Supervisory Guidance on Complex Wholesale Borrowin

SupervisoryGuidanceonComplexWholesaleBorrowingsOverthepastseveralyears,commercialbankshavebecomeincreasinglyreliantonwholesaleborrowingsobtainedfromanumberoffinancialintermediaries,includingFederalHomeLoanBanks,othercommercialbanks,andsecuritiesfirms.Theseborrowingsfrequentlyhaveattractivefeaturesandpricing,andcan,ifproperlyassessedandprudentlymanaged,enhanceabank'sfundingoptionsandassistincontrollinginterestrateandliquidityrisks.Amongthereasonsbanksusethesetypesofborrowingsisthattheinitialcostoffundsislowwhencomparedtootherliabilitieswithsimilarmaturities.Atthesametime,however,certainwholesaleborrowingshavebecomemorecomplex,andsomestructuresincludevarioustypesofembeddedoptions.1Ifnotthoroughlyassessedandprudentlymanaged,thesemorecomplexfundinginstrumentshavethepotentialovertimetosignificantlyincreaseabank'ssensitivitytomarketandliquidityrisks.Maturitymismatchesortheembeddedoptionsthemselvescan,insomecircumstances,adverselyaffectabank'sfinancialcondition,especiallywhenthetermsandconditionsoftheborrowingsaremisunderstood.Thegrowinguseofwholesaleborrowings,incombinationwiththerisksassociatedwiththecomplexstructuresofsomeoftheseborrowings,makesitincreasinglyimportantforbanksupervisorstoassesstherisksandriskmanagementprocessesassociatedwiththesesourcesoffunds.Thisletterprovidesadditionalsupervisoryguidanceforthereviewofcomplexwholesaleborrowingsthatsupplementsandexpandsuponexistinggeneralguidanceonbankfundingandborrowings.2Inadditiontothesoundpracticeguidanceregardingbankliabilitymanagementandfundingingeneral,supervisorsshouldtakethefollowingsteps,asappropriate,whenassessingabankwithmaterialamountsofwholesaleborrowings:1.Areviewofthebank'sborrowingcontractsforembeddedoptionsorotherfeaturesthatmayaffectthebank'sliquidityandsensitivitytomarketrisks.Inaddition,examinersshouldreviewthecollateralagreementsforfees,collateralmaintenancerequirements,includingtriggersforincreasesincollateral,andotherfeaturesthatmayaffectthebank'sliquidityandearnings.2.Anassessmentofbank'smanagementprocessesforidentifyingandmonitoringtherisksofthevarioustermsofeachborrowingcontract,includingpenaltiesandoptionfeaturesovertheexpectedlifeofthecontract.Examinersshouldreviewforevidencethatbankmanagementoranindependentthirdpartycompletedstresstestsbeforethebankenteredintotheborrowingagreementaswellasperiodicallythereafter.Ifthebankreliesuponindependentthirdpartytesting,examinersshouldverifythatmanagementreviewedandacceptedtheunderlyingassumptionsandtestresults.Inanycase,managementshouldnotrelysolelyonthewholesaler'sstresstestresults.Also,thestresstestsemployedshouldcoverareasonablerangeofcontractualtriggersandexternalevents,suchasinterestratechangesthatmayresultintheexerciseofembeddedoptionsorthebank'sterminationoftheagreement,whichmayentailprepaymentpenalties.Ingeneral,stresstestresultsshoulddepictthepotentialimpactofthesevariablesontheindividualborrowingfacility,aswellasontheoverallearningsandliquiditypositionofthebank.3.Anevaluationofmanagementprocessesforcontrollingrisks,includinginterestraterisksarisingfromtheborrowings,aswellasliquidityrisks.Propercontrolsincludecontingentfundingplansintheeventthatborrowingsorlinesareterminatedpriortotheoriginalexpectedmaturity,andhedgesorotherplansforminimizingtheadverseaffectsresultingfrompenaltiesorinterestratechangesandothertriggersforembeddedoptions.4.Adeterminationastowhethertheasset/liabilitymanagementcommitteeorboardofdirectors,asappropriate,isfullyinformedoftherisksandramificationsofcomplexwholesaleborrowingagreementspriortoengaginginthetransactionsaswellasonanongoingbasis.5.Adeterminationastowhetherfundingstrategiesregardingwholesaleborrowings,especiallythosewithoptionality,areconsistentwithboththeportfolioobjectivesofthebankandthelevelofsophisticationofthebank'sriskmanagement.Bankswithoutthetechnicalknowledgeandriskmanagementsystemssufficienttoadequatelyidentify,assess,monitor,andcontroltherisksofcomplexwholesaleborrowingsshouldnotusethisfunding.Relianceonwholesaleborrowingsisconsistentwithsafeandsoundbankingwhenmanagementunderstandstherisksoftheseactivitiesandhassystemsandproceduresinplacetoproperlymonitorandcontroltherisks.Supervisorsandexaminersshouldtakeappropriatefollow-upstepswithrespecttoinstitutionsthatutilizecomplexfundinginstrumentswithoutanadequateunderstandingoftherisksorwithoutproperriskmanagementsystemsandcontrols.Examinersshouldalsoseekcorrectiveactionwhenfundingmechanismsorstrategiesareinconsistentwithprudentfundingneedsandobjectives.ReserveBanksareaskedtoforwardthisSRlettertoallbankingorganizationssupervisedbytheFederalReserve.Shouldyouhaveanyquestions,callMollyS.Wassom,AssociateDirector(202/452-2305),JamesA.Embersit,AssistantDirector(202/452-5249),orRichardC.Watkins,SupervisoryFinancialAnalyst(202/452-3421).RichardSpillenkothenDirectorNotes:1.Wholesaleborrowingswithembeddedoptionsmayhavevariableinterestpaymentsoraveragelivesorredemptionvaluesthataredependentonexternalmeasuressuchasreferencerates,indexes,orformulas.Embeddedoptionsincludeputable,callable,convertible,andvariable