any individuals who representthe company from the company’s legal coun-sel, and summarize the matters in litigation(or in threatened litigation) and any com-promiseactions.Evaluate thepotential effectson the company’s financial condition.

12. Evaluate contracts and service agreementswith affiliates. Identify whether the com-pany receives or provides services or prod-ucts. Determine that the services or prod-ucts are needed and received or provided,and that the contract or agreement termsrepresent market rates.

13. Review income and expense accounts andtransactions with affiliates for compliancewith section 23B of the Federal ReserveAct.

14. Evaluate whether the nonbank activities arebeing performed by affiliate bank personnelor whether bank assets are being used. If so,is the bank adequately compensated?

15. Review FR System approvals, and checkconformance with any specified limitationsor commitments.


17. Review the advisory contracts to determineif there are any conflicts of interests involv-ing the parent company or affiliates, as wellas the officers, directors, or principal share-holders and their related interests of theholding company and its affiliates.

18. Evaluate insurance, including bond cover-age, for adequacy. Determine the extent ofcurrent liability insurance relating to theadviser function, and evaluate the adequacyof such coverage—particularly the extent towhich possible significant surcharges wouldbe covered by such insurance.

19. Obtain a listing of shareholders for eachclass of stock outstanding and a schedule ofofficers, directors, and their related interests.



20. Obtain or update biographical and experi-ence information for key management per-sonnel, together with overall staffing andsalary levelsasappropriate for full evaluation.

21. Determine whether operating practices pro-vide for adequate legal documents and agree-ments such that the account activities, ingeneral, are consistent with contractualresponsibilities.

22. Ascertain if senior management is aware, orhas adopted the procedures necessary tobecome aware, of its current and potentialresponsibilities in connection with anyregulatory-reporting and/or regulatory-compliance requirements.

23. Obtain or verify that workpapers containthe following permanent documentation:a. System approval lettersb. date of incorporation or date acquiredc. date activity commencedd. articles of incorporation and by-lawse. commitmentsf. supervisory actionsg. other pertinent correspondence

3130.1.3.1 Scope of Inspection

It is expected that inspections of investmentadviser subsidiaries will generally be conductedas part of regularly scheduled bank holdingcompany inspections. If, however, the invest-ment adviser subsidiary provides portfolio man-agement services for a significant portion oftrust assets held by a state member bank, theReserve Bank should inspect the investmentadviser subsidiary at the same time it examinesthe trust operations of the bank subsidiary. Thescope of the inspection should be based on areview of the nature and complexity of thefinancial services provided to customers. Anadviser which merely provides investment adviceand does not provide any additional financialservices, such as portfolio management, safe-keeping, recordkeeping, or trading services, maynot require an inspection. However, an adviserwhich provides portfolio management, safekeep-ing, or other services will require an inspection.To determine the scope of the inspection, it isessential to identify what types of services arebeing offered to customers and to assess therisks associated with those services.

The examiner needs to understand the advis-er’s operations, including how it represents itselfto clients and whether the adviser has any vested

interests in the financial services which it offers.Examiners should use their discretion to sched-ule inspections based on the size and complex-ity of the adviser’s operations. Most section4(c)(8) BHC subsidiaries will be subject to SECregistration requirements. (See SR-91-4 (SA).)Appropriate checklist questions should be com-pleted for registered investment advisers whichprovide investment advice to affiliated banks ortrust companies and for investment adviserswhich engage in activities which could have asignificant impact on the bank holding company’sfinancial safety and soundness. The checklistshould also be completed for all advisers thatmanage investment portfolios for their custom-ers. The checklist is only a guideline and someof the sections in the checklist may not beapplicable. Conversely, the scope of suchexaminations is not limited to the items includedin this checklist.

3130.1.3.2 Inspection Checklist

The questions in this checklist will assist theexaminer in evaluating various areas of supervi-sory concerns.

3130.1.3.2.1 Review of FundamentalPolicies and Procedures

The investment adviser’s policies and proce-dures should be reviewed using the followingchecklist to ensure that fundamental policiesand procedures have been established andimplemented.

1. Are adequate minutes of the board and boardcommittee meetings prepared?

2. Is the adviser properly chartered andregistered?

3. Does the adviser have sufficient blanket bondor other fidelity or liability coverage in place?

4. Is corporate and regulatory reporting per-formed on a timely basis?

5. Does the above reporting fairly present theaccounting and supplemental data reflectedby the corporate records?

6. Are internal accounting controls, providedby a segregation of duties or a need foradministrative approvals, adequate?

7. Are duties properly segregated in the receiv-ing, disbursing, and recording of cash andcash transactions?

8. Are fee calculations and billing proceduresadequate to ensure accuracy and propriety?



9. Are all security transactions authorized orapproved by the appropriate managementlevel, and is there documented evidence ofthe authorization or approval?

3130.1.3.2.2 Supervision andOrganization

Supervision refers to the conduct of an adviser’sboard of directors and senior management inestablishing, communicating, and enforcing asystem of policies, procedures, and practicessuitable to its business objectives and legalrequirements. Organization may be character-ized as the framework of committees and theassigned responsibilities through which supervi-sion functions. The examiner should (1) reviewthe structure of the organization for adequacy ofmanagement information systems and (2) theorganization framework as both relate to meet-ing the entity’s stated responsibilities as well asgenerally accepted standards of conduct. Theexaminer should review the supervisory func-tion by first identifying the duties andresponsibilities of the board of directors. Thedirectors owe the duty of reasonable supervi-sion, including appropriate attention to areas inwhich the adviser is assuming sensitive andcomplex fiduciary responsibilities. The next levelof review is the committee and officer positionsto which certain authority has been delegated. Inreviewing this level of supervision, the exam-iner should keep in mind that certain functionscannot be delegated; for example, approval ofsignificant new services or lines of business,approval of formal policies designed to ensurethat the adviser operates in basic compliancewith laws and regulations, and the selection andsupervision of senior management cannot ordi-narily be delegated. Informal delegations andoperating practices represent the last level ofreview. In reviewing both formal and informaldelegations, consideration should be given tothe institution’s size and complexity. A finaldetermination of the adequacy of supervisionand organization must be based on findings ofthe entire inspection of the bank holding com-pany or its nonbank subsidiaries. While topicsthat have direct or indirect impact on the ade-quacy of director supervision and managementcompetence are of particular sensitivity, examin-ers nevertheless have a responsibility to care-fully address and comment upon such issues.During the course of the inspection, the exam-iner should review the supervisory and organi-zational structure of the bank holding company,with particular reference to investment-related

activities. The examiner should determinewhether the board of directors has developedadequate objectives and policies.

3130.1.3.2.2.1 Supervision and OrganizationChecklist

1. If the board of directors does not directlysupervise investment adviser activities—a. has a responsible board committee(s)

been named to exercise this function?b. are any delegations consistent with by-

law provisions and other appropriateprinciples?

c. do theboard’sminutesnevertheless reflectperiodic but timely review of the con-duct and operating results of the function?

2. Do minutes of the board, or its commit-tee(s), reflect that members—a. attend meetings with reasonable

frequency?b. require and approve, where necessary,

appropriate written policies, strategicplans, and management reports relatingthereto?

c. review audit and regulatory reports (andmanagement proposals and correctivemeasures in response thereto), litigationdevelopments, earnings and expensereports, and changes to fee schedules?

3. Through adoption of formal policies andprovisions for auditing, does the boardadequately seek to ensure the integrity ofthe organization’s records and operationalsystems?

4. Are policies and procedures adequately com-municated to officers and staff?

5. Does the board or a board committee con-sider, periodically review, and provide forinsurance protection?

6. Does the bank holding company maintainaccess to competent legal counsel and, whereappropriate, obtain written opinions on sig-nificant legal questions such as—a. pending or threatened litigation?b. account agreements whose terms are

unclear or ambiguous or raise compli-cated points of law?

c. proposed actions or policies involvingmatters such as conflicts of interest,restricted securities, ERISA, and othermatters involvingpossible legalexposure?

7. If an account’s securities are registered in anominee name(s)—



a. is the nominee agreement current?b. is the nominee registered with the Ameri-

can Society of Corporate Secretaries (toguard against duplication of the nomineename) and state authorities (whererequired by local law)?

8. Is staffing adequate, in terms of both num-bers and qualifications, to handle the cur-rent volume of business?

9. Is there adequate provision for managementsuccession, or for continuing operations incase of the loss of key personnel?

10. Is senior management aware of its responsi-bilities in connection with, and has it estab-lished written policies and procedures toensure compliance with, any applicableregulatory-reporting requirements?

11. Are significant functions of the investmentadviser subject to either internal or externalaudit? If not, ascertain whether an auditprogram should either be developed orexpanded.

12. When appropriate in light of the size andcomplexity of the adviser’s operations, hasmanagement had an audit of financial state-ments performed by certified publicaccountants?

13. Have all significant exceptions and recom-mendations in audits or examinations orinspection reports been corrected, imple-mented, or otherwise satisfactorily resolved?

3130.1.3.2.3 Portfolio Management

Investment selection is the process whereby theadviser evaluates, selects, and reevaluates thosesecurities or other financial assets it will buy orsell for its clients, or for which it will makerecommendations. It includes the process ofresearching and selecting recommended indi-vidual stocks and bonds, and setting objectivesor strategies for diversifications by types andclasses of securities into general or specializedportfolios, as well as the process of communi-cating and executing overall strategies for par-ticular accounts.

When an adviser holds itself out as a profes-sional, the adviser will be held to a high stan-dard of prudence and expertise in the investment-selectionand-reviewprocess.Therefore,advisersmust carefully consider policies and proceduresin this area in accordance with the size andcharacter of the investment-selection responsi-bilities undertaken. In furnishing portfolio invest-

ment advice, particularly to retail clients, aninvestment adviser should observe the standardsof care and conduct applicable to fiduciaries.1

3130.1.3.2.3.1 Investment Standards andResearch

1. Are the general investment standards andreview and selection responsibilities definedand approved by the board of directors?

2. Does management or senior investment per-sonnel review overall investment policy andpotential investment problems at leastannually?

3. Is portfolio management policy adequatelycommunicated to appropriate personnel (forexample, by including it in committee min-utes, directives, or memoranda circulated tosuch personnel)?

4. Does the institution, where appropriate,diversify investments according to—a. types of assets, such as common stocks,

fixed-income securities, and real estate?b. types of securities by characteristics such

as income, growth, and size of company?c. types of securities by industry and specific

companies within industries?d. maturities of debt securities?e. geographic location of companies of issue,

such as utilities?f. tax-exempt income?

5. If the institutionhasa listofsecuritiesapprovedfor purchase, retention, and/or sale—a. are recommendations for additions to or

deletions from such list(s) approved by acommittee or group with appropriateauthority and expertise?

b. are periodic reviews made of the lists ofsecurities approved for purchase, reten-tion, or sale to assess the current appropri-ateness of the investments listed?

6. If the institution uses any research or analy-sis in its general investment-review and-selection process—a. are appropriate factors taken into account?b. is appropriate documentation obtained and

filed to reflectconsiderationofsuch factors?7. If the size and character of the entity’s discre-

tionary investment responsibilities are suchthat the type of detailed research consider-

1. The term ‘‘portfolio investment’’ is intended to refergenerally to the investment of funds in a ‘‘security’’ as definedin section 2(1) of the Securities Act of 1933 (15 U.S.C. 77b)or in real property interests, except when the real property isto be used in the trade or business of the person being advised.In furnishing portfolio investment advice, bank holding com-panies and their subsidiaries shall observe the standards ofcare and conduct applicable to fiduciaries.



ations and files envisioned in the previousquestion are not relied on, does it use ratingsby acceptable financial-rating agencies, suchas Moody’s or Standard and Poor’s, togetherwith evaluation of basic relevant factors per-taining to the type of security underconsideration?

8. Where appropriate, does the organization dif-ferentiate its investment-selection process asto the type of account in question, such asthose for which the need for growth or incomeis paramount, or for taxable versus tax-freetrusts or retail versus institutional accounts?

9. Do personnel possess sufficient expertiseand experience to properly implement thefirm’s investment-selection systems andresponsibilities?

3130.1.3.2.3.2 Account Administration

Special consideration has to be given to accountssubject to the Employee Retirement IncomeSecurity Act of 1974 (ERISA), which imposesfiduciary responsibilities upon any person whohas any power of control, management, or dis-position over the funds or other property of anyemployee benefit fund. When an adviser exer-cises investment discretion over such plans, theextensive fiduciary responsibility and prohibitedtransaction rules of ERISA will apply.

1. Does the adviser have portfolio manage-ment procedures which provide for—a. consideration of the needs and objectives

of particular types of accounts, such asthe need for income versus growth ortaxable versus tax-free income?

b. conformity with investment provisionsof governing instruments?

c. consideration of the liquidity needs ofthe account for anticipated distributions?

d. appropriate diversification, includingavoidance or elimination of concentra-tions in individual securities and by typeand subclass of securities?

2. When assets in discretionary accounts areconsidered unsuitable, is a program of pru-dent and timely sale of such assets followedunless retention is required?

3. In order to determine the advisability ofretaining or changing assets, does the adviserhave procedures for periodic reviews?

4. Do minute books or other records—a. identify reviewed accounts?b. report written conclusions on the advis-

ability of retaining or disposing of assetsin the accounts?

5. As appropriate to the size and character ofbusiness, are account synopses and histori-cal data used in the review of accountassets?

6. Does the investment-review informationinclude—a. amount and description of investment?b. categories of investment, such as bonds

and stocks?c. types of investments within each cate-

gory, such as industry groups for stocks?d. cost?e. market or appraised value at review date?f. annual income?g. yield at market?h. rating of recognized financial service?

7. For accounts in which the adviser makesinvestments at the direction of the client,does the adviser—a. review the account to detect illegal, non-

conforming, substandard, or otherwiseunsuitable investments?

b. advise the power holder of any improperinvestments?

c. inform parties at interest in the accountif any improper investment is not dis-posed of, and seek legal relief, ifnecessary?

d. resign from the account if correctiveaction is not taken concerning improperinvestments?

8. Have proxy voting policies and proceduresas listed below been established for ERISAaccounts that are suitable in relation toassumed responsibilities?a. voting of routine proxies?b. identification and handling of proxy or

tender determinations when sensitivesocial issues, conflicts of interest, signifi-cant increases in management power orperquisites, or merger or buy-out propos-als are involved?

NOTE: For requirements relating toproxy processing and the ShareholderCommunications Act of 1985, seeOperations and Internal Controls in theTrust Examination Manual.For ques-tions relating to the voting of affiliatestock, see Conflicts of Interest in theTrust Examination Manual.When an adviser invests accounts in

options and/or futures, the following check-list questions (numbers 9 through 13) shouldbe completed. For additional information asto appropriate uses of options and futures



contracts, see SR-83-2(SA) and SR-83-39(SA).

9. When an adviser uses options and/or futures,has the board of directors or a directors’-level committee approved a policy and strat-egy for their use? Does the policy address—a. the investment objectives to be accom-

plished by the use of these contracts?b. the specific types of contracts to be used?c. the types of accounts authorized to use

these contracts?d. restrictions and/or conditions upon use

of contracts, such as selection of broker-age houses, position limits, time frames,leveraging, etc.?

10. Was adequate disclosure made and adequateauthorization obtained to execute contracttransactions for various types of participat-ing accounts?

11. Are adequate systems and controls in effectto ensure—a. proper tax treatment?b. proper segregation of securities and/or

monies?c. conformance with account objectives?d. adherence to adopted strategy, position

limits, and related program parameters?e. periodic management evaluation and

reporting systems with respect to—• results of contract activities upon over-

all investment performance?• market developments, including cur-

rent liquidity of relevant futures andoptions contracts in which positionsare taken?

• financial condition, fee competitive-ness, and performance of involvedbroker-dealers?

12. Does theaccountingsystemaccurately reflectcontract activities with respect to—a. transaction details?b. current gains or losses on open contract

positions?c. necessary tax information?

13. Do operating personnel appear sufficientlyknowledgeable relative to the level ofcontract-transactions activity?

3130.1.3.2.4 Conflicts of Interests

The inspection of an investment adviser subsid-iary which provides services to an affiliated trustcompany or bank with a trust department requiresexpanded inspectionprocedures.Often the invest-

ment adviser subsidiary was organized for thepurpose of providing investment advice and ser-vices for the trust accounts held at one or moreof its affiliates. These subsidiaries often employthe same individuals who worked in the banksor trust company which they advise.

Conflict-of-interest problems may arise whenthe adviser exercises any ‘‘discretion’’ whenthere are mutually opposing interests. The mostserious conflict of interest is self-dealing, whichcould include transactions such as an investmentin affiliated banks or the purchase of securitiesfrom or through an affiliate. To resolve conflictsof interest, such transactions and the fees associ-ated with them must be fully disclosed andauthorized by the appropriate parties.

Potential conflict-of-interest situations are notlimited to transactions between affiliates, butcan be between the adviser and any of its direc-tors, officers, or employees individually. Due tothecomplexity, sensitivity,andexposure involvedin conflicts of interest, it is particularly impor-tant that an adviser develop the awareness andpolicies and procedures to identify and dealwith conflicts situations. Therefore, it is consid-ered highly desirable, even when not specifi-cally required by regulation, that written poli-cies be adopted and periodically revised asnecessary.

3130.1.3.2.4.1 Self-Dealing

1. Has the adviser—a. acquired any assets from itself or its

affiliates?b. acquired any assets from directors, offi-

cers, or employees of the organization orits affiliates, or from any other individu-als with whom a connection exists thatmight affect their best judgment?

2. Has the adviser sold or transferred anyaccount assets, by loan or otherwise, to—a. any affiliates?b. directors, officers, or employees of any

affiliates?c. other individuals or corporations with

whom such a connection exists or otherorganizations in which such an interestexists that might affect the exercise of itsbest judgment?

3. Has the company purchased any securitiesfor a customer account from any member ofan undivided syndicate for which the adviseror any of its affiliates are participating, orfrom a private placement which the adviserassisted?



4. Does the company have satisfactory poli-cies and procedures, in terms of its size andcharacter of business, to address the preced-ing situations?

5. If the company directs extra fee-producingbusiness to itself or an affiliate (for exam-ple, brokerage services or options-tradingservices), or if it charges separate fees toaccounts for securities transactions or otherservices commonly provided as part of gen-eral account administration (for example,fees for cash management or investments inmutual funds when management or admin-istration fees are received by the companyor an affiliate)—a. has it identified those accounts which

may properly participate in such servicesin accordance with adopted policy, legalopinion, a Department of Labor ruling,and/or other necessary determinations?

b. has it made appropriate prior disclosuresand obtained adequate specific authoriza-tions for those accounts identified asentitled to the services?

6. Have any assets held by the company in oneaccount been sold to another account?NOTE: The transaction may be permissibleif appropriate disclosure is made, authoriza-tion is received, and the law or the govern-ing instrument do not prohibit it. However,an interaccount transaction for ERISAaccounts may be a prohibited transaction. Inaddition, difficult problems can arise inestablishing or documenting a ‘‘fair’’ pricefor the transaction, particularly if the assetis a thinly traded security or is a uniqueasset.

7. Does the company have appropriate poli-cies and procedures to ensure—a. its discretionary accounts are not left in

uninvested cash positions beyond a mini-mum period of time?

b. its accounts are invested in affiliateinterest-bearing deposits only for appro-priate temporary or other purposes?NOTE: To the extent the company haslong-term affiliate deposits or significantaggregate holdings, a special reviewshould be made of the company’s docu-mentation evidencing the suitability ofsuch investments in view of availablealternate vehicles.

8. Are securities of affiliates only purchasedupon proper direction or specific authoriza-tion in account instruments?

9. When the adviser purchases securities whichare underwritten by an affiliate, does theadviser do so only upon proper direction

and specific authorization of the customer?10. Does the company act as investment adviser

to an open-end or closed-end investmentcompany that is registered under the Invest-ment Company Act of 1940? If so, do itsactivities conform with the Board’s inter-pretation at 12 C.F.R. 225.125, which definesthe scope of permissible activities?

3130.1.3.2.4.2 Broker Selection

1. When volume of activity warrants, is alloca-tion of brokerage business controlled throughanapproved listwhich isperiodically reviewedand approved by the company’s board or asenior-officer-level committee?

2. Does management attempt to obtain the bestservice for customers, including periodicevaluations of broker qualifications such as—a. financial condition?b. past record of good and timely delivery

and payment on trades?c. quality of execution and ability to handle

specialized transactions?d. quality of research received, if applicable?

3. Are there procedures to monitor or periodi-cally survey available negotiated commis-sion prices in order to ascertain reasonablecosts for the execution requirements of itsaccounts?

4. If commissions higher than the ‘‘lowest’’available negotiated commissions are beingpaid for executions in order to receive goodsand/or services—a. have such goods and/or services been

determined to reasonably qualify as ‘‘bro-kerage and research services’’ as definedin section 28(e)(3) of the SecuritiesExchange Act of 1934?

b. does an appropriate committee periodi-cally (at least annually) review and deter-mine that the value of the goods and ser-vices justifies the payment of the higherbrokerage commissions?

5. Does the entity periodically review and main-tain records of all goods and/or servicesreceived from brokers or third parties inreturn for brokerage and/or dealer businessallocated to particular firms?

6. Do policies and procedures preclude—a. selection of broker-dealers on the basis of

deposit balances?b. agreements or understandings for alloca-

tion of specific amounts of business to a



broker-dealer such that the adviser com-pany would not be able to cease allocatingbusiness to the firm if it were no longerproviding acceptable execution?

7. Are auditing and other monitoring controlsand reporting procedures in effect to verifythe compliance of traders with policiesregarding broker selection and payment ofcommissions? NOTE: Under section 28(e)of the Securities Exchange Act of 1934, theadviser may also legitimately pay more thanthe lowest-available commission for reasonsof execution, financial soundness, and effi-ciency of delivery and payment.

8. In addition to advisory services, are broker-age services provided for customers pursuantto section 225.28(b)(7)(i) of Regulation Y? Ifso, the examiner should refer to the securitiesbrokerage inspection procedures and check-list questions for the inspection of brokerageactivities.

3130.1.3.2.4.3 Trading Policies and Practices

1. When trading specialists are employed, arethere adequate written or unwritten standardsof competence, education, and training forsuch individuals?

2. When specialists are not employed, are theindividuals responsible for trading reason-ably trained and informed in relation to thevolume and character of trading activity theyare required to perform?

3. When transactions are permitted to be crossedbetween accounts, are procedures adequateto ensure fair pricing of the transactions? If itis not clear the transactions are permitted,has the company determined through counselthat crossing is permissible under applicablelaw?

4. When specialists are employed and volumeof activity permits, are block trades consid-ered in order to obtain more favorable tradeprices and execution prices for accounts?

5. If applicable, do procedures, including estab-lishment of time frames in advance of suchtrading, require special authorization andattention for large or block trades which areto be executed in a number of transactions?

6. If procedures permit the combining of pur-chase or sale orders of the same security—a. are resulting benefits in price and/or

execution costs applied on a pro rata oraverage basis to the participating accounts?

b. are allocable shares similarly pro-rated toparticipating accounts when a combinedtrade is not executed at once, but in anumber of transactions over a period oftime?

7. Does the adviser maintain policies ‘‘reason-ably designed to prevent the misuse of mate-rial non-public information?’’

3130.1.3.2.5 Recordkeeping

Registered investment advisers are subject toextensive recordkeeping requirements. SEC Rule204-2 imposes recordkeeping standards andrequires that registered investment advisers keepaccurate records. In addition to this recordkeep-ing, the adviser is subject to the ‘‘brochure rule’’(Rule 204-3). This rule requires an investmentadviser to deliver a specified disclosure state-ment with respect to its background and busi-ness practices to every client or prospectiveclient. In addition to an initial disclosure, theadviser must offer annually to deliver a currentdisclosure statement upon request. Those advis-ers which have custody or possession of securi-ties of any client must maintain certain addi-tional records, including separate ledger accountsfor each client, copies of confirmations, and aposition record showing the interest of eachclient and the location of the securities.

1. Does the investment adviser make and keepcurrent appropriate books and recordsincluding—a. journals or summary journals?b. a memorandum of each order given by the

firmor instructions received, showing termsand conditions of the orders?

c. all checkbooks, bank statements, canceledchecks, and cash reconciliations?

d. all bills or statements, paid or unpaid?e. trial balances, financial statements, and

internal audit papers?f. written communications received or sent

by the firm?g. list of discretionary accounts?h. powers of attorney and discretionary

powers?i. written agreements?j. copies of each notice, circular, advertise-

ment, newspaper article, investment letter,bulletin, or other communication recom-mending the purchase or sale of a security?

2. Does the adviser maintain a record of everytransaction in which the adviser or any



‘‘advisory representative’’ has a direct orindirect beneficial interest?

3. Are partnership articles, articles of incorpora-tion, charter, minute books, and stock certifi-cate books maintained at the adviser’s princi-pal office?

4. If required books and records are photocop-ied or microfilmed, or if they are produced orreproduced on computer storage media—a. are such media indexed and arranged to

permit immediate location of any particu-lar record?

b. wereanycopiesorprintoutsof such recordspromptly provided on request?

c. is at least one copy of the original recordsthat are now on such media stored in aseparate location from the original for thetime required?

d. does the adviser maintain procedures forthe maintenance and preservation of, andaccess to, records so as to reasonably safe-guard them from loss, alteration, ordestruction?

e. does the adviser have facilities for theimmediate, easily readable projection ofmicrofilmed records and for producingeasily readable facsimile enlargements?

5. Do the entries in the general ledger and jour-nals properly reflect payments or receipts ofmonies or other goods or services?

6. Do the financial statements, canceled checks,deposit slips, and check register properlyreflect payments or receipts of monies orother goods or services?

7. When the adviser’s financial records indicatethat it is capitalized with client funds (througheither loans or equity), have adequate disclo-sures been made to clients about the risksand conflicts of interest involved?

3130.1.3.2.6 Security Storage andProcessing

Investment advisers generally do not take pos-session and control of client funds and securi-ties. However, in those cases in which suchresponsibilities are assumed, the inspection mustevaluate those internal controls which are inplace for the safeguarding of client funds andsecurities. Controls and related processing pro-cedures must be appropriately designed andimplemented by the adviser to efficiently andsafely facilitate such operations.

1. Does the adviser have custody of clientfunds or securities?

2. Does the adviser gain effective access toclient assets through practices, arrange-ments, or relationships with clients, such astrustee, executor, or account signator?

3. When the adviser has custody of clientfunds or securities, does the adviser main-tain the following records:a. a record reflecting all purchases, sales,

receipts, and deliveries of securities, andall debits and credits to such accounts?

b. a separate ledger account for each client,showing purchases, sales receipts, anddeliveries of securities?

c. copies of confirmations of all transac-tions for such clients?

d. a record for each security in which anyclient has a position, reflecting the nameof the client, amount of interest, andlocation of security?

4. When the adviser renders investment-management services, are the followingrecords maintained:a. for each client, a record of securities

purchased and sold, containing the date,amount, and price of each transaction?

b. a record for each security in which anyclient has a current position, showing thename of each client and current interestor number of shares owned by eachclient?

5. Are client assets physically segregated fromthe adviser’s own assets?

6. For the vault and other related security-processing areas, are adequate controls/safeguards in effect which include thefollowing:a. Are assets maintained under a system of

joint custody or dual control?b. Is access to these areas restricted to

designated/authorized personnel?c. As appropriate, are other controls/

safeguards systems in place (for exam-ple, rotation of assignments, key/lockcombinations, or vault or area entrancelog(s))?

d. Is a security-ticket system used as a vaultand asset-movement control system?

7. If a security-ticket system is used, areadequate controls/safeguards in effect whichinclude the following:a. Are security tickets prenumbered?b. Does each copy of the security ticket

clearly indicate its destination to ensureprompt and accurate delivery?



c. Does the security ticket provide the nec-essary information to ensure proper pro-cessing and recording of the transaction?

d. Does the security ticket contain suffi-cient copies to ensure that sound internalcontrol is maintained over the physicalsecurity-movement process by providingthe following with a copy (or copies):• portfolio managers who initiated the

transactions?• appropriatevault/operationspersonnel?• the audit/asset control function?

e. Are unissued security tickets properlysafeguarded and subject to adequatenumeric controls?

8. Does the control of security ticket/transaction cancellation and replacementinclude—a. restricting the ability to initiate such

action to supervisory personnel?b. reporting such activity to the audit/asset

control function and other function(s)affected by such action?

c. procedures to ensure that securities arereturned to the vault or that funds chargedfrom an account are redeposited, or thatthe securities or funds are immediatelyplaced under the control of a new secu-rity ticket/transaction?

d. identifying a replacement security ticketby recording such information on thereplacement ticket?

e. requiring all copies of the replaced secu-rity ticket to be forwarded to the audit/asset control function?

9. For assets received, are adequate controls/safeguards in effect which include thefollowing:a. Are all assets received promptly placed

under joint custody or control?b. Is appropriate documentation required

and on file for all assets received, and isit compared to actual assets received andposted to control ledgers?

c. As applicable, are procedures in placefor controlling and properly handlingassets received by other means, includ-ing delivery by mail or messenger?

d. If assets are not to be physically heldor issued (for example, mutual fundshares), is a receipt, statement, or acknow-ledgment obtained from the issuer orholder and processed by receipt ticketor other means to ensure properaccountability?

e. If securities received are not properlyregistered in the company’s nomineename, are procedures in place to ensureprompt re-registration, control, andfollow-up until re-registration?

10. For the delivery of assets, are adequatecontrol/safeguards in place which includethe following:a. Are appropriate receipts obtained and on

file for securities delivered?b. Are procedures in place to ensure that

bearersecuritiesarenotmailed inamountsin excess of the company’s insurancelimits?

11. Do vault custodians—a. compare securities received/withdrawn

to the security ticket?b. for withdrawals, verify that the security

ticket is signed (initialed) by authorizedpersonnel?

c. for securities temporarily withdrawn fromthe vault (for example, for transfer,re-registration, or account/portfolio man-ager review), is a copy of the securityticket retained by vault personnel pend-ing the return of the security to the vault?

12. For pending security transactions, areadequate controls in effect which includethe following:a. Are pending items periodically reviewed

by operations personnel?b. Do procedures provide for prompt

follow-up on items which have not beencompleted within established timeperiods?

c. Are exceptions promptly reported andresolved by appropriate personnel (forexample, management, supervisors,and/or the audit/asset control function)?

d. Are current pending security itemsin compliance with established proce-dures for reporting exceptions, and arethose transactions which have notbeen completed within established timeperiods been followed up satisfactorily?NOTE: Examiner judgment should beused in determining the scope of thisreview. However, at a minimum, thereview should include procedures forhandling security transactions pending30 days or more.

13. Does the security-processing system—a. contain a sufficient number of controls/

safeguards to properly reflect the currentstatus of and limit an individual’s con-trol over a security transaction?



b. contain sufficient information to identify,locate, and trace the movement of eachasset?

c. provide for adequate segregation of dutiesand responsibilities?

14. Has individual accountability or responsi-bility been properly assigned for the physi-cal protection of the securities and relatedcash flow, if applicable, throughout thesecurity-processing system?

15. Do procedures require that orders for tradesoriginate with account or portfolio manag-ers, with the signature or initials of theauthorizing party shown on the order formor purchase/sale ticket?

16. Are transactions made on a first-in, first-outbasis (that is, executed in order of receipt),except when combined in blocks for execu-tion pursuant to appropriate writtenprocedures?

17. Do operations personnel perform indepen-dently of account or portfolio managersto—

a. reconcile trade tickets to brokers’confirmations?

b. monitor and promptly follow up on anyoutstanding transactions, such as confir-mations not received within specifiedtime periods or purchases/sales whichhave not settled on settlement date?

c. promptly post payments for purchases/sales to the recordkeeping system andpromptly record/remove assets?

3130.1.3.2.7 Other Matters

1. Is the adviser or any of its principals involvedin litigation or arbitration which will have animpact on its ability to fulfill its contract withclients?

2. Were any matters of a material nature foundin the adviser’s correspondence, such as sig-nificant client complaints?

3. Did a review of customer-complaint filesreveal any possible areas for special inspec-tion focus?

4. Did a review of the adviser’s current finan-cial condition raise concerns as to the advis-er’s solvency or its ability to otherwise con-tinue to provide advisory services?

5. Are there any other aspects of the adviser’soperations, or the operations of an affiliate,which raise concerns?

3130.1.4 INSPECTION FINDINGS

A written summary of the subsidiary’s activitiesshould be presented to the examiner in charge ofthe bank holding company inspection and shouldbe included in the inspection report or its sup-porting workpapers. Material exceptions shouldbe noted with management’s responses under anappropriate caption in the open section of thereport. Any comments in the report regardingthe scope of the investment advisory inspectionsshould note that such inspections are primarilyfocused on safety-and-soundness considerationsand not on compliance with securities laws.

In those cases in which a separate Report ofBank Holding Company Inspection on Invest-ment Advisory Activities is prepared, examinersmay use the Uniform Interagency Trust RatingSystem (see SR-98-37 FRB, revised October13, 1998, and effective January 1, 1999), whichprovides a basis for the evaluation of criticalareas of supervisory concern. The rating systemis generally used by federal supervisory agen-cies to assess the condition of trust companies.However, the system can be adopted to reporton advisory operations as well. When theinspectionuncovers significantdeficiencieswhichrequire corrective action, and the inspection wasnot done in conjunction with a concurrent bankholding company inspection, a separate reportshould be prepared and delivered to the inspectednonbank adviser. Send a copy of the summaryand any report comments to the Trust ActivitiesProgram, Washington, DC 20551.

3130.1.5 ON-SITE INSPECTION BYTRUST EXAMINERS

An investment advisory subsidiary of a bankholding company will normally be registered asan investment adviser under the federal securi-ties laws, and will be subject to examinations ofits advisory activities by the Securities andExchange Commission (SEC). Nevertheless,because investment responsibility is involved inany investment adviser’s activities, and sincethe SEC’s routine examinations may be infre-quent, periodic on-site inspections should beconducted as an integral part of BHC inspections.

Consideration should be given to using trustexaminers to conduct, or at least participate in,on-site inspections of financial and investmentadvisory nonbank subsidiaries, especially whenthe subsidiary provides services to an affiliate



bank trust department examined by the Board ofGovernors of the Federal Reserve System. If thebank holding company has to ‘‘spin off’’ theinvestment research and selection process of itsbanks’ trust departments into an investmentadvisory subsidiary, there may be a need toreview the activities of the trust departmentstogether with those of the advisory subsidiarythrough an on-site inspection.

The companies being advised on a contrac-tual basis and which were sponsored by theholding company or any affiliate are also definedas affiliates in sections 23A and 23B of theFederal Reserve Act. The examiner should there-fore be alert to any intercompany transactionsbetween a bank subsidiary and the advised com-pany. A review of financial statements of suchcompanies is warranted.



Limitations andactivity approval

15 U.S.C.80; section23A FRA371c

225.28(b)(6)225.125

4–177 1997 FRB 2751971 FRB 5121972 FRB 149,571

Activity approval—real estate developmentadvisers for stateand local governments

225.28(b)(6) 1997 FRB 2751980 FRB 962and 984

Merger of two BHCsunder Section 3 of theBHC Act, acquisitionof a bank, and followedby the acquisition of non-banking subsidiariesengaged in financial andinvestment advisoryactivities

1843(c)(8)and (j)

225.28(b)(6) 225.125 2015 FRB 82(Board OrderNo. 2015-26




4(c)(8)—Advice on Mergers and Similar Corporate Structurings,Capital Structurings, and Financing Transactions Section 3130.3

This section renders inspection guidance onfinancial and investment advisory activities thatare provided in connection with mergers, acqui-sitions, divestitures, investments, joint ventures,leveragedbuyouts, recapitalizations,capitalstruc-turings, and financing transactions and similartransactions, and on conducting financial-feasibility studies.1 This section also provideshistorical examples of financial and investmentadvice previously approved by Board order. Theexamples consist of various kinds of advicewith regard to mergers and similar corporatetransactions under the current Regulation Y, sec-tion 225.28(b)(6)(iii). Some of the examples ofadvisory nonbank activities were approved forinclusion into Regulation Y long before therevision of Regulation Y that was effective April21, 1997. The reader of these examples mustonly take into consideration the current provi-sions of Regulation Y. There should be no reli-ance on Board order commitments, old regula-tory provisions, supervisory policies, andinterpretationsmadebeforeApril 21,1997,unlessthey were not revised. Certain former provisionsor commitments may no longer be applicable.The historical examples discussed in this sectionhave been revised according to the new regula-tory provisions.

If inspection objectives and procedures arestated in a specific section, the examiner shoulduse this specialized guidance. In addition, theexaminer should use the generalized inspectionobjectives and procedures in section 3130.0,which are generally applicable to all advisoryactivities.

3130.3.1 ADVISER TO A MORTGAGEOR REAL ESTATE INVESTMENTTRUST

An adviser to a mortgage or real estate invest-ment trust (REIT) furnishes expertise in theareas of funds acquisition, lending, investing,and servicing that is similar to the role of adviserto a mutual fund. The contracted service isperformed on a fee basis that is generally basedon a percentage of the trust’s total assets. Theintention of the exemption, found in section225.28(b)(iii) of Regulation Y, is to allow therelationship to be advisory in nature as opposedto controlling. However, in some instances, the

relationship between trusts and their advisershas gone beyond the parameters of advice andresulted in legal entanglements, conflicts ofinterest, and financial exposure for the bankholding company. Because of the potential riskexposures which may result when a bank hold-ing company or its subsidiary engages in thisactivity, the overall relationship must be subjectto particular scrutiny during an inspection.

REITs were established by the U.S. Congressin 1960, effective January 1, 1961. A REIT is ahybrid form of an investment vehicle which isessentially a financial intermediary specializingin real estate lending and investment. A REITobtains funds by borrowing from financial insti-tutions or other lenders or by issuing shares(equity capital). It invests the funds in realestate, either as a lender or equity owner. REITsare usually owned by passive owners, not opera-tors. REITs are designed to take advantage ofbenefits within the federal Internal RevenueCode.

There are generally four types of REITs:equity, mortgage, hybrid, and ‘‘finite-life.’’ Anequity REIT acquires income-producing proper-ties, deriving its earnings mostly from rents. Amortgage REIT provides financing to real estateprojects that are owned by others, deriving itsearnings from interest charged on the loans. Ahybrid REIT combines the equity REIT and themortgage REIT. The finite-life REIT is struc-tured to self-liquidate within an established timeframe.

By meeting certain prescribed requirementsduring a taxable year, a REIT may function as aconduit with respect to income distributed to itsbeneficiaries. If at least 95 percent of the trust’sincome is distributed to the beneficiaries (exclud-ing capital gains), the trust pays no taxes on thedistributed income, thus avoiding the doubletaxation associated with corporations. There-fore, this investment vehicle has the tax advan-tage of a partnership but offers the limited liabil-ity and perpetuity of a corporation.

A REIT must be a corporation (other than aninsurance company or bank), an association, ora trust, or it must be managed by at least onetrustee, with transferable shares of beneficialinterest as form and evidence of ownership.There must be at least 100 beneficial owners,and the trust must elect to be treated as a REITfor tax purposes. A REIT must meet the follow-ing threefold gross income test. At least 95 per-

1. Feasibility studies do not include assisting managementwith the planning or marketing for a given product or provid-ing general operational or management advice.


cent of the trust’s income must come from realproperty rentals, dividends, abatements andrefunds of real property taxes, interest on loans,or gains from the sale of securities or real estate,with the further stipulation that no less than75 percent of the trust’s income must be directlyrelated to real property. Also, less than 30 per-cent of the trust’s income can be derived fromthe sale of any securities held for less than sixmonths and from foreclosure property and realproperty held for less than four years that is notinvoluntarily converted.

In addition to the threefold gross income test,there is a twofold investment test which must bemet. First, at least 75 percent of the value of thetrust’s total assets must be real estate assets,government securities, and cash. Second, 25 per-cent of the trust’s total assets may be securities,but the trust cannot hold securities from oneissuer which amount to greater than 5 percent ofthe trust’s total assets and more than 10 percentof the outstanding voting securities of the issuer.

3130.3.1.1 Evaluating Advisory Activitiesfor a REIT

A bank holding company may have an insignifi-cant amount of capital invested in the advisorycompany. However, if the bank holding com-pany or its subsidiaries have extensions of creditor unfunded commitments outstanding, an evalu-ation of the credit may be needed using normalclassification criteria as to their collectibility,particularly if there is substantial risk exposure.Examination/inspection reports of subsidiariesshould be reviewed to determine the consoli-dated exposure. The holding company or itsbanking subsidiaries may be participating inexchanges or swaps with the advised REIT,whereby trust assets are exchanged for forgive-ness of bank debt. Such pending asset swapsshould be considered in conjunction with thecredit evaluations. The swaps may be for thepurpose of reducing the REIT’s liabilities, whichcan involve an exchange of assets with thelender. The lender’s balance sheet reflects anexchange of one asset for another together with,possibly, a lump-sum payment of cash to thetrust. If a swap is pending, review the criteriathat the holding company used to (1) determinethe benefit of the swap to the company and(2) select which of the REIT’s assets would beconsidered for the swap. Also, determine the

amount of any cash or earning assets that will begiven to the trust.

A holding company and a trust have separateand distinct shareholders but common manage-ment. The potential exposure in such cases maybe pronounced. Such relationships should bereviewed for conflicts of interest. Loans may bebooked by the holding company or its subsidi-ary and subsequently sold to the trust. The creditdecision may have been made by the subsidiary,and the REIT’s purchase of the loans may havebeen approved by the affiliated adviser. Thebenefits to the holding company may includereceiving the origination fee and selling the loanto the trust, thereby increasing the REIT’s assets,upon which the holding company’s advisory feeis based. Following receipt of the sale’s pro-ceeds, the process may be repeated. If the hold-ing company has participated in this type ofprocess, there is potential for a conflict of inter-est. The holding company or its subsidiary mayhave to repurchase the credit.

Theatened or pending litigation may resultfrom loans that were originated by the holdingcompany or its subsidiaries or that were recom-mended by the adviser. The number of suchloans together with the current payment statusof the credit should be determined. If there arenumerous loans on a nonaccrual status, the hold-ing company may have accumulated a signifi-cant loss. Finally, any suit involving the adviserwhich pertains to services it performed shouldbe explored as to its validity and potential finan-cial exposure.


1. To determine the level of risk involved whenthe bank holding company or its subsidiarieshave extensions of credit and unfunded com-mitments outstanding to the advised trust.

2. To review for conflicts of interests in caseswhen a holding company and a trust haveseparate and distinct shareholders but com-mon management.

3. To review all threatened or pending litigationinvolving loans originated by the holdingcompany or its subsidiaries that were recom-mended by the adviser.

4. To review all covered transactions between abank holding company’s subsidiary bank anda REIT, if the REIT is sponsored and advisedon a contractual basis by the bank or anysubsidiary or affiliate of the bank, to ensurethat transactions are permitted pursuant tosections 23A and 23B of the Federal ReserveAct.

Advice on Mergers and Similar Corporate Structurings, Capital Structurings, and Financing Transactions3130.3


5. To determine whether the REIT has beenadvised to sell real estate in the ordinarycourse of business and, if so, whether theappropriate liability account for corporatefederal and state taxes has been establishedby the advised subsidiary.

6. To determine whether the REIT adviser isproviding the appropriate advice to the REITto generate nonspeculative high yields;adequate liquidity; portfolio diversification;sufficient cash flow to pay dividends; con-tinuous repricing; and adequate public dis-closure, including the extent of risk involved.

7. To determine the adequacy and quality ofprofessional management and the level ofmanagement’s equity stake in the REIT.

8. To determine the effect on net earnings fromfloating interest rates on asset yields that mayhave been caused by prepayment risk.


1. Determine if there are any significant exten-sions of credit or unfunded commitmentsoutstanding. If so—a. evaluate the credit using normal classifi-

cation criteria as to collectibility;b. review examination or inspection reports

of the holding company’s subsidiaries anddetermine the consolidated exposure; and

c. review any pending asset swaps in con-junction with the credit evaluations, if theholding company or its banking subsidi-aries are participating in exchanges orswaps with the advised REIT wherebytrust assets are exchanged for forgivenessof bank debt.• Review the lender’s balance sheet to

make certain that it reflects an exchangeof one asset for another, as well as anylump-sum payment of cash to the trust.

• Review the criteria the holding com-pany used to (1) determine the benefitof the swap to the company and (2) selectwhich of the REIT’s assets would beconsidered for the swap.

• Determine the amount of any cash orearning assets that will be given to thetrust.

2. Determine and evaluate any significant con-flicts of interests in cases when a holdingcompany and a trust have separate and dis-tinct shareholders but common management.a. Determine if there are any loans booked

by the holding company or its subsidiaryand subsequently sold to the trust, if thecredit decision was made by the subsidi-

ary, and if the REIT’s purchase of theloans was approved by the affiliated adviser.

b. If significant conflicts of interest exist,determine whether the holding companyor its subsidiary must repurchase anyassociated credit.

3. Review all threatened or pending litigationinvolving loans originated by the holdingcompany or its subsidiaries that were recom-mended by the adviser.a. Determine the number and amount of

such loans together with the current pay-ment status of the credit and whether anyloans are on a nonaccrual status.

b. Evaluate any suit involving the adviserthat pertains to services it performed as tothe suit’s validity and potential financialexposure.

4. Evaluate the effect on net earnings and divi-dends that declining rates (floating-rate assets)have on the prices of floating-rate mortgageassets. Determine the results and the natureof any hedging strategies that are used tooffset a decline in net earnings.

See also the inspection procedures in sections3130.0 and 3130.1.

3130.3.4 FINANCIAL ADVICE ONISSUING SECURITIES OF FOREIGNGOVERNMENTS IN THE UNITEDSTATES

3130.3.4.1 Financial Advice to theCanadian Federal, Provincial, andMunicipal Governments

An example of providing financial and invest-ment advisory activities is a Board order thatwas previously approved (now authorized undersection 225.28(b)(6)(iii) of Regulation Y). Theorder specifically authorized the providing offinancial advice to the Canadian federal andprovincial governments for issuing their securi-ties in the United States. Also, the Board’sRegulation K authorizes the provision of suchinvestment, financial, or economic advisory ser-vices to foreign governmental entities (see sec-tion 211.10(a)(8)). The Board approved the pro-posed activity on February 12, 1988 (1988 FRB249).

Another Board order authorized a foreignbank, subject to the BHC Act, to acquire asecurities firm to engage in this activity, but to

Advice on Mergers and Similar Corporate Structurings, Capital Structurings, and Financing Transactions 3130.3


expand the activity to include the providing ofsuch advice to the Canadian municipal govern-ments in addition to the federal and provincialgovernments. The Board concluded that theslight modification would not alter the activityto render it less closely related to banking. TheBoard approved the order on March 28, 1988(1988 FRB 334). Other approved Board ordersfor this activity are 1988 FRB 500 and 1988FRB 571.

3130.3.4.2 Providing Financial Advice tothe Japanese National and MunicipalGovernments and Their Agencies

Another example of providing advice to foreigngovernments is a bank holding company thatapplied for the Board’s approval to engage,through its wholly owned securities subsidiary,in certain securities-related, foreign-exchange,and investment and financial advisory activities.The activity, which consisted of providing finan-cial advice to the Japanese national and munici-pal governments, had not previously been autho-rized for bank holding companies. When makingits decision, the Board referred to similar ordersas well as to the facts provided. It approvedthese advisory services by order on June 4,1990. (See 1990 FRB 654.)

The Board, effective September 10, 1992,added the providing of financial advice to for-eign governments, such as advice with respectto the issuance of their securities, to the activi-ties permissible by Regulation Y, currently autho-rized by section 225.28(b)(iii).

3130.3.5 PROVIDINGFINANCIAL-FEASIBILITY STUDIESAND VALUATION SERVICES

The following provides an example of a bankholding company that was authorized to providefinancial-feasibility studies and valuation ser-vices, including expert-witness testimony in con-nection with the valuation services. A bankholding company (the applicant) had requestedthe Board’s approval to acquire 100 percent ofthe voting shares of a company (the company)that engaged in investment advisory, investmentmanagement, and financial advisory services.The company engaged in providing (1) finan-cial-feasibility studies for specific projects ofprivate corporations, (2) valuations of compa-

nies and of large blocks of utility stock for avariety of purposes, and (3) expert-witness testi-mony on behalf of utility companies in ratecases.

In providing financial-feasibility studies, allfinancial aspects of the particular project wereevaluated, including economic conditions, salesand earnings statements, balance sheets, andcash-flow data. Each engagement involved ana-lyzing and projecting the income to be gener-ated by a particular project. The Board believedthat this activity was functionally similar to thefinancial advice traditionally offered by banks totheir commercial lending customers. The appli-cant provided evidence revealing that certainmajor banks perform similar financial-feasibilityanalysis services for their customers. The Boardthus approved the provision of such financial-feasibility studies for corporations. Certain com-mitments were made to guard against any pos-sible conflicts of interests and related adverseeffects between the applicant’s credit-extendingsubsidiaries and the company, acting as an adviserregarding the financial-feasibility studies.Included was the condition that the company’sfinancial advisory activities would not encom-pass the performance of routine tasks or opera-tions for a customer on a daily or continuousbasis.

Upon consideration of the above, the Boardalso determined the activity of providing valua-tions of companies, as well as the expert-witnesstestimony incidental to such valuations, to bepermissible. The commercial lending and trustdepartments of banks commonly make valua-tions of a broad range of tangible and intangibleproperty, including the securities of closely heldcompanies. The applicant provided evidencethat numerous banks compete directly with thecompany in offering corporate valuations for afee.

The Board, effective September 10, 1992,added the providing of financial-feasibility stud-ies to the list of nonbanking activities permittedby Regulation Y (see section 225.28(b)(6)(iii)).With the Regulation Y revisions, effective April1997, the Board specifically determined thatfeasibility studies do not include assisting man-agement with the planning or marketing for agiven project or providing general operationalor management advice. The 1992 amendment tothis regulation permitted bank holding compa-nies to conduct feasibility studies for high networth individuals, as well as corporations, andfinancial and nonfinancial institutions. With theApril 1997 amendment, such services could beprovided to any person.

Advice on Mergers and Similar Corporate Structurings, Capital Structurings, and Financing Transactions 3130.3


3130.3.5.1 Valuation Services

The valuation services included the followingactivities:

1. the valuation of a company for purposes ofacquisitions, mergers, and divestitures

2. tender-offer evaluations3. advice for management or for a bankruptcy

court on the viability and capital adequacy offinancially troubled companies and on thefairness of bankruptcy reorganizations

4. valuation opinions on transactions in pub-licly held securities

5. valuationson the fairmarketvalueofemployeestock ownership trusts

6. periodic valuation of stock of privately ownedcompanies held in pension or profit-sharingplans, charitable trusts, or venture-capitalfunds

7. the valuation of a privately owned companyor of a large block of publicly owned securi-ties for estate-tax purposes

8. for estate-tax purposes, valuations of acompany’s common stock and other securi-ties for recapitalization of a privately heldcompany

3130.3.5.2 Utility-Rate Testimony inSupport of Utility-Company Valuations

The company frequently provided expert wit-ness testimony on behalf of utility firms in ratecases. The company’s personnel were retainedto give expert testimony on financial matterssuch as the cost of capital, economic conditions,and the rate of return expected by investors inutility securities. The Board believed that to alarge degree the activity may be consideredincidental to the company’s general provision ofeconomic information and advice which is per-missible under section 225.28(b)(6)(ii) of Regu-lation Y. Also, banks routinely calculate the costof capital for customers to advise them regard-ing financial alternatives.

3130.3.6 EDUCATION-FINANCINGADVISORY SERVICES

Four bank holding companies (collectively, thenotificants)gavenoticepursuant tosection4(c)(8)of the Bank Holding Company Act (BHC Act)(12 U.S.C. 1843(c)(8)) and section 225.23 of theBoard’s Regulation Y (12 C.F.R. 225.23) oftheir intention to each acquire more than 5 per-cent of a company (the company) that would

provide education-financing advisory services.2

The company would enable state governmentsto assist parents in financing the higher educa-tion of their children.

The company will (1) develop and manage aneducational savings and lending program onbehalf of the state, (2) design and provide neces-sary computer software for the program, (3) pro-vide marketing and program materials, and(4) train state personnel to implement the pro-gram. The notificants would eventually providethe services to various state governmentsnationwide.

As part of developing the education savingsand lending program, the company would assistin formulating and defining its overall scope;provide the research necessary to begin opera-tions; design the program’s operations; andorganize the program in cooperation with allinterested parties, including coordinating partici-pation among the state authorities. The com-pany would also coordinate key functions of acollege-funding program, such as marketing,public relations, training, investment, lending,legal documentation, financial recordkeeping,and ongoing program evaluation. In addition,the company would design, install, and maintainthe computer software necessary to implementthe program’s services. The company’s compen-sationwouldbebasedonapplication fees receivedby a state educational assistance authority andthe amount of investment and loan balancesheld by the program.

All of the intended services are integrallyrelated to advising and administering student-loan and college-savings programs. Banks offer-ing their own student-loan and college-savingsprograms engage in many of the planned activi-ties and are uniquely suited to advise and assistother potential providers, including state gov-ernments, in structuring and implementingstudent-loan and college-savings programs.3 TheBoard previously concluded that bank holdingcompanies may provide similar advisory andsupport services to state authorities that areengaged in making student loans.4 Accordingly,

2. The notificants would have varying ownership interestsin excess of 5 percent. Other individual ownership interests ofless than 5 percent would be held by various banks andsavings institutions located in one state. Each notificant com-mitted that the company would be treated as a subsidiarywithin the meaning of the BHC Act (12 U.S.C. 1841(d)).

3. See 12 C.F.R. 225.28(b)(1) and (6).4. See 1985 FRB 725.



based on all the facts of record, the Boardconcluded that the proposed activities are closelyrelated to banking under section 4(c)(8) of theBHC Act. The Board approved the notice on

September 25, 1995 (1995 FRB 1042). Approvalof this proposal is specifically conditioned onthe notificants’ compliance with the commit-ments made in connection with this notice.





Providing financial-feasibility stud-ies, valuation services, utility-ratetestimony, but not ‘‘public’’ creditratings

225.28(b)(6)(iii) 1985 FRB 118,120

Financial-feasibility studies forissues of tax-exempt revenue bondsand private corporations

1987 FRB 59

Advice in connection with merger,acquisition/ divestiture, and financ-ing transactions and advice regard-ing loan syndications, interest-rateswaps, and interest-rate-captransactions

225.28(b)(6)(iii) 1987 FRB 59

Providing financial advice to theCanadian federal, municipal, andprovincial governments, such aswith respect to the issuance of theirsecurities in the United States

225.28(b)(6)(iii) 1988 FRB 2491988 FRB 334

Financial advice to the Japan-ese national and municipalgovernments

225.28(b)(6)(iii) 1990 FRB 654

Financial advice to state and localgovernments

225.28(b)(6)(iii) 1973 FRB 701

Financial advice vs. managementconsulting

1972 FRB 674,676

Investment advice pertaining toincome-producing real property

1983 FRB 564

Investment advisory activities andjoint ventures with securities firms

225.28(b)(6)(iii) 1994 FRB 638

Education-Financing AdvisoryServices

1995 FRB 1042

Regulation Y revision 62FederalRegister9290 to 9307(February 28,1997)

1997 FRB 275





4(c)(8)—Informational, Statistical Forecasting, Advisory Services for Transactions inForeign Exchange and Swaps, Commodities, and Derivative Instruments Section 3130.4

3130.4.1 INFORMATIONAL,STATISTICAL FORECASTING, ANDADVICE ON SUCH TRANSACTIONSAS FOREIGN EXCHANGE, SWAPS,COMMODITIES, AND DERIVATIVES

Providing financial and investment advisoryactivities may consist of a bank holding compa-ny’s providing information, statistical forecast-ing, and advice with respect to any transactionin foreign exchange, swaps, caps, and similartransactions, commodities, and any forward con-tract, option, future, option on a future, andsimilar instruments.1 The Board has found finan-cial advice regarding interest-rate swap and captransactions to be permissible. The Board hasalso found that providing advice in connectionwith currency swaps is permissible,2 as well asproviding advice regarding loan syndications.3

This section provides an example of a February16, 1983, Board order permitting a bank holdingcompany to establish a de novo subsidiary tooffer certain informational, advisory, and trans-actional services including the provision of thefollowing:

1. General economic information and statisticalforecasting with respect to foreign exchangeand money markets through time-sharingnetworks. The services included the analysisof foreign-exchange and money market trendsin the context of economic and politicaldevelopments and the provision of informa-tion with respect to foreign exchange.

2. Advisory services designed to assist custom-ers in monitoring, evaluating, and managingtheir foreign-exchange exposure, includingmaking recommendations regarding policiesand procedures to enhance a customer’s abil-ity to identify, measure, and manage finan-cial risks in a multicurrency environment.The newly formed subsidiary would also pro-vide advice on the timing of purchases andsales of foreign exchange in both spot andforward markets.

3. Transactional services with respect to foreign-exchange exposures. The subsidiary wouldarrangeforeign-exchangetransactionsbyanaf-filiated bank holding company and othercommercial banks.

As a condition for approval, the applicants wererequired to seek the Board’s authorization ifthey engaged in any additional activities withinthe United States. (See 1983 FRB 221.)

Effective February 6, 1984, the Board amendedRegulation Y to allow bank holding companiesto offer foreign-exchange advisory and transac-tional services that include providing generalinformationandstatistical forecastingwith respectto foreign-exchange markets. The activityincluded arranging for ‘‘swaps’’ among custom-ers with complementary foreign-exchange expo-sures and the execution of foreign-exchangetransactions, provided the activity would be con-ducted through a separately incorporated subsid-iary of the bank holding company that willobserve the standards of care and conduct appli-cable to fiduciaries with respect to its foreign-exchange advisory and transactional services.

3130.4.1.1 Inspection Objectives

1. To determine the financial effect of the activ-ity on the parent BHC and its bank subsidi-ary (or subsidiaries).

2. To determine that the specific activities pro-vided by the company are permissible.

3. To determine that the company is not expos-ing itself to conflicts of interest between itsown role of recommending foreign-exchangepositions to its customers and any role itsaffiliates may have in executing foreign-exchange transactions.

3130.4.1.2 Inspection Procedures

1. Review the company’s financial statementsfor accuracy, and determine if there are anyfactors or trends that could have an adverseimpact on the parent holding company or thebank subsidiary (or subsidiaries).

2. Review the company’s policies and proce-dures to determine that the following arepresent:a. adequate minutes of the board and board

committee meetingsb. adequate blanket bond coverage


1. See 62 Federal Register 9,290 (February 28, 1997) (12C.F.R. 225.28 (b)(6)) or 1997 FRB 275.

2. See 1989 FRB 308.3. See 1987 FRB 220.


4. Review the company’s fee schedule for pro-viding advice and the fees charged by affili-ated banks to conduct foreign-exchange trans-actions for the company’s customers.Determinewhetherbanksubsidiariesarebeingadequately compensated for executing trades,or whether these profits are accruing largelyto the benefit of the bank holding companyor its nonbank subsidiaries.

5. Review the company’s revenue sources todetermine that it has not taken foreign-exchange positions and does not executeforeign-exchange transactions.

3130.4.2 FINANCIAL ADVICE AS TOTHE STRUCTURING OF ANDARRANGING FOR LOANSYNDICATIONS, INTEREST-RATESWAPS, CAPS, AND SIMILARTRANSACTIONS

A bank holding company may provide informa-tion, statistical forecasting, and advice withrespect to any transaction in swaps, caps, andsimilar transactions; commodities; and any for-ward contract, option, future, option on a future,and similar instruments.4 The Board has foundfinancial advice regarding interest-rate swap andcap transactions to be permissible.5 The Boardhas also found the provision of advice regardingloan syndications to be permissible.6

An example of a Board order regarding pro-viding financial advice is one in which a bankholding company (BHC) applied for the Board’sapproval to establish its company de novo as afinancial advisory firm. The Board had not pre-viously approved the structuring of and arrang-ing for loan syndications (see section225.25(b)(6)(ii) of Regulation Y) or arrangingfor interest-rate ‘‘swaps’’ and interest-rate caps,and similar transactions (see section 225.28(b)(6)(iv) of Regulation Y). Interest-rate capsare contractual agreements wherein the seller ofa cap agrees to make payment to the purchaserof a cap if a particular interest-rate index (prime)exceeds a predetermined level, with payments

calculated on an assumed principal amount for adeferred time period. The caps and swaps aretypically used to manage or hedge outstandingpositions in the financial markets.

The Board’s authorization included the fol-lowing conditions:

1. The advice rendered by the company on anexplicit fee basis will be rendered withoutregard to correspondent balances maintainedby the customers of the company at anydepository institution subsidiary of the BHC.

2. Company’s financial advisory activities shallnot encompass the performance of routinetasks or operations for a customer on a dailyor continuous basis. The Board, on Novem-ber 28, 1986, approved the activity by order(1987 FRB 59). (See 1990 FRB 756.) TheBoard subsequently, effective September 10,1992, added this nonbanking activity to thelist of activities permitted by Regulation Y.(See section 225.28(b)(6)(iii) for loan syndi-cations and 225.28(b)(6)(iv) for interest-rateswaps and caps.)

Reference can also be made to another Boardorder (1991 FRB 184) relating to providingadvice on joint ventures, leveraged buyouts,restructurings, recapitalizations, and other cor-porate transactions (see 225.28 (b)(6)(iii) ofRegulation Y), as well as to providing adviceregarding the structuring and arranging of swaps,caps, and similar transactions relating to interestrates, currency and exchange rates and prices,and economic and financial indexes (see225.28(b)(6)(iv) of Regulation Y).

3130.4.3 ADVICE RELATING TO THESTRUCTURING OF ANDARRANGING FOR CURRENCYSWAPS

A foreign bank subject to the BHC Act appliedfor the Board’s approval to acquire a companyengaged in certain securities, foreign-exchange,and financial advisory activities. The Board pre-viously determined the activities proposed bythe BHC, except for providing advice relating tothe structuring of and arranging for currencyswaps, to be closely related to banking. As foradvice on currency swaps, it was noted thatmostbanks thatprovideadvice relating to interest-rate swaps also provide advice relating to cur-rency swaps. Providing advice as to currencyswaps was deemed to be functionally and opera-tionally similar to providing advice relating tothe structuring of and arranging for interest-

4. See 62 Federal Register 9,290 (February 28, 1997) (12C.F.R. 225.28 (b)(6)) or 1997 FRB 275.

5. See 1989 FRB 308.6. See 1987 FRB 220.

4(c)(8)—Informational, Statistical Forecasting, and Advisory Services 3130.4


rate swaps. Both transactions have the commonobjectives of securing low-cost funds and con-verting one type of risk to another, and bothtransactions require similar documentation. TheBoard approved the activity by order on Febru-ary 13, 1989 (1989 FRB 308). The Board, effec-tive September 10, 1992, added providing adviceas to currency swaps to the nonbanking activi-ties permitted by regulation. See section225.28(b)(iv) of Regulation Y.

3130.4.4 ADVICE WITH RESPECT TOFUTURES CONTRACTS

3130.4.4.1 Limited Advisory Serviceswith Respect to Futures Contracts onStock Indexes and Options on SuchFutures Contracts

The following is an example of a bank holdingcompany that applied to the Board to engage denovo, through a wholly owned subsidiary, in theprovision of advisory services with respect tofutures contracts on stock indexes and optionsthereon. The advisory services to be providedconsisted of general research and advice onmarket conditions and hedging strategies, client-account information and reconciliation of trades,and communication linkage between clients andexchange floors in connection with the subsid-iary’s futures commission merchant activities.The services offered to customers were pro-vided either as part of an integrated package ofservices or for a separate fee.

The futures advisory services were essentiallyidentical to the advisory services previouslyapproved by the Board by regulation and orderwith respect to other financially related futurescontracts. The Board concluded the applicant’sprovision of advisory services for futures con-tracts on stock indexes and for options thereonto be permissible (1987 FRB 220 and section225.28(b)(6)(iv) of Regulation Y).

Previously, the Board had approved theexecution and clearance of futures contracts onstock indexes and options thereon (1985 FRB251). At that time, however, the Board had notapproved a proposal to provide investment advi-sory services in connection with the executionand clearance of such instruments.

3130.4.4.2 Advice on Certain Futures andOptions on Futures

This section is a historical example of a bankholding company that requested the Board’s

approval to provide de novo investment adviceconcerning futures and options on futures con-tracts on foreign exchange, government securi-ties, and bullion and money market instruments.In addition, the company would provide port-folio investment advice, for which applicant hadpreviously received authorization pursuant toRegulation Y (the authorization is currentlyincluded in section 225.28(b)(6)(iv)).

Previously, the Board had approved theprovision of investment advice as a futures com-mission merchant (FCM) (section 225.28(b)(7)(iv)(A)) or as a commodity trading adviser (CTA)registered with the Commodity Futures TradingCommission (CFTC). The provision by an FCMor CTA of such advice could include providingcounsel, publications, written analyses, andreports relating to the purchase and sale offutures contracts and options on futures con-tracts that bank holding company futures com-mission merchant subsidiaries are permitted toexecute and clear. Such advisory services couldalso consist of providing written or oral presen-tations on the historical relationship between thecash and futures markets or the functions offutures as hedging devices, demonstratingexamples of financial futures uses for hedging,and assisting in structuring a hedging strategyfor a cash position. FCMs and CTAs are subjectto registration with and regulation by the Com-modity Futures Trading Commission pursuantto the Commodity Exchange Act, as amended.(7 U.S.C. 1).

Before incorporation of the advisory activityinto Regulation Y (see 1986 FRB 369), theBoard had determined by order that the provi-sion of futures and options advice by FCMs ispermissible and closely related to banking (see1985 FRB 168 and 111, 1984 FRB 780, and1984 FRB 369). A CTA could provide suchadvice even though it is not acting as an FCM.

The issue presented by this latter proposalwas whether the conduct of this activity bycompany would be a proper incident to bankingif company, serving as an adviser, did not meetthe former Regulation Y requirement of regis-tering with the CFTC as a CTA or FCM. Theapplicant expected to qualify for a statutoryexemption (7 U.S.C.6m) from the registrationunder section 4m of the Commodity ExchangeAct. This exemption provides that any personwho, during the previous 12 months, has notfurnished commodity advisory services to morethan 15 persons and has not represented himselfor herself to the public as a CTA is exempt from



the registration requirements for CTAs underthe act. The applicant’s proposal permitted com-pany to provide commodity trading advice with-out those safeguards. The Board held that itexpects the adviser to disclose to its customerssubstantially the same information required forregistered CTAs, including the CTA’s perfor-mance record, conflicts of interest, possible trad-ing risks, and civil and criminal actions againstthe CTA.

The Board concluded that the possible adverseeffects would be further minimized by the fol-lowing conditions:

1. Company will remain subject to the antifraudprovisions of the Commodity Exchange Actas well as other restrictions in the act.

2. The adviser will not trade for its own account(except to hedge), will limit its advice toinstruments that banks deal in extensively(foreign exchange, bullion, government secu-rities, and money market instruments), andwill only serve customers that are financiallysophisticated and have significant dealings orholdings in the underlying commodities orinstruments. The Board approved the appli-cation by order on October 18, 1988 (1988FRB 820).

3130.4.5 PROVIDINGDISCRETIONARY PORTFOLIOMANAGEMENT SERVICES ONFUTURES AND OPTIONS ONFUTURES ON NONFINANCIALCOMMODITIES

With respect to the Regulation Y provisionseffective April 21, 1997, discretionary portfoliomanagement advice is not separately listed insection 225.28(b)(6)(iv). Discretionary invest-ment advice is discussed, however, within thepreamble to the final rule. The preamble empha-sizes that such advice may be provided to anyperson (such advice is no longer limited toinstitutional investors) regarding contracts relat-ing to financial and nonfinancial assets.

Foreign banking organizations (applicants)subject to the BHC Act provided notice toengage through their subsidiary (company) inproviding investment advisory services withrespect to futures and options on futures onfinancial and nonfinancial commodities, includ-ing discretionary portfolio management ser-

vices.7 The Board previously determined thatthe proposed activities, with the exception ofproviding discretionary portfolio managementservices with respect to futures and options onfutures on nonfinancial commodities, are closelyrelated to banking.

The Board had permitted bank holding com-panies to provide investment advice with respectto futures and options on futures on both finan-cial and nonfinancial commodities. (See section225.28(b)(6)(iv) of Regulation Y.) The Boardalso previously approved providing discretion-ary portfolio management services with respectto futures and options on futures on financialcommodities. (See 1995 FRB 386.) In addition,the Office of the Comptroller of the Currencypermits national banks to engage in discretion-ary funds management with respect to futuresand options on futures on nonfinancial com-modities. (See OCC Interpretive Letter No. 494(December 20, 1989).)

In this regard, applicants committed that com-pany would provide the proposed discretionaryportfolio management services only at the requestof the customer. Applicants also committed thatcompany would comply with applicable law,including fiduciary principles. In addition,applicants proposed that company exercise itsdiscretionary portfolio management authorityonly in purchasing and selling exchange-tradedfutures and options on futures contracts previ-ously approved by the Board. The Board gaveits approval on June 30, 1995 (1995 FRB 803).

3130.4.6 COMBINATION OFPROVIDING ADVICE WITH OTHERNONBANKING ACTIVITIES

3130.4.6.1 Providing NonfinancialFutures Advice and the Combining ofForeign-Exchange, Government SecuritiesAdvisory, and Execution Services

A BHC applicant requested the Board’s permis-sion to engage in trading options on foreignexchange and offering investment advice onfinancial and nonfinancial options and futurescontracts, securities, and interest-rate and cur-rency swaps. The applicant applied to providethese advisory services through a partnership, ofwhich it would own 80 percent of its equity.

7. Company does not trade futures or options on futures forits own account or provide futures commission merchantexecution or clearance services.



This partnership would provide these advisoryservices only to the applicant, its affiliates, andthe applicant’s partner, a commodity tradingorganization. The partnership would provideexecution services only to the applicant and itsaffiliates, not to the applicant’s partner.

The Board had not previously approved theprovision of nonfinancial futures advice for bankholding companies. The Board noted that theOffice of the Comptroller of the Currency (OCC),by OCC Interpretive Letter 494 (December 20,1989), determined that a national bank couldprovide execution, clearing, and advisory ser-vices for customer transactions in standardized,exchange-traded ‘‘nonfinancial’’ futures con-tracts and options, such as futures on oil andagricultural products. The OCC determined thatthe contracts are financial products and that theprovision of investment advice was essentiallythe same as the advice given with respect tofinancial futures contracts. The OCC contendsthat investment advice is incidental to the bank’sauthority to purchase and sell the instruments onbehalf of its customers.

The Board has permitted bank holding com-panies to provide advice with respect to futuresand options on futures relating to bank-eligiblesecurities, bullion, and foreign exchange (12C.F.R. 225.28(b)(6)(iv)). The Board also haspermitted bank holding companies to provideinvestment advice with respect to options andfutures contracts based on broad-based indexesof stock and bonds (1990 FRB 770). The Boardthus determined that the provision of investmentadvice with respect to investing in options andfutures, based on nonfinancial instruments, to bethe functional equivalent of providing advice onoptions and futures based on financial instru-ments. In each case, the bank holding companysubsidiary is furnishing advice with respect totrading of a financial instrument. The partner-

ship would not provide advice to third partieswithout Federal Reserve approval. The Boardthus approved the providing of investment adviceon nonfinancial futures, options, and options onfutures.

The applicant also proposed that the partner-ship provide execution services to the appli-cant’s wholly owned subsidiary and to the appli-cant’s U.S. branches with respect to—

1. over-the-counter options on foreign exchange,U.S. government securities, and other moneymarket instruments, and indexes on suchsecurities and instruments;

2. exchange-traded transactions in futures,options, and options on futures on foreignexchange, U.S. government securities, andother money market instruments, and indexeson such securities and instruments; and

3. spot and forward transactions in foreignexchange.

The Board previously approved the combina-tion of advice and execution for—

1. foreign-exchange transactions (1990 FRB649),

2. transactions on derivative instruments basedonU.S.governmentsecuritiesandothermoneymarket instruments (1990 FRB 664), and

3. securities brokerage (1989 FRB 396).

The Board approved by order the providing ofthe combination of foreign-exchange and gov-ernment securities advisory and execution ser-vices on December 21, 1990 (1991 FRB 126).

For these reasons, the Board approved theproviding of discretionary portfolio manage-ment services with respect to futures and optionson futures on nonfinancial commodities on June30, 1995. (See 1995 FRB 803).





Provide information and advice onforeign operations and arrangeforeign-exchange transactions

1983 FRB 221

Foreign-exchange and advisory andtransactional services added toRegulation Y

225.28(b)(6)(iv)

Financial advice as to the structur-ing of, and arranging for loan syn-dications, interest-rate swap, caps,and similar transactions

225.28(b)(6)(iii)and (iv)

1987 FRB 591990 FRB 756

Advisory services with respect tofutures contracts on stock indexesand options on such futurescontracts

225.28(b)(6)(iv) 1987 FRB 220

Providing discretionary portfoliomanagement services on futuresand options on futures on nonfi-nancial commodities

225.28(b)(6)(iv) 1995 FRB 803

Providing nonfinancial futuresadvice and the combining offoreign-exchange, governmentsecurities advisory, and executionservices

225.28(b)(6)(iv) 1995 FRB 803

Advice in connection with cur-rency swaps

225.28(b)(6)(iv) 1989 FRB 309


3. Federal Reserve Regulatory Servicereference.



4(c)(8)—Providing Educational Courses and Instructional Materialsfor Consumers on Individual Financial Management Section 3130.5

The financial and investment advisory nonbank-ing activity of consumer financial counselingmay consist of providing advice, educationalcourses, and instructional materials to individu-als on consumer-oriented financial-managementmatters, including debt consolidation, applyingfor a mortgage, bankruptcy, budget manage-ment, real estate tax shelters, tax planning,retirement and estate planning, insurance, andgeneral investment management. The authorityfor this advisory activity is currently derivedfrom section 225.28(b)(6)(v) of Regulation Y.

This nonbanking activity was added to theRegulation Y ‘‘laundry list’’ in 1986. Previ-ously, the Board authorized the provision ofconsumer financial counseling services by order.(See 1979 FRB 65, 1979 FRB 265, 1985 FRB253, and 1985 FRB 662. These references areonly historical examples.) A bank holding com-pany may provide information, statistical fore-casting, and advice with respect to any transac-tion in foreign exchange, swaps, caps, and similartransactions, commodities, and any forward con-tract, option, future, option on a future, andsimilar instruments.1 The Board has found finan-cial advice regarding interest-rate swap and captransactions to be permissible. The Board hasalso found that providing advice in connection

with currency swaps is permissible,2 as well asproviding advice regarding loan syndications.3

The revised Regulation Y, effective April 1997,deleted restrictions on consumer-counseling ser-vices that prohibited bank holding companiesfrom promoting specific products and services,and from obtaining or disclosing confidentialcustomer information without the customer’sconsent. These restrictions do not apply to banksthat engage in the above activities.

Prudent management should take into consid-eration certain actions to prevent potential con-flicts fromarising.Whenconsidering theseorders,the Board was concerned that the provision ofconsumer financial counseling activities couldpotentially result in unfair competition, conflictsof interest, and other adverse effects. (See 1979FRB 267.) Examiners should be alert to prob-lems that may arise from such conflicts as theyreview this nonbanking activity. Further, theexaminer should determine whether counselors,as a general practice, are advising each cus-tomer that they are not required to purchase anyservices from affiliates, and determine whethercustomers have the option to exclude them-selves from service and product offerings pro-vided by affiliates.



Providing financial-managementcourses, counseling, and relatedinstructional materials

1979 FRB 265

Engaging, through an acquiredbank, in consumer financialcounseling

1985 FRB 253

Providing consumer financial coun-seling services as a permissiblenonbanking activity

225.28(b)(6)(v) 1986 FRB 8331985 FRB 662



1. See 62Federal Register9,290 (February 28, 1997) (12C.F.R. 225.28 (b)(6)) or 1997 FRB 275.

2. See 1989 FRB 308.3. See 1987 FRB 220.


4(c)(8)—Tax-Planning and Tax-Preparation ServicesSection 3130.6

Financial and investment advisory servicesinclude tax-planning and tax-preparation ser-vices. Tax planning involves providing adviceand strategies designed to minimize tax liabili-ties. For individuals, this includes analysis ofthe tax implications of retirement plans, estateplanning, and family trusts; for corporations, itincludes analysis of the tax implications ofmergers and acquisitions, the portfolio mix, spe-cific investments, previous tax payments, andyear-end tax planning. Tax preparation involvesthe preparation of tax forms and advice concern-ing liability based on records and receipts sup-plied by the client. This nonbanking activitywas included in the Regulation Y ‘‘laundry list’’in 1986. (See section 225.28(b)(6)(vi).) Suchservices may be provided to any person. Effec-tive April 21, 1997, certain restrictions wereremoved. These Regulation Y revisions deletedrestrictions in the area of tax-planning and tax-preparation services that prohibited bank hold-ing companies from promoting specific productsor services and from obtaining or disclosingconfidential customer information without thecustomer’s consent. These restrictions do notapply to banks. This fact needs to be consideredwhen referring to the historical examples thatfollow.

The Board had previously approved, by order(1985 FRB 168), the activity of tax-preparationservices for individuals. Since tax-preparationservices for corporations is functionally oroperationally similar to the tax-preparation ser-vices that banks already provide to individualsas well as to their affiliates and other financialinstitutions, the Board approved the providingof corporate tax-preparation services. When thenonbanking activity was incorporated into Regu-lation Y in 1986, tax-planning and tax-preparation services were authorized, not onlyfor individuals and corporations, but for noncor-porate businesses, such as partnerships and soleproprietorships and tax-exempt nonprofit orga-nizations. Tax-planning and tax-preparation ser-vices must be conducted in accordance withapplicable jurisdictional law.


1. To ascertain whether the customer has theoption to be excluded from promotions ofother specific products and services.

2. To determine what financial effect the activ-ity has on the parent company and itssubsidiaries.

3. To determine whether the company has for-mal written policies and procedures to ensureaccurate, timely, and confidential preparationand maintenance of customers’ tax returns.

4. To determine whether the tax-return prepar-ers are appropriately qualified to providesuch tax services, and to determine the extentof management’s involvement in the activity.

6. To identify the potential and extent of off-balance-sheet risk associated with the activity.


1. Review the company’s financial statementsfor accuracy, and determine if there are anyfactors or trends that could have an adverseimpact on the parent company or the banksubsidiaries.

2. Determine whether bonding and other insur-ance coverage is adequate in relation to therisks associated with the activity.

3. Review pertinent contracts, client lists, pub-lic advertising and information, correspon-dence, and other documentation representingtheservicesprovided,anddetermine if chargesfor the tax-preparation service are on anexplicit fee basis that is not dependent on theamount of tax savings achieved.

4. Determine if the client has a written legalopinion on file certifying that the activity isnot considered the practice of law.

5. Review pertinent correspondence and theminutes of board of directors and board com-mittee meetings, and determine if any signifi-cant law suits, Internal Revenue Serviceadverse actions, or other potential or contin-gency lossesarependingandprobablebecauseof inaccurate tax-return preparation. Analyzetheir probable effect in relation to the finan-cial condition of the company.

6. Review the company’s formal written poli-cies and procedures for assurance of profes-sional competence in providing sound tax-planning advice and the accurate, timely, andconfidential preparation and maintenance ofcustomer’s tax returns. The policies and pro-cedures should require that tax-planningadvice be clearly communicated by personswho are adequately supervised and who pos-sess the necessary professional technical train-ing and experience needed to provide tax-planning advice.




Preparation of tax returns in a non-fiduciary capacity is closely relatedto banking

1985 FRB 168

Permissible nonbanking activity 225.28(b)(6)(vi) 1986 FRB 833



4(c)(8)—Tax-Planning and Tax-Preparation Services 3130.6


Section 4(c)(8) of the BHC Act(Leasing Personal or Real Property) Section 3140.0


This section has been revised (subsection3140.0.2.2) to include a brief summary of a June10, 2016, Board order (FRB Order no. 2016-07)that approved a notice by a foreign bank holdingcompany and its foreign wholly owned subsidi-ary bank to engage in permissible nonbankingactivities under section 4(c)(8) of the BHC Actand section 225.24 of the Board’s Regulation Y.The nonbanking activities include railcar leas-ing and the provision of certain railcar fleetmanagement services pursuant to section225.28(b)(3) of Regulation Y (leasing personalproperty and acting as an agent, broker, or advi-sor in leasing personal property) and section225.21(a)(2) (engaging in incidental activitiesthat are necessary to carrying on permissiblenonbanking activities). The table of Laws, Regu-lations, Interpretations, and Orders has beenamended to include the order in subsection3140.0.7.

3140.0.1 LEASING AUTHORIZATIONSWITHIN REGULATION Y

Leasing is a form of financing that provides alessee (the customer) the right to use land ordepreciable assets without tying up workingcapital. As a result of the tax benefits that canarise from the ownership of equipment, realproperty, or tangible personal property, leasingprovides the lessor (the owner of the property)with a generally higher rate of return than whatcould be achieved through lending. In 1971,‘‘leasing personal property or acting as agent,broker, or adviser in leasing such property’’ wasadded to the Regulation Y list of permissiblenonbanking activities for bank holding compa-nies. In 1974, the authority to engage in thisactivity was expanded to include the leasing ofreal property.

In 1997, restrictions on leasing activities wereremoved to permit greater flexibility to acquireleaseable property in quantity and to sell orre-lease property upon the lease’s expiration.The removed restrictions consisted of the maxi-mum lease term, maximum holding period forleased property, limit on acquisitions of prop-erty to specific leasing transactions, restrictionon leases to those that served as the functionalequivalent of extensions of credit, and 100 per-cent limit on the amount of reliance that couldbe placed on the value of leased property. The

added clarifications consisted of more details onthe requirements for a nonoperating lease, par-ticularly those for automobile rentals.

3140.0.2 PERMISSIBLE LEASINGACTIVITIES

Two types of leasing activities are permissiblefor bank holding companies: full-payout leasingand high-residual-value leasing. A full-payoutlease is the functional equivalent of an exten-sion of credit that relies primarily on rentalpayments and tax benefits to recover the cost ofthe leased property and related financing costs.High-residual-value leasing may involve sig-nificant reliance on the expected residual valueof the leased property—on average, under 50 per-cent. However, this value can extend up to thefull original cost of the property (that is, torecover the full acquisition cost of the leasedproperty plus related financing costs).

When leasing personal or real property, oracting as agent, broker, or adviser, only thoseleasing transactions meeting the following crite-ria are considered permissible:

1. The lease must be on a nonoperating basis.2. The initial lease term must be at least 90 days.3. For leasing involving real property—

a. at the inception of the initial lease, theeffect of the transaction must yield a returnthat will compensate the bank holdingcompany, as lessor, for its full investmentin the property plus the estimated totalcost of financing the property over theterm of the lease (this includes rental pay-ments, estimated tax benefits, and the esti-mated residual value of the property at theexpiration of the initial lease); and

b. the estimated residual value (yield) of theproperty at the expiration of the initialterm of the lease may not exceed 25 per-cent of the acquisition cost of the propertyto the bank holding company (lessor).

With respect to leasing personal or real propertyon a nonoperating basis, the bank holding com-pany or its subsidiary may not engage in operat-ing, servicing, maintaining, or repairing leasedproperty during the lease term. A bank holdingcompany, however, can arrange for a third party


to provide the services or products. (See Regula-tion Y, section 225.28(b)(3).)

As for automobiles, a bank holding companymay not (1) provide servicing, repair, or mainte-nance of the leased vehicle during the leaseterm; (2) purchase parts and accessories eitherin bulk or for an individual vehicle after itsdelivery to the lessee; (3) provide the loan of anautomobile during the vehicle’s servicing; (4) pur-chase insurance for the lessee; or (5) provide forthe renewal of the vehicle’s license (registra-tion) without authorization from the lessor.

3140.0.2.1 Automobile Fleet Leasing andFleet-Management Services

A foreign banking organization (FBO) that istreated as a bank holding company requested anopinion from the Board’s staff regarding leasingactivities that the Board has determined to bepermissible under section 225.28(b)(3) of Regu-lation Y. (See 12 C.F.R. 225.28(b)(3).) In con-nection with its automobile-leasing activities,the FBO provides, through a wholly ownedautomobile fleet leasing subsidiary (AFLS), fleet-management services to its automobile fleetleasing customers. In connection with makingautomobile and equipment leases that conformwith the requirements of Regulation Y, AFLSengages in the business of commercial lendingand financial leasing of motor vehicle fleets andequipment located throughout the United States,and providing fleet-management services to com-panies that lease corporate automobile fleets.AFLS and other participants in the businessmarket and deliver the three services as a bundledservice to clients.1

To better provide fleet-management servicesto its automobile-leasing customers (in connec-tion with leases that conform with RegulationY), AFLS acquired another fleet-management-services subsidiary company (FMSS) that(1) arranges for third parties to provide vehiclemaintenance, accident-management services, andsafety-management services and (2) directlyprovides client-support services in connectionwith the services arranged by AFLS. FMSS, inaddition to permissible leasing activities, con-ducts some fleet-management services for auto-

mobiles that are owned by the client and that arenot, therefore, subject to a lease.

As represented, approximately 90 percent ofthe vehicles serviced by FMSS are leased and10 percent are client-owned. Revenues earnedfrom fleet-management services that are pro-vided for client-owned vehicles are less than2 percent of the AFLS’s total revenues. TheFBO asked whether it would be permissible forit to provide fleet-management services withregard to automobile fleets if the customer ownsrather than leases the vehicles.

In an opinion issued on December 19, 2003,Board staff noted that Regulation Y, as a generalmatter, permits a bank holding company toengage in any incidental activities that are nec-essary to carry on an activity permitted by theregulation.2 Board staff stated also that, in lightof the nature of the practices in the fleet-management industry and the difficulty in con-tinually monitoring the migration between leasedand owned vehicles in the same fleet, someability to perform fleet servicing for ownedvehicles is necessary to retain customers in con-nection with AFLS’s fleet-leasing activities.Board staff determined, in view of all the factsof record, including this necessity, the minimalamount of revenue earned from servicing ownedvehicles,3 and the fact that the activity is primar-ily an agency activity, that the FBO could pro-vide fleet-management services to owned vehi-cles as an activity incidental to the FBO’sauthorized leasing activities. In a December 19,2003, opinion, Board staff stated that the provi-sion of fleet-management services on ownedvehicles is subject to the same restrictions setforth in Regulation Y for leased vehicles.4

3140.0.2.2 Railcar Leasing and RailcarFleet Management Services

On June 10, 2016, the Board approved a notice(FRB Order no. 2016-07) by a foreign bankholding company and its foreign wholly ownedsubsidiary bank to engage in nonbanking activi-ties under section 4(c)(8) of the BHC Act andsection 225.24 of the Board’s Regulation Y.Fifty percent of the voting shares of a rail trans-

1. The Board previously found providing fleet-management services to be permissible if the fleet involvesvehicles that are under a lease that conforms to Regulation Y.(See 12 C.F.R. 225.28(b)(3).) Permissible leases are consid-ered to be the financial equivalent of a loan.

2. See 12 C.F.R. 225.21(a)(2). Staff also noted that thecourts have recognized the authority of bank holding compa-nies to engage in incidental activities that are reasonablynecessary to the conduct of closely related activities.

3. AFLS has stated that it will limit its fleet-managementservices involving vehicles not subject to a Regulation Ypermissible lease to no more than 15 percent of the fleet-management revenues and to 5 percent of the total leasingrevenues of AFLS.

4. See 12 C.F.R. 225.28(b)(3).

Section 4(c)(8) of the BHC Act (Leasing Personal or Real Property) 3140.0


port company (Delaware Corporation) would beacquired, thereby acquiring its wholly ownedIllinois corporate subsidiary that engages in rail-car leasingand relatedactivities inNorthAmerica.As a result of the acquisition, the wholly ownedsubsidiary bank would engage in certain non-banking activities. The nonbanking activitiesinclude railcar leasing and the provision of cer-tain railcar fleet management services pursuantto section 225.28(b)(3) of Regulation Y (leasingpersonal property and acting as an agent, broker,or advisor in leasing personal property) andsection 225.21(a)(2) (engaging in incidental ac-tivities that are necessary to carrying on permis-sible nonbanking activities).

3140.0.3 ACCOUNTING FOR LEASES

Leasing has become a prominent financing vehi-cle. Lessors have employed a number of differ-ent methods in structuring and accounting forleases. Standards for lease accounting are setforth inAccountingStandardsCodification (ASC)Topic 840, “Leases” (formerly FASB StatementNo. 13, “Accounting for Leases,” as amendedand interpreted).

Accounting for leases must be viewed fromthe perspective of the parties involved in theleasing transaction, the lessee and the lessor.Negotiations and closing costs incurred withrespect to the lease should be written off overthe life of the lease. In applying ASC Topic 840,certain terminology is used. Basic terms thatshould be considered are described below.

Inception of a lease. The inception of a leaserefers to the date the lease contract was signedor to the date that the construction was com-pleted, or, if earlier, to the date of the writtencommitment stating the significant terms.

Term of the lease. The lease term consists of

the noncancelable term and the period compris-ing the bargain renewal option.

Fair value of lease property. The fair value ofa lease consists of the price that the propertycould be sold in an arm’s-length transaction.

Economic life of the leased property. Theeconomic life of the leased property representsthe period over which the property is expectedto be economically beneficial to one or moreusers for its intended purpose.

Estimated residual value of the leased prop-erty (ERV). The residual value is the estimatedfair value of the leased property at the expira-tion of the lease term.

Interest rate implicit in the lease. The implicitinterest rate is the discount rate that causesthe sum of the minimum lease payments and theunguaranteed residual value at the end of thelease term to be equal to the fair value of theproperty at the beginning of the lease term.

Lessee’s incremental borrowing rate. Theincremental borrowing rate is the interest rate atwhich the lessee could borrow the funds topurchase the leased property.

3140.0.3.1 Accounting for Leases by aLessee

The two methods for accounting for leasingtransactions by a lessee are the operating methodand the capitalized-lease method.

3140.0.3.1.1 Operating Method ofAccounting for Leases

The operating accounting method merely re-cords the cost of the rental payments as anexpense when it is required to be paid in accor-dance with the terms of the lease agreement.

Example: Assume that equipment is leased for $100,000 per year for three years. Under thismethod, the annual cost would be recorded as a rental expense on the income statement:

Dr. Rent $100,000Cr. Cash $100,000

To record an annual payment of rent based on an operating-lease agreement.



3140.0.3.1.2 Capitalized-Lease Method ofAccounting for Leases

3140.0.3.1.2.1 When a Lessee Is to Use theCapitalized-Lease Method

If any one of the following conditions exist, thelessee must capitalize the lease:1. The asset is owned by the lessee at the end

of the lease term.*2. The lease term is equal to or more than

75 percent of the estimated economic life ofthe asset.

3. The lessee can purchase the asset below itsfair market value before or at the end of thelease term (bargain purchase option).

*4. The present value of the minimum leasepayments at the beginning of the least term

is equal to or more than 90 percent of thefair market value of the property.

* If the lease begins in the remaining 25 percent ofthe asset’s estimated economic life, these items do notapply; such leases are considered operating leases.

Using this method, the lease is recorded as anasset at the lesser of the present value of therental and other minimum lease payments or thefair value of the leased property as though thelease obligation was being purchased on credit.The payment made is treated as a payment madeon an installment debt. At the same time, theasset is being amortized over the lease term. Thelease obligation is treated as a long-term debt.The discount rate that is used to capitalize thelease is the lessee’s incremental borrowing rateor the interest rate implicit in the lease agreement.

Example #1: This example illustrates the capitalized-lease method using the same example asabove with the added fact that the lease agreement contains an interest rate of 10 percent. Assumethat the interest rate of the lease agreement is the same as the lessee’s marginal borrowing rate.

Dr. Capitalized Lease $248,685Cr. Lease Obligation $248,685

To record an equipment lease obligation under a capitalized-lease agreement.

(Present value of $100,000 per year for three years at a 10 percent interest rate)

1st Year

Interest Expense $ 24,869Lease Obligation 75,131

Cash $100,000

To record the first year’s payment on an equipment lease obligation.

($248,685 2 .10 = $24,869)

Dr. Equipment Lease Amortization $ 82,895Cr. Capitalized Lease $ 82,895

To record the annual amortization of a capitalized equipment lease.

($248,685/3 years)

2nd Year

Dr. Interest Expense $ 17,355Dr. Lease Obligation 82,645

Cr. Cash $100,000



To record the second annual lease payment under a three-year capitalized-lease agreement.

(Interest = $248,685 + 24,869 2 $100,000 = $173,554 2 .10 = $17,355)

Dr. Lease Amortization $ 82,895Cr. Capitalized Lease $ 82,895

To record the second year’s lease amortization under a three-year capitalized lease.

3rd Year

Dr. Interest Expense $ 9,091Dr. Lease Obligation 90,909

Cr. Cash $100,000

To record the third year’s lease payment under a three-year capitalized-lease obligation.

(Interest = $173,554 + $17,355 = $190,909 2 $100,000 = $90,909 2 .10 = $9,091)

The financial statements are to include foot-notes that disclose the present value of noncan-celable lease commitments where the lessoreither recovers more than 75 percent of theeconomic life of the asset leased or recovers theinvestment plus a reasonable return.

3140.0.3.2 Accounting for Leases by aLessor

3140.0.3.2.1 Operating Lease (Lessor)

A lessor would have the following accountingentries for an operating lease:

Dr. Cash $xxx,xxxCr. Rent Income on Leased Assets5 $xxx,xxx

Dr. Depreciation Expense $xxx,xxxCr. Accumulated Depreciation—Leased Assets $xxx,xxx

In order for the lessor to be able to capitalizea direct-financing lease, any one of the samefour criteria for a lessee must apply along withtwo additional criteria:

5. Any rent received in advance would be initially creditedto “unearned rent revenue.”


BHC Supervision Manual January 2017Page 4.1

1. Collectibility of the minimum lease pay-ments must be reasonably predictable.

2. No important uncertainties exist as the amountof unreimbursable costs incurred.

In accounting for the lessor’s capitalized leasetransactions, there are some common accountsthat are used. These are described below.

Unearned income from lease financingreceivables.Unearned income represents theunearned interest liability account that is nettedagainst the total of lease payments receivablewhich includes the estimated residual value forbalance-sheet presentation. It represents the‘‘interest’’ income equal to the excess of rentalsreceivable over the fair value of the property atthe inception of the lease.

Leasefinancing receivables.Thisassetaccountis established in the amount of total lease pay-ments to be received from the lessee. The amountby which the rentals receivable exceeds the costof the property is the functional equivalent ofinterest and represents a portion of the income

to be recognized over the life of the lease. In theexample below, the cost of the property is tem-porarily charged to a fixed asset account, thentransferred to lease payments receivable.

Throughout the lease term, the rentals receiv-able account is periodically reduced by the fullamount of each rental payment received.

3140.0.3.2.2 Direct FinancingCapitalized Lease

In this situation, a finance company purchasesequipment from a manufacturer (recorded asequipment [asset] when purchased). The financecompany (lease financing nonbanking subsidi-ary) then leases that equipment and records it asa normal financing lease. There isno dealerprofit from the sale of the asset. Unearned inter-est income is recognized over the life of thelease using the effective interest method. Sincethe lessor has ‘‘sold’’ the asset, no depreciationis recorded.

Example #1: Lease with No Guaranteed Residual Value by the LesseeAssume that the finance company purchases equipment costing $100,000. It then leases the

equipment to a lessee under a five-year lease agreement that requires annual payments of $25,000per year. At the end of the lease term, the lessee will own the equipment. The implied interest rate is7.931 percent (comparison of the present value of the equipment of $100,000 against the $25,000annual payment for five years).

Dr. Equipment $100,000Cr. Cash $100,000

To record the purchase of equipment to be leased

Dr. Lease Financing Receivables $125,000Cr. Equipment $100,000Cr. Unearned Income from Lease Financing Receivables 25,000

To record the initial lease

Year 1

Dr. Cash $ 25,000Cr. Lease Financing Receivables $ 25,000

Dr. Unearned Income from Lease Financing Receivables $ 7,931Cr. Income from Lease Financing Receivables 7,931

To record the receipt of the first equipment lease payment.

Lease Payments Receivable $125,000Unearned Interest Revenue −25,000

$100,0002 .07931 = $7,931



Year 2


Dr. Unearned Income from Lease Financing Receivables $ 6,577Cr. Income from Lease Financing Receivables $ 6,577

To record the receipt of the second equipment lease payment.

Lease Payments Receivable $100,000Unearned Interest −17,069 ($25,000− 7,931)(Present Value of Remaining Receivable $ 82,931)2 .07931 = $6,577

Year 3



To record the receipt of the third equipment lease payment.

Lease Payments Receivable $ 75,000Unearned Interest −10,492 ($17,069− $6,577)(Present Value of Remaining Receivable $ 64,508)2 .07931 = $5,116

Year 4

Dr. Cash $ 25,000Cr. Lease Financing Receivables $25,000


To record the receipt of the fourth equipment lease payment.


Year 5

Dr. Cash $ 25,000Cr. Leases Financing Receivables $ 25,000


To record the receipt of the fifth equipment lease payment.




Example #2: Lease with a Residual Value (Guaranteed by the Lessee)A lessor acquires property to be leased for $14,000 (its fair value at the inception of the lease).

The estimated economic life of the property is five years. The lease has a noncancelable lease termof four years with a rental payment due of $3,649 at the end of each year. The lessee guarantees theresidual value at the end of the four-year lease term in the amount of $4,000. The lessor’s impliedrate of interest in the lease is 10.8695 percent. The present value of the minimum lease payments atthis interest rate and monthly payments exceeds 90 percent of the fair value of the property at theinception of the lease (.902 $14,000 = $12,600).

Year 1

January 1, 19x1

Dr. Equipment $ 14,000Cash $ 14,000

To record purchase of equipment for the purpose of a financing lease.

Dr. Lease Financing Receivables $ 18,596Cr. Equipment $ 14,000Cr. Unearned Income from Lease Financing Receivables 4,596

To record investment in direct-financing lease

December 31, 19x1


To recognize the portion of unearned income that is earned at the end of the first year of investment.

(Fair value of property at inception of the lease of $14,0002 10.8695% = $1,521)


To record receipt of the first year’s rental

Year 2

Dr. Unearned Income from Lease Financing Receivables $ 1,290Cr. Interest Income from Lease Financing Receivables $ 1,290

To recognize the portion of unearned income that is earned at the end of the second year ofinvestment

($14,000 + 1,521− 3,649 = $11,8722 10.8695% = $1,290)


To record the receipt of the second year’s rental

Year 3


($11,872 + 1,290− 3,649 = $9,5132 10.8695% = $1,034)



To recognize the portion of unearned income that is earned at the end of the third year of investment


To record the receipt of the third year’s rental.

Year 4

Dr. Unearned Income from Lease Financing Receivables $ 751Cr. Income Lease Financing Receivables $ 751

To recognize the portion of unearned income that is earned at the end of the fourth year ofinvestment.

($9,513 + 1,034− $3,649 = $6,8982 10.8695% = $751)

Dr. Cash $ 3,649Cr. Lease Financing Receivable $ 3,649

To record the receipt of the fourth year’s rental.

Dr. Cash $4,000Cr. Lease Financing Receivables $ 4,000

To record the receipt of the lessor’s guaranteed residual value (guaranteed by the lessee) at the endof the lease term.

($6,898 + 751− $3,649 = $4,000)

3140.0.3.2.3 Balance-Sheet Presentation

The lease payments receivable would be reportedon the balance sheet as a single amount ‘‘netinvestment’’ (Lease Financing Receivables lessthe balance of the Unearned Income from LeaseFinancing Receivables). If the lessor has estab-lished an allowance for possible lease losses,this amount is shown separately as a deductionfrom the net investment. The net investmentin the direct financing lease is $18,000 forexample #2 above. It consists of the grossinvestment of $18,596 ($3,6492 4 annualrental payments) plus the $4,000 residual valueless the unearned income of $4,596.

3140.0.3.2.4 Classification

If it is deemed appropriate to classify a lease,the amount to be classified (in example #2above) would be the net investment. For illustra-tion, assume that two of the four payments hadbeen received on the lease, that income has beenrecognized monthly according to the effective

interest rate method, and that the lease is nowconsidered a loss. Further assume that the thirdpayment should have been received eight monthsago. It is determined during the inspection thatthe lease should be classified as doubtful ofcollection. The balance to be classified is the netinvestment of $7,728. This consists of the bal-ance of Lease Financings Receivable of $9,513(includes the $4,000 estimated guaranteed resi-dual value) less the balance of Unearned Incomefrom Lease Financings Receivable of $1,785($1,034 + $751 = amount due on regular pay-ment intervals) or a net investment of $7,728.

3140.0.3.2.5 Delinquency

It is considered appropriate to state in theinspection report the percentage of delinquencyin the lease portfolio. The percentage is calcu-lated by deviding the aggregate rentals receiv-able on delinquent leases (less unearned incomeon the delinquent leases) by the total of rentalsreceivable on all leases (less their unearnedincome). Estimated realizable values would notbe included in the delinquent amounts unlessthey were guaranteed by the lessee.



3140.0.4 LEVERAGED LEASES

The lessor can ‘‘leverage’’ a lease transaction byborrowing a substantial portion of the acquisi-tion cost from a long-term lender, with the rent-als and the property pledged as collateral for theloan. The lessor borrows in order to finance aleasing transaction with a small, or perhaps, anegative equity in the property to be leased.

The initial step in accounting for this type oflease involves calculating the cash flows overthe term of the lease. The cash flows includethe income tax effects of tax deductions to thelessor, the lessor’s initial investment in the prop-erty, the rental receipts net of debt service, andthe proceeds expected to be received from thesale of any residual. The next step in accountingfor a leverage lease involves determining theapplied interest rate that, when applied to the netinvestment in the years that the net investmentwill be positive, would precisely allocate the netincome to the positive years. See appendix E ofSFAS 13 for an example as to how to accountfor a leveraged lease.


1. To determine the effect of the investment inthe leasing subsidiary upon consolidatedoperations, and indirectly upon the bank sub-sidiaries’ safety and soundness.

2. To determine if the company is operating incompliance with applicable laws and regula-tions, and to ensure that corrective action isinitiated if warranted.

3. To determine if policies, procedures, andcontrols are adequate to protect the companyfrom mismanagement, unnecessary risk, andloss.

4. To assess the management’s ability to oper-ate the company in a safe and sound manner.

5. To determine that accounting practices donot overstate income.


The decision whether the operations of a leasingsubsidiary will be inspected ‘‘on-site’’ is basedon the availability and adequacy of leasing com-pany data at the offices of the parent company.Item 1 below provides a listing of informationnecessary to the inspection process. If this andany other information necessary to assess theoverall condition of the subsidiary is availableat the parent’s office or can be obtained througha written request to the subsidiary, an on-site

inspection may not be necessary. The inspectionfrequency requirements, found in section5000.0.4, should be reviewed in making such adetermination.1. The following information should be avail-

able at the start of the inspection:a. trial balance of all leases and outstanding

credits,b. listing of accounts on which payments

are delinquent 30 days or more, or onwhich payments are otherwise not beingmade according to schedule,

c. comparative interim and fiscal financialstatements of the leasing company,

d. listing of unbooked assets and contin-gent liabilities,

e. cash-flow projections for the current fis-cal year and the next fiscal year,

f. listing of available lines of credit,g. copies of the most recent internal and

external audit reports, andh. minutes of board and executive commit-

tee meetings since the date of the previ-ous inspection.

2. Establish a ‘‘credit line’’ above which allleases will be reviewed. The line can be setat an amount that will cause a certain per-centage of the dollar volume of the leaseportfolio tobereviewed(e.g.,between70per-cent and 80 percent), or at an amount thatwill cause the review of each lease exceed-ing a certain percentage of gross capital.Leases on which payments are delinquentare to be reviewed regardless of amount.

3. Analyze the creditworthiness of the lessees.Consideration is given to the figures derivedfrom the lessee’s financial statements, aswell as cash flow, trends and projections ofgrowth in sales and income, and the qualifi-cations of management.

Delinquency on a lease obligation ispotentially more serious than delinquencyon a conventional loan. If the propertyunder lease is necessary for the lessee’scontinued production of income, as is fre-quently the case, the lessee’s financial con-dition will be seriously deteriorated beforethe lessee is willing to risk losing the prop-erty by default.

4. For those leases which might result in lossto the lessor, or for which financial informa-tion was not adequate to make such a deter-mination, transcribe the following informa-tion to line sheets:a. name and line of business of lessee



b. name of guarantor(s)c. original date of the lease contractd. original amount of the rentals receivablee. ERV of the propertyg. book value of the investment in the lease

as of the inspection dateh. cost of the propertyi. description and location of the propertyj. amount and frequency of rental paymentsk. original amount, term, rate, and schedule

of amortization of any nonrecourse debtassociated with the lease

l. lessor’s percentage of equity participa-tion in the lease obligation, if applicable

m. summary financial data indicating thecreditworthiness of the lessee, and guar-antors, if applicable

5. Before the conclusion of the inspection, dis-cuss with management all classified leases.Inadequate or negative cash flow and unfa-vorable trends reflected in financial state-ments of the lessee are usually indicative ofa substandard lease. Leases classified doubt-ful typically include those on which pay-ments are delinquent for an extended periodand those on which the lessor’s recovery ofinvestment is dependent upon an event ofunknown probability, such as a pendinglawsuit or insurance claim.

A loss classification results from the les-see’s inability or refusal to continue makingpayments.

6. Prepare a write-up to support the classifica-tions. The write-up should include the les-see’s type of business, present financial sta-tus, circumstances which led to theclassification, the probability that the termsof the lease can be met, and the amount ofprotection afforded by sale or re-lease of theunderlying property.

7. Review a sample of the lessor’s computa-tions of lease yields to determine whetherthe lessor will recover not less than the fullinvestment in the property plus the esti-mated total cost of financing the propertyover the term of the lease. This includesrental payments, estimated tax benefits, andthe estimated residual value of the propertyat the expiration of the initial lease.

With respect to the full-payout lease,governmental entities may be prohibitedfrom entering into leases for periods exceed-ing one year. In that case, the bank holdingcompany or its subsidiary (as lessor) shoulddemonstrate that the lease is expected to be

continually renewed until the cost is fullyrecovered.

8. Ascertain whether title to the property restswith the lessor, and that the lessor has takensteps to protect its ownership rights. Evi-dence of filing under the Uniform Commer-cial Code, where appropriate, should befound in the documentation file. Aircraftshould be registered with the FAA, inter-state vehicles with the ICC, and ships withthe Coast Guard.

9. Check for cancellation or other provisionsin the contract which could jeopardize thefull-payout status of the lease. There is noneed to take exception to a cancellationprovision which provides for payment bythe lessee of an amount which allows thelessor to recover fully its investment in theproperty.

10. Check that insurance coverage is effectiveon leased property and is provided by thelessee in compliance with all insurance pro-visions of the contract in an amount suffi-cient to protect against loss from propertydamage. Public liability insurance shouldalso be provided to protect against loss fromlawsuits which could arise from situationssuch as the crash of leased aircraft.

11. Review the lessee’s duties under the con-tract with respect to repairs and taxes. Deter-mine whether the lessor has instituted pro-cedures to check that the lessee’s requiredduties are being performed.

12. Review the status of all property acquiredfor lease purposes but which is not nowunder lease. Determine the reason for the‘‘off-lease’’ status of the property, ascertainthe realizable value of the property, andinvestigate whether the off-lease propertywill be sold or re-leased within the requiredtwo-year period.

13. Investigate the lessor’s procedures forperiodic review of the reasonableness of theestimated residualvalue.Theestimateshouldbe reviewed at least annually and reducedin amount on the books if the value hasdeclined on a presumably permanent basis.

14. Review past operations of the lease companyto determine if projections of income andERV have been realistic in light of actualexperience.

15. Review the minutes of the meetings of theboard and executive committees to deter-mine whether purchases of property anddelinquent leases are reported to the board.

16. Determine if the company has entered intoleases with companies owned or controlledby any director, officer, or 10 percent share-



holder of the leasing company or holdingcompany. Compare the rates and terms onsuch leases to the rates and terms offered onleases to companies of similar credit standing.

17. Check for lease concentrations to any onelessee or industry and prepare a commentfor the inspection report if any concentra-tion is considered unwarranted.

18. Determine whether the company hasestablished limits for the maximum amountof ‘‘credit’’ to be extended to a single les-see. If such limits have been established,investigate whether the company adheres tothem. If they have not been established,inquire as to the company’s policy on thismatter.

19. Provide the examiner-in-charge withinformation to be included in the inspectionreport, including:a. scope of the inspection (on- or off-

premises)b. comments concerning any policies or

conditions having an adverse effect onthe leasing company or parent company

c. brief history of the company and adescription of its activities

d. summary analysis of financial factors ofthe company, including trends in thevolume and classification of receivables,adequacy of capital and reserves, returnon assets, and contribution to consoli-dated income and consolidated assets

e. statutory authority under which the com-pany operates

f. details of all borrowings of the companyfrom within the holding company sys-tem and from external sources

g. details of any litigation in which thecompany is a defendant

h. scope and frequency of audit of thecompany by both internal and externalauditors

20. Compare current earnings performance andbalance-sheet ratios of the company withpast performance and industry composites.

21. Determine whether cash flows of the com-pany are adequate to service all debts.

22. Assess the adequacy of internal controlsover the company’s operations.

23. Check for action taken on matters criticizedin the most recent audit reports and theprevious inspection report. Determine ifleases classified ‘‘loss’’ were removed fromthe books.

24. Investigatewhetheranyaffiliatedbanksmain-tain compensating balances for lines of creditof the leasing company, and if so, whetherthe leasing company compensates the bankfor maintenance of the balances. If ‘‘loss’’leases have not been removed from thebooks, discuss with management the rea-sons why the charge-offs were not made.Determine whether the financial statementsand reports submitted to the Board of Gov-ernors were misstated as a result of the ‘‘nocharge-off’’ decision.

25. For higher residual value leasing, determinethat—a. the residual values have been estimated

accurately;b. residual values are reviewed and adjusted

annually;c. the initial terms of the lease are at least

90 days;d. the lessor relies on a residual value of

the leased property that will recoup theacquisition cost of the property and anyrelated financing or other associatedcosts;

e. the aggregate book value of all tangiblepersonal property held for such a lease,having an estimated residual value inexcess of 25 percent of the acquisitioncost of the property, does not exceed10 percent of the BHC’s consolidateddomestic and foreign assets;

f. the BHC maintains separately identifi-able records of the leasing transactionsand activities; and

g. each company maintains capitalizationfully adequate to meet its obligationsand support its activities, and that itscapital levels are commensurate withindustry standards for companies engagedin comparable leasing activities.





Automobile Leasing 1976 FRB 930

Consumer leasing 15 U.S.C. 1667

Higher residual valueleasing

1991 FRB 490, 1871990 FRB 462, 960

Personal or real propertyleasing activities of bankholding companies

225.28(b)(3)

Special-purpose leasingcorporation

3-712

Railcar leasing, railcar fleetmanagement services(leasing personal propertyand acting as agent,broker, or adviser inleasing personal property)

225.28(b)(3) 2016 FRB Q2 BoardOrder 2016-07

Engaging in incidentalactivities reasonablynecessary to carrying onpermissible nonbankingactivities

225.21(a)(2)




Section 4(c)(8) of the BHC Act(Community Welfare Projects) Section 3150.0

The Board considers the making of equity anddebt investments in corporations or projectsdesigned ‘‘primarily to promote’’ communitywelfare as an activity closely related to banking.The Board includes such investments in the listof permissible nonbanking activities in Regula-tion Y; however, bank holding companies mustobtain prior approval to engage in these activi-ties.TheBoard,effectiveApril 21,1997, includedthe provision of advisory and related servicesfor programs designed primarily to promotecommunity welfare into Regulation Y. Suchadvisory activities had previously been permit-ted only by Board order. For examples of advi-sory services approved for community develop-ment projects, see 1990 FRB 671, 1989 FRB576, and 1988 FRB 140.

3150.0.1 INVESTMENTS INCORPORATIONS OR PROJECTS TOPROMOTE COMMUNITYWELFARE—BOARDINTERPRETATION

The Board also provides guidance with regardto investments in community welfare projectsthrough its interpretation (see section 225.127of Regulation Y (12 C.F.R. 225.127)). Thisinterpretation describes projects that the Boardhas considered as promoting community wel-fare as their primary intent. These include butare not limited to—

1. projects to construct or rehabilitate housingfor low- or moderate-income persons,

2. projects for construction or rehabilitation ofancillary local commercial facilities neces-sary to provide goods or services principallyto persons residing in low- or moderate-income housing, and

3. projectsdesignedexplicitly tocreate improvedjob opportunities for low- or moderate-income groups.

Because the Board believes that bank holdingcompanies should take an active role in thequest for solutions to the nation’s social prob-lems, it has not defined other types of invest-ments designed primarily to promote the com-munity welfare in order to give bank holdingcompanies greater flexibility in developing newand creative approaches to resolving communityproblems. Accordingly, the Board has main-tained the flexibility to determine whether an

activity is primarily designed to promote thecommunity welfare. Factors that the Board mightconsider include whether the activity benefitslow- and moderate-income individuals in areassuch as housing and employment and the needfor specialized community development activi-ties in different localities. The Board will con-sider a range of different activities, but willprobably not approve a proposal that does not insome way either benefit low- or moderate-income individuals or benefit the specializedneeds of local communities.

Once a bank holding company has obtainedBoard approval to engage in community devel-opment activities pursuant to Regulation Y, theholding company may, without further Systemapproval, engage either directly or through asubsidiary in certain community developmentactivities, so long as such activities do notexceed 5 percent of the bank holding company’stotal consolidated capital stock and surplus.

A bank holding company may invest andprovide financing—

1. to a corporation or project or class of corpo-rations or projects that the Board previouslyhas determined is a public welfare projectpursuant to paragraph 23 of section 9 of theFederal Reserve Act (12 U.S.C. 338a);

2. to a corporation or project that the Office ofthe Comptroller of the Currency previouslyhas determined, by order or regulation, is apublic welfare investment pursuant to sec-tion 5136 of the Revised Statutes (12 U.S.C.24 (Eleventh));

3. to a community development financial insti-tution (other than a bank or bank holdingcompany) pursuant to section 103(5) of theCommunityDevelopmentBankingandFinan-cial Institutions Act of 1994 (12 U.S.C.4702(5));

4. for the development, rehabilitation, manage-ment, sale, and rental of residential propertyif a majority of the units will be occupied bylow- and moderate-income persons or if theproperty is a ‘‘qualified low-income build-ing’’ as defined in section 42(c)(2) of theInternal Revenue Code (26 U.S.C. 42(c)(2));

5. for the development, rehabilitation, manage-ment, sale, and rental of nonresidential realproperty or other assets located in a low- ormoderate-income area provided the property


is used primarily for low- and moderate-income persons;

6. to one or more small businesses located in alow- or moderate-income area to stimulateeconomic development;

7. for the development of, and to otherwiseassist with, job training or placement facili-ties or to foster programs designed primarilyfor low- and moderate-income persons;

8. to an entity located in a low- or moderate-income area if that entity creates long-termemploymentopportunities,amajorityofwhich(based on full-time equivalent positions) willbe held by low- and moderate-income per-sons; and

9. forproviding technicalassistance,credit coun-seling, research, and program developmentassistance to low- and moderate-income per-sons, small businesses, or nonprofit corpora-tions tohelpachievecommunitydevelopment.

3150.0.2 EXAMPLES OFBOARD-APPROVED ACTIVITIESDESIGNED TO PROMOTECOMMUNITY WELFARE

With its primary thrust to promote communitywelfare rather than creating a focus on a collat-eral effect, economic rehabilitation and develop-ment should focus on providing housing, ser-vices, or jobs for low- or moderate-incomeresidents or groups. Examples of projects previ-ously approved by the Board include an invest-ment in—

1. an agricultural test farm (testing crops, equip-ment, alternative farming methods and chemi-cals, and providing student agriculturalresearch opportunities and financial planningworkshops for farmers (see 1990 FRB 671);

2. an entity that provides education to youngpersons (see 1991 FRB 70) through a non-profit, tax-exempt bank holding company(educational programs consisted of the Ameri-can economic system, how to start a busi-ness, college financial planning, and careeropportunities in banking);

3. the acquisition and redevelopment of a solemedical clinic in a small rural town withoutpublic transportation that was located 30miles from another facility and was neededto attract new physicians to replace thoseretiring (see 1991 FRB 63); and

4. a limited partnership to develop a nearlyvacant office building into a hotel complex

within a major city, located adjacent to apublichousingproject.Commitments includedproviding training to welfare recipients resid-ing in public housing projects and employinglow- and moderate-income individuals at thehotel complex, and donating a portion of theprofits to a nonprofit corporation designatedto provide low-cost housing, employment,and business opportunities for disadvantagedresidents. (See 1996 FRB 679.)

3150.0.3 EXAMPLES OFINVESTMENTS VIEWED AS NOTPROMOTING COMMUNITYWELFARE

The Board has indicated that some investmentsare not designed primarily to promote commu-nity welfare unless there is substantial evidenceto the contrary, even though the investment maybenefit the community to some extent. Examplesinclude investments to build or rehabilitate high-income housing or commercial, office, or indus-trial facilities which are not designed explicitlyto create job opportunities for low-income per-sons, even though the investment may benefitthe community to some extent. This latter pointwas made in an order (see 1996 FRB 679)whereby the Board denied an application by abank holding company to acquire an investmentin an industrial development corporationinvolved in the construction of a shopping andoffice complex in an urban renewal area. TheBoard identified the critical issue as whether theproject was devised primarily to promote thecommunity welfare or primarily designed as aprofit-making venture in which the benefits tothe community were merely a collateral effect.

In another case, the Board denied a proposalintended to acquire a company that indirectlyacted as a managing general partner of a privatedevelopment venture. The venture was a large-scale, urban redevelopment initiative, jointlysponsored by government and private entities,that was intended to revitalize a geographic areathat was largely abandoned within a workingmiddle-class community. (See 1990 FRB 672.)


1. To determine that new investments and financ-ing in community development and othercorporations and projects are designed pri-marily to promote community welfare.

2. To determine that previous investments andfinancings continue to meet the standards

Section 4(c)(8) of the BHC Act (Community Welfare Projects) 3150.0


imposed by section 225.28(b)(12) of Regula-tion Y.

3. To determine that the activity remains withinthe scope of regulatory approval when suchapproval involves specific rather than gen-eral investments.

4. To determine that advisory and related ser-vices for programs designed primarily to pro-mote community welfare are being con-ducted within the scope of their regulatoryapproval.


As is standard practice in the examination ofother subsidiaries engaged in nonbanking activi-ties,a thoroughreviewofpertinentbooks, records,contracts, and financial statements should beundertaken by the examiner. To fulfill theinspection objectives concerning this activity,the examiner may have to go beyond routineinvestigative practices. Since this activity

encompasses a wide variety of programs, proce-dures will have to be developed on an ad hocbasis. When federal or state approval of theprogram is required, the examiner may wish toreview applications and other materials submit-ted to such authorities. The terms or conditionsimposed by such bodies as well as the subsid-iary’s continued eligibility may also be ofimportance. Contact with responsible federal orstate officials may be deemed appropriate incertain cases. Such contacts, however, should beinitiated only in accordance with respectiveReserve Bank procedures. When a communitywelfare project or financing does not include theinvolvement of another governmental body, theexaminer will need to verify directly whethergoals essential to the nature of the activity, suchas providing housing for the elderly or jobs forlow- or moderate-income people, are being met.In this regard, the burden should be on theholding company to provide such data. In someinstances, an on-site visit to the project may beappropriate.





Permissible investmentsdescribed

1701 225.28(b)(12)225.127

4–178 1972 FRB 4951978 FRB 451984 FRB 452

Provision of communitydevelopment advice on afee-for-service basis

1988 FRB 1401989 FRB 576

Purchase of landfor agriculturaltesting activities

1990 FRB 672

Nonprofit, tax-exempt BHC—educationalprograms in economics,starting businesses,financial planning,career opportunities inbanking

1991 FRB 70

Projects to createimproved job opportunitiesfor low- or moderate-income groups

1992 FRB 619

Approval of communitydevelopment converting anoffice building into ahotel complex, locatednext to a publichousing projectdesignated as‘‘difficult to develop’’

1996 FRB 679

Denial of a bankholding companyformation by acommunity developmentcorporation

1976 FRB 639

Denial of a venturethat would revitalizean abandoned areain a middle-classcommunity

1994 FRB 733





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Section 4(c)(8) of the BHC Act (Mortgage Banking—Derivative Commitments to Originate ...€¦ ·...

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