SECURITIES AND DERIVATIVES

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SECURITIES AND DERIVATIVESSection 3.3System, Office of Thrift Supervision, and National CreditUnion Administration, effective May 26, 1998. The PolicyStatement provides guidance and sound principles tobankers for managing investment securities and derivativesrisks. It makes clear the importance of board oversight andmanagement supervision, and focuses on risk management.The Policy Statement covers all securities used forinvestment purposes and all end-user derivativeinstruments used for non-trading purposes. It applies to allfederally-insured commercial banks, savings banks, andsavings associations. Notably, the Policy Statement:INTRODUCTIONOverviewSecurities and end-user derivatives (investment) activitiescan provide banks with earnings, liquidity, and capitalappreciation. Carefully constructed positions can alsoreduce overall bank risk exposures. However, investmentactivities can also create considerable risk exposures,particularly: Market risk,Credit risk,Liquidity risk,Operating risk,Legal risk,Settlement risk, andInterconnection risk. This section provides guidance, policy, and sound practicesregarding: Policies, procedures and risk limits,Internal controls,Unsuitable investment activities,Risk Identification, measurement, and reporting,Board and senior management oversight,Compliance,Report of examination treatment, andOther guidance (trading, accounting, and informationservices).The Policy Statement declares that banks shouldimplement programs to manage the market, credit,liquidity, legal, operational, and other risks that result frominvestment activities.Adequate risk managementprograms identify, measure, monitor, and control theserisks.Failure to understand and adequately manage investmentactivity risks is an unsafe and unsound practice.Use this section to assess how effectively a bank’s boardand management identifies, measures, monitors, andcontrols investment activity risks. Incorporate findingsinto relevant examination assessments, including sensitivityto market risk, liquidity, asset quality, and management.Risk Management Process SummaryThis subsection provides guidance for evaluating a riskmanagement program’s effectiveness at identifying,measuring, monitoring, and controlling investment activityrisks. It also includes guidance for assessing those risksrelative to overall risk exposure.Refer to the Capital Markets Examination Handbook forreference information on a wide range of activities andinstruments, including fixed income instruments, mutualfunds, derivatives, sensitivity to market risk, portfoliomanagement, and specialized examination procedures.That handbook’s information focuses more closely onspecific activities and instruments than this section’sgeneral guidance.Management should establish a risk management programthat identifies, measures, monitors, and controls investmentactivity risks.Its intricacy and detail should becommensurate with the bank’s size, complexity, andinvestment activities. Thus, the program should be tailoredto the bank’s needs and circumstances. Regardless, aneffective risk management program will include thefollowing processes:Policy Statement The Supervisory Policy Statement on Investment Securitiesand End-User Derivatives Activities (Policy Statement)was adopted by the FDIC, Office of the Comptroller of theCurrency, Board of Governors of the Federal ReserveDSC Risk Management Manual of Examination PoliciesFederal Deposit Insurance CorporationUnderscores the importance of board oversight andmanagement supervision,Emphasizes effective risk management,Contains no specific constraints on holding “high risk”mortgage derivative products,Eliminates the requirement to obtain the formerregulatory volatility test for mortgage derivativeproducts, andApplies to all permissible investment securities andend-user derivatives. 3.3-1The board should adopt policies that establish cleargoals and risk limits.The board should review and act upon management’sreports.Securities and Derivatives (12-04)

SECURITIES AND DERIVATIVES Section 3.3The board should establish an independent reviewfunction and review its reports.Management should develop investment strategies toachieve the board’s goals.Management should analyze and select investmentsconsistent with its strategies.Management should maintain an effective internalcontrol program.Management should regularly measure the portfolio’srisk levels and performance.Management should provide periodic reports to theboard.The board and management should periodicallyevaluate and, when warranted, modify the program.POLICIES,LIMITS The board’s investment goals,Authorized activities and instruments,Internal controls and independent review,Selecting broker/dealers,Risk limits,Risk and performance measurement,Reporting, andAccounting and taxation.At most banks, the investment portfolio serves as asecondary source of both earnings and liquidity. At somebanks, the investment portfolio is a primary earningscomponent. The policies should articulate the investmentportfolio’s purpose, risk limits, and return goals. Returngoals should express the board’s earnings objectives for theinvestment portfolio. The board may also establishportfolio performance targets.Banks that engage in less complex activities mayeffectively manage investment activity risk on anindividual instrument basis. That is, each instrument’s riskand return is evaluated independently. An instrument’scontribution to overall portfolio risk and return may onlybe considered in general terms. This approach requiresrather specific individual instrument risk limits, buttypically does not involve aggregate portfolio analysis.Policies should describe all authorized investmentactivities and set guidelines for new products or activities.Further, policies should delegate investment authority,including naming specific personnel.The board’sapproved policies should also provide management withgeneral guidelines for selecting securities broker/dealersand limiting broker/dealer credit risk exposure.Banks with complex or extensive investment activitiesshould strongly consider the portfolio approach formanaging investment activity risk. Under a portfolioapproach, management evaluates an instrument’scontribution to overall portfolio risk and return. It requiresportfolio risk limits and a system for aggregating andmeasuring overall portfolio risk and return. More complexaggregate portfolio risk and return measurements should beincorporated into overall interest rate risk or asset/liabilitymanagement programs.The bank should have policies that ensure anunderstanding of the market risks associated withinvestment securities and derivative instruments beforepurchase. Accordingly, banks should have policies thatdefine the characteristics of authorized instruments. Thepolicy should sufficiently detail the characteristics ofauthorized instruments. For example, a policy that merelyauthorizes the purchase of agency securities would not besufficiently detailed. The price sensitivities of agencypass-throughs, step-up structured notes, agency callabledebt or leveraged inverse floaters are very different.Therefore, the policy should delineate the authorized typesof agency securities that may be purchased. Managementshould analyze the risks in an instrument that has not beenauthorized and should seek the board’s permission to alterthe list of authorized instruments before purchase.In recommending that all banks consider portfolio orwhole bank risk management, the Policy Statement notesthat such approaches generally provide certain advantagesover the individual instrument approach, including:Integrated management of risk and returnUnderstanding of each instrument’s contribution tooverall risk and returnIncreased flexibility when selecting instrumentsSecurities and Derivatives (12-04)RISKThe board is responsible for adopting comprehensive,written investment policies that clearly express the board’sinvestment goals and risk tolerance. Policies should betailored to the bank’s needs and should address:Management must determine, consistent with board policy,how investment activity risks will be managed. The PolicyStatement provides considerable flexibility by permittingbanks to manage risk on an individual instrument basis, onan aggregate portfolio basis, or on a whole bank basis. ANDPoliciesThe following sections of the guidance cover each of theabove steps in greater detail. PROCEDURES,3.3-2DSC Risk Management Manual of Examination PoliciesFederal Deposit Insurance Corporation

SECURITIES AND DERIVATIVESSection 3.3Banks should have policies that specify the analysis of therisk of an investment that must be conducted prior topurchase. The pre-purchase analysis is meant to discoverand quantify all relevant risks in the investment. Not allinvestments will require pre-purchase analysis. Relativelysimple or standardized instruments, the risks of which arewell known to the bank, would likely require no orsignificantly less analysis than would more complex orvolatile instruments. Policies should delineate which of theauthorized investments do not require pre-purchaseanalysis.Credit risk limits should generally restrict management toinvestment grade instruments. The board may permitmanagement to acquire nonrated instruments; however,these instruments should be consistent with investmentgrade standards. For example, management may wish topurchase a nonrated bond issued by a local municipality.Regardless, the board should carefully monitor suchactivity.Liquidity risk limits should restrict positions in lessmarketable instruments. These limits should apply tosecurities that management would have difficulty selling ator near fair value. Less marketable instruments may notmeet the board’s investment goals, and holdings shouldgenerally be small. Obscure issues, complex instruments,defaulted securities, and instruments with thin markets mayall have limited liquidity.The list of authorized instruments may include instrumentsof varying characteristics. Policies should divide thespectrum of authorized investments into segments ofinstruments of similar risk characteristics. Policies shouldalso require appropriate pre-purchase analysis for eachsegment.Asset type limits should limit concentrations in specificissuers, market sectors, and instrument types. These limitswill require management to diversify the portfolio. Whenproperly diversified, a portfolio can have lower risk for agiven yield or can earn a higher yield for a given risk level.For example, the board may limit total investment in aparticular instrument type to a specific percentage ofcapital.Risk LimitsTo effectively oversee investment activities, the board mustapprove the bank’s risk limits. Management should setthese risk limits, consistent with the board’s goals,objectives, and risk appetite. The risk limits should beformally approved and incorporated within the board’spolicies. Limits may be expressed in terms of bank-widerisk, investment portfolio risk, portfolio segment risk, oreven individual instrument risk.Maturity limits should place restrictions on the maximumstated maturity, weighted average maturity, or duration ofinstruments that management may purchase. Longer-termsecurities have greater interest rate risk, price risk, andcash flow uncertainty than shorter-term instrumentspossess. Therefore, maturity limits should complementmarket risk limits, liquidity risk limits, and the board’sinvestment goals.Risk limits should be consistent with the bank’s strategicplans and overall asset/liability management objectives.Limits should be placed on: Market risk,Credit risk,Liquidity risk,Asset types, andMaturities.In addition, management should establish a standard riskmeasurement methodology. The measurement system mustcapture all material risks and accurately calculate riskexposures. Management should provide the board withconsistent, accurate risk measurements in a format thatdirectly illustrates compliance with the board’s risk limits.Refer to the Risk and Performance Measurementsubsection for additional guidance.At a minimum, risk limits should be expressed relative tomeaningful standards, such as capital or earnings. Morecomplex investment activities may require more detailedrisk limits.Market risk limits should at least quantify maximumpermissible portfolio or individual instrument pricesensitivity as percentage of capital or earnings. Capitalbased risk limits clearly illustrate the potential threat to thebank’s viability, while earnings-based limits reflectpotential profitability effects. In addition, the board maychoose to establish limits relative to earnings, total assets,total investment securities, or other standards.DSC Risk Management Manual of Examination PoliciesFederal Deposit Insurance CorporationINTERNAL CONTROLSInternal Control ProgramEffective internal controls are the first line of defense insupervising investment activity operating risks. Ineffectivecontrols can lead to bank failures.Consequently,examiners will carefully evaluate the internal control3.3-3Securities and Derivatives (12-04)

SECURITIES AND DERIVATIVESSection 3.3 program. Examiners will emphasize separation of dutiesbetween the individuals who execute, settle, and accountfor transactions.Invoice review requirements should address standards forall securities and derivatives sold or purchased. Invoicesand confirmations display each instrument’s originalpurchase price, which provides a basis to establish bookvalue and to identify reporting errors. Invoice reviews canalso be used when determining if the bank is involved inany of the following inappropriate activities:The internal control program should be commensurate withthe volume and complexity of the investment activityconducted, and should be as independent as practical fromrelated operations.The board has responsibility for establishing generalinternal control guidelines, which management shouldtranslate into clear procedures that govern daily operations.Management’s internal control program should includeprocedures for the following: Saving and safeguarding important documents, andInvoice review. Portfolio valuation,Personnel,Settlement,Physical control and documentation,Conflict of interest,Accounting,Reporting, andIndependent review. Engaging one securities dealer or representative forvirtually all transactions.Purchasing from or selling to the bank’s tradingdepartment.Unsuitable investment practices (refer to followingpage.).Inaccurate reporting.Conflict of interest guidelines should govern allemployees authorized to purchase and sell securities for thebank. These guidelines should ensure that all directors,officers, and employees act in the bank’s best interest. Theboard should adopt polices that address authorizedemployees’ personal relationships, including securitiestransactions, with the bank’s approved securitiesbroker/dealers. The board may also adopt policies thataddress the circumstances under which directors, officers,and employees may accept gifts, gratuities, or travelexpenses from securities broker/dealers and associatedpersonnel.Internal controls should promote efficiency, reliableinternal and regulatory reporting, and compliance withregulations and bank independent portfolio pricing.The availability ofindependent pricing provides an effective gauge of themarket depth for thinly traded instruments, allowingmanagement to assess the potential liquidity of specificissues.For these and other illiquid or complexinstruments, completely independent pricing may bedifficult to obtain. In such cases, estimated or modeledvalues may be used. However, management shouldunderstand and agree with the methods and assumptionsused to estimate value.Accounting practices should be evaluated against thestandards, opinions, and interpretations listed in thissection.Reporting procedures should be evaluated against theguidelines discussed in the Risk Reporting subsection RiskIdentification, Assessment and Reporting.Physical control and documentation requirements shouldinclude:Independent review of the risk management programshould be conducted at regular intervals to ensure theintegrity, accuracy, and reasonableness of the program.Independent review may encompass external audits or aninternal audit program.At many banks, however,evaluation by personnel independent of the portfoliomanagement function will suffice. The independent reviewprogram’s scope and formality should correspond to thesize and complexity of the bank’s investment activities.Independent review of investment activity should be atleast commensurate with the independent review of otherprimary bank activities. It should assess: Personnel guidelines should require sufficient staffingresources and expertise for the bank’s approved investmentactivities.Settlement practices should be evaluated against theguidelines provided in the Settlement Practices,Confirmation and Delivery Requirements, and DeliveryDocumentation Addenda.Possessing and controlling purchased instruments,Securities and Derivatives (12-04)3.3-4Adherence to the board’s policies and risk limits,DSC Risk Management Manual of Examination PoliciesFederal Deposit Insurance Corporation

SECURITIES AND DERIVATIVES Section 3.3trading may be intended to defer loss recognition, asunrealized losses on debt securities in such categories donot directly affect regulatory capital and generally are notreported in income until the security is sold.The risk measurement system’s adequacy andaccuracy,The reporting system’s timeliness, accuracy, andusefulness,Personnel resources and capabilities,Compliance with regulatory standards,The internal control environment,Accounting and documentation practices, andConflicts of interest.Examiners should scrutinize institutions with a pattern ofreporting significant amounts of realized gains on sales ofnon-trading securities (typically, AFS securities) after shortholding periods while continuing to hold other non-tradingsecurities with significant amounts of unrealized losses. If,in the examiner’s judgment, such a practice has occurred,the examiner should consult with the Regional Office foradditional guidance on whether some or all of the securitiesreported outside of the trading category will be designatedas trading assets.Banks with complex investment activities should consideraugmenting the independent review with internal orexternal auditors, while banks with less complexinvestment activities may rely on less formal review.Sophisticated risk measurement systems, particularly thosedeveloped in-house, should be independently tested andvalidated.When-issued securities trading is the buying and sellingof securities in the period between the announcement of anoffering and the issuance and payment date of thesecurities. A purchaser of a when-issued security acquiresthe risks and rewards of owning a security and may sell thewhen-issued security at a profit before having to takedelivery and pay for it.Independent review findings should be reported directly tothe board at least annually. The board should carefullyreview the independent review reports and ensure thatmaterial exceptions are corrected.Examiners will evaluate the independent review’s scopeand veracity, and will rely on sound independent reviewfindings during examinations.However, when theindependent review is unsatisfactory, examiners willperform review procedures to reach independentconclusions. When warranted, examiners will conduct adetailed review of all investment activities.Pair-offs are security purchase transactions that are closedout or sold at or before the settlement date. In a pair-off,an institution commits to purchase a security. Then, beforethe predetermined settlement date, the bank pairs-off thepurchase with a sale of the same security. Pair-offs aresettled net when one party to the transaction remits thedifference be

SECURITIES AND DERIVATIVES Section 3.3 INTRODUCTION Overview Securities and end-user derivatives (investment) activities can provide banks with earnings, liquidity, and capital appreciation. Carefully constructed positions can also reduce overall bank risk exposures. However, investment activities can also create considerable risk exposures,

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