Risk Management Manual of Examination Policies - FDIC

LOANS Section 3.2
result in management being unaware how significant
economic events might impact the overall portfolio. This
will also allow management to consider areas where
concentration reductions may be necessary. Management
and the board can monitor any reduction program using
accurate concentration reports. If management is not
properly monitoring concentration levels and limits,
examiners may consider criticizing management.
To establish a meaningful tracking system for
concentrations of credit, financial institutions should be
encouraged to consider the use of codes to track individual
borrowers, related groups of borrowers, industries, and
individual foreign countries. Financial institutions should
also be encouraged to use the standard industrial
classification (SIC) or similar code to track industry
concentrations. Any monitoring program should be
reported regularly to the board of directors.
Refer to the Report of Examination Instructions for
guidance in identifying and listing concentrations in the
examination report.
FEDERAL FUNDS SOLD AND
REPURCHASE AGREEMENTS
Federal funds sold and securities purchased under
agreement for resale represent convenient methods to
employ excess funds to enhance earnings. Federal funds
are excess reserve balances and take the form of a one-day
transfer of funds between banks. These funds carry a
specified rate of interest and are free of the risk of loss due
to fluctuations in market prices entailed in buying and
selling securities. However, these transactions are usually
unsecured and therefore do entail potential credit risk.
Securities purchased under agreement for resale represent
an agreement between the buying and selling banks that
stipulates the selling bank will buy back the securities sold
at an agreed price at the expiration of a specified period of
time.
Federal funds sold are not "risk free" as is often supposed,
and the examiner will need to recognize the elements of
risk involved in such transactions. While the selling of
funds is on a one-day basis, these transactions may evolve
into a continuing situation. This development is usually
the result of liability management techniques whereby the
buying bank attempts to utilize the acquired funds to
support a rapid expansion of its loan-investment posture
and as a means of enhancing profits. Of particular concern
to the examiner is that, in many cases, the selling bank will
automatically conclude that the buying bank's financial
condition is above reproach without proper investigation
and analysis. If this becomes the case, the selling bank
may be taking an unacceptable risk unknowingly.
Another area of potential risk involves selling Federal
funds to a bank which may be acting as an intermediary
between the selling bank and the ultimate buying bank. In
this instance, the intermediary bank is acting as agent with
the true liability for repayment accruing to the third bank.
Therefore, it is particularly important that the original
selling bank be aware of this situation, ascertain the
ultimate disposition of its funds, and be satisfied as to the
creditworthiness of the ultimate buyer of the funds.
Clearly, the "risk free" philosophy regarding the sale of
Federal funds is inappropriate. Selling banks must take the
necessary steps to assure protection of their position. The
examiner is charged with the responsibility of ascertaining
that selling banks have implemented and adhered to policy
directives in this regard to forestall any potentially
hazardous situations.
Examiners should encourage management of banks
engaged in selling Federal funds to implement a policy
with respect to such activity. This policy should include
consideration of such matters as the aggregate sum to be
sold at any one time, the maximum amount to be sold to
any one buyer, the maximum duration of time the bank will
sell to any one buyer, a list of acceptable buyers, and the
terms under which a sale will be made. As in any form of
lending, thorough credit evaluation of the prospective
purchaser, both before granting the credit extension and on
a continuing basis, is a necessity. Such credit analysis
should emphasize the borrower's ability to repay, the
source of repayment, and alternative sources of repayment
should the primary source fail to materialize. While sales
of Federal funds are normally unsecured unless otherwise
regulated by State statutes, and while collateral protection
is no substitute for thorough credit review, the selling bank
should consider the possibility of requiring security if sales
agreements are entered into on a continuing basis for
specific but extended periods of time, or for overnight
transactions which have evolved into longer term sales.
Where the decision is made to sell Federal funds on an
unsecured basis, the selling bank should be able to present
logical reasons for such action based on conclusions drawn
from its credit analysis of the buyer and bearing in mind
the potential risk involved.
A review of Federal funds sold between examinations may
prompt examiners to broaden the scope of their analysis of
such activity if the transactions are not being handled in
accordance with sound practices as outlined above. Where
the bank has not developed a formal policy regarding the
sale of Federal funds or fails to conduct a credit analysis of
the buyer prior to a sale and during a continuous sale of
Loans (12-04) 3.2-52 DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation