investment securities and end-user activities section 3000includes the balance of a bank’s...

Investment Securities and End-User ActivitiesSection 3000.1

A depository institution’s investment and end-user activities involve the use of securities(both available-for-sale and held-to-maturity)and derivative contracts to achieve earningsand risk-management objectives that involvelonger time horizons than those typically as-sociated with trading activities.1 These‘‘nontrading’’ activities involve the full array ofcash securities, money market instruments, andderivative contracts. Cash securities includefixed- and floating-rate notes and bonds,structured notes, mortgage pass-through andother asset-backed securities, and mortgage-derivative products. OBS derivative contractsinclude swaps, futures, and options.

When institutions acquire and manage secu-rities and derivative instruments, they mustensure that these activities are permissible andappropriate within the established limitationsand restrictions on banks’ holdings. Institutionsmust also employ sound risk-management prac-tices consistently across these varying productcategories, regardless of their legal characteris-tics or nomenclature. This section providesexaminers with guidance on—

• the permissibility and appropriateness ofsecurities holdings by state member banks;

• sound risk-management practices and internalcontrols used by banking institutions in theirinvestment and end-user activities;

• interaffiliate derivatives transactions;• securities and derivatives acquired by the

bank’s international division and overseasbranches for its own account, as well as on thebank’s foreign equity investments that areheld either directly or through Edge Actcorporations; and

• unsuitable investment practices.

LIMITATIONS ANDRESTRICTIONS ON SECURITIESHOLDINGS

Many states extend the same investment authori-ties available to national banks to their charteredbanks—often with direct reference. In turn, the

security investments of national banks aregoverned by the seventh paragraph of 12 USC24 (section 5136 of the Revised Statutes) and bythe investment-securities regulation of the Officeof the Comptroller of the Currency (OCC).

Under 12 USC 24, an ‘‘investment security’’is defined as a debt obligation that is not pre-dominantly speculative. A security is not pre-dominantly speculative if it is rated investment-grade. An ‘‘investment-grade security’’ has beenrated in one of the four highest rating categoriesby two or more nationally recognized statisticalrating organizations (one rating may suffice ifthe security has only been rated by oneorganization). In the case of split ratings—different ratings from different ratingorganizations—the lower rating applies.

The OCC’s investment-securities regulation,which was revised in 2001, identifies five basictypes of investment securities (types I, II, III, IV,and V) and establishes limitations on a bank’sinvestment in these types of securities based onthe percentage of capital and surplus that suchholdings represent. For calculating concentra-tion limits, the term ‘‘capital and surplus’’includes the balance of a bank’s allowance forloan and lease losses not included in tier 2capital. Table 1 summarizes bank-eligible secu-rities and their investment limitations.

Type I securities are those debt instrumentsthat national and state member banks can dealin, underwrite, purchase, and sell for their ownaccounts without limitation. Type I securitiesare obligations of the U.S. government orits agencies, general obligations of states andpolitical subdivisions, and mortgage-relatedsecurities. As a result of the Gramm-Leach-Bliley Act (GLB Act), municipal revenue bondsthat are not general obligation bonds are theequivalent of type I investment securities forwell-capitalized state member banks. A bankmay purchase type I securities for its ownaccount subject to no limitations, other than theexercise of prudent banking judgment (see 12USC 24 (seventh) and 15 USC 78c(a)(41)).

Type II securities are those debt instrumentsthat national and state member banks may dealin, underwrite, purchase, and sell for their ownaccounts subject to a 10 percent limitation of abank’s capital and surplus for any one obligor.Type II investments include obligations issuedby the International Bank for Reconstruction

1. In general terms, derivatives are financial contractswhose value derives from the value of one or more underlyingassets, interest rates, exchange rates, commodities, or financialor commodity indexes.

Trading and Capital-Markets Activities Manual January 2009

and Development; the Inter-American Develop-ment Bank; the Asian Development Bank; theTennessee Valley Authority; the U.S. PostalService; obligations issued by any state orpolitical subdivision for housing, university, ordormitory purposes; and other issuers specifi-cally identified in 12 USC 24 (seventh).

Type III is a residual securities categoryconsisting of all types of investment securitiesnot specifically designated to another security‘‘type’’ category. Banks cannot deal in orunderwrite type III securities, and their holdingsof these instruments are limited to 10 percent ofthe banks’ capital and surplus for any oneobligor.

Type IV securities include the followingasset-backed securities (ABS) that are fullysecured by interests in pools of loans made tonumerous obligors:

• investment-grade residential mortgage–relatedsecurities offered or sold pursuant to section4(5) of the Securities Act of 1933 (15 USC77d(5))

• residential mortgage–related securities asdescribed in section 3(a)(41) of the SecuritiesExchange Act of 1934 (15 USC 78c(a)(41))that are rated in one of the two highestinvestment-grade rating categories

• investment-grade commercial mortgage secu-rities offered or sold pursuant to section 4(5)of the Securities Act of 1933 (15 USC 77d(5))

• commercial mortgage securities as describedin section 3(a)(41) of the Securities ExchangeAct of 1934 (15 USC 78c(a)(41)) that arerated in one of the two highest investment-grade rating categories

• investment-grade, small-business-loan securi-ties as described in section 3(a)(53)(A) of theSecurities Exchange Act of 1934 (15 USC78c(a)(53)(A))

For all type IV commercial and residentialmortgage securities and for type IV small-business-loan securities rated in the top twocategories, there is no limitation on the amounta bank can purchase or sell for its own account.Type IV investment-grade, small-business-loansecurities that are not rated in the top two ratingcategories are subject to a limit of 25 percent ofa bank’s capital and surplus for any one issuer.In addition to being able to purchase and selltype IV securities, subject to the above limita-tion, a bank may deal in those type IV securitiesthat are fully secured by type I securities.

Type V securities consist of all ABS that arenot type IV securities. Specifically, they aredefined as marketable, investment-grade-ratedsecurities that are not type IV and are ‘‘fullysecured by interests in a pool of loans tonumerous obligors and in which a national bankcould invest directly.’’ They include securitiesbacked by auto loans, credit card loans, home-equity loans, and other assets. Also included areresidential and commercial mortgage securitiesas described in section 3(a)(41) of the SecuritiesExchange Act of 1934 (15 USC 78c(a)(41)).These securities are not rated in one of the twohighest investment-grade-rating categories, butthey are still investment grade. A bank maypurchase or sell type V securities for its ownaccount provided the aggregate par value of typeV securities issued by any one issuer held by thebank does not exceed 25 percent of the bank’scapital and surplus.

As mentioned above, type III securitiesrepresent a residual category. The OCC requiresa national bank to determine (1) that the type IIIinstrument it plans to purchase is marketableand of sufficiently high investment quality and(2) that the obligor will be able to meet allpayments and fulfill all the obligations it hasundertaken in connection with the security. Forexample, junk bonds, which are often issued tofinance corporate takeovers, are usually notconsidered to be of investment quality becausethey are predominately speculative and havelimited marketability.

The purchase of type II and III securities islimited to 10 percent of equity capital andreserves for each obligor when the purchase isbased on adequate evidence of the maker’sability to perform. That limitation is reduced to5 percent of equity capital and reserves for allobligors in the aggregate when the judgment ofthe obligor’s ability to perform is based predom-inantly on ‘‘reliable estimates.’’ The term ‘‘reli-able estimates’’ refers to projections of incomeand debt-service requirements or conditionalratings when factual credit information is notavailable and when the obligor does not have arecord of performance. Securities purchasedsubject to the 5 percent limitation may, in fact,become eligible for the 10 percent limitationonce a satisfactory financial record has beenestablished. Additional limitations on specificsecurities that have been ruled eligible for invest-ment are detailed in 12 CFR 1.3. The par value,not the book value or purchase price, of the

3000.1 Investment Securities and End-User Activities

January 2009 Trading and Capital-Markets Activities Manual

security is the basis for computing the limita-tions. However, the limitations do not apply to

securities acquired through debts previouslycontracted.

Table 1—Summary of New Investment-Type Categories

Type Category Characteristics Limitations

Type Isecurities

• U.S. government securities• general obligations of a state or

political subdivision• obligations backed by the full faith

and credit of the U.S. government• FHLB, FNMA, and FHLMC debt• for well-capitalized banks, muni-

cipal revenue bonds that are notgeneral obligation bonds

No limitations on banks’ investment,dealing, or underwriting abilities.

Type IIsecurities

• state obligations for housing,university, or dormitory purposesthat would not qualify as atype I municipal security

• obligations of development banks• debt of Tennessee Valley

Authority• debt of U.S. Postal Service

Banks may deal in, underwrite,or invest subject to the limitation thatthe aggregate par value of the obligationof any one obligor may not exceed10 percent of a bank’s capitaland surplus.

Type IIIsecurities

• an investment security that doesnot qualify as type I, II, IV, or V

• municipal revenue bonds, exceptthose that qualify as a type Imunicipal security

• corporate bonds

Banks may not deal in orunderwrite these securities. Theaggregate par value of a bank’spurchases and sales of the securitiesof any one obligor may not exceed10 percent of a bank’s capital andsurplus.

Type IVsecurities

• small business–related securitiesthat are rated investment gradeor the equivalent and that arefully secured by a loan pool

• residential and commercialmortgage–related securities ratedAA, Aa, or higher

For securities rated AA or Aa or higher,no investment limitations. For securitiesrated A or Baa, the aggregate par valueof a bank’s purchases and sales of thesecurities of any one obligor may notexceed 25 percent of a bank’s capitaland surplus.

For mortgage-related securities, noinvestment limitations.

A bank may deal in type IV securitiesthat are fully secured by type Isecurities, with limitations.

Investment Securities and End-User Activities 3000.1


Type Category Characteristics Limitations

Type Vsecurities

• asset-backed securities (creditcard, auto, home equity, studentloan, manufactured housing) thatare investment grade andmarketable

• residential and commercialmortgage–related securities notrated AA or Aa or higher butstill investment grade

The aggregate par value of a bank’spurchases and sales of the securitiesof any one obligor may not exceed25 percent of a bank’s capital andsurplus.

UNIFORM AGREEMENT ON THECLASSIFICATION OF ASSETSAND THE APPRAISAL OFSECURITIES

On June 15, 2004, the agencies2 issued a jointinteragency statement that revised the UniformAgreement on the Classification of Assets andAppraisal of Securities Held by Banks andThrifts (the uniform agreement). (See SR-04-9.)The uniform agreement amends the examinationprocedures that were established in 1938 andthen revised and issued on July 15, 1949, and onMay 7, 1979. The uniform agreement sets forththe definitions of the classification categoriesand the specific examination procedures andinformation for classifying bank assets, includ-ing securities. The uniform agreement’s classi-fication of loans remains unchanged from the1979 revision.

The June 15, 2004, agreement changes theclassification standards applied to banks’ hold-ings of debt securities by—

• eliminating the automatic classification ofsub-investment-grade debt securities when abanking organization has developed an accu-rate, robust, and documented credit-risk-management framework to analyze its securi-ties holdings;

• conforming the uniform agreement to currentgenerally accepted accounting principles bybasing the recognition of depreciation on allavailable-for-sale securities on the bank’sdetermination as to whether the impairment of

the underlying securities is ‘‘temporary’’ or‘‘other than temporary’’;

• eliminating the preferential treatment given todefaulted municipal securities;

• clarifying how examiners should addresssecurities that have two or more differentratings, split or partially rated securities, andnonrated debt securities;

• identifying when examiners may diverge fromconforming their ratings to those of the ratingagencies; and

• addressing the treatment of Interagency Coun-try Exposure Review Committee ratings.

The uniform agreement’s classification catego-ries also apply to the classification of assets heldby the subsidiaries of banks. Although theclassification categories for bank assets andassets held by bank subsidiaries are the same,the classification standards may be diffıcult toapply to the classification of subsidiary assetsbecause of differences in the nature and riskcharacteristics of the assets. Despite the differ-ences that may exist between assets held directlyby a bank and those held by its subsidiary, thestandards for classifying investment securitiesare to be applied directly to securities held by abank and its subsidiaries.

Classification of Assets inExaminations

Classification units are designated as Substan-dard, Doubtful, and Loss. A Substandard asset isinadequately protected by the current soundworth and paying capacity of the obligor or ofthe collateral pledged, if any. Assets so classi-fied must have a well-defined weakness orweaknesses that jeopardize the liquidation of thedebt. They are characterized by the distinct

2. The statement was issued by the Board of Governors ofthe Federal Reserve System, the Office of the Comptroller ofthe Currency, the Federal Deposit Insurance Corporation, andthe Office of Thrift Supervision (the agencies).



possibility that the institution will sustain someloss if the deficiencies are not corrected. Anasset classified Doubtful has all the weaknessesinherent in one classified Substandard, with theadded characteristic that the weaknesses makecollection or liquidation in full, on the basis ofcurrently existing facts, conditions, and values,highly questionable and improbable. Assetsclassified Loss are considered uncollectible andof such little value that their continuance asbankable assets is not warranted. This classifi-cation does not mean that the asset hasabsolutely no recovery or salvage value butrather that it is not practical or desirable to deferwriting off this basically worthless asset eventhough partial recovery may be effected in thefuture. Amounts classified Loss should bepromptly charged off.

Appraisal of Securities in BankExaminations

In an effort to streamline the examinationprocess and achieve as much consistency aspossible, examiners will use the publishedratings provided by nationally recognized statis-tical ratings organizations (NRSROs) as a proxyfor the supervisory classification definitions.Examiners may, however, assign a more- orless-severe classification for an individual secu-rity, depending on a review of applicable factsand circumstances.

Investment-Quality Debt Securities

Investment-quality debt securities are market-able obligations in which the investment char-acteristics are not distinctly or predominantlyspeculative. This group generally includes invest-ment securities in the four highest ratingcategories provided by NRSROs and includesunrated debt securities of equivalent quality.

Because investment-quality debt securities donot exhibit weaknesses that justify an adverseclassification rating, examiners will generallynot classify them. However, published creditratings occasionally lag demonstrated changesin credit quality, and examiners may, in limitedcases, classify a security notwithstanding aninvestment-grade rating. Examiners may usesuch discretion, when justified by credit infor-mation the examiner believes is not reflected in

the rating, to properly reflect the security’scredit risk.

Sub-Investment-Quality Debt Securities

Sub-investment-quality debt securities are thosein which the investment characteristics aredistinctly or predominantly speculative. Thisgroup generally includes debt securities, includ-ing hybrid equity instruments (for example, trustpreferred securities), in grades below the fourhighest rating categories; unrated debt securitiesof equivalent quality; and defaulted debtsecurities.

In order to reflect asset quality properly, anexaminer may in limited cases ‘‘pass’’ a debtsecurity that is rated below investment quality.Examiners may use such discretion when, forexample, the institution has an accurate androbust credit-risk-management framework andhas demonstrated, based on recent, materiallypositive credit information, that the security isthe credit equivalent of investment grade.

Rating Differences

Some debt securities may have investment-quality ratings by one (or more) rating agenciesand sub-investment-quality ratings by others.Examiners will generally classify such securi-ties, particularly when the most recently assignedrating is not investment quality. However, anexaminer has discretion to ‘‘pass’’ a debtsecurity with both investment-quality and sub-investment-quality ratings. The examiner mayuse that discretion if, for example, the institutionhas demonstrated through its documented creditanalysis that the security is the credit equivalentof investment grade.

Split or Partially Rated Securities

Some individual debt securities have ratings forprincipal but not interest. The absence of arating for interest typically reflects uncertaintyregarding the source and amount of interest theinvestor will receive. Because of the speculativenature of the interest component, examiners willgenerally classify such securities, regardless ofthe rating for the principal.



Nonrated Debt Securities

The agencies expect institutions holding indi-vidually large nonrated debt security exposures,or having significant aggregate exposures fromsmall individual holdings, to demonstrate thatthey have made prudent pre-acquisition creditdecisions and have effective, risk-based stan-dards for the ongoing assessment of credit risk.Examiners will review the institution’s programfor monitoring and measuring the credit risk ofsuch holdings and, if the assessment process isconsidered acceptable, generally will rely uponthose assessments during the examination pro-cess. If an institution has not establishedindependent risk-based standards and a satisfac-tory process to assess the quality of suchexposures, examiners may classify such securi-ties, including those of a credit quality deemedto be the equivalent of subinvestment grade, asappropriate.

Some nonrated debt securities held in invest-ment portfolios represent small exposures rela-tive to capital, both individually and in aggre-gate. While institutions generally have the samesupervisory requirements (as applicable to largeholdings) to show that these holdings are thecredit equivalent of investment grade at pur-chase, comprehensive credit analysis subse-quent to purchase may be impractical and notcost effective. For such small individual expo-sures, institutions should continue to obtain andreview available financial information, andassign risk ratings. Examiners may rely upon thebank’s internal ratings when evaluating suchholdings.

Foreign Debt Securities

The Interagency Country Exposure ReviewCommittee (ICERC) assigns transfer-risk rat-ings for cross-border exposures. Examinersshould use the guidelines in this uniformagreement rather than ICERC transfer-riskratings in assigning security classifications,except when the ICERC ratings result in amore-severe classification.

Treatment of Declines in Fair ValueBelow Amortized Cost on Debt Securities

Under generally accepted accounting principles(GAAP), an institution must assess whether a

decline in fair value3 below the amortized costof a security is a ‘‘temporary’’ or an ‘‘other-than-temporary’’ impairment. When the decline infair value on an individual security represents‘‘other-than-temporary’’ impairment, the costbasis of the security must be written down to fairvalue, thereby establishing a new cost basis forthe security, and the amount of the write-downmust be reflected in current-period earnings. Ifan institution’s process for assessing impairmentis considered acceptable, examiners may usethose assessments in determining the appropri-ate classification of declines in fair value belowamortized cost on individual debt securities.

Any decline in fair value below amortizedcost on defaulted debt securities will be classi-fied as indicated in table 2. Apart fromclassification, for impairment write-downs orcharge-offs on adversely classified debt securi-ties, the existence of a payment default willgenerally be considered a presumptive indicatorof ‘‘other-than-temporary’’ impairment.

Classification of Other Types ofSecurities

Some investments, such as certain equityholdings or securities with equity-like risk andreturn profiles, have highly speculative perfor-mance characteristics. Examiners should gener-ally classify such holdings based on an assess-ment of the applicable facts and circumstances.

Summary Table of Debt SecurityClassification Guidelines

Table 2 outlines the uniform classificationapproach the agencies will generally use whenassessing credit quality in debt securitiesportfolios.

The general debt security classification guide-lines do not apply to private debt and equityholdings in a small business investment com-pany or an Edge Act corporation. The uniformagreement does not apply to securities held intrading accounts, provided the institution dem-

3. As currently defined under GAAP, the fair value of anasset is the amount at which that asset could be bought or soldin a current transaction between willing parties, that is, otherthan in a forced or liquidation sale. Quoted market prices arethe best evidence of fair value and must be used as the basisfor measuring fair value, if available.



onstrates through its trading activity a short-term holding period or holds the security as ahedge for a customer’s valid derivative contract.

Credit-Risk-Management Frameworkfor Securities

When an institution has developed an accurate,robust, and documented credit-risk-managementframework to analyze its securities holdings,examiners may choose to depart from thegeneral debt security classification guidelines infavor of individual asset review in determiningwhether to classify those holdings. A robustcredit-risk-management framework entailsappropriate pre-acquisition credit due diligenceby qualified staff that grades a security’s creditrisk based on an analysis of the repaymentcapacity of the issuer and the structure andfeatures of the security. It also involves theongoing monitoring of holdings to ensure thatrisk ratings are reviewed regularly and updatedin a timely fashion when significant newinformation is received.

The credit analysis of securities should varybased on the structural complexity of the

security, the type of collateral, and externalratings. The credit-risk-management frameworkshould reflect the size, complexity, quality, andrisk characteristics of the securities portfolio;the risk appetite and policies of the institution;and the quality of its credit-risk-managementstaff, and should reflect changes to these factorsover time. Policies and procedures shouldidentify the extent of credit analysis anddocumentation required to satisfy sound credit-risk-management standards.

Transfers of Low-Quality Securitiesand Assets

The purchase of low-quality assets by a bankfrom an affiliated bank or nonbank affiliate is aviolation of section 23A of the Federal ReserveAct. The transfer of low-quality securities fromone depository institution to another may bedone to avoid detection and classification duringregulatory examinations; this type of transfermay be accomplished through participations,purchases or sales, and asset swaps with otheraffiliated or nonaffiliated financial institutions.

Table 2—General Debt Security Classification Guidelines

Type of security Classification

Substandard Doubtful Loss

Investment-quality debt securities with‘‘temporary’’ impairment

— — —

Investment-quality debt securities with‘‘other-than-temporary’’ impairment

— — Impairment

Sub-investment-quality debt securitieswith ‘‘temporary’’ impairment1

Amortizedcost

— —

Sub-investment-quality debt securitieswith ‘‘other-than-temporary’’ impair-ment, including defaulted debtsecurities

Fairvalue

— Impairment

Note. Impairment is the amount by which amortized costexceeds fair value.

1. For sub-investment-quality available-for-sale (AFS) debtsecurities with ‘‘temporary’’ impairment, amortized costrather than the lower amount at which these securities arecarried on the balance sheet, i.e., fair value, is classifiedSubstandard. This classification is consistent with the regu-tory capital treatment of AFS debt securities. Under GAAP,

unrealized gains and losses on AFS debt securities areexcluded from earnings and reported in a separate componentof equity capital. In contrast, these unrealized gains and lossesare excluded from regulatory capital. Accordingly, the amountclassified Substandard on these AFS debt securities, i.e.,amortized cost, also excludes the balance-sheet adjustment forunrealized losses.



Broadly defined, low-quality securities includedepreciated or sub-investment-quality securi-ties. Situations in which an institution appears tobe concealing low-quality securities to avoidexamination scrutiny and possible classificationrepresent an unsafe and unsound activity.

Any situations involving the transfer oflow-quality or questionable securities should bebrought to the attention of Reserve Banksupervisory personnel who, in turn, shouldnotify the local office of the primary federalregulator of the other depository institutioninvolved in the transaction. For example, if anexaminer determines that a state member bankor holding company has transferred or intends totransfer low-quality securities to another deposi-tory institution, the Reserve Bank should notifythe recipient institution’s primary federal regu-lator of the transfer. The same notificationrequirement holds true if an examiner deter-mines that a state member bank or holdingcompany has acquired or intends to acquire low

quality securities from another depository insti-tution. This procedure applies to transfersinvolving savings associations and savingsbanks, as well as commercial banking organiza-tions.

Situations may arise when transfers of secu-rities are undertaken for legitimate reasons. Inthese cases, the securities should be properlyrecorded on the books of the acquiring institu-tion at their fair value on the date of transfer. Ifthe transfer was with the parent holdingcompany or a nonbank affiliate, the records ofthe affiliate should be reviewed as well.

Permissible Stock Holdings

The purchase of securities convertible into stockat the option of the issuer is prohibited (12 CFR1.6). Other than as specified in table 3, banks areprohibited from investing in stock.

Table 3—Permitted Stock Holdings by Member Banks

Type of stock Authorizing statute and limitation

Federal Reserve Bank Federal Reserve Act, sections 2 and 9 (12 USC 282 and 321) andRegulation I (12 CFR 209). Subscription must equal 6 percent ofthe bank’s capital and surplus, 3 percent paid in.

Safe deposit corporation 12 USC 24. 15 percent of capital and surplus.

Corporation holding bankpremises

Federal Reserve Act, section 24A (12 USC 371(d)). 100 percent ofcapital stock. Limitation includes total direct and indirectinvestment in bank premises in any form (such as loans).Maximum limitation may be exceeded with permission of theFederal Reserve Bank for state member banks and the Comptrollerof the Currency for national banks.

Small business investmentcompany

Small Business Investment Act of August 21, 1958, section 302(b)(15 USC 682(b)). Banks are prohibited from acquiring shares ofsuch a corporation if, upon making the acquisition, the aggregateamount of shares in small business investment companies thenheld by the bank would exceed 5 percent of its capital and surplus.

Edge Act and agreementcorporations andforeign banks

Federal Reserve Act, sections 25 and 25A (12 USC 601 and 618).The aggregate amount of stock held in all such corporations maynot exceed 10 percent of the member bank’s capital and surplus.Also, the member bank must possess capital and surplus of$1 million or more before acquiring investments pursuant tosection 25.




Bank service company Bank Service Corporation Act of 1958, section 2 (12 USC 1861and 1862). (Redesignated as Bank Service Company Act.)10 percent of paid in and unimpaired capital and surplus.Limitation includes total direct and indirect investment in anyform. No insured banks shall invest more than 5 percent of theirtotal assets.

Federal National MortgageCorporation

National Housing Mortgage Association Act of 1934, sec-tion 303(f) (12 USC 1718(f)). No limit.

Bank’s own stock 12 USC 83. Shares of the bank’s own stock may not be acquiredor taken as security for loans, except as necessary to prevent lossfrom a debt previously contracted in good faith. Stock so acquiredmust be disposed of within six months of the date of acquisition.

Corporate stock acquiredthrough debt previouslycontracted (DPC) transaction

Case law has established that stock of any corporation debt may beacquired to prevent loss from a debt previously contracted in goodfaith. See Oppenheimer v. Harriman National Bank & Trust Co. ofthe City of New York, 301 US 206 (1937). However, if the stockis not disposed of within a reasonable time period, it loses its statusas a DPC transaction and becomes a prohibited holding under12 USC 24(7).

Operations subsidiaries 12 CFR 250.141. Permitted if the subsidiary is to perform, atlocations at which the bank is authorized to engage in business,functions that the bank is empowered to perform directly.

State housing corporationincorporated in the statein which the bank is located

12 USC 24. 5 percent of its capital stock, paid in and unimpaired,plus 5 percent of its unimpaired surplus fund when consideredtogether with loans and commitments made to the corporation.

Agricultural creditcorporation

12 USC 24. 20 percent of capital and surplus unless the bank ownsover 80 percent. No limit if the bank owns 80 percent or more.

Government NationalMortgage Association

12 USC 24. No limit.

Student Loan MarketingAssociation

12 USC 24. No limit.

Bankers’ banks 12 USC 24. 10 percent of capital stock and paid-in and unimpairedsurplus. Bankers’ banks must be insured by the FDIC, ownedexclusively by depository institutions, and engaged solely inproviding banking services to other depository institutions andtheir officers, directors, or employees. Ownership shall not result inany bank’s acquiring more than 5 percent of any class of votingsecurities of the bankers’ bank.

Mutual funds 12 USC 24(7). Banks may invest in mutual funds as long as theunderlying securities are permissible investments for a bank.




Community developmentcorporation

Federal Reserve Act, section 9, paragraph 23 (12 USC 338a). Upto 10 percent of capital stock and surplus1 subject to 12 CFR208.22.

1. Section 208.2(d) of Regulation H defines ‘‘capital stockand surplus’’ to mean tier 1 and tier 2 capital included in amember bank’s risk-based capital and the balance of amember bank’s allowance for loan and lease losses notincluded in its tier 2 capital for calculation of risk-basedcapital, based on the bank’s most recent consolidated Reportof Condition and Income. Section 9 of the Federal ReserveAct (12 USC 338a) provides that the Board has the authority

under this law to approve public-welfare or other suchinvestments, up to the sum of 5 percent of paid-in andunimpaired capital stock and 5 percent of unimpaired surplus,unless the Board determines by order that the higher amountwill pose no significant risk to the affected deposit insurancefund, and the bank is adequately capitalized. In no case maythe aggregate of such investments exceed 10 percent of thebank’s combined capital stock and surplus.

LIMITED EQUITY INVESTMENTS

Investing in the equity of nonfinancial compa-nies and lending to private-equity-financedcompanies (that is, companies financed byprivate equity) have emerged as increasinglyimportant sources of earnings and businessrelationships at a number of banking organiza-tions (BOs). In this guidance, the term privateequity refers to shared-risk investments outsideof publicly quoted securities and also coversactivities such as venture capital, leveragedbuyouts, mezzanine financing, and holdings ofpublicly quoted securities obtained throughthese activities. While private equity securitiescan contribute substantially to earnings, theseactivities can give rise to increased volatility ofboth earnings and capital. The supervisoryguidance in SR-00-9 on private equity invest-ments and merchant banking activities is con-cerned with a BO’s proper risk-focused manage-ment of its private equity investment activitiesso that these investments do not adversely affectthe safety and soundness of the affiliated insureddepository institutions.

An institution’s board of directors and seniormanagement are responsible for ensuring thatthe risks associated with private equity activitiesdo not adversely affect the safety and soundnessof the banking organization or any otheraffiliated insured depository institutions. To thisend, sound investment and risk-managementpractices and strong capital positions are criticalelements in the prudent conduct of theseactivities.

Legal and Regulatory Authority

Depository institutions are able to make limited

equity investments under the following statutoryand regulatory authorities:

• Depository institutions may make equityinvestments through small business invest-ment corporations (SBICs). Investments madeby SBIC subsidiaries are allowed up to a totalof 50 percent of a portfolio company’soutstanding shares, but can only be made incompanies defined as a small business, accord-ing to SBIC rules. A bank’s aggregateinvestment in the stock of SBICs is limited to5 percent of the bank’s capital and surplus.

• Under Regulation K, which implements sec-tions 25 and 25A of the Federal Reserve Act(FRA) and section 4(c)(13) of the BankHolding Company Act of 1956 (BHC Act), adepository institution may make portfolioinvestments in foreign companies, providedthe investments do not in the aggregate exceed25 percent of the tier 1 capital of the bankholding company. In addition, individualinvestments must not exceed 19.9 percent of aportfolio company’s voting shares or 40 per-cent of the portfolio company’s total equity.4

Equity investments made under the authori-ties listed above may be in publicly tradedsecurities or privately held equity interests. Theinvestment may be made as a direct investmentin a specific portfolio company, or it may bemade indirectly through a pooled investmentvehicle, such as a private equity fund.5 In

4. Shares of a corporation held in trading or dealingaccounts or under any other authority are also included in thecalculation of a depository institution’s investment. Portfolioinvestments of $25 million or less can be made without priornotice to the Board. See Regulation K for more detailedinformation.

5. For additional stock holdings that state member banksare authorized to hold, see table 3.



general, private equity funds are investmentcompanies, typically organized as limited part-nerships, that pool capital from third-partyinvestors to invest in shares, assets, and owner-ship interests in companies for resale or otherdisposition. Private-equity-fund investments mayprovide seed or early-stage investment funds tostart-up companies or may finance changes inownership, middle-market business expansions,and mergers and acquisitions.

MORTGAGE-DERIVATIVEPRODUCTS

In April 1998, the FFIEC rescinded its Supervi-sory Policy Statement on Securities Activities,published in February 1992, including thehigh-risk test for mortgage-derivative products.

EVALUATING RISKMANAGEMENT AND INTERNALCONTROLS

Examiners are expected to conduct an adequateevaluation of the risk-management process aninstitution uses to acquire and manage thesecurities and derivative contracts used innontrading activities. In conducting this analy-sis, examiners should evaluate the followingfour key elements of a sound risk-managementprocess:

• active board and senior management oversight• adequate risk-management policies and limits• appropriate risk-measurement and -reporting

systems• comprehensive internal controls

This section identifies basic factors that exam-iners should consider in evaluating these ele-ments for investment and end-user activities. Itreiterates and supplements existing guidanceand directives on the use of these instrumentsfor nontrading purposes as provided in varioussupervisory letters and examination manuals.6

In evaluating an institution’s risk-managementprocess, examiners should consider the natureand size of its holdings. Examiner judgmentplays a key role in assessing the adequacy of aninstitution’s risk-management process for secu-rities and derivative contracts. Examiners shouldfocus on evaluating an institution’s understand-ing of the risks involved in the instruments itholds. Regardless of any responsibility, legal orotherwise, assumed by a dealer or counterpartyfor a particular transaction, the acquiring insti-tution is ultimately responsible for understand-ing and managing the risks of the transactionsinto which it enters. Failure of an institution toadequately understand, monitor, and evaluatethe risks involved in its securities or derivativepositions, either through lack of internal exper-tise or inadequate outside advice, constitutes anunsafe and unsound banking practice.

As with all risk-bearing activities, institutionsshould fully support the risk exposures ofnontrading activities with adequate capital.Banking organizations should ensure that theircapital positions are sufficiently strong tosupport all the risks associated with theseactivities on a fully consolidated basis andshould maintain adequate capital in all affiliatedentities engaged in these activities. In evaluatingthe adequacy of an institution’s capital, exam-iners should consider any unrecognized netdepreciation or appreciation in an institution’ssecurities and derivative holdings. Further con-sideration should also be given to the institu-tion’s ability to hold these securities and therebyavoid recognizing losses.

Board of Directors and SeniorManagement Oversight

Active oversight by the institution’s board ofdirectors and relevant senior management is

6. Existing policies and examiner guidance on varioussupervisory topics applicable to securities and off-balance-sheet instruments can be found in this manual, the Commer-cial Bank Examination Manual, the Bank Holding CompanySupervision Manual, and the Trust Activities ExaminationManual, as well as in various supervision and regulation (SR)letters, including SR-90-16, ‘‘Implementation of Examination

Guidelines for the Review of Asset Securitization Activities’’;SR-91-4, ‘‘Inspections of Investment-Adviser Subsidiaries ofBank Holding Companies’’; SR-92-1, ‘‘Supervisory PolicyStatement on Securities Activities’’; SR-93-69, ‘‘Risk Man-agement and Internal Controls for Trading Activities’’;SR-95-17, ‘‘Evaluating the Risk Management and InternalControls of Securities and Derivative Contracts Used inNontrading Activities’’; and SR-98-12, ‘‘FFIEC PolicyStatement on Investment Securities and End-User DerivativesActivities.’’ Examiners of U.S. branches and agencies offoreign banks should take the principles included in theseguidelines into consideration in accordance with the proce-dures set forth in the Examination Manual for Branches andAgencies of Foreign Banking Organizations.



critical to a sound risk-management process.Examiners should ensure that these individualsare aware of their responsibilities and that theyadequately perform their appropriate roles inoverseeing and managing the risks associatedwith nontrading activities involving securitiesand derivative instruments.

Board of Directors

The board of directors has the ultimate respon-sibility for the level of risk taken by theinstitution. Accordingly, the board shouldapprove overall business strategies and signifi-cant policies that govern risk-taking, includingthose involving securities and derivative con-tracts. In particular, the board should approvepolicies identifying managerial oversight andarticulating risk tolerances and exposure limitsfor securities and derivative activities. Theboard should also actively monitor the perfor-mance and risk profile of the institution and itsvarious securities and derivative portfolios.Directors should periodically review informa-tion that is sufficiently detailed and timely toallow them to understand and assess the credit,market, and liquidity risks facing the institutionas a whole and its securities and derivativepositions in particular. These reviews should beconducted at least quarterly and more frequentlywhen the institution holds significant positionsin complex instruments. In addition, the boardshould periodically reevaluate the institution’sbusiness strategies and significant risk-management policies and procedures, placingspecial emphasis on the institution’s financialobjectives and risk tolerances. The minutes ofboard meetings and accompanying reports andpresentation materials should clearly demon-strate the board’s fulfillment of these basicresponsibilities. The section of this guidance onmanaging specific risks provides guidance onthe types of objectives, risk tolerances, limits,and reports that directors should consider.

The board of directors should also conductand encourage discussions between its membersand senior management, as well as betweensenior management and others in the institution,regarding the institution’s risk-management pro-cess and risk exposures. Although it is notessential for board members to have detailedtechnical knowledge of these activities, if theydo not, it is their responsibility to ensure thatthey have adequate access to independent legal

and professional advice on the institution’ssecurities and derivative holdings and strategies.The familiarity, technical knowledge, and aware-ness of directors and senior management shouldbe commensurate with the level and nature of aninstitution’s securities and derivative positions.Accordingly, the board should be knowledge-able enough or have access to independentadvice to evaluate recommendations presentedby management or investment advisers.

Senior Management

Senior management is responsible for ensuringthat there are adequate policies and proceduresfor conducting investment and end-user activi-ties on both a long-range and day-to-day basis.Management should maintain clear lines ofauthority and responsibility for acquiring instru-ments and managing risk, setting appropriatelimits on risk-taking, establishing adequatesystems for measuring risk, setting acceptablestandards for valuing positions and measuringperformance, establishing effective internalcontrols, and enacting a comprehensive risk-reporting and risk-management review process.To provide adequate oversight, managementshould fully understand the institution’s riskprofile, including that of its securities andderivative activities. Examiners should reviewthe reports to senior management and evaluatewhether they provide both good summaryinformation and sufficient detail to enablemanagement to assess the sensitivity of securi-ties and derivative holdings to changes in creditquality, market prices and rates, liquidity condi-tions, and other important risk factors. As part ofits oversight responsibilities, senior manage-ment should periodically review the organiza-tion’s risk-management procedures to ensurethat they remain appropriate and sound. Seniormanagement should also encourage and partici-pate in active discussions with members of theboard and with risk-management staff regardingrisk-measurement, reporting, and managementprocedures.

Management should ensure that investmentand end-user activities are conducted by com-petent staff whose technical knowledge andexperience is consistent with the nature andscope of the institution’s activities. There shouldbe sufficient depth in staff resources to managethese activities if key personnel are not avail-able. Management should also ensure that



back-office and financial-control resources aresufficient to manage and control risks effectively.

Independence in managing risks. The processof measuring, monitoring, and controlling riskswithin an institution should be managed asindependently as possible from those individu-als who have the authority to initiate transac-tions. Otherwise, conflicts of interest coulddevelop. The nature and extent of this indepen-dence should be commensurate with the size andcomplexity of an institution’s securities andderivative activities. Institutions with large andcomplex balance sheets or with significantholdings of complex instruments would beexpected to have risk managers or risk-management functions fully independent of theindividuals who have the authority to conducttransactions. Institutions with less complexholdings should ensure they have some mecha-nism for independently reviewing both the levelof risk exposures created by securities andderivative holdings and the adequacy of theprocess used in managing those exposures.Depending on the size and nature of theinstitution, this review function may be carriedout by either management or a board committee.Regardless of size and sophistication, institu-tions should ensure that back-office, settlement,and transaction-reconciliation responsibilitiesare conducted and managed by personnel whoare independent of those initiating risk-takingpositions.

Policies, Procedures, and Limits

Institutions should maintain written policies andprocedures that clearly outline their approachfor managing securities and derivative instru-ments. These policies should be consistent withthe organization’s broader business strategies,capital adequacy, technical expertise, and generalwillingness to take risks. They should identifyrelevant objectives, constraints, and guidelinesfor both acquiring instruments and managingportfolios. In doing so, policies should establisha logical framework for limiting the variousrisks involved in an institution’s securities andderivative holdings. Policies should clearlydelineate lines of responsibility and authorityover securities and derivative activities. Theyshould also provide for the systematic review ofproducts new to the firm, specify accounting

guidelines, and ensure the independence of therisk-management process. Written policies andprocedures governing municipal securities under-writing, dealing, and investment should bemaintained by banks engaged in these activities.The types of policies and procedures that areappropriate are described in SR-01-13 (May 14,2001). Examiners should evaluate the adequacyof an institution’s risk-management policies andprocedures in relation to its size, its sophistica-tion, and the scope of its activities.

Specifying Objectives

Institutions can use securities and derivativeinstruments for several primary and complemen-tary purposes.7 Banking organizations shouldarticulate these objectives clearly and identifythe types of securities and derivative contracts tobe used for achieving them. Objectives shouldalso be identified at the appropriate portfolio andinstitutional levels. These objectives shouldguide the acquisition of individual instrumentsand provide benchmarks for periodically evalu-ating the performance and effectiveness of aninstitution’s holdings, strategies, and programs.Whenever multiple objectives are involved,management should identify the hierarchy ofpotentially conflicting objectives.

Identifying Constraints, Guidelines, andLimits

An institution’s policies should clearly articulatethe organization’s risk tolerance by identifyingits willingness to take the credit, market, andliquidity risks involved in holding securities andderivative contracts. A statement of authorizedinstruments and activities is an importantvehicle for communicating these risk tolerances.This statement should clearly identify permis-sible instruments or instrument types and thepurposes or objectives for which the institutionmay use them. The statement also shouldidentify permissible credit-quality, market-risk-sensitivity, and liquidity characteristics of theinstruments and portfolios used in nontradingactivities. For example, in the case of market

7. Such purposes include, but are not limited to, generatingearnings, creating funding opportunities, providing liquidity,hedging risk exposures, taking risk positions, modifying andmanaging risk profiles, managing tax liabilities, and meetingpledging requirements.



risk, policies should address the permissibledegree of price sensitivity or effective maturityvolatility, taking into account an instrument’s orportfolio’s option and leverage characteristics.Specifications of permissible risk characteristicsshould be consistent with the institution’soverall credit-, market-, and liquidity-risk limitsand constraints and should help delineate a clearset of institutional limits for use in acquiringspecific instruments and managing portfolios.Limits can be specified either as guidelineswithin the overall policies or as managementoperating procedures. Further guidance on man-aging specific risks and on the types ofconstraints and limits an institution might use inmanaging the credit, market, and liquidity riskof securities and derivative contracts is providedlater in this section.

Limits should be set to guide acquisition andongoing management decisions, control expo-sures, and initiate discussion within the organi-zation about apparent opportunities and risks.Although procedures for establishing limits andoperating within them may vary among institu-tions, examiners should determine whether theorganization enforces its policies and proce-dures through a clearly identified system of risklimits. The organization’s policies should alsoinclude specific guidance on the resolution oflimit excesses. Positions that exceed establishedlimits should receive the prompt attention ofappropriate management and should be resolvedaccording to approved policies.

Limits should implement the overall risktolerances and constraints articulated in generalpolicy statements. Depending on the nature ofan institution’s holdings and its general sophis-tication, limits can be identified for individualbusiness units, portfolios, instrument types, orspecific instruments. The level of detail in risklimits should reflect the characteristics of theinstitution’s holdings, including the types of riskto which the institution is exposed. Regardlessof their specific form or level of aggregation,limits should be consistent with the institution’soverall approach to managing various types ofrisks. Limits should also be integrated to thefullest extent possible with institution-widelimits on the same risks as they arise in otheractivities of the firm. Later in this section,specific examiner considerations for evaluatingthe policies and limits used in managing each ofthe various types of risks involved in nontradingsecurities and derivative activities are addressed.

New-Product Review

An institution’s policies should also provide foreffective review of any products being consid-ered that would be new to the firm. Aninstitution should not acquire a meaningfulposition in a new instrument until seniormanagement and all relevant personnel (includ-ing those in internal-control, legal, accounting,and auditing functions) understand the productand can integrate it into the institution’srisk-measurement and control systems. Aninstitution’s policies should define the terms‘‘new product’’ and ‘‘meaningful position’’consistent with its size, complexity, and sophis-tication. Institutions should not be hesitant todefine an instrument as a new product. Smallchanges in the payment formulas or other termsof relatively simple and standard products cangreatly alter their risk profiles and justifydesignation as a new product. New-productreviews should analyze all of the relevant risksinvolved in an instrument and assess how wellthe product or activity achieves specified objec-tives. New-product reviews should also includea description of the relevant accounting guide-lines and identify the procedures for measuring,monitoring, and controlling the risks involved.

Accounting Guidelines

The accounting systems and procedures used forgeneral-purpose financial statements and regu-latory reporting purposes are critically importantto enhancing the transparency of an institution’srisk profile. Accordingly, an institution’s poli-cies should provide clear guidelines on account-ing for all securities and derivative holdings.Accounting treatment should be consistent withspecified objectives and with the institution’sregulatory requirements. Furthermore, institu-tions should ensure that they designate eachcash or derivative contract for accountingpurposes consistent with appropriate accountingpolicies and requirements. Accounting for non-trading securities and derivative contracts shouldreflect the economic substance of the transac-tions. When instruments are used for hedgingpurposes, the hedging rationale and perfor-mance criteria should be well documented.Management should reassess these designationsperiodically to ensure that they remainappropriate.



Risk-Measurement andRisk-Reporting Systems

Clear procedures for measuring and monitoringrisks are the foundation of a sound risk-management process. Examiners should ensurethat an institution sufficiently integrates thesefunctions into its ongoing management processand that relevant personnel recognize their roleand understand the instruments held.

Risk Measurement

An institution’s system for measuring thecredit, market, liquidity, and other risksinvolved in cash and derivative contractsshould be as comprehensive and accurate aspracticable. The degree of comprehensivenessshould be commensurate with the nature of theinstitution’s holdings and risk exposures.Exposures to each type of risk (that is, credit,market, liquidity) should be aggregated acrosssecurities and derivative contracts and inte-grated with similar exposures arising fromlending and other business activities to obtainthe institution’s overall risk profile.

Examiners should evaluate whether the riskmeasures and the risk-measurement process aresufficient to accurately reflect the different typesof risks facing the institution. Institutions shouldestablish clear risk-measurement standards forboth the acquisition and ongoing managementof securities and derivative positions. Risk-measurement standards should provide a com-mon framework for limiting and monitoringrisks and should be understood by relevantpersonnel at all levels of the institution—fromindividual managers to the board of directors.

Acquisition standards. Institutions conductingsecurities and derivative activities should havethe capacity to evaluate the risks of instrumentsbefore acquiring them. Before executing anytransaction, an institution should evaluate theinstrument to ensure that it meets the variousobjectives, risk tolerances, and guidelines iden-tified by the institution’s policies. Evaluations ofthe credit-, market-, and liquidity-risk exposuresshould be clearly and adequately documentedfor each acquisition. Documentation should beappropriate for the nature and type of instru-ment; relatively simple instruments would prob-ably require less documentation than instru-

ments with significant leverage or optioncharacteristics.

Institutions with significant securities andderivative activities are expected either toconduct in-house preacquisition analyses or usespecific third-party analyses that are indepen-dent of the seller or counterparty. Analysesprovided by the originating dealer or counter-party should be used only when a clearly definedinvestment advisory relationship exists. Lessactive institutions with relatively uncomplicatedholdings may use risk analyses provided by thedealer only if the analyses are derived usingstandard industry calculators and market con-ventions. Such analyses must comprehensivelydepict the potential risks involved in theacquisition, and they should be accompanied bydocumentation that sufficiently demonstratesthat the acquirer understands fully both theanalyses and the nature of the institution’srelationship with the provider of the analyses.Notwithstanding information and analysesobtained from outside sources, management isultimately responsible for understanding thenature and risk profiles of the institution’ssecurities and derivative holdings.

It is a prudent practice for institutions toobtain and compare price quotes and riskanalyses from more than one dealer beforeacquisition. Institutions should ensure that theyclearly understand the responsibilities of anyoutside parties that provide analyses and pricequotes. If analyses and price quotes provided bydealers are used, institutions should assume thateach party deals at arm’s length for its ownaccount unless a written agreement statesotherwise. Institutions should exercise cautionwhen dealers limit the institution’s ability toshow securities or derivative contract proposalsto other dealers to receive comparative pricequotes or risk analyses. As a general soundpractice, unless the dealer or counterparty is alsoacting under a specific investment advisoryrelationship, an investor or end-user should notacquire an instrument or enter into a transactionif its fair value or the analyses required to assessits risk cannot be determined through a meansthat is independent of the originating dealer orcounterparty.

Portfolio-management standards. Institutionsshould periodically review the performanceand effectiveness of instruments, portfolios,and institutional programs and strategies. Thisreview should be conducted at least quarterly



and should evaluate the extent to which theinstitution’s securities and derivative holdingsmeet the various objectives, risk tolerances,and guidelines established by its policies.8Institutions with large or highly complexholdings should conduct reviews more frequently.

For internal measurements of risk, effectivemeasurement of the credit, market, and liquidityrisks of many securities and derivative contractsrequires mark-to-market valuations. Accord-ingly, the periodic revaluation of securities andderivative holdings is an integral part of aneffective risk-measurement system. Periodicrevaluations should be fully documented. Whenavailable, actual market prices should be used.For less liquid or complex instruments, institu-tions with only limited holdings may useproperly documented periodic prices and analy-ses provided by dealers or counterparties. Moreactive institutions should conduct periodicrevaluations and portfolio analyses using eitherin-house capabilities or outside-party analyticalsystems that are independent of sellers orcounterparties. Institutions should recognizethat indicative price quotes and model revalua-tions may differ from the values at whichtransactions can be executed.

Stress testing. Analyzing the credit, market, andliquidity risk of individual instruments, port-folios, and the entire institution under a varietyof unusual and stressful conditions is animportant aspect of the risk-measurement pro-cess. Management should seek to identify thetypes of situations or the combinations of creditand market events that could produce substantiallosses or liquidity problems. Typically, securi-ties and derivative contracts are managed on thebasis of an institution’s consolidated exposures,and stress testing should be conducted on thesame basis. Stress tests should evaluate changesin market conditions, including alternatives inthe underlying assumptions used to valueinstruments. All major assumptions used instress tests should be identified.

Stress tests should not be limited to quantita-tive exercises that compute potential losses orgains, but should include qualitative analyses ofthe tools available to management to deal with

various scenarios. Contingency plans outliningoperating procedures and lines of communica-tion, both formal and informal, are importantproducts of such qualitative analyses.

The appropriate extent and sophistication ofan institution’s stress testing depend heavily onthe scope and nature of its securities andderivative holdings and on its ability to limit theeffect of adverse events. Institutions holdingsecurities or derivative contracts with complexcredit, market, or liquidity risk profiles shouldhave an established regime of stress testing.Examiners should consider the circumstances ateach institution when evaluating the adequacyor need for stress-testing procedures.

Risk Reporting

An accurate, informative, and timely manage-ment information system is essential. Examinersshould evaluate the adequacy of an institution’smonitoring and reporting of the risks, returns,and overall performance of security and deriva-tive activities to senior management and theboard of directors. Management reports shouldbe frequent enough to provide the responsibleindividuals with adequate information to judgethe changing nature of the institution’s riskprofile and to evaluate compliance with statedpolicy objectives and constraints.

Management reports should translate mea-sured risks from technical and quantitativeformats to formats that can be easily read andunderstood by senior managers and directors,who may not have specialized and technicalknowledge of all financial instruments used bythe institution. Institutions should ensure thatthey use a common conceptual framework formeasuring and limiting risks in reports to seniormanagers and directors. These reports shouldinclude the periodic assessment of the perfor-mance of appropriate instruments or portfoliosin meeting their stated objective, subject to therelevant constraints and risk tolerances.

Management evaluation and review. Manage-ment should regularly review the institution’sapproach and process for managing risks. Thisincludes regularly assessing the methodologies,models, and assumptions used to measure risksand limit exposures. Proper documentation ofthe elements used in measuring risks is essentialfor conducting meaningful reviews. Limitsshould be compared to actual exposures. Reviews

8. For example, the performance of instruments andportfolios used to meet objectives for tax-advantaged earningsshould be evaluated to ensure that they meet the necessarycredit-rating, market-sensitivity, and liquidity characteristicsestablished for this objective.



should also consider whether existing measuresof exposure and limits are appropriate in view ofthe institution’s holdings, past performance, andcurrent capital position.

The frequency of the reviews should reflectthe nature of an institution’s holdings and thepace of market innovations in measuring andmanaging risks. At a minimum, institutionswith significant activities in complex cash orderivative contracts should review the under-lying methodologies of the models they use atleast annually—and more often as marketconditions dictate—to ensure that they areappropriate and consistent. Reviews by externalauditors or other qualified outside parties, suchas consultants with expertise in highly technicalmodels and risk-management techniques, mayoften supplement these internal evaluations.Institutions depending on outside parties toprovide various risk-measurement capabilitiesshould ensure that the outside institution haspersonnel with the necessary expertise to iden-tify and evaluate the important assumptionsincorporated in the risk-measurement method-ologies it uses.

Comprehensive Internal Controls andAudit Procedures

Institutions should have adequate internal con-trols to ensure the integrity of the managementprocess used in investment and end-useractivities. Internal controls consist of proce-dures, approval processes, reconciliations,reviews, and other mechanisms designed toprovide a reasonable assurance that the institu-tion’s risk-management objectives for theseactivities are achieved. Appropriate internalcontrols should address all of the variouselements of the risk-management process, includ-ing adherence to policies and procedures and theadequacy of risk identification, risk measure-ment, and reporting.

An important element of a bank’s internalcontrols for investment and end-user activitiesis comprehensive evaluation and review bymanagement. Management should ensure thatthe various components of the bank’s risk-management process are regularly reviewed andevaluated by individuals who are independent ofthe function they are assigned to review.Although procedures for establishing limits andfor operating within them may vary among

banks, periodic management reviews should beconducted to determine whether the organiza-tion complies with its investment and end-userrisk-management policies and procedures. Anypositions that exceed established limits shouldreceive the prompt attention of appropriatemanagement and should be resolved accordingto the process described in approved policies.Periodic reviews of the risk-management pro-cess should also address any significant changesin the nature of instruments acquired, limits, andinternal controls that have occurred since thelast review.

Examiners should also review the internalcontrols of all key activities involving securitiesand derivative contracts. For example, examin-ers should evaluate and assess adherence to thewritten policies and procedures for transactionrecording and processing. They should analyzethe transaction-processing cycle to ensure theintegrity and accuracy of the institution’srecords and management reports. Examinersshould review all significant internal controlsassociated with management of the credit,market, liquidity, operational, and legal risksinvolved in securities and derivative holdings.

The examiner should review the frequency,scope, and findings of any independent internaland external auditors relative to the institution’ssecurities and derivative activities. When appli-cable, internal auditors should audit and test therisk-management process and internal controlsperiodically. Internal auditors are expected tohave a strong understanding of the specificproducts and risks faced by the organization. Inaddition, they should have sufficient expertise toevaluate the risks and controls of the institution.The depth and frequency of internal auditsshould increase if weaknesses and significantissues exist or if portfolio structures, modelingmethodologies, or the overall risk profile of theinstitution has changed.

In reviewing risk management of nontradingsecurities and derivative activities, internalauditors should thoroughly evaluate the effec-tiveness of the internal controls used formeasuring, reporting, and limiting risks. Internalauditors should also evaluate compliance withrisk limits and the reliability and timeliness ofinformation reported to the institution’s seniormanagement and board of directors, as well asthe independence and overall effectiveness ofthe institution’s risk-management process. Thelevel of confidence that examiners place in aninstitution’s audit programs, the nature of the



internal and external audit findings, and man-agement’s response to those findings willinfluence the scope of the current examinationof securities and derivative activities.

Examiners should pay special attention tosignificant changes in the nature of instrumentsacquired, risk-measurement methodologies,limits, and internal controls that have occurredsince the last examination. Significant changesin earnings from securities and derivativecontracts, in the size of positions, or in thevalue-at-risk associated with these activitiesshould also receive attention during theexamination.

EVALUATING MANAGEMENT OFSPECIFIC RISKS

Specific considerations in evaluating the keyelements of sound risk-management systems asthey relate to the credit, market, liquidity,operating, and legal risks involved in securitiesand derivative contracts for nontrading activitiesare described below.

Credit Risk

Broadly defined, credit risk is the risk that anissuer or counterparty will fail to perform on anobligation to the institution. The policies of aninstitution should recognize credit risk as asignificant risk posed by the institution’s secu-rities and derivative activities. Accordingly,policies should identify credit-risk constraints,risk tolerances, and limits at the appropriateinstrument, portfolio, and institutional levels. Indoing so, institutions should ensure that credit-risk constraints are clearly associated withspecified objectives. For example, credit-riskconstraints and guidelines should be defined forinstruments used to meet pledging requirements,generate tax-advantaged income, hedge posi-tions, generate temporary income, or meet anyother specifically defined objective.

As a matter of general policy, an institutionshould not acquire securities or derivativecontracts until it has assessed the creditworthi-ness of the issuer or counterparty and deter-mined that the risk exposure conforms with itspolicies. The credit risk arising from thesepositions should be incorporated into the overallcredit-risk profile of the institution to the fullest

extent possible. Given the interconnectedness ofthe various risks facing the institution, organi-zations should also evaluate the effect ofchanges in issuer or counterparty credit standingon an instrument’s market and liquidity risk.The board of directors and responsible seniormanagement should be informed of the institu-tion’s total credit-risk exposures at leastquarterly.

Selection of Securities Dealers

In managing their credit risk, institutions alsoshould consider settlement and presettlementcredit risk. The selection of dealers, investmentbankers, and brokers is particularly important inmanaging these risks effectively. An institu-tion’s policies should identify criteria for select-ing these organizations and list all approvedfirms. The management of a depository institu-tion must have sufficient knowledge about thesecurities firms and personnel with whom theyare doing business. A depository institutionshould not engage in securities transactions withany securities firm that is unwilling to providecomplete and timely disclosure of its financialcondition. Management should review the secu-rities firm’s financial statements and evaluatethe firm’s ability to honor its commitments bothbefore entering into transactions with the firmand periodically thereafter. An inquiry into thegeneral reputation of the dealer is also neces-sary. The board of directors or an appropriatecommittee of the board should periodicallyreview and approve a list of securities firms withwhom management is authorized to do business.The board or an appropriate committee thereofshould also periodically review and approvelimits on the amounts and types of transactionsto be executed with each authorized securitiesfirm. Limits to be considered should includedollar amounts of unsettled trades, safekeepingarrangements, repurchase transactions, securi-ties lending and borrowing, other transactionswith credit risk, and total credit risk with anindividual dealer.

At a minimum, depository institutions shouldconsider the following when selecting andretaining a securities firm:

• the ability of the securities dealer and itssubsidiaries or affiliates to fulfill commitmentsas evidenced by their capital strength, liquid-ity, and operating results (this evidence should



be gathered from current financial data,annual reports, credit reports, and othersources of financial information)

• the dealer’s general reputation or financialstability and its fair and honest dealings withcustomers (other depository institutions thathave been or are currently customers of thedealer should be contacted)

• information available from state or federalsecurities regulators and securities industryself-regulatory organizations, such as theNational Association of Securities Dealers,concerning any formal enforcement actionsagainst the dealer, its affiliates, or associatedpersonnel

• when the institution relies on the advice of adealer’s sales representative, the experienceand expertise of the sales representative withwhom business will be conducted

In addition, the board of directors (or anappropriate committee of the board) must ensurethat the depository institution’s management hasestablished appropriate procedures to obtain andmaintain possession or control of securitiespurchased. In this regard, purchased securitiesand repurchase-agreement collateral should onlybe left in safekeeping with selling dealers when(1) the board of directors or an appropriatecommittee thereof is completely satisfied as tothe creditworthiness of the securities dealer and(2) the aggregate market value of securities heldin safekeeping is within credit limitations thathave been approved by the board of directors (oran appropriate committee of the board) forunsecured transactions (see the October 1985FFIEC policy statement ‘‘Repurchase Agree-ments of Depository Institutions with SecuritiesDealers and Others’’).

State lending limits generally do not extend tothe safekeeping arrangements described above.Notwithstanding this general principle, a bank’sboard of directors should establish prudentlimits for safekeeping arrangements. Theseprudential limits generally involve a fiduciaryrelationship, which presents operational ratherthan credit risks.

To avoid concentrations of assets or othertypes of risk, banking organizations should, tothe extent possible, try to diversify the firmsthey use for safekeeping arrangements. Further,while certain transactions with securitiesdealers and safekeeping custodians may entailonly operational risks, other transactions withthese parties may involve credit risk that could

be subject to statutory lending limits, depend-ing on applicable state laws. If certain trans-actions are deemed subject to a state’s legallending limit statute because of a particularsafekeeping arrangement, the provisions of thestate’s statutes would, of course, control theextent to which the safekeeping arrangementcomplies with an individual state’s legal lendinglimit.

Limits

An institution’s credit policies should alsoinclude guidelines on the quality and quantity ofeach type of security that may be held. Policiesshould provide credit-risk diversification andconcentration limits, which may define concen-trations to a single or related issuer or counter-party, in a geographical area, or in obligationswith similar characteristics. Policies should alsoinclude procedures, such as increased monitor-ing and stop-loss limits, for addressing deterio-ration in credit quality.

Sound credit-risk management requires thatcredit limits be developed by personnel who areindependent of the acquisition function. Inauthorizing issuer and counterparty credit lines,these personnel should use standards that areconsistent with those used for other activitiesconducted within the institution and with theorganization’s overall policies and consolidatedexposures. To assess the creditworthiness ofother organizations, institutions should not relysolely on outside sources, such as standardizedratings provided by independent rating agencies,but should perform their own analysis of acounterparty’s or issuer’s financial strength. Inaddition, examiners should review the credit-approval process to ensure that the credit risksof specific products are adequately identifiedand that credit-approval procedures are followedfor all transactions.

For most cash instruments, credit exposure ismeasured as the current carrying value. In thecase of many derivative contracts, especiallythose traded in OTC markets, credit exposureis measured as the replacement cost of theposition, plus an estimate of the institution’spotential future exposure to changes in thereplacement value of that position in response tomarket price changes. Replacement costs ofderivative contracts should be determined usingcurrent market prices or generally acceptedapproaches for estimating the present value of



future payments required under each contract, atcurrent market rates.

The measurement of potential future credit-risk exposure for derivative contracts is moresubjective than the measurement of currentexposure and is primarily a function of the timeremaining to maturity; the number of exchangesof principal; and the expected volatility of theprice, rate, or index underlying the contract.Potential future exposure can be measured usingan institution’s own simulations or, more sim-ply, by using add-ons such as those included inthe Federal Reserve’s risk-based capital guide-lines. Regardless of the method an institutionuses, examiners should evaluate the reasonable-ness of the assumptions underlying the institu-tion’s risk measure.

For derivative contracts and certain types ofcash transactions, master agreements (includingnetting agreements) and various credit enhance-ments (such as collateral or third-party guaran-tees) can reduce settlement, issuer, and counter-party credit risk. In such cases, an institution’scredit exposures should reflect these risk-reducing features only to the extent that theagreements and recourse provisions are legallyenforceable in all relevant jurisdictions. Thislegal enforceability should extend to any insol-vency proceedings of the counterparty. Institu-tions should be prepared to demonstrate suffi-cient due diligence in evaluating theenforceability of these contracts.

In reviewing credit exposures, examinersshould consider the extent to which positionsexceed credit limits and whether exceptions areresolved according to the institution’s adoptedpolicies and procedures. Examiners should alsoevaluate whether the institution’s reports ade-quately provide all personnel involved in theacquisition and management of financial instru-ments with relevant, accurate, and timelyinformation about the credit exposures andapproved credit lines.

Market Risk

Market risk is the exposure of an institution’sfinancial condition to adverse movements in themarket rates or prices of its holdings before suchholdings can be liquidated or expeditiouslyoffset. It is measured by assessing the effect ofchanging rates or prices on the earnings oreconomic value of an individual instrument, a

portfolio, or the entire institution. Althoughmany banking institutions focus on carryingvalues and reported earnings when assessingmarket risk at the institutional level, othermeasures focusing on total returns and changesin economic or fair values better reflect thepotential market-risk exposure of institutions,portfolios, and individual instruments. Changesin fair values and total returns directly measurethe effect of market movements on the economicvalue of an institution’s capital and providesignificant insights into their ultimate effects onthe institution’s long-term earnings. Institutionsshould manage and control their market risksusing both an earnings and an economic-valueapproach, and at least on an economic orfair-value basis.

When evaluating capital adequacy, examinersshould consider the effect of changes in marketrates and prices on the economic value of theinstitution by evaluating any unrealized losses inan institution’s securities or derivative positions.This evaluation should assess the ability of theinstitution to hold its positions and function as agoing concern if recognition of unrealized losseswould significantly affect the institution’s capi-tal ratios. Examiners should also consider theimpact that liquidating positions with unrealizedlosses may have on the institution’s prompt-corrective-action capital category.

Market-risk limits should be established forboth the acquisition and ongoing managementof an institution’s securities and derivativeholdings and, as appropriate, should addressexposures for individual instruments, instrumenttypes, and portfolios. These limits should beintegrated fully with limits established for theentire institution. At the institutional level, theboard of directors should approve market-riskexposure limits. Such limits may be expressedas specific percentage changes in the economicvalue of capital and, when applicable, in theprojected earnings of the institution undervarious market scenarios. Similar and comple-mentary limits on the volatility of prices or fairvalue should be established at the appropriateinstrument, product-type, and portfolio levels,based on the institution’s willingness to acceptmarket risk. Limits on the variability of effectivematurities may also be desirable for certaintypes of instruments or portfolios.

The scenarios an institution specifies forassessing the market risk of its securities andderivative products should be sufficiently rigor-ous to capture all meaningful effects of any



options. For example, in assessing interest-raterisk, scenarios such as 100-, 200-, and 300-basis-point parallel shifts in yield curves should beconsidered as well as appropriate nonparallelshifts in structure to evaluate potential basis,volatility, and yield curve risks.

Accurately measuring an institution’s marketrisk requires timely information about thecurrent carrying and market values of itssecurities and derivative holdings. Accordingly,institutions should have market-risk measure-ment systems commensurate with the size andnature of their holdings. Institutions withsignificant holdings of highly complex instru-ments should ensure that they have independentmeans to value their positions. Institutions usinginternal models to measure risk should haveadequate procedures to validate the models andperiodically review all elements of the modelingprocess, including its assumptions and risk-measurement techniques. Institutions relying onthird parties for market-risk-measurement sys-tems and analyses should fully understand theassumptions and techniques used by the thirdparty.

Institutions should evaluate the market-riskexposures of their securities and derivativepositions and report this information to theirboards of directors regularly, not less frequentlythan each quarter. These evaluations shouldassess trends in aggregate market-risk exposureand the performance of portfolios relative totheir established objectives and risk constraints.They should also identify compliance withboard-approved limits and identify any excep-tions to established standards. Examiners shouldensure that institutions have mechanisms todetect and adequately address exceptions tolimits and guidelines. Examiners should alsodetermine that management reporting on marketrisk appropriately addresses potential exposuresto basis risk, yield curve changes, and otherfactors pertinent to the institution’s holdings. Inthis connection, examiners should assess aninstitution’s compliance with broader guidancefor managing interest-rate risk in a consolidatedorganization.

Complex and illiquid instruments ofteninvolve greater market risk than broadly traded,more liquid securities. Frequently, the higherpotential market risk arising from this illiquidityis not captured by standardized financial-modeling techniques. This type of risk isparticularly acute for instruments that are highlyleveraged or that are designed to benefit from

specific, narrowly defined market shifts. Ifmarket prices or rates do not move as expected,the demand for these instruments can evaporate.When examiners encounter such instruments,they should review how adequately the institu-tion has assessed its potential market risks. If therisks from these instruments are material, theinstitution should have a well-documented pro-cess for stress testing their value and liquidityassumptions under a variety of market scenarios.

Liquidity Risk

Banks face two types of liquidity risk in theirsecurities and derivative activities: risks relatedto specific products or markets and risks relatedto the general funding of their activities. Theformer, market-liquidity risk, is the risk that aninstitution cannot easily unwind, or offset, aparticular position at or near the previous marketprice because of inadequate market depth ordisruptions in the marketplace. The second,funding-liquidity risk, is the risk that the bankwill be unable to meet its payment obligationson settlement dates. Since neither type ofliquidity risk is unique to securities and deriva-tive activities, management should evaluatethese risks in the broader context of theinstitution’s overall liquidity.

When specifying permissible securities andderivative instruments to accomplish establishedobjectives, institutions should take into accountthe size, depth, and liquidity of the markets forspecific instruments, and the effect these char-acteristics may have on achieving an objective.The market liquidity of certain types of instru-ments may make them entirely inappropriate forachieving certain objectives. Moreover, institu-tions should consider the effects that market riskcan have on the liquidity of different types ofinstruments. For example, some governmentagency securities may have embedded optionsthat make them highly illiquid during periods ofmarket volatility and stress, despite their highcredit rating. Accordingly, institutions shouldclearly articulate the market-liquidity character-istics of instruments to be used in accomplishinginstitutional objectives.

The funding risk of an institution becomes amore important consideration when its unreal-ized losses are material; therefore, this riskshould be a factor in evaluating capital ade-quacy. Institutions with weak liquidity positions



are more likely to be forced to recognize theselosses and suffer declines in their accountingand regulatory capital. In extreme cases, theseeffects could force supervisors to take promptcorrective actions.

Examiners should assess whether the institu-tion adequately considers the potential liquidityrisks associated with the liquidation of securitiesor the early termination of derivative contracts.Many forms of standardized contracts forderivative transactions allow counterparties torequest collateral or terminate their contractsearly if the institution experiences an adversecredit event or a deterioration in its financialcondition. In addition, under situations ofmarket stress, customers may ask for the earlytermination of some contracts within the contextof the dealer’s market-making activities. Inthese circumstances, an institution that owesmoney on derivative transactions may berequired to deliver collateral or settle a contractearly, possibly at a time when the institutionmay face other funding and liquidity pressures.Early terminations may also open additional,unintended market positions. Management anddirectors should be aware of these potentialliquidity risks and address them in the institu-tion’s liquidity plan and in the broader contextof the institution’s liquidity-management process.In their reviews, examiners should consider theextent to which such potential obligations couldpresent liquidity risks to the institution.

Operating and Legal Risks

Operating risk is the risk that deficiencies ininformation systems or internal controls willresult in unexpected loss. Some specific sourcesof operating risk include inadequate procedures,human error, system failure, or fraud. Inaccu-rately assessing or controlling operating risks isone of the more likely sources of problemsfacing institutions involved in securities andderivative activities.

Adequate internal controls are the first lineof defense in controlling the operating risksinvolved in an institution’s securities andderivative activities. Of particular importanceare internal controls to ensure that personsexecuting transactions are separated from thoseindividuals responsible for processing contracts,confirming transactions, controlling variousclearing accounts, approving the accounting

methodology or entries, and performingrevaluations.

Institutions should have approved policies,consistent with legal requirements and internalpolicies, that specify documentation require-ments for transactions and formal proceduresfor saving and safeguarding important docu-ments. Relevant personnel should fully under-stand these requirements. Examiners shouldalso consider the extent to which institutionsevaluate and control operating risks throughinternal audits, stress testing, contingencyplanning, and other managerial and analyticaltechniques.

An institution’s operating policies shouldestablish appropriate procedures to obtain andmaintain possession or control of instrumentspurchased. Institutions should ensure thattransactions consummated orally are confirmedas soon as possible. As noted earlier in thissection, banking organizations should, to theextent possible, seek to diversify the firms theyuse for their safekeeping arrangements to avoidconcentrations of assets or other types of risk.

Legal risk is the risk that the contracts aninstitution enters into are not legally enforceableor documented correctly. This risk should belimited and managed through policies developedby the institution’s legal counsel. At a mini-mum, guidelines and processes should be inplace to ensure the enforceability of counter-party agreements. Examiners should determinewhether an institution is adequately evaluatingthe enforceability of its agreements beforeindividual transactions are consummated. Insti-tutions should also ensure that a counterpartyhas sufficient authority to enter into the pro-posed transaction and that the terms of theagreement are legally sound. Institutions shouldfurther ascertain that their netting agreementsare adequately documented, have been executedproperly, and are enforceable in all relevantjurisdictions. Institutions should know aboutrelevant tax laws and interpretations governingthe use of netting instruments.

An institution’s policies should also provideconflict-of-interest guidelines for employeeswho are directly involved in purchasing securi-ties from and selling securities to securitiesdealers on behalf of their institution. Theseguidelines should ensure that all directors,officers, and employees act in the best interest ofthe institution. The board of directors may wishto adopt policies prohibiting these employeesfrom engaging in personal securities transac-



tions with these same securities firms withoutthe specific prior approval of the board. Theboard of directors may also wish to adopt apolicy applicable to directors, officers, andemployees that restricts or prohibits them fromreceiving gifts, gratuities, or travel expensesfrom approved securities dealer firms and theirpersonnel.

FEDERAL RESERVE ACTSECTIONS 23A AND 23B

In May 2001, the Board published the followingrules interpreting sections 23A and 23B of theFederal Reserve Act (FRA):

• a final rule, effective June 11, 2001, thatadopts an interpretation and exemptions fromthe quantitative limits and collateral require-ments of section 23A for certain loans to thirdparties that are used to purchase securities orother assets through an affiliate of the deposi-tory institution

• a final rule, effective June 11, 2001, thatadopts an interpretation that expands the typesof asset purchases that are eligible for theexemption for purchases from a broker-dealeraffiliate of assets with a readily identifiableand publicly available market quotation

• an interim rule, effective January 1, 2002,addressing the treatment under section 23B ofderivative transactions between an insureddepository institution and its affiliates (interaf-filiate derivative transactions) and intradayextensions of credit by an insured depositoryinstitution to its affiliates

Loans to Third Parties to PurchaseSecurities or Assets from an Affiliate

The final rule provides three exemptions fromsection 23A. First, an exemption is providedfor extensions of credit by an insureddepository institution to customers that use theloan proceeds to purchase a security or otherasset through an affiliate of the depositoryinstitution, provided that the affiliate is actingexclusively as a broker in the transaction andretains no portion of the loan proceeds inexcess of a market-rate brokerage commissionor agency fee. To take advantage of thisexemption, the security or other asset cannotbe issued, underwritten by, or sold from the

inventory of an affiliate of the depositoryinstitution.

Second, the rule adopts an exemption fromsection 23A for extensions of credit by aninsured depository institution to customers thatuse the proceeds to purchase a security issued bya third party through an SEC-registered broker-dealer affiliate of the institution that is acting asriskless principal in the securities transaction,provided that the markup for executing the tradeis on or below market terms. The security cannotbe issued, underwritten by, or sold from theinventory of an affiliate. This limitation does notpreclude a broker-dealer affiliate from selling tothe customer a security it purchased immedi-ately before the sale to effect the riskless-principal transaction initiated by the customer.However, the broker-dealer affiliate should nothave purchased the security from anotheraffiliate of the insured depository institution.

Finally, the rule provides an exemption forextensions of credit by an insured depositoryinstitution to customers that use the proceeds topurchase securities from a broker-dealer affiliateof the institution when the extension of credit ismade pursuant to a preexisting line of credit notentered into in contemplation of the purchase ofsecurities from the affiliate. The extension ofcredit should be consistent with any restrictionsimposed by the line of credit. In determiningwhether this exemption is being used in goodfaith, examiners should consider the timing ofthe line of credit, the conditions imposed on theline, and whether the line of credit has been usedfor purposes other than the purchase of securi-ties from an affiliate. The fact that a line of credithas been preapproved does not necessarily leadto a conclusion that the line is preexisting.Rather, the line should be actively used by thecustomer.

Purchases of Assets with a ReadilyIdentifiable and Publicly AvailableMarket Quotation

The rule exempts from section 23A the purchaseof a security by an insured depository institutionfrom an affiliated SEC-registered broker-dealerif the following conditions are met:

• the security has a ready market, as defined bythe SEC9

9. The SEC defines a ‘‘ready market’’ as including a



• the security is eligible for purchase directly bya state member bank, and the transaction isrecorded as a purchase of securities on theinstitution’s call report

• the security is not a low-quality asset• if an affiliate is the underwriter of the security,

the security is not purchased during or within30 days of an underwriting; however, thisrestriction does not apply to the purchase ofobligations of, or fully guaranteed as toprincipal and interest by, the United States orits agencies

• the security’s price is quoted routinely on anunaffiliated electronic service that providesreal-time financial data, provided that—— the price paid by the depository institution

is at or below the current market quotationfor the security, and

— the size of the transaction does not castdoubt on the appropriateness of relying onthe current market quotation

• the security is not issued by an affiliate

Any such purchases remain subject to theprovisions of section 23B that require thetransaction to be on market terms and consistentwith safe and sound banking practices. Recordsrelating to such purchases must be maintainedby the depository institution for a period of twoyears after the purchase.

Derivative Transactions withAffiliates and Intraday Extensionsof Credit to Affiliates

The interim rule confirms that interaffiliatederivative transactions (IDTs) and intradayextensions of credit by an insured depositoryinstitution to an affiliate are subject to themarket-terms requirement of section 23B.10 Aninsured depository institution must establish andmaintain policies and procedures that, at a

minimum, provide for the monitoring andcontrol of the bank’s credit exposure from thesetransactions, with each affiliate and with allaffiliates in the aggregate. Policies should alsoensure that the transactions comply with section23B. To comply with section 23B, the transac-tions should be on terms and conditions at leastas favorable to the insured depository institutionas those transactions conducted with unaffiliatedcounterparties that are engaged in similarbusiness and substantially equivalent in size andcredit quality. Specifically, credit limits imposedon IDTs and intraday extensions of credit toaffiliates should be at least as strict as thoseimposed on comparable unaffiliated companies.The institution should monitor exposures toaffiliates at least as rigorously as it monitorsunaffiliated exposures to comparable companies.Finally, the pricing and collateral requirementsimposed on IDTs and intraday extensions ofcredit to affiliates should be at least as favorableto the institution as those imposed on compa-rable unaffiliated companies.

INTERNATIONAL DIVISIONINVESTMENTS

The same types of instruments exist in interna-tional banking as in domestic banking. Securi-ties and derivative contracts may be acquiredby a bank’s international division and overseasbranches, and foreign equity investments maybe held by the bank directly or through Edge Actcorporations. The investments held by mostinternational divisions are predominately secu-rities issued by various governmental entities ofthe countries in which the bank’s foreignbranches are located. These investments are heldfor a variety of purposes:

• They are required by various local laws.• They are used to meet foreign reserve

requirements.• They result in reduced tax liabilities.• They enable the bank to use new or increased

rediscount facilities or benefit from greaterdeposit or lending authorities.

• They are used by the bank as an expression of‘‘goodwill’’ toward a country.

The examiner should be familiar with theapplicable sections of Regulation K (12 CFR211) governing a member bank’s international

recognized established securities market (1) in which thereexists independent bona fide offers to buy and sell so that aprice reasonably related to the last sales price or current bonafide competitive bid and offer quotations can be determinedfor a particular security almost instantaneously and (2) inwhich payment will be received in settlement of a sale at suchprice within a relatively short time conforming to tradecustom.

10. IDTs are defined under the interim rule as anyderivative contract subject to the Board’s risk-based capitalguidelines (that is, most interest-rate, currency, equity, orcommodities derivatives and other similar contracts, includingcredit derivatives.)



investment holdings as well as with otherregulations discussed in this section. Because ofthe mandatory investment requirements of somecountries, securities held cannot always be as‘‘liquid’’ and ‘‘readily marketable’’ as requiredin domestic banking. However, the amount of abank’s ‘‘mandatory’’ international holdings willnormally be a relatively small amount of its totalinvestments or capital funds.

A bank’s international division may alsohold securities strictly for investment purposes;these are expected to provide a reasonable rateof return commensurate with safety consider-ations. As with domestic investment securities,the bank’s safety must take precedence, fol-lowed by liquidity and marketability require-ments. Securities held by international divisionsare considered to be liquid if they are readilyconvertible into cash at their approximatecarrying value. They are marketable if they canbe sold in a very short time at a pricecommensurate with yield and quality. Specula-tion in marginal foreign securities to generatemore favorable yields is an unsound bankingpractice and should be discouraged.

Banks are generally prohibited from investingin stocks. However, a number of exceptions(detailed earlier in this section) are oftenapplicable to the international division. Forexample, the bank may, under section 24A ofthe Federal Reserve Act (12 USC 371d), holdstock in overseas corporations that hold title toforeign bank premises. A foreign branch of amember bank may invest in the securities of thecentral bank, clearinghouses, governmental enti-ties, and government-sponsored developmentbanks of the country where the branch is locatedand may make other investments necessary tothe business of the branch. Other sections ofRegulation K permit the bank to make equityinvestments in Edge Act and agreement corpo-rations and in foreign banks, subject to certainlimitations.

Standard & Poor’s, Moody’s, and otherpublications from U.S. rating services rateCanadian and other selected foreign securitiesthat are authorized for U.S. commercial bankinvestment purposes under 12 USC 24 (sev-enth). However, in many other countries,securities-rating services are limited or nonex-istent. When they do exist, the ratings are onlyindicative and should be supplemented withadditional information on legality, credit sound-ness, marketability, and foreign-exchange andcountry-risk factors. The opinions of local

attorneys are often the best source of determin-ing whether a particular foreign security has thefull faith and credit backing of a country’sgovernment.

Sufficient analytical data must be provided tothe bank’s board of directors and seniormanagement so they can make informed judg-ments about the effectiveness of the interna-tional division’s investment policy and proce-dures. The institution’s international securitiesand derivative contracts should be included onall board and management reports detailingdomestic securities and derivative contracts.These reports should be timely and sufficientlydetailed to allow the board of directors andsenior management to understand and assess thecredit, market, and liquidity risks facing theinstitution and its securities and derivativepositions.

UNSUITABLE INVESTMENTPRACTICES

Institutions should categorize each of theirsecurity activities as trading, available-for-sale,or held-to-maturity consistent with GAAP (thatis, Statement of Financial Accounting StandardsNo. 115, ‘‘Accounting for Certain Investmentsin Debt and Equity Securities,’’ as amended) andregulatory reporting standards. Managementshould reassess the categorizations of its secu-rities periodically to ensure that they remainappropriate.

Securities that are intended to be heldprincipally for the purpose of selling in the nearterm should be classified as trading assets.Trading activity includes the active and frequentbuying and selling of securities for the purposeof generating profits on short-term fluctuationsin price. Securities held for trading purposesmust be reported at fair value, with unrealizedgains and losses recognized in current earningsand regulatory capital. The proper categoriza-tion of securities is important to ensure thattrading gains and losses are promptlyrecognized—which will not occur when securi-ties intended to be held for trading purposes arecategorized as held-to-maturity or available-for-sale.

It is an unsafe and unsound practice to reportsecurities held for trading purposes as available-for-sale or held-to-maturity securities. A closeexamination of an institution’s actual securitiesactivities will determine whether securities it



reported as available-for-sale or held-to-maturityare, in reality, held for trading. When thefollowing securities activities are conducted inavailable-for-sale or held-to-maturity accounts,they should raise supervisory concerns. The firstfive practices below are considered tradingactivities and should not occur in available-for-sale or held-to-maturity securities portfolios,and the sixth practice is wholly unacceptableunder all circumstances.

Gains Trading

Gains trading is the purchase of a security andthe subsequent sale of that security at a profitafter a short holding period. However, at thesame time, securities acquired for gains tradingthat cannot be sold at a profit are retained in theavailable-for-sale or held-to-maturity portfolio;unrealized losses on debt securities in these twocategories do not directly affect regulatorycapital and are not reported in income until thesecurity is sold. Examiners should note institu-tions that exhibit a pattern or practice ofreporting significant amounts of realized gainson sales of nontrading securities (typically,available-for-sale securities) after short holdingperiods, while continuing to hold other nontrad-ing securities with significant amounts ofunrealized losses. In these situations, examinersmay designate some or all of the securitiesreported outside of the trading category astrading assets.

When-Issued Securities Trading

When-issued securities trading is the buying andselling of securities in the period between theannouncement of an offering and the issuanceand payment date of the securities. A purchaserof a when-issued security acquires all of therisks and rewards of owning a security and maysell this security at a profit before having to takedelivery and pay for it. These transactionsshould be regarded as trading activities.

Pair-Offs

Pair-offs are security purchases that are closedout or sold at or before settlement date. In apair-off, an institution commits to purchase asecurity. Then before the predetermined settle-

ment date, the institution will pair off thepurchase with a sale of the same security.Pair-offs are settled net when one party to thetransaction remits the difference between thepurchase and sale price to the counterparty.Other pair-off transactions may involve thesame sequence of events using swaps, optionson swaps, forward commitments, options onforward commitments, or other derivativecontracts.

Extended Settlements

Regular-way settlement for U.S. governmentand federal-agency securities (except mortgage-backed securities and derivative contracts) isone business day after the trade date. Regular-way settlement for corporate and municipalsecurities is 3 business days after the trade date,and settlement for mortgage-backed securitiescan be up to 60 days or more after the trade date.Using a settlement period that exceeds theregular-way settlement periods to facilitatespeculation is considered a trading activity.

Short Sales

A short sale is the sale of a security that is notowned. Generally, the purpose of a short sale isto speculate on a fall in the price of the security.Short sales should be conducted in the tradingportfolio. A short sale that involves the deliveryof the security sold short by borrowing it fromthe depository institution’s available-for-saleor held-to-maturity portfolio should not bereported as a short sale. Instead, it should bereported as a sale of the underlying security withgain or loss recognized. Short sales are notpermitted for federal credit unions.

Adjusted Trading

Adjusted trading involves the sale of a securityto a broker or dealer at a price above theprevailing market value and the simultaneouspurchase and booking of a different security,frequently a lower-grade issue or one with alonger maturity, at a price above its marketvalue. Thus, the dealer is reimbursed for itslosses on the initial purchase from the institutionand ensured a profit. Adjusted-trading trans-actions inappropriately defer the recognition of



losses on the security sold and establish anexcessive reported value for the newly acquiredsecurity. Consequently, these transactions are

prohibited and may be in violation of 18 USC1001 (False Statements or Entries) and 1005(False Entries).



Investment Securities and End-User ActivitiesExamination Objectives Section 3000.2

1. To determine if policies, practices, proce-dures, and internal controls for investmentsare adequate.

2. To determine if bank officers are operating inconformance with the established guidelines.

3. To determine the scope and adequacy of theaudit function.

4. To determine the overall quality of the invest-ment portfolio and how that quality relates tothe soundness of the bank.

5. To determine compliance with laws andregulations.

6. To initiate corrective action when policies,practices, procedures, or internal controls aredeficient or when violations of laws or regu-lations have been noted.

Trading and Capital-Markets Activities Manual February 1998Page 1

Investment Securities and End-User ActivitiesExamination Procedures Section 3000.3

These procedures represent a list of processesand activities that may be reviewed during afull-scope examination. The examiner-in-chargewill establish the general scope of examinationand work with the examination staff to tailorspecific areas for review as circumstances war-rant. As part of this process, the examinerreviewing a function or product will analyze andevaluate internal audit comments and previousexamination workpapers to assist in designingthe scope of examination. In addition, after ageneral review of a particular area to be exam-ined, the examiner should use these procedures,to the extent they are applicable, for furtherguidance. Ultimately, it is the seasoned judg-ment of the examiner and the examiner-in-charge as to which procedures are warranted inexamining any particular activity.

1. Based on the evaluation of internal controlsand the work performed by internal andexternal auditors, determine the scope of theexamination.

2. Test for compliance with policies, practices,procedures, and internal controls in con-junction with performing the examinationprocedures. Also, obtain a listing of anydeficiencies noted in the latest review con-ducted by internal and external auditors anddetermine if corrections have been accom-plished. Determine the extent and effective-ness of investment-policy supervision by—a. reviewing the abstracted minutes of board

of directors meetings and minutes ofappropriate committee meetings;

b. determining that proper authorizationshave been made for investment officersor committees;

c. determining any limitations or restric-tions on delegated authorities;

d. evaluating the sufficiency of analyticaldata used by the board or investmentcommittee;

e. reviewing the reporting methods usedby department supervisors and internalauditors to ensure compliance withestablished policy; and

f. preparing a memo for the examiner whois assigned to review the duties andresponsibilities of directors and for theexaminer responsible for the interna-tional examination, if applicable. This

memo should state conclusions on theeffectiveness of directors’ supervision ofthe domestic and international-divisioninvestment policy. All conclusions shouldbe documented.

3. Obtain the following:a. trial balances of investment-account hold-

ings, money market instruments, andend-user derivative positions includingcommercial paper, banker’s acceptances,negotiable certificates of deposit, securi-ties purchased under agreements to resell,and federal funds sold (Identify anydepository instruments placed throughmoney brokers.)

b. a list of any assets carried in loans andany discounts on which interest is exemptfrom federal income taxes and which arecarried in the investment account on callreports

c. a list of open purchase-and-salecommitments

d. a schedule of all securities, forward place-ment contracts, and derivative contractsincluding contracts on exchange-tradedputs and calls, option contracts on futuresputs and calls, and standby contractspurchased or sold since the lastexamination

e. a maturity schedule of securities soldunder repurchase agreements

f. a list of pledged assets and securedliabilities

g. a list of the names and addresses of allsecurities dealers doing business with thebank

h. a list of the bank’s personnel authorizedto trade with dealers

i. a list of all U.S. government–guaranteedloans which are recorded and carried asan investment-account security

j. for international division and overseasbranches, a list of investments—• held to comply with various foreign

governmental regulations requiring suchinvestments,

• used to meet foreign reserverequirements,

• required as stock exchange guaranteesor used to enable the bank to providesecurities services,


• representing investment of surplusfunds,

• used to obtain telephone and telexservices,

• representing club and schoolmemberships,

• acquired through debts previouslycontracted,

• representing minority interests in non-affiliated companies,

• representing trading-account securities,• representing equity interests in Edge

Act and agreement corporations and inforeign banks, and

• held for other purposes.4. Using updated data available from reports

of condition, UBPR printouts, and invest-ment advisor and correspondent bank port-folio analysis reports, obtain or prepare ananalysis of investment, money market, andend-user derivative holdings that includes—a. a month-by-month schedule of par, book,

and market values of issues maturing inone year;

b. schedules of par, book, and market val-ues of holdings in the investment port-folio (these schedules should be indexedby maturity date, and the schedule shouldbe detailed by maturity dates over thefollowing time periods: over 1 through 5years, over 5 through 10 years, and over10 years);

c. book value totals of holdings by obligoror industry, related obligors or industries,geographic distribution, yield, and spe-cial characteristics, such as moral obli-gations, conversion, or warrant features;

d. par value schedules of type I, II, and IIIinvestment holdings, by those legallydefined types; and

e. for the international division, a list ofinternational investment holdings(foreign-currency amounts and U.S. dol-lar equivalents) to include—• descriptions of securities held (par,

book, and market values),• names of issuers,• issuers’ countries of domicile,• interest rates, and• pledged securities.

5. Review the reconcilement of the trial bal-ances investment and money market accountsto general-ledger control accounts.

6. Using either an appropriate sampling tech-nique or the asset-coverage method, select

from the trial balances the internationalinvestments, municipal investments, andmoney market and derivative holdings forexamination. If transaction volume permits,include in the population of items to bereviewed all securities purchased since thelast general examination.

7. Perform the following procedures for eachinvestment and money market holdingselected in step 6.a. Check appropriate legal opinions or pub-

lished data outlining legal status.b. If market prices are provided to the bank

by an independent party (excludingaffiliates and securities dealers sellinginvestments to the bank), or if they areindependently tested as a documentedpart of the bank’s audit program, thoseprices should be accepted. If the inde-pendence of the prices cannot be estab-lished, test market values by referring toone of the following sources:• published quotations, if available• appraisals by outside pricing services,

if performedc. For investments and money market obli-

gations in the sample that are rated,compare the ratings provided to the mostrecent published ratings.

Before continuing, refer to steps 15 through17. They should be performed in conjunctionwith steps 8 through 14. International-divisionholdings should be reviewed with domesticholdings to ensure compliance, when combined,with applicable legal requirements.

8. To the extent practicable under the circum-stances, test that the institution has analyzedthe following:a. the obligors on securities purchased under

agreements to resell, when the readilymarketable value of the securities is notsufficient to satisfy the obligation

b. all international investments, nonratedsecurities, derivatives, and money mar-ket instruments selected in step 6 oracquired since the last examination

c. all previously detailed or currently knownspeculative issues

d. all defaulted issuese. any issues in the current Interagency

Country Exposure Review Committeecredit schedule (obtained from the inter-national loan portfolio manager):

3000.3 Investment Securities and End-User Activities: Examination Procedures

February 1998 Trading and Capital-Markets Activities ManualPage 2

• compare the schedule to the foreignsecurities trial balance obtained in step3 to ascertain which foreign securitiesare to be included in Interagency Coun-try Exposure Review Committee credits

• for each security so identified, tran-scribe the following appropriate infor-mation to a separate examiner’s linesheet or a related examiner’s creditline sheet:— amount (and U.S. dollar equivalent

if a foreign currency) to includepar, book, and market values

— how and when acquired— maturity dates— default date, if appropriate— any pertinent comments

• return the schedule and appropriateexaminer’s line sheets to the examinerwho is assigned to international—loanportfolio management.

9. Review the most recent reports of examina-tion of the bank’s Edge Act and agreementcorporation affiliates and foreign subsidi-aries to determine their overall conditions.Also, compile data on Edge Act and agree-ment corporations and foreign subsidiariesthat are necessary for the commercial reportof examination (such as asset criticisms,transfer risk, and other material examina-tion findings).

10. Classify speculative and defaulted issuesaccording to the following standards (exceptthose securities in the Interagency CountryExposure Review and other securitieson which special instructions have beenissued):a. The entire book value of speculative-

grade municipal general obligationsecurities which are not in default willbe classified substandard. Market depre-ciation on other speculative issues shouldbe classified doubtful. The remainingbook value usually is classifiedsubstandard.

b. The entire book value of all defaultedmunicipal general obligation securitieswill be classified doubtful. Market depre-ciation on other defaulted bonds shouldbe classified loss. The remaining bookvalue usually is classified substandard.

c. Market depreciation on nonexempt stockshould be classified loss.

d. Report comments should include:• description of issue

• how and when each issue was acquired• default date, if appropriate• date interest was paid to the issue• rating at time of acquisition• comments supporting the classification

11. Review the bank’s maturity program.a. Review the maturity schedules by—

• comparing book and market valuesand, after considering the gain or losson year-to-date sales, determine if thecosts of selling intermediate and long-term issues appear prohibitive, and

• determine if recent acquisitions show atrend toward lengthened or shortenedmaturities. Discuss such trends withmanagement, particularly with regardto investment objectives approved bythe investment committee.

b. Review the pledged-asset and secured-liability schedules and isolate pledgedsecurities by maturity segment, thendetermine the market value of securitiespledged in excess of net secured liabilities.

c. Review the schedule of securities soldunder repurchase agreement anddetermine—• if financing for securities purchases is

provided via repurchase agreement bythe securities dealer who originallysold the security to the bank,

• if funds acquired through the sale ofsecurities under agreement to repur-chase are invested in money marketassets or if short-term repurchase agree-ments are being used to fund longer-term, fixed-rate assets,

• the extent of matched-asset repo andliability repo maturities and the overalleffect on liquidity resulting fromunmatched positions,

• if the interest rate paid on securitiessold under agreement to repurchase isappropriate relative to current moneymarket rates, and

• if the repurchase agreement is at theoption of the buying or selling bank.

d. Review the list of open purchase-and-sale commitments and determine theeffect of their completion on maturityscheduling.

e. Submit investment portfolio informationregarding the credit quality and practicalliquidity of the investment portfolio tothe examiner who is assigned to asset/liability management.

Investment Securities and End-User Activities: Examination Procedures 3000.3


12. Consult with the examiner responsible forthe asset/liability management analysis todetermine what information is needed toassess the bank’s sensitivity to interest-ratefluctuations and its ability to meet short-term funding requirements. If requested,compile the information using bank recordsor other appropriate sources. (See theInstructions for the Report of Examinationsection of this manual for factors to be takeninto account when compiling this informa-tion.) Information which may be required tobe furnished includes—a. the market value of unpledged govern-

ment and federal-agency securitiesmaturing within one year;

b. the market value of other unpledgedgovernment and federal-agency securi-ties which would be sold without loss;

c. the market value of unpledged municipalsecurities maturing within one year;

d. the book value of money market instru-ments, such as banker’s acceptances,commercial paper, and certificates ofdeposit (provide amounts for each cate-gory); and

e. commitments to purchase and sell secu-rities, including futures, forward, andstandby contracts. (Provide a descriptionof the security contract, the purchase orsales price, and the settlement or expira-tion date.)

13. Determine whether the bank’s investmentpolicies and practices are balancing earn-ings and risk satisfactorily.a. Use UBPR or average call report data to

calculate investments as a percentage oftotal assets and average yields on U.S.government and nontaxable investments.• Compare results to peer-group statistics.• Determine the reasons for significant

variances from the norm.• Determine if trends are apparent and

the reasons for such trends.b. Calculate current market depreciation as

a percentage of gross capital funds.c. Review the analysis of municipal and

corporate issues by rating classification.• Determine the total in each rating class

and the total of nonrated issues.• Determine the total of nonrated invest-

ment securities issued by obligorslocated outside of the bank’s servicearea (exclude U.S. government–guaranteed issues).

• Review acquisitions since the priorexamination and ascertain reasons fortrends that may suggest a shift in therated quality of investment holdings.

d. Review coupon rates or yields (whenavailable) and compare those recentlyacquired investments and money marketholdings with coupon rates or yields thatappear high or low to similarly acquiredinstruments of analogous types, ratings,and maturity characteristics. Discusssignificant rate or yield variances withmanagement.

e. Review the schedule of securities, futures,forward, and standby contracts purchasedand sold since the last examination anddetermine whether the volume of tradingis consistent with policy objectives.If the bank does not have a separatetrading account, determine whether suchan account should be established, includ-ing appropriate recordkeeping andcontrols.

f. If the majority of sales resulted in gains,determine if profit-taking is consistentwith stated policy objectives or ismotivated by anxiety for short-termincome.

g. Determine whether the bank has dis-counted or has plans to discount futureinvestment income by selling interestcoupons in advance of interest-paymentdates.

h. Review the list of commitments to pur-chase or sell investments or money mar-ket investments. Determine the effect ofcompletion of these contracts on futureearnings.

14. Review the bank’s federal income taxposition.a. Determine, by discussion with appropri-

ate officers, if the bank is taking advan-tage of procedures to minimize taxliability in view of other investmentobjectives.

b. Review or compute the bank’s actual andbudgeted tax-exempt holdings as a per-centage of total assets and its applicableincome taxes as a percentage of netoperating income before taxes.

c. Discuss with management the tax impli-cations of losses resulting from securitiessales.



15. Determine that proper risk diversificationexists within the portfolio.a. Review totals of holdings by single

obligor or industry, related obligors orindustries, geographic distribution, yields,and securities that have special charac-teristics (include individual due frombank accounts from the list receivedfrom the bank or from the examiner whois assigned to due from banks and allmoney market instruments).• Detail, as concentrations, all holdings

equaling 25 percent or more of capitalfunds.

• List all holdings equaling at least10 percent but less than 25 percent ofcapital funds and submit that informa-tion to the examiner who is assigned toloan portfolio management. These hold-ings will be combined with any addi-tional advances in the lending areas.

b. Perform a credit analysis of all nonratedholdings determined to be a concentra-tion (if not performed in step 8).

16. If the bank is engaged in financial futures,exchange-traded puts and calls, forwardplacements, or standby contracts, determinethe following.a. The policy is specific enough to outline

permissible contract strategies and theirrelationships to other banking activities.

b. Recordkeeping systems are sufficientlydetailed to permit a determination ofwhether operating personnel have actedin accordance with authorized objectives.

c. The board of directors or its designeehas established specific contract-positionlimits and reviews contract positions atleast monthly to ascertain conformancewith those limits.

d. Gross and net positions are within autho-rized positions and limits, and tradeswere executed by persons authorized totrade futures.

e. The bank maintains general-ledger memo-randum accounts or commitment regis-ters which, at a minimum, include—• the type and amount of each contract,• the maturity date of each contract,• the current market price and cost of

each contract, and• the amount held in margin accounts,

including—— all futures contracts and forward,

standby, and options contracts

revalued on the basis of market orthe lower of cost or market at eachmonth-end;

— securities acquired as the result ofcompleted contracts valued atthe lower of cost or market uponsettlement;

— fee income received by the bank onstandby contracts accounted forproperly;

— financial reports disclosing futures,forwards, options, and standbyactivity;

— a bank-instituted system for moni-toring credit-risk exposure in for-ward and standby contract activity;and

— the bank’s internal controls, man-agement reports, and audit proce-dures to ensure adherence to policy.

17. If the bank is engaged in financial futures,forward placement, options, or standby con-tracts, determine if the contracts have areasonable correlation to the bank’s busi-ness needs (including gap position) and ifthe bank fulfills its obligations under thecontracts.a. Compare the contract commitment and

maturity dates to anticipated offset.b. Report significant gaps to the examiner

who is assigned to asset/liability manage-ment (see step 12).

c. Compare the amounts of outstandingcontracts to the amounts of the antici-pated offset.

d. Ascertain the extent of the correlationbetween expected interest-rate move-ments on the contracts and the antici-pated offset.

e. Determine the effect of the loss recog-nition on future earnings, and, if signifi-cant, report it to the examiner who isassigned to analytical review and incomeand expense.

18. On the basis of the pricings, ratings, andcredit analyses performed above, and usingthe investments selected in step 6 or fromlists previously obtained, test for compli-ance with applicable laws and regulations.a. Determine if the bank holds type II or III

investments that are predominantly specu-lative or if it holds securities that are notmarketable (12 CFR 1.3(b)).

b. Review the recap of investment securi-ties by legal types, as defined by 12 CFR



1, on the basis of the legal restrictionsof 12 USC 24 and competent legalopinions.

c. For those investment securities that areconvertible into stock or which havestock purchase warrants attached—• determine if the book value has been

written down to an amount that repre-sents the investment value of the secu-rity, independent of the conversion orwarrant provision (12 CFR 1.10) and

• determine if the par values of othersecurities that have been ruled eligiblefor purchase are within specified capi-tal limitations.

d. Review pledge agreements and securedliabilities and determine that—• proper custodial procedures have been

followed,• eligible securities are pledged,• securities pledged are sufficient to

secure the liability that requiressecuring,

• Treasury tax and loan remittance optionsand note options are properly secured,and

• private deposits are not being secured.

(Information needed to perform the above stepswill be in the pledge agreement; Treasury cir-culars 92 and 176, as amended.)

e. Review accounting procedures to deter-mine that—• investment premiums are being extin-

guished by maturity or call dates(12 CFR 1.11);

• premium amortization is charged tooperating income (12 CFR 1.11);

• accretion of discount is included incurrent income for banks required touse accrual accounting for reportingpurposes;

• accretion of bond discount requires aconcurrent accrual of deferred incometax payable; and

• securities gains or losses are reportednet of applicable taxes, and net gainsor losses are reflected in the period inwhich they are realized.

f. Determine if securities purchased underagreement to resell are in fact securities(not loans), are eligible for investmentby the bank, and are within prescribedlimits (12 USC 24 and 12 CFR 1). If not,

determine whether the transaction iswithin applicable legal lending limits inthe state.

g. Review securities sold under agreementto repurchase and determine whetherthey are, in fact, deposits (Regulation D,12 CFR 204.2(a)(1)).

h. Determine that securities and money mar-ket investments held by foreign branchescomply with section 211.3 of RegulationK—Foreign Branches of Member Banks(12 CFR 211.3) as to—• acquiring and holding securities (sec-

tion 211.3(b)(3)) and• underwriting, distributing, buying, and

selling obligations of the national gov-ernment of the country in which thebranch is located (section 211.3(b)(4)).

(Further considerations relating to the above arein other sections of Regulation K. Also reviewany applicable sections of Regulation T—Creditby Brokers and Dealers (12 CFR 220), Regula-tion X—Borrowers of Securities Credit (12 CFR224), and Board interpretations 6150 (regardingsecurities issued or guaranteed by the Interna-tional Bank for Reconstruction and Develop-ment) and 6200 (regarding borrowing by adomestic broker from a foreign broker). EdgeAct and agreement corporations are discussed inthe bank-related organizations section.

i. Determine that the bank’s equity invest-ments in foreign banks comply with theprovisions of section 25 of the FederalReserve Act and section 211.5 of Regu-lation K as to—• investment limitations (section 211.5(b))

and• investment procedures (section

211.5(c)).19. Test for compliance with other laws and

regulations as follows.a. Review lists of affiliate relationships and

lists of directors and principal officersand their interests.• Determine if the bank is an affiliate of

a firm that is primarily engaged inunderwriting or selling securities (12USC 377).

• Determine if directors or officers areengaged in or employed by firms thatare engaged in similar activities (12USC 78, 377, and 378). (It is anacceptable practice for bank officers to



act as directors of securities companiesnot doing business in the United States,the stock of which is owned by thebank as authorized by the Board ofGovernors of the Federal ReserveSystem.)

• Review the list of federal funds sold,securities purchased under agreementsto resell, interest-bearing time depos-its, and commercial paper, and deter-mine if the bank is investing in moneymarket instruments of affiliated banksor firms (section 23A, Federal ReserveAct and 12 USC 371(c)).

• Determine if transactions involvingaffiliates, insiders, or their interestshave terms that are less favorable tothe bank than transactions involvingunrelated parties (sections 23A and 22of the Federal Reserve Act (12 USC371c, 375, 375a, and 375b)).

b. Determine if Federal Reserve stockequals 3 percent of the subject bank’sbooked capital and surplus accounts(Regulation I and 12 CFR 209).

c. Review the nature and duration of fed-eral funds sales to determine if termfederal funds are being sold in an amountexceeding the limit imposed by statelegal lending limits.

20. With regard to potential unsafe and unsoundinvestment practices and possible violationsof the Securities Exchange Act of 1934,review the list of securities purchased and/orsold since the last examination.a. Determine if the bank engages one secu-

rities dealer or salesperson for virtuallyall transactions. If so—• evaluate the reasonableness of the

relationship on the basis of the dealer’slocation and reputation and

• compare purchase and sale prices toindependently established market pricesas of trade dates, if appropriate.

b. Determine if investment-account securi-ties have been purchased from the bank’sown trading department. If so—• independently establish the market

price as of trade date,• review trading-account purchase and

sale confirmations and determine if thesecurity was transferred to the invest-ment portfolio at market price, and

• review controls designed to preventdumping.

c. Determine if the volume of tradingactivity in the investment portfolio appearsunwarranted. If so—• review investment-account daily led-

gers and transaction invoices to deter-mine if sales were matched by a likeamount of purchases,

• determine whether the bank is financ-ing a dealer’s inventory,

• compare purchase and sale prices withindependently established market pricesas of trade dates, if appropriate (thecarrying value should be determinedby the market value of the securities asof the trade date), and

• cross reference descriptive details oninvestment ledgers and purchase con-firmations to the actual bonds or safe-keeping receipts to determine if thebonds delivered are those purchased.

21. Discuss with appropriate officers and pre-pare report comments on—a. defaulted issues;b. speculative issues;c. incomplete credit information;d. the absence of legal opinions;e. significant changes in maturity

scheduling;f. shifts in the rated quality of holdings;g. concentrations;h. unbalanced earnings and risk

considerations;i. unsafe and unsound investment practices;j. apparent violations of laws, rulings, and

regulations and the potential personalliability of the directorate;

k. significant variances from peer-groupstatistics;

l. market-value depreciation, if significant;m. weaknesses in supervision;n. policy deficiencies; ando. material problems being encountered by

the bank’s Edge Act and agreement cor-poration affiliates and other related inter-national concerns that could affect thecondition of the bank.

22. The following guidelines are to be imple-mented while reviewing securities partici-pations, purchases and sales, swaps, or othertransfers. The guidelines are designed toensure that securities transfers involvingstate member banks, bank holding compa-nies, and nonbank affiliates are carefullyevaluated to determine if they were carriedout to avoid classification and to determine



the effect of the transfer on the condition ofthe institution. In addition, the guidelinesare designed to ensure that the primaryregulator of the other financial institutioninvolved in the transfer is notified.a. Investigate any situations in which secu-

rities were transferred before the date ofexamination to determine if any weretransferred to avoid possible criticismduring the examination.

b. Determine whether any of the securitiestransferred were nonperforming at thetime of transfer, classified at the pre-vious examination, depreciated or sub-investment-grade, or for any other reasonconsidered to be of questionable quality.

c. Review the bank’s policies and proce-dures to determine whether securitiespurchased by the bank are given anindependent, complete, and adequatecredit evaluation. If the bank is a holdingcompany subsidiary or a member of achain banking organization, review secu-rities purchases or participations fromaffiliates or other known members of thechain to determine if the securities pur-chases are given an arm’s-length andindependent credit evaluation by the pur-chasing bank.

d. Determine whether bank purchases ofsecurities from an affiliate are in con-formance with section 23A, which gen-erally prohibits purchases of low-qualityassets from an affiliate.

e. Determine that any securities purchasedby the bank are properly reflected on itsbooks at fair market value (fair marketvalue should at a minimum reflect boththe rate of return being earned on suchassets and an appropriate risk premium).Determine that appropriate write-offs aretaken on any securities sold by the bankat less than book value.

f. Determine that transactions involvingtransfers of low-quality securities to theparent holding company or a nonbankaffiliate are properly reflected at fairmarket value on the books of both thebank and the holding company affiliate.

g. If poor-quality securities were trans-ferred to or from another financial insti-tution for which the Federal Reserve isnot the primary regulator, prepare amemorandum to be submitted to ReserveBank supervisory personnel. The ReserveBank will then inform the local office ofthe primary federal regulator of the otherinstitution involved in the transfer. Thememorandum should include the follow-ing information, as applicable:• names of originating and receiving

institutions• the type of securities involved and

type of transfer (such as participation,purchase or sale, or swap)

• dates of transfer• the total number and dollar amount of

securities transferred• the status of the securities when trans-

ferred (for example, rating, deprecia-tion, nonperforming, or classified)

• any other information that would behelpful to the other regulator

23. Evaluate the quality of department manage-ment. Communicate your conclusion to theexaminer who is assigned to managementassessment and the examiner responsiblefor the international examination, ifapplicable.

24. Update workpapers with any informationthat will facilitate future examinations. Ifthe bank has overseas branches, indicatethose securities that will require reviewduring the next overseas examination andthe reasons for the review.



Investment Securities and End-User ActivitiesInternal Control Questionnaire Section 3000.4

Review the bank’s internal controls, policies,practices, and procedures regarding purchases,sales, and servicing of the investment portfolio.The bank’s system should be documented com-pletely and concisely, and should include, whereappropriate, narrative descriptions, flow charts,copies of forms used, and other pertinent infor-mation.Items in the questionnaire marked withan asterisk require substantiation by observa-tion or testing.

POLICIES

1. Has the board of directors, consistent withits duties and responsibilities, adopted writ-ten investment-securities policies, includ-ing policies for when-issued securities,futures, and forward placement contracts?Do policies outline the following:a. objectivesb. permissible types of investmentsc. diversification guidelines to prevent

undue concentrationd. maturity schedulese. limitations on quality ratingsf. policies for exceptions to standard

policyg. valuation procedures and their frequency

2. Are investment policies reviewed at leastannually by the board to determine if theyare compatible with changing marketconditions?

3. At the time of purchase, are securitiesdesignated as to whether they are invest-ments for the portfolio or trading account?

4. Have policies been established governingthe transfer of securities from the tradingaccount to the investment-securitiesaccount?

5. Have limitations been imposed on theinvestment authority of officers?

*6. Do security transactions require dualauthorization?

7. Does the bank have any of the following:due from commercial banks or from otherdepository institutions, time accounts, fed-eral funds sold, commercial paper, securi-ties purchased under agreements to resell,or any other money market type of invest-ment? If so, determine the following:a. Is purchase or sale authority clearly

defined?

b. Are purchases or sales reported to theboard of directors or its investmentcommittee?

c. Are maximums established for theamount of each type of asset?

d. Are maximums established for theamount of each type of asset that maybe purchased from or sold to any onebank?

e. Do money market investment policiesoutline acceptable maturities?

f. Have credit standards and review pro-cedures been established?

8. Are the bank’s policies in compliance withsections 23A and 23B of the FederalReserve Act and the Board’s rules there-under?

CUSTODY OF SECURITIES

*9. Do procedures preclude the custodian ofthe bank’s securities from—a. having sole physical access to securities;b. preparing release documents without

the approval of authorized persons;c. preparing release documents not subse-

quently examined or tested by a secondcustodian; and

d. performing more than one of the fol-lowing transactions: (1) execution oftrades, (2) receipt or delivery of secu-rities, (3) receipt and disbursement ofproceeds?

*10. Are securities physically safeguarded toprevent loss or their unauthorized removalor use?

11. Are securities, other than bearer securities,held only in the name or nominee of thebank?

12. When a negotiable certificate of deposit isacquired, is the certificate safeguarded inthe same manner as any other negotiableinvestment instrument?

RECORDS

13. Do subsidiary records of investmentsecurities show all pertinent data describ-ing the security; its location; pledged orunpledged status; premium amortization;

Trading and Capital-Markets Activities Manual April 2002Page 1

discount accretion; and interest earned,collected, and accrued?

*14. Is the preparation and posting of subsidi-ary records performed or reviewed bypersons who do not also have sole custodyof securities?

*15. Are subsidiary records reconciled, at leastmonthly, to the appropriate general-ledgeraccounts, and are reconciling items inves-tigated by persons who do not also havesole custody of securities?

16. For international division investments, areentries for U.S. dollar carrying values ofsecurities denominated in foreign currenciesrechecked at inception by a second person?

PURCHASES, SALES, ANDREDEMPTIONS

*17. Is the preparation and posting of the pur-chase, sale, and redemption records ofsecurities and open contractual commit-ments performed or reviewed by personswho do not also have sole custody ofsecurities or authorization to execute trades?

*18. Are supporting documents, such as bro-ker’s confirmations and account state-ments for recorded purchases and sales,checked or reviewed subsequently by per-sons who do not also have sole custodyof securities or authorization to executetrades?

*19. Are purchase confirmations compared withdelivered securities or safekeeping receiptsto determine if the securities delivered arethe securities purchased?

DERIVATIVE-CONTRACTSCONTROLS

20. Do end-user policies—a. outline specific strategies andb. relate permissible strategies to other

banking activities?21. Are the formalized procedures used by the

trader—a. documented in a manual andb. approved by the board or an appropriate

board committee?22. Are the bank’s futures commission mer-

chants and forward brokers—a. notified in writing to trade with only

those persons authorized as traders and

b. notified in writing of revocation oftrading authority?

23. Has the bank established end-user limits—a. for individual traders and total outstand-

ing contracts?b. that are endorsed by the board or an

appropriate board committee?c. whose basis is fully explained?

24. Does the bank obtain prior written approvaldetailing the amount of, duration, andreason—a. for deviations from individual limits

andb. for deviations from gross trading limits?

25. Are these exceptions subsequently submit-ted to the board or an appropriate boardcommittee for ratification?

26. Does the trader prepare a prenumberedtrade ticket?

27. Does the trade ticket contain all of thefollowing information:a. trade dateb. purchase or salec. contract descriptiond. quantitye. pricef. reason for tradeg. reference to the position being matched

(immediate or future case settlement)h. signature of trader

28. Are the accounting records maintained andcontrolled by persons who cannot initiatetrades?

29. Are accounting procedures documented ina procedures manual?

30. Are all incoming trade confirmations—a. received by someone independent of

the trading and recordkeeping functionsand

b. verified to the trade tickets by thisindependent party?

31. Does the bank maintain general-ledgercontrol accounts disclosing, at aminimum—a. futures or forward contracts memo-

randa accounts,b. deferred gains or losses, andc. margin deposits?

32. Are futures and forward contractsactivities—a. supported by detailed subsidiary records

andb. agreed daily to general-ledger controls

by someone who is not authorized toprepare general-ledger entries?

3000.4 Investment Securities and End-User Activities: Internal Control Questionnaire

April 2002 Trading and Capital-Markets Activities ManualPage 2

33. Do periodic statements received fromfutures commission merchants reflect—a. trading activity for the period,b. open positions at the end of the period,c. the market value of open positions,d. unrealized gains and losses, ande. cash balances in accounts?

34. Are all of these periodic statements—a. received by someone independent of

both the trading and recordkeeping func-tions and

b. reconciled to all of the bank’s account-ing records?

35. Are the market prices reflected on thestatements—a. verified with listed prices from a pub-

lished source andb. used to recompute gains and losses?

36. Are daily reports of unusual increases intrading activity reviewed by senior man-agement?

37. Are weekly reports prepared for an appro-priate board committee and do reportsreflect—a. all trading activity for the week,b. open positions at the end of the week,c. the market value of open positions,d. unrealized gains and losses,e. total trading limits outstanding for the

bank, andf. total trading limits for each authorized

trader?38. Is the futures and forward contracts port-

folio revalued monthly to market value orthe lower of cost or market?

39. Are revaluation prices provided by per-sons or sources who are totally indepen-dent of the trading function?

OTHER

40. Does the board of directors receive regularreports on domestic and international divi-sion investment securities, and do reportsinclude—a. valuations,b. maturity distributions,c. the average yield, andd. reasons for holding and benefits received

(international division and overseasholdings only)?

41. Are purchases, exchanges, and sales ofsecurities and open contractual commit-ments ratified by action of the board ofdirectors or its investment committee andthereby made a matter of record in theminutes?

CONCLUSION

42. Is the foregoing information an adequatebasis for evaluating internal control? Arethere significant deficiencies in areas notcovered in this questionnaire that impairany controls? Explain any deficienciesbriefly and indicate any additional exami-nation procedures deemed necessary.

43. Based on a composite evaluation, as evi-denced by answers to the foregoing ques-tions, is internal control adequate orinadequate?

Investment Securities and End-User Activities: Internal Control Questionnaire 3000.4

Trading and Capital-Markets Activities Manual April 2002Page 3

Liquidity RiskSection 3005.1

FACTORS INFLUENCINGLIQUIDITY MANAGEMENT ANDTYPES OF LIQUIDITY RISK

Liquidity is a financial institution’s capacity tomeet its cash and collateral obligations withoutincurring unacceptable losses. Adequate liquid-ity is dependent upon the institution’s ability toefficiently meet both expected and unexpectedcash flows and collateral needs withoutadversely affecting either daily operations orthe financial condition of the institution. Aninstitution’s obligations and the funding sourcesused to meet them depend significantly on itsbusiness mix, balance-sheet structure, and thecash-flow profiles of its on- and off-balance-sheet obligations. In managing their cashflows, institutions confront various situationsthat can give rise to increased liquidity risk.These include funding mismatches, marketconstraints on the ability to convert assets intocash or in accessing sources of funds (i.e.,market liquidity), and contingent liquidityevents. Changes in economic conditions orexposure to credit, market, operation, legal,and reputation risks also can affect aninstitution’s liquidity-risk profile and should beconsidered in the assessment of liquidity andasset/liability management.

Liquidity risk is the risk to an institution’sfinancial condition or safety and soundnessarising from its inability (whether real orperceived) to meet its contractual obligations.Because banking organizations employ a signifi-cant amount of leverage in their businessactivities—and need to meet contractual obliga-tions in order to maintain the confidence ofcustomers and fund providers—adequate liquid-ity is critical to an institution’s ongoing opera-tion, profitability, and safety and soundness.

To ensure it has adequate liquidity, aninstitution must balance the costs and benefits ofliquidity: Too little liquidity can expose aninstitution to an array of significant negativerepercussions arising from its inability to meetcontractual obligations. Conversely, too muchliquidity can entail substantial opportunity costsand have a negative impact on the firm’sprofitability.

Effective liquidity management entails thefollowing three elements:

• assessing, on an ongoing basis, the currentand expected future needs for funds, andensuring that sufficient funds or access tofunds exists to meet those needs at theappropriate time

• providing for an adequate cushion of liquid-ity with a stock of liquid assets to meetunanticipated cash-flow needs that may arisefrom a continuum of potential adversecircumstances that can range from high-probability/low-severity events that occur indaily operations to low-probability/high-severity events that occur less frequently butcould significantly affect an institution’ssafety and soundness

• striking an appropriate balance between thebenefits of providing for adequate liquidity tomitigate potential adverse events and the costof that liquidity

The primary role of liquidity-risk manage-ment is to (1) prospectively assess the need forfunds to meet obligations and (2) ensure theavailability of cash or collateral to fulfill thoseneeds at the appropriate time by coordinatingthe various sources of funds available to theinstitution under normal and stressed conditions.Funds needs arise from the myriad of bankingactivities and financial transactions that createcontractual obligations to deliver funds, includ-ing business initiatives for asset growth, theprovision of various financial products andtransaction services, and expected and unex-pected changes in assets and the liabilities usedto fund assets. Liquidity managers have an arrayof alternative sources of funds to meet theirliquidity needs. These sources generally fallwithin one of four broad categories:

• net operating cash flows• the liquidation of assets• the generation of liabilities• an increase in capital funds

Funds obtained from operating cash flowsarise from net interest payments on assets; netprincipal payments related to the amortizationand maturity of assets; and the receipt of fundsfrom various types of liabilities, transactions,

Note: The guidance complements existing guidance in theBank Holding Company Supervision Manual (section 4010.2)and various SR-letters (see the ‘‘References’’ section).

Trading and Capital-Markets Activities Manual July 2011Page 1

and service fees. Institutions obtain liquidityfrom operating cash flows by managing thetiming and maturity of their asset and liabilitycash flows, including their ongoing borrowingand debt-issuance programs.

Funds can also be obtained by reducing orliquidating assets. Most institutions incorporatescheduled asset maturities and liquidations aspart of their ongoing management of operatingcash flows. They also use the potential liquida-tion of a portion of their assets (generally aportion of the investment portfolio) as acontingent source of funds to meet cash needsunder adverse liquidity circumstances. Suchcontingent funds need to be unencumbered forthe purposes of selling or lending the assets andare often termed liquidity reserves or liquiditywarehouses and are a critical element of safeand sound liquidity management. Assessmentsof the value of unencumbered assets shouldrepresent the amount of cash that can beobtained from monetized assets under normal aswell as stressed conditions.

Asset securitization is another method thatsome institutions use to fund assets. Securitiza-tion involves the transformation of on-balance-sheet loans (e.g., auto, credit card, commercial,student, home equity, and mortgage loans) intopackaged groups of loans in various forms,which are subsequently sold to investors.Depending on the business model employed,securitization proceeds can be both a materialsource of ongoing funding and a significanttool for meeting future funding needs. Securiti-zation markets may provide a good source offunding; however, institutions should be cau-tious in relying too heavily on this market as ithas been known to shutdown under marketstress situations.

Funds are also generated through deposit-taking activities, borrowings, and overall liabil-ity management. Borrowed funds may includesecured lending and unsecured debt obligationsacross the maturity spectrum. In the short term,borrowed funds may include purchased fedfunds and securities sold under agreements torepurchase (repos). Longer-term borrowed fundsmay include various types of deposit products,collateralized loans, and the issuance of corpo-rate debt. Depending on their contractual char-acteristics and the behavior of fund providers,borrowed funds can vary in maturity andavailability because of their sensitivity togeneral market trends in interest rates andvarious other market factors. Considerations

specific to the borrowing institution also affectthe maturity and availability of borrowed funds.

External Factors and Exposure toOther Risks

The liquidity needs of a financial institution andthe sources of liquidity available to meet thoseneeds depend significantly on the institution’sbusiness mix and balance-sheet structure, aswell as on the cash-flow profiles of its on- andoff-balance-sheet obligations. While manage-ment largely determines these internal attributes,external factors and the institution’s exposure tovarious types of financial and operating risks,including interest-rate, credit, operational, legal,and reputational risks, also influence its liquidityprofile. As a result, an institution should assessand manage liquidity needs and sources byconsidering the potential consequences ofchanges in external factors along with theinstitution-specific determinants of its liquidityprofile.

Changes in Interest Rates

The level of prevailing market interest rates, theterm structure of interest rates, and changes inboth the level and term structure of rates cansignificantly affect the cash-flow characteristicsand costs of, and an institution’s demand for,assets, liabilities, and off-balance-sheet (OBS)positions. In turn, these factors significantlyaffect an institution’s funding structure orliquidity needs, as well as the relative attractive-ness or price of alternative sources of liquidityavailable to it. Changes in the level of marketinterest rates can also result in the accelerationor deceleration of loan prepayments and depositflows. The availability of different types offunds may also be affected, as a result of optionsembedded in the contractual structure of assets,liabilities, and financial transactions.

Economic Conditions

Cyclical and seasonal economic conditions canalso have an impact on the volume of aninstitution’s assets, liabilities, and OBSpositions—and, accordingly, its cash-flow andliquidity profile. For example, during reces-

3005.1 Liquidity Risk

July 2011 Trading and Capital-Markets Activities ManualPage 2

sions, business demand for credit may decline,which affects the growth of an organization andits liquidity needs. At the same time, subpareconomic growth and its impact on employ-ment, bankruptcies, and business failures oftencreate direct and indirect incentives for retailcustomers to reduce their deposits; a recessionmay also lead to higher loan delinquencies forfinancial institutions. All of these conditionshave negative implications for an institution’scash flow and overall liquidity. On the otherhand, periods of economic growth may spurasset or deposit growth, thus introducing differ-ent liquidity challenges.

Credit-Risk Exposures of an Institution

An institution’s exposure to credit risk can havea material impact on its liquidity. Nonperform-ing loans directly reduce otherwise expectedcash inflows. The reduced credit quality ofproblem assets impairs their marketability andpotential use as a source of liquidity (either byselling the assets or using them as collateral).Moreover, problem assets have a negativeimpact on overall cash flows by increasing thecosts of loan-collection and -workout efforts.

In addition, the price that a bank pays forfunds, especially wholesale and brokered bor-rowed funds and deposits, will reflect theinstitution’s perceived level of risk exposure inthe marketplace. Fund suppliers use a variety ofcredit-quality indicators to judge credit risk anddetermine the returns they require for the risk tobe undertaken. Such indicators include aninstitution’s loan-growth rates; the relative sizeof its loan portfolio; and the levels of delinquentloans, nonperforming loans, and loan losses. Forinstitutions that have issued public debt, thecredit ratings of nationally recognized statisticalrating organizations (NRSOs) are particularlycritical.

Other Risk Exposures of an Institution

Importantly, exposures to operational, legal,reputational, and other risks can lead to adverseliquidity conditions. Operating risks can mate-rially disrupt the dispersal and receipt ofobligated cash flows and give rise to significantliquidity needs. Exposure to legal and reputa-tional risks can lead fund providers to questionan institution’s overall credit risk, safety and

soundness, and ability to meet its obligations inthe future. A bank’s reputation for operating ina safe and sound manner, particularly its abilityto meet its contractual obligations, is animportant determinant in its costs of funds andoverall liquidity-risk profile.

Given the critical importance of liquidity tofinancial institutions and the potential impactthat other risk exposures and external factorshave on liquidity, effective liquidity managersensure that liquidity management is fully inte-grated into the institution’s overall enterprise-wide risk-management activities. Liquidity man-agement is therefore an important part of aninstitution’s strategic and tactical planning.

Types of Liquidity Risk

Banking organizations encounter the followingthree broad types of liquidity risk:

• mismatch risk• market liquidity risk• contingent liquidity risk

Mismatch risk is the risk that an institution willnot have sufficient cash to meet obligations inthe normal course of business, as a result ofineffective matches between cash inflows andoutflows. The management and control offunding mismatches depend greatly on the dailyprojections of operational cash flow, includingthose cash flows that may arise from seasonalbusiness fluctuations, unanticipated new busi-ness, and other everyday situations. To accu-rately project operational cash flows, an institu-tion needs to estimate its expected cash-flowneeds and ensure it has adequate liquidity tomeet small variations to those expectations.Occurrences of funding mismatches may befrequent. If adequately managed, these mis-matches may have little to no impact on thefinancial health of the firm.

Market liquidity risk is the risk that aninstitution will encounter market constraints inits efforts to convert assets into cash or to accessfinancial market sources of funds.

The planned conversion of assets into cash isan important element in an institution’s ongoingmanagement of funding cash-flow mismatches.In addition, converting assets into cash is oftena key strategic tool for addressing contingentliquidity events. As a result, market constraints

Liquidity Risk 3005.1


on achieving planned, strategic, or contingentconversions of assets into cash can exacerbatethe severity of potential funding mismatches andcontingent liquidity problems.

Contingent liquidity risk is the risk that ariseswhen unexpected events cause an institution tohave insufficient funds to meet its obligations.Unexpected events may be firm-specific or arisefrom external factors. External factors may begeographic, such as local economic factors thataffect the premiums required on deposits withcertain local, state, or commercial areas, or theymay be market-oriented, such as increases in theprice volatility of certain types of securities inresponse to financial market developments.External factors may also be systemic, such as apayment-system disruption or major changes ineconomic or financial market conditions.

The nature and severity of contingent liquid-ity events vary substantially. At one extreme,contingent liquidity risk may arise from the needto fund unexpected asset growth as a result ofcommitment requests or the unexpected runoffof liabilities that occurs in the normal course ofbusiness. At the other extreme, institution-specific issues, such as the lowering of a publicdebt rating or general financial market stress,may have a significant impact on an institution’sliquidity and safety and soundness. As a result,managing contingent liquidity risk requires anongoing assessment of potential future eventsand circumstances in order to ensure thatobligations are met and adequate sources ofstandby liquidity and/or liquidity reserves arereadily available and easily converted to cash.

Diversification plays an important role inmanaging liquidity and its various componentrisks. Concentrations in particular types ofassets, liabilities, OBS positions, or businessactivities that give rise to unique types offunding needs or create an undue reliance onspecific types of funding sources can undulyexpose an institution to the risks of fundingmismatches, contingent events, and marketliquidity constraints. Therefore, diversificationof both the sources and uses of liquidity is acritical component of sound liquidity-riskmanagement.

SOUND LIQUIDITY-RISKMANAGEMENT PRACTICES

Like the management of any type of risk,sound liquidity-risk management involves effec-

tive oversight of a comprehensive process thatadequately identifies, measures, monitors, andcontrols risk exposure. This process includesoversight of exposures to funding mismatches,market liquidity constraints, and contingentliquidity events. Both international and U.S.banking supervisors have issued supervisoryguidance on safe and sound practices formanaging the liquidity risk of banking organi-zations. Guidance on liquidity risk manage-ment was published by the Basel Committeeon Banking Supervision, Bank for InternationalSettlements, ‘‘Principles for Sound LiquidityRisk Management and Supervision,’’ in Septem-ber 2008.1 The U.S. regulatory agenciesimplemented these principles, jointly agreeingto incorporate those principles into theirexisting guidance. The revised guidance, ‘‘Inter-agency Policy Statement on Funding andLiquidity Risk Management’’ was issued onMarch 10, 2010 (see SR-10-6 and its attachment).

In summary, the critical elements of a soundliquidity-risk management process are—

• Effective corporate governance consisting ofoversight by the board of directors and activeinvolvement by management in an institu-tion’s control of liquidity risk.

• Appropriate strategies, policies, procedures,and limits used to manage and mitigateliquidity risk.

• Comprehensive liquidity-risk measurementand monitoring systems (including assess-ments of the current and prospective cashflows or sources and uses of funds) that arecommensurate with the complexity and busi-ness activities of the institution.

• Active management of intraday liquidity andcollateral.

• An appropriately diverse mix of existing andpotential future funding sources.

• Adequate levels of highly liquid marketablesecurities free of legal, regulatory, or opera-tional impediments that can be used to meetliquidity needs in stressful situations.

• Comprehensive contingency funding plans(CFPs) that sufficiently address potentialadverse liquidity events and emergency cashflow requirements.

• Internal controls and internal audit processes

1. Basel Committee on Banking Supervision, ‘‘Principlesfor Sound Liquidity Risk Management and Supervision,’’September 2008. See www.bis.org/publ/bcbs144.htm.



sufficient to determine the adequacy of theinstitution’s liquidity-risk-management process.

Each of these elements should be customized toaccount for the sophistication, complexity, andbusiness activities of an institution. The follow-ing sections discuss supervisory expectations foreach of these critical elements.

Corporate Governance and Oversight

Effective liquidity-risk management requiresthe coordinated efforts of both an informedboard of directors and capable senior manage-ment. The board should establish and commu-nicate the institution’s liquidity-risk tolerancein such a manner that all levels of managementclearly understand the institution’s approach tomanaging the trade-offs between managementof liquidity risk and short-term profits. Theboard should ensure that the organizationalstructures and staffing levels are appropriate,given the institution’s activities and the risksthey present.

Involvement of the Board of Directors

The board of directors is ultimately responsiblefor the liquidity risk assumed by the institution.The board should understand and guide thestrategic direction of liquidity-risk management.Specifically, the board of directors or a del-egated committee of board members shouldoversee the establishment and approval ofliquidity management strategies, policies andprocedures, and review them at least annually.In addition, the board should ensure that it

• understands the nature of the institution’sliquidity risks and periodically reviews infor-mation necessary to maintain thisunderstanding;

• understands and approves those elements ofliquidity-risk management policies that articu-late the institution’s general strategy formanaging liquidity risk, and establishes accept-able risk tolerances;

• establishes executive-level lines of authorityand responsibility for managing the institu-tion’s liquidity risk;

• enforces management’s duties to identify,measure, monitor, and control liquidity risk.

• understands and periodically reviews the

institution’s CFP for handling potential adverseliquidity events; and

• understands the liquidity-risk profile of impor-tant subsidiaries and affiliates and their influ-ence on the overall liquidity of the financialinstitution, as appropriate.

Role of Senior Management

Senior management should ensure that liquidity-risk management strategies, policies, and proce-dures are adequate for the sophistication andcomplexity of the institution. Managementshould ensure that these policies and proceduresare appropriately executed on both a long-termand day-to-day basis, in accordance with boarddelegations. Management should oversee thedevelopment and implementation of—

• an appropriate risk-measurement system andstandards for measuring the institution’sliquidity risk;

• a comprehensive liquidity-risk reporting andmonitoring process;

• establishment and monitoring of liquid assetbuffers of unencumbered marketable securities;

• effective internal controls and review pro-cesses for the management of liquidity risk;and

• monitoring of liquidity risks for each entityacross the institution on an on-going basisand;

• an appropriate CFP, including (1) adequateassessments of the institution’s contingentliquidity risks under adverse circumstancesand (2) fully developed strategies and plansfor managing such events.

Senior management should periodicallyreview the organization’s liquidity-risk manage-ment strategies, policies, and procedures, aswell as its CFP, to ensure that they remainappropriate and sound. Management should alsocoordinate the institution’s liquidity-risk man-agement with its efforts for disaster, contin-gency, and strategic planning, as well as with itsbusiness and risk-management objectives, strat-egies, and tactics. Senior management is alsoresponsible for regularly reporting to the boardof directors on the liquidity-risk profile of theinstitution.



Strategies, Policies, Procedures, andRisk Tolerances

Institutions should have documented strategiesfor managing liquidity and have formal writtenpolicies and procedures for limiting and control-ling risk exposures. Strategies, policies, andprocedures should translate the board’s goals,objectives, and risk tolerances into operatingstandards that are well understood by institu-tional personnel and that are consistent with theboard’s intended risk tolerances. Policies shouldalso ensure that responsibility for managingliquidity is assigned throughout the corporatestructure of the institution, including separatelegal entities and relevant operating subsidiariesand affiliates, where appropriate. Strategies setout the institution’s general approach for man-aging liquidity, articulate its liquidity-risk toler-ances, and address the extent to which keyelements of funds management are centralizedor delegated throughout the institution. Strate-gies also communicate how much emphasis theinstitution places on using asset liquidity,liabilities, and operating cash flows to meet itsday-to-day and contingent funding needs. Quan-titative and qualitative targets, such as thefollowing, may also be included in policies:

• guidelines or limits on the composition ofassets and liabilities

• the relative reliance on certain funding sources,both on an ongoing basis and under contingentliquidity scenarios

• the marketability of assets to be used ascontingent sources of liquidity

An institution’s strategies and policies shouldidentify the primary objectives and methods for(1) managing daily operating cash flows, (2) pro-viding for seasonal and cyclical cash-flowfluctuations, and (3) addressing various adverseliquidity scenarios. The latter includes formulat-ing plans and courses of actions for dealing withpotential temporary, intermediate-term, and long-term liquidity disruptions. Policies and proce-dures should formally document—

• lines of authority and responsibility formanaging liquidity risk,

• liquidity-risk limits and guidelines,• the institution’s measurement and reporting

systems, and

• elements of the institution’s comprehensiveCFP.

Incorporating these elements of liquidity-riskmanagement into policies and procedures helpsinternal control and internal audit fulfill theiroversight role in the liquidity-risk managementprocess. Policies, procedures, and limits shouldaddress liquidity separately for individual cur-rencies, where appropriate and material. Allliquidity-risk policies, procedures, and limitsshould be reviewed periodically and revised asneeded.

Delineating Clear Lines of Authority andResponsibility

Through formal written policies or clear operat-ing procedures, management should delineatemanagerial responsibilities and oversight, includ-ing lines of authority and responsibility for thefollowing:

• developing liquidity-risk management poli-cies, procedures, and limits

• developing and implementing strategies andtactics for managing liquidity risk

• conducting day-to-day management of theinstitution’s liquidity

• establishing and maintaining liquidity-riskmeasurement and monitoring systems

• authorizing exceptions to policies and limits• identifying the potential liquidity risk associ-

ated with the introduction of new products andactivities

Institutions should clearly identify the individu-als or committees responsible for liquidity-riskdecisions. Less complex institutions often assignsuch responsibilities to the CFO or an equivalentsenior management official. Other institutionsassign responsibility for liquidity-risk manage-ment to a committee of senior managers,sometimes called a finance committee or anasset/liability committee (ALCO). Policiesshould clearly identify individual or committeeduties and responsibilities, the extent of thedecision-making authority, and the form andfrequency of periodic reports to senior manage-ment and the board of directors. In general, anALCO (or a similar senior-level committee) isresponsible for ensuring that (1) measurementsystems adequately identify and quantify theinstitution’s liquidity-risk exposure and



(2) reporting systems communicate accurate andrelevant information about the level and sourcesof that exposure.

When an institution uses an ALCO or othersenior management committee, the committeeshould actively monitor the liquidity profile ofthe institution and should have sufficiently broadrepresentation from the major institutional func-tions that influence liquidity risk (e.g., thelending, investment, deposit, or funding func-tions). Committee members should includesenior managers who have authority over theunits responsible for executing transactions andother activities that can affect liquidity. Inaddition, the committee should ensure that(1) the risk-measurement system adequatelyidentifies and quantifies risk exposure and(2) the reporting process communicates accu-rate, timely, and relevant information about thelevel and sources of risk exposure.

In general, committees overseeing liquidity-risk management delegate the day-to-day respon-sibilities to the institution’s treasury departmentor, at less complex institutions, to the CFO,treasurer, or other appropriate staff. The person-nel charged with measuring and monitoring theday-to-day management of liquidity risk shouldhave a well-founded understanding of all aspectsof the institution’s liquidity-risk profile. Whilethe day-to-day management of liquidity may bedelegated, the oversight committee should notbe precluded from aggressively monitoringliquidity management.

In more-complex institutions that have sepa-rate legal entities and operating subsidiaries oraffiliates, effective liquidity-risk managementrequires senior managers and other key person-nel to have an understanding of the fundingposition and liquidity of any member of thecorporate group that might provide or absorbliquid resources from another member. Central-ized liquidity-risk assessment and managementcan provide significant operating efficienciesand comprehensive views of the liquidity-riskprofile of the integrated corporate entity as wellas members of the corporate group—includingdepository institutions. This integrated view isparticularly important for understanding theimpact other members of the group may have oninsured depository entities. However, legal andregulatory restrictions on the flow of fundsamong members of a corporate group, inaddition to differences in the liquidity character-istics and dynamics of managing the liquidity ofdifferent types of entities within a group, may

call for decentralizing various elements ofliquidity-risk management. Such delegation andassociated strategies, policies, and proceduresshould be clearly articulated and understoodthroughout the organization. Policies, proce-dures, and limits should also address liquidityseparately for individual currencies, legal enti-ties, and business lines, when appropriate andmaterial, as well as allow for legal, regulatory,and operational limits for the transferability ofliquidity.

Diversified Funding

An institution should establish a funding strat-egy that provides effective diversification in thesources and tenor of funding. It should maintainan ongoing presence in its chosen fundingmarkets and strong relationships with fundsproviders to promote effective diversification offunding sources. An institution should regularlygauge its capacity to raise funds quickly fromeach source. It should identify the main factorsthat affect its ability to raise funds and monitorthose factors closely to ensure that estimates offund raising capacity remain valid.

An institution should diversify availablefunding sources in the short-, medium- andlong-term. Diversification targets should be partof the medium- to long-term funding plans andshould be aligned with the budgeting andbusiness planning process. Funding plans shouldtake into account correlations between sourcesof funds and market conditions. Funding shouldalso be diversified across a full range of retail aswell as secured and unsecured wholesale sourcesof funds, consistent with the institution’s sophis-tication and complexity. Management shouldalso consider the funding implications of anygovernment programs or guarantees it utilizes.As with wholesale funding, the potential unavail-ability of government programs over theintermediate- and long-term should be fullyconsidered in the development of liquidity riskmanagement strategies, tactics, and risk toler-ances. Funding diversification should be imple-mented using limits addressing counterparties,secured versus unsecured market funding, instru-ment type, securitization vehicle, and geo-graphic market. In general, funding concentra-tions should be avoided. Undue over reliance onany one source of funding is considered anunsafe and unsound practice.

An essential component of ensuring funding



diversity is maintaining market access. Marketaccess is critical for effective liquidity riskmanagement, as it affects both the ability to raisenew funds and to liquidate assets. Seniormanagement should ensure that market access isbeing actively managed, monitored, and testedby the appropriate staff. Such efforts should beconsistent with the institution’s liquidity-riskprofile and sources of funding. For example,access to the capital markets is an importantconsideration for most large complex institu-tions, whereas the availability of correspondentlines of credit and other sources of whole fundsare critical for smaller, less complex institutions.

An institution needs to identify alternativesources of funding that strengthen its capacity towithstand a variety of severe institution-specificand market-wide liquidity shocks. Dependingupon the nature, severity, and duration of theliquidity shock, potential sources of fundinginclude, but are not limited to, the following:

• Deposit growth.• Lengthening maturities of liabilities.• Issuance of debt instruments.• Sale of subsidiaries or lines of business.• Asset securitization.• Sale (either outright or through repurchase

agreements) or pledging of liquid assets.• Drawing-down committed facilities.• Borrowing.

Liquidity-Risk Limits and Guidelines

Liquidity-risk tolerances or limits should beappropriate for the complexity and liquidity-riskprofile of an institution. They should employboth quantitative targets and qualitative guide-lines and should be consistent with the institu-tion’s overall approach and strategy for measur-ing and managing liquidity. Policies shouldclearly articulate a liquidity-risk tolerance that isappropriate for the business strategy of theinstitution, considering its complexity, businessmix, liquidity-risk profile, and its role in thefinancial system. Policies should also containprovisions for documenting and periodicallyreviewing assumptions used in liquidity projec-tions. Policy guidelines should employ bothquantitative targets and qualitative guidelines.These measurements, limits, and guidelines maybe specified in terms of the following measuresand conditions, as applicable:

• Discrete or cumulative cash-flow mismatchesor gaps (sources and uses of funds) overspecified future short- and long-term timehorizons under both expected and adversebusiness conditions. Often, these are expressedas cash-flow coverage ratios or as specificaggregate amounts.

• Target amounts of unpledged liquid-assetreserves suffıcient to meet liquidity needsunder normal and reasonably anticipatedadverse business conditions. These targets areoften expressed as aggregate amounts or asratios calculated in relation to, for example,total assets, short-term assets, various types ofliabilities, or projected-scenario liquidityneeds.

• Volatile liability dependence and liquid-assetcoverage of volatile liabilities under bothnormal and stress conditions. These guide-lines, for example, may include amounts ofpotentially volatile wholesale funding to totalliabilities, volatile retail (e.g., high-cost orout-of-market) deposits to total deposits,potentially volatile deposit-dependency mea-sures, or short-term borrowings as a percent oftotal funding.

• Asset concentrations that could increaseliquidity risk through a limited ability toconvert to cash (e.g., complex financialinstruments, bank-owned (corporate-owned)life insurance, and less-marketable loanportfolios).

• Funding concentrations that address diversi-fication issues, such as a large liability anddependency on borrowed funds, concentra-tions of single funds providers, funds provid-ers by market segments, and types of volatiledeposit or volatile wholesale funding depen-dency. For small community banks, fundingconcentrations may be difficult to avoid.However, banks that rely on just a fewprimary sources should have appropriatesystems in place to manage the concentrationsof funding liquidity, including limit structuresand reporting mechanisms.

• Funding concentrations that address the term,re-pricing, and market characteristics offunding sources. This may include diversifi-cation targets for short-, medium-, and long-term funding, instrument type and securitiza-tion vehicles, and guidance on concentrationsfor currencies and geographical markets.

• Contingent liabilities, such as unfunded loancommitments and lines of credit supportingasset sales or securitizations, and collateral



requirements for derivatives transactions andvarious types of secured lending.

• The minimum and maximum average matu-rity of different categories of assets andliabilities.

Institutions may use other risk indicators tospecify their risk tolerances. Some institutionsmay use ratios such as loans to deposits, loansto equity capital, purchased funds to totalassets, or other common measures. However,when developing and using such measures,institutions should be fully aware that somemeasures may not appropriately assess thetiming and scenario-specific characteristics ofthe institution’s liquidity-risk profile. Liquidity-risk measures that are constructed using staticbalance-sheet amounts may hide significantliquidity risk that can occur in the future underboth normal and adverse business conditions.As a result, institutions should not rely solelyon these static measures to monitor andmanage liquidity.

Policies on Measuring and ManagingReporting Systems

Policies and procedures should also identify themethods used to measure liquidity risk, as wellas the form and frequency of reports to variouslevels of management and the board of directors.Policies should identify the nature and form ofcash-flow projections and other liquidity mea-sures to be used. Policies should provide for thecategorization, measurement, and monitoring ofboth stable and potentially volatile sources offunds. Policies should also provide guidance onthe types of business-condition scenarios used toconstruct cash-flow projections and shouldcontain provisions for documenting and periodi-cally reviewing the assumptions used in liquid-ity projections.

Moreover, policies should explicitly providefor more-frequent reporting under adverse busi-ness or liquidity conditions. Under normalbusiness conditions, senior managers shouldreceive liquidity-risk reports at least monthly,while the board of directors should receiveliquidity-risk reports at least quarterly. If the riskexposure is more complex, the reports should bemore frequent. These reports should tell seniormanagement and the board how much liquidityrisk the bank is assuming, whether managementis complying with risk limits, and whether

management’s strategies are consistent with theboard’s expressed risk tolerance.

Policies on Contingency Funding Plans

Policies should also provide for senior manage-ment to develop and maintain a written,comprehensive, and up-to-date liquidity CFP.Policies should also ensure that, as part ofongoing liquidity-risk management, senior man-agement is alerted to early-warning indicators ortriggers of potential liquidity problems.

Compliance with Laws and Regulations

Institutions should ensure that their policies andprocedures take into account compliance withappropriate laws and regulations that can havean impact on an institution’s liquidity-riskmanagement and liquidity-risk profile. Theselaws and regulations include the Federal DepositInsurance Corporation Improvement Act(FDICIA) and its constraints on an institution’suse of brokered deposits, as well as pertinentsections of Federal Reserve regulations A, D, F,and W. (See appendix 2, for a summary of someof the pertinent legal and regulatory issues thatshould be factored into the management ofliquidity risk.)

Liquidity-Risk Measurement Systems

The analysis and measurement of liquidity riskshould be tailored to the complexity and riskprofile of an institution, incorporating the cashflows and liquidity implications of all theinstitution’s material assets, liabilities, off-balance-sheet positions, and major businessactivities. Liquidity-risk analysis should con-sider what effect options embedded in theinstitution’s sources and uses of funds may haveon its cash flows and liquidity-risk measures.The analysis of liquidity risk should also beforward-looking and strive to identify potentialfuture funding mismatches as well as currentimbalances. Liquidity-risk measures shouldadvance management’s understanding of theinstitution’s exposure to mismatch, market, andcontingent liquidity risks. Measures should alsoassess the institution’s liquidity sources andneeds in relation to the specific business



environments it operates in and the time framesinvolved in securing and using funds.

Adequate liquidity-risk measurement requiresthe ongoing review of an institution’s sourcesand uses of funds and generally includesanalysis of the following:

• trends in balance-sheet structure and fundingvehicles

• pro forma cash-flow statements and fundingmismatch gaps over varying time horizons

• trends and expectations in the volume andpricing trends for assets, liabilities, andoff-balance-sheet items that can have a signifi-cant impact on the institution’s liquidity

• trends in the relative costs of funds requiredby existing and alternative funds providers

• the diversification of funding sources andtrends in funding concentrations

• the adequacy of asset liquidity reserves, trendsin these reserves, and the market dynamicsthat could influence their market liquidity

• the sensitivity of funds providers to bothfinancial market and institution-specific trendsand events

• the institution’s exposure to both broad-basedmarket and institution-specific contingentliquidity events

The formality and sophistication of liquidity-risk measurement, and the policies and proce-dures used to govern the measurement process,depend on the sophistication of the institution,the nature and complexity of its fundingstructures and activities, and its overall liquidity-risk profile.

(See appendix 1, for background informationon the types of liquidity analysis and measuresof liquidity risk used by effective liquidity-riskmanagers. The appendix also discusses theconsiderations for evaluating the liquidity-riskcharacteristics of various assets, liabilities, OBSpositions, and other activities, such as assetsecuritization, that can influence an institution’sliquidity.)

Pro Forma Cash-Flow Analysis

Regardless of the size and complexity of aninstitution, pro forma cash-flow statements are acritical tool for adequately managing liquidityrisk. In the normal course of measuring andmanaging liquidity risk and analyzing theirinstitution’s sources and uses of funds, effective

liquidity managers project cash flows underexpected and alternative liquidity scenarios.Such cash-flow-projection statements range fromsimple spreadsheets to very detailed reports,depending on the complexity and sophisticationof the institution and its liquidity-risk profile.

A sound practice is to project, on an ongoingbasis, an institution’s cash flows under normalbusiness-as-usual conditions, incorporatingappropriate seasonal and business-growth con-siderations over varying time horizons. Thiscash-flow projection should be regularlyreviewed under both short-term and intermediate-to long-term institution-specific contingent sce-narios. Institutions that have more-complexliquidity-risk profiles should also assess theirexposure to broad systemic and adverse finan-cial market events, as appropriate to theirbusiness mix and overall liquidity-risk profile(e.g., securitization, derivatives, trading, process-ing, international, and other activities).

The construction of pro forma cash-flowstatements under alternative scenarios and theongoing monitoring of an institution’s liquidity-risk profile depend importantly on liquiditymanagement’s review of trends in the institu-tion’s balance-sheet structure and its fundingsources. This review should consider pastexperience and include expectations for thevolume and pricing of assets, liabilities, andoff-balance-sheet items that may significantlyaffect the institution’s liquidity.

Effective liquidity-risk monitoring systemsshould assess (1) trends in the relative cost offunds, as required by the institution’s existingand alternative funds providers; (2) the diversi-fication or concentration of funding sources;(3) the adequacy of the institution’s assetliquidity reserves; and (4) the sensitivity offunds providers to both financial market andinstitution-specific trends and events. Detailedexamples and further discussion of cash-flowsare included in appendix 1, section I, ‘‘BasicCash-Flow Projections.’’

Assumptions

Given the critical importance of assumptions inconstructing liquidity-risk measures and projec-tions of future cash flows, institutions shouldensure that all their assumptions are reasonableand appropriate. Institutions should documentand periodically review and approve key assump-tions. Assumptions used in assessing the liquid-



ity risk of complex instruments and assets;liabilities; and OBS positions that have uncer-tain cash flows, market value, or maturitiesshould be subject to rigorous documentation andreview.

Assumptions about the stability or volatilityof retail deposits, brokered deposits, wholesaleor secondary-market borrowings, and otherfunding sources with uncertain cash flows areparticularly important—especially when suchassumptions are used to evaluate alternativesources of funds under adverse contingentliquidity scenarios (such as a deterioration inasset quality or capital). When assumptionsabout the performance of deposits and othersources of funds are used in the computation ofliquidity measures, these assumptions should bebased on reasoned analysis considering suchfactors as the following:

• the historical behavior of deposit customersand funds providers

• how current or future business conditions maychange the historical responses and behaviorsof customers and other funds providers

• the general conditions and characteristics ofthe institution’s market for various types offunds, including the degree of competition

• the anticipated pricing behavior of fundsproviders (for instance, wholesale or retail)under the scenario investigated

• haircuts (that is, the reduction from the statedvalue of an asset) applied to assets earmarkedas contingent liquidity reserves

Further discussion of liquidity characteristics ofassets, liabilities, and off-balance-sheet items isincluded in appendix 1, section III, ‘‘LiquidityCharacteristics of Assets, Liabilities, Off-Balance-Sheet Positions, and Various Types ofBanking Activities.’’ Institutions that have com-plex liquidity profiles should perform sensitivitytests to determine what effect any changes to itsmaterial assumptions will have on its liquidity.

Institutions should ensure that assets areproperly valued according to relevant financialreporting and supervisory standards. An institu-tion should fully factor into its risk managementthe consideration that valuations may deteriorateunder market stress and take this into account inassessing the feasibility and impact of assetsales on its liquidity position during stressevents.

Institutions should ensure that their vulner-abilities to changing liquidity needs and liquid-

ity capacities are appropriately assessed withinmeaningful time horizons, including intraday,day-to-day, short-term weekly and monthlyhorizons, medium-term horizons of up to oneyear, and longer-term liquidity needs over oneyear. These assessments should include vulner-abilities to events, activities, and strategies thatcan significantly strain the capability to generateinternal cash.

Stress Testing

Once normal operating cash-flow statements areestablished then those tools can be used togenerate stress tests. Stress assumptions aresimply layered on top of the normal operatingcash-flow projections. The quantitative resultsprovided by the stress test also serve as a keycomponent within the CFP.

Institutions should conduct stress tests on aregular basis for a variety of institution-specificand market-wide events across multiple timehorizons. The magnitude and frequency of stresstesting should be commensurate with the com-plexity of the financial institution and the levelof its risk exposures. Stress test outcomesshould be used to identify and quantify sourcesof potential liquidity strain and to analyzepossible impacts on the institution’s cash flows,liquidity position, profitability, and solvency.

Stress tests should also be used to ensure thatcurrent exposures are consistent with the finan-cial institution’s established liquidity-risk toler-ance. The stress test serves as a key componentof the CFP and the quantification of the risk towhich the institution may be exposed. Manage-ment’s active involvement and support is criticalto the effectiveness of the stress-testing process.Management should discuss the results of stresstests and take remedial or mitigating actions tolimit the institution’s exposures, build up aliquidity cushion, and adjust its liquidity profileto fit its risk tolerance. The results of stress teststherefore play a key role in determining theamount of buffer assets the institution shouldmaintain.

Cushion of Liquid Assets

Liquid assets are an important source of bothprimary (operating liquidity) and secondary(contingent liquidity) funding at many institu-tions. Indeed, a critical component of an



institution’s ability to effectively respond topotential liquidity stress is the availability of acushion of highly liquid assets without legal,regulatory, or operational impediments (i.e.,unencumbered) that can be sold or pledged toobtain funds in a range of stress scenarios. Theseassets should be held as insurance against arange of liquidity stress scenarios, includingthose that involve the loss or impairment oftypically available unsecured and/or securedfunding sources. The size of the cushion of suchhigh-quality liquid assets should be supportedby estimates of liquidity needs performed underan institution’s stress testing as well as alignedwith the risk tolerance and risk profile of theinstitution. Management estimates of liquidityneeds during periods of stress should incorpo-rate both contractual and non-contractual cashflows, including the possibility of funds beingwithdrawn. Such estimates should also assumethe inability to obtain unsecured funding as wellas the loss or impairment of access to fundssecured by assets other than the safest, mostliquid assets.

Management should ensure that unencum-bered, highly liquid assets are readily availableand are not pledged to payment systems orclearing houses. The quality of unencumberedliquid assets is important as it will ensureaccessibility during the time of most need. Forexample, an institution could utilize its holdingsof high-quality U.S. Treasury securities, orsimilar instruments, and enter into repurchaseagreements in response to the most severe stressscenarios.

Liquidity-Risk Monitoring andReporting Systems

Methods used to monitor and measure liquidityrisk should be sufficiently robust and flexibleto allow for the timely computation of themetrics an institution uses in its ongoingliquidity-risk management. Risk monitoringand reporting systems should regularly provideinformation on day-to-day liquidity manage-ment and risk control; this information shouldalso be readily available during contingentliquidity events.

In keeping with the other elements of soundliquidity-risk management, the complexity andsophistication of management reporting andmanagement information systems (MIS) should

be consistent with the liquidity profile of theinstitution. For example, complex institutionsthat are highly dependent on wholesale fundsmay need daily reports on the use of variousfunding sources, maturities of various instru-ments, and rollover rates. Less complex institu-tions may require only simple maturity-gap orcash-flow reports that depict rollovers andmismatch risks; these reports may also includepertinent liquidity ratios. Liquidity-risk reportscan be customized to provide management withaggregate information that includes sufficientsupporting detail to enable them to assess thesensitivity of the institution to changes in marketconditions, its own financial performance, andother important risk factors. Reportable itemsmay include, but are not limited to—

• cash-flow gap-projection reports and forward-looking summary measures that assess bothbusiness-as-usual and contingent liquidityscenarios;

• asset and funding concentrations that high-light the institution’s dependence on fundsthat may be highly sensitive to institution-specific contingent liquidity or market liquid-ity risk (including information on the typesand amounts of negotiable certificates ofdeposit (CDs) and other bank obligations, aswell as information on major liquidity fundsproviders);

• critical assumptions used in cash-flow projec-tions and other measures;

• the status of key early-warning signals or riskindicators;

• funding availability;• reports on the impact of new products and

activities;• reports documenting compliance with estab-

lished policies and procedures; and• where appropriate, both consolidated and

unconsolidated reports for institutions thathave multiple offices, international branches,affiliates, or subsidiaries.

• Institutions should also report on the use ofand availability of government support, suchas lending and guarantee programs, andimplications on liquidity positions, particu-larly since these programs are generallytemporary or reserved as a source for contin-gent funding.

The types of reports or information and theirtiming should be tailored to the institution’sfunding strategies and will vary according to



the complexity of the institution’s operationsand risk profile. For example, institutionsrelying on investment securities for theirprimary source of contingent liquidity shouldemploy reports on the quality, pledging status,and maturity distribution of those assets.Similarly, institutions conducting securitizationactivities, or placing significant emphasis onthe sale of loans to meet contingent liquidityneeds, should customize their liquidity reportsto target these activities.

Collateral-Position Management

An institution should have the ability tocalculate all of its collateral positions in a timelymanner, including assets currently pledgedrelative to the amount of security required andunencumbered assets available to be pledged.An institution’s level of available collateralshould be monitored by legal entity, by jurisdic-tion, and by currency exposure. Systems shouldbe capable of monitoring shifts between intra-day and overnight or term-collateral usage. Aninstitution should be aware of the operationaland timing requirements associated with access-ing the collateral given its physical location (i.e.,the custodian institution or securities settlementsystem with which the collateral is held).Institutions should also fully understand thepotential demand on required and availablecollateral arising from various types of contrac-tual contingencies during periods of both market-wide and institution-specific stress.

Liquidity Across Legal Entities, andBusiness Lines

An institution should actively monitor andcontrol liquidity-risk exposures and fundingneeds within and across legal entities andbusiness lines, taking into account legal, regu-latory, and operational limitations to the trans-ferability of liquidity. Separately regulatedentities will need to maintain liquidity commen-surate with their own risk profiles on astand-alone basis.

Regardless of its organizational structure, it isimportant that an institution actively monitorand control liquidity risks at the level ofindividual legal entities, and the group as awhole, incorporating processes that aggregatedata across multiple systems in order to develop

a group-wide view of liquidity-risk exposuresand identify constraints on the transfer ofliquidity within the group.

Assumptions regarding the transferability offunds and collateral should be described inliquidity-risk management plans.

Intraday Liquidity Position Management

Intraday liquidity monitoring is an importantcomponent of the liquidity-risk managementprocess for institutions engaged in significantpayment, settlement, and clearing activities. Aninstitution’s failure to manage intraday liquidityeffectively, under normal and stressed condi-tions, could leave it unable to meet payment andsettlement obligations in a timely manner,adversely affecting its own liquidity positionand that of its counterparties. Among large,complex organizations, the interdependenciesthat exist among payment systems and theinability to meet certain critical payments hasthe potential to lead to systemic disruptions thatcan prevent the smooth functioning of allpayment systems and money markets. There-fore, institutions with material payment, settle-ment and clearing activities should activelymanage their intraday liquidity positions andrisks to meet payment and settlement obliga-tions on a timely basis under both normal andstressed conditions. Senior management shoulddevelop and adopt an intraday liquidity strategythat allows the institution to

• monitor and measure expected daily grossliquidity inflows and outflows.

• manage and mobilize collateral when neces-sary to obtain intraday credit.

• identify and prioritize time-specific and othercritical obligations in order to meet themwhen expected.

• settle other less critical obligations as soon aspossible.

• control credit to customers when necessary.

Contingency Funding Plans

A CFP is a compilation of policies, procedures,and action plans for responding to contingentliquidity events. It is a sound practice for allinstitutions, regardless of size and complexity,to engage in comprehensive contingent liquidityplanning. The objectives of the CFP are to



provide a plan for responding to a liquiditycrisis, identify a menu of contingent liquiditysources that the institution can use underadverse liquidity circumstances, and describesteps that should be taken to ensure that theinstitution’s sources of liquidity are sufficient tofund scheduled operating requirements and meetthe institution’s commitments with minimalcosts and disruption. CFPs should be commen-surate with an institution’s complexity, riskprofile, and scope of operations.

Contingent liquidity events are unexpectedsituations or business conditions that mayincrease the risk that an institution will not havesufficient funds to meet liquidity needs. Theseevents can negatively affect any institution,regardless of its size and complexity, by

• interfering with or preventing the funding ofasset growth,

• disrupting the institution’s ability to renew orreplace maturing funds.

Contingent liquidity events may be institution-specific or arise from external factors. Institution-specific risks are determined by the risk profileand business activities of the institution. Theygenerally are a result of unique credit, market,operational, and strategic risks taken by theinstitution. A potential result of this type ofevent would be customers unexpectedly exercis-ing options to withdraw deposits or exerciseoff-balance-sheet (OBS) commitments.

In contrast, external contingent events may besystemic financial-market occurrences, such as

• increases or decreases in the price volatility ofcertain types of securities in response tomarket events;

• major changes in economic conditions, mar-ket perception, or dislocations in financialmarkets;

• disturbances in payment and settlement sys-tems due to operational or local disasters.

Contingent liquidity events range from high-probability/low-impact events that occur duringthe normal course of business to low-probability/high-impact events that may have an adverseimpact on an institution’s safety and soundness.Institutions should incorporate planning forhigh-probability/low-impact liquidity risks intotheir daily management of the sources and usesof their funds. This objective is best accom-plished by assessing possible variations in

expected cash-flow projections and provisioningfor adequate liquidity reserves in the normalcourse of business.

Liquidity risks driven by lower-probability,higher-impact events should be addressed in theCFP, which should—

• identify reasonably plausible stress events;• evaluate those stress events under different

levels of severity;• make a quantitative assessment of funding

needs under the stress events;• identify potential funding sources in response

to a stress event; and• provide for commensurate management pro-

cesses, reporting, and external communicationthroughout a stress event.

The CFP should address both the severity andduration of contingent liquidity events. Theliquidity pressures resulting from low-probability, high-impact events may be immedi-ate and short term, or they may present sustainedsituations that have long-term liquidity implica-tions. The potential length of an event shouldfactor into decisions about sources of contingentliquidity.

Identifying Liquidity Stress Events

Stress events are those events that may have asignificant impact on an institution’s liquidity,given its specific balance-sheet structure, busi-ness lines, organizational structure, and othercharacteristics. Possible stress events includechanges in credit ratings, a deterioration in assetquality, a prompt-corrective-action (PCA) down-grade, and CAMELS ratings downgrade widen-ing of credit default spreads, operating losses,negative press coverage, or other events that callinto question an institution’s ability to meet itsobligations.

An institution should customize its CFP.Separate CFPs may be required for the parentcompany and the consolidated banks in amultibank holding company, for separate sub-sidiaries (when appropriate), or for each signifi-cant foreign currency and global political entity,as necessary. These separate CFPs may benecessary because of legal requirements andrestrictions, or the lack thereof. Institutions thathave significant payment-system operationsshould have a formal, written plan in place formanaging the risk of both intraday and end-of-



day funding failures. Failures may occur as aresult of system failure at the institution or at aninstitution from which payments are expected.Clear, formal communication channels shouldbe established between the institution’s opera-tional areas responsible for handling payment-system operations.

Assessing Levels of Severity and Timing

The CFP should delineate the various levels ofstress severity that can occur during a contingentliquidity event and, for each type of event,identify the institution’s response plan at eachstage of an event. (As an event unfolds, it oftenprogresses through various stages and levels ofseverity.) The events, stages, and severity levelsidentified should include those that causetemporary disruptions, as well as those that maycause intermediate- or longer-term disruptions.Institutions can use the different stages or levelsof severity to design early-warning indicators,assess potential funding needs at various pointsduring a developing crisis, and specify compre-hensive action plans.

Assessing Funding Needs and Sources ofLiquidity

A critical element of the CFP is an institution’squantitative projection and evaluation of itsexpected funding needs and funding capacityduring a stress event. The institution shouldidentify the sequence of responses that it willmobilize during a stress event and commitsources of funds for contingent needs well inadvance of a stress-related event. To accomplishthis objective, the institution needs to analyzepotential erosion in its funding at alternativestages or severity levels of the stress event, aswell as analyze the potential cash-flow mis-matches that may occur during the variousstress scenarios and levels. Institutions shouldbase their analyses on realistic assessments ofthe behavior of funds providers during theevent; they should also incorporate alternativecontingency funding sources into their plans.The analysis should also include all materialon-and OBS cash flows and their relatedeffects, which should result in a realisticanalysis of the institution’s cash inflows,outflows, and funds availability at differenttime intervals throughout the potential liquidity

stress event—and allow the institution tomeasure its ability to fund operations over anextended period.

Common tools to assess funding mismatchesinclude

• Liquidity-gap analysis—A cash-flow reportthat essentially represents a base case estimateof where funding surpluses and shortfalls willoccur over various future timeframes.

• Stress tests—A pro forma cash-flow reportwith the ability to estimate future fundingsurpluses and shortfalls under various liquid-ity stress scenarios and the institution’s abilityto fund expected asset growth projections orsustain an orderly liquidation of assets undervarious stress events.

Identify Potential Funding Sources

Because of the potential for liquidity pressuresto spread from one source of funding to anotherduring a significant liquidity event, institutionsshould identify, well in advance, alternativesources of liquidity and ensure that they haveready access to contingent funding sources.These funding sources will rarely be used in thenormal course of business. Therefore, institu-tions should conduct advance planning to ensurethat contingent funding sources are readilyavailable. For example, the sale, securitization,or pledging of assets as collateral requires areview of these assets to determine the appro-priate haircuts and to ensure compliance withthe standards required for executing the strategy.Administrative procedures and agreementsshould also be in place before the institutionneeds to access the planned source of liquidity.Institutions should identify what advance stepsthey need to take to promote the readiness ofeach of their sources of standby liquidity.

Processes for Managing Liquidity Events

The CFP should identify a reliable crisis-management team and an administrative struc-ture for responding to a liquidity crisis,including realistic action plans executing eachelement of the plan for each level of a stressevent. Frequent communication and reportingamong crisis team members, the board ofdirectors, and other affected managers opti-mizes the effectiveness of a contingency plan



by ensuring that business decisions are coordi-nated to minimize further liquidity disruptions.Effective management of a stress eventrequires the daily computation of regularliquidity-risk reports and supplemental informa-tion. The CFP should provide for more-frequent and more-detailed reporting as a stresssituation intensifies. Reports that should beavailable in a funding crisis include—

• a CD breakage report to identify earlyredemptions of CDs;

• funding-concentration reports;• cash-flow projections and run-off reports;• funding-availability or -capacity reports, by

types of funding; and• reports on the status of contingent funding

sources.

Framework for MonitoringContingent Events

Financial institutions should monitor for poten-tial liquidity stress events by using early-warning indicators and event triggers. Theseindicators should be tailored to an institution’sspecific liquidity-risk profile. By recognizingpotential stress events early, the institution canproactively position itself into progressive statesof readiness as an event evolves. This proactivestance also provides the institution with aframework for reporting or communicatingamong different institutional levels and tooutside parties. Early-warning signals mayinclude but are not limited to—

• rapid asset growth that is funded withpotentially volatile liabilities;

• growing concentrations in assets or liabilities;• negative trends or heightened risk associated

with a particular product line;• rating-agency actions (e.g., agencies watch-

listing the institution or downgrading its creditrating);

• negative publicity;• significant deterioration in the institution’s

earnings, asset quality, and overall financialcondition;

• widening debt or credit-default-swap spreads;• difficulty accessing longer-term funding;• increasing collateral margin requirements;• rising funding costs in a stable market;• increasing redemptions of CDs before

maturity;

• counterparty resistance to OBS products;• counterparties that begin requesting backup

collateral for credit exposures; and• correspondent banks that eliminate or decrease

their credit lines.

To mitigate the potential for reputationcontagion when liquidity problems arise,effective communication with counterparties,credit-rating agencies, and other stakeholders isof vital importance. Smaller institutions thatrarely interact with the media should haveplans in place for how they will manage pressinquiries that may arise during a liquidityevent. In addition, group-wide CFPs, liquiditycushions, and multiple sources of funding aremechanisms that may mitigate reputationconcerns.

In addition to early-warning indicators, insti-tutions that issue public debt, use warehousefinancing, securitize assets, or engage in mate-rial OTC derivative transactions typically haveexposure to event triggers that are embedded inthe legal documentation governing these trans-actions. These triggers protect the investor orcounterparty if the institution, instrument, orunderlying asset portfolio does not perform atcertain predetermined levels. Institutions thatrely upon brokered deposits should also incor-porate PCA-related downgrade triggers intotheir CFPs since a change in PCA status couldhave a material bearing on the availability ofthis funding source. Contingent event triggersshould be an integral part of the liquidity-riskmonitoring system.

Asset-securitization programs pose height-ened liquidity concerns because an early-amortization event could produce unexpectedfunding needs. Liquidity contingency plansshould address this risk, if it is material to theinstitution. The unexpected funding needs asso-ciated with an early amortization of a securiti-zation event pose liquidity concerns for theoriginating bank. The triggering of an early-amortization event can result in the securitiza-tion trust immediately passing principal pay-ments through to investors. As the holder of theunderlying assets, the originating institution isresponsible for funding new charges that wouldnormally have been purchased by the trust.Financial institutions that engage in assetsecuritization should have liquidity contingencyplans that address this potential unexpectedfunding requirement. Management shouldreceive and review reports showing the perfor-



mance of the securitized portfolio in relation tothe early-amortization triggers.2

Securitization covenants that cite supervisorythresholds or adverse supervisory actions astriggers for early-amortization events are con-sidered an unsafe and unsound banking practicethat undermines the objective of supervisoryactions. An early amortization triggered by asupervisory action can create or exacerbateliquidity and earnings problems that can lead tofurther deterioration in the financial condition ofthe banking organization.3

Securitizations of asset-backed commercialpaper programs (ABCPs) are generally sup-ported by a liquidity facility or commitment topurchase assets from the trust if funds areneeded to repay the underlying obligations.Liquidity needs can result from either cash-flowmismatches between the underlying assets andscheduled payments of the overriding securityor from credit-quality deterioration of theunderlying asset pool. Therefore, the use ofliquidity facilities introduces additional risk tothe institution, and a commensurate capitalcharge is required.4

Institutions that rely upon secured fundingsources also are subject to potentially highermargin or collateral requirements that may betriggered upon the deterioration of a specificportfolio of exposures or the overall financialcondition of the institution. The ability of afinancially stressed institution to meet calls foradditional collateral should be considered in theCFP. Potential collateral values also should besubject to stress tests since devaluations ormarket uncertainty could reduce the amount ofcontingent funding that can be obtained frompledging a given asset.

Testing the CFP

Periodic testing of the operational elements ofthe CFP is an important part of liquidity-riskmanagement. By testing the various operationalelements of the CFP, institutions can preventunexpected impediments or complications inaccessing standby sources of liquidity during acontingent liquidity event. It is prudent to test

the operational elements of a CFP that areassociated with the securitization of assets,repurchase lines, Federal Reserve discountwindow borrowings, or other borrowings, sinceefficient collateral processing during a crisis isespecially important for such sources. Institu-tions should carefully consider whether toinclude unsecured funding lines in their CFPs,since these lines may be unavailable during acrisis.

Larger, more-complex institutions can benefitfrom operational simulations that test commu-nications, coordination, and decision-making ofmanagers who have different responsibilities,who are in different geographic locations, orwho are located at different operating subsidi-aries. Simulations or tests run late in the day canhighlight specific problems, such as late-daystaffing deficiencies or difficulty selling assets orborrowing new funds near the closing time ofthe financial markets.

Internal Controls

An institution’s internal controls consist ofpolicies, procedures, approval processes, recon-ciliations, reviews, and other types of controlsto provide assurances that the institutionmanages liquidity risk in accordance with theboard’s strategic objectives and risk tolerances.Appropriate internal controls should addressrelevant elements of the risk-managementprocess, including the institution’s adherenceto polices and procedures; the adequacy of itsrisk identification, risk measurement, and riskreporting; and its compliance with applicablerules and regulations. The results of reviews ofthe liquidity-risk management process, alongwith any recommendations for improvement,should be reported to the board of directors,which should take appropriate and timelyaction.

An important element of a bank’s internalcontrols is management’s comprehensive evalu-ation and review. Management should ensurethat an independent party regularly reviewsand evaluates the components of the institu-tion’s liquidity-risk management process. Thesereviews should assess the extent to which theinstitution’s liquidity-risk management com-plies with both supervisory guidance andindustry sound practices, taking into accountthe level of sophistication and complexity of

2. See sections 2130.1, 3020.1, and 4030.1, and the OCCHandbook on Credit Card Lending, October 1996.

3. SR-02-14, ‘‘Covenants in Securitization DocumentsLinked to Supervisory Actions or Thresholds.’’

4. SR-02-14, ‘‘Covenants in Securitization DocumentsLinked to Supervisory Actions or Thresholds.’’



the institution’s liquidity-risk profile. In larger,complex institutions, an internal audit functionusually performs this review. Smaller, lesscomplex institutions may assign the responsi-bility for conducting an independent evaluationand review to qualified individuals who areindependent of the function they are assignedto review. The independent review shouldreport key issues requiring attention, includinginstances of noncompliance, to the appropriatelevel of management to initiate a promptcorrection of the issues, consistent withapproved policies.

Periodic reviews of the liquidity-risk manage-ment process should address any significantchanges that have occurred since the last review,such as changes in the institution’s types orcharacteristics of funding sources, limits, andinternal controls. Reviews of liquidity-riskmeasurement systems should include assess-ments of the assumptions, parameters, andmethodologies used. These reviews should alsoseek to understand, test, and document thecurrent risk-measurement process; evaluate thesystem’s accuracy; and recommend solutions toany identified weaknesses.

Controls for changes to the assumptions theinstitution uses to make cash-flow projectionsshould require that the assumptions not bealtered without clear justification consistentwith approved strategies. The name of theindividual authorizing the change, along withthe date of the change, the nature of thechange, and justification for each change,should be fully documented. Documentationfor all assumptions used in cash-flow projec-tions should be maintained in a readily acces-sible, understandable, and auditable form.Because liquidity-risk measurement systemsmay incorporate one or more subsidiarysystems or processes, institutions should ensurethat multiple component systems are wellintegrated and consistent with each other.

LIQUIDITY MANAGEMENT FORHOLDING COMPANIES ANDBRANCHES AND AGENCIESOF FOREIGN BANKINGORGANIZATIONS

The sound practices described above are fullyapplicable to financial holding companies(FHCs) and bank holding companies (BHCs).

FHCs and BHCs should develop and maintainliquidity-risk management processes and fund-ing programs that are consistent with their levelof sophistication and complexity. Small one-bank or ‘‘shell’’ holding companies obviouslyrequire programs that are less detailed thanthose required for larger multibank holdingcompanies that have nonbank subsidiaries.Liquidity-risk management processes and fund-ing programs should take into full account thefirm’s lending, investment, and other activitiesand should ensure that adequate liquidity ismaintained at the parent company and any of itsbank and nonbank subsidiaries. These processesand programs should fully incorporate real andpotential constraints on the transfer of fundsamong subsidiaries and between affiliates andthe parent company, including legal and regula-tory restrictions.

Liquidity-risk management processes shouldconsider the responsibilities and obligations ofthe board of directors and senior management atsubsidiaries. For example, a bank holdingcompany may manage the liquidity of thecorporate entity on a centralized basis; however,directors and senior managers at subsidiarybanks remain responsible and accountable forthe liquidity risks taken by their institutions. Asa result, effective communication and an under-standing of the interrelationships between hold-ing company and subsidiary liquidity-management policies, practices, strategies, andtactics are critical to the safety and soundness ofthe entire organization. Appropriate liquidity-risk management is especially important forBHCs; liquidity difficulties at the holdingcompany can easily spread to subsidiary bank-ing institutions, particularly to similarly namedinstitutions in which customers do not alwaysunderstand the legal distinctions between theholding company and the bank.5

In general, BHCs do not have as manyoptions as banks do for managing their assetsand liabilities. Therefore, the liquidity-riskprofile of BHCs is generally higher than therisk profile of their subsidiary banks. Anotherconsideration is the ability of BHC manage-ment to quickly change the liquidity profile of

5. See the Federal Reserve’s Bank Holding CompanySupervision Manual, sections 2010.1, 2080.0, 2080.1, 2080.2,2080.4, 2080.5, 2080.6, 4010.0, 4010.1, 4010.2, 5010.27, and5010.28 for in-depth information on liquidity-risk manage-ment for BHCs. The manual also discusses legal andregulatory restrictions on the flow of funds between BHCs andtheir subsidiaries.



the company by issuing or repurchasing stock,paying dividends, or investing in subsidiaries.The board of directors and senior managementof the parent company should establish a clearstrategic direction for the level of liquidity thatshould be maintained at the parent level; thisstrategy should include liquidity provisions forits subsidiary banks in times of stress.

Bank holding company liquidity should bemaintained at levels sufficient to fund holdingcompany and nonbank affiliate operations for anextended period of time in a stressenvironment—when access to normal fundingsources is disrupted—without having a negativeimpact on insured depository institution subsid-iaries. The stability, flexibility, and diversity ofprimary and contingent sources of fundingliquidity should be identified not just at thesubsidiary bank but also at the parent level. Theimpact of bank holding company liquidity andthe composition of liquidity sources on thebank’s access to the funding markets should beconsidered carefully.

BHCs should have comprehensive liquidityand liquidity-risk management processes toadequately address their mismatch, market, andcontingent liquidity risks. A CFP is animportant element of these processes. The CFPshould be tailored to the specific business mixand liquidity-risk profile of the BHC. Strate-gies devised to address potential contingentliquidity situations may include limiting parentcompany funding of long-term assets andsecuring reliable, long-term backup fundingsources. Backup funding contracts should bereviewed to determine the extent to which any‘‘material adverse change clauses’’ wouldconstrain the company’s access to funding ifthe company’s financial condition deteriorated.A common stress test used by many multibankholding companies is to analyze whether theholding company has adequate liquidity tomeet its potential debt obligations and coveroperating expenses over the next 12 months,assuming that the firm loses access to fundingmarkets and dividends from subsidiaries.

Many of the sound liquidity-risk managementpractices advanced in this guidance for banksand BHCs are applicable to U.S. branches oragencies of foreign banking organizations(FBOs). However, several unique liquidityconsiderations apply to these entities. TheFederal Reserve’s Examination Manual for U.S.Branches and Agencies of Foreign BankingOrganizations provides detailed guidance on

supervisory expectations for the management ofliquidity risk at these entities.6

SUPERVISORY PROCESS FOREVALUATING LIQUIDITY RISK

Liquidity risk is a primary concern for allbanking organizations and is an integral compo-nent of the CAMELS rating system. Examinersshould consider liquidity risk during the prepa-ration and performance of all on-site safety-and-soundness examinations as well as duringtargeted supervisory reviews. To meet examina-tion objectives efficiently and effectively andremain sensitive to potential burdens imposedon institutions, examiners should follow astructured, risk-focused approach for the exami-nation of liquidity risk. Key elements of thisexamination process include off-site monitoringand a risk assessment of the institution’sliquidity-risk profile. These elements will helpthe examiner develop an appropriate plan andscope for the on-site examination, thus ensuringthe exam is as efficient and productive aspossible. A fundamental tenet of the risk-focused examination approach is the targeting ofsupervisory resources at functions, activities,and holdings that pose the most risk to the safetyand soundness of an institution.

For smaller institutions that have less com-plex liquidity profiles, stable funding sources,and low exposures to contingent liquiditycircumstances, the liquidity element of anexamination may be relatively simple andstraightforward. On the other hand, if aninstitution is experiencing significant asset andproduct growth; is highly dependent on poten-tially volatile funds; or has a complex businessmix, balance-sheet structure, or liquidity-riskprofile that exposes the institution to contingentliquidity risks, that institution should generallyreceive greater supervisory attention. Given thecontingent nature of liquidity risk, institutionswhose corporate structure gives rise to inherentoperational risk, or institutions encounteringdifficulties associated with their earnings, assetquality, capital adequacy, or market sensitivity,should be especially targeted for review of theadequacy of their liquidity-risk management.

6. See sections 3200 through 3330, Examination Manualfor U.S. Branches and Agencies of Foreign Banking Organi-zations, Board of Governors of the Federal Reserve System.



Off-Site Risk Assessment

In off-site monitoring and analysis, a prelimi-nary view, or risk assessment, is developedbefore initiating an on-site examination. Boththe inherent level of an institution’s liquidity-risk exposure and the quality of its liquidity-riskmanagement should be assessed to the fullestextent possible during the off-site phase of theexamination process. The following informationcan be helpful in this assessment:

• organizational charts and policies that identifyauthorities and responsibilities for managingliquidity risk

• liquidity policies, procedures, and limits• ALCO committee minutes and reports (min-

utes and reports issued since the last exami-nation or going back at least six to twelvemonths before the examination)

• board of directors reports on liquidity-riskexposures

• audit reports (both internal and external)• other available internal liquidity-risk manage-

ment reports, including cash-flow projectionsthat detail key assumptions

• internal reports outlining funding concentra-tions, the marketability of assets, analysis thatidentifies the relative stability or volatility ofvarious types of liabilities, and various cash-flow coverage ratios projected under adverseliquidity scenarios

• supervisory surveillance reports and supervi-sory screens

• external public debt ratings (if available)

Quantitative liquidity exposure should beassessed by conducting as much of the supervi-sory review off-site as practicable. This off-sitework includes assessing the bank’s overallliquidity-risk profile and the potential for otherrisk exposures, such as credit, market, opera-tional, legal, and reputational risks, that mayhave a negative impact on the institution’sliquidity under adverse circumstances. Theseassessments can be conducted on a preliminarybasis using supervisory screens, examiner-constructed measures, internal bank measures,and cash-flow projections obtained from man-agement reports received before the on-siteengagement. Additional factors to be incorpo-rated in the off-site risk assessment include theinstitution’s balance-sheet composition and theexistence of funding concentrations, the market-

ability of its assets (in the context of liquidation,securitization, or use of collateral), and theinstitution’s access to secondary markets ofliquidity.

The key to assessing the quality of manage-ment is an organized discovery process aimed atdetermining whether appropriate corporate-governance structures, policies, procedures, lim-its, reporting systems, CFPs, and internalcontrols are in place. This discovery processshould, in particular, ascertain whether all theelements of sound liquidity-risk managementare applied consistently. The results and reportsof prior examinations, in addition to internalmanagement reports, provide important informa-tion about the adequacy of the institution’s riskmanagement.

Examination Scope

The off-site risk assessment provides theexaminer with a preliminary view of both theadequacy of liquidity management and themagnitude of the institution’s exposure. Thescope of the on-site liquidity-risk examinationshould be designed to confirm or reject theoff-site hypothesis and should target specificareas of interest or concern. In this way,on-site examination procedures are tailored tothe institution’s activities and risk profile anduse flexible and targeted work-documentationprograms. In general, if liquidity-risk manage-ment is identified as adequate, examiners canrely more heavily on a bank’s internal liquiditymeasures for assessing its inherent liquidityrisk.

The examination scope for assessing liquidityrisk should be commensurate with the complex-ity of the institution and consistent with theoff-site risk assessment. For example, onlybaseline examination procedures would be usedfor institutions whose off-site risk assessmentindicates that they have adequate liquidity-riskmanagement processes and low levels of inher-ent liquidity exposure. These institutions includethose that have noncomplex balance-sheet struc-tures and banking activities and that also meetthe following criteria:

• well capitalized; minimal issues with assetquality, earnings, and market-risk-sensitiveactivities

• adequate reserves of marketable securities that



can serve as standby sources of liquidity• minimal funding concentrations• funding structures that are principally com-

posed of stable liabilities• few OBS items, such as loan commitments,

that represent contingent liquidity draws• minimal potential exposure to legal and

reputational risk• formal adoption of well-documented liquidity-

management policies, procedures, and CFPs

For these and other institutions identified aspotentially low risk, the scope of the on-siteexamination would consist of only those exami-nation procedures necessary to confirm therisk-assessment hypothesis. The adequacy ofliquidity-risk management could be verifiedthrough a basic review of the appropriateness ofthe institution’s policies, internal reports, andcontrols and its adherence to them. The integrityand reliability of the information used to assessthe quantitative level of risk could be confirmedthrough limited sampling and testing. In general,if basic examination procedures validate the riskassessment, the examiner may conclude theexamination process.

High levels of inherent liquidity risk mayarise if an institution has concentrations inspecific business activities, products, andsectors, or if it has balance-sheet risks, such asunstable liabilities, risky assets, or plannedasset growth without an adequate plan forfunding the asset growth. OBS items that haveuncertain cash inflows may also be a source ofinherent liquidity risk. Institutions for which arisk assessment indicated high levels ofinherent liquidity-risk exposure and strongliquidity management may require a moreextensive examination scope to confirm theassessment. These expanded procedures mayentail more analysis of the institution’s liquidity-risk measurement system and its liquidity-riskprofile. When high levels of liquidity-riskexposure are found, examiners should focusspecial attention on the sources of this risk.When a risk assessment indicates an institutionhas high exposure and weak risk-managementsystems, an extensive work-documentationprogram is required. The institution’s internalmeasures should be used cautiously, if at all.

Regardless of the sophistication or complex-ity of an institution, examiners must use careduring the on-site phase of an examination toconfirm the off-site risk assessment andidentify issues that may have escaped off-site

analysis. Accordingly, the examination scopeshould be adjusted as on-site findings dictate.

Assessing CAMELS ‘‘L’’ Ratings

The assignment of the ‘‘L’’ rating is integral tothe CAMELS ratings process for commercialbanks. Examination findings on both (1) theinherent level of an institution’s liquidity riskand (2) the adequacy of its liquidity-riskmanagement process should be incorporated inthe assignment of the ‘‘L’’ rating. Findings onthe adequacy of liquidity-risk managementshould also be reflected in the CAMELS ‘‘M’’rating for risk management.

Examiners can develop an overall assess-ment of an institution’s liquidity-risk exposureby reviewing the various characteristics of itsassets, liabilities, OBS instruments, and mate-rial business activities. An institution’s assetcredit quality, earnings integrity, and marketrisk may also have significant implications forits liquidity-risk exposure. Importantly, assess-ments of the adequacy of an institution’sliquidity-management practices may affect theassessment of its inherent level of liquidityrisk. For institutions judged to have sound andtimely liquidity-risk measurement and report-ing systems and CFPs, examiners may use theresults of the institution’s adverse-scenariocash-flow projections in order to gain insightinto its level of inherent exposure. Institutionsthat have less-than-adequate measurement andreporting systems and CFPs may have higherexposure to liquidity risk as a result of theirpotential inability to respond to adverseliquidity events.

Elements of strong liquidity-risk managementare particularly important during stress eventsand include many of the items discussedpreviously: communication among the depart-ments responsible for managing liquidity, reportsthat indicate a diversity of funding sources,standby funding sources, cash-flow analyses,liquidity stress tests, and CFPs. Liquidity-riskmanagement should also manage the ongoingcosts of maintaining liquidity.

Liquidity risk should be rated in accordancewith the Uniform Financial Institutions RatingSystem (UFIRS).7 The assessment of theadequacy of liquidity-risk management should

7. SR-96-38, ‘‘Uniform Financial Institutions RatingSystem’’ and section A.5020.1.



provide the primary basis for reaching an overallassessment on the ‘‘L’’ component rating since itis a leading indicator of potential liquidity-riskexposure. Accordingly, overall ratings forliquidity-risk sensitivity should be no greaterthan the rating given to liquidity-riskmanagement.

In evaluating the adequacy of a financialinstitution’s liquidity position, considerationshould be given to the current level andprospective sources of liquidity compared withfunding needs, as well as to the adequacy offunds-management practices relative to theinstitution’s size, complexity, and risk profile. Ingeneral, funds-management practices shouldensure that an institution is able to maintain alevel of liquidity sufficient to meet its financialobligations in a timely manner and to fulfill thelegitimate banking needs of its community.Practices should reflect the ability of theinstitution to manage unplanned changes infunding sources, as well as react to changes inmarket conditions that affect the ability toquickly liquidate assets with minimal loss. Inaddition, funds-management practices shouldensure that liquidity is not maintained at a highcost or through undue reliance on fundingsources that may not be available in times offinancial stress or adverse changes in marketconditions.

Liquidity is rated based upon, but not limitedto, an assessment of the following evaluationfactors:

• the adequacy of liquidity sources comparedwith present and future needs and the abilityof the institution to meet liquidity needswithout adversely affecting its operations orcondition

• the availability of assets readily convertible tocash without undue loss

• access to money markets and other sources offunding

• the level of diversification of funding sources,both on- and off-balance-sheet

• the degree of reliance on short-term, volatilesources of funds, including borrowings andbrokered deposits, to fund longer-term assets

• the trend and stability of deposits• the ability to securitize and sell certain pools

of assets• the capability of management to properly

identify, measure, monitor, and control theinstitution’s liquidity position, including theeffectiveness of funds-management strategies,

liquidity policies, management informationsystems, and CFPs

Ratings of liquidity-risk management shouldfollow the general framework used to rateoverall risk management:

• A rating of 1 indicates strong liquidity levelsand well-developed funds-management prac-tices. The institution has reliable access tosufficient sources of funds on favorable termsto meet present and anticipated liquidityneeds.

• A rating of 2 indicates satisfactory liquiditylevels and funds-management practices. Theinstitution has access to sufficient sources offunds on acceptable terms to meet present andanticipated liquidity needs. Modest weak-nesses may be evident in funds-managementpractices.

• A rating of 3 indicates liquidity levels orfunds-management practices in need ofimprovement. Institutions rated 3 may lackready access to funds on reasonable terms ormay evidence significant weaknesses in funds-management practices.

• A rating of 4 indicates deficient liquiditylevels or inadequate funds-management prac-tices. Institutions rated 4 may not have or beable to obtain a sufficient volume of funds onreasonable terms to meet liquidity needs.

• A rating of 5 indicates liquidity levels orfunds-management practices so criticallydeficient that the continued viability of theinstitution is threatened. Institutions rated 5require immediate external financial assis-tance to meet maturing obligations or otherliquidity needs.

Unsafe liquidity-risk exposures and weak-nesses in managing liquidity risk should be fullyreflected in the overall liquidity-risk ratings.Unsafe exposures and unsound managementpractices that are not resolved during the on-siteexamination should be addressed through sub-sequent follow-up actions by the examiner andother supervisory personnel.

REFERENCES

The following sources provide additional infor-mation on liquidity-risk management:



• Bank Holding Company Supervision Manual,Board of Governors of the Federal ReserveSystem.

• Basel Committee on Banking Supervision,‘‘Sound Practices for Managing Liquidity inBanking Organisations,’’ publication 69, Feb-ruary 2000.

• Commercial Bank Examination Manual, Boardof Governors of the Federal Reserve System.

• ‘‘Determining Conformance With InterestRate Restrictions for Less Than Well Capital-ized Institutions,’’ Federal Deposit InsuranceCorporation, November 3, 2009 (FIL 62-2009)

• Federal Deposit Insurance Corporation, RiskManagement Manual of Examination Poli-cies, section 6.1—‘‘Liquidity and FundsManagement.’’

• Federal Financial Institutions ExaminationCouncil, Uniform Bank Performance Report.

• Interagency Policy Statement on Funding andLiquidity Risk Management, March 17, 2010

• Office of the Comptroller of the Currency,Comptroller’s Handbook (Safety & Sound-

ness), ‘‘Liquidity,’’ February 2001.• ‘‘Process for Determining If An Institution

Subject to Interest-Rate Restrictions is Oper-ating in a High-Rate Area,’’ Federal DepositInsurance Corporation, December 4, 2009(FIL 69-2009)

• SR-01-08, ‘‘Supervisory Guidance on Com-plex Wholesale Borrowings,’’ Board of Gov-ernors of the Federal Reserve System, April 5,2001.

• SR-01-14, ‘‘Joint Agency Advisory on Rate-Sensitive Deposits,’’ Board of Governors ofthe Federal Reserve System, May 31, 2001.

• SR-03-15, ‘‘Interagency Advisory on the Useof the Federal Reserve’s Primary CreditProgram in Effective Liquidity Management,’’Board of Governors of the Federal ReserveSystem, July 25, 2003.

• SR-10-6, ‘‘Interagency Policy Statement onFunding and Liquidity-Risk Management,’’Board of Governors of the Federal ReserveSystem, March 17, 2010.



Liquidity RiskExamination Objectives Section 3005.2

1. To appropriately risk-focus the scope of theexamination (that is, ensure that the scope isappropriate, given the institution’s activitiesand the risks they present).

2. To assess the relative volatility or stabilityof the institution’s liability funding sources.

3. To assess the institution’s access to liquidity.4. To assess the institution’s potential liquidity

needs.5. To assess (1) the institution’s exposure to

mismatched risk under normal businessconditions and (2) its planned strategies foraddressing this risk.

6. To assess the institution’s exposure tocontingent liquidity risk.

7. To assess the appropriateness and integrityof the institution’s corporate-governancepolicies for management of liquidity risk.

8. To determine whether the institution’s

policies, procedures, and limits are adequate,given its size, complexity, and sophistication.

9. To determine if management is adequatelyplanning for intermediate-term and longer-term liquidity or funding needs.

10. To assess the adequacy of the institution’sliquidity-risk measurement systems.

11. To assess the adequacy of the institution’sliquidity-risk management informationsystems.

12. To assess the adequacy of the institution’scontingency funding plans.

13. To assess the adequacy of the institution’sinternal controls for its liquidity-risk man-agement process.

14. To determine whether the institution iscomplying with applicable laws andregulations.


Liquidity RiskExamination Procedures Section 3005.3

EXAMINATION SCOPE

1. Review the following documents to identifyissues that may require follow-up:a. prior examination findings and

workpapersb. audit reports, andc. ongoing monitoring risk assessments (if

available)2. Review appropriate surveillance material,

including the Uniform Bank PerformanceReport (UBPR), BHC Performance Report,and other reports, to identify liquidity trendsand the liquidity-risk profile of the institu-tion. This review should include assess-ments of the marketability of assets and therelative stability or volatility of fundingsources.

3. Request and review internal reports man-agement uses to monitor liquidity risk,including the following reports:a. senior management, asset/liability com-

mittee (ALCO), and for the board ofdirectors’ meetings

b. cash-flow-projection reportsc. contingency funding plans (CFPs)d. funding-concentration reports

4. Request and review organizational chartsand liquidity-risk management policies andprocedures.

5. Review the potential liquidity-risk exposurearising from the financial condition of theinstitution or other trends, such as assetgrowth, asset quality, earnings trends, capi-tal adequacy, market-risk exposures(interest-rate risk (IRR) exposures for boththe banking book and the trading book),business-line operational considerations, andthe potential for legal and reputational risk.

On the basis of the hypothesis developed forboth the institution’s inherent liquidity-riskexposure and the adequacy of its liquiditymanagement, select the steps necessary to meetexamination objectives from the followingprocedures.

ASSESSMENT OF INHERENTLIQUIDITY RISK

1. Review the institution’s deposit structure.

Discuss the following issues with manage-ment: the institution’s customer base, costs,and pricing strategies, as well as thestability of various types of deposits. Thisreview should include—a. assumptions about deposit behaviors the

institution uses in making its cash-flowprojections and in conducting its IRRanalyses;

b. the competitiveness of rates paid ondeposits, from both a national and local-market-area perspective;

c. lists of large depositors, potential depositconcentrations, and large depositmaturities;

d. the institution’s use of brokered depositsand deposits from entities that may beespecially sensitive to market rates andcredit quality; and

e. public fund deposits, including pledgingrequirements and pricing policies.

2. Review the institution’s use of nondepositliabilities. Discuss with management itsstrategies for employing such funds, thesensitivity of such funds to market rates,and the credit quality of the institution. Thisreview should include—a. the types, costs, amounts, and concentra-

tions of nondeposit liabilities used by theinstitution;

b. the strategies underlying the use of anyFederal Home Loan Bank (FHLB)advances and the specific features ofthose borrowings, including the exis-tence of any options, to determine if theinstitution adequately understands therisk profile of these borrowings;

c. the activities the institution funds withnondeposit liabilities;

d. the institution’s use of short-term liabili-ties; and

e. compliance with the written agreementsfor borrowings.

3. Review the institution’s holdings of market-able assets as liquidity reserves. This reviewshould include—a. the quality, maturity, marketability, and

amount of unpledged investmentsecurities;

b. pledgable and securitizable loans andexisting activities in this area; and

c. a discussion with management on its


strategies for maintaining liquid assetreserves.

4. When applicable, review the institution’saccess to debt markets as a source ofliquidity. This review should include—a. the strength of current short- and longer-

term debt ratings, including an assess-ment of the potential for ‘‘watch-listing’’or downgrades;

b. the breadth of the investor base for thecompany’s debt;

c. current and future issuance plans;d. concentrations of borrowed funds;e. the availability to utilize FHLB or other

wholesale funds providers; andf. the institution’s reputation in the capital

markets and with major funds providers.5. Review the institution’s business activities

that may have a significant impact on itsliquidity needs. This review shouldinclude—a. the institution’s ability to securitize

assets and the amount of its current andanticipated securitization activities;

b. payments- or securities-processing activi-ties and other activities that may heightenthe impact of operational risk on theliquidity of the firm;

c. the amount and nature of trading andover-the-counter (OTC) derivative activi-ties that may have an impact on liquidity;

d. the extent of off-balance-sheet (OBS)loan commitments;

e. the balance-sheet composition, includingsignificant concentrations that may havean impact on liquidity; and

f. operational risks associated with theinstitution’s business activities, risksinherent in the corporate structure, orexternal factors that may have an impacton liquidity.

6. Review the institution’s cash-flowprojections.

7. Discuss with management the institution’sstrategies for dealing with seasonal, cycli-cal, and planned asset-growth funding strat-egies, including its assessment of alterna-tive funding sources.

8. Review and discuss with management theinstitution’s identification of potential con-tingent liquidity events and the variouslevels of stress those events entail. Deter-mine if the chosen scenarios are appropri-ate, given the institution’s business activi-ties and funding structure.

9. Review cash-flow projections the institutionhas constructed for selected contingentliquidity events. Review the assumptionsunderlying the projections, including sourcesof funds to be used in a contingent liquidityevent and the reports and assumptions onbehavioral cash flows.

10. Review the assumptions and trends in theinstitution’s liquidity-risk ‘‘triggers.’’

11. Review CFPs.12. When appropriate, review reports on

liquidity-risk triggers in the institution’ssecuritization activities.

13. On the basis of the above procedures,determine if the institution’s inherent liquid-ity risk is low, limited, moderate, consider-able, or high.

ASSESSMENT OF THE QUALITYOF LIQUIDITY-RISKMANAGEMENT

1. Review formally adopted policies and pro-cedures, as well as reports to the board ofdirectors and senior management, to deter-mine the adequacy of their oversight. Thisreview should include whether the boardand senior management—a. have identified lines of authority and

responsibility;b. have articulated the institution’s general

liquidity strategies and its approach toliquidity risk;

c. understand the institution’s liquidityCFPs; and

d. periodically review the institution’sliquidity-risk profile.

2. Review senior management structures inorder to determine their adequacy foroverseeing and managing the institution’sliquidity. This review should include—a. whether the institution has designated an

ALCO or other management decision-making body;

b. the frequency of ALCO meetings and theadequacy of the reports presented;

c. decisions made by the ALCO andvalidation of follow-up on those deci-sions, including ongoing assessment ofopen issues;

d. the technical and managerial expertise ofmanagement and personnel involved inliquidity management; and

3005.3 Liquidity Risk: Examination Procedures


e. whether the institution has clearly delin-eated centralized and decentralizedliquidity-management responsibilities.

3. Review and discuss with management theinstitution’s liquidity-risk policies, proce-dures, and limits, and determine theirappropriateness, comprehensiveness, andaccuracy. Policies, procedures, and limitsshould—a. identify the objectives and strategies of

the institution’s liquidity managementand its expected and preferred relianceon various sources of funds to meetliquidity needs under alternativescenarios;

b. delineate clear lines of responsibility andaccountability over liquidity-risk man-agement and management decision-making;

c. be consistent with institution practices;d. identify the process for setting and

reassessing limits, and communicate therationale for the limit structure;

e. specify quantitative limits andguidelines that define the acceptablelevel of risk for the institution, such asthe use of maximum and targetedamounts of cash-flow mismatches,liquidity reserves, volatile liabilities,and funding concentrations;

f. specify the frequency and methods usedto measure, monitor, and control liquid-ity risk; and

g. define the specific procedures andapprovals necessary for exceptions topolicies, limits, and authorizations.

4. Review and discuss with management thebank’s budget projections for the appropri-ate planning period. Ascertain if manage-ment has adequately—a. planned the future direction of the bank,

noting the projected growth, the sourceof funding for the growth, and anyprojected changes in its asset or liabilitymix;

b. developed future plans for meetingongoing liquidity needs; and

c. assessed the reasonableness of its plansto achieve (1) the amounts and types offunding projected and (2) the amountsand types of asset growth projected.

Determine if management has identifiedalternative sources of funds if plans are notmet.

5. Review the reasonableness of bank-

established parameters for the use of vola-tile liabilities.

6. Review liquidity-risk measurement poli-cies, procedures, methodologies, models,assumptions, and other documentation. Dis-cuss with management the—a. adequacy and comprehensiveness of

cash-flow projections and supportinganalysis used to manage liquidity;

b. appropriateness of summary measuresand ratios to adequately reflect theliquidity-risk profile of the institution;

c. appropriateness of the identification ofstable and volatile sources of funding;

d. comprehensiveness of alternative contin-gent liquidity scenarios incorporated inthe ongoing estimation of liquidity needs;and

e. the validity and appropriateness ofassumptions used in constructingliquidity-risk measures.

7. Review liquidity-risk management policies,procedures, and reports. Discuss with man-agement the frequency and comprehensive-ness of liquidity-risk reporting for thevarious levels of management that areresponsible for monitoring and managingliquidity risk. These considerations shouldinclude the following:a. management’s need to receive reports

that—• determine compliance with limits and

controls;• evaluate the results of past strategies;• assess the potential risks and returns of

proposed strategies;• identify the major changes in a bank’s

liquidity-risk profile; and• consolidate holding company and bank

subsidiary information.b. the need for the reporting system to be

flexible enough to—• quickly collect and edit data, summa-

rize results, and adapt to changingcircumstances or issues without com-promising data integrity; and

• increase the frequency of reportpreparation as business conditionsdeteriorate.

c. the need for reports to properly focus onmonitoring liquidity and supportingdecisionmaking. These reports often helpbank management to monitor—• sources and uses of cash flows (i.e.,

cash flows from operating, investing,

Liquidity Risk: Examination Procedures 3005.3


and financing activities), facilitatingthe evaluation of trends and structuralbalance-sheet changes;

• CFPs;• projected cash-flow or maturity gaps,

identifying potential future liquidityneeds (reports should show projec-tions using both contractual principaland interest runoffs and maturities(original maturity dates) andbehavioral principal and interestrunoffs and maturities (maturities at-tributable to the expected behaviors ofcustomers));

• consolidated large funds providers,identifying customer concentrations(reports should identify and aggregatemajor liability instruments used bylarge customers across all banks in theholding company); and

• the cost of funds from all significantfunding sources, enabling manage-ment to quickly compare costs.

8. Review the liquidity CFP and the minutesof ALCO meetings and board meetings.Discuss with management the adequacy ofthe institution’s—a. customization of its CFP to fit its

liquidity-risk profile;b. identification of potential stress events

and the various levels of stress that canoccur under those events;

c. quantitative assessment of its short-termand intermediate-term funding needsduring stress events, particularly thereasonableness of the assumptions theinstitution used to forecast its potentialliquidity needs;

d. comprehensiveness in forecasting cashflows under stress conditions (forecastsshould incorporate OBS and paymentsystems and the operational implicationsof cash-flow forecasts);

e. identification of potential sources ofliquidity under stress events;

f. operating policies and procedures, includ-ing the delineation of responsibilities,to be implemented in stress events,for communicating with variousstakeholders;

g. prioritization of actions for responding tostress situations;

h. identification and use of contingentliquidity-risk triggers to monitor, on anongoing basis, the potential for contin-

gent liquidity events; andi. testing of the operational elements of the

CFP.9. Determine whether the board and senior

management have established clear lines ofauthority and responsibility for monitoringadherence to policies, procedures, andlimits. Review policies, procedures, andreports to ascertain whether theinstitution’s—a. measurement system adequately cap-

tures and quantifies risk;b. limits are comprehensive, appropriately

defined, and communicated to manage-ment in a timely manner; and

c. risk reports are regularly and formallydiscussed by management and whethermeeting minutes are adequatelydocumented.

10. Determine whether internal controls andinformation systems are adequately testedand reviewed by ascertaining if theinstitution’s—a. risk-measurement tools are accurate,

independent, and reliable;b. testing of controls is adequate and

frequent enough, given the level of riskand sophistication of risk-managementdecisions; and

c. reports provide relevant information,including comments on major changes inrisk profiles.

11. Determine whether the liquidity-management function is audited internallyor is evaluated by the risk-managementfunction. Determine whether the audit and/orevaluation is independent and of sufficientscope.

12. Determine whether audit findings and man-agement responses to those findings arefully documented and tracked for adequatefollow-up.

13. Determine whether line management is heldaccountable for unsatisfactory or ineffectivefollow-up.

14. Determine whether risk managers giveidentified material weaknesses appropriateand timely attention.

15. Assess whether actions taken by manage-ment to deal with material weaknesses havebeen verified and reviewed for objectivityand adequacy by senior management or theboard.

16. Determine whether the board and seniormanagement have established adequate pro-

3005.3 Liquidity Risk: Examination Procedures


cedures for ensuring compliance with appli-cable laws and regulations.

17. Assess the institution’s compliance withapplicable laws and regulations as theypertain to deposit accounts.

18. Assess the institution’s compliance withlaws and regulations, as well as potentialrisk exposures arising from interbank creditexposure.

19. Assess the institution’s compliance with

regulations A, D, F, and W; statutoryrestrictions on the use of brokered deposits;and legal restrictions on dividends. Assesswhether CFPs comply with these regula-tions and restrictions.

20. On the basis of the above procedures,determine whether the quality of the insti-tution’s liquidity-risk management is unsat-isfactory, marginal, fair, satisfactory, orstrong.

Liquidity Risk: Examination Procedures 3005.3


Liquidity RiskInternal Control Questionnaire Section 3005.4

Review the bank’s internal controls, policies,practices, and procedures for managing fundingliquidity risk. The bank’s system should bedocumented completely and concisely andshould include, when appropriate, narrativedescriptions, flow charts, copies of forms used,and other pertinent information.

1. Has the board of directors, consistent with itsduties and responsibilities, reviewed andratified funds-management policies, prac-tices, and procedures that include—a. clear lines of authority, responsibility, and

accountability for liquidity-riskmanagement decisions?

b. an articulated general liquidity strategyand approach to liquidity-riskmanagement?

c. the review and approval of policies,including liquidity contingency fundingplans?

d. the specific procedures and approvalsnecessary for exceptions to policies, lim-its, and authorizations?

e. established procedures for ensuring com-pliance with applicable laws andregulations?

2. Does senior management provide adequateoversight to manage the institution’s liquid-ity risk?a. Has senior management established clear

lines of authority and responsibility formonitoring adherence to policies, proce-dures, and limits?

b. Are clear lines of responsibility andaccountability delineated over liquidity-risk management and managementdecisionmaking?

c. Is there a designated asset/liability com-mittee (ALCO) or other managementdecisionmaking body in which liquidityrisk is appropriately discussed? Does theinstitution have a separate liquidity-riskmanagement function?

d. Is the frequency of ALCO meetingsappropriate, and are the reports presentedat meetings adequate?

e. Does management regularly and formallydiscuss risk reports, and are meetingminutes and decisions adequatelydocumented?

f. Is the technical and managerial expertise

of management and personnel involved inliquidity management appropriate for theinstitution?

g. Are senior management’s centralized anddecentralized liquidity-managementresponsibilities clearly delineated?

3. Are the institution’s policies, procedures, andlimits for liquidity risk appropriate andsufficiently comprehensive to adequatelycontrol the range of liquidity risk for the levelof the institution’s activity?a. Do the policies and procedures identify

the objectives and strategies of the insti-tution’s liquidity management, and dothey include the institution’s expected andpreferred reliance on various sources offunds to meet liquidity needs underalternative scenarios?

b. Are policies and procedures consistentwith institution practices?

c. Are the limits comprehensive and appro-priately defined for the institution’s levelof activity? Are limit exceptions commu-nicated to management in a timelymanner?

d. Is there a formal process for setting,reassessing, and communicating the ratio-nale for the limit structure?

e. Do quantitative limits and guidelinesdefine the acceptable level of risk for theinstitution (i.e., maximum and targetedamounts of cash-flow mismatches, liquid-ity reserves, volatile liabilities, fundingconcentrations, etc.)?

f. Are the frequency and methods used tomeasure, monitor, and control liquidityrisk specified?

4. Are liquidity-risk measurement methodolo-gies, models, assumptions, and reports, aswell as other liquidity-risk managementdocumentation, sufficiently adequate, com-prehensive, and appropriate?a. Is liquidity-risk management involved in

the financial institution’s new-productdiscussions?

b. Has the institution developed future growthplans and ongoing funding needs, and thesources of funding to meet those needs?

c. Has the institution developed alternativesources of funds to be used if its futureplans are not met?

d. Does management adequately utilize com-


prehensive cash-flow projections andsupporting analysis in order to manage theinstitution’s liquidity?

e. Does the institution utilize appropriatesummary measures and ratios thatadequately reflect its liquidity-risk profile?

f. Do the above reports provide relevantinformation, including comments on majorchanges in risk profiles?

g. Does the planning and budgeting functionconsider liquidity requirements?

h. Are internal management reports concern-ing liquidity needs and sources of funds tomeet those needs prepared regularly andreviewed, as appropriate, by senior man-agement and the board of directors?

5. Does an independent party regularly reviewand evaluate the components of the liquidity-risk management function?a. Is the liquidity-risk management function

audited internally, or is it evaluated by therisk-management function? Are the auditand/or evaluation of the liquidity-riskmanagement process and controls indepen-dent and of sufficient scope?

b. Are audit findings and managementresponses to those findings fully docu-

mented and tracked for adequatefollow-up?

c. Do the internal controls and internal auditreviews ensure compliance with internalliquidity-management policies andprocedures?

d. Is line management held accountable forunsatisfactory or ineffective follow-up?

e. Do risk managers give identified materialweaknesses appropriate and timely atten-tion? Are their actions verified andreviewed for objectivity and adequacy bysenior management or the board?

6. Are internal controls and information sys-tems adequately tested and reviewed?a. Are risk-measurement tools accurate, inde-

pendent, and reliable?b. Is the frequency for the testing of controls

adequate, given the level of risk andsophistication of risk-managementdecisions?

7. On the basis of a composite evaluation, asevidenced by answers to the foregoingquestions, are the internal controls andinternal audit procedures consideredadequate?

3005.4 Liquidity Risk: Internal Control Questionnaire


Liquidity RiskAppendixes Section 3005.5

APPENDIX 1—FUNDAMENTALSOF LIQUIDITY-RISKMEASUREMENT

Measuring a financial institution’s liquidity-riskprofile and identifying alternative sources offunds to meet cash-flow needs are criticalelements of sound liquidity-risk management.The liquidity-measurement techniques and theliquidity measures employed by depositoryinstitutions vary across a continuum of granu-larity, specificity, and complexity, depending onthe specific characteristics of the institution andthe intended users of the information. At oneextreme, highly granular cash-flow projectionsunder alternative scenarios are used by bothcomplex and noncomplex firms to manage theirday-to-day funding mismatches in the normalcourse of business and for assessing theircontingent liquidity-risk exposures. At the otherend of the measurement spectrum, aggregatemeasures and various types of liquidity ratiosare often employed to convey summary views ofan institution’s liquidity-risk profile to variouslevels of management, the board of directors,and other stakeholders. As a result of this broadcontinuum, effective managers generally use acombination of cash-flow analysis and summaryliquidity-risk measures in managing theirliquidity-risk exposures, since no one measureor measurement technique can adequately cap-ture the full dynamics of a financial institution’sliquidity-risk exposure.

This appendix provides background materialon the basic elements of liquidity-risk measure-ment and is intended to enhance examiners’understanding of the key elements of liquidity-risk management. First, the fundamental struc-ture of cash-flow-projection worksheets andtheir use in assessing cash-flow mismatchesunder both normal business conditions andcontingent liquidity events are discussed. Theappendix then discusses the key liquidity char-acteristics of common depository institutionassets, liabilities, off-balance-sheet (OBS) items,and other activities. These discussions alsopresent key management considerations sur-rounding various sources and uses of liquidity inconstructing cash-flow worksheets and address-ing funding gaps under both normal and adverseconditions. Finally, commonly used summaryliquidity measures and ratios are discussed,

along with special considerations that shouldenter into the construction and use of thesesummary measures.1

I. Basic Cash-Flow Projections

In measuring an institution’s liquidity-risk pro-file, effective liquidity managers estimate cashinflows and cash outflows over future periods.For day-to-day operational purposes, cash-flowprojections for the next day and subsequent daysout over the coming week are used in order toensure that contractual obligations are met ontime. Such daily projections can be extended outbeyond a one-week horizon, although it shouldbe recognized that the further out such projec-tions are made, the more susceptible theybecome to error arising from unexpectedchanges.

For planning purposes, effective liquiditymanagers project cash flows out for longer timehorizons, employing various incremental timeperiods, or ‘‘buckets,’’ over a chosen horizon.Such buckets may encompass forward weeks,months, quarters, and, in some cases, years. Forexample, an institution may plan its cash inflowsand outflows on a daily basis for the next 5–10business days, on a weekly basis over thecoming month or quarter, on a monthly basisover the coming quarter or quarters, and on aquarterly basis over the next half-year or year.Such cash-flow bucketing is usually compiledinto a single cash-flow-projection worksheet orreport that represents cash flows under a specificfuture scenario. The goal of this bucketingapproach is a measurement system with suffi-cient granularity to (1) reveal the time dimen-sion of the needs and sources of liquidity and(2) identify potential liquidity-risk exposure tocontingent events.

In its most basic form, a cash-flow-projectionworksheet is a table with columns denoting theselected time periods or buckets for which cashflows are to be projected. The rows of this tableconsist of various types of assets, liabilities, andOBS items, often grouped by their cash-flow

1. Material presented in this appendix draws from the OCCLiquidity Handbook, FDIC guidance, Federal Reserve guid-ance, findings from Federal Reserve supervision reviews, andother material developed for the Federal Reserve byconsultants and other outside parties.


characteristics. Different groupings may be usedto achieve different objectives of the cash-flowprojection. For each row, net cash flows arisingfrom the particular asset, liability, or OBSactivity are projected across the time buckets.

The detail and granularity of the rows, andthus the projections, depend on the sophistica-tion and complexity of the institution. Complexbanks generally favor more detail, while lesscomplex banks may use higher levels ofaggregation. Static projections based only on thecontractual cash flows of assets, liabilities, andOBS items as of a point in time are helpful foridentifying gaps between needs and sources ofliquidity. However, static projections may inad-equately quantify important aspects of potentialliquidity risk because they ignore new business,funding renewals, customer options, and otherpotential events that may have a significantimpact on the institution’s liquidity profile.Since liquidity managers are generally inter-ested in evaluating how available liquiditysources may cover both expected and potentialunexpected liquidity needs, a dynamic analysisthat includes management’s projected changesin cash flows is normally far more useful than astatic projection based only on contractual cashflows as of a given projection date.

In developing a cash-flow-projection work-sheet, cash inflows occurring within a giventime horizon or time bucket are represented aspositive numbers, while outflows are repre-sented as negative numbers. Cash inflowsinclude increases in liabilities as well asdecreases in assets, and cash outflows includedecreases in liabilities as well as increases inassets. For each type of asset, liability, or OBSitem, and in each time bucket, the values shownin the cells of the projected worksheet are netcash-flow numbers. One format for a cash-flow-projection worksheet arrays sources of net cashinflows (such as loans and securities) in onegroup and sources of net cash outflows (such asdeposit runoffs) in another. For example, theentries across time buckets for a loan or loancategory would net the positives (cash inflows)of projected interest, scheduled principal pay-ments, and prepayments with the negatives(cash outflows) of customer draws on existingcommitments and new loan growth in eachappropriate time bucket. Summing the net cashflows within a given column or time bucketidentifies the extent of maturity mismatches thatmay exist. Funding shortfalls caused by mis-matches in particular time frames are revealed

as a ‘‘negative gap,’’ while excess funds withina time bucket denote a ‘‘positive gap.’’ Identi-fying such gaps early can help managers takethe appropriate action to either fill a negativegap or reduce a positive gap. The subtotals ofthe net inflows and net outflows may also beused to construct net cash-flow coverage ratiosor the ratio of net cash inflows to net cashoutflows.

The specific worksheet formats used to arraysources and uses of cash can be customized toachieve multiple objectives. Exhibit 1 providesan example of one possible form of a cash-flow-projection worksheet. The time buckets (col-umns) and sources and uses (rows) are selectedfor illustrative purposes, as the specific selectionwill depend on the purpose of the particularcash-flow projection. In this example, assets andliabilities are grouped into two broad categories:those labeled ‘‘customer-driven cash flows’’ andthose labeled ‘‘management-controlled cashflows.’’ This grouping arrays projected cashflows on the basis of the relative extent to whichfunding managers may have control over changesin the cash flows of various assets, liabilities,OBS items, and other activities that have animpact on cash flow. For example, managersgenerally have less control over loan and depositcash flows (e.g., changes arising from eithergrowth or attrition) and more control over suchitems as fed funds sold, investment securities,and borrowings.

The net cash-flow gap illustrated in thenext-to-the-last row of exhibit 1 is the sum ofthe net cash flows in each time-bucket columnand reflects the funding gap that will have to befinanced in that time period. For the daily timebuckets, this gap represents the net overnightposition that needs to be funded in the unsecuredshort-term (e.g., fed funds) market. The finalrow of the exhibit identifies a cumulative netcash-flow gap, which is constructed as the sumof the net cash flows in that particular timebucket and all previous time buckets. It providesa running picture across time of the cumulativefunding sources and needs of the institution. Theworksheet presented in exhibit 1 is only one ofmany alternative formats that can be used inmeasuring liquidity gaps.

3005.5 Liquidity Risk: Appendixes


II. Scenario Dependency ofCash-Flow Projections

Cash-flow-projection worksheets describe aninstitution’s liquidity profile under an estab-lished set of assumptions about the future.

The set of assumptions used in the cash-flowprojection constitutes a specific scenario custom-ized to meet the liquidity manager’s objectivefor the forecast. Effective liquidity managersgenerally use multiple forecasts and scenarios toachieve an array of objectives over planningtime horizons. For example, they may use threebroad types of scenarios every time they makecash-flow projections: normal-course-of-businessscenarios; short-term, institution-specific stressscenarios; and more-severe, intermediate-term,institution-specific stress scenarios. Larger, more

complex institutions that engage in significantcapital-markets and derivatives activities alsoroutinely project cash flows for various systemicscenarios that may have an impact on the firm.Each scenario requires the liquidity manager toassess and plan for potential funding shortfalls.Importantly, no single cash-flow projectionreflects the range of liquidity sources and needsrequired for advance planning.

Normal-course-of-business scenarios estab-lish benchmarks for the ‘‘normal’’ behavior ofcash flows of the institution. The cash flowsprojected for such scenarios are those theinstitution expects under benign conditions andshould reflect seasonal fluctuations in loans ordeposit flows. In addition, expected growth inassets and liabilities is generally incorporated toprovide a dynamic view of the institution’s

Exhibit 1—Example Cash-Flow-Projection Worksheet

Day1

Week1

Week2

Week3

Month1

Month3

Months4–6

Months7–12

Customer-driven cash flowsConsumer loansBusiness loansResidential mortgage loansFixed assetsOther assetsNoninterest-bearing depositsNOW accountsMMDAsPassbook savingsStatement savingsCDs under $100,000Jumbo CDsNet noninterest incomeMiscellaneous and other

liabilitiesOther

Subtotal

Management-controlled cashflows

Investment securitiesRepos, FFP, & other short-

term borrowingsFHLB & other borrowingsCommitted linesUncommitted linesOther

Subtotal

Net cash-flow gapCumulative position

Liquidity Risk: Appendixes 3005.5


liquidity needs under normal conditions.Adverse, institution-specific scenarios are

those that subject the institution to constrainedliquidity conditions. Such scenarios are gener-ally defined by first specifying the type ofliquidity event to be considered and thenidentifying various levels or stages of severityfor that type of event. For example, institutionsthat do not have publicly rated debt generallyemploy scenarios that entail a significant dete-rioration in the credit quality of their loan andsecurity holdings. Insitutions that have publiclyrated debt generally include a debt-ratingdowngrade scenario in their CFPs. The down-grade of an institution’s public debt rating mightbe specified as one type of event, withsuccessively lower ratings grades, includingbelow-investment-grade ratings, to identifyincreasing levels of severity. Each level ofseverity can be viewed as an individual scenariofor planning purposes. Effective liquidity man-agers ensure that they choose potential adverseliquidity scenarios that entail appropriate degreesof severity and model cash flows consistent witheach level of stress. Events that limit access toimportant sources of funding are the mostcommon institution-specific scenarios used.

The same type of cash-flow-projection work-sheet format shown in exhibit 1 can be used foradverse, institution-specific scenarios. However,in making such cash-flow projections, someinstitutions find it useful to organize theaccounts differently to accommodate a set ofvery different assumptions from those used inthe normal-course-of-business scenarios. Exhibit2 presents a format in which accounts areorganized by those involving potential cashoutflows and cash inflows. This format focusesthe analysis first on liability erosion andpotential off-balance-sheet draws, followed byan evaluation of the bank’s ability to coverpotential runoff, primarily from assets that canbe sold or pledged. Funding sources arearranged by their sensitivity to the chosenscenario. For example, deposits may be segre-gated into insured and uninsured portions. Thetime buckets used are generally of a shorter termthan those used under business-as-usual sce-narios, reflecting the speed at which deteriorat-ing conditions can affect cash flows.

A key goal of creating adverse-situationcash-flow projections is to alert management asto whether incremental funding resources avail-able under the constraints of each scenario aresufficient to meet the incremental funding needs

that result from that scenario. To the extent thatprojected funding deficits are larger than (orprojected funding surpluses are smaller than)desired levels, management has the opportunityto adjust its liquidity position or developstrategies to bring the institution back within anacceptable level of risk.

Adverse systemic scenarios entail macroeco-nomic, financial market, or organizational eventsthat can have an adverse impact on theinstitution and its funding needs and sources.Such scenarios are generally customized to theindividual institution’s funding characteristicsand business activities. For example, an institu-tion involved in clearing and settlement activi-ties may choose to model a payments-systemdisruption, while a bank heavily involved incapital-markets transactions may choose tomodel a capital-markets disruption.

The number of cash-flow projections neces-sary to fully assess potential adverse liquidityscenarios can result in a wealth of informationthat often requires summarization in order toappropriately communicate contingent liquidity-risk exposure to various levels of management.Exhibit 3 presents an example of a report formatthat assesses available sources of liquidity underalternative scenarios. The worksheet shows theamount of anticipated funds erosion and poten-tial sources of funds under a number of stressscenarios, for a given time bucket (e.g., over-night, one week, one month, etc.). In thisexample, two rating-downgrade scenarios ofdifferent severity are used, along with a scenariobuilt on low-earnings projections and a potentialreputational-risk scenario.

Exhibit 4 shows an alternative format forsummarizing the results of multiple scenarios.In this case, summary funding gaps are pre-sented across various time horizons (columns)for each scenario (rows). Actual reports usedshould be tailored to the specific liquidity-risk profile and other institution-specificcharacteristics.

III. Liquidity Characteristics ofAssets, Liabilities, Off-Balance-SheetPositions, and Various Types ofBanking Activities

A full understanding of the liquidity andcash-flow characteristics of the institution’sassets, liabilities, OBS items, and banking



Exhibit 2—Example Cash-Flow-Projection Worksheet—Liquidity Under anAdverse Scenario

Potential outflows/fundingerosion

Day1

Day2

Days3–7

Week2

Week3

Week4

Month2

Months2+

Federal funds purchasedUncollateralized borrowings

(sub-debt, MTNs, etc.)Nonmaturity deposits:

insured— Noninterest-bearing

deposits— NOW accounts— MMDAs— Savings

Nonmaturity deposits:uninsured

— Retail CDs under$100,000

— Jumbo CDs— Brokered CDs— Miscellaneous and

other liabilitiesSubtotal

Off-balance-sheet fundingrequirements

Loan commitmentsAmortizing securitizationsOut-of-the-money derivativesBackup lines

Total potential outflows

Potential sources to coveroutflows

Overnight funds soldUnencumbered investment

securities (withappropriate haircut)

Residential mortgage loansConsumer loansBusiness loansFixed/other assetsUnsecured borrowing

capacityBrokered-funds capacity

Total potential inflows

Net cash flowsCoverage ratio

(inflows/outflows)Cumulative coverage ratio



Exhibit 3—Example Summary Contingent-Liquidity-Exposure Report(for an Assumed Time Horizon)

Events: Current Ratings downgrade EarningsRepu-tation Other (?)

Scenarios:1 cate-gory

BBBto BB RoA = ?

Potential funding erosionLarge fund providers

Fed fundsCDsEurotakings / foreign

depositsCommercial paper

SubtotalOther funds providers

Fed fundsCDsEurotakings / foreign

depositsCommercial paperDDAsConsumer

MMDAsSavingsOther

Total uninsured fundsTotal insured fundsTotal funding

Off-balance-sheet needsLetters of creditLoan commitmentsSecuritizationsDerivativesTotal OBS items

Total funding erosion

Sources of fundsSurplus money marketUnpledged securitiesSecuritizations

Credit cardsAutosMortgages

Loan salesOtherTotal internal sources

Borrowing capacityBrokered-funds capacityFed discount borrowingsOther



activities is critical to the identification andmanagement of mismatch risk, contingent liquid-ity risk, and market liquidity risk. This under-standing is required for constructing meaningfulcash-flow-projection worksheets under alterna-tive scenarios, for developing and executingstrategies used in managing mismatches, and forcustomizing summary liquidity measures orratios.

A. Assets

The generation of assets is one of the primary

uses of funds at banking organizations. Onceacquired, assets provide cash inflows throughprincipal and interest payments. Moreover, theliquidation of assets or their use as collateral forborrowing purposes makes them an importantsource of funds and, therefore, an integral tool inmanaging liquidity risk. As a result, the objec-tives underlying an institution’s holdings ofvarious types of assets range along a continuumthat balances the tradeoffs between maximizingrisk-adjusted returns and ensuring the fulfill-ment of an institution’s contractual obligationsto deliver funds (ultimately in the form of cash).

Exhibit 4—Example Summary Contingent-Liquidity-Exposure Report(Across Various Time Horizons)

Projected liquidity cushion

1 week 2–4 weeks 2 months 3 months 4+ months

Normal course of businessTotal cash inflowsTotal cash outflowsLiquidity cushion (shortfall)Liquidity coverage ratio

Mild institution-specificTotal cash inflowsTotal cash outflowsLiquidity cushion (shortfall)Liquidity coverage ratio

Severe institution-specificTotal cash inflowsTotal cash outflowsLiquidity cushion (shortfall)Liquidity coverage ratio

Severe credit crunchTotal cash inflowsTotal cash outflowsLiquidity cushion (shortfall)Liquidity coverage ratio

Capital-markets disruptionTotal cash inflowsTotal cash outflowsLiquidity cushion (shortfall)Liquidity coverage ratio

Custom scenarioTotal cash inflowsTotal cash outflowsLiquidity cushion (shortfall)Liquidity coverage ratio



Assets vary by structure, maturity, credit quality,marketability, and other characteristics thatgenerally reflect their relative ability to beconvertible into cash.

Cash operating accounts that include vaultcash, cash items in process, correspondentaccounts, accounts with the Federal Reserve,and other cash or ‘‘near-cash’’ instruments arethe primary tools institutions use to execute theirimmediate cash-transaction obligations. Theyare generally not regarded as sources ofadditional or incremental liquidity but act as theoperating levels of cash necessary for executingday-to-day transactions. Accordingly, well-managed institutions maintain ongoing balancesin such accounts to meet daily business trans-actions. Because they generate no or very lowinterest earnings, such holdings are generallymaintained at the minimum levels necessary tomeet day-to-day transaction needs.

Beyond cash and near-cash instruments, theextent to which assets contribute to an institu-tion’s liquidity profile and the management ofliquidity risk depends heavily on the contractualand structural features that determine an asset’scash-flow profile, its marketability, and itsability to be pledged to secure borrowings. Thefollowing sections discuss important aspects ofthese asset characteristics that effective manag-ers factor into their management of liquidity riskon an ongoing basis and during adverse liquidityevents.

Structural cash-flow attributes of assets. Knowl-edge and understanding of the contractual andstructural features of assets, such as theirmatu-rity, interest and amortization paymentsched-ules, and any options (either explicit orembedded) that might affect contractual cashflows under alternative scenarios, is critical forthe adequate measurement and management ofliquidity risk. Clearly, the maturity of assets is akey input in cash-flow analysis. Indeed, themanagement of asset maturities is a critical toolused in matching expected cash outflows andinflows. This matching is generally accom-plished by ‘‘laddering’’ asset maturities in orderto meet scheduled cash needs out through shortand intermediate time horizons.

Short-term money market assets (MMAs) arethe primary ‘‘laddering’’ tools used to meetfunding gaps over short-term time horizons.They provide vehicles for institutions to ensurefuture cash availability while earning a return.Given the relatively low return on such assets,

managers face important tradeoffs betweenearnings and the provision of liquidity indeploying such assets. In general, larger institu-tions employ a variety of MMAs in making suchtradeoffs, while smaller community organiza-tions face fewer potential sources of short-terminvestments.

The contractual and structural features, suchas the maturity and payment streams of allfinancial assets, should be factored into bothcash-flow projections and the strategies devel-oped for filling negative funding gaps. Thispractice includes the assessment of embeddedoptions in assets that can materially affect anasset’s cash flow. Effective liquidity managersincorporate the expected exercise of options inprojecting cash flows for the various scenariosthey use in measuring liquidity risk. Forexample, normal ‘‘business as usual’’ projec-tions may include an estimate of the expectedamount of loan and security principal prepay-ments under prevailing market interest rates,while alternative-scenario projections mayemploy estimates of expected increases inprepayments (and cash flows) arising fromdeclining interest rates and expected declines inprepayments or ‘‘maturity extensions’’ resultingfrom rising market interest rates.

Market liquidity, or the ‘‘marketability’’ ofassets. Marketability is the ability to convert anasset into cash through a quick ‘‘sale’’ and at afair price. This ability is determined by themarket in which the sale transaction is con-ducted. In general, investment-grade securitiesare more marketable than loans or other assets.Institutions generally view holdings of invest-ment securities as a first line of defense forcontingency purposes, but banks need to fullyassess the marketability of these holdings. Theavailability and size of a bid-asked spread for anasset provides a general indication of the marketliquidity of that asset. The narrower the spread,and the deeper and more liquid the market, themore likely a seller will find a willing buyer ator near the asked price. Importantly, however,the market liquidity of an asset is not a staticattribute but is a function of conditions prevail-ing in the secondary markets for the particularasset. Bid-asked spreads, when they exist,generally vary with the volume and frequency oftransactions in the particular type of assets.Larger volumes and greater frequency of trans-actions are generally associated with narrowerbid-asked spreads. However, disruptions in the



marketplace, contractions in the number ofmarket makers, the execution of large blocktransactions in the asset, and other marketfactors may result in the widening of thebid-asked spread—and thus reduce the marketliquidity of an instrument. Large transactions, inparticular, can constrain the market liquidity ofan asset, especially if the market for the asset isnot deep.

The marketability of assets may also beconstrained by the volatility of overall marketprices and the underlying rates, which maycause widening bid-asked spreads on market-able assets. Some assets may be more subject tothis type of market volatility than others. Forexample, securities that have inherent credit orinterest-rate risk can become more difficult totrade during times when market participantshave a low tolerance for these risks. This may bethe case when market uncertainties promptinvestors to shun risky securities in favor ofmore-stable investments, resulting in a so-calledflight to quality. In a flight to quality, investorsbecome much more willing to sacrifice yield inexchange for safety and liquidity.

In addition to reacting to prevailing marketconditions, the market liquidity of an asset canbe affected by other factors specific to individualinvestment positions. Small pieces of securityissues, security issues from nonrated and obscureissuers, and other inactively traded securitiesmay not be as liquid as other investments. Whilebrokers and dealers buy and sell inactivesecurities, price quotations may not be readilyavailable, or when they are, bid-asked spreadsmay be relatively wide. Bids for such securitiesare unlikely to be as high as the bids for similarbut actively traded securities. Therefore, eventhough sparsely traded securities can almostalways be sold, an unattractive price can makethe seller unenthusiastic about selling or resultin potential losses in order to raise cash throughthe sale of an asset.

Accounting conventions can also affectthe market liquidity of assets. For example,Accounting Standards Codification (ASC) 320,‘‘Investments—Debt and Equity Securities,’’ (orStatement of Financial Accounting StandardsNo. 115 (FAS 115)) requires investment securi-ties to be categorized as held-to-maturity (HTM),available-for-sale (AFS), or trading, signifi-cantly affects the liquidity characteristics ofinvestment holdings. Of the three categories,securities categorized as HTM provide the leastliquidity, as they cannot be sold to meet liquidity

needs without potentially onerous repercussions.2Securities categorized as AFS can be sold at

any time to meet liquidity needs, but care mustbe taken to avoid large swings in earnings ortriggering impairment recognition of securitieswith unrealized losses.

Trading account securities are generally con-sidered the most marketable from an accountingstandpoint, since selling a trading accountinvestment has little or no income effect.

While securities are generally considered tohave greater market liquidity than loans andother assets, liquidity-risk managers increas-ingly consider the ability to obtain cash fromthe sale of loans as a potential source ofliquidity. Many types of bank loans can besold, securitized, or pledged as collateral forborrowings. For example, the portions of loansthat are insured or guaranteed by the U.S.government or by U.S. government–sponsoredenterprises are readily saleable under mostmarket conditions. From a market liquidityperspective, the primary difference betweenloans and securities is that the process ofturning loans into cash can be less efficient andmore time-consuming. While securitizations ofloan portfolios (discussed below) are morecommon in practice, commercial loans andportfolios of mortgages or retail loans can be,and often are, bought and sold by bankingorganizations. However, the due diligence andother requirements of these transactions gener-ally take weeks or even months to complete,depending on the size and complexity of theloans being sold. Liquidity-risk managers mayinclude selling marketable loans as a potentialsource of cash in their liquidity analyses, butthey must be careful to realistically time theexpected receipt of cash and should carefullyconsider past experience and market conditionsat the expected time of sale. Institutions that donot have prior experience selling a loan or amortgage portfolio often need more time toclose a loan sale than does an institution thatmakes such transactions regularly. Addition-ally, in systemic liquidity or institution-specificcredit-quality stress scenarios, the ability to sellloans outright may not be a realistic assumption.

Securitization can be a valuable method forconverting otherwise illiquid assets into cash.

2. HTM securities can be pledged, however, so they do stillprovide a potential source of liquidity. Furthermore, since theHTM-sale restriction is only an accounting standard(FAS 115)—not a market limitation—HTM securities can besold in cases of extreme need.



Advances in the capital markets have maderesidential mortgage, credit card, student, homeequity, automobile, and other loan types increas-ingly amenable to securitization. As a result, thesecuritization of loans has become an importantfunds-management tool at many depositoryinstitutions. Many institutions have businesslines that originate assets specifically for secu-ritization in the capital markets. However, whilesecuritization can play an important role inmanaging liquidity, it can also increase liquidityrisk—especially when excessive reliance isplaced on securitization as a single source offunding.

Securitization can be regarded as an ongoing,reliable source of liquidity only for institutionsthat have experience in securitizing the specifictype of loans under consideration. The time andeffort involved in structuring loan securitiza-tions make them difficult to use as a source ofasset liquidity for institutions that have limitedexperience with this activity. Moreover, pecu-liarities involved in the structures used tosecuritize certain types of assets may introduceadded complexity in managing an institution’scash flows. For example, the securitization ofcertain retail-credit receivables requires plan-ning for the possible return of receivablebalances arising from scheduled or early amor-tization, which may entail the funding of sizablebalances at unexpected or inopportune times.Institutions using securitization as a source offunding should have adequate monitoring sys-tems and ensure that such activities are fullyincorporated into all aspects of their liquidity-risk management processes—which includesassessing the liquidity impact of securitizationsunder adverse scenarios. This assessment isespecially important for institutions that origi-nate assets specifically for securitization sincemarket disruptions have the potential to imposethe need for significant contingent liquidity ifsecuritizations cannot be executed. As a result,effective liquidity managers ensure that theimplications of securitization activities are fullyconsidered in both their day-to-day liquiditymanagement and their liquidity contingencyplanning.

Pledging of assets to secure borrowings. Thepotential to pledge securities, loans, or otherassets to obtain funds is another important toolfor converting assets into cash to meet fundingneeds. Since the market liquidity of assets is asignificant concern to the lender of secured

funds, assets with greater market liquidity aremore easily pledged than less marketable assets.An institution that has a largely unpledgedinvestment-securities portfolio has access toliquidity either through selling the investmentsoutright or through pledging the investments ascollateral for borrowings or public deposits.However, once pledged, assets are generallyunavailable for supplying contingent liquiditythrough their sale. When preparing cash-flowprojections, liquidity-risk managers do notclassify pledged assets as ‘‘liquid assets’’ thatcan be sold to generate cash since the liquidityavailable from these assets has already been‘‘consumed’’ by the institution. Accordingly,when computing liquidity measures, effectiveliquidity managers avoid double-countingunpledged securities as both a source of cashfrom the potential sale of the asset and as asource of new liabilities from the potentialcollateralization of the the same security. Inmore-sophisticated cash-flow projections, thetying of the pledged asset to the funding is madeexplicit.

Similar to the pledging of securities, manyinvestments can be sold under an agreement torepurchase. This agreement provides the insti-tution with temporary cash without having tosell the investment outright and avoids thepotential earnings volatility and transactioncosts that buying and selling securities wouldentail.

Use of haircuts in measuring the funds thatcan be raised through asset sales, securitiza-tions, or repurchase agreements. The planneduse of asset sales, asset securitizations, orcollateralized borrowings to meet liquidityneeds necessarily involves some estimation ofthe value of the asset at the future point in timewhen the asset is anticipated to be convertedinto cash. Based on changes in market factors,future asset values may be more or less thancurrent values. As a result, liquidity managersgenerally apply discounts, or haircuts, to thecurrent value of assets to represent a conserva-tive estimate of the anticipated proceeds avail-able from asset sales or securitization in thecapital markets. Similarly, lenders in securedborrowings also apply haircuts to determine theamount to lend against pledged collateral asprotection if the value of that collateral declines.In this case, the haircut represents, in addition toother factors, the portion of asset value thatcannot be converted to cash because secured



lenders wish to have a collateral-protectionmargin.

When computing cash-flow projections underalternative scenarios and developing plans tomeet cash shortfalls, liquidity managers ensurethat they incorporate haircuts in order to reflectthe market liquidity of their assets. Such haircutsare applied consistent with both the relativemarket liquidity of the assets and the specificscenario utilized. In general, longer-term, riskierassets, as well as assets with less liquid markets,are assigned larger haircuts than are shorter-term, less risky assets. For example, within thesecurities portfolio, different haircuts might beassigned to short-term and long-term Treasuries,rated and unrated municipal bonds, and differenttypes of mortgage securities (e.g., pass-throughsversus CMOs). When available and appropriate,historical price changes over specified timehorizons equal to the time until anticipatedliquidation or the term of a borrowing are usedby liquidity-risk managers to establish suchhaircuts. Haircuts used by nationally recognizedstatistical ratings organizations (NRSROs) are astarting point for such calculations but shouldnot be unduly relied on since institution- andscenario-specific considerations may have impor-tant implications.

Haircuts should be customized to the particu-lar projected or planned scenario. For example,adverse scenarios that hypothesize a capital-markets disruption would be expected to uselarger haircuts than those used in projectionsassuming normal markets. Under institution-specific, adverse scenarios, certain assets, suchas loans anticipated for sale, securitization,or pledging, may merit higher haircuts thanthose used under normal business scenarios.Institutions should fully document the haircutsthey use to estimate the marketability of theirassets.

Bank-owned life insurance (BOLI) is apopular instrument offering tax benefits as wellas life insurance on bank employees. SomeBOLI policies are structured to provideliquidity; however, most BOLI policies onlygenerate cash in the event of a coveredperson’s death and impose substantial fees ifredeemed. In general, BOLI should not beconsidered a liquid asset. If it is included as apotential source of funds in a cash-flowanalysis, a severe haircut reflecting the termsof the BOLI contract and current marketconditions should be applied.

Liquid assets and liquidity reserves. Soundpractices for managing liquidity risk call forinstitutions to maintain an adequate reserve ofliquid assets to meet both normal and adverseliquidity situations. Such reserves should bestructured consistent with the considerationsdiscussed above regarding the marketability ofdifferent types of assets. Many institutionsidentify a specific portion of their investmentaccount to serve as a liquidity reserve, orliquidity warehouse. The size of liquidityreserves should be based on the institution’sassessments of its liquidity-risk profile andpotential liquidity needs under alternativescenarios, giving full consideration to the costsof maintaining those assets. In general, theamount of liquid assets held will be a functionof the stability of the institution’s fundingstructures and the potential for rapid loangrowth. If the sources of funds are stable, ifadverse-scenario cash-flow projections indicateadequate sources of contingent liquidity (includ-ing sufficient sources of unused borrowingcapacity), and if asset growth is predictable,then a relatively low asset liquidity reservemay be required. The availability of theliquidity reserves should be tested from time totime. Of course, liquidity reserves should beactively managed to reflect the liquidity-riskprofile of the institution and current trends thatmight have a negative impact on the institu-tion’s liquidity, such as—

• trading market, national, or financial markettrends that might lead rate-sensitive customersto pursue investment alternatives away fromthe institution;

• significant actual or planned growth in assets;• trends evidencing a reduction in large liability

accounts;• a substantial portion of liabilities from

rate-sensitive and credit-quality-sensitivecustomers;

• significant liability concentrations by producttype or by large deposit account holders;

• a loan portfolio consisting of illiquid, nonmar-ketable, or unpledgeable loans;

• expectations for substantial draws on loancommitments by customers;

• significant loan concentrations by product,industry, customer, and location;

• significant portions of assets pledged againstwholesale borrowings; and

• impaired access to the capital markets.



B. Liabilities

Similar to its assets, a depository institution’sliabilities present a complicated array ofliquidity characteristics. Banking organizationsobtain funds from a wide variety of sourcesusing an array of financial instruments. Theprimary characteristics that determine a liabil-ity’s liquidity-risk profile include its term,optionality, and counterparty risk tolerance(which includes the counterparty’s need forinsurance or collateral). These features help todetermine if an individual liability can beconsidered as stable or volatile. A stableliability is a reliable source of funds that islikely to remain available in adverse circum-stances. A volatile liability is a less stablesource of funds that may disappear or beunavailable to the institution under heavy pricecompetition, deteriorating credit or market-risk conditions, and other possible adverseevents. Developing assumptions on the relativestability or volatility of liabilities is a crucialstep in forecasting a bank’s future cash flowsunder various scenarios and in constructingvarious summary liquidity measures. As aresult, effective liquidity managers segmenttheir liabilities into volatile and stable compo-nents on the basis of the characteristics of theliability and on the risk tolerance of thecounterparty. These funds may be character-ized as credit-sensitive, rate-sensitive, or both.

Characteristics of stability and risk tolerance.The stability of an individual bank liability isclosely related to the customer’s or counter-party’s risk tolerance, or its willingness andability to lend or deposit money for a given riskand reward. Several factors affect the stabilityand risk tolerance of funds providers, includingthe fiduciary responsibilities and obligations offunds providers to their customers, the availabil-ity of insurance on the funds advanced bycustomers to banking organizations, the relianceof customers on public debt ratings, and therelationships funds providers have with theinstitution.

Institutional providers of funds to bankingorganizations, such as money market funds,mutual funds, trust funds, public entities, andother types of investment managers, havefiduciary obligations and responsibilities toadequately assess and monitor the relativerisk-and-reward tradeoffs of the investmentsthey make for their customers, participants, or

constituencies. These fund providers are espe-cially sensitive to receiving higher returns forhigher risk, and they are more apt to withdrawfunds if they sense that an institution has adeteriorating financial condition. In general,funds from sources that lend or deposit moneyon behalf of others are less stable than fundsfrom sources that lend their own funds. Forexample, a mutual fund purchaser of aninstitution’s negotiable CD may be expected tobe less stable than a local customer buying thesame CD.

Institutionally placed funds and other fundsproviders often depend on the published evalu-ations or ratings of NRSROs. Indeed, many suchfunds providers may have bylaws or internalguidelines that prohibit placing funds withinstitutions that have low ratings or, in theabsence of actual guidelines, may simply beaverse to retaining funds at an institution whoserating is poor or whose financial conditionshows deterioration. As a result, funds providedby such investors can be highly unstable inadverse liquidity environments.

The availability of insurance on deposits orcollateral on borrowed funds are also importantconsiderations in gauging the stability of fundsprovided. Insured or collateralized funds areusually more stable than uninsured or unsecuredfunds since the funds provider ultimately relieson a third party or the value of collateral toprotect its investment.

Clearly, the nature of a customer’s relation-ship with an institution has significant implica-tions for the potential stability or volatility ofvarious sources of funds. Customers who havea long-standing relationship with an institutionand a variety of accounts, or who otherwise usemultiple banking services at the institution, areusually more stable than other types ofcustomers.

Finally, the sensitivity of a funds provider tothe rates paid on the specific instrument ortransaction used by the banking organization toaccess funds is also critical for the appropriateassessment of the stability or volatility of funds.Customers that are very rate-driven are morelikely not to advance funds or remove existingfunds from an institution if more competitiverates are available elsewhere.

All of these factors should be analyzed for themore common types of depositors and fundsproviders and for the instruments they use toplace funds with the institution. Such assess-ments lead to general conclusions regarding



each type of customer’s or counterparty’s risksensitivity and the stability of the funds pro-vided by the instruments they use to place fundswith the institution. Exhibit 5 provides aheuristic schematic of how effective liquidity-risk managers conduct such an assessmentregarding the array of their different fundsproviders. It uses a continuum to indicate thegeneral level of risk sensitivity (and thus theexpected stability of funds) expected for eachtype of depositor, customer, or investor in aninstitution’s debt obligations. Of course, indi-vidual customers and counterparties may havevarious degrees of such concerns, and greatergranularity is generally required in practice. Anadditional instrument assessment of the stabilityor volatility of funds raised using that instru-ment from each type of fund provider is alogical next step in the process of evaluating therelative stability of various sources of funds toan institution.

There are a variety of methods used to assessthe relative stability of funds providers. Effec-tive liquidity managers generally review depositaccounts by counterparty type, e.g., consumer,small business, or municipality. For each type,an effective liquidity manager evaluates theapplicability of risk or stability factors, such aswhether the depositor has other relationshipswith the institution, whether the depositor ownsthe funds on deposit or is acting as an agent ormanager, or whether the depositor is likely to bemore aware of and concerned by adverse newsreports. The depositors and counterparties con-sidered to have a significant relationship withthe institution and who are less sensitive tomarket interest rates can be viewed as providing

stable funding. Statistical analysis of fundsvolatility is often used to separate total volumesinto stable and nonstable segments. While suchanalysis can be very helpful, it is important to bemindful that historical volatility is unlikely toinclude a period of acute liquidity stress.

The following discussions identify impor-tant considerations that should be factoredinto the assessment of the relative stability ofvarious sources of funds utilized by bankingorganizations.

Maturity of liabilities used to gather funds. Animportant factor in assessing the stability offunds sources is the remaining contractual life ofthe liability. Longer-maturity liabilities obvi-ously provide more-stable funding than doshorter maturities. Extending liability maturitiesto reduce liquidity risk is a common manage-ment technique and an important sound practiceused by most depository institutions. It is also amajor part of the cost of liquidity management,since longer-term liabilities generally requirehigher interest rates than are required for similarshort-term liabilities.

Indeterminate maturity deposits. Evaluationsof the stability of deposits with indeterminatematurities, such as various types of transactionaccounts (e.g., demand deposits, negotiableorder of withdrawal accounts (NOWs) or moneymarket demand accounts (MMDAs), and sav-ings accounts) can be made using criteria similarto those shown in exhibit 5. In doing so,effective liquidity managers recognize that therelative stability or volatility of these accountsderives from the underlying characteristics of

Exhibit 5—General Characteristics of Stable and Volatile Liabilities

Characteristics of funds providers that affect the stability/volatility of the funds provided

Types of funds providers

Fiduciaryagent or

own funds

Insuredor

secured

Relianceon public

information RelationshipStability

assessment

Consumers owner yes low high highSmall business owner in part low high mediumLarge corporate owner no medium medium lowBanks agent no high medium mediumMunicipalities agent in part high medium mediumMoney market mutual funds quasi-

fiduciaryno high low low

Other



the customers that use them and not on theaccount type itself. As a result, most institutionsdelineate the relative volatility or stability ofvarious subgroups of these account types on thebasis of customer characteristics. For example,MMDA deposits of customers who have fidu-ciary obligations may be less stable than thoseof individual retail customers. Additionally,funds acquired through a higher pricing strategyfor these types of deposit accounts are generallyless stable than are deposits from customers whohave long-standing relationships with the insti-tution. Increasingly, liquidity managers recog-nize that traditional measures of ‘‘core’’ depositsmay be inappropriate, and thus these depositsrequire more in-depth analysis to determinetheir relative stability.

Assessment of the relative stability or volatil-ity of deposits that have indeterminate maturi-ties can be qualitative as well as quantitative,consistent with the size, complexity, and sophis-tication of the institution. For example, at largerinstitutions, models based on statistical analysiscan be used to estimate the stability of varioussubsets of such funds under alternative liquidityenvironments. Such models can be used toformulate expected behaviors in reaction to ratechanges and other more-typical financial events.As they do when using models to manage anytype of risk, institutions should fully documentand understand the assumptions and methodolo-gies used. This is especially the case whenexternal parties conduct such analysis. Effectiveliquidity managers aggressively avoid ‘‘black-box’’ estimates of funding behaviors.

In most cases, insured deposits from consum-ers may be less likely to leave the institutionunder many liquidity circumstances than arefunds supplied by more-institutional funds pro-viders. Absent extenuating circumstances (e.g.,the deposit contract prohibits early withdrawal),funds provided by agents and fiduciaries aregenerally treated by banking organizations asvolatile liabilities.

Certificates of deposit and time deposits. Atmaturity, certificates of deposit (CDs) and timedeposits are subject to the general factorsregarding stability and volatility discussed above,including rate sensitivity and relationship fac-tors. Nonrelationship and highly-rate-sensitivedeposits tend to be less stable than depositsplaced by less-rate-sensitive customers whohave close relationships with the institution.Insured CDs are generally considered more

stable than uninsured ‘‘jumbo’’ CDs in denomi-nations of more than $100,000. In general,jumbo CDs and negotiable CDs are morevolatile sources of funds—especially duringtimes of stress—since they may be lessrelationship-driven and have a higher sensitivityto potential credit problems.

Brokered deposits and other rate-sensitive depos-its. Brokered deposits are funds a bank obtains,directly or indirectly, by or through any depositbroker, for deposit into one or more accounts.Thus, brokered deposits include both those inwhich the entire beneficial interest in a givenbank deposit account or instrument is held by asingle depositor and those in which the depositbroker pools funds from more than one investorfor deposit in a given bank deposit account.Rates paid on brokered deposits are often higherthan those paid for local-market-area retaildeposits since brokered-deposit customers aregenerally focused on obtaining the highestFDIC-insured rate available. These rate-sensitivecustomers have easy access to, and are fre-quently well informed about, alternative mar-kets and investments, and they may have noother relationship with or loyalty to the bank. Ifmarket conditions change or more-attractivereturns become available, these customers mayrapidly transfer their funds to new institutions orinvestments. Accordingly, these rate-sensitivedepositors may exhibit characteristics moretypical of wholesale investors, and liquidity-riskmanagers should model brokered depositsaccordingly.

The use of brokered deposits is governed bylaw and covered by the 2001 Joint AgencyAdvisory on Brokered and Rate-Sensitive Depos-its.3 Under 12 USC 1831f and 12 CFR 337.6,determination of ‘‘brokered’’ status is basedinitially on whether a bank actually obtains adeposit directly or indirectly through a depositbroker. Banks that are considered only‘‘adequately capitalized’’ under the ‘‘promptcorrective action’’ (PCA) standard must receivea waiver from the FDIC before they can accept,renew, or roll over any brokered deposit. Theyare also restricted in the rates they may offer onsuch deposits. Banks falling below the ade-quately capitalized range may not accept, renew,

3. Board of Governors of the Federal Reserve System,Office of the Comptroller of the Currency, Federal DepositInsurance Corporation, and Office of Thrift Supervision.May 11, 2001. See SR-01-14.



or roll over any brokered deposit, nor solicitdeposits with an effective yield more than75 basis points above the ‘‘national rate.’’ Thenational rate is defined as ‘‘a simple average ofrates paid by all insured depository institutionsand branches for which data are available.’’ Ona weekly basis, the ‘‘national rate’’ is posted onthe FDIC’s website. If a depository institutionbelieves that the ‘‘national rate’’ does notcorrespond to the actual prevailing rate in theapplicable market, the institution may seek adetermination from the FDIC that the institutionis operating in a ‘‘high-rate area.’’ If the FDICmakes such a determination, the bank will beallowed to offer the actual prevailing rate plus75 basis points. In any event, for depositsaccepted outside the applicable market area, thebank will not be allowed to offer rates in excessof the ‘‘national rate’’ plus 75 basis points.

These restrictions will reduce the availabilityof funding alternatives as a bank’s conditiondeteriorates. The FDIC is not authorized to grantwaivers for banks that are less than adequatelycapitalized. Bank managers who use brokereddeposits should be familiar with the regulationsgoverning brokered deposits and understand therequirements for requesting a waiver. Furtherdetailed information regarding brokered depos-its can be found in the FDIC’s FinancialInstitution Letter (FIL), 69-2009.

Deposits attracted over the Internet, throughCD listing services, or through special advertis-ing programs that offer premium rates to cus-tomers who do not have another bankingrelationship with the institution also requirespecial monitoring. Although these depositsmay not fall within the technical definition of‘‘brokered’’ in 12 USC 1831f and 12 CFR337.6, their inherent risk characteristics may besimilar to those of brokered deposits. That is,such deposits are typically attractive to rate-sensitive customers who may not havesignificant loyalty to the bank. Extensive reli-ance on funding products of this type, espe-cially those obtained from outside a bank’sgeographic market area, has the potential toweaken a bank’s funding position in times ofstress.

Under the 2001 joint agency advisory, banksare expected to perform adequate due diligencebefore entering any business relationship witha deposit broker; assess the potential risks toearnings and capital associated with brokereddeposits; and fully incorporate the assessmentand control of brokered deposits into all

elements of their liquidity-risk managementprocesses, including CFPs.

Public or government deposits. Public fundsgenerally represent deposits of the U.S. govern-ment, state governments, and local politicalsubdivisions; they typically require collateral tobe pledged against them in the form ofsecurities. In most banks, deposits from the U.S.government represent a much smaller portion oftotal public funds than that of funds obtainedfrom states and local political subdivisions.Liquidity-risk managers generally consider thesecured nature of these deposits as being adouble-edged sword. On the one hand, theyreduce contingent liquidity risk because securedfunds providers are less credit-sensitive, andtherefore their deposits may be more stable thanthose of unsecured funds providers. On the otherhand, such deposits reduce standby liquidity by‘‘consuming’’ the potential liquidity in thepledged collateral.

Rather than pledge assets as collateral forpublic deposits, banks may also purchase aninsurance company’s surety bond as coveragefor public funds in excess of FDIC insurancelimits. Here, the bank would not pledge assets tosecure deposits, and the purchase of suretybonds would not affect the availability of fundsto all depositors in the event of insolvency. Thecosts associated with the purchase of a suretybond must be taken into consideration whenusing this alternative.

Deposits from taxing authorities (most schooldistricts and municipalities) also tend to behighly seasonal. The volume of public fundsrises around tax due dates and falls near the endof the period before the next tax due date. Thisfluctuation is clearly a consideration for liquid-ity managers projecting cash flows for normaloperations. State and local governments tend tobe very rate-sensitive. Effective liquidity man-agers fully consider the contingent liquidity riskthese deposits entail, that is, the risk that thedeposits will not be maintained, renewed, orreplaced unless the bank is willing to offer verycompetitive rates.

Eurodollar deposits. Eurodollar time depositsare certificates of deposit issued by banksoutside of the United States. Large, internation-ally active U.S. banks may obtain Eurodollarfunding through their foreign branches—including offshore branches in the CaymanIslands or other similar locales. Eurodollar



deposits are usually negotiable CDs issued inamounts of $100,000 or more, with rates tied toLIBOR. Because they are negotiable, the con-siderations applicable to negotiable CDs setforth above also apply to Eurodollar deposits.

Federal funds purchased. Federal funds (fedfunds) are excess reserves held at FederalReserve Banks. The most common type offederal funds transaction is an overnight, unse-cured loan. Transactions that are for a periodlonger than one day are called term fed funds.The day-to-day use of fed funds is a commonoccurrence, and fed funds are considered animportant money market instrument used inmanaging daily liquidity needs and sources.

Many regional and money-center banks,acting in the capacity of correspondents tosmaller community banks, function as bothproviders and purchasers of federal funds.Overnight fed funds purchased can pose acontingent liquidity risk, particularly if a bank isunable to roll over or replace the maturingborrowing under stress conditions. Term fedfunds pose almost the same risk since the term isusually just a week or two. Fed funds purchasedshould generally be treated as a volatile sourceof funds.

Loans from correspondent banks. Small andmedium-sized banks often negotiate loans fromtheir principal correspondent banks. The loansare usually for short periods and may be securedor unsecured. Correspondent banks are usuallymoderately credit-sensitive. Accordingly, cash-flow projections for normal business conditionsand mild adverse scenarios may often treat thesefunds as stable. However, given the creditsensitivity of such funds, projections computedfor severe adverse liquidity scenarios shouldtreat these funds as volatile.

FHLB borrowings. The Federal Home LoanBanks (FHLBs) provide loans, referred to asadvances, to members. Advances must besecured by collateral acceptable to the FHLB,such as residential mortgage loans and mortgage-backed securities. Both short-term and long-term FHLB borrowings, with maturities rangingfrom overnight to 10 years, are available tomember institutions at generally competitiveinterest rates. For some small and medium-sizedbanks, long-term FHLB advances may be asignificant or the only source of long-termfunding.

It should be noted that FHLBs may also selltheir excess cash into the market in the form offed funds. This is a transaction where the FHLBis managing its excess funding and has chosento invest that excess in short-term unsecured fedfunds. This transaction is executed through thecapital markets and is not done with specificmembers of the FHLB.

Some FHLB advances contain embeddedoptions or other features that may increasefunding risk. For example, some types ofadvances, such as putable and convertibleadvances, provide the FHLB with the option toeither recall the advance or change the inter-est rate on an advance from a fixed rate to afloating rate under specified conditions. Whensuch optionality exists, institutions should fullyassess the implications of this optionality on theliquidity-risk profile of the institution.

In general, an FHLB establishes a line ofcredit for each of its members. Members arerequired to purchase FHLB stock before a lineof credit is established, and the FHLB has theability to restrict the redemption of its stock. AnFHLB may also limit or deny a member’srequest for an advance if the member engages inany unsafe or unsound practice, is inadequatelycapitalized, sustains operating losses, is defi-cient with respect to financial or managerialresources, or is otherwise deficient.

Because FHLB advances are secured bycollateral, the unused FHLB borrowing capacityof a bank is a function of both its eligible,unpledged collateral and its unused line of creditwith its FHLB.

FHLBs have access to bank regulatoryinformation not available to other lenders. Thecomposite rating of an institution is a factor inthe approval for obtaining an FHLB advance,as well as the level of collateral required andthe continuance of line availability. Because ofthis access to regulatory data, an FHLB canreact quickly to reduce its exposure to atroubled institution by exercising options or notrolling over unsecured lines of credit. Depend-ing on the severity of a troubled institution’scondition, an FHLB has the right to increasecollateral requirements or to discontinue orwithdraw (at maturity) its collateralized fund-ing program because of concerns about thequality or reliability of the collateral or othercredit-related concerns. On the one hand, thisright may create liquidity problems for aninstitution, especially if it has large amounts ofshort-term FHLB funding. At the same time,



because FHLB advances are fully collateral-ized, the various FHLBs have historicallyworked with regulators prior to exercising theiroption to fully withdraw funding frommembers. To this extent, FHLB borrowings areviewed by many liquidity managers as arelatively stable source of funding, barring themost severe of adverse funding situations.

Sound liquidity-risk management practicescall for institutions to fully document thepurpose of any FHLB-borrowing transaction.Each transaction should be analyzed on anongoing basis to determine whether the arrange-ment achieves the stated purpose or whether theborrowings are a sign of liquidity deficiencies.Some banks may use their FHLB line of creditto secure public funds; however, doing so willreduce their available funds and may presentproblems if the FHLB reduces the institution’scredit line. Additionally, the institution shouldperiodically review its borrowing agreementwith the FHLB to determine the assets collater-alizing the borrowings and the potential riskspresented by the agreement. In some instances,the borrowing agreement may provide forcollateralization by all assets not already pledgedfor other purposes.

Repurchase agreements and dollar rolls. Theterms repurchase agreement4 (repo) and reverserepurchase agreement refer to transactions inwhich a bank acquires funds by selling securi-ties and simultaneously agreeing to repurchasethe securities after a specified time at a givenprice, which typically includes interest at anagreed-on rate. A transaction is considered arepo when viewed from the perspective of thesupplier of the securities (the borrower) and areverse repo or matched sale–purchase agree-ment when described from the point of view ofthe supplier of funds (the lender).

A repo commonly has a near-term maturity(overnight or a few days) with tenors rarelyexceeding three months. Repos are also usuallyarranged in large dollar amounts. Repos maybe used to temporarily finance the purchase ofsecurities and dealer securities inventories.Banking organizations also use repos as asubstitute for direct borrowings. Bank securi-ties holdings as well as loans are often soldunder repurchase agreements to generate tem-porary working funds. These types of agree-ments are often used because the rate on this

type of borrowing is less than the rate onunsecured borrowings, such as federal fundspurchased.

U.S. government and agency securities are themost common type of instruments sold underrepurchase agreements, since they are exemptfrom reserve requirements. However, marketparticipants sometimes alter various contractprovisions to accommodate specific investmentneeds or to provide flexibility in the designationof collateral. For example, some repo contractsallow substitutions of the securities subject tothe repurchase commitment. These transactionsare often referred to as dollar repurchaseagreements (dollar rolls), and the initial seller’sobligation is to repurchase securities that aresubstantially similar, but not identical, to thesecurities originally sold. To qualify as afinancing, these agreements require the return of‘‘substantially similar securities’’ and cannotexceed 12 months from the initiation of thetransaction. The dollar-roll market primarilyconsists of agreements that involve mortgage-backed securities.

Another common repo arrangement is calledan open repo, which provides a flexible term tomaturity. An open repo is a term agreementbetween a dealer and a major customer in whichthe customer buys securities from the dealer andmay sell some of them back before the finalmaturity date.

Effective liquidity-risk managers ensure thatthey are aware of special considerations andpotential risks of repurchase agreements,especially when the bank enters into large-dollar-volume transactions with institutional investorsor brokers. It is a fairly common practice toadjust the collateral value of the underlyingsecurities daily to reflect changes in marketprices and to maintain the agreed-on margin.Accordingly, if the market value of the repo-edsecurities declines appreciably, the borrowermay be asked to provide additional collateral.Conversely, if the market value of thesecurities rises substantially, the lender may berequired to return the excess collateral to theborrower. If the value of the underlyingsecurities exceeds the price at which therepurchase agreement was sold, the bank couldbe exposed to the risk of loss if the buyer isunable to perform and return the securities.This risk would increase if the securities werephysically transferred to the institution orbroker with which the bank has entered intothe repurchase agreement.4. See section 3010.1.



Because these instruments are usually veryshort-term transactions, institutions using themincur contingent liquidity risk. Accordingly,cash-flow projections for normal and mildscenarios usually treat these funds as stable.However, projections computed for severe sce-narios generally treat these funds as volatile.

International borrowings. International borrow-ings may be direct or indirect. Common formsof direct international borrowings include loansand short-term call money from foreign banks,borrowings from the Export-Import Bank ofthe United States, and overdrawn nostroaccounts (due from foreign bank demandaccounts). Indirect forms of borrowing includenotes and trade bills rediscounted with thecentral banks of various countries; notes,acceptances, import drafts, or trade bills soldwith the bank’s endorsement or guarantee;notes and other obligations sold subject torepurchase agreements; and acceptance poolparticipations. In general, these borrowings areoften considered to be highly volatile, non-stable sources of funds.

Federal Reserve Bank borrowings. In 2003, theFederal Reserve Board revised Regulation A toprovide for primary and secondary creditprograms at the discount window.5 (See section4025.1.) Reserve Banks will extend primarycredit at a rate above the target fed funds rateon a short-term basis (typically, overnight) toeligible depository institutions, and acceptablecollateral is required to secure all obligations.Discount window borrowings can be securedwith an array of collateral, including consumerand commercial loans. Eligibility for primarycredit is based largely on an institution’sexamination rating and capital status. Ingeneral, institutions with composite CAMELSratings of 1, 2, or 3 that are at least adequatelycapitalized are eligible for primary creditunless supplementary information indicatestheir condition is not generally sound. Otherconditions exist to determine eligibility for 4-and 5-rated institutions.

An institution eligible for primary credit neednot exhaust other sources of funds before

coming to the discount window. However,because of the above-market price of primarycredit, the Reserve Banks expect institutions tomainly use the discount window as a backupsource of liquidity rather than as a routinesource. Generally, Reserve Banks extend pri-mary credit on an overnight basis with minimaladministrative requirements to eligible institu-tions. Reserve Banks may also extend primarycredit to eligible institutions for periods of up toseveral weeks if funding is not available fromother sources. These longer extensions of creditare subject to greater administrative oversight.Reserve Banks also offer secondary credit toinstitutions that do not qualify for primarycredit. Secondary credit is another short-termbackup source of liquidity, although its avail-ability is more limited and is generally used foremergency backup purposes. Reserve Banksextend secondary credit to assist in an institu-tion’s timely return to a reliance on traditionalfunding sources or in the resolution of severefinancial difficulties. This program entails ahigher level of Reserve Bank administration andoversight than primary credit.

Treasury Tax and Loan deposits. Treasury Taxand Loan accounts (TT&L accounts) are main-tained at banks by the U.S. Treasury to facilitatepayments of federal withholding taxes. Banksmay select either the ‘‘remittance-option’’ or the‘‘note-option’’ method of forwarding depositedfunds to the U.S. Treasury. In the remittanceoption, the bank remits the TT&L accountdeposits to the Federal Reserve Bank the nextbusiness day after deposit, and the remittanceportion is not interest-bearing. The note optionpermits the bank to retain the TT&L deposits. Inthe note option, the bank debits the TT&Lremittance account for the amount of theprevious day’s deposit and simultaneously cred-its the note-option account. Note-option accountsare interest-bearing and can grow to a substan-tial size.

TT&L funds are considered purchasedfunds, evidenced by an interest-bearing, variable-rate, open-ended, secured note callable ondemand by Treasury. As per 31 CFR 203.24,the TT&L balance requires pledged collateral,usually from the bank’s investment portfolio.Because they are secured, TT&L balancesreduce standby liquidity from investments, andbecause they are callable, TT&L balances areconsidered to be volatile and they must becarefully monitored. However, in most banks,

5. See the ‘‘Interagency Advisory on the Use of the FederalReserve’s Primary Credit Program in Effective LiquidityManagement,’’ Board of Governors of the Federal ReserveSystem, Office of the Comptroller of the Currency, FederalDeposit Insurance Corporation, and Office of Thrift Supervi-sion, July 25, 2003, and SR-03-15. See also section 3010.1.



TT&L deposits constitute only a minor portionof total liabilities.

C. Off-Balance-Sheet Obligations

Off-balance-sheet transactions have been one ofthe fastest-growing areas of banking activity.While these activities may not be reflected onthe balance sheet, they must be thoroughlyreviewed in assessing an institution’s liquidity-risk profile, as they can expose the institution tosignificant contingent liquidity risk. Effectiveliquidity-risk managers pay particular attentionto potential liquidity risks in loan commitments,lines of credit, performance guarantees, andfinancial guarantees. Banks should estimateboth the amount and the timing of potential cashflows from off-balance-sheet claims.

Effective liquidity managers ensure that theyconsider the correlation of draws on varioustypes of commitments that can trend withmacroeconomic conditions. For example,standby letters of credit issued in lieu ofconstruction completion bonds are often drawnwhen builders cannot fulfill their contracts.Some types of credit lines, such as those used toprovide working capital to businesses, are mostheavily used when either the borrower’s accountsreceivable or inventory is accumulating fasterthan its collections of accounts payable or sales.Liquidity-risk managers should work with theappropriate lending managers to track suchtrends.

In addition, funding requirements arisingfrom some types of commitments can be highlycorrelated with the counterparty’s credit quality.Financial standby letters of credit (SBLOCs) areoften used to back the counterparty’s directfinancial obligations, such as commercial paper,tax-exempt securities, or the margin require-ments of securities and derivatives exchanges.At some institutions, a major portion of off-balance-sheet claims consists of SBLOCs sup-porting commercial paper. If the institution’scustomer issues commercial paper supported byan SBLOC and if the customer is unable torepay the commercial paper at maturity, theholder of the commercial paper will request thatthe institution perform under the SBLOC.Liquidity-risk managers should work with theappropriate lending manager to (1) monitor thecredit grade or default probability of suchcounterparties and (2) manage the industrydiversification of these commitments in order to

reduce the probability that multiple counterpar-ties will be forced to draw against the bank’scommitments at the same time.

Funding under some types of commitmentscan also be highly correlated with changes in theinstitution’s own financial condition or per-ceived credit quality. Commitments supportingvarious types of asset-backed securities, asset-backed commercial paper, and derivatives canbe subject to such contingent liquidity risk. Thesecuritization of assets generally requires someform of credit enhancement, which can takemany forms, including SBLOCs or other typesof guarantees issued by a bank. Similarly, manystructures employ special-purpose entities(SPEs) that own the collateral securing theasset-backed paper. Bank SBLOCs or guaran-tees often support those SPEs. As long as theinstitution’s credit quality remains above definedminimums, which are usually based on ratingsfrom NRSROs, few or none of the SBLOCs willfund. However, if the institution’s credit ratingfalls below the minimum, a significant amountor all of such commitments may fund at thesame time.

Financial derivatives can also give rise tocontingent liquidity risk arising from financialmarket disruptions and deteriorating creditquality of the banking organization. Deriva-tives contracts should be reviewed, and theirpotential for early termination should beassessed and quantified, to determine theadequacy of the institution’s available liquidity.Many forms of standardized derivatives con-tracts allow counterparties to request collateralor to terminate contracts early if the institutionexperiences an adverse credit event or deterio-ration in its financial condition. In addition,under situations of market stress, a customermay ask for early termination of somecontracts. In such circumstances, an institutionthat owes money on derivatives transactionsmay be required to deliver collateral or settle acontract early, when the institution is encoun-tering additional funding and liquidity pres-sures. Early terminations may also createadditional, unintended market exposures. Man-agement and directors should be aware of thesepotential liquidity risks and address them in theinstitution’s CFP. All off-balance-sheet commit-ments and obligations should receive thefocused attention of liquidity-risk managersthroughout the liquidity-risk management process.



D. Specialized Business Activities

Institutions that engage in specialized bankingactivities should ensure that all elements ofthese activities are fully incorporated into theirassessment of liquidity-risk exposure and theirongoing management of the firm’s liquidity.Such activities may include mortgage servicing,trading and dealer activities, and various typesof fee-income-generating businesses.

Institutions engaged in significant payment,clearing, and settlement activities face particularchallenges. Institutions that are active in pay-ment, settlement, or clearing activities shouldensure that they have mechanisms for measur-ing, monitoring, and identifying the amount ofliquidity they may need to settle obligations innormal as well as stressed environments. Theseinstitutions should fully consider the uniquerisks that may result from their participation indifferent payment-system activities and factorthese risks into their liquidity contingencyplanning. Factors that banks should considerwhen developing liquidity plans related topayment activities include—

• the impact of pay-in rules of individualpayment systems, which may result inshort-notice payment adjustments and theneed to assess peak pay-in requirements thatcould result from the failure of anotherparticipant;

• the potential impact of operational disruptionsat a payment utility and the potential need tomove activity to another venue in whichsettlement is gross rather than net, therebyincreasing liquidity requirements to settle;

• the impact that the deteriorating credit qualityof the institution may have on collateralrequirements, changes in intraday lendinglimits, and the institution’s intraday fundingneeds; and

• for clearing and nostro service providers, theimpact of potential funding needs that couldbe generated by their clearing customers inaddition to the bank’s own needs.

IV. Summary Measures ofLiquidity-Risk Exposure

Cash-flow projections constructed assumingnormal and adverse conditions provide awealth of information about the liquidity

profile of an institution. However, liquiditymanagers, bank supervisors, rating agencies,and other interested parties use a myriad ofsummary measures of liquidity to identifypotential liquidity risk. These measures includevarious types of financial ratios. Many of thesemeasures attempt to achieve some of the sameinsights provided by comprehensive cash-flowscenario analyses but use significantly lessdata. When calculated using standard defini-tions and comparable data, such measuresprovide the ability to track trends over timeand facilitate comparisons across peers. At thesame time, however, many summary measuresnecessarily entail simplifying assumptions regard-ing the liquidity of assets, the relative stabilityor volatility of liabilities, and the ability of theinstitution to meet potential funding needs.Supervisors, management, and other stakehold-ers that use these summary measures shouldfully understand the effect of these assumptionsand the limitations associated with summarymeasures.

Although general industry conventions maybe used to compute various summary measures,liquidity managers should ensure that thespecific measures they use for internal purposesare suitably customized for their particularinstitution. Importantly, effective liquidity man-agers recognize that no single summary measureor ratio captures all of the available sources anduses of liquidity for all situations and for all timeperiods. Different ratios capture different facetsof liquidity and liquidity risk. Moreover, thesame summary measure or ratio calculated usingdifferent assumptions can also capture differentfacets of liquidity. This is an especially impor-tant point since, by definition, many liquidityratios are scenario-specific. Measures con-structed using normal-course-of-businessassumptions can portray liquidity profiles thatare significantly different from those constructedassuming stress contingency events. Indeed,many liquidity managers use the same summarymeasures and financial ratios computed underalternative scenarios and assumptions to evalu-ate and communicate to senior management andthe board of directors the institution’s liquidity-risk profile and the adequacy of its CFPs.

A. Cash-Flow Ratios

Cash-flow ratios are especially valuable sum-mary liquidity measures. These measures sum-



marize the information contained in detailedcash-flow projections and forecasts. They aregenerally constructed as the ratio of totalprojected cash inflows divided by total projectedcash outflows for a particular time period orcash-flow-projection time bucket. The ratio for agiven time bucket indicates the relative amountby which the projected sources of liquiditycover projected needs. For example, a ratio of1.20 indicates a liquidity ‘‘surplus’’ equal to20 percent of projected outflows. In general,such coverage ratios are compiled for eachtime bucket in the cash-flow projections usedto assess both normal and adverse liquiditycircumstances.

Some institutions also employ cumulativecash-flow ratios that are computed as the ratioof the cumulative sum of cash inflows to thecumulative sum of cash outflows for all timebuckets up to a given time bucket. However,care should be taken to recognize that cumula-tive cash-flow ratios used alone and without thebenefit of assessing the individual time-periodexposures for each of their component timebuckets may mask liquidity-risk exposures thatcan exist at intervals up to the cumulative timehorizons chosen.

B. Other Summary Liquidity Measures

Other common summary liquidity measuresemploy assumptions about, and depend heavilyon, the assessment and characterization of therelative marketability and liquidity of assets andthe relative stability or volatility of fundingneeds and sources, consistent with the consider-ations discussed in the prior section. Liquiditymanagers use these other measures to reviewhistorical trends, summarize their projections ofpotential liquidity-risk exposures under adverseliquidity conditions, and develop strategies toaddress contingent liquidity events. In selectingfrom the myriad of available measures, effectiveliquidity managers focus primarily on thosemeasures that are most related to the liquidity-management strategies pursued by the institu-tion. For example, institutions that focus onmanaging asset liquidity place greater emphasison measures that gauge such conditions, whileinstitutions placing greater emphasis on manag-ing liability liquidity emphasize measures thataddress those aspects of their liquidity-riskprofile.

The following discussions briefly describe

some of the more common summary measuresof liquidity and liquidity risk. Some of thesemeasures are employed by liquidity managers,rating agencies, and supervisors using defini-tions and calculation methods amenable topublicly available Call Report or BHC Perfor-mance Report data. Because such data requirethe use of assumptions on the liquidity of broadclasses of assets and on the stability of varioustypes of aggregated liabilities, liquidity manag-ers and supervisors should take full advantage ofthe available granularity of internal data tocustomize the summary measures they areusing. Incorporating internal data ensures thatsummary measures fit the specific liquidityprofile of the institution. Such customizationpermits a more robust assessment of theinstitution’s liquidity-risk profile.

In general, most common summary measuresof liquidity and liquidity risk can be groupedinto the following three broad categories:

1. those that portray the array of assets along acontinuum of liquidity and cash-flow charac-teristics for normal and potentially adversecircumstances

2. those that portray the array of liabilities alonga continuum of potential volatility andstability characteristics under normal andpotentially adverse circumstances

3. those that assess the balance between fund-ing needs and sources based on assumptionsabout both the relative liquidity of assets andthe relative stability of liabilities

Relative liquidity of assets. Summary measuresthat address the liquidity of assets usually startwith assessments of the maturity or type ofassets in an effort to gauge their contributions toactual cash inflows over various time horizons.In general, they represent an attempt to summa-rize and characterize the expected cash inflowsfrom assets that are estimated in more-detailedcash-flow-projection worksheets assuming nor-mal business conditions. Summary measuresassessing the liquidity of assets include suchmeasures as—

• short-term investments (defined as maturingwithin a specified time period, such as 3months, 6 months, or 1 year) as a percent oftotal investments, and

• short-term assets (defined as maturing withina specified time period) as a percent of totalassets.



Other measures within this category attempt toassess the expected time period over whichlonger-term, illiquid assets may need to befunded. These measures, which use broad assetcategories and employ strong assumptions onthe liquidity of these assets, include—

• loans and leases as a percent of total assets,and

• long-term assets (defined as maturing beyonda specified time period) as a percent of totalassets.

To better gauge the potential for assets to beused as sources of liquidity to meet uncertainfuture cash needs, effective liquidity managersuse additional ‘‘liquid asset’’ summary measuresthat are customized to take into account theability (or inability) to convert assets into cashor borrowed funds. Such measures attempt tosummarize the potential for sale, securitization,or use as collateral of different types of assets,subject to appropriate scenario-specific haircuts.Such measures also attempt to recognize theconstraints on potential securitization and onthose assets that have already been pledged ascollateral for existing borrowings. Examples ofthese measures include—

• marketable securities (as determined by theassessment of cash-flow, accounting, andhaircut considerations discussed in the previ-ous section) to total securities;

• marketable securities as a percent of totalassets;

• marketable assets (as determined by theassessment of cash-flow, accounting, andhaircut considerations discussed in the previ-ous section) to total assets;

• pledgable assets (e.g., unpledged securitiesand loans) as a percent of total assets;

• pledged securities (or pledged assets) to totalpledgable securities (or pledgable assets);

• securitizable assets to total assets (sometimescomputed to include some assessment of thetime frame that may be involved); and

• liquid assets to total assets with the measure ofliquid assets being some combination ofshort-term assets, marketable securities, andsecuritizable and pledgable assets (ensuringthat any pledged assets are not double-counted).

Relative stability or volatility of liabilities as asource of funding. Summary measures used to

assess the relative stability or volatility ofliabilities as sources of funding often start withassessments of the maturity of liabilities andtheir ability to be ‘‘rolled-over’’ or renewedunder both normal business and potentiallyadverse circumstances. These measures alsorepresent an attempt to summarize and charac-terize the use of actual and potential sources offunds, which are estimated in more-detailedcash-flow-projection worksheets. In fact, properconstruction of many of these summarymeasures requires the same analytical assessmentsrequired for cash-flow projections. Such mea-sures attempt to gauge and array the relativesensitivity and availability of different sourcesof funds on the basis of the anticipatedbehavior of various types of transactions,business activities, funds providers, or otherattributes.

Given the difficulties involved in portrayingfunding sources across the entire continuum ofstability and volatility characteristics, alongwith the complexity of overlaying alternativecontingent scenarios on such portrayals, somecommon summary measures attempt to groupfunding sources as falling on one side or theother of this continuum. Financial ratios thatattempt to portray the extent to which aninstitution’s funding sources are stable include—

• total deposits as a percent of total liabilities ortotal assets;

• insured deposits as a percent of total deposits;• deposits with indeterminate maturities as a

percent of total deposits; and• long-term liabilities (defined as maturing

beyond a specified time period) to totalliabilities.

These measures necessarily employ assump-tions about the stability of an institution’sdeposit base in an attempt to define a set ofrelatively stable or core funding sources. Liquid-ity managers and examiners should take care inconstructing their estimates of stable or coreliabilities for use in such measures. This cautionhas become especially important as changes incustomer sophistication and interest-rate sensi-tivity have altered behavioral patterns and,therefore, the stability characteristics tradition-ally assumed for retail and other types ofdeposits traditionally termed ‘‘core.’’ As aresult, examiners, liquidity managers, and otherparties should use more-granular breakouts offunding sources to assess the relative stability of



deposits and should not place undue reliance onstandardized traditional measures of core depos-its. Breakouts that use such a greater granularityinclude—

• various breakouts of retail deposits to totaldeposits based on product type (MMDA,demand deposit, savings account, etc.) andcustomer segmentation to total deposits orliabilities;

• breakouts of various types of institutionaldeposits (e.g., collateralized deposits ofmunicipal and government entities) as apercent of deposits; and

• various breakouts of brokered deposits (bysize, types of fund providers, and maturity).

At the other end of the stability/volatilitycontinuum, some summary measures focus onidentifying those sources of funding that need tobe rolled over in the short term under normalbusiness conditions and those whose rollover orusage in the future may be especially sensitiveto institution-specific contingent liquidity events.These measures include—

• short-term liabilities (defined as fund sourcesmaturing within a specified time period, suchas 3 months, 6 months, or 1 year) as a percentof total liabilities;

• short-term brokered deposits as a percent oftotal deposits;

• insured short-term brokered deposits as apercent of total deposits;

• purchased funds (including short-term liabilitiessuch as fed funds purchased, repos, FHLBborrowings, and other funds raised insecondary markets) as a percent of totalliabilities;

• uncollateralized purchased funds as a percentof total liabilities; and

• short-term purchased funds to total purchasedfunds.

When computing measures to assess theavailability of potential sources of funds undercontingent liquidity scenarios, institutions mayadjust the carrying values of their liabilities inorder to develop best estimates of availablefunding sources. Similar to the haircuts appliedwhen assessing marketable securities and liquidassets, such adjustments endeavor to identifymore-realistic rollover rates on current andpotential funding sources.

Balance between funding needs and sources.Measures used to assess the relationship betweenactual or potential funding needs and fundingsources are constructed across a continuum thatarrays both the tenor or relative liquidity ofassets and the potential volatility or stability ofliabilities. Many of these measures use conceptsdiscussed earlier regarding the liquidity of assetsand the relative stability or volatility of liabili-ties as funding sources. Some measures expressvarious definitions of short-term liquid assets tototal liabilities or alternative definitions ofvolatile or stable liabilities to total assets. Suchmeasures may include—

• net short-term liabilities (short-term liabilitiesminus short-term assets) as a percent of totalassets;

• stable deposits as a percent of total assets;• total purchased funds as a percent of total

assets;• uncollateralized borrowings as a percent of

total assets; and• liquid assets as a percent of total liabilities.

Other measures attempt to identify therelationships between different classificationsof liquid or illiquid assets and stable or volatileliabilities. Exhibit 6 provides a conceptualschematic of the range of relationships that areoften addressed in such assessments.

Some commonly used summary liquiditymeasures and ratios focus on the amount ofdifferent types of liquid assets that are funded byvarious types of short-term and potentiallyvolatile liabilities (upper-left quadrant of exhibit6). One of the most common measures of thistype is the ‘‘net short-term position’’ (used bysome NRSROs). Liquidity managers, banksupervisors, and rating agencies use this mea-sure to assess an institution’s ability to meet itspotential cash obligations over a specifiedperiod of time. It is computed as an institution’sliquid assets (incorporating appropriate haircutson marketable assets) minus the potential cashobligations expected over the specified timeperiod (e.g., 3 months, 6 months, or 1 year).Other measures used to assess the relationshipor coverage of potentially volatile liabilities byliquid assets include—

• short-term investments (defined as invest-ments maturing within a specified time period,such as 3 months, 6 months, or 1 year) as apercent of short-term and potentially volatile



liabilities; and• short-term investments (defined as invest-

ments maturing within a specified timeperiod, such as 3 months, 6 months, or 1year) as a percent of short-term liabilities(defined as liabilities maturing within aspecified time period, such as 3 months, 6months, or 1 year).

Other summary liquidity measures take amore expansive approach to assessing thecontinuum of liquid assets and volatile liabilitiesby including more items or expanding thebreadth of analysis. Such measures include—

• liquid assets (defined as a combination ofshort-term assets, marketable securities, andsecuritizable and pledgable assets—ensuringthat any pledged assets are not double-counted—over a certain specified time frame)as a percent of liabilities judged to be volatile(over the same time period);

• liquidity-surplus measures, such as liquidassets minus short-dated or volatile liabilities;and

• liquid assets as a percent of purchased funds.

Other common summary measures of liquid-

ity focus on the potential mismatch of usingshort-term or potentially volatile liabilities tofund illiquid assets (upper-right-hand quadrantof exhibit 6). Often these measures factor onlythose volatile liabilities in excess of short-termand highly liquid assets or marketable invest-ment securities into this assessment. Suchvolatile-liability-dependence measures provideinsights as to the extent to which alternativefunding sources might be needed to fundlong-term liquidity needs under adverse liquid-ity conditions. These measures include—

• net short-term noncore-funding-dependencemeasures, such as short-term volatile fundingminus short-term investments as a percent ofilliquid assets; and

• net volatile-funding-dependence measures,such as volatile funding minus liquid assets asa percent of illiquid assets.

Another set of summary liquidity ratios canbe constructed to focus on the extent to whichilliquid assets are match-funded by stableliabilities (lower-right quadrant of exhibit 6).Common examples of such measures includetraditional loan-to-deposit ratios (which incor-rectly assume all deposits are stable) and

Exhibit 6—Relationships Between Liquid or Illiquid Assets and Stable orVolatile Liabilities

Liquid AssetCoverage of Volatile

Liabilities

Matching of IlliquidAssets with Stable

Liabilities

Liquid AssetsFunded by Stable

Liabilities

Illiquid AssetsFunded by Volatile

Liabilities

Liabilities

Volatile

Stable

Asset Liquidity/Marketability/MaturityLiquid Illiquid



loan-to-core-deposit ratios (which often take aproduct-specific approach to defining the stabil-ity of certain types of deposits). However, sincesuch traditional measures necessarily require theuse of broad assumptions on the stability ofdeposits, they should not be relied on to providemeaningful insights regarding potential fundingmismatches between stable funding sources andilliquid assets.

One meaningful measure used to gauge suchrelationships is the concept of ‘‘net cash capital’’(which is also used by some NRSROs). Thismeasure is the dollar amount by which stablesources of funds exceed illiquid assets; it can becomputed as a percent of total assets to facilitatecomparisons across institutions. In addition, itcan be computed using customized assessmentsof the relative stability of different types ofliabilities and the ability to convert assets intocash through sale, securitization, or collateral-ization. For example, firms may choose toexclude portions of loans sold regularly (e.g.,loans conforming to secondary-market stan-dards) as illiquid assets, or they may choose toinclude long-term debt as stable liabilities.

A final set of summary measures are used byliquidity managers to optimize the liquidityprofiles of their institutions. These measuresassess the extent to which relatively stablefunding sources are used to fund short-term andliquid assets (lower-left quadrant of exhibit 6).Since short-term liquid assets generally entailrelatively lower returns than longer-term less-liquid assets, measures assessing such potentialmismatches focus liquidity managers on the costof carrying liquid assets.

V. Liquidity-MeasurementConsiderations for Bank HoldingCompanies

Because of their unique liquidity-risk profile,bank holding companies (BHCs) confront somedifferent liquidity-risk management issues thando banks. BHCs cannot accept deposits, pur-chase fed funds, or borrow from the discountwindow; as a result, they are more reliant thanbanks on more-credit-sensitive wholesale fund-ing sources. Accordingly, BHCs depend ondifferent sources of funds and have a higherliquidity-risk profile than that of banks. Thenature of this risk profile depends greatly on thesize and complexity of the firm. Small one-bank

shell holding companies face significantly sim-pler liquidity-risk profiles than do multibankholding companies and those with nonbanksubsidiaries.

The flow of funds between a BHC and itssubsidiaries introduces challenges for liquiditymanagers at both the bank and the BHC. Forexample, BHCs may place cash with their banksubsidiaries. These cash deposits may representthe temporary placement of idle funds, or theymay constitute a more permanent source of bankfunding. In the latter case, the cash deposits maynot be a ready source of liquidity for the BHC.As a result, liquidity managers at both the bankand the BHC level should fully assess the abilityof the subsidiary bank to replace the funds in themarketplace through other sources if suchdeposits are required by the BHC.

A BHC may also have loans or debtoutstanding to its subsidiaries, which may havean impact on the parent company’s liquidityprofile. A large, negative net short-term positionmay result if these loans cannot be repaidreadily by the subsidiaries in the event ofliquidity needs at the holding company. Asubsidiary may be unable to readily repay loansor debt from its parent if it does not haveadequate sources of alternative liquidity or if therepayment of the loan would breach regulatoryrequirements or covenants between the subsidi-ary and other lenders.

BHCs may enter into sweep agreements withthe customers of a nonbank subsidiary to investthose customers’ excess funds on an overnightbasis, and those funds are usually placed with aninsured depository institution subsidiary. Inview of the extremely short-term maturity ofthis funding source, care should be taken toinvest the proceeds in short-term, highly liquid,readily marketable assets. Use of sweep-accountproceeds to finance longer-term assets may leadto serious liquidity mismatches that compromisesafety and soundness.

Liquidity support for the BHC may be avail-able from nonbank subsidiaries of the BHC.Nonbank subsidiaries may have fewer regula-tory restrictions on ‘‘upstreaming’’ dividends totheir parent companies. Nonetheless, they mayalso have significant creditor restrictions orlimited liquidity available to upstream.

Commercial paper issuances are often impor-tant sources of funding liquidity for BHCs.Commercial paper (CP) is a short-term,fixed-maturity, unsecured promissory note issuedin the public markets as an obligation of the



issuer. The rate of interest paid on CPgenerally tracks the rates paid on other moneymarket instruments. Most CP is issued withmaturities of less than 270 days, the thresholdunder which SEC registration is not required.Most investors limit purchases of CP to ratedor high-quality paper. A superior CP ratingdepends in part on the adequacy of the issuer’sshort-term liquidity. To obtain a superiorrating, an issuer may need to obtain creditsupport to guarantee payment. Credit supportgenerally takes the form of a letter of credit orthe collateralization of the CP issuance withhigh-quality assets. The costs of providing thiscredit support, including the opportunity costsof pledging high-quality assets, should beconsidered in determining the cost-effectivenessof this source of funding liquidity.

CP proceeds are used by BHCs to fund avariety of activities. However, care must betaken to ensure CP and other short-term debtare not used to fund long-term assets,corporate dividends, or current expenses.Maintaining a high CP rating is important, asCP investors are credit-sensitive. Losing accessto the CP market can seriously compromise thefunding of the operations of the BHC, given itslimited sources of alternative liquidity. BHCsshould endeavor to ensure that the distributionof their CP is as broad as possible so that thefailure of one holder to continue to participatein the CP program does not place the companyin a liquidity squeeze, thus forcing the BHC toresort to more-drastic and expensive fundingsources.

Liquidity managers and supervisors shouldmonitor the extent to which a BHC’s CPprogram is supported by backup lines of creditfrom unaffiliated banks to cover any unexpectedCP runoff. Commitments for lines of creditshould be in writing, and the impact of any‘‘material adverse change clauses’’ or restrictivecovenants should be considered carefully. Linesof credit should be structured to be immediatelyavailable in the event that access to the CPmarkets is interrupted. Owing to the potentialfor contagion effects between the BHC and banksubsidiaries, BHCs’ frequent or extended use ofbackup lines of credit for liquidity purposes mayunintentionally compromise perceptions of thesafety and soundness of the subsidiarybank(s)—a particular concern if the bank doesnot have a significant source of stable liabilities.Holding companies may look to backup lines ofcredit as an ultimate source of liquidity. In such

cases, market perception is critical for accessingbackup lines. The drawdown of a liquidityfacility may be a signal to the market that thecompany is facing funding difficulties through-out the consolidated organization and couldraise questions about the funding stability of itsbanks. These concerns can be ameliorated to theextent that the subsidiary banks are largelycore-funded. Conversely, if the subsidiary banksdo not have ample sources of stable funds, theparent company’s reliance on backup lines maybe misplaced.

A. Liquidity Measurement for BHCs

Cash-flow projections under alternative sce-narios are critical liquidity measures at alllevels within a complex BHC structure, suchas a multibank holding company or a firm withnonbank subsidiaries. In addition, several typesof liquidity measures discussed in the previoussections can be adapted for use at the BHClevel—particularly measures of the concentra-tion of funding sources and needs based on themarketability of assets or the relative stabilityof liabilities. However, as a result of the uniquefunding structure and liquidity-risk profile ofBHCs, liquidity-risk managers, supervisors,rating agencies, and other parties often usesummary measures customized for BHCs. Theimportance of debt ratings to institutions thathave publicly rated debt issuances meansliquidity managers at such institutions shouldbe fully knowledgeable of the measures ratingagencies use to assess the liquidity of theholding company and its subsidiaries.

One common type of summary measure usedin analyzing holding company liquidity is theevaluation of the company’s ability to self-fundits cash obligations for a minimum period ofone year. The excess of liquid assets overpotential cash demands (net short-term position)expressed as a percentage of consolidatedearnings is one such measure. It providesinsights as to the extent to which a deficiencycould be addressed by upstreamed dividendsfrom subsidiaries to the parent. In such analyses,regulatory and creditor limitations on dividendpayments from subsidiaries must be taken fullyinto consideration. The liquid-assets componentof this measure includes cash and deposits inbanks, securities (net of haircuts), and interestincome and fees generated at the holdingcompany. Liquid assets may be adjusted to



include dividends from nonbank subsidiariesthat are not subject to regulatory or creditorlimitations and are reasonably expected to bepaid within the year. Cash demands include allshort-term debt, the portion of long-term debtmaturing within one year, and all operatingexpenses at the holding company. Cash demandsare netted against the holding company’sunpledged liquid assets to arrive at a netshort-term position. This net short-term positionis then compared with the net income generatedon a consolidated basis, in order to provide arough indication of the scope of any potentialliquidity shortfall. If the ratio is positive, itindicates that a sale of the holding company’sliquid assets would be sufficient to meet its cashdemands over the next year. If the ratio isnegative, potential cash demands outstrip liquidassets, and the holding company may have todevelop a strategic plan to address the potentialliquidity shortfall.

Other common types of measures used toassess the liquidity of BHCs are fixed-charge-coverage ratios. The fixed-charge-coverage ratiomeasures the parent holding company’s abilityto pay its fixed contractual obligations tocreditors (including the payment of taxes) andpreferred stockholders. The ratio is calculated asafter-tax income, plus an add-back of interestand lease expense (already deducted fromafter-tax income), as a percentage of fixedcontractual obligations to creditors and pre-ferred stockholders. The common-stock cash-dividend-coverage ratio measures the ability ofthe parent to continue to pay cash dividends. Itis calculated as after-tax income minus fixedcontractual obligations as a percentage of thecommon-stock-dividend payout. Coverage ratiosin excess of 1:1 are critical for both of theseratios.

Declining trends in these and other liquidityratios may signal a need for the company tocurtail common-stock dividends or take otheraction to bolster liquidity. Supervisors should beaware that BHCs may bolster these ratiosthrough increasing the dividends paid by sub-sidiaries. While subsidiary dividends are animportant component of earnings for manyBHCs, dividends upstreamed from an insuredinstitution’s subsidiary should be reasonable andprudent in light of the subsidiary’s financialcondition and capital position. If dividends froman insured institution’s subsidiary are deemedexcessive in light of the subsidiary’s resources,

a written program of corrective action may berequired.

APPENDIX 2—SUMMARY OFMAJOR LEGAL ANDREGULATORY CONSIDERATIONS

The following discussions summarize some ofthe major legal and regulatory considerationsthat should be taken into account in managingthe liquidity risk of banking organizations. Thediscussions are presented only to highlightpotential issues and to direct bankers andsupervisors to source documents on those issues.

A. Federal Reserve Regulation A

Federal Reserve Regulation A addresses bor-rowing from the discount window. Rules defin-ing eligible collateral can be found in thisregulation.

B. Federal Reserve Regulation D

Federal Reserve Regulation D addresses requiredreserves for deposits. One portion of theregulation, however, restricts the type of eligiblecollateral that can be pledged for repurchase-agreement borrowings.

C. Federal Reserve Regulation F

Federal Reserve Regulation F imposes limits oninterbank liabilities. This regulation implementssection 308 of the Federal Deposit InsuranceCorporation Improvement Act (FDICIA). Banksthat sell funds to other banks must have writtenpolicies to limit excessive exposure, mustreview the financial condition or credit rating ofthe debtor, must have internal limits on the sizeof exposures that are consistent with the creditrisk, may not lend more than 25 percent of theircapital to a single borrowing bank, and mustundertake other steps.

Banks that borrow federal funds or otherborrowings from correspondent banks may find,as a result of the seller’s compliance withRegulation F, that the amount they may borrowhas suddenly declined as a result of a reduction



in their credit rating or credit quality. RegulationF may make it harder for a bank to useborrowings as a liquidity source for a bank-specific liquidity crisis.

D. Federal Reserve Regulation W

Federal Reserve Regulation W governs transac-tions between an insured bank or thrift and itsaffiliates. The regulation establishes a consis-tent and comprehensive compilation of require-ments found in section 23A of the FederalReserve Act, 70 years of Board interpretationsof section 23A, section 23B of the FederalReserve Act, and portions of the Gramm-Leach-Bliley Act of 1999. Covered transactionsinclude purchases of assets from an affiliate,extensions of credit to an affiliate, investmentsin securities issued by an affiliate, guaranteeson behalf of an affiliate, and certain othertransactions that expose the member bank to anaffiliate’s credit or investment risk. Derivativestransactions and intraday extensions of creditare also covered.

The intentions of the regulation are (1) toprotect the depository institution, (2) to ensurethat all transactions between the bank and itsaffiliates are on terms and conditions that areconsistent with safe and sound banking prac-tices, and (3) to limit the ability of a depositoryinstitution to transfer to its affiliates the subsidyarising from the institution’s access to thefederal safety net. The regulation achieves thesegoals in four major ways:

1. It limits a member bank’s covered transac-tions with any single affiliate to no morethan 10 percent of the bank’s capital stockand surplus, and limits transactions with allaffiliates combined to no more than 20 per-cent of the bank’s capital stock and surplus.

2. It requires all transactions between a memberbank and its affiliates to be on terms andconditions that are consistent with safe andsound banking practices.

3. It prohibits a member bank from purchasinglow-quality assets from its affiliates.

4. It requires that a member bank’s extensionsof credit to affiliates and guarantees on behalfof affiliates be appropriately secured by astatutorily defined amount of collateral.

Section 23B protects member banks by

requiring that certain transactions between thebank and its affiliates occur on market terms,that is, on terms and under circumstances thatare substantially the same, or at least asfavorable to the bank, as those prevailing at thetime for comparable transactions with unaffili-ated companies. Section 23B applies the market-terms restriction to any covered transaction (asdefined in section 23A) with an affiliate as wellas certain other transactions, such as (1) any saleof assets by the member bank to an affiliate,(2) any payment of money or furnishing ofservices by the member bank to an affiliate, and(3) any transaction by the member bank with athird party if an affiliate has a financial interestin the third party or if an affiliate is a participantin the transaction.

Liquidity-risk managers working in banksthat have affiliates must give careful attention toRegulation W, which addresses transactionsbetween banks and their affiliates. In the normalcourse of business, the prohibition on unsecuredfunding can tie up collateral, complicate collat-eral management, and restrict the availability offunding from affiliates. In stressed conditions,all of those problems—plus the size limit andthe prohibition on sales of low-quality assets toaffiliates—effectively close down many transac-tions with affiliates.

E. Statutory Restriction of FHLBAdvances

The Federal Home Loan Banks (FHLBs) pro-vide a number of different advance programswith very attractive terms to member banks.Many banks now use the FHLBs for termfunding. The FHLBs are very credit-sensitivelenders.

A federal regulation (12 CFR 935, FederalHousing Finance Board—Advances) requiresthe FHLBs to be credit-sensitive. In addition tomonitoring the general financial condition ofcommercial banks and using rating informationprovided by bank rating agencies, the FHLBshave access to nonpublic regulatory informa-tion and supervisory actions taken againstbanks. The FHLBs often react quickly,sometimes before other funds providers, toreduce exposure to a troubled bank by not roll-ing over unsecured borrowing lines. Dependingon the severity of a troubled bank’s condition,even the collateralized funding program may



be discontinued or withdrawn at maturitybecause of concerns about the quality or relia-bility of the collateral or other credit-relatedconcerns. Contractual provisions requiringincreases in collateral may also be invoked.Any of these changes in FHLB-loan avail-ability or terms can create significant liquidityproblems, especially in banks that use largeamounts of short-term FHLB funding.

F. Statutory Restriction on the Use ofBrokered Deposits

The use of brokered deposits is restricted by12 CFR 337.6. Well-capitalized banks mayaccept brokered deposits without restriction.Adequately capitalized banks must obtain awaiver from the FDIC to solicit, renew, or rollover brokered deposits. Adequately capitalizedbanks must also comply with restrictions on therates that they pay for these deposits. Banks thathave capital levels below adequately capitalizedare prohibited from using brokered deposits. Inaddition to these restrictions, banking regulatorshave also issued detailed guidance, discussed insection H below, on the use of brokereddeposits.

G. Legal Restrictions on Dividends

A number of statutory restrictions limit theamount of dividends that a bank may pay to itsstockholders. As a result, a bank holding com-pany that depends on cash from its bank sub-sidiaries can find this source of funds limited or

closed. This risk is particularly significant forbank holding companies with nonbank sub-sidiaries that require funding or debt service.

H. Restrictions on Investments ThatAffect Liquidity-Risk Management

Interagency guidance issued in 1998 by theFFIEC, ‘‘Supervisory Policy Statement onInvestment Securities and End-User Activi-ties,’’ contains provisions that may affectliquidity and liquidity management. (SeeSR-98-12.) The following points summarizesome of these potential impacts, althoughreaders should review the entire rule formore-complete information.

1. When banks specify permissible instrumentsfor accomplishing established objectives,they must take into account the liquidity ofthe market for those investments and theeffect that liquidity may have on achievingtheir objective.

2. Banks are required to consider the effects thatmarket risk can have on the liquidity ofdifferent types of instruments under variousscenarios.

3. Banks are required to clearly articulatethe liquidity characteristics of the instru-ments they use to accomplish institutionalobjectives.

In addition, the policy statement specificallyhighlights the greater liquidity risk inherent incomplex and less actively traded instruments.

