Seal of the Board of Governors of the Federal Reserve System
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C.  20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 07-5
April 17, 2007

TO THE OFFICER IN CHARGE OF SUPERVISION
AT EACH FEDERAL RESERVE BANK
SUBJECT:  Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities

The Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the Securities and Exchange Commission recently issued the attached Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities.1  The statement is supervisory guidance that addresses risk management principles that should assist financial institutions to identify, evaluate, and manage the heightened legal and reputational risks that may arise from their involvement in complex structured finance transactions (CSFTs). Because CSFTs are typically conducted by a limited number of large financial institutions, the statement will not affect or apply to the vast majority of financial institutions, including most small institutions.2  Attachment 1 provides the interagency statement. Attachment 2 provides the accompanying Federal Register notice.

Background

The statement was developed on an interagency basis to formalize supervisory expectations for the internal control structure and risk management procedures that institutions should have in place to manage the legal and reputational risks arising from CSFTs. In recent years, certain large financial institutions have engaged in CSFTs that were used to misrepresent the true financial condition of public companies to investors and regulators. These financial institutions incurred significant legal costs and reputational harm as a result of their involvement in these transactions.

The Federal Reserve System, OCC and SEC have taken enforcement actions related to CSFT activities.3  These agencies also have conducted special reviews of several large financial institutions engaged in CSFTs and have focused on the CSFT activities of certain financial institutions in the normal course of the supervisory process. These reviews indicated that many of the large financial institutions engaged in CSFTs have taken meaningful steps in recent years to improve their control infrastructure relating to CSFTs. Against this background, the Federal Reserve, together with the other agencies, issued the attached principles-based statement outlining the types of risk management processes and internal controls that may help institutions in their identification, review, and approval processes for “elevated risk CSFTs,” defined as those CSFTs that may present heightened levels of legal or reputational risk to the institution.

Key Elements of the Statement

The statement provides that financial institutions engaged in CSFTs should have procedures to identify elevated risk CSFTs and to conduct a heightened level of due diligence for these transactions as part of their transaction and new product approval controls. The statement recognizes that the level and amount of risk that a CSFT presents to an institution may vary according to the role that the institution plays in the transaction. The statement includes examples of transactions that an institution may determine warrant additional scrutiny.

A financial institution’s procedures should provide that elevated risk CSFTs are reviewed and approved by appropriate levels of management and control personnel, including control function representatives from outside the business line, who should take appropriate steps to address risks that CSFTs present to the institution. Specifically, the statement provides that an institution should decline to participate in an elevated risk CSFT if, after conducting appropriate due diligence and taking appropriate steps to address the risks from the transaction, the institution determines that the transaction presents unacceptable risk to the institution or would result in a violation of applicable laws, regulations, or accounting principles. The statement also describes the documentation practices that institutions should have in place to monitor and manage CSFT risks.

In addition, the statement describes some of the key risk management procedures and internal controls for managing the elevated risks that may be associated with CSFTs. The statement provides that the board of directors and senior management should establish a “tone at the top” and formalized policies that send a strong message throughout the institution about the importance of compliance with the law and overall good business ethics. The statement also describes the training, reporting, and audit mechanisms that institutions should have in place for elevated risk CSFTs.

Implementation

Federal Reserve Banks are asked to distribute the attached interagency statement to relevant supervisory and examination staff and to Federal Reserve-supervised financial institutions engaged in CSFTs. As noted above, over the past several years, examiners have conducted reviews and evaluations of certain institutions’ management practices for CSFT activities. The principles of the statement should continue to be reflected in appropriate supervisory plans. Further, examiners should be observant of new trends and practices in CSFT activities at financial institutions and institutions’ risk management practices, including board and senior management oversight, related to those activities.

Questions pertaining to the statement should be directed to Sabeth Siddique, Assistant Director, (202) 452-3861, or Virginia Gibbs, Senior Supervisory Financial Analyst, (202) 452-2521, Division of Banking Supervision and Regulation; or Kieran Fallon, Assistant General Counsel, (202) 452-5270, or Anne Zorc, Senior Attorney, (202) 452-3876, Legal Division.

Steven M. Roberts
Deputy Director


Attachments:
  1. Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities (62 KB PDF)
  2. Federal Register notice ( 85 KB PDF  |  Text )


Notes:
  1. 72 FR 1372, January 11, 2007.  Return to text
  2. Financial institutions refers to bank holding companies (other than foreign banks), national banks, state banks, federal and state savings associations, savings and loan holding companies, U.S. branches and agencies of foreign banks, and SEC-registered broker-dealers and investment advisors.  Return to text
  3. In these enforcement actions, certain large institutions were required to revise their risk management practices where examiners found failures by the institutions to identify those transactions that presented heightened legal and reputational risk, particularly in cases where transactions were used to facilitate a customer’s accounting or tax objective that resulted in misrepresenting the company’s true financial condition to the public and regulators.  Return to text


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