Originally published May 24, 2004
The SEC, FRB, FDIC, OCC and OTS (collectively, the "Agencies") issued a proposed interagency statement (the "Proposed Statement") concerning complex structured finance activities of financial institutions. The Proposed Statement describes the types of internal controls and risk management procedures that the Agencies believe will assist banks, bank holding companies, savings and loan associations, savings and loan holding companies and SEC-registered broker dealers and investment advisers to identify the risks associated with complex structured finance transactions. Comments on the Proposed Statement are due by July 18, 2004.
The Proposed Statement provides that financial institutions will need to define what constitutes a "complex structured finance transaction" and states that typically these transactions (a) expose a financial institution to elevated levels of market, credit, operational, legal or reputational risk, (b) consist of a non-standard structured product designed to meet specific financial objectives of a customer, (c) require participation by professionals from multiple disciplines within the financial institution, (d) may have significant fees or high returns in relation to the market and credit risks associated with the transaction, and (e) may use special purpose entities ("SPEs").
The Proposed Statement provides that financial institutions engaged in complex structured finance transactions should maintain comprehensive policies and procedures that provide for the identification, documentation, evaluation and control of the full range of credit, market, operational, legal and reputational risks associated with the transactions. Specifically, the Proposed Statement provides that the policies and procedures should at a minimum: (1) address the process for obtaining approval of a complex structured finance transaction at the financial institution; (2) identify the transactions that represent a new product and provide an internal approval process for the new product; (3) provide for the identification and evaluation of the legal and reputational risks related to the transaction; (4) for transactions with elevated risks, obtain information from the customer regarding accounting treatment, financial disclosures and customer objectives; (5) identify documentation standards; (6) establish internal reporting requirements; (7) identify procedures for periodic "independent" reviews of the transactions; (8) establish audit procedures; and (9) provide training on complex structured finance transactions.
In the joint release accompanying the Proposed Statement, the Agencies referenced regulatory actions against certain financial institutions that participated in complex structured finance transactions with Enron Corp. as an example of the substantial legal and reputational risks faced by financial institutions that participate in structured finance transactions designed or used for improper purposes. The Proposed Statement provides examples of transactions that may pose elevated reputational or legal risk, including transactions with questionable economic substance or business purpose or that are designed primarily to exploit accounting, regulatory or tax guidelines. The Proposed Statement also referred to a December 4, 2003 letter from the SEC’s Division of Market Regulation to the FRB and the OCC that identifies the circumstances under which a financial institution’s participation in a structured finance transaction may violate the federal securities laws and serve as a basis for potential liability.
Basel Committee Reaches Consensus on Several Key Areas
The Basel Committee on Banking Supervision ("Basel Committee") published a notice citing several key areas where it had achieved consensus regarding the new capital accord ("Basel II"). A summary of these areas follows:
Timing:
The standardized and foundation approaches will continue to be implemented at the end of 2006. However, the most advanced capital and operational risk approaches (which are the only ones applicable to the internationally-active US banks) will not be implemented until year-end 2007.Revolving Retail Exposures
: The asset correlation for qualifying revolving retail exposures ("QRRE") will be fixed at 4%, rather than a variable correlation as was previously contemplated. As to securitized portfolios of QRRE, they will reflect market economics, with the seller’s share of undrawn lines included in the Internal Ratings-Based approach, and the investor’s share addressed through a revised credit conversion factor table provided by Basel II (and set forth in the notice).Required measures for Loss-Given-Default ("LGD"
): Notwithstanding the concerns the Basel Committee raised in 2003 about LGD rising during economic downturns, the Basel Committee has decided to retain the concept of a single assigned LGD (which should reflect economic downturn conditions). The Basel Committee, however, seeks additional industry input regarding this matter.Calibration of Basel II
: The Basel Committee reiterated its position that while Basel II should incent banks to adopt the more advanced approaches, aggregate capital should be broadly equivalent to current standards. To achieve this objective without skewing the framework of Basel II, the Basel Committee has decided to add a calibration factor, which could be more or less than 1, as a multiplier of the Basel II results. The calibration factor currently is anticipated to be 1.06.Cross-Border Cooperation
: Seeking to ease the compliance burden of internationally active banks, the Basel Committee also addressed several issues relating to the relations between home and host supervisors with cross-border issues. Among other things, the Basel Committee stated that: (1) host country supervisors should ask for information from the host country supervisor before asking for it from the bank; (2) home country supervisors should play the leading role in approval and validation of advanced techniques and redundant work between home and host supervisors should be avoided; (3) while significant subsidiaries of banking organizations may not make use of general capital allocation mechanisms, the home country supervisor generally should oversee the coordination of the capital approaches; (4) when organizations operate on a business line rather than legal entity basis, they nonetheless should evaluate operational risk on a legal entity basis (although individual entities can leverage off of the resources of the group in determining that risk).OCC Issues Guidance on Risk Management of New, Expanded or Modified Bank Products and Services
The OCC issued guidance (OCC Bulletin 2004-20, the "Bulletin") concerning the principles and process national banks (each a "Bank") should follow to manage effectively the risks associated with new, expanded or modified bank products and services ("New Products"). The OCC states that effective risk management of New Products requires: (1) performing adequate due diligence before introducing the New Products; (2) developing and implementing controls and processes to see that risks "are properly measured, monitored and controlled"; and (3) developing and overseeing effective performance monitoring and review systems. A Bank’s board of directors and management are expected to oversee the risk management of New Products and failure to provide effective risk management will be regarded by the OCC as an unsafe and unsound banking practice. The Bulletin reviews additional risks involved when New Products are provided through third party vendors and discusses the need for a Bank to oversee the third-party vendor’s activities and a Bank’s need to develop a contingency plan if the vendor does not perform as expected. The Bulletin then summarizes categories of risk associated with the introduction of New Products and OCC supervision of a Bank’s risk management process. Finally, the Bulletin provides an appendix that lists various types of bank products and services and identifies published OCC guidance related to risk management of each such product and service.
Other Item of Note
SEC to Consider Adopting Breakpoint Disclosure and Adviser Code of Ethics Proposals
At its open meeting on May 26, 2004, the SEC will consider whether to adopt amendments to Form N-1A that would require open-end management investment companies to provide enhanced prospectus disclosure regarding breakpoint discounts on front-end sales loads (see the December 30, 2003 edition of the Alert for a discussion of the proposed). The SEC will also consider whether to adopt new Rule 204A-1 under the Investment Advisers Act of 1940, as amended ( the "Advisers Act"), and related amendments to Advisers Act Rule 204-2, Advisers Act Form ADV and Rule 17j-1 under the Investment Company Act of 1940, as amended. The new rule would require investment advisers to adopt codes of ethics that would set forth standards of conduct for, and address conflicts that arise from personal trading by, adviser personnel (see the January 20, 2004 edition of the Alert for a discussion of the adviser code of ethics proposal).
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