Clarification on the Responsibilities of the Board of Directors February 26, 2021: As described in SR letter 21-4/ CA letter 21-2, "Inactive or Revised SR Letters Related to Federal Reserve Expectations for Boards of Directors," this SR letter was revised as of February 26, 2021 to better reflect the Federal Reserve's guidance for boards of directors in SR letter 21-3 / CA letter 21-1, "Supervisory Guidance on Board of Directors' Effectiveness," and SR letter 16-11, "Supervisory Guidance for Assessing Risk Management at Supervised Institutions with Total Consolidated Assets Less than $100 Billion." No other material changes were made to this letter. TO THE OFFICER IN CHARGE OF SUPERVISION AT EACH FEDERAL RESERVE BANK
Within the last several months, some bank holding
companies whose subsidiaries act as investment advisers to
proprietary money market mutual funds have provided financial
support to their respective funds to offset declines in portfolio
values resulting from reductions in the market value of complex
investment products such as high risk CMOs and structured
securities.1 A few state member banks have had to address similar
circumstances with respect to their trust departments' common
investment funds (CIFs) that are advised by the bank.
These events underscore the importance to banking
organizations acting as investment advisers of having appropriate
policies and procedures that address the management and operations
of investment adviser activities. These policies and procedures
should assure that the adviser is aware of the risks associated
with the investment products it recommends to its client funds,
particularly with respect to complex derivative products,
structured notes, and other high-risk investments. Further, the
adviser should determine that investment products are appropriate
and consistent with the funds' prospectuses and stated objectives.2
Banking organizations that engage in investment adviser
activities should have policies and procedures for addressing,
monitoring, and controlling all significant risks associated with
the advisory activity, including legal, operating, reputational,
fiduciary, and financial risks. The latter includes the possible
exposure associated with providing direct financial support to
advised funds. Losses incurred by the advised fund could also pose
an indirect financial risk to the advising banking organization if
depositors or other providers of funds were to lose confidence in
the organization, leading to possible deposit withdrawals or the
termination of credit lines. Before commencing the activity of
acting as investment adviser, banking organizations should assess
all significant risks associated with the activity and should
establish policies and systems to monitor and control such risks.
As a result of recent events, it is appropriate to
reiterate the importance of the Federal Reserve's established bank
and bank holding company3 supervision policies and examination
procedures that address the risks associated with acting as an
investment adviser. Reserve Banks are instructed to continue to
monitor carefully investment adviser activities and, where
necessary, to enhance their review and assessment of bank and bank
holding company policies, procedures and internal controls in the
investment adviser function during the examination of banks, bank
holding companies, or nonbank subsidiaries that act as investment
advisers to mutual funds or CIFs.
Review of Investment Adviser Activities
Examiners should give special attention to the
organization's policies and procedures pertaining to investment
adviser activities and to contingencies that could arise with this
activity. The Federal Reserve's examination guidelines and related
procedures pertaining to investment advisory activities of bank
holding companies and their nonbank subsidiaries and state member
banks' trust departments are contained in the Bank Holding Company
Supervision Manual (Section 3130)4. These examination procedures
indicate that an adviser is obligated to provide advice that is
consistent with the stated investment objectives as set forth in
the prospectus and with the liquidity needs applicable to a fund or
account.
In addition, a recent supervisory letter on structured
securities5 which focused on the use of these instruments by
banking organizations in trading, investment, or trust operations,
emphasized that failure of management to understand adequately the
dimensions of the risks in complex derivative products can
constitute an unsafe and unsound practice. Similarly, an
investment adviser is expected to understand fully the risks
involved in any investment product recommended to its client funds
and how these risks relate to the funds' stated investment
objectives.
In this regard, examiners should determine whether an
investment adviser has policies and procedures to ensure that the
fund portfolios it advises are operated in a manner fully
consistent with the funds' objectives or, if applicable, SEC
requirements. Investment advisers should have policies and
procedures that subject advised funds to appropriate "stress
testing" or contingency planning on a periodic basis in an effort
to determine whether the investments will continue to conform to
the funds' objectives in periods of market uncertainty and
volatility.
Examiners should also determine that the investment
adviser has policies and procedures in place that ensure compliance
with applicable laws and SEC requirements such as those pertaining
to the permissibility of certain high risk investments for money
market mutual funds. Further, the adviser should have procedures
to ensure that management of advised funds is fully informed of the
risk character of the overall portfolio, including the presence of
any complex investment products or other high risk investments.
This is necessary to ensure that the funds' management and their
distributors are able to make any necessary disclosures to
investors in conformance with SEC requirements.
With regard to the inspection of the parent bank holding
company, examiners should determine that the holding company's
senior management have policies and
procedures in place to monitor the activities of investment adviser
subsidiaries to ensure that the risks associated with the conduct
of this activity are not in conflict with the parent company's
overall risk tolerance parameters. The parent should be able to
assess at all times the extent of its exposure to financial,
litigation, or reputational risk, if any, that stems from the
investment advisory activities conducted by subsidiaries, and
whether any such exposure would have a material adverse effect on
the parent company's ability to act as a source of strength to its
banks. In addition, the parent bank holding company should assure
that the internal audit function monitors the activities of the
investment adviser for compliance with any limits or internal
controls that are intended to restrict its activities.
The examination frequency of investment adviser
activities historically has been dependent on the volume and scope
of advisory activities and the results of previous Reserve Bank (or
SEC) examinations. Given the significance of investment advisory
activities and the potential for off-balance sheet risk, such
activities should generally be examined as part of the bank holding
company's or bank's annual safety and soundness or trust
examination. Particular attention should be focused on an
investment adviser that places orders directly on behalf of a fund,
or provides other portfolio management services such as safekeeping
of securities or recordkeeping. As in the past, Reserve Banks
should consider using trust examiners to conduct or participate in
examinations and inspections of investment advisory activities
because of their familiarity with the subject.6
It is requested that you distribute a copy of this letter
to bank holding companies, state member banks, and state-licensed
U.S. branches and agencies of foreign banks in your district that
are engaged or intend to engage in the activity of providing
investment advisory services to mutual funds or trust department
CIFs. Should you have any questions regarding this letter or the
examination of investment advisory activities, please contact
either Howard Amer (x2958) or Angela Desmond (x3497).
Director
Cross Reference: SR 81-216
Footnotes 1. Some bank holding companies have chosen, for business reasons, to provide the financial support necessary to maintain the $1.00 per share net asset value of proprietary money market mutual funds even though the companies were under no legal obligation, barring a breach of fiduciary responsibility, to do so. In general, the support provided was treated as an expense by the bank holding companies. Return to text 2. In a June 16, 1994 letter to the CEOs of large money market funds, the Chairman of the SEC strongly encouraged the management of every fund that holds derivative instruments to take steps that will ensure the proper understanding and effective management of derivatives risk. He also indicated that fund managers must implement policies to ensure that use of derivatives is fully consistent with the fund's investment objectives. In a June 30, 1994 follow-up letter to the ICI, SEC staff advised that funds should dispose of five types of structured securities, specifically, inverse floaters, cost-of-funds index floaters, constant-maturity Treasury floaters, dual-index floaters and range floaters. Return to text 3. This supervisory letter is applicable throughout to foreign banking organizations and their U.S. branches and agencies. Return to text 4. See SR 91-4 (SA), dated February 8, 1991, which also incorporated previously issued supervisory policy and procedures contained in earlier supervisory letters. Return to text 5. SR 94-45, dated August 5, 1994. Return to text 6. See Section 3130.1.3 of the Bank Holding Company Supervision Manual and SR 88-11, dated April 28, 1988. Return to text |
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