The financial institutions industry has changed significantly in the last two decades. The conventional model of providing and receiving financial services has disappeared in the era since the Gramm-Leach-Bliley (GLB) Financial Services Modernization Act of 1999. The continuous wave of consolidations in the financial services industry has resulted in fewer but bigger financial institutions, and they are often perceived as being too big to fail. Financial services and products of banks, insurance companies, mutual funds, and brokerage firms that once were distinguishable and whose roles were separated are now consolidated and converged. Regulatory changes and increased global competition have further blurred the lines among depository institutions, mortgage banking activities, investment companies, credit unions, investment banks, insurance companies, finance companies, and securities brokers and dealers.

Global competition has increased as all types of financial services firms conduct business directly with potential depositors and borrowers. Transactions traditionally executed through depository institutions are now handled by all types of financial institutions. Increased global competition has heightened the depository institutions' desire for innovative approaches to attracting depositors and borrowers worldwide. Financial institutions are seeking higher levels of noninterest income, restructuring banking operations to reduce costs, and continuing consolidation within the industry. Consolidation, convergence, and competition derived primarily from deregulation and technological advances have reshaped the financial services industry. The passage of the GLB Act has accelerated the pace of consolidation and convergence in the financial services industry and has raised some concerns that its implementation has created concentration of economic power that would have made it more difficult for government to effectively oversee the industry's activities and strategies in managing risk. Some overriding reasons for the current financial crises are:

Ineffective regulation
Greed and incompetence of executives of troubled financial institutions
Nature of bank lending and investment
Inadequate risk assessment
Conflicts of interest financial services activities

This chapter presents an overview of the financial services industry, its role in the economy, types and nature of financial firms and their regulatory framework, financial activities, and related risks.

(b) Role in the Economy

Financial services firms play an important role in our economy by financing individual and business projects, lending to individuals and businesses, and investing in capital markets. Financial institutions can promote economic growth and prosperity for the nation, and their inefficiency can cause significant threats and the uncertainty and volatility in the markets, which adversely affect investor confidence worldwide. This lack of public trust and investor confidence has caused once-prominent Wall Street firms to either disappear or reorganize; for example, Bear Stearns merged with JP Morgan Chase; Lehman Brothers went bankrupt; Merrill Lynch was acquired by Bank of America; and Morgan Stanley and Goldman Sachs changed their corporate structures, becoming bank holding companies. It appears that the government facilitates the establishment of giant companies (e.g., AIG, Fannie Mae, Freddie Mac) to promote its social, economic, and political policies. Executives of these giant companies continuously make high-risk decisions, and while they receive outrageous compensation to make these decisions, lawmakers and regulators have failed to hold them accountable for their excessive risk-taking activities and appetite. These companies became too large to fail; in efforts to prevent their collapse, the government steps in to bail them out at the taxpayers' expense. Financial institutions worldwide have lost more than $1.5 trillion on mortgage-related losses during the 2007–2009 global financial crisis. The failed financial institutions of Bear Sterns, Lehman Brothers, AIG, and Merrill Lynch all played a vital role in the recent economic meltdown, as they all engaged in risky mortgage-lending practices, credit derivatives, hedge funds, and corporate loans.

Financial institutions are essential financial intermediaries in the economy in the sense that they provide liquidity transformation and monitoring mechanisms. Financial institutions in their basic role provide a medium of exchange; however, they may also serve as a tool to regulate the economy. In a complex financial and economic environment, the regulation of financial institutions—directly and indirectly—is used to impact economic activity. The Dodd-Frank Act of 2010 was passed to minimize the probability of future financial crisis and systemic distress by empowering regulators to mandate higher capital requirements and to establish a new regulatory regime for large financial firms, by developing regulatory and market structures for financial derivatives and by creating systemic risk assessment and monitoring. Dodd-Frank created a Financial Services Oversight Council (FSOC) that identifies and monitors systematic risk in the financial sector. The FSOC recommends appropriate leverage, liquidity, capital, and risk management rules to the Federal Reserve. The FSOC can practically take control of and liquidate troubled financial services firms if their failure would pose significant threat to the nation's financial stability. Ineffective functioning of financial institutions can be detrimental to the real economy, as evidenced in the recent financial crisis when many U.S. and European banks went bankrupt, had to be rescued by government, or were taken over by other financial institutions.

(c) Types of Financial Institutions

There are many types of financial services firms including commercial banks, investment banks, insurance firms, pension plans, mutual funds and sovereign wealth funds that are vital to the financial markets. The more common types of financial institutions are described in this chapter. In view of the range and diversity within financial institutions, this chapter focuses on three major types of entities/activities: banks and savings institutions, mortgage banking activities, and investment companies.

(i) Banks and Savings Institutions

Banks and savings institutions (including thrifts) continue in their traditional role as financial intermediaries. They provide a link between entities that have capital and entities that need capital while also providing an efficient means for payment and transfer of funds between these entities. Banks also provide a wide range of services to their customers, including cash management and fiduciary services, accepting demand and time deposits, making loans to individuals and organizations, and providing other financial services of documentary collections, international banking, trade financing.

Financial modernization and financial reform legislation (Dodd-Frank Act of 2010) continues to change the way banks and savings institutions conduct business. Banks and savings institutions have developed sophisticated products to meet customer needs and technological advances to support such complex and specialized transactions. Continued financial reform may change the types and nature of permissible banking activities and affiliations.

(ii) Mortgage Banking Activities

Mortgage banking activities include the origination, sale, and servicing of mortgage loans. Mortgage loan origination activities are performed by entities such as mortgage banks, mortgage brokers, credit unions, and commercial banks and savings institutions. Mortgages are purchased by government-sponsored entities, sponsors of mortgage-backed security (MBS) programs, and private companies such as insurance companies, other mortgage banking entities, and pension funds. These financial institutions typically provide the long-term loans to businesses and individuals.

(iii) Investment Companies

Investment companies pool shareholders' funds to provide the shareholders with professional investment management. Typically, an investment company sells its capital shares to the public, invests the proceeds to achieve its investment objectives, and distributes to its shareholders the net income and net gains realized on the sale of its investments. The types of investment companies include management investment companies, unit investment trusts, collective trust funds, investment partnerships, certain separate accounts of insurance companies, and offshore funds. Investment companies have grown significantly in recent years, primarily due to growth in mutual funds.

(iv) Credit Unions

Credit unions are member-owned, not-for-profit cooperative financial institutions, organized around a defined membership. The members pool their savings, borrow funds, and obtain other related financial services. A credit union relies on volunteers (owners and users) who represent the members. Its primary objective is to provide services to its members rather than to generate earnings for its owners. More recently, many credit unions have made arrangements to share branch offices with other credit unions and depository institutions to reduce operating costs. Traditionally, credit unions have owned and managed by several members to provide financial services to its members and now have evolved to thousands of members with multi-billion dollars in assets.

(v) Investment Banks

Investment banks or merchant banks deal with the financing requirements of corporations and institutions. They may be organized as corporations or partnerships. Investment banks are financial institutions that assist corporations and governments in raising capital by underwriting and acting as the agent in the issuance of securities. An investment bank also assists companies involved in mergers and acquisitions and derivatives, and provides ancillary services, such as market making and the trading of derivatives, fixed income instruments, foreign exchange, commodity, and equity securities.

(vi) Insurance Companies

The primary purpose of insurance is the spreading of risks. The two major types of insurance are life, and property and casualty. The primary purpose of life insurance is to provide financial assistance at the time of death. It typically has a long period of coverage. Property and casualty insurance companies provide policies to individuals (personal lines) and to business enterprises (commercial lines). Examples of personal lines include homeowner's and individual automobile policies. Examples of commercial lines include general liability and workers' compensation. Banks, mutual funds, and health maintenance organizations are aggressively trying to expand into products traditionally sold by insurance companies. During the 1990s and early 2000s, the insurance industry benefited from the strong stock and bond markets; however, recent slow premium growth and the increased competition and economic meltdown continued to pressure insurers to reduce costs and improve profitability. Many companies in the insurance sector in particular have been adversely affected by the 2007–2009 financial crisis. Insurance companies that were involved in activities traditionally associated with investment banks, and are designated as savings and loan holding companies (SLHCs) and typically offer leverage and risk-based financial products (security-based swaps) have been deeply impacted by the recent crisis.

Implementation of provisions of Dodd-Frank will have significant effects on insurance companies by impacting their business transactions. The newly established Federal Insurance Office (FIO) is intended to play an important role in overseeing and coordinating insurance activities between the international insurance market and the U.S. insurance market. Nonetheless, the FIO will not be in charge of state regulation of insurance companies. The Dodd-Frank Act directed the Securities and Exchange Commission (SEC) to establish rules and standards for broker-dealers and investment advisors will have a substantial impact on insurance companies. The FIO will oversee all aspects of the insurance industry, including systemic risk, capital standards, consumer protection, and international coordination of insurance regulation.

(vii) Finance Companies

Finance companies are non-banking lenders that do not receive deposits but provide lending and financing services to consumers (consumer financing) and to business enterprises (commercial financing). The more common types of consumer financing include mortgage loans, retail sales contracts, auto loans, debt consolidation loans and insurance service. The more common types of commercial financing include factoring, revolving loans, installment, term and floor plan loans, portfolio purchase agreements, and lease financing. Captive finance entities represent manufacturers, retailers, wholesalers, and other business enterprises that provide financing to encourage customers to buy their products and services. Many captive finance companies also finance third-party products. In the pre-financial crisis era, many mortgage finance companies and diversified finance companies increased their presence by increasing the number of loans made to higher-risk niches at higher yields.

(viii) Securities Brokers and Dealers

Securities brokers and dealers serve in various roles within the securities industry. Brokers, acting in an agency capacity, buy and sell securities, commodities, and related financial instruments for their customers and charge a commission. Dealers or traders, acting in a principal capacity, buy and sell for their own account and trade with customers and other dealers. Broker-dealers perform a wide range of both types of activities, such as assisting with private placements, underwriting public securities, developing new products, facilitating international investment activity, serving as a depository for customers' securities, extending credit, and providing research and advisory services.

(ix) Real Estate Investment Trusts

The new class of real estate investment trusts (REITs), formed since 1991, are basically self-contained real estate companies. They are designed to align the interests of active management and passive investors, generate cash flow growth, and create long-term value. Traditionally, REITs relied on mortgage debt to finance their development and acquisition activities. Recently many REITs have taken advantage of their large market capitalization and strong balance sheets to raise cash by issuing debt on an unsecured basis.

30.2 Banks and Savings Institutions

(a) Primary Risks of Banks and Savings Institutions

General business and economic risk factors exist for many industries; however, increased competition and consolidation among banks and savings institutions has resulted in the industry's aggressive pursuit of profitable activities. Techniques for managing assets and liabilities and financial risks have been enhanced in order to maximize income levels. Technological advances have accommodated increasingly complex transactions, such as the sale of securities backed by cash flows from other financial assets. Regulatory policy has radically changed the business environment for banks, savings, and other financial institutions. Additionally, there are other risk factors common to most banks and savings institutions, based on their business activities. The Dodd-Frank Act establishes stricter disclosure requirements and restricts banks' risk-taking appetite by encouraging them to redesign their business lines and services. The other primary risk factors are described next.

(i) Interest Rate Risk

Interest rate risk is the risk that adverse movements in interest rates may result in loss of profits since banks and savings institutions routinely earn on assets at one rate and pay on liabilities at another rate. Techniques used to minimize interest rate risk are a part of asset/liability management.

(ii) Liquidity Risk

Liquidity risk is the risk that an institution may be unable to meet its obligations as they become due. An institution may acquire funds short term and lend funds long term to obtain favorable interest rate spreads, thus creating liquidity risk if depositors or creditors demand repayment. The primary function of banks in transforming short-term deposits into long-term loans makes them vulnerable to liquidity risk. Effective liquidity risk management is essential to banks to ensure their ability to meet cash flow obligations. The Basel Committee on Banking Supervision of the Bank for International Settlements (BIS) has released several publications designed to strengthen global capital and liquidity regulations to promote a more resilient global banking sector. The BIS (2010, 2011) has established guidance on managing liquidity risk that provides details on:

the importance of establishing a liquidity risk tolerance;
the maintenance of an adequate level of liquidity, including through a cushion of liquid assets;
the necessity of allocating liquidity costs, benefits and risks to all significant business activities;
the identification and measurement of the full range of liquidity risks, including contingent liquidity risks;
the design and use of severe stress test scenarios;
the need for a robust and operational contingency funding plan;
the management of intraday liquidity risk and collateral; and
public disclosure in promoting market discipline.

(iii) Asset-Quality Risk

Asset-quality risk is the risk that the loss of expected cash flows due to, for example, loan defaults and inadequate collateral will result in significant losses. Examples include credit losses from loans and declines in the economic value of mortgage servicing rights, resulting from prepayments of principal during periods of falling interest rates.

(iv) Fiduciary Risk

Fiduciary risk is the risk of loss arising from failure to properly process transactions or handle the custody, management, or both, of financial-related assets on behalf of third parties. Examples include administering trusts, managing mutual funds, and servicing the collateral behind asset-backed securities.

(v) Processing Risk

Processing risk is the risk that transactions will not be processed accurately or timely, due to large volumes, short periods of time, unauthorized access of computerized records, or the demands placed on both computerized and manual systems. Examples include electronic funds transfers, loan servicing, and check processing.

(vi) Operating Risk

Operating risk is the risk that losses can occur from internal failures and external events aside from financial risk. Operating risk is the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from adverse effects of external events. This risk imposes a new capital charge to cover losses associated with operational risk.

(vii) Market Risk

Market risk is a risk that associated with earning volatility that caused by adverse price movements in the bank's principal trading positions. Market risk can be measured in terms of value at risk (VAR).

(b) Regulation and Supervision of Banks and Savings Institutions

The legal system that governed the financial services industry in the United States was created in response to the stock market crash of 1929 and the resulting Great Depression. Thousands of banks went out of business, and, in response, Congress passed the Glass-Steagall Act in 1933. Glass-Steagall prohibited commingling the businesses of commercial and investment banking. Its intent was to restrict banks from engaging in business activities that allegedly contributed to and accelerated the stock market crash. In the view of legislators, the way to do this was to confine banks to certain strictly defined activities.

In 1945, Congress enacted the McCarran-Ferguson Act as comprehensive legislation governing the insurance industry. McCarran-Ferguson effectively delegated the responsibility for regulating the business of insurance to the states. Since then, the states have maintained autonomy in their regulatory role with relatively minor, but increasing, exceptions. With the Bank Holding Company Act of 1956 and amendments in 1970, Congress limited affiliations between bank and nonbank businesses.

Section 20 of the Glass-Steagall Act took on a life of its own. It limited banks' ability to own subsidiaries principally engaged in securities underwriting. Over time, that section evolved from being considered a prohibition against any securities underwriting to permitting banks to do so through a subsidiary, as long as underwriting revenues did not exceed 25 percent of total revenues of that subsidiary—thus allowing them to meet the not principally engaged test. Over the years, the effective relaxation of those restrictions enabled numerous acquisitions of securities firms by U.S. bank holding companies and by foreign banks.

These barriers also eroded over time through a combination of changes in customer demands and market activities, the increasing use of more sophisticated financial management techniques, advances in technology, regulatory interpretations, and legal decisions. Product innovation played a role, as the industry learned how to rapidly bundle and unbundle risk, creating new securitization products and accessing the capital markets in ways that had not been contemplated under the then-existing regulatory framework.

As banks assumed a larger role in insurance sales, brokerage, and securities underwriting activities, products began to converge in the marketplace, and the perceived benefits from the convergence of these and related activities instilled a new urgency in the effort to modernize and clarify the regulatory framework governing financial services companies.

The GLB Act amended the Bank Holding Company Act to allow a bank holding company or foreign bank that qualifies as a financial holding company to engage in a broad range of activities that are defined by the Act to be financial in nature or incidental to a financial activity, or that the Federal Reserve Board (the Fed), in consultation with the secretary of the Treasury, determines to be financial in nature or incidental to a financial activity. The GLB Act also allows a financial holding company to seek Board approval to engage in any activity that the Fed determines both to be complementary to a financial activity and not to pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. Bank holding companies that do not qualify as financial holding companies are limited to engaging in those nonbanking activities that were permissible for bank holding companies before the GLB Act was enacted.

On July 21, 2010, President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), which is considered the most sweeping financial reform since the Great Depression. The Act is named after Senate Banking Committee chairman Christopher Dodd (D-CT) and House Financial Services Committee chairman Barney Frank (D-MA), and its provisions pertain to banks, hedge funds, credit rating agencies, and the derivatives market. Dodd-Frank is about 2,300 pages long, and more than 200 regulations that will arise from the Act have not yet been written. Dodd-Frank authorizes the establishment of an oversight council to monitor systemic risk of financial institutions and the creation of a consumer protection bureau within the Federal Reserve. Dodd-Frank requires the development of over 240 new rules by the SEC, the Government Accountability Office (GAO), and the Federal Reserve to implement its provisions over a five-year period. Dodd-Frank will impact many aspects of the financial services industry, including:

Foreign banking organizations and foreign nonbank financial companies
SEC examination and enforcement
Systemic risk/prudential supervision
Banks/bank holding companies
Credit rating agencies
Non-U.S. asset managers
Derivatives
Consumer and mortgage banking
Alternatives (hedge funds/private equity)
Large asset managers
Brokers/dealers
Insurance companies

Some provisions of the Dodd-Frank Act of 2010 are summarized next.

Dodd-Frank broadens the supervisory and oversight role of the Fed to include all entities that own an insured depository institution and other large and nonbank financial services firms that could threaten the nation's financial system.
It establishes a new Financial Services Oversight Council to indentify and address existing and emerging systematic risks threatening the health of financial services firms.
It develops new processes to liquidate failed financial services firms.
It establishes an independent Consumer Financial Protection Bureau to oversee consumer and investor financial regulations and their enforcement.
Dodd-Frank creates rules to regulate over-the-counter (OTC) derivatives.
It coordinates and harmonizes the supervision, setting, and regulatory authorities of the SEC and the Commodities Futures Trading Commission (CFTC).
The Act mandates registration of advisers of private funds and disclosures of certain information of those funds.
It empowers shareholders with a say on pay of nonbonding votes on executive compensation.
The Act increases accountability and transparency for credit rating agencies.
It creates a Federal Insurance Office within the Treasury Department.
It restricts and limits some activities of financial firms, including limiting bank proprietary investing and trading in hedge funds and private equity funds as well as limiting bank swaps activities.
The Act provides cooperation and consistency with international financial and banking standards.
It makes permanent the exemption from its Section 404(b) requirement for nonaccelerated filers (those with less than $75 million in market capitalization).
It requires auditors of all broker-dealers to register with the Public Company Accounting Oversight Board (PCAOB) and gives the PCAOB rulemaking power to require a program of inspection for those auditors.
It empowers the Financial Stability Oversight Council to monitor domestic and international financial regulatory proposals and developments in order to strengthen the integrity, efficiency, competitiveness and stability of the U.S. financial markets.
It makes it easier for the SEC to prosecute aiders and abettors of those who commit securities fraud under the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Advisers Act of 1940 by lowering the legal standard from knowing to knowing or reckless.
Dodd-Frank directs the SEC to issue rules requiring companies to disclose in the proxy statement why they have separated, or combined, the positions of chairman and chief executive officer.

In August 2010, the Basel Committee issued its guidance entitled Microfinance Activities and the Core Principles for Effective Banking Supervision. This supervisory guidance highlights the application of the Basel Core Principles for Effective Banking Supervision (BCP) to microfinance activities in order to improve practices on regulating and supervising microfinance activities. The guidance is intended to assist global banking organizations to develop a coherent and comprehensive approach to microfinance supervision that addresses:

Adequate and specialized knowledge of supervisors to effectively identify and assess risks that are specific to microfinance and microlending
Proper and effective allocation of supervisory resources to microfinance activities
Establishment of a regulatory and supervisory framework that is cost effective and efficient.

(c) Regulatory Background

Banks and savings institutions have special privileges and protections granted by government. These incentives, such as credit through the Federal Reserve System and federal insurance of deposits, have not been similarly extended to commercial enterprises. Accordingly, the benefits and responsibilities associated with their public role as financial intermediaries have brought banks and savings institutions under significant governmental oversight. For example, to stabilize the financial system during the financial crisis caused by subprime mortgage in late 2007 and 2008, several bailouts were implemented by the governments in the United States, the United Kingdom, and some western European countries. In the United States, after the government brokered sale of investment banks Bear Stearns and Lehman Brothers, Treasury secretary Paulson and the chairman of the Federal Reserve Ben S. Bernanke proposed a $700 billion bailout for the stabilization of the financial institutions in September 2008.

As a result of the financial repercussions of the Great Depression, the government took certain measures to maintain the stability of the country's financial system. Several new regulatory and supervisory agencies were created to promote economic stability, particularly in the banking industry, and to strengthen the regulatory and supervisory agencies that were in existence at the time. Among the agencies created were the Federal Deposit Insurance Corporation (FDIC), the SEC, the Federal Home Loan Bank Board (FHLBB), and the Federal Savings and Loan Insurance Corporation (FSLIC). The agencies that were strengthened included the Office of the Comptroller of the Currency (OCC) and the Fed. These entities were responsible for designing and establishing policies and procedures for the regulation and supervision of national and state banks, foreign banks doing business in the United States, and other depository institutions. This regulatory and supervisory structure, created during the 1930s, was in place for almost 60 years. In 1989, Congress enacted the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA), which changed the regulatory and supervisory structure of thrift institutions. The FIRREA eliminated the FHLBB and the FSLIC. In their place, it created the Office of Thrift Supervision (OTS) as the primary regulator of the thrift industry and the Savings Association Insurance Fund (SAIF) as the thrift institutions' insurer to be administered by the FDIC.

Even though several of the aforementioned federal agencies have overlapping regulatory and supervisory responsibilities over depository institutions, in general terms, the OCC has primary responsibility for national banks; the Fed has primary responsibility over state banks that are members of the Fed, all financial holding companies and bank holding companies and their nonbank subsidiaries, and most U.S. operations of foreign banks; the FDIC has primary responsibility for all state-insured banks that are not members of the Fed (nonmember banks); and the OTS has primary responsibility for thrift institutions. Exhibit 30.1 lists these regulatory responsibilities.

Exhibit 30.1 Supervisor and Regulator

(i) Office of the Comptroller of the Currency

The OCC charters, regulates, and supervises all national banks. It also supervises the federal branches and agencies of foreign banks. Headquartered in Washington, DC, the OCC has six district offices plus an office in London to supervise the international activities of national banks.

The OCC was established in 1863 as a bureau of the U.S. Department of the Treasury. The OCC is headed by the Comptroller, who is appointed by the president, with the advice and consent of the Senate, for a five-year term. The Comptroller also serves as a director of the FDIC and a director of the Neighborhood Reinvestment Corporation.

The OCC's nationwide staff of examiners conducts on-site reviews of national banks and provides sustained supervision of bank operations. The agency issues rules, legal interpretations, and corporate decisions concerning banking, bank investments, bank community development activities, and other aspects of bank operations.

National bank examiners supervise domestic and international activities of national banks and perform corporate analyses. Examiners analyze a bank's loan and investment portfolios, funds management, capital, earnings, liquidity, sensitivity to market risk, and compliance with consumer banking laws, including the Community Reinvestment Act. They review the bank's internal controls, internal and external audit, and compliance with law. They also evaluate bank management's ability to identify and control risk.

In regulating national banks, the OCC has the power to:

Examine the banks.
Approve or deny applications for new charters, branches, capital, or other changes in corporate or banking structure.
Take supervisory actions against banks that do not comply with laws and regulations or that otherwise engage in unsound banking practices. The agency can remove officers and directors, negotiate agreements to change banking practices, and issue cease-and-desist orders as well as civil money penalties.
Issue rules and regulations governing bank investments, lending, and other practices.

(ii) Federal Reserve Board

The Fed was created by Congress in 1913 by the Federal Reserve Act. The primary role of the Fed as the nation's central bank is to establish and conduct monetary policy as well as to regulate and supervise a wide range of financial activities. The structure of the Fed includes a board of governors, 12 Federal Reserve banks, and the member banks. The board of governors consists of seven members appointed by the president, subject to Senate confirmation. National banks must be members of the Fed. State banks are not required to, but may elect to, become members. Member banks and other depository institutions are required to keep reserves with the Fed, and member banks must subscribe to the capital stock of the reserve bank in the district to which they belong.

Since all national banks are supervised by the OCC, the Fed primarily regulates and supervises member state banks, including administering the registration and reporting requirements of the 1934 Act.

The regulatory and supervisory functions and other services provided by the Fed include:

Examining the Federal Reserve banks, state member banks, bank holding companies and their nonbank subsidiaries, and state licensed U.S. branches of foreign banks
Requiring reports of member and other banks
Setting the discount rate
Providing credit facilities to members and other depository institutions for liquidity and other purposes
Monitoring compliance with the money-laundering provisions contained in the Bank Secrecy Act
Regulating transactions between banking affiliates
Approving or denying applications by state banks to become members and to branch or merge with nonmember banks
Approving or denying applications to become bank holding companies and for bank holding companies to acquire bank or nonbank subsidiaries
Approving or denying applications by foreign banks to establish representative offices, branches, agencies, or bank subsidiaries in the United States
Supplying currency when needed
Regulating the establishment of foreign operations of national and state member banks and the operations of foreign banks doing business in the United States
Enforcing legislation and issuing rules and regulations dealing with consumer protection
Operating the nation's payment system

The Fed recently undertook several initiatives to mitigate the negative impacts of the financial crisis. These include:

Extending credit facilities to financial institutions and thus improved market liquidity
Lowering interest rates to eventually a zero-interest-rate policy by the end of 2008
Taking several quantitative measures to reduce long-term-interest rates and purchase treasury bonds and Fannie Mae and Freddie Mac MBS
Increasing deposit insurance limits and guaranteeing bank debt
Ordering the 19 largest banks holding companies to conduct compensation stress tests to ensure that they had sufficient capital to with stand financial difficulties and be able to raise needed capital

(iii) Federal Deposit Insurance Corporation

The FDIC was created under the Banking Act of 1933. The main reason for its creation was to insure bank deposits in order to maintain economic stability in the event of bank failures. FIRREA restructured the FDIC during 1989 to carry out broadened functions by insuring thrift institutions as well as banks. The FDIC now insures all depository institutions except credit unions.

The FDIC is an independent agency of the U.S. government, managed by a five-member board of directors, consisting of the Comptroller of the Currency, the director of the OTS, and three other members, including a chairman, appointed by the president, subject to Senate confirmation.

The FDIC insures deposits under two separate funds: the Bank Insurance Fund (BIF) and the SAIF. From its BIF, the FDIC insures national and state banks that are members of the Fed. These institutions are required to be insured. Also insured from this fund are state nonmember banks and a limited number of insured branches of foreign banks. (After 1991, foreign bank branches could no longer apply for FDIC insurance.)

From its SAIF, the FDIC insures all federal savings and loan associations and federal savings banks. These institutions are required to be insured. State thrift institutions are also insured from this fund.

Currently, each account, subject to certain FDIC rules, in an insured depository institution is insured to a maximum of $250,000. Other responsibilities of the FDIC include:

Supervising the liquidation of insolvent insured depository institutions
Providing financial support and additional measures to prevent insured depository institution failures
Supervising state nonmember insured banks by conducting bank examinations; regulating bank mergers, consolidations, and establishment of branches; and establishing other regulatory controls
Administering the registration and reporting requirements of the 1934 Act as applied to state nonmember banks

(iv) Office of Thrift Supervision

In 1989, FIRREA created the OTS under the Department of the Treasury. The OTS regulates federal and state thrift institutions and thrift holding companies. As a principal rule maker, examiner, and enforcement agency, OTS exercises primary regulatory authority to grant federal thrift institution charters, approve branching applications, and allow mutual-to-thrift charter conversions. OTS is headed by a presidentially appointed director. The 12 district Federal Home Loan Banks (FHLBs) continue to be the primary source of credit for thrift institutions.

(d) Regulatory Environment

The early 1980s were marked by the removal of interest rate ceilings, the applications of reserve requirements to all depository institutions, expanded thrift powers, and related deregulatory actions. However, the failures of a large number of thrift institutions and commercial banks caused legislators in 1989 and 1991 to increase regulatory oversight. Both FIRREA and the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) were directed toward protection of federal deposit insurance funds through early detection of an intervention in problem institutions with an emphasis on capital adequacy. FIRREA also established the Resolution Trust Corporation (RTC), which took over the conservatorship and liquidation of a large number of failed thrift institutions due to the bankruptcy of the FSLIC. The RTC completed its mission in 1996 at a net cost of approximately $150 billion to the federal government.

In addition to safety and soundness considerations, current banking regulations recognize economic issues, such as the desire for banks and savings institutions to compete successfully with other, less regulated financial services providers and to address social issues, such as community reinvestment, nondiscrimination, and fair treatment in consumer credit, including residential lending. Costs and benefits of regulations are weighed as the approach to regulation of the industry is redefined.

Many provisions of Dodd-Frank are considered to be positive and useful in protecting consumers and investors, including the establishment of a consumer protection bureau and a systemic risk regulator and provisions requiring derivatives to be put on clearinghouses/exchanges. The new Consumer Financial Products Commission (CFPC) will make rules for most retail products offered by banks, such as certificates of deposit and consumer loans. The Dodd-Frank Act requires managers of hedge funds (but not the funds themselves) with more than $150 million in assets to register with the SEC. Some provisions are subject to study and further regulatory actions by regulators, including the so-called Volcker rule to be implemented. Dodd-Frank fails to address the misconception of too-big-to-fail financial institutions, the main cause of the financial crisis—Fannie Mae, Freddie Mac, and the housing agencies and the excessive use of market-based short-term funding by financial services firms.

The Basel Committee on Banking Supervision is intended to strengthen global capital and liquidity regulations to promote a more resilient banking sector with proper ability to absorb shocks arising from financial and economic stress and to improve risk management, governance, transparency, and disclosures. The Basel Committee examines the market failures caused by the recent financial crisis and establishes measures to strengthen bank-level and micro-prudential regulation to address the stability of the global financial system.

(e) Federal Deposit Insurance Corporation Improvement Act Section 112

Regulations implementing Section 36 of the Federal Deposit Insurance Act (FDI Act), as added by Section 112 of FDICIA, became effective July 2, 1993. These regulations imposed additional audit, reporting, and attestation responsibilities on management, directors (especially the audit committee), internal auditors, and independent accountants of banks and savings institutions with $500 million or more in total assets. The reporting requirements were effective for fiscal years ending on or after December 31, 1993. Congress amended the law in 1996 to eliminate attestation reports concerning compliance with certain banking laws; however, management is still required to report on compliance with such laws.

(i) The Regulation and Guidelines

The Dodd-Frank Act of 2010 is aimed at minimizing the probability of future financial crises and systemic distress by empowering regulators to mandate higher capital requirements and establish a new regulatory regime for large financial firms. The Act is intended to provide more cost-effective and efficient regulatory guidelines for financial service firms and other impacted organizations. These regulatory guidelines are presented in Appendix A to the Act. The guidelines often leave discretion to an institution or its board, while simultaneously providing guidance that, if followed, would provide a safe harbor from examiner criticism.

(ii) Basic Requirements

Each FDIC-insured depository institution with assets in excess of $500 million at the beginning of its fiscal year (covered institutions) is subject to requirements concerning its annual report, corporate governance, and audit committee.

Annual Report

Covered institutions must file an annual report, within 90 days of their fiscal year-end, with the FDIC and other appropriate state or federal bank regulators. The annual report must include:

1. Audited financial statements prepared in accordance with generally accepted accounting principles (GAAP) and audited by a qualified independent public accountant (IPA).

2. A management report signed by its CEO and chief financial officer or chief accounting officer containing:

A statement of management's responsibilities for:
- Preparing the annual financial statements
- Establishing and maintaining an adequate internal control structure and procedures for financial reporting.
- Complying with particular laws designated by the FDIC as affecting the safety and soundness of insured depositories.
Assessment by management of:
- The effectiveness of the institution's internal control structure and procedures for financial reporting as of the end of the fiscal year.
- The institution's compliance, during the fiscal year, with the designated safety and soundness laws. Only two kinds of safety and soundness laws must be addressed in the compliance report: (a) federal statutes and regulations concerning transactions with insiders and (b) federal and state statutes and regulations restricting the payment of dividends.

3. An attestation report, by an IPA, on internal control structure and procedures for financial reporting. The institution's IPA must examine, attest to, and report separately on management's assertions about internal controls and about compliance. The attestations are to be made in accordance with generally accepted standards for attestation engagements.

In Financial Institution Letter (FIL) No. 86-94, the FDIC indicated that financial reporting, at a minimum, includes financial statements prepared under GAAP and the schedules equivalent to the basic financial statements that are included in the institution's appropriate regulatory report (e.g., Schedules RC, RI, and RI-A in the Call Report).

On February 6, 1996, the Board of the FDIC amended the procedures that IPAs follow in testing compliance to streamline the procedures and to reduce regulatory burden. Financial services firms must also comply with Sections 302, 906, and 404 of the Sarbanes-Oxley Act of 2002 (SOX) to include executive certifications of both financial statements and internal control over financial reporting in their annual reports files with regulators and submitted to shareholders.

Corporate Governance

The globalization of capital markets and financial institutions demands convergence in regulatory reforms and corporate governance measures and practices. Corporate governance measures are state and federal statutes, judicial deliberations, listing standards, and best practices. In the United States, SOX and financial reform legislation signed into law in July 2010 the Dodd–Frank Wall Street Reform and Consumer Protection Act have established new regulatory reforms for financial institutions. The U.K. corporate governance reforms are specified in the 2003 Combined Code on Corporate Governance.

In October 2010, the Basel Committee issued its Principles for Enhancing Corporate Governance to promote effective corporate governance of financial institutions and banking organizations worldwide. These corporate governance principles address:

The role of the board
The qualifications and composition of the board
The importance of an independent risk management function, including a chief risk officer or equivalent
The importance of monitoring risks on an ongoing firm-wide and individual entity basis
The board's oversight of the compensation systems
The board's and senior management's understanding of the bank's operational structure and risks

The International Federation of Accountants (IFAC) and the United Nations Conference on Trade and Development (UNCTAD) hosted an Accountancy Summit on October 12, 2010. Participants from more than 50 countries collectively supported the next points relevant to convergence in global corporate governance (IFAC, 2010):

The accountancy profession has a key role to play in strengthening corporate governance and facilitating the integration of governance and sustainability into the strategy, operations, and reporting of an organization.

Boards should be focused on the long-term sustainability of their businesses. As such, corporate governance reform must include strengthening board oversight of management, positioning risk management as a key board responsibility, and encouraging remuneration practices that balance risk and long-term (social, environmental, and economic) performance criteria.

Governance is more than having the right structures, regulation, and principles in place—it is about ensuring that the right behaviors and processes are in place.

Governance mechanisms need to be strengthened at banks and other companies to ensure better oversight of risk management and executive compensation.

More dialogue is needed between policy makers, the accounting profession, and other financial industries to consider how we can work together effectively on a global level.

Audit Committee

Covered institutions must establish an independent audit committee composed of directors who are independent of management. The entire board of directors annually is required to adopt a resolution documenting its determination that the audit committee has met all FDIC-imposed requirements.

The audit committee of any large financial institutions (i.e., total assets of more than $3 billion, measured as of the beginning of each fiscal year) must include members with banking or related financial management expertise, have access to its own outside counsel, and not include any large customers of the institution. If a large institution is a subsidiary of a holding company and relies on the audit committee of the holding company to comply with this rule, the holding company audit committee must not include any members who are large customers of the subsidiary institution. Appendix A to Part 363 of the Federal Deposit Insurance Act provides guidelines in determining whether the audit committee meets these criteria.

The audit committee is required to review with management and the IPA the basis for the reports required by the FDIC's regulation. The FDIC suggests, but does not mandate, additional audit committee duties, including overseeing internal audit, selecting the IPA, and reviewing significant accounting policies.

Each subject institution must provide its independent accountant with copies of the institution's most recent reports of condition and examination; any supervisory memorandum of understanding or written agreement with any federal or state regulatory agency; and a report of any action initiated or taken by federal or state banking regulators.

Recent global financial crises and related economic meltdown underscore the importance of board committees, particularly the audit committee in overseeing managerial function of troubled banks and other financial institutions. Audit committees in the post-SOX world are required to protect investor interests by assuming more effective oversight responsibilities in the areas of internal controls, financial reporting, risk assessment, audit activities, and compliance with applicable laws and regulations. In the post-SOX period, the audit committee selects the bank's external auditor and reviews the company's annual audited financial statements and internal control over financial reporting.

Lawmakers (SOX), regulators (SEC rules), and listing standards of national stock exchanges (New York Stock Exchange, Nasdaq, American Stock Exchange) generally require public committees to have an audit committee, which must be composed of independent directors with no personal, financial, or family ties to management. Rezaee (2007) states that:

Audit committee members must be independent.
Audit committee members to select and oversee the issuer's independent account.
There must be a procedural process for handling complaints regarding the issuer's accounting practice.
The audit committee is authorized to engage advisors.

Audit committee oversight responsibilities can be grouped into eight categories:

1. Corporate governance. The audit committee should protect investor interests by overseeing managerial functions in planning, coordinating, and monitoring bank's financial activities.

2. Internal controls. The audit committee should review management and external auditor reports on the effectiveness of internal control over financial reporting.

3. Financial reporting. The audit committee should review and oversee executive certifications on the completeness and accuracy of financial statements.

4. Audit activities. The audit committee should be in charge of hiring, firing, compensating, and overseeing audit activities as well as reviewing external auditors' reports on financial statements and internal control over financial reporting.

5. Code of ethics conduct. The audit committee should review and oversee the design, implementation and enforcement of the bank's code of ethical conduct.

6. Whistleblower program. The audit committee should oversee the design and implementation of banks' whistleblower policies and programs to ensure that employees, customers, and others can come forward in reporting bank irregularities, violations of laws, and other concerns without being retaliated against.

7. Enterprise risk management. The audit committee should oversee the proper development and functioning of bank risk management in addressing liquidity, interest rate, operating, credit, and other risks presented in the previous sections.

8. Financial statement fraud. The audit committee should oversee bank antifraud policies and procedures designed to prevent and detect financial reporting fraud.

(iii) Holding Company Exception

In some instances, FDIC regulation requirements may be satisfied by a bank's or savings association's parent holding company. The requirement for audited financial statements always may be satisfied by providing audited financial statements of the consolidated holding company. The requirements for other reports, as well as for an independent audit committee, may be satisfied by the holding company if:

The holding company's services and functions are comparable to those required of the depository institution.
The depository institution has total assets as of the beginning of the fiscal year either of less than $5 billion or equal to or greater than $5 billion and a Capital adequacy, Asset quality, Management administration, Earnings, and Liquidity (CAMELS) composite rating of 1 or 2. Section 314(a) of the Riegle Community Development and Regulatory Improvement Act of 1994 amended Section 36(i) of the FDI Act to expand the holding company exception to be equal to or greater than $5 billion. The requirement that the institution must have a CAMELS composite rating of 1 or 2 remained unchanged.

The appropriate federal banking agency may revoke the exception for any institution with total assets in excess of $9 billion for any period of time during which the appropriate federal banking agency determines that the institution's exception would create a significant risk to the affected deposit insurance fund.

(iv) Availability of Reports

All of management's reports are made publicly available. The independent accountant's report on the financial statements and attestation report on financial reporting controls is also made publicly available. SOX requires public reporting on:

The audit committee review of both financial statements and internal control over financial reporting
Management certifications of accuracy and completeness of financial statements and the effectiveness of internal control over financial reporting
External auditor report on fair presentation of financial statements and the effectiveness of internal control over financial reporting
Other financial reports released by management (management Discussion &Analysis, MD&A, earnings guidance).

(f) Capital Adequacy Guidelines

Capital is one of the primary tools used by regulators to monitor the financial health of insured banks and savings institutions. Statutorily mandated supervisory intervention is focused primarily on an institution's capital levels relative to regulatory standards. The federal banking agencies detail these requirements in their respective regulations under capital adequacy guidelines. The capital adequacy requirements are implemented through quarterly regulatory financial reporting (Call Reports and Thrift Financial Reports (TFRs)).

On September 12, 2010, global bank regulators agreed to require banks to significantly increase their amount of top-quality capital in an attempt to prevent further international financial crisis. The Basel III a global regulatory standard on bank capital liquidity, will require banks to maintain top-quality capital totaling 7 percent of their risk-bearing assets compared to the currently required 2 percent. Effective compliance with Basel III rules, which become effective in January 2019, would require banks to raise substantial new capital over the next several years. The primary objective of Basel III rules is to strengthen global capital standards to ensure sustainable financial stability and growth for banks worldwide. The rules are intended to encourage banks to engage in appropriate risk strategies to ensure their financial health and their ability to withstand financial shocks without government bailout supports. Specifically, Basel III will require banks to: (1) maintain top-quality capital (Tier 1 capital, consisting or equity and retained earnings) up to 4.5 percent of their assets; (2) hold a new separate capital conservation buffer of common equity worth at least 2.5 percent of their assets; and (3) build a separate countercyclical buffer of up to 2.5 percent when their credit markets are booming. The Tier 1 rule will take effect from January 2015, and the requirement for the capital conversation buffer will be phased in between January 2016 and January 2019.

(i) Risk-Based and Leverage Ratios

Capital adequacy is measured mainly through two risk-based capital ratios and a leverage ratio, with thrifts subject to an additional tangible capital ratio.

(ii) Tier 1, Tier 2, and Tier 3 Components

Regulatory capital is composed of three components: core capital or Tier 1, supplementary capital or Tier 2, and for those institutions meeting market risk capital requirements, Tier 3. Tier 1 capital includes elements such as common stock, surplus, retained earnings, minority interest in consolidated subsidiaries and qualifying preferred stock, adjustments for foreign exchange translation, and unrealized losses on equity securities available for sale with readily determinable market values. Tier 2 capital includes, with certain limitations, elements such as general loan loss reserves, certain forms of preferred stock, long-term preferred stock, qualifying intermediate-term preferred stock and term subordinated debt, perpetual debt, and other hybrid debt/equity instruments. Tier 3 capital consists of short-term subordinated debt that meets certain conditions and may be used only by institutions subject to market-risk capital requirements to the extent that Tier 1 and Tier 2 capital elements do not provide adequate Tier 1 and total risk-based capital ratio levels.

Specifically, Tier 3 capital:

Must have an original maturity of at least two years
Must be unsecured and fully paid up
Must be subject to a lock-in clause that prevents the issuer from repaying the debt even at maturity if the issuer's capital ratio is, or with repayment would become, less than the minimum 8 percent risk-based capital ratio
Must not be redeemable before maturity without the prior approval of the institution's supervisor
Must not contain or be covered by any covenants, terms, or restrictions that may be inconsistent with safe and sound banking practices.

Tier 2 capital elements individually and together are variously restricted in proportion to Tier 1 capital, which is intended to be the dominant capital component.

Certain deductions are made to determine regulatory capital, including goodwill and other disallowed intangibles, excess portions of qualifying intangibles and deferred tax assets, investments in unconsolidated subsidiaries, and reciprocal holdings of other bank's capital instruments. Certain adjustments made to equity under GAAP for unrealized gains and losses on debt and equity securities available for sale under Financial Accounting Standards Board (FASB) Statement No. 115, mainly unrealized gains, are excluded from Tier 1 and total capital. Portions of qualifying, subordinated debt, and limited-life preferred stock exceeding 50 percent of a bank's Tier 1 capital are also deducted. Any regulatory capital deduction is also made to average total assets for ratio computation purposes. The new market-risk capital guidelines discussed in section vi also contained further capital constraints, by stating that the sum of Tier 2 and Tier 3 capital allocated for market risk may not exceed 250 percent of Tier 1 capital allocated for market risk. Thrift's tangible capital is generally defined as Tier 1 capital less intangibles.

(iii) Risk-Weighted Assets

The capital ratios are calculated using the applicable regulatory capital component in the numerator and either risk-weighted assets or total adjusted on-balance-sheet assets as the denominator, as appropriate. Risk-weighted assets are ascertained pursuant to the regulatory guidelines that allocate gross average assets among four categories of risk weights (0, 20, 50, and 100 percent). The allocations are based mainly on type of asset, type of obligor, and nature of collateral, if any. Gross assets include on-balance-sheet assets, credit equivalents of certain off-balance-sheet exposures, and credit equivalents of certain assets sold with recourse, limited recourse, or that are treated as financings for regulatory reporting purposes.

Credit equivalents of off-balance-sheet exposures are determined by the nature of the exposure. For example, direct credit substitutes (e.g., standby letters of credit) are credit converted at 100 percent of the face amount. Other off-balance-sheet activities are subject to the current exposure method, which is composed of the positive mark-to-market value (if any) and an estimate of the potential increase in credit exposure over the remaining life of the contract. These add-ons are estimated by applying defined credit conversion factors, differentiated by type of instrument and remaining maturity, to the contract's notional value. The nature and extent of recourse impacts the calculation of credit equivalents amounts of assets sold or securitized. In December 2001, the banking agencies issued a final rule amending the agencies' regulatory capital standards to align more closely the risk-based capital treatment of recourse obligations and direct credit substitutes. The rule also varies the capital requirements for position in securitized transactions and certain other exposures according to their relative credit risk and requires capital commensurate with the risks associated with residual interests.

(iv) Capital Calculations and Minimum Requirements

The capital ratios, calculations, and minimum requirements are presented in Exhibit 30.2.

Exhibit 30.2 Capital Ratio Calculations and Minimum Requirements

Source: Basel III Accord: The new Basel III framework. www.basel-iii-accord.com

In summary, Basel III rules set forth tougher capital requirements by providing more restrictive capital definitions, requiring higher risk-weighted assets, capital buffers, and higher minimum capital ratios. These Basel III standards are expected to affect profitability and transformation of the business models of many banks as well as other bank activities in regard to stress testing, counterparty risk, and capital management infrastructure. Implementation of provisions of Basel III is expected to demand more standardized risk-adjusted capital requirements that will enable investors to better analyze and compare risk-adjusted performance

In the United State, the Supervisory Capital Assessment Program (SCAP) has increased capital levels by requiring many U.S. banks to increase their capital levels (the current Tier 1 common median for U.S. banks is 9 percent) and providing an adequate transition period of eight years to generate further capital buffers through earnings generation.

(v) Interest Rate Risk and Capital Adequacy

OTS capital rules require that certain savings associations with excessive interest rate risk exposure (as defined) must deduct 50 percent of the estimated decline in its net portfolio value resulting from a 200 basis point change in market interest rates in excess of 2 percent of the estimated economic value of portfolio assets. In August 1995, the banking agencies amended their minimum capital requirements explicitly to include consideration of interest rate risk but did not establish a means for quantifying that risk to a specific amount of additional capital. During 1996, the federal bank regulatory agencies approved a policy statement on sound practices for managing interest rate risk in commercial banks but did not include a standardized framework for measuring interest rate risk. The agencies elected not to pursue a standardized measure and explicit capital charge for interest rate risk due to concerns about the burden, accuracy, and complexity of a standardized measure and recognition that industry techniques for measuring interest rate risk are continuing to evolve.

(vi) Capital Allocated for Market Risk

In September 1996, the federal bank regulatory agencies—the OCC, FDIC, and Fed—amended their respective risk-based capital standards to address market risk. Specifically, an institution subject to the market risk capital requirement must adjust its risk-based capital ratio to take into account the general market risk of all positions located in its trading account and foreign exchange and commodity positions, wherever located and for the specific risk of debt and equity positions located in its trading account. Market risk capital requirements generally apply to any bank or bank holding company whose trading activities equal 10 percent or more of its total assets or whose trading activity equals $1 billion or more. In addition, on a case-by-case basis, an agency may require an institution that does not meet the applicability criteria to comply with the market risk guidelines, if the agency deems it necessary for safety and soundness purposes, or may exclude an institution that meets the applicability criteria.

No later than January 1, 1998, institutions with significant market risk were required to:

Maintain regulatory capital on a daily basis at an overall minimum of 8 percent ratio of total qualifying capital to risk-weighted assets, adjusted for market risk
Include a supplemental market-risk capital charge in their risk-based capital calculations and quarterly regulatory reports
Maintain appropriate internal measurement, reporting, and risk management systems to generate and monitor the basis for the VAR and the associated capital charge

The institution's risk-based capital ratio adjusted for market risk is its risk-based capital ratio for purposes of prompt corrective action and other statutory and regulatory purposes.

Institutions are permitted to use different assumptions and modeling techniques reflecting distinct business strategies and approaches to risk management. The agencies do not specify VAR modeling parameters for internal risk management purposes; however, they do specify minimum qualitative requirements for internal risk management processes as well as certain quantitative requirements for the parameters and assumptions for internal models used to measure market risk exposure for regulatory capital purposes.

There are several models of risk assessment and management, including most widely used models of VAR developed through statistical ideas and probability theories. VAR utilizes a group of related models that share a mathematical framework by measuring the boundaries of risk in a portfolio over short durations. The portfolio can consist of equities, bonds, derivatives, or other financial instruments, and risks can be measured in terms of diversification, leverage, and volatility as a proxy for market risk. VAR takes into consideration both individual risks and firm-wide risks.

Financial institutions use VAR to quantify their risk positions for both internal and external purposes. The extensive use of derivatives by many firms in the late 1990s and the early 2000s encouraged regulators such as the SEC and the Basel Committee to establish rules and guidance to require public quantitative disclosures of market risks in their financial statements. VAR then became the primary model of assessing and managing risks. The Basel Committee even allowed banks to rely on their own internal VAR measures in determining their capital requirements.

Backtesting

Institutions must perform backtests of their VAR measures as calculated for internal risk management purposes. The backtests must compare daily VAR measures calibrated to a one-day movement in rates and prices and a 99 percent (one-tailed) confidence level against the institution's actual daily net trading profit or loss (trading outcome) for each of the preceding 250 business days. The backtests must be performed once each quarter. An institution's obligation to backtest for regulatory capital purposes does not arise until the institution has been subject to the final rule for 250 business days (approximately one year) and, thus, has accumulated the requisite number of observations to be used in backtesting. Institutions that are found not to have appropriate models and backtesting programs or if backtesting results reflect insufficient accuracy likely will be required to incorporate more conservative calculation factors that would result in a higher capital charge for market risk. It has been argued that too much reliance on VAR and its widespread use in determining capital requirement do not consider the important risk of potential financial meltdown.

Basel rules require that bank stress tests consist of:

The stressed VAR (SVAR), which is computed on a 10-day 99 percent confidence level and three times the 10-day 99 percent stressed VAR will should be maintained
Model inputs that are calibrated to historical data from a continuous 12-month period of significant financial stress
Maintenance, on a daily basis, of the capital requirements determined based on the higher of its latest stress VAR number and an average of SVAR numbers calculated over the preceding 60 business days multiplied by the multiplication factor

Risk factors considered in pricing models should also be included in VAR calculations.

(g) Prompt Corrective Action

The federal banking agencies are statutorily mandated to assign each FDIC-insured depository institution to one of five capital categories, quantitatively defined by the risk-based and leverage capital ratios.

1. Well capitalized. The capital level significantly exceeds the required minimum level for each relevant capital category.

2. Adequately capitalized. The capital level meets the minimum level.

3. Undercapitalized. The capital level fails to meet one or more of the minimum levels.

4. Significantly undercapitalized. The capital level is significantly below one or more of the minimum levels.

5. Critically undercapitalized. The ratio of tangible equity (as statutorily defined) to total assets is 2 percent or less.

Institutions falling into the last three categories are subject to a variety of prompt corrective actions, such as limitations on dividends, prohibitions on acquisitions and branching, restrictions on asset growth, and removal of officers and directors. Irrespective of the ratios reported, the agencies may downgrade an institution's capital category based on adverse examination findings.

The regulatory capital ratio ranges defining the prompt corrective action capital categories are summarized in Exhibit 30.3.

Exhibit 30.3 Regulatory Capital Categories

Federally insured banks and savings institutions are required to have periodic full-scope, on-site examinations by the appropriate agency. In certain cases, an examination by a state regulatory agency is accepted. Full-scope and other examinations are intended primarily to provide early identification of problems at insured institutions rather than as a basis for expressing an opinion on the fair presentation of the institution's financial statements. The Dodd-Frank Act has substantially increased the enforcement oversight function of the SEC and the Federal Reserve Board and their examination programs to regulate the financial services industry effectively.

(i) Scope

The scope of an examination is generally unique to each institution based on risk factors assessed by the examiner. Some examinations are targeted to a specific area of operations, such as real estate lending or trust operations. Separate compliance examination programs also exist to address institutions' compliance with laws and regulations in areas such as consumer protection, insider transactions, and reporting under the Bank Secrecy Act.

(ii) Regulatory Rating Systems

Regulators use regulatory rating systems to assign ratings to banks, thrifts, holding companies, parents of foreign banks, and U.S. branches and agencies of foreign banking organizations. The rating scales vary, although each is based on a 5-point system, with 1 (or A) being the highest rating. The rating systems are presented in Exhibit 30.4. Additionally, in November 1995, the Fed issued Supervision and Regulation Letters (SR) No. 95-51, Rating the Adequacy of Risk Management Processes and Internal Controls at State Member Banks and Bank Holding Companies. It states that Federal Reserve System examiners, beginning in 1996, are instructed to assign a formal supervisory rating to the adequacy of an institution's risk management processes, including its internal controls.

Exhibit 30.4 Regulatory Rating Systems

The Dodd-Frank Act addresses activities, practices and structure of the nationally recognized statistical rating organizations (NRSROs), better known as credit rating agencies. Specifically, provisions of Dodd-Frank pertaining to NRSROs include:

Mandating internal control requirements for NRSROs
Improvements in governance practices of NRSROs
Addressing potential conflicts of interest of NRSROs
Imposing new liability exposure on NRSROs
Requiring new methodology and procedures to be used in credit ratings process
Requiring more transparent disclosures on credit ratings process
Increasing SEC oversight of NRSROs

(iii) Risk-Focused Examinations

Over the last two decades, the banking agencies have been developing and implementing a risk-focused examination/supervisory program that focuses on the business activities that pose the greatest risks to the institutions and assesses an organization's management systems to identify, measure, monitor, and control its risks. Bank examiners should learn from factors that caused the global financial crisis, pay attention to all types of bank risks, and recognize the importance of risk-focused examination and supervision in preventing further financial crises. It is evidenced the extend, nature and complexity of international financial transactions, in the years preceding the start of financial crisis in 2007, bank supervisors and examiners failed to develop adequate and effective risk-focused techniques to properly deal with the complex situations.

(h) Enforcement Actions

Regulatory enforcement is carried out through a variety of informal and formal mechanisms. Informal enforcement measures are consensual between a bank and its regulator but are not legally enforceable. Formal measures carry the force of law and are issued subject to certain legal procedures, requirements, and penalties. Examples of formal enforcement measures include ordering an institution to cease and desist from certain practices of violations, removing an officer, prohibiting an officer from participating in the affairs of the institution or the industry, assessing civil money penalties, and terminating insurance of an institution's deposits. As previously discussed, other mandatory and discretionary actions may be taken by regulators under prompt corrective action provisions of the FDI Act. The Dodd-Frank Act has provided more resources and mechanisms for U.S. regulators such as the SEC and the Federal Reserve to more effectively enforce irregularities and violations of securities laws that threaten the health and financial stability of the nation. The Dodd-Frank Act directs regulators to issue more than 240 rules in implementing its provisions such as the Volcker rule, which would ban proprietary trading by those banks that benefit from Fed borrowing privileges and deposit insurance as well as whistle-blowing rules in providing incentives and protections for whistleblowers to report violations of securities laws and other irregularities to regulators.

(i) Disclosure of Capital Matters

Beginning in 1996, the American Institute of Certified Public Accountants (AICPA) Audit Guide for Banks and Savings Institutions required that GAAP financial statements of banks and savings associations include footnote disclosures of regulatory capital adequacy/prompt corrective action categories. There are five minimum disclosures:

1. A description of the regulatory capital requirements (a) for capital adequacy purposes and (b) established by the prompt corrective action provisions

2. The actual or possible material effects of noncompliance with such requirements

3. Whether the institution is in compliance with the regulatory capital requirements, including, as of each balance sheet date presented:

a. The institution's required and actual ratios and amounts of Tier 1 leverage, Tier 1 risk-based, total risk-based capital, and, for savings institutions, tangible capital, and (for certain banks and bank holding companies) Tier 3 capital for market risk

b. Factors that may significantly affect capital adequacy, such as potentially volatile components of capital, qualitative factors, and regulatory mandates

4. The prompt corrective action category in which the institution was classified as of its most recent notification, as of each balance sheet date presented

5. Whether management believes any conditions or events since notification have changed the institution's category, as of the most recent balance sheet date

If, as of the most recent balance sheet date presented, the institution is (1) not in compliance with capital adequacy requirements, (2) considered less than adequately capitalized under the prompt corrective action provisions, or (3) both, the possible material effects of such conditions and events on amounts and disclosures in the financial statements should be disclosed. Additional disclosures may be required where there is substantial doubt about the institution's ability to continue as a going concern.

These disclosures should be presented for all significant subsidiaries of a holding company. Bank holding companies should also present the disclosures as they apply to the holding company, except for the prompt corrective disclosure required by item 4.

As with all footnotes to the financial statements, any management representations included in the footnotes, such as with respect to capital matters, would be subject to review by the independent accountant. Provisions of Dodd-Frank and Basel III rules have significantly increase disclosures of capital requirements for many banks and other financial institutions.

(j) Securities and Exchange Commission

(i) Background

The SEC was created by Congress in 1934 to administer the Securities Act of 1933 (1933 Act) and the Securities Exchange Act of 1934 (1934 Act). The SEC is an independent agency of the U.S. government, consisting of five commissioners appointed by the president, subject to Senate confirmation.

The 1933 Act requires companies to register securities with the SEC before they may be sold, unless the security or the transaction is exempt. Banks are exempt from the registration requirements of the 1933 Act; however, bank holding companies and their nonbank subsidiaries are not.

(ii) Reporting Requirements

SEC registrants are required to comply with certain industry-specific financial statement requirements set forth in Article 9 for bank holding companies of SEC Regulation S-X. In addition, they must comply with other nonfinancial disclosures required by industry Guide 3for bank holding companies of Regulation S-K.

In 1997, the SEC amended rules and forms for domestic and foreign issuers to clarify and expand existing disclosure requirements for market risk-sensitive instruments. Refer to Financial Reporting Release No. 48, Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative Information about Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments, for further discussion. Other SEC guidance is listed in Section 30.5. Additionally, the SEC is undertaking a review of Guide 3 to evaluate potential changes to improve the usefulness of financial institution disclosures.

On December 12, 2001, the SEC issued a financial reporting release, Final Rule (FR) 60, Cautionary Advice Regarding Disclosure about Critical Policies. The SEC's Cautionary Advice alerts public companies to the need for improved disclosures about critical accounting policies. FR 60 defines critical accounting policies as those most important to the financial statement presentation and that require the most difficult, subjective, complex judgments.

Perhaps because FR 60 was released late in the year, the management's discussion and analysis (MD&A) disclosures made by registrants in response to FR 60 did not meet the SEC's expectations. As a result, on May 10, 2002, the SEC published a proposed rule, Disclosure in Management's Discussion and Analysis about the Application of Critical Accounting Policies, by focusing on the MD&A disclosure about critical accounting estimates that was encouraged in FR 60, but it is much more specific than FR 60 as to the nature of the disclosures and the basis for the sensitivity analysis.

On January 22, 2002, the SEC issued a financial reporting release, FR 61, which provides specific considerations for MD&A disclosures. The SEC issued FR 61 to remind public companies of existing MD&A disclosure requirements and to suggest steps for meeting those requirements in 2001 annual reports. FR 61 focuses on MD&A disclosure about liquidity and off-balance-sheet arrangements (including special-purpose entities [SPE]), trading activities that include non-exchange traded commodity contracts accounted for at fair value, and the effects of transactions with related and certain other parties. These areas have received particular public and regulatory scrutiny following the collapse of Enron. The SEC believes that the quality of information provided by public companies in these areas should be improved. The SEC expects registrants to consider FR 61 when preparing year-end and interim financial reports, effective immediately. Finally, in December 2003, the SEC released its interpretive guidance regarding MD&A, FR 72, which promotes more meaningful disclosure pertaining to overall presentation and content of MD&A by focusing on demands, trends, events, commitments, uncertainties, risk assessment, capital resources and critical accounting policies, methods and estimates.

Dodd-Frank enhances the SEC's oversight function on the financial services industry in five ways by:

1. Providing incentives and protection for witnesses to come forward in reporting violations of the security laws

2. Expanding the types of charges that the SEC can bring against those who help others violate the securities laws with aiding and abetting or secondary liability

3. Giving the SEC additional resources and means to sanction wrongdoers

4. Encouraging cooperation among regulators, such as the PCAOB and foreign securities regulators

5. Requiring disclosure of additional information to the SEC, including requiring foreign auditors to produce workpapers upon request and institutional investors to report on data on their short sales activities on at least a monthly basis.

(k) Financial Statement Presentation

(i) Income Statements

Banks and savings institutions place heavy emphasis on the interest margin (i.e., the difference between interest earned and the cost of funds). Accordingly, a specialized income statement format has evolved that focuses on net interest income. Supplemental income statement information may be provided separately to show the impact of investing in certain tax-exempt securities. Such taxable equivalent data purports to illustrate income statement data as if such tax-exempt securities were fully taxable.

(ii) Balance Sheets

The balance sheets of banks and savings institutions are not classified into short-term and long-term categories for assets and liabilities but are generally presented in descending order of maturity. Supplemental information is also presented by many banking institutions showing average balances of assets and liabilities and the associated income or expense and average rates paid or earned.

(iii) Statements of Cash Flow

The statements of cash flow are presented in accordance with Statement of Financial Accounting Standards (SFAS) No. 95, Statement of Cash Flows, amended by SFAS No. 102, Statement of Cash Flows—Exemption of Certain Enterprises and Classification of Cash Flows from Certain Securities Acquired for Resale (an Amendment of FASB Statement No. 95), and SFAS No. 104, Statement of Cash Flows—Net Reporting of Certain Cash Receipts and Cash Payments and Classification of Cash Flows for Hedging Transactions (an amendment of FASB Statement No. 95). The amendments permit certain financial institutions, such as banks and savings institutions, to net the cash flows for selected activities such as trading, deposit taking, and loan activities. The FASB, in December 2004, issued revised SFAS No. 123R, Share-Based Payment. SFAS No. 123R replaces SFAS No. 123, Accounting for Stock-Based Compensation. Among other provisions, SFAS No. 123R amends SFAS No. 95, Statement of Cash Flows, requiring firms to report excess tax benefits arising from expensing employee stock options as a financial cash flow rather than an operating cash flow.

(iv) Commitments and Off-Balance-Sheet Risk

Banks and savings institutions offer a variety of financial services, and, accordingly, they enter into a wide range of financial transactions and issue a variety of financial instruments. Depending on the nature of these transactions, they may not appear on the balance sheet and are only disclosed in the footnotes to the financial statements. SFAS No. 105, Disclosure of Information about Financial Instruments Off-Balance Sheet Risk and Financial Instruments with Concentrations of Credit Risk, footnote disclosures of off-balance-sheet financial instruments and derivatives provide additional risk-relevant information above and beyond that provided by the balance sheet.

(v) Disclosures of Certain Significant Risks and Uncertainties

AICPA Statement of Position (SOP) No. 94-6, Disclosure of Certain Significant Risks and Uncertainties, requires institutions to include in their financial statements disclosures about the nature of their operations and the use of estimates in the preparation of their financial statements.

SOP No. 94-6 also requires disclosure regarding:

Certain significant estimates. Estimates used in the determination of the carrying amounts of assets or liabilities or in gain or loss contingencies are required to be disclosed when information available prior to issuance of the financial statements indicates that (a) it is at least reasonably possible that the estimate of the effect on the financial statements of a condition, situation or set of circumstances that existed at the date of the financial statements will change in the near term due to one or more future confirming events, and (b) the effect of the change would be material to the financial statements.
SOP No. 94-6 further states that (a) the disclosure should indicate the nature of the uncertainty and include an indication that it is at least reasonably possible that a change in the estimate will occur in the near term and (b) if the estimate involves a loss contingency covered by SFAS No. 5, Accounting for Contingencies, the disclosure should also include an estimate of the possible loss or range of loss, or state that such an estimate cannot be made.
Current vulnerability due to certain concentrations. Institutions are required to disclose concentrations, as defined in the Statement, if, based on information known to management prior to issuance of the financial statements, (a) the concentration exists at the date of the financial statements, (b) the concentration makes the institution vulnerable to the risk of a near-term severe impact, and (c) it is at least reasonably possible that the events that could cause the severe impact will occur in the near term
Provisions of Dodd-Frank and Basel III rules are considered as macroprudential reforms intended to focus on systemic risks. The systemic risk is the risk that banks and other financial institutions may pose on the global financial system. Financial institutions should provide proper disclosure of their systemic risk.

(l) Accounting Guidance

In addition to the main body of professional accounting literature that comprises GAAP, more specific industry guidance is provided in the industry-specific audit and accounting guides published by the AICPA, specifically Banks and Savings Institutions issued in 2000. Additionally, the Emerging Issues Task Force (EITF) of the FASB addresses current issues.

(m) Generally Accepted Accounting Principles versus Regulatory Accounting Principles

Under the Federal Financial Institutions Examination Council (FFIEC), the three federal banking agencies have developed uniform reporting standards for commercial banks that are used in the preparation of the reports of condition and income (Call Reports). The FDIC has also applied these uniform Call Report standards to savings banks under its supervision. Effective with the March 31, 1997, reports, the reporting standards set forth for the Call Reports are based on GAAP for banks. As a matter of law, many banks deviate from GAAP to a more stringent requirement only in those instances where statutory requirements or overriding supervisory concerns warrant a departure from GAAP. The OTS maintains its own separate reporting forms for the savings institutions under its supervision. The reporting form used by savings institutions, known as the TFR, is based on GAAP as applied by savings institutions, which differs in some respects from GAAP for banks.

Certain differences between GAAP and regulatory accounting principles remain after the amendments to the March 1997 Call Report Instructions. Many of these differences remain because the agencies generally default to SEC reporting principles for registrants. The more significant remaining differences between Call Report Instructions and GAAP are related to these areas:

Impaired collateral-dependent loans
Pushdown accounting
Credit losses on off-balance-sheet commitments and contingencies
Related party transactions
Application of accounting changes

(n) Loans and Commitments

Loans generate the largest proportion of revenues of most banks and saving institutions. Institutions originate, purchase and sell (in whole or in part), and securitize loans. The parameters used to create the loan portfolio include many of the institution's key strategies, such as credit risk strategy, diversification strategy, liquidity, and interest rate margin strategy. Accordingly, the composition of the loan portfolio varies by institution. The loan portfolio is critical to the institutions' overall asset/liability management strategy.

(i) Types of Loans

Loans are offered on a variety of terms to meet the needs of the borrower and of the institution. The types of loan arrangements normally issued are discussed next.

Commercial Loans

Institutions have developed different types of credit facilities to address the needs of commercial customers. Some of the characteristics that distinguish these facilities are:

Security (whether the loan is collateralized or unsecured)
Term (whether the loan matures in the short term, long term, on demand, or on a revolving credit arrangement)
Variable or fixed interest rates
Currency (whether the loan is repayable in the local currency or in a foreign currency)

Loan facilities can be tailored to match the needs of commercial borrowers and may include many combinations of specific loan terms. Some of the common general types are described next.

Secured Loans

Collateral (security) to a loan is usually viewed as a characteristic of any type of loan rather than as a loan category itself. Nevertheless, it is not uncommon for institutions to analyze their loan portfolios in part by looking at the proportion of secured credits and the entire balance.

A significant portion of bank lending is not supported by a specific security. The less creditworthy a potential borrower, however, the more likely it becomes that an institution will require some form of collateral in order to minimize its risk of loss.

Loan security is normally not taken with the intention of liquidating it in order to obtain repayment. Maintenance and liquidation of collateral is, in fact, often time consuming and unprofitable for the foreclosing bank. Most loan security takes the form of some kind of fixed or floating claim over specified assets or a mortgage interest in property.

Lines of Credit

Lines of credit, including facilities that are referred to as revolving lines of credit, originate with an institution extending credit to a borrower with a specified maximum amount and a stated maturity. The borrower then draws and repays funds through the facility in accordance with its requirements. Lines of credit are useful for short-term financing of working capital or seasonal borrowings. A commitment fee is usually charged on the unused portion of the facility.

Demand Loans

Demand loans are short-term loans that may be called by the institution at any time, hence the term demand. Demand loans are often unsecured and are normally made to cover short-term funding requirements. There is usually no principal reduction during the loan term; the entire balance comes due at maturity.

Term Loans

Term loans are often used to finance the acquisition of capital assets such as plant and equipment. Due to their longer term, they involve greater credit risk than short-term advances (all other things being equal). To reduce the credit risk, these loans typically are secured and require amortization of principal over the loan term. Loan agreements often contain restrictive covenants that require the borrower to maintain specified financial ratios and to refrain from defined types of transactions for as long as the loan is outstanding.

Asset-Based Lending

Asset-based lending is a form of revolving line of credit that is related directly to the value of specific underlying assets (typically accounts receivable or inventory). The primary difference between asset-based lending and a simple line of credit is the direct correlation, upon which the institution insists, between the funds advanced and the underlying security. While funds may be advanced on a line of credit up to the approved maximum amount, they may be drawn under an asset-based lending arrangement only to the extent allowed by predetermined formulas related to collateral value. Requests for funds are normally monitored closely, and repayments may be demanded where collateral values fall.

Syndications

A syndicated loan is one where a number of institutions, in a form of joint venture, provide funds they would individually be unwilling or unable to provide. Syndications are used for customers requiring large-scale financing, too great for any single institution to accommodate without distorting its loan portfolio. In addition, consortium banks group together banks from different countries to specialize in and centralize large-scale finance for specific projects.

In a syndicate, its members appoint one or more members as the managing bank. In certain cases, the borrower might appoint the managing bank, in which case the other members commonly appoint an agent bank to act on their behalf. The managing bank is responsible for negotiating with the borrower, preparing the appropriate documentation, collecting the loan funds from the syndicate and disbursing them to the borrower, and collecting amounts due from the borrower and distributing them to the syndicate members.

Apart from the managing bank, the syndicate members will not necessarily have any direct dealings with the borrower, although the borrower is aware of the existence of the syndicate. Credit risk rests with each syndicate member to the extent of its participation.

Participations

Banks sell loans, or part shares in loans, to other financial institutions for a number of reasons, including to: serve large customers whose financing needs exceed their lending ability; diversify their loan portfolios; alter the maturity structure of their loan portfolios; or increase their liquidity. Participation agreements usually specify such matters as the method of payment of proceeds from the borrower, responsibilities in the event of default, and interest in collateral. Loans may be sold with or without recourse and on terms that may or may not agree with those of the underlying loan.

Loans that are participated out (i.e., sold) are normally reported on the seller's balance sheet net of the sold portion (which is reported with other loan assets by the buyer). The fact that another institution has researched and agreed to extend the loan does not reduce the risk of the purchasing bank.

Loans Held for Resale

Loans may be originated by an institution that intends to resell them to other parties. They may be purchased with the intention to resell. The reasons for such transactions vary. Some institutions wish to provide a type of loan service to their customers that they do not wish to retain in their portfolio. Some institutions use loan origination as a source of fee income. Some purchase debt to use as securitization for other instruments that they package and sell to specialized markets.

Real Estate Loans

Real estate loans may be made for commercial or personal purposes, and most banks differentiate their portfolios between the two uses. The rationale for this segregation lies in the fact that while both are classified as real estate lending, the portfolios are subject to different types of risk and/or different degrees of risk. Also, the type and level of expertise required to manage residential and commercial real estate loan portfolios successfully differs, just as the type of financing provided to the homeowner is typically not the same as to an owner or developer of commercial real estate.

Incremental knowledge with respect to the particular financing provided must be obtained and constantly updated to manage commercial real estate property lending successfully. For example, construction loan monitoring, appraisal methods, comparable properties in the area, the status of the economy, use of the property, future property developments, occupancy rates, and projected operating cash flows are all important factors in reaching lending decisions.

Mortgage Loans

Real estate mortgage loans are term loans collateralized by real estate. The loans are generally fairly long term, though some are short term with a large principal (balloon) payment due at maturity. The loan commitments usually involve a fee to be paid by the borrower upon approval or upon closing.

Some institutions originate residential mortgage loans for sale to investors. Under these arrangements, the bank usually continues to service the loans on a fee basis. The sale allows the bank to provide mortgage financing services for its customers without funding a large volume of loans.

Construction Loans

Construction loans are used to finance the construction of particular projects and normally mature at the scheduled completion date. They are generally secured by a first mortgage on the property and are backed by a purchase (or takeout) agreement from a financially responsible permanent lender. They may include the financing of loan interest through the construction period.

Construction loans are vulnerable to a number of risks related to the uncertainties that are characteristic of building projects. Examples of risks associated with construction loans include construction delays, nonpayment of material bills or subcontractors, and the financial collapse of the project contractor prior to project completion.

Construction loan funds are generally disbursed on a standard payment plan (for relatively small, predictable projects) or a progress payment plan (for more complex projects). Extent of completion may be verified by an architect's certification or by evidence of labor and material costs.

In certain construction loans, consideration should be given to accounting for the loan as an investment in real estate if the lender is subject to virtually the same risks and rewards as the owner.

Direct Lease Financing

Leasing is a form of debt financing for fixed assets that, although differing in legal form, is similar to substance to term lending. Like a more conventional loan, the institution's credit concerns in extending lease financing are ones of cash flow, credit history, management, and projections of future operations. The type of property to be leased and its marketability in the event of default or termination of the lease are concerns quite parallel to the bank's evaluation of collateral. In a leasing arrangement, the bank formally owns the property rather than having a lien on it.

Lease financing arrangements may be accounted for either as financings (i.e., as loans) or as operating leases, depending on the precise terms of the transaction and on the applicable accounting principles.

Consumer Loans

Consumer loans—personal loans to individual borrowers—can originate through a bank's own customers (direct loans) or through merchants with whom the borrowers deal (indirect loans). They may relate specifically to the purchase of items that can serve as collateral for the borrowing (e.g., vehicles, mobile homes, boats, furniture) or to other needs that provide no basis for a security interest (e.g., vacations, income tax payments, medical expenses, educational costs). Consumer loans may be made on an installment, single payment, or demand basis. They are often broken down into classifications that describe the purpose of the financing (student loans or home equity loans) or the terms of disbursement and repayment (installment loans, credit card loans, check credit).

Installment Loans

Installment loans are the most common type of consumer credit. Their terms normally include repayment over a specified period of time with fixed minimum periodic (usually monthly) payments. Interest rates are generally fixed on origination but may be variable over the term of the loan. The term is generally determined by the type of purchase being financed and is usually relatively short—10 years or less.

Standby Letters of Credit

A standby letter of credit is a promise made by an institution to provide compensation to a third party on behalf of its customer in the event that the customer fails to perform in accordance with the terms specified by an underlying contract. Standby letters of credit may be available under a credit facility or may be issued for a specified amount with an expiration date. Normally, payment under such agreements depends on performance or lack of performance of some act required by the underlying contract.

Standby letters of credit are typically recorded as contingent liabilities in memorandum records and are offset by customer liability memorandum accounts. In the event that funds are disbursed under a standby letter of credit agreement, the drawing would be recorded as a loan.

Sovereign Risk

Sovereign risk lending involves the granting of credit facilities to foreign governments or to companies based in foreign countries. The facilities are normally denominated in a currency other than the domestic currency of the borrower and are typically used to finance imports or to refinance existing foreign currency debt.

In addition to all of the customary considerations surrounding credit risk, sovereign risk lending involves economic, social, and political considerations that bear on the ability of the borrower to repay foreign currency obligations.

Trade Finance

Trade finance is made up of letters of credit and bankers' acceptances.

Letters of credit are instruments used to facilitate trade (most commonly international trade) by substituting an institution's credit for that of a commercial importing company. A letter of credit provides assurance to a seller that he or she will be paid for goods shipped. At the same time, it provides assurance to the buyer that payment will not be made until conditions specified in the sales contract have been met.

Letter of credit transactions can vary in any number of ways. The issuing and advising institutions may deal with each other through their own local correspondent banks. Some of the documents may flow in different patterns. The requirements for payment and security will certainly vary from transaction to transaction. One of the attractive features of letter of credit financing from the customer's point of view is its flexibility. Facilities can be tailored to individual transactions or groups of transactions.

A bankers' acceptance is like a letter of credit in that it provides a seller of goods with a guarantee of payment, thus facilitating trade. The institution's customer is the buyer who, having established an acceptance facility with the bank, notifies the seller to draw up a bill of exchange. The bank accepts that bill (by physically stamping accepted on its face and having an authorized bank officer sign it) and, in so doing, commits itself to disburse funds on the bill's due date.

A banker's acceptance represents both an asset and a liability to the accepting bank. The asset is a receivable from the bank's customer, the buyer in the transaction. The liability is a payable to the holder of the acceptance. The bank's accounting for open acceptances varies from country to country. In some countries, the asset and liability are both reflected on the bank's balance sheet. In others, they are netted against each other and thus become, in effect, off-balance-sheet items. In European Union countries, they appear as memorandum items on the face of the balance sheet.

By substituting its own credit for that of the buying company, the accepting bank creates a financial instrument that is readily marketable. Bankers' acceptances trade as bearer paper on active secondary markets.

Mortgage-Backed Securities

Mortgage-backed securities (MBSs) are asset-backed securities having cash flows backed by the principal and interest payments of a pool of mortgage loans that are made periodically over the lifetime of the underlying loans. Collateralized mortgage obligations (CMOs) are more complex than MBSs and consist of pools of home mortgages backed by government-insured agencies, such as Freddie Mac and Fannie Mae. MBSs and CMOs became popular with investors in the late 1990s and the early 2000s. During the subprime mortgage crisis period in late 2006 and 2007, many investors holding MBSs or CMOs suffered substantial losses because the values of the underlying assets sharply declined.

(ii) Accounting for Loans

Principal

Loans expected to be held until maturity should be reported as outstanding principal, net of charge-offs, specific valuation accounts and any deferred fees or costs, or unamortized premiums or discounts on purchased loans. Total loans should be reduced by the allowance for credit losses.

Loans held for sale should be reported at the lower of cost or fair value determined as of the balance sheet. Mortgage loans held for sale should be reported at the lower of cost or market value in conformity with SFAS No. 65, Accounting for Certain Mortgage Banking Activities. Mortgage-backed securities held for sale in conjunction with mortgage banking activities shall be classified as trading securities and reported at fair value in conformity with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities.

The amount by which the cost exceeds the fair value may be accounted as a valuation allowance. Any change in the valuation allowance maybe included for determining the net income. This may be accounted for the period for which the change is occurring. The fair value of mortgage loans and mortgage backed securities held for sale is essentially determined by the type of loan. The loans are further determined by the next classes:

Committed loans. The investor commitment will form the base for fair values of loans.
Uncommitted loans. The fair value for these loans is based on the market where the mortgage banking entity functions.
Uncommitted MBSs. The fair value for such loans collateralized by a mortgage banking entity's own loans are based on the fair value of the securities.

Interest

Interest income on all loans should be accrued and credited to interest income as it is earned using the interest method. Interest income on certain impaired loans should be recognized in accordance with SFAS No. 114, Accounting by Creditors for Impairment of a Loan, as amended by SFAS No. 118, Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures.

The accrual of interest is usually suspended on loans that are in excess of 90 days past due, unless the loan is both well secured and in the process of collection. When a loan is placed on such nonaccrual status, interest that has been accrued but not collected is reversed, and interest subsequently received is recorded on a cash basis or applied to reduce the principal balance depending on the bank's assessment of ultimate collectability of the loan. An exception to this rule is that many banks do not place certain types of consumer loans on nonaccrual status since they automatically charge off such loans within a relatively short period of becoming delinquent—generally within 120 days.

Loan Fees

Various types of fees are collected by banks in connection with lending activities. SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (an Amendment of FASB Statements No. 13, 60, and 65 and a Rescission of FASB Statement No. 17), requires that the majority of such fees and associated direct origination costs be offset. The net amount must be deferred as part of the loan (and reported as a component of loans in the balance sheet) and recognized in interest income over the life of the loan and/or loan commitment period as an adjustment of the yield on the loan. The requirements for cost deferral under this standard are quite restrictive and require direct linkage to the loan origination process. Activities for which costs may be deferred include: (1) evaluating the borrower, guarantees, collateral, and other security; (2) preparation and processing of loan documentation for loan origination; and (3) negotiating and closing the loan. Certain costs are specifically precluded from deferral—for example, advertising and solicitation, credit supervision and administration, costs of unsuccessful loan originations, and other activities not directly related to the extension of a loan.

Loan fees and costs for loans originated or purchased for resale are deferred and are recognized when the related loan is sold.

Commitment fees to purchase or originate loans, net of direct origination costs, are generally deferred and amortized over the life of the loan when it is extended. If the commitment expires, then the fees are recognized in other income on expiration of the commitment. There are two main exceptions to this general treatment:

1. If past experience indicates that the extension of a loan is unlikely, then the fee is recognized over the commitment period.

2. Nominal fees, which are determined retroactively, on a commitment to extend funds at a market rate may be recognized in income at the determination date.

Certain fees, primarily loan syndication fees, may be recognized when received. Generally, the yield on the portion of the loan retained by the syndicating bank must at least equal the yield received by the other members of the syndicate. If this is not the case, a portion of the fees designated as a syndication fee must be deferred and amortized to income to achieve a yield equal to the average yield of the other banks in the syndicate. EITF Issue No. 97-3, Accounting for Fees and Costs Associated with Loan Syndication's and Loan Participation's after the Issuance of FASB Statement No. 125, states that loan participation should be accounted for in accordance with the provision of SFAS No. 140 and loan syndications should be accounted for in accordance with the provision of SFAS No. 91.

Purchased loans are recorded at cost net of fees paid/received. The difference between this recorded amount and the principal amount of the loan is amortized to income over the life of the loan to produce a level yield. Acquisition costs are not deferred but are expensed as incurred. AICPA Statement of Position (SOP) 03-3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer, was issued in December 2003 which addresses purchased loan with certain deterioration and requires the portion of the acquired or selling institution's allowance relevant to the purchased impaired loans should no longer be added to the acquiring bank's allowance.

Acquisition, Development, and Construction Arrangements

Certain transactions that appear to be loans are considered effectively to be investments in the real estate property financed. These transactions are required to be presented separately from loans and accounted for as real estate investments using the guidance set forth in the AICPA Notice to Practitioners dated February 1986. This notice was reprinted without any change in November 1987 issues as Exhibit I in the Appendix of the AICPA Practice Bulletin. Factors indicating such treatment include six arrangements whereby the financial institution:

1. Provides substantially all financing to acquire, develop, and construct the property (i.e., borrower has little or no equity in the property)

2. Funds the origination or commitment fees through the loan

3. Funds substantially all interest and fees through the loan

4. Has security only in the project with no recourse to other assets or guarantee of the borrower

5. Can recover its investment only through sale to third parties, refinancing, or cash flow of the project

6. Is unlikely to foreclose on the project during development since no payments are due during this period and therefore the loan cannot normally become delinquent

Troubled Debt Restructurings and Impaired Loans

Banks may routinely restructure loans to meet a borrower's changing circumstances. The new loan terms are reflected in the financial statements essentially as if a new loan has been made. However, if a creditor for economic or legal reasons related to the debtor's financial difficulties grants a concession…that it would not otherwise consider, then SFAS No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, as amended by FASB Statements No. 114; No. 121, Accounting for Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed Of; and No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, applies.

The guidance in the impairment or disposal of Long-Lived Assets Subsections is applicable to the following activities:

A. The transactions relating to the long lived assets to be held and used or to be disposed of, including:

Capital leases of lessees
Long-lived assets of lessors subject to operating leases
Proved oil and gas properties that are being accounted for using the successful-efforts method of accounting
Long-term prepaid assets

B. The following relates to assets and liabilities which are further considered part of an asset group or a disposal group:

In case a long lived asset belongs to a group which further includes other assets and liabilities not covered; the guidance will apply to such group. In such scenarios the unit of accounting is its group. If the long lived asset has to held and used, it is classified as an asset group. In case the long lived asset is to be disposed of by sale or otherwise, it is then classified as a disposal group.
The guidance does not affect the GAAP applicable to those other individual assets and liabilities not covered by the Impairment or Disposal of Long-Lived Assets Subsections that are included in such groups.

The guidance in the impairment or disposal of Long-Lived Assets Subsections of SFAS No.114 (ASC-310) is not applicable to certain transactions. They include the following activities but are not limited to such activities:

Goodwill
Intangible assets not being amortized that are to be held and used
Servicing assets
Financial instruments, including investments in equity securities accounted for under the cost or equity method
Deferred policy acquisition costs
Deferred tax assets

Troubled Debt Restructurings

Troubled debt restructurings may include one or more of these changes:

Transfers of assets of the debtor or an equity interest in the debtor to partially or fully satisfy a debt
Modification of debt terms, including reduction of one or more of the following: (1) interest rates with or without extensions of maturity date(s), (2) face or maturity amounts, and (3) accrued interest

Prior to the release of SFAS No. 114, under a SFAS No. 15 restructuring involving a modification of terms, the creditor accumulated the undiscounted total future cash receipts and compared them to the recorded investment in the loan. If these cash receipts exceeded the recorded investment in the loan, no loss or impairment was deemed to exist; however, if the total cash receipts did not exceed the recorded investment, the recorded investment was adjusted to reflect the total undiscounted future cash receipts. For restructurings involving a modification of terms that occurred before the effective date of SFAS No. 114, this accounting still applies as long as the loan does not become impaired relative to the restructured terms. Restructurings involving a modification of terms after the effective date of SFAS No. 114 must be accounted for in accordance with SFAS No. 114.

Impaired Loans

In May 1993, SFAS No. 114 was issued primarily to provide more consistent guidance on the application of SFAS No. 5 loss criteria and to provide additional direction on the recognition and measurement of loan impairment in determining credit reserve levels. The application of this statement was required beginning in 1995.

SFAS No. 114 applies to all impaired loans, uncollateralized as well as collateralized, except:

Large groups of smaller balance homogeneous loans that are collectively evaluated for impairment, such as credit card, residential mortgage, and consumer installment loans
Loans that are measured at fair value or at the lower of cost or fair value
Leases
Debt securities, as defined in SFAS No. 115

A loan is impaired when, based on current information and events, it is probable (consistent with its use in SFAS No. 5—an area within a range of the likelihood that a future event or events will occur confirming the fact of the loss) that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. As used in SFAS No. 114 and in SFAS No. 5, as amended, all amounts due according to the contractual terms means that both the contractual interest payments and the contractual principal payments of a loan will be collected as scheduled in the loan agreement.

It is important to note that an insignificant delay or insignificant shortfall in the amount of payments does not require application of SFAS No. 114. A loan is not impaired during a period of delay in payment if the creditor expects to collect all amounts due including interest accrued at the contractual interest rate for the period of delay.

SFAS No. 114 provides that the measurement of impaired value should be based on one of these methods:

Present value of expected cash flows discounted at the loan's effective interest rate
The observable value of the loan's market price
The fair value of the collateral if the loan is collateral dependent

The effective rate of a loan is the contractual interest rate adjusted for any net deferred loan fees or costs, premium, or discount existing at the origination or acquisition of the loan. For variable rate loans, the loan's effective interest rate may be calculated based on the factor as it changes over the life of the loan, or it may be fixed at the rate in effect at the date the loan meets the SFAS No. 114 impairment criterion. However, that choice should be applied consistently for all variable rate loans.

All impaired loans do not have to be measured using the same method; the method selected may vary based on the availability of information and other factors. However, the ultimate valuation should be critically evaluated in determining whether it represents a reasonable estimate of impairment.

If the measure of the impaired loan is less than the recorded investment in the loan (including accrued interest, net deferred loan fees or costs, and unamortized premium or discount), a creditor should recognize an impairment by creating a valuation allowance with a corresponding charge to bad-debt expense.

Subsequent to the initial measurement of impairment, if there is a significant change (increase or decrease) in the amount or timing of an impaired loan's expected future cash flows, observable market price, or fair value of the collateral, a creditor should recalculate the impairment by applying the procedures described earlier and by adjusting the valuation allowance. However, the net carrying amount of the loan should at no time exceed the recorded investment in the loan.

Any restructurings performed under the provisions of SFAS No. 15 need not be reevaluated unless the borrower is not performing in accordance with the contractual terms of the restructuring.

EITF Issue No. 96-22, Applicability of the Disclosures Required by FASB Statement No. 114 When a Loan Is Restructured in a Troubled Debt Restructuring into Two (or More) Loans (now ASC Topic 310), states that when a loan is restructured in a troubled debt restructuring into two (or more) loan agreements, the restructured loans should be considered separately when assessing the applicability of the disclosures in years after the restructuring because they are legally distinct from the original loan. However, the creditor would continue to base its measure of loan impairment on the contractual terms specified by the original loan agreements.

In-Substance Foreclosures

SFAS No. 114 clarified the definition of in-substance foreclosures as used in SFAS No. 15 by stating that the phrase foreclosure by the creditor in paragraph 34 should be read to mean physical possession of debtor's assets regardless of whether formal foreclosure proceedings take place. Further, until foreclosure occurs, these assets should remain as loans in the financial statements.

(o) Credit Losses

Credit loss estimates are subjective and, accordingly, require careful judgments in assessing loan collectability and in estimating losses.

(i) Accounting Guidance

SFAS No. 114 and SFAS No. 5, are the primary sources of guidance on accounting for the allowance for loan losses. Also, the Accounting Standards Update 2010-20 released by the FASB mentions the Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. In summary, this update offers greater transparency about an entity's allowance for credit losses and the credit quality of its financing receivables. SFAS No. 5 requires that an estimated loss from a contingency should be accrued by a charge to income if both of the next conditions are met:

Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
The amount of loss can be reasonably estimated.

SFAS No. 5 states that when a loss contingency exists, the likelihood that the future event or events will confirm the loss or impairment of an asset (whether related to contractual principal or interest) can range from remote to probable. Probable means the future event or events are likely to occur; however, the conditions for accrual are not intended to be so rigid that they require virtual certainty before a loss is accrued.

The allowance for loan losses should be adequate to cover probable credit losses related to specifically identified loans as well as probable credit losses inherent in the remainder of the loan portfolio that have been incurred as of the balance sheet date. Credit losses related to off-balance-sheet instruments should also be accrued if the conditions of SFAS No. 5 are met.

Actual credit losses should be deducted from the allowance, and the related balance should be charged off in the period in which it is deemed uncollectable. Recoveries of loans previously charged off should be added to the allowance when received.

SFAS No. 114 addresses the accounting by creditors for impairment of certain loans, as discussed in Subsection 30.2(n)(ii).

(ii) Regulatory Guidance

The regulatory agencies issued the Interagency Policy on the Allowance for Loan and Lease Losses (ALLL) in December 1993. The policy statement provides guidance with respect to:

The nature and purpose of the allowance
The related responsibilities of the board of directors, management, and the bank examiners
Adequacy of loan review systems
Issues related to international transfer risk

The policy statement also includes an analytical tool to be used by bank examiners for assessing the reasonableness of the allowance; however, the policy statement cautions the bank examiners against placing too much emphasis on the analytical tool rather than performing a full and thorough analysis.

The OCC also provides guidance in its Comptrollers' Handbook, Allowance for Loan and Lease Losses, issued in June 1996.

In separate releases on July 6, 2001, the SEC and the FFIEC issued guidance on methodologies and documentation related to the allowance for loan losses. In Staff Accounting Bulletin (SAB) No. 102, Selected Loan Loss Allowance Methodology and Documentation Issues, the SEC Staff expressed certain of their views on the development, documentation, and application of a systematic methodology as required by FR 28 for determining allowances for loan and lease losses in accordance with GAAP. In particular, the guidance focuses on the documentation the staff normally would expect registrants to prepare and maintain in support of their allowances for loan losses. Concurrent with the release of SAB No. 102, the federal banking agencies issued related guidance through the FFIEC entitled Policy Statement on Allowance for Loan and Lease Losses (ALLL) Methodologies and Documentation for Banks and Savings Institutions. The Policy Statement, developed in consultation with the SEC Staff, provides guidance on the design and implementation of ALLL methodologies and supporting documentation practices. Both SAB No. 102 and the Policy Statement reaffirm the applicability of existing accounting guidance; neither attempts to overtly change GAAP as they relate to the ALLL.

(iii) Allowance Methodologies

An institution's method of estimating credit losses is influenced by many factors, including the institution's size, organization structure, business environment and strategy, management style, loan portfolio characteristics, loan administration procedures, and management information systems.

Common Factors to Consider

Although allowance methodologies may vary between institutions, the factors to consider in estimating credit losses are often similar. Both SAB No. 102 and the Policy Statement require that when developing loss measurements, banks consider the effect of current environmental factors and then document which factors were used in the analysis and how those factors affected the loss measurements. Examples of factors that should be considered are presented next:

Levels of and trends in delinquencies and impaired loans
Levels of and trends in charge-offs and recoveries
Trends in volume and terms of loans
Effects of any changes in risk selection and underwriting standards, and other changes in lending policies, procedures, and practices
Experience, ability, and depth of lending management and other relevant staff
National and local economic trends and conditions
Industry conditions
Effects of changes in credit concentrations

Supplemental data, such as historical loss rates or peer group analyses, can be helpful; however, they are not, by themselves, sufficient basis for an allowance methodology.

Portfolio Segments

Another common practice is dividing the loan portfolio into different segments. Each segment typically includes similar characteristics, such as risk classification and type of loan. Segments typically include large problem loans by industry or collateral type and homogeneous pools of smaller loans, such as credit cards, automobile loans, and residential mortgages.

Credit Classification Process

A credit classification process involves categorizing loans into risk categories and is often applied to large loans that are evaluated individually. The categorization is based on conditions that may affect the ability of borrowers to service their debt, such as current financial information, historical payment experience, credit documentation, public information, and current trends. Many institutions classify loans using a rating system that incorporates the regulatory classification system. These definitions are presented next.

Special Mention

Some loans are considered criticized but not classified. Such loans have potential weaknesses that deserve management's close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the assets or of the institution's credit position at some future date. Special mention loans are not adversely classified and do not expose an institution to sufficient risk to warrant adverse classification.

Substandard

Loans classified as substandard are inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Doubtful

Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loss

Loans classified as loss are considered uncollectable and of such little value that their continuance as bankable assets is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value but rather that it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be effected in the future.

Pools of Smaller-Balance Homogeneous Loans

Loans not evaluated individually are included in pools and loss rates are derived for each pool.

The loss rates to be applied to the pools of loans are typically derived from the combination of a variety of factors. Examples of the factors include historical experience, expected future performance, trends in bankruptcies and troubled collection accounts, and changes in the customer's performance patterns.

Foreign Loans

The Interagency Country Exposure Risk Committee (ICERC) requires certain loans to have allocated transfer risk reserves (ATRRs). ATRRs are minimum specific reserves related to loans in particular countries and, therefore, must be reviewed by each institution. The ICERC's supervisory role is pursuant to the International Supervision Act of 1983. The collectability of foreign loans that do not have ATRRs should be assessed in the same way as domestic loans.

Documentation, Completeness, and Frequency

The institution's allowance methodology should be based on a comprehensive, adequately documented, and consistently applied analysis. The analysis should consider all significant factors that affect collectability of the portfolio and should be based on an effective loan review and credit grading (classification) system. Additionally, the evaluation of the adequacy of the allowance should be performed as of the end of each quarter, and appropriate provisions should be made to maintain the allowance at an adequate level.

SAB No. 102 and the 2001 Policy Statement specifically require, for any adjustments of loss measurements for environmental factors, that banks maintain sufficient objective evidence (1) to support the amount of the adjustment and (2) to explain why the adjustment is necessary to reflect current information, events, circumstances, and conditions in the loss measurements.

SAB No. 102 requires that bank methodology in determining ALLL should:

1. Provide a detailed analysis of the loan portfolio performed on a regular basis

2. Consider all loans (whether on an individual or group basis)

3. Identify loans to be assessed for impairment on an individual basis under SFAS No. 114 and segment the remainder of the portfolio into groups of loans with similar risk characteristics for evaluation and analysis under SFAS No. 5

4. Consider all known relevant internal and external factors that may affect loan collectability

5. Be applied consistently but, when appropriate, be modified for new factors affecting ALLL

(p) Loan Sales and Mortgage Banking Activities

Banks may originate and sell loans for a variety of reasons, such as generating income streams from servicing and other fees, increasing liquidity, minimizing interest rate exposure, enhancing asset/liability management, and maximizing their use of capital.

(i) Underwriting Standards

When loans are originated for resale, the origination process includes not only finding an investor but also preparing the loan documents to fit the investor's requirements. Loans originated for resale must normally comply with specific underwriting standards regarding items such as borrower qualifications, loan documentation, appraisals, mortgage insurance, and loan terms. Individual loans that do not meet the underwriting standards are typically eliminated from the pool of loans eligible for sale. Generally, the originating institutions may be subject to recourse by the investor for underwriting exceptions identified subsequent to the sale of the loans and any related defaults by borrowers.

(ii) Securitizations

Securitization is simply a method of financing a pool of assets intended to generate cash where sellers of assets can transfer part of ownership's risk and benefit to a third party who is willing or has the ability to take the risks. A common method of transforming real estate assets into liquid marketable securities is through securitization. Securitization is where loans are sold to a separate entity that finances the purchase through the issuance of debt securities or undivided interest in the loans. The real estate securities are backed by the cash flows of the loans.

Securitization of residential mortgages has expanded to include commercial and multifamily mortgages, auto and home equity loans, credit cards, and leases. The securitization of mortgage loans is a complex process affected by many players with different incentives that are often conflicting and thus create frictions among players. Ashcraft and Schuermann (2008) identified seven frictions among securitization players;

1. Frictions between the mortgagor and the originator: predatory lending

2. Frictions between the originator and the arranger: predatory borrowing and lending

3. Frictions between the arranger and third parties: adverse selection

4. Frictions between the servicer and the mortgagor: moral hazard

5. Frictions between the servicer and third parties: moral hazard

6. Frictions between the asset manager and investor: principal–agent

7. Frictions between the investor and the credit rating agencies: model error.

The accounting guidance for sales of loans through securitizations is discussed in Section 30.3.

(iii) Loan Servicing

When loans are sold, the selling institution sometimes retains the right to service the loans for a servicing fee, which is collected over the life of the loans as payments are received. The servicing fee is often based on a percentage of the principal balance of the outstanding loans. A typical servicing agreement requires the servicer to perform the billing, collection, and remittance functions as well as maintain custodial bank accounts. The servicer may also be responsible for certain credit losses.

(iv) Regulatory Guidance

Regulatory guidance with respect to loan sales and mortgage banking activities continues to evolve with the increased activity by institutions. In December 1997, the OCC issued regulatory guidance for national banks in its Comptroller's Handbook: Asset Securitization. The FDIC Board of Governors of the Federal Reserve System (Board), OCC, and OTS agencies collectively issued guidance regarding correspondent concentration risks for financial institutions. These financial institutions include all banks and their subsidiaries, bank holding companies and their nonbank subsidiaries, savings associations and their subsidiaries, and savings and loan holding companies and their subsidiaries. The guidelines mention the expectations from all banks and their subsidiaries, bank holding companies and their nonbank subsidiaries, savings associations and their subsidiaries, and savings and loan holding companies and their subsidiaries to other institutions. They lay down the guidance to conduct relevant and appropriate due diligence for credit exposures with other financial institutions. The Fed issued a Supervision and Regulation Letter, Risk Management and Capital Adequacy of Exposures Arising from Secondary Market Credit Activities, July 11, 1997. In August 2010, the Basel Committee on Banking Supervision issued its Microfinance Activities and Core Principles for Effective Banking Supervision, which addresses:

Efficient allocation of supervisory resources
Effective evaluation of the risks of microfinance activities through development of specialized knowledge within the supervisory team
Establishment of proven control and managerial practices relevant to microfinance activities
Achievement of clarity in the regulations pertaining to microfinance activities

(v) Accounting Guidance

The accounting guidance for purchasing, acquiring, and selling mortgage servicing rights is discussed in Section 30.3.

(vi) Valuation

The accounting guidance addressing the valuation of loans held for sale is discussed in Section 30.3.

(q) Real Estate Investments, Real Estate Owned, and Other Foreclosed Assets

The type and nature of assets included in real estate investments, former bank premises, and other foreclosed assets can vary significantly. Such assets are described next.

(i) Real Estate Investments

Certain institutions make direct equity investments in real estate projects, and other institutions may grant real estate loans that have virtually the same risks and rewards as those of joint venture participants. Both types of transactions are considered to be real estate investments, and such arrangements are treated as if the institution has an ownership interest in the property.

Specifically, GAAP for real estate investments is established in this authoritative literature:

AICPA SOP 78-9, Accounting for Investments in Real Estate Ventures
SFAS No. 34, Capitalization of Interest Cost
SFAS No. 58, Capitalization of Interest Cost in Financial Statements That Include Investments Accounted for by the Equity Method
SFAS No. 66, Accounting for Sales of Real Estate
SFAS No. 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects
SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets
SFAS 140, Accounting for Transfer and Servicing of Financial Assets and Extinguishments of Liabilities
International Accounting Standards 39, Financial Instruments and Standards issued by IASB in 2003

(ii) Former Bank Premises

Many institutions have former premises that are no longer used in operations. Such former bank premises may be included in real estate owned.

(iii) Foreclosed Assets

Foreclosed assets include all assets received in full or partial satisfaction of a receivable and include real and personal property; equity interests in corporations, partnerships, and joint ventures; and beneficial interests in trusts. However, the largest component of real estate owned by banks and savings institutions is comprised of foreclosed real estate assets. Subprime loans account for the majority of loans in foreclosure. In 2008, about 11 percent of subprime loans were in foreclosure, and this rate is as high as 20 percent in some States as of December 2011.

Guidance on accounting for and reporting of foreclosed assets is established in the next authoritative literature:

SFAS No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings
SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets
SOP No. 92-3, Accounting for Foreclosed Assets

In October 2001, the FASB issued SFAS No. 144. The Statement supersedes FASB Statement No. 121 ; however, it retains the fundamental provisions of that Statement related to the recognition and measurement of the impairment of long-lived assets to be held and used. In addition, the Statement provides more guidance on estimating cash flows when performing a recoverability test, requires that a long-lived asset (group) to be disposed of other than by sale (e.g., abandoned) be classified as held and used until it is disposed of, and establishes more restrictive criteria to classify as asset (group) as held for sale.

The Statement is effective for year-ends beginning after December 15, 2001 (e.g., January 1, 2002, for a calendar-year entity) and interim periods within those fiscal years. Transition is prospective for committed disposal activities that are initiated after the effective date of the Statement or an entity's initial application of the Statement. The Statement also provides transition provisions for assets held for sale that were initially recorded under previous models (Accounting Principles Board No. 30 or SFAS No. 121) and do not meet the new held for sale criteria within one year of the initial application of the Statement (e.g., December 31, 2002, for a calendar-year-end entity that adopts the Statement effective January 1, 2002). In 2003, the FASB issued SFAS No. 147, Acquisitions of Certain Financial Institutions, which amended SFAS Nos. 121 and 144.

(r) Investments in Debt and Equity Securities

Banks use a variety of financial instruments for various purposes, primarily to provide a source of income through investment or resale and to manage interest rate and liquidity risk as part of an overall asset/liability management strategy.

Institutions purchase U.S. government obligations, such as U.S. Treasury bills, notes, and bonds, in addition to the debt of U.S. government agencies and government-sponsored enterprises, such as the U.S. Government National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). Institutions also purchase municipal obligations, such as municipal bonds and tax anticipation notes.

Another common form of investments, which can be tailored to a wide variety of needs, is called asset-backed securities (ABSs). ABS values are based on the values of specific assets that back, or get pooled into, the securities. Those assets can include mortgage loans, student loans, credit card payments, auto loans and nearly any other kind of asset that provides a steady flow of payments. Securitization helps expand the availability and lowers the cost of credit for homeowners, consumers, and businesses because as lenders pool the assets into securities and sell them to investors, the lenders then get more money to turn into loans.

For the purpose of categorizing ABSs, each individual ABS should be included in the item that most closely describes the predominant type of asset that collateralizes the security, and this categorization should be used consistently over time. In 2010, the SEC voted to issue new regulatory proposals covering more than $2 trillion of the ABS market. It reasoned that the securitization fostered poor lending practices by encouraging lenders to shift their risk of loss to investors, resulting in investors largely withdrawing from the market when those securities went bad after the U.S. housing bust. Because of the role played by the MBSs in the current financial crisis, the securitized U.S. subprime mortgages are considered to have served as the crisis's immediate trigger. During the financial crisis, ABS holders suffered significant losses, which reveals that many investors are not fully aware of the risk in the underlying mortgages within the pools of securitized assets and over rely on credit ratings assigned by rating agencies. The proposed rules seek to address the problems highlighted by the crisis and to head off the next one, by giving investors the tools they need to accurately assess risk and by better aligning the interests of the issuer with those of the investor.

Banks can hold ABSs as securities, or they can be the issuer of ABSs along with both governmental and private issuers. The ABSs are repaid from the underlying cash flow generated from other financial instruments, such as mortgage loans, credit card receivables, and mobile home loans. ABSs secured by real estate mortgages are often called MBSs.

The level of risk related to ABSs is often related to the level of risk in the collateral. For example, securitized subprime auto loans, experiencing a decline in credit quality, may also cause a reduction in the value of the ABS, if receipt of the underlying cash flow becomes questionable.

ABSs often include a credit enhancement designed to reduce the degree of credit risk to the holder of the ABS security. Examples of credit enhancement include guarantees, letters of credit, overcollateralization, private insurance, and senior/subordinate structures. The degree of protection provided by the credit enhancement depends on the nature of the collateral and the type and extent of the credit enhancement.

ABSs are structured into a variety of products, many of which are complex. Risk variables, such as prepayment risk, changes in prevailing interest rates, and delayed changes in indexed interest rates, make the forecasting of future cash flows more difficult. ABSs with several investment classes may have varying terms such as maturity dates, interest rates, payment schedules, and residual rights, which further complicates an analysis of the investment. CMOs and real estate mortgage investment conduits (REMICs) are two examples of multiclass mortgage securities. The underlying objective of all types of ABSs and mortgage securities is to redistribute the cash flows generated from the collateral to all security holders, consistent with their contractual rights, without a shortfall or an overage.

Banks are generally restricted in the types of financial instruments they may deal in, underwrite, purchase, or sell. Essentially banks may only deal in U.S. government and U.S. government agency securities, municipal bonds, and certain other bonds, notes, and debentures. These restrictions are also limited based on capitalization. The FFIEC policy statement issued in February 1992 addresses the selection of securities dealers, policies and strategies for securities portfolios, unsuitable investment practices, and mortgage derivations. In September 2010, FFIEC announced the availability of data on mortgage lending transactions at 8,124 U.S. financial institutions covered by the Home Mortgage Disclosure Act (HMDA). Covered institutions include banks, savings associations, credit unions, and mortgage companies. The HMDA data cover 2009 lending activity—applications, originations, denials (and other actions such as incomplete or withdrawn applications), and purchases of loans.

(i) Accounting for Investments in Debt and Equity Securities

SFAS No. 115, issued in May 1993, addresses the accounting and reporting for investments in equity securities that have readily determinable fair values and for all investments in debt securities. It superseded SFAS No.12, Accounting for Certain Marketable Securities, and related interpretations and amended FASB Statement No. 65, Accounting for Certain Mortgage Banking Activities, to eliminate MBSs from its scope. This Statement does not apply to unsecuritized loans. However, after mortgage loans are converted to MBSs, they are subject to its provisions. To reduce the problem with fair-value estimation, the FASB issued SFAS 157 (now FASB ASC Topic 820), which uses different levels of input to assess the value of assets and liabilities.

Held to Maturity

Debt securities for which an institution has both the ability and positive intent to hold to maturity are classified as held to maturity and are carried at amortized cost (Any difference between cost and fair value is recorded as a premium or discount, which is amortized to income using the level yield method over the life of the security).

Trading

Securities that are purchased and held principally for the purpose of selling them in the near term are carried at fair value with unrealized gains and losses included in earnings.

Available for Sale

All other securities are classified as available for sale and carried at fair value with unrealized gains and losses included as a separate component of shareholder's equity.

SFAS No. 115 addresses changes in circumstances that may cause an enterprise to change its intent to hold a certain security to maturity without calling into question its intent to hold other debt securities to maturity in the future.

For individual securities classified as either available for sale or held to maturity, entities are required to determine whether a decline in fair value below the amortized cost basis is other than temporary. If such a decline is judged to be other than temporary, the cost basis of the individual security should be written down to fair value as the new cost basis. The amount of the write-down should be treated as a realized loss and recorded in earnings. The new cost basis must not be changed for subsequent recoveries.

Investment securities are required to be recorded on a trade date basis. Interest income on investment securities is recorded separately as a component of interest income. Realized gains and losses on available-for-sale securities and realized and unrealized gains and losses on trading securities are recorded as a separate component of noninterest income or loss. Upon the sale of an available-for-sale security, any unrealized gain or loss previously recorded in the separate component of equity is reversed and recorded as a separate component of noninterest income or loss.

Discounts and premiums should be accreted or amortized using the interest method in accordance with SFAS No. 91. The interest method provides for a periodic interest income at a constant effective yield on the net investment. The amortization or accretion period should be from the purchase date to the maturity date rather than an earlier call date, except for large numbers of similar loans where prepayments are expected and can be reasonably estimated, such as with certain ABSs.

Transfers among the three categories are performed at fair value. Transfers out of held to maturity should be rare.

(ii) Wash Sales

If the same financial asset is purchased shortly before or after the sale of a security, it is called a wash sale. SFAS No. 140 addresses wash sales, stating that unless there is a concurrent contract to repurchase or redeem the transferred financial assets from the purchaser, the seller does not maintain effective control over the transferred assets, and, therefore, the sale should be recorded. SFAS No. 140 provides the accounting guidance for recognizing gains and losses from wash sales, as more fully discussed in Section 30.3.

(iii) Short Sales

An institution may sell a security it does not own with the intention of buying or borrowing securities at an agreed-upon future date to cover the sale. Given the nature of these transactions, such sales should be within the trading portfolio. Obligations incurred in these short sales should be reported as liabilities and recorded at fair value at each reporting date with change in fair value recorded through income. The Dodd-Frank Act directs the SEC to issue rules requiring financial institutions to publicly report on their short sales activities on at least a monthly basis.

(iv) Securities Borrowing and Lending

An institution may borrow securities from a counterparty to fulfill its obligations and may advance cash, pledge other securities, or issue letters of credit as collateral for borrowed securities. If cash is pledged as collateral, the institution that loans the securities typically earns a return by investing that cash at rates higher than the rate paid or rebated back to the institution that borrows the securities. If the collateral is other than cash, the institution that loans the collateral typically receives a fee. Because most securities lending transactions are short term, the value of the pledged collateral is usually required to be higher than the value of the securities borrowed, and collateral is usually valued daily and adjusted frequently for changes in the market price, most securities lending transactions by themselves do not represent significant credit risks. However, other risks exist in securities lending transactions, such as market and credit risks, relative to the maintenance and safeguarding of the collateral. For example, the manner in which cash collateral is invested could present market and credit risk.

SFAS No. 140 (now ASC Topic 310) addresses the accounting for securities lending transactions i.e. for transfers and servicing of financial assets and extinguishments of liabilities a replacement of FASB Statement No. 125. Those standards are based on consistent application of a financial-components approach that focuses on control. It provides that if the transferor (institution loaning the securities) surrenders control over those securities, the transfer shall be accounted for as a sale, to the extent that consideration (other than beneficial interest) is received in exchange. SFAS No. 140 states that the transferor has surrendered control over the transferred asset only if all three of the next conditions have been met:

1. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership (paragraphs 27 and 28).

2. Each transferee (or, if the transferee is a qualifying SPE (paragraph 35), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor (paragraphs 29–34).

3. The transferor does not maintain effective control over the transferred assets through either (a) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity (paragraph. 47–49) or (b) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call (paragraphs 50–54).

If all three of these conditions are met, the securities lending transaction shall be accounted for as a sale, in this manner:

Institution loaning the securities. Recognizes the sale of the loaned securities, proceeds consisting of the collateral. Also recognizes the forward repurchase commitment.
Institution borrowing the securities. Recognizes the purchase of the borrowed securities, consideration representing the collateral. Also recognizes the forward resale commitment.

Lending securities transactions accompanied by an agreement that entitles and obligates the institution loaning the securities to repurchase or redeem them before their maturity should be accounted for as secured borrowings. The cash (or securities) received as collateral is considered the amount borrowed, and the securities loaned are considered pledged as collateral against the cash borrowed. Any rebate paid to the institution borrowing the securities is treated as interest on the cash borrowed.

When the transfer is recorded as a sale, the cash (or securities) received in conjunction with loaning securities should be recognized as an asset and a corresponding liability established, recording the obligation to return the cash (or securities).

However, most securities lending transactions are accompanied by an agreement that entitles and obligates the securities lender to repurchase or redeem the transferred assets before their maturity. Such transactions typically will not be reported as sales under SFAS No. 140 because of the obligation of the transferor to repurchase the transferred assets. However, the provisions of SFAS No. 140 relating to the recognition of collateral could require that the transfer of securities and related collateral be recorded. The principal criterion to determine whether the collateral will be required to be recorded is whether the parties to the arrangement have the right to sell or repledge it. If such a right is present, the securities lender records the cash or noncash collateral received as its own asset as well as a corresponding obligation to return it. If the securities lender sells the collateral, it would recognize the proceeds and derecognize the collateral. The securities borrower will typically not record the securities received or an obligation to return them unless they are sold. Additionally, the securities borrower typically will not be required to reclassify the collateral provided, if such collateral is in the form of securities.

Additional guidance on accounting for and reporting of investments in debt and equity securities was established in these documents:

FASB Technical Bulletin (TB) No. 94-1, Application of SFAS No. 115 to Debt Securities Restructured in a Troubled Debt Restructuring, which clarifies that any loan that was restructured in a troubled debt restructuring involving a modification of terms would be subject to SFAS No. 115 if the debt instrument meets the definition of a security.
SFAS No. 15, Accounting by Debtors and Creditors for Troubled Debt Restructurings, which applies to troubled debt restructurings involving debt securities.
SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, which specifies that discounts or premiums associated with the purchase of debt securities should be accreted or amortized using the interest method.
SFAS No. 114, Accounting by Creditors for Impairment of a Loan (an Amendment, FASB No. 5 and 15), which addresses troubled debt restructurings involving a modification of terms of a receivables (i.e., creditor should evaluate the collectability of both contractual interest and contractual principal of all receivables when assessing the need for a loss accrual). This Statement applies to financial statements for fiscal years beginning after December 15, 1994.

(s) Deposits

Generally, the most significant source of a bank's funding is customer deposits. Institutions now offer a wide range of deposit products having a variety of interest rates, terms, and conditions. The more common types of deposits are described next.

(i) Demand Deposits

Customer deposit accounts from which funds may be withdrawn on demand. Checking and negotiable order of withdrawal (NOW) accounts are the most common form of demand deposits. Deposits and withdrawals are typically made through a combination of deposits, check writing, automatic teller machines (ATMs), point-of-sale terminals, electronic funds transfers (EFTs), and preauthorized deposits and payment transactions, such as payroll deposits and loan payments.

(ii) Savings Deposits

Interest-bearing deposit accounts that normally carry with them certain access restrictions or minimum balance requirements. Passbook and statement savings accounts and money market accounts are the most common form of savings accounts. Deposits and withdrawals are typically made at teller windows, ATMs, by ETF, or by preauthorized payment. Money market accounts often permit the customer to write checks, although the number of checks that may be written is limited.

(iii) Time Deposits

Interest-bearing deposit accounts that are subject to withdrawal only after a fixed term. Certificates of deposit (CDs), individual retirement accounts (IRAs), and open accounts are the most common form of time deposits.

CDs may be issued in bearer form or registered form and may be negotiable and nonnegotiable. Negotiable CDs, for which there is an active secondary market, are generally short term and are most commonly sold to corporations, pension funds, and government bodies in large denominations, such as $100,000 to $1 million. Nonnegotiable CDs are generally in smaller denominations, and depositors are subject to a penalty fee if they elect to withdraw their funds prior to the stated maturity.

Individual retirement accounts, Keogh accounts, and self-employed-person accounts (SEPs) are generally maintained as CDs; however, due to the tax benefits to depositors, they typically have longer terms than most CDs.

Brokered deposits are third-party time deposits placed by or through the assistance of a deposit broker. Deposit brokers sometimes sell interests in placed deposits to third parties. Federal law restricts the acceptance and renewal of brokered deposits by an institution based on its capitalization.

(t) Federal Funds and Repurchase Agreements

Federal funds and repurchase agreements are often used as a source of liquidity and as a cost-effective source of funds.

(i) Federal Funds Purchased

Generally, short-term funds maturing overnight bought between banks that are members of the Federal Reserve System. Federal funds transactions can be secured or unsecured. If the funds are secured, U.S. government securities are placed in a custody account for the seller.

(ii) Repurchase Agreements

Repurchase agreements, or repos, occur when an institution sells securities and agrees to repurchase the identical (or substantially the same) securities at a specified date for a specified price. The institution may be a seller or a buyer. Most repo transactions occur with other depository institutions, dealers in securities, state and local governments, and customers (retail repurchase agreements), and involve obligations of the federal government or its agencies, commercial paper, bankers' acceptances, and negotiable CDs. The difference between the sale and repurchase price represents interest for the use of the funds. There are also several types of repurchase agreements, such as collar repurchase agreements, fixed-coupon agreements, and yield-maintenance agreements. The terms of the agreements are often structured to reflect the substance of the transaction, such as a borrowing and lending of funds versus a sale and purchase of securities. Some repurchase agreements are similar to securities lending transactions, whereby the seller may (or may not) have the right to sell or repledge the securities to a third party during the term of the repurchase agreement.

SFAS No. 140 provides the accounting guidance for repurchase agreements. In addition to replacing FASB Statement No. 125 and rescinding FASB Statement No. 127, Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125, this Statement carries forward the actions taken by FASB Statement No. 125. In general, SFAS No. 140 uses the three conditions discussed previously in Subsection 30.2(r)(iv), when accounting for repurchase agreements. If all three conditions specified in SFAS No. 140 are met, the seller accounts for the repurchase agreement as a sale of financial assets and a forward repurchase commitment, and the buyer accounts for the agreement as a purchase of financial assets and a forward resale commitment. This Statement was made effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001, and for the recognition and reclassification of collateral and for disclosures relating to securitization transactions and collateral for fiscal years ending after December 15, 2000.

Government securities dealers, banks, other financial institutions, and corporate investors commonly use repurchase agreements to obtain or use short-term funds. Under those agreements, the transferor (repo party) transfers a security to a transferee (repo counterparty or reverse party) in exchange for cash and concurrently agrees to reacquire that security at a future date for an amount equal to the cash exchanged plus a stipulated interest factor. Repurchase agreements can be effective in a variety of ways. Some repurchase agreements are similar to securities lending transactions in that the transferee has the right to sell the securities to a third party during the term of the repurchase agreement. In other repurchase agreements, the transferee does not have the right to sell the securities during the term of the repurchase agreement.

Two reasons advanced in support of the treatment of repurchase agreements and securities lending transactions as secured borrowings are that (1) those transactions are difficult to characterize because they have attributes of both borrowings and sales and (2) supporting arguments can be found for accounting for those transactions as borrowings or sales. The only supporting arguments cited for the treatment of repurchase agreements and securities lending transactions as secured borrowings that are not equally applicable to certain securitizations are that (1) forward contracts that are fully secured should be treated differently from those that are unsecured and (2) making a change in existing accounting practice would have a substantial impact on the reported financial position of certain entities and on the markets in which they participate.

Also similar to the treatment for securities lending transactions, repurchase agreements where the institution selling the securities maintains effective control over the securities (and thereby not meeting the three sale conditions, described previously, provided by SFAS No. 140) should be accounted for as secured borrowings.

(u) Debt

Banks and savings institutions use long- and short-term borrowings as a source of funds.

(i) Long-Term Debt

Debentures and notes are the most common form of long-term debt; however, institutions also use long-term mortgages, obligations, commitments under capital leases, and mandatorily redeemable preferred stock to provide long-term funding. Funds are also borrowed through Eurodollar certificates, CMOs, and REMICs; mortgage-backed bonds (MBBs), mortgage-revenue bonds, and FHLB advances. The terms of long-term debt vary; they may be secured or unsecured, and they may be convertible.

(ii) Short-Term Debt

Repurchase agreements and federal funds purchased are the most common form of the short-term debt described earlier. Commercial paper is another common source of short-term funding. Commercial paper is an unsecured short-term promissory note typically issued by bank or savings institution holding companies.

MBBs are any borrowings (other than those from an FHLB) collateralized in whole or in part by one or more real estate loans.

Member institutions may borrow from their regional Federal Reserve Bank in the form of discounts and advances, which are used primarily to cover shortages in the required reserve account and also in times of liquidity problems.

(iii) Accounting Guidance

In general, the accounting for debt is the same for banks and savings institutions as for other enterprises although banks and savings institutions have unclassified balance sheets. SFAS No. 140 provides guidance for transfers of financial assets and extinguishments of liabilities. While few respondents support the reasoning of FASB No. 125, others argue that existing accounting guidance found in the AICPA Statement, Definition of the Term Substantially the Same for Holders of Debt Instruments, as Used in Certain Audit Guides and a Statement of Position (now FASB Accounting Standards Codification (ASC) No. 105), has proven adequate to constrain the characteristics of assets that are to be reacquired.

(v) Taxation

Taxation of financial institutions is extremely complex; specific discussion is therefore beyond the scope of this book. However, certain significant factors affecting bank and thrift taxation are discussed next.

(i) Loan Loss Reserves

Banks

Prior to the Tax Reform Act of 1986 (1986 Act), banks were permitted to deduct loan loss provisions based on either the experience method or on a percentage of eligible loans method. Since the mid-198Os, provision for loan losses has been one of the most important factors affecting bank profitability. The federal banking regulators (FDIC, OCC, and Fed) require that all banks include in their financial statements an account named as allowance for loan losses (also known as reserves for loan losses). When loan losses are recognized (i.e., when a bank decides that some portion of a loan will not be collected and therefore must be charged off or written down), the amount of the loss is deducted from the asset category loans and also from reserves for loan losses.

The 1986 Act passed by Congress simplified the tax code and eliminated some deductions quoting its significance in the tax structure of the United States and it modified the Internal Revenue Code (IRC) Section 585, which now allows only a small bank with $500 million or less in average assets (calculated by taking into account the average assets of all other members of an institution's controlled group, if applicable) to calculate an addition to the bad debt reserve using the experience method.

A large bank with over $500 million in assets may not use the reserve method. It is limited to the specific charge-off method under IRC Section 166. If a bank becomes a large bank, it is required to recapture its reserve, usually over a four-year period. A deduction under Section 166 generally is allowed for wholly or partially worthless debt for the year in which the worthlessness occurs. The total or partial worthlessness of a debt is a facts-and-circumstance, loan-by-loan determination. Larger banks may claim losses only when loans are written off. A bank may make a conformity election, however, which provides a presumptive conclusion of worthlessness for charge-offs made for regulatory purposes.

In comparison to GAAP, the specific charge-off method generally results in an unfavorable temporary difference (i.e., the book expense is recognized prior to the tax deduction being allowed) because the actual charge-off of a loan usually occurs later than the time the reserve is established for it. The Act also eliminated the deductibility of nonmortgage consumer interest payments such as interest on credit card balances, automobile loans, and life insurance loans.

Thrifts

Effective for tax years beginning after December 31, 1995, thrift institutions are subject to the same loan loss rules as banks. Thrifts that qualify as small banks (average assets of $500 million or less) can use the experience-based reserve method just described. Thrifts that are treated as large banks must use the specific charge-off method.

A thrift that is treated as either a large or small bank is required to recapture or recognize as income its applicable excess reserves. Such income is generally recognized ratably over a six-year period beginning with the first tax year beginning after 1995.

If a thrift becomes a large bank, the amount of the thrift's applicable excess reserves is generally the excess of (1) the balance of its reserves as of the close of its last taxable year beginning before January 1, 1996, over (2) the balance of its reserves as of the close of its last taxable year beginning before January 1, 1988 (its pre-1988 or base year reserve). Thus, a thrift treated as a large bank generally is required to recapture all post-1987 additions to it bad debt reserves.

In the case of a thrift becoming a small bank, the thrift's applicable excess reserves is the excess of (1) the balance of its reserves as of the close of its last taxable year beginning before January 1, 1996, over (2) the greater of the balance of (a) its pre-1988 reserves, or (b) what the thrift's reserves would have been at the close of its last taxable year beginning before January 1, 1996, had the thrift always used the experience method. Thus, a thrift treated as a small bank may not have any applicable excess reserves (and therefore no recapture) if it had always used the experience method.

A special rule, the residential loan requirement, may allow the six-year recapture period to be delayed for one or two years (i.e., recapture could actually start as late as the first taxable year beginning after 1997). An institution meets the requirement for a taxable year if the principal amount of residential loans made by the institution during the year is not less than its base amount, defined generally as the average of the principal amounts of residential loans made by the institution during the six most recent tax years beginning before January 1, 1996.

A residential loan is generally defined as a loan secured by residential real property, but only to the extent the loan is made to the property owner to acquire, construct, or improve the property. Thus, mortgage refinancing and home equity loans are not considered to be residential loans, except to the extent the proceeds of the loan are used to acquire, construct, or improve qualified real property. Other rules govern the calculation of the base amount for purposes of the requirement.

The residential loan requirement is applicable only for taxable years beginning after December 31, 1995, and before January 1, 1998, and must be applied separately with respect to each such year. Thus, all institutions are required to recapture their applicable excess reserves within the first six, seven, or eight taxable years beginning after December 31, 1995.

(ii) Mark to Market

Contrary to normal realization-based tax accounting principles, IRC Section 475 requires dealers in securities to recognize gain or loss through marking-to-market their securities holdings, unless such securities are validly identified by the taxpayer as excepted from the provisions.

As used in this context, the terms dealer and securities have very broad application. Virtually all financial institutions are considered dealers in securities for mark-to-market purposes though regulations provide exceptions for certain institutions not engaging in more than de minimus dealer activities. Securities required to be marked (unless validly identified as excepted) include notes, bonds, and other evidences of indebtedness; stock; notional principal contracts; or any evidence of an interest in or a derivative of such security (other than Section 1256(a) contracts); and any clearly identified hedge of such security.

Securities that may be identified as exempted from the mark-to-market provisions are:

Securities held for investment, and property identified as such for tax purposes.
Notes and other evidences of indebtedness (and obligations to acquire such) that are acquired or originated by the taxpayer in the ordinary course of a trade or business that are not held for sale.
Hedges of positions or liabilities that are not securities in the hands of the taxpayer, and hedges of positions or liabilities that are exempt from mark to market under the two foregoing provisions. This does not apply for hedges held as a dealer.

To be exempted from mark to market, the security must be identified by the taxpayer on a contemporaneous basis (generally, day of acquisition) as meeting one of the exceptions.

Whether a security is required to be marked to market for financial accounting purposes is not dispositive for purposes of determining whether such security is treated as held for investment or not held for sale.

Some financial institutions identify all or a significant portion of their loans to customers as exempted from the mark-to-market provisions because they intend to hold those loans to maturity. A possible exception are mortgages that are originated for sale (pipeline or warehoused loans), which do not meet the exception criteria and must be marked to market.

(iii) Tax-Exempt Securities

For tax purposes, gross income does not include interest on any obligation of a state or political subdivision thereof (e.g., county, city). Interest on certain nonqualified private activity bonds, unregistered bonds, and arbitrage bonds does not qualify for this exemption.

A deduction is not allowed for interest expense on indebtedness incurred to purchase or carry tax-exempt obligations. Deposit-taking financial institutions (banks and thrifts) are subject to a special two-part formula to determine how much of the total interest expense of an institution is disallowed interest expense.

Interest expense related to tax-exempt obligations acquired after August 1986 is disallowed and is calculated by multiplying total interest expense by the ratio of the tax basis of such obligations to the tax basis of all assets.

Interest expense related to tax-exempt obligations acquired between January 1983 and August 1986 is 20 percent disallowed and is calculated in a manner similar to that just described.

Certain qualified tax-exempt obligations (generally, obligations issued by an entity that will not issue more than $10 million of tax-exempt obligations during the year and that are not private activity bonds) issued after August 1986 are treated as if issued prior to that date (i.e., subject to the 20 percent disallowance rule rather than the 100 percent disallowance rule).

(iv) Nonaccrual Loans

Generally, interest on a loan must be accrued as income unless the taxpayer can demonstrate that the interest is uncollectable at the time of accrual. The tax rule is dependent on the facts and circumstances for the nonaccrual loans at issue. The SFAS No. 114 uses a probable test in determining when a loan is impaired. When it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement, the loan is considered impaired. Use of this analysis may now provide substantiation of the tax treatment for impairment of loans.

(v) Hedging

Financial institutions that are involved in hedging transactions treat the gain or loss from these transactions as ordinary for tax purposes. A hedging transaction must be entered into primarily to manage a taxpayer's risk of interest rate changes, price changes, or currency fluctuations. A taxpayer must also have risk on an overall (or macro) basis. A hedge of a single ordinary asset or liability will be respected if it is reasonably expected to manage the taxpayer's overall risk. Hedges entered into as part of an overall risk reduction program also will qualify.

Fixed to floating hedges (e.g., hedges that convert a fixed-rate liability into a floating-rate liability) may satisfy the risk management requirement if, for example, a taxpayer's income varies with interest rates. In addition, hedges entered into to reverse or counteract another hedging transaction may qualify for ordinary gain or loss treatment. Because tax hedges are permissible only with ordinary property, hedges of mortgage servicing rights generally do not qualify as tax hedges, since mortgage servicing rights are generally capital assets.

Hedges of ordinary liabilities qualify as hedging transactions regardless of the use of the proceeds from the borrowing. Consequently, gain or loss from a hedge of a liability used to fund the purchase of a capital asset will be ordinary. However, recent guidance in the form of final Treasury regulations provide that the purchase or sale of a debt instrument, an equity security, or an annuity contract is not hedging a transaction even if the transaction limits or reduces the taxpayer's risk.

The timing of the gain or loss from a hedging transaction must reasonably be matched with the gain or loss of the item being hedged. This applies to global hedges and other hedges of aggregate risk.

If a taxpayer disposes of a hedged item but retains the hedge, the taxpayer may redesignate the hedge. The taxpayer generally must mark to market the hedge on the date that he or she disposes of the hedged item.

There are detailed contemporaneous identification and record-keeping requirements with which an institution must comply to support its treatment of hedging transactions. Failure to comply could lead to characterization of losses from these transactions as capital losses (which may be used only to offset capital gains).

(vi) Loan Origination Fees and Costs

Loan origination fees are be deferred and recognized over the life of the loan as an adjustment of yield (interest income). Loan origination fees and related direct loan origination costs for a given loan are offset, and only the net amount is deferred and amortized. The practice of recognizing a portion of loan origination fees as revenue in a period to offset all or part of the costs of origination is no longer acceptable.

For financial accounting purposes, SFAS No. 91 requires that all loan origination fees (including loan commitment fees and points) be deferred and generally recognized over the life of the related loan or commitment period as an adjustment of yield. This Statement establishes the accounting for nonrefundable fees and costs associated with originating or acquiring loans and initial direct costs of leases (i.e., association with lending, committing to lend, or purchasing a loan or group of loans). The Statement specifies that loan origination fees must be recognized over the life of the related loan as an adjustment of yield. All loan commitment fees are deferred except for certain retrospectively determined fees; commitment fees meeting specified criteria are recognized over the loan commitment period; all other commitment fees are recognized as an adjustment of yield over the related loan's life or, if the commitment expires unexercised, recognized in income upon expiration of the commitment. Overall, the Statement changes the practice of recognizing loan origination and commitment fees at or prior to inception of the loan.

For tax accounting purposes, loan fees received as cash payments incident to a lending transaction (e.g., points) that represent an amount charged for the use of forbearance of money (rather than payment for services) are deferred. Points received in connection with a lending transaction are applied as a reduction to the issue price of the loan and generally create original issue discount (OID) to be recognized over the life of the loan on a constant yield method. In instances where the OID on a loan is de minimus (as defined in regulations), the de minimus OID is recognized in proportion to principal payments received.

For book purposes, the costs associated with origination of a loan are deferred and recognized over the life of the loan together with the origination fees. For tax purposes, institutions generally deduct these costs currently because to date there has been no published guidance requiring capitalization.

(vii) Foreclosed Property

Banks

Generally, a bank recognizes gain or loss on foreclosure of property securing a loan but is not permitted to deduct any further decrease in or impairment of value. Any decrease in value occurring after foreclosure is recognized when the property is disposed of by the institution. If real property acquired through foreclosure is operated in a trade or business after foreclosure (e.g., as rental property), the institution may deduct depreciation (and other operating expenses) computed in accordance with general tax depreciation provisions.

Thrifts

Effective for taxable years beginning after December 31, 1995, thrift institutions are subject to the same rules as banks.

Under prior law, a special rule treated the acquisition of property by a thrift as a nontaxable event, with no gain or loss recognized at time of foreclosure and no depreciation allowed on the property. A subsequent write-down charge to the bad debt reserve was allowed if the fair market value of the property was less than the tax basis of the loan. Upon final disposition, the gain or loss was credited or charged to the bad debt reserve.

(viii) Leasing Activities

Direct financing activities may qualify as financings for tax purposes. As a result, a bank will be considered the owner of the leased property for tax purposes. Accordingly, rental income and depreciation deductions on the leased asset will be recognized for tax purposes but not for financial reporting purposes. This will result in a difference between book and tax accounting under SFAS No. 109.

(ix) FHLB Dividends

Banks and savings institutions may become members of the FHLB by purchasing stock in individual FHLB member banks. Banks generally become a member of the FHLB for access to additional funding for borrowed funds. The FHLB member banks, of which there are 12, generally pay cash or stock dividends to shareholders, depending on the member bank. Cash dividends paid on FHLB stock that was issued prior to March 28, 1942, are exempt from federal income taxes. This exemption applied even for such stock that was subsequently acquired through merger or otherwise. Cash dividends on FHLB stock issued on or after March 28, 1942, are not exempt from taxation. Stock dividends on FHLB stock are generally not taxable when distributed. These stock dividends create a book/tax difference that is recognized on the sales or redemption of the FHLB shares.

(x) Bank-Owned Life Insurance

Bank-owned life insurance (BOLI) is commonly used by financial institutions for its financial benefits to help fund benefit programs and to offset certain costs typically incurred when losing key employees of the bank. BOLI is life insurance purchased by a financial institution on the lives of specific employees. The economically beneficial aspects of BOLI are tax-free growth in the cash surrender value of the policy and a tax-tree treatment of the death proceeds, which are both realized by the bank as the owner of a given policy. Insurance premiums on life insurance policies are not tax deductible.

(xi) Original Issue Discount

OID rules apply to all debt instruments after July 1, 1982, with certain exceptions. Generally, OID is the excess of what a borrower is obligated to repay when the loan comes due over the amount borrowed. More technically, OID is the excess of the stated redemption price at maturity over its issue price. Under OID rules, the holder of the debt must accrue stated interest under the constant yield method.

(xii) Market Discount

The primary difference between OID and market discount is that purchase of a security at its original purchase versus the secondary market, respectively. Generally, if a debt instrument has declined in value from the time when it was originally issued (other than as a result of principal payments), a purchaser of the bond will acquire it with market discount.

A holder of a market discount may choose between two methods of recognizing accrued market discount. Market discount accrues under a ratable method, in proportion to the payment of principal, unless a constant interest method is elected. The primary difference between market discount and OID is that the borrower is not required to include accrued market discount in taxable income currently but may elect to do so. Instead, the market discount rules require borrowers to recognize accrued market discount only on receipt of the proceeds of a disposition or a principal payment is made.

(w) Futures, Forwards, Options, Swaps, and Similar Financial Instruments

Futures, forwards, swaps, and options and other financial instruments with similar characteristics (collectively, derivatives) have become important financial management tools for banks. The complexity and volume of derivatives and derivatives trading have increased significantly in recent years. Institutions continue to enhance risk management systems to enable them to monitor the risks involved. Bank regulatory agencies continue to encourage institutions to upgrade policies and procedures, risk measurement and reporting systems, and independent oversight and internal control processes. Senior management has increased its knowledge of the derivative products and how risks are monitored.

Derivatives are receiving considerable attention primarily due to the underlying volatility in the markets, relatively large size of the transactions, and the potential for significant earnings fluctuations. Derivatives have many similar risk characteristics as other credit products, such as credit risk, market risk, legal risk, and control risk. The specific risks in a derivatives portfolio are often difficult to identify due to the complexity of the transactions. For example, two or more basic risks are often used in combination, which may be further complicated by the fact that economic interaction between various positions within an institution (on- and off-balance sheet) may be difficult to assess.

Underlying cash flows for derivatives are often referenced to such items as rates, indexes (which measure changes in specific markets), value of underlying positions in financial instruments, equity instruments, foreign currencies, commodities, or other derivatives.

Derivatives generally can be described as either forward-based or option-based, or combinations of the two. A forward-based contract (futures, forwards, and swap contracts) obligates one party to buy and a counterparty to sell an underlying financial instrument, foreign currency, or commodity at a future date at an agreed-upon price. An option-based derivative (options, interest rate caps, and interest rate floors) are one-sided in that if the right is exercised, only the holder can have a favorable outcome and the writer can have only an unfavorable outcome. Most derivatives are generally combinations of these two types of contracts.

Derivatives traded through an organized exchange typically have standardized contracts, such as futures and certain options, and the risk characteristics are more related to market risk than to credit risk. Alternatively, derivatives traded over-the-counter are customized to meet certain objectives or needs and often vary in structure, such as swaps and forward contracts. Customized derivative products traded privately typically present a greater degree of credit risk and liquidity risk, depending on the counterparty's financial strength, value of the collateral, if any, and the liquidity of the specific instrument.

The complexity of derivative instruments is largely the result of the pricing mechanisms, flexibility and options features, and value calculation formulas. In addition, derivatives can be structured to be more sensitive to general price movements than the cash market instruments from which their value is derived. The types of derivatives products available vary considerably; a brief description of the basic types of contracts is presented next.

(i) Futures

A futures contract is an agreement to make or take delivery of a financial instrument (interest rate instrument, currency, and certain stock indices) at a future date. Most futures contracts are closed out prior to the delivery date by entering into an offsetting contract.

The type of financial instrument delivered depends on the type of futures contract. For example:

Investment-grade financial instruments, such as U.S. Treasury securities or MBSs are delivered under interest rate futures.
Foreign currency (in the currency specified) is delivered under foreign currency futures contracts.
Commodities such as oil, gold bullion, or coffee are delivered under commodities futures contracts.

Buyers and sellers are required to deposit assets (such as cash, government securities, or letters of credit) with a broker. The assets are called a margin and are subject to increases and decreases, if losses or gains are incurred on the open position.

(ii) Forwards

A forward contract is a contract between two parties to purchase and sell a specified quantity of a financial instrument, foreign currency, or commodity at a specified price, with delivery and settlement at a specified future date. Such contracts are not traded on exchanges and therefore may have a high degree of credit and liquidity risk. Forward rate agreements are forward contracts used to manage interest rate risk.

(iii) Options

Option contracts provide the purchaser of the option with the right, but not the obligation, to buy (or sell) a specified instrument, such as currencies, interest rate products, or futures. They also put the seller under the obligation to deliver (or take delivery of) the instrument to the buyer of the option but only at the buyer's option.

A premium is typically paid to the seller of the option, representing both the time value of money and any intrinsic value. Intrinsic value, which cannot be less than zero, is derived from the excess of market price for the underlying item in the contract over the price specified in the contract (strike price).

Holders of option contracts can minimize downside price risks because the loss on a purchased option contracts is limited to the amount paid for the option. However, while the profit on written option contracts is limited to the premium received, the loss potential is unlimited because the writer is obligated to settle at the strike price if the option is exercised. Options are often processed through a clearinghouse, which guarantees the writer's performance and minimizes credit risk.

Option-based derivative contracts, such as caps, floors, collars, and swaptions, can be combined to transfer risks form one entity to another. Each type of contract is described next.

Interest rate caps are contracts in which a cap writer, in return for a premium, agrees to make cash payments to the cap holder equal to the excess of the market rate over the strike price multiplied by the notional principal amount if rates go above specified interest rate (strike price). The cap holder has the right, not the obligation, to exercise the option, and if rates move down, the cap holder will lose only the premium paid. The cap writer has virtually unlimited risk resulting from increases in interest rates above the cap rate.
Interest rate floors are contracts in which a floor writer, in return for a premium, agrees to limit the risk of declining interest rates based on a notional amount such that if rates go below a specified interest rate (strike price), the floor holder will receive cash payments equal to the difference between the market rate and the strike price multiplied by the notional principal amount. As with interest rate caps, the floor holder has the right, not the obligation, to exercise the option, and if rates move up, the floor holder will lose only the premium paid. The floor writer has risk resulting from decreases in interest rates below the floor rate.
Interest rate collars are combinations of interest rate caps and interest rate floors (i.e., one held and one written). Such contracts are often used by institutions to lock a floating rate contract into a predetermined interest rate range.
Swaptions are option contracts to enter into an interest rate swap contract at some future date or to cancel an existing swap in the future.

(iv) Swaps

Swaps are contracts between parties to exchange sets of cash flows based on a predetermined notional principal; only the cash flows are exchanged (usually on a net basis) with no principal exchanged. Swaps are used to change the nature or cost of existing transactions—for example, exchanging fixed-rate debt cash flows for floating rate cash flows. Swap contracts are not exchange traded; therefore, they are not as liquid as futures contracts. The principal types of swaps are interest rate swaps and currency swaps. However, there are also basis swaps, equity swaps, commodity swaps, and mortgage swaps. A brief description of seven swaps follows.

1. Interest rate swaps. Interest rate swaps are used to manage interest rate risks, such as from floating to fixed or fixed to floating. Periodic fixed payments are made by one party, while another counterparty is obligated to make variable payments, depending on a market interest rate. Master netting agreements are used to permit entities to legally set off related payable and receivable swap contract positions for settlement purposes.

2. Foreign currency swaps. Foreign currency swaps are used to fix the value of foreign currency exchange transactions that will occur in the future. Typically, principal is exchanged at inception, interest is paid in accordance with the agreed upon rate and term, and principal is re-exchanged at maturity.

3. Fixed-rate currency swaps. Fixed-rate currency swaps occur when two counterparties exchange fixed-rate interest in one currency for fixed-rate interest in another currency.

4. Basis swaps. Basis swaps represent a variation on interest-rate swap contracts where both rates are variable but tied to different index rates.

5. Equity swaps. Equity swaps occur when counterparties exchange cash flow streams tied to an equity index with a fixed or floating interest.

6. Commodity swaps. Commodity swaps occur when counterparties exchange cash flow streams tied to the difference between a commodity's agreed-on price and its variable price, applied to an agreed-on price of the commodity.

7. Mortgage swaps. Typical mortgage swaps occur when an investor exchanges interest payments tied to a short-term floating rate, for cash flows based on a generic class of MBSs over a specified period. The cash flows received by the investor include the fixed coupon on the generic class or MBSs and any discount or premium. The notional amount of the mortgage swap is adjusted monthly, based on amortization and prepayment experience of the generic class of MBSs. When the contract expires, the investor may either have to take physical delivery of the mortgages (at a predetermined price) or settle in cash for the difference between the predetermined price and the current market value for the mortgages. Collateral may be posted to reduce counterparty credit risk.

(v) Foreign Exchange Contracts

Foreign exchange contracts are used both to provide a service to customers and as a part of the institution's trading or hedging activities. The bank profits by maintaining a margin between the purchase price and sale price. Contracts may be for current trades (spot contract), future dates (forward contract), or swap contracts. The bank may also enter into these contracts to hedge a foreign currency exposure.

(vi) Other Variations

Other types of derivative products are discussed in Chapter 26 of this Handbook.

(vii) Accounting Guidance

The FASB issued Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, in June 1998 (now ASC 815). Statement No. 133 provides a comprehensive and consistent standard for the recognition and measurement of derivatives and hedging activities. The first step in considering whether the benefits of a new accounting standard will justify the related costs is to identify the problems in the existing accounting guidance that a new standard seeks to resolve. Hence this Statement resolves the inconsistencies that existed with respect to accounting for derivatives and changes considerably the way many derivatives transactions and hedged items are reported.

This Statement mitigates several issues. It increases the visibility, comparability, and understandability of the risks associated with derivatives by requiring that all derivatives be reported as assets or liabilities and measured at fair value. It reduces the inconsistency, incompleteness, and difficulty of applying previous accounting guidance and practice by providing comprehensive guidance for all derivatives and hedging activities. The comprehensive guidance in this Statement also eliminates some accounting practices, such as synthetic instrument accounting, that had evolved beyond the authoritative literature. This Statement accommodates a range of hedge accounting practices by (1) permitting hedge accounting for most derivative instruments, (2) permitting hedge accounting for cash flow hedges of forecasted transactions for specified risks, and (3) eliminating the requirement in Statement No. 80 that an entity demonstrate risk reduction on an entity-wide basis to qualify for hedge accounting. The combination of accommodating a range of hedge accounting practices and removing the uncertainty about the accounting requirements for certain strategies should facilitate, and may actually increase, entities' use of derivatives to manage risks.

SFAS No. 133 requires all derivatives to be recorded on the balance sheet at fair value and establishes special accounting for these three types of hedges: hedges of changes in the fair value of assets, liabilities, or firm commitments (referred to as fair value hedges); hedges of the variable cash flows of forecasted transactions (cash flow hedges); and hedges of foreign currency exposures of net investments in foreign operations. The accounting treatment and criteria for each of the three types of hedges are unique. Changes in fair value of derivatives that do not meet the criteria of one of these three categories of hedges are included in income.

The four basic underlying premises of the new approach are:

1. Derivatives represent rights or obligations that meet the definitions of assets (future cash inflows due from another party) or liabilities (future cash outflows owed to another party) and should be reported in the financial statements.

2. Fair value is the most relevant measure for financial instruments and the only relevant measure for derivatives. Derivatives should be measured at fair value, and adjustments to the carrying amount of hedged items should reflect changes in their fair value (i.e., gains and losses) attributable to the risk being hedged arising while the hedge is in effect.

3. Only items that are assets or liabilities should be reported as such in the financial statements. (The FASB believes that gains and losses from hedging activities are not assets or liabilities and, therefore, should not be deferred.)

4. Special accounting for items designated as being hedged should be provided only for qualifying transactions, and one aspect of qualification should be an assessment of the expectation of the effectiveness of the hedge (i.e., offsetting changes in fair values or cash flows).

See Chapter 26 for further guidance on SFAS No. 133 (ASC 815).

(x) Fiduciary Services and Other Fee Income

(i) Fiduciary Services

In their fiduciary capacity, banks must serve their clients' interests and must act in good faith at a level absent in most other banking activities. In view of this high degree of fiduciary responsibility, banks usually segregate the responsibilities of the trust department from that of the rest of the bank. This segregation is designed to maintain a highly objective viewpoint in the fiduciary area. Fiduciary services range from the simple safekeeping of valuables to the investment management of large pension funds.

Custodial, safekeeping, and safe deposit activities involve the receipt, storage, and issuance of receipts for a range of valuable assets. This may involve the holding of bonds, stocks, and currency in escrow pending the performance under a contract, or merely the maintenance of a secure depository for valuables or title deeds. As custodian, the bank may receive interest and dividends on securities for the account of customers.

Investment management may be discretionary, whereby the bank has certain defined powers to make investments, or nondiscretionary, whereby the bank may execute investment transactions based only on customers' instructions. The former obviously involves a higher degree of risk to the institution and creates an obligation to make prudent investment decisions.

Other fiduciary services include trust administration, stock and bond registrar, and bank trustee. Trust administration involves holding or management of property, such as pension funds and estates for the benefit of others. Stock and bond registrar and bank trustee functions include the maintenance of records and execution of securities transactions, including changes in ownership and payment of dividends and interest.

Since the assets and liabilities of the trust department of the bank are held in an agency capacity, they are not recorded on the balance sheet of the bank. These activities can, however, generate significant fee income, which is recorded when earned in the statement of income.

(ii) Other Fee Income

Emphasis on fee income-generating activities has increased in response to both the risk-based capital guidelines, which created more pressure to reduce the size of the balance sheet, and a general increase in competition in the financial services industry.

Some of the principal forms of fee-generating activity include:

Annuities. Banks sell fixed and variable annuities.
Brokerage. Banks may arrange for the purchase and sale of securities on behalf of customers in return for a commission.
Corporate and advisory services. These activities involve advice on mergers and acquisitions, capital raising, and Treasury management in return for a fee.
Private banking. This activity involves investment planning, tax assistance, and credit extensions to wealthy individuals.
Private placements. This activity normally involves the placement of securities on a best efforts basis as opposed to an underwriting commitment.
Underwriting. Banks may guarantee to purchase certain allowable securities if they are not fully subscribed to in an offering.
401(k) plans and mutual funds. Banks may distribute mutual funds in a 401(k) plan.

Many of the activities, particularly underwriting, are subject to restriction by regulation as to the type of securities that may be transacted, and separately capitalized subsidiaries may be required.

These activities generate fee income that is recorded when earned. Certain activities are conducted in conjunction with credit extension activities, and therefore particular attention is required to ensure that fees generated are appropriately recorded. It is essential to distinguish between fees that may be recorded immediately and fees that are essentially loan origination fees to be accounted for over the life of the loan (SFAS No. 91).

(y) Electronic Banking and Technology Risks

Conducting banking by personal computer is a growing area for many institutions. The types of transactions customers can perform online has also increased. For example, customers can transfer funds, pay bills, and apply for loans by using electronic banking. The start-up costs of an e-bank are high. Establishing a trusted brand is very costly as it requires significant advertising expenditure in addition to the purchase of expensive technology (as security and privacy is key to gaining customer approval). E-banking services are designed to support the true integration of trade documentation with financing products and cash management on consistent platforms linking banks with corporate customers via multiple channels, from Web-based to fully integrated using Web services or electronic data interchange–related technologies. Advantage should be taken of the current technology as it can help manage fair lending, pricing, fraud detection, and other aspects of compliance and risk.

Transaction/operations risk arises from fraud, processing errors, system disruptions, or other unanticipated events resulting in the institution's inability to deliver products or services. This risk exists in each product and service offered. The level of transaction risk is affected by the structure of the institution's processing environment, including the types of services offered and the complexity of the processes and supporting technology. In most instances, e-banking activities will increase the complexity of the institution's activities and the quantity of its transaction/operations risk. E-banking has unique characteristics that may increase an institution's overall risk profile and the level of risks associated with traditional financial services, particularly strategic, operational, legal, and reputation risks. These unique e-banking characteristics include:

Speed of technological change
Changing customer expectations
Increased visibility of publicly accessible networks (e.g., the Internet)
Less face-to-face interaction with financial institution customers
Need to integrate e-banking with the institution's legacy computer systems
Dependence on third parties for necessary technical expertise
Proliferation of threats and vulnerabilities in publicly accessible networks

The central authority should define the rules and regulations and share them with all banking organizations in order to reduce the level of risk. The risk can be measured both quantitatively and qualitatively. Information security is essential to a financial institution's ability to deliver e-banking services, protect the confidentiality and integrity of customer information, and ensure that accountability exists for changes to the information and the processing and communications systems. Depending on the extent of in-house technology, a financial institution's e-banking systems can make information security complex with numerous networking and information technology (IT) control issues. Financial institutions should have processes to identify, monitor, and address training needs. Each financial institution should train personnel in the technologies used and the institution's rules governing the use of that technology. Technical training is particularly important for those who oversee the key technology controls, such as firewalls, intrusion detection, and device configuration. Security awareness training is important for all users, including the institution's e-banking customers. Additionally, many institutions are using client/server systems and personal computers, rather than mainframe computers, to process customer transactions and maintain bank records. Accordingly, security and database management controls surrounding these client/servers and personal computers becomes very important.

Information technology (IT) has significantly impacted the financial services industry. IT has enabled transfers between different accounts at the tip of the fingers through the use of mobile and online banking. Banks offer a variety of capabilities with their mobile applications. For example, financial services firms of Citi, Wells Fargo, State Farm's Bank, and J. P. Morgan Chase provide several services such as: remote deposits, initiate or approve wire transfers and outgoing payments for corporate customers, online view transaction details, and other online banking services. Regulatory agencies have issued guidance addressing the safety and soundness aspects of electronic banking and personal computer banking and the security risks associated with the Internet and phone banking.

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Table of Contents for Chapter 30: Financial Institutions

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30.1 Overview

(a) Changing the Environment