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Trading and Capital-Markets Activities Manual 

Examination Policy : Preparation for Examination 
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

The globalization of markets, increased transaction volume and volatility, and the introduction of complex products and trading strategies have led capital-markets and trading activities to take on an increasingly important role at financial institutions over the last decade. These activities include the use of a range of financial products and strategies, from the most liquid fixed income securities to complex derivative instruments. The risk dimensions of these products and strategies should be fully understood, monitored, and controlled by bank management. Accordingly, adequate risk-management systems and controls at financial institutions are essential to prevent losses and protect capital. The role of regulators in supervising capital markets and trading activities is to evaluate management's ability to identify, measure, monitor, and control the risks involved in these activities and to ensure that institutions have sufficient capital to support the risks they take. The level of risk an institution may reasonably assume through capital-markets and trading activities should be determined by the board of directors' stated tolerance for risk, the ability of senior management to effectively govern these operations, and the capital position of the institution. 

OVERVIEW OF RISK 

For capital-markets and trading activities, risk is generally defined as the potential for loss on an instrument, portfolio, or activity. Thus, the risks referred to in this manual will be discussed in terms of the impact of some event on value (value-at-risk) and income (earnings-at-risk) from the instrument, activity, or portfolio being addressed. 

Risk management is the process by which managers identify, assess, monitor, and control all risks associated with a financial institution's activities. The increasing complexity of the financial industry and the range of financial instruments have made risk management more difficult to accomplish and to evaluate. In more sophisticated institutions, the role of risk management is to identify the risks associated with particular business activities and to aggregate summary data into generic components, ultimately allowing exposures to be evaluated on a common basis. This methodology enables institutions to manage risks by portfolio and to consider exposures in relationship to the institution's global strategy and risk tolerance. 

A financial institution's risk-management process should not only be assessed by business line, but also in the context of the global, consolidated institution. A review of the global organization may reveal risk concentrations not readily identifiable from the limited view of a branch, agency, Edge Act institution, non-bank subsidiary, or head office on a stand-alone basis. The consolidation of risk information also allows the institution to identify, measure, and control its risks, while giving the necessary consideration to the breakdown of exposure by legal entity. Sometimes, if applicable rules and laws allow, identified risks at a branch or subsidiary may be compensated for by offsetting exposures at another related institution. However, this management of risks across separate entities must be done in a way that is consistent with the authorities granted to each entity. Some financial institutions and their subsidiaries may not be permitted to hold, trade, deal, or underwrite certain types of financial instruments, including some of those instruments discussed in the 4000 sections of this manual, unless they have specifically received regulatory approval. Furthermore, conditions and commitments may be attached to regulatory approvals to engage in certain capital-markets activities. Examiners should ensure that financial institutions have the proper regulatory authority for the activities they engage in and that activities are conducted consistent with their specific regulatory approvals. 

Ideally, an institution should be able to identify the relevant generic risks and should have measurement systems in place to conceptualize, quantify, and control these risks on an institutional level using a common measurement framework. However, it is recognized that not all institutions have an integrated risk-management system that aggregates all business activities. In addition, risk-management methodologies in the marketplace and an institution's scope of business are continually evolving, making risk management a dynamic process. Nonetheless, an institution's risk-management system should always be able to identify, aggregate, and control all risks posed by capital-markets and trading activities that could have a significant impact on capital or equity.

Examiners need to determine the ability of the institution's risk-management system to measure and control risks. The assessment of risk-management systems and controls should be performed by type of instrument and type of risk. Some of the risks inherent in the trading process are described below: 

  Market (price) risk is the risk that the value of a financial instrument or a portfolio of financial instruments will change as a result of a change in market conditions (for example, interest-rate movement). 
  Funding-liquidity risk refers to the ability to meet investment and funding requirements arising from cash-flow mismatches. 
  Market-liquidity risk refers to the risk of being unable to close out open positions quickly enough and in sufficient quantities at a reasonable price to avoid adverse financial impacts.
  Counterparty credit risk is the risk that a counterparty to a transaction will fail to perform according to the terms and conditions of the contract, thus causing the holder of the claim to suffer a loss in cash flow or market value. 
  Clearing/settlement credit risk is (1) the risk that a counterparty who has received a payment or delivery of assets defaults before delivery of the asset or payment or (2) the risk that technical difficulties interrupt delivery or settlement despite the counterparty's ability or willingness to perform. 
  Operations and systems risk is the risk of human error or fraud or the risk that systems will fail to adequately record, monitor, and account for transactions or positions. 
  Legal risk is the risk that a transaction cannot be consummated because of some legal barrier, such as inadequate documentation, a regulatory prohibition on a specific counterparty, and non-enforceability of bilateral and multilateral close-out netting and collateral arrangements in bankruptcy. 
  Reputational risk is the risk arising from negative public opinion regarding an institution's products or activities. 

The examiner must be prepared to identify and evaluate exposures that arise out of any part of a capital-markets operation. To that end, the examiner must become familiar with the institution's overall reporting structure and segregation of duties, range of business activities, global risk-management framework, risk-measurement models, and system of internal controls. Furthermore, the examiner must assess the qualitative and quantitative assumptions implicit in the overall risk-management system and the effectiveness of the institution's approach to controlling risks. In addition, the examiner must determine that the management information system and other forms of communication are adequate for the institution's level of business activity. 

Banking supervision is a dynamic process and this is especially evident in the oversight of capital-markets and trading activities. As capital markets, financial instruments, and secondary market activities continue to expand and develop, they have an increasingly significant impact on the safety and soundness of financial institutions. Consequently, it has become equally necessary for bank supervisors to focus their attention on the capital-markets and trading activities arena. Policies and practices for evaluating the exposures, management tools, and controls employed by banking institutions have had to be constructed and adapted to keep pace with changes in the industry. In this context, the manual encourages the examiner to ask the following basic questions: 

  Are the tools employed by management to measure and monitor risk exposure adequate? 
  Is the level of risk exposure appropriate given the financial institution's size, sophistication, and financial condition? 
  Are the risks in the institution's portfolio of products and activities recognized, understood, measured, and managed? 
  Are the activities conducted consistent with the goals and risk tolerance of senior management and the board of directors? 

To prepare for the on-site portion of the examination of any capital-markets or trading activity, a preliminary overview of the range of products and activities of the institution should be developed. This overview will help examiners formulate a scope and objective for the upcoming exam that is consistent with the types and levels of risk exposure assumed by the institution. 

PRE-EXAMINATION REVIEW 

The review of trading activities is generally conducted on the basis of a financial institution's organizational structure. These structures may vary widely depending on the size and sophistication of the institution, the markets and geographies in which it competes, and the objectives and strategies of its management and board of directors. 

Many banks and bank holding companies have several subsidiaries that conduct business independent of affiliated entities, and some branches and agencies may operate autonomously. The overlap of business lines, sharing of information and personnel, and transaction netting agreements that exist among affiliated legal entities force examiners to go beyond the basic business-unit review and focus on functional exposures within the global institution. It is also important for an examiner to ensure that an institution respects divisions between legal entities, such as firewall and bank/non-bank separations. For example, while a bank holding company must be aware of the level of its consolidated risk, it cannot ignore legal boundaries completely in the management of that risk. Exposure in the bank is not automatically hedged by offsetting positions in the bank holding company and vice versa. In some cases, transactions may be offset by a transaction between these affiliates which may, however, be subject to other regulatory requirements. Bank holding companies should manage and control risk exposures on a consolidated basis, while recognizing legal distinctions among subsidiaries. Examiners should always maintain a view of the ''big picture'' impact of capital-markets and trading activities on consolidated risk exposure. 

The examiner team should meet before the examination begins to summarize the institution's status and assign responsibilities for completing preparatory work. Generally, examination assignments may be segregated based on products, activities, or functions. For example, for trading operations, examiners may be given administrative responsibility for the following areas of review: 

  interest-rate products including fixed-income securities, swaps, futures, forward-rate agreements (FRAs), options, caps, and floors 
  currency-related activities including customer-driven and discretionary foreign-exchange (FX) trading, cross-currency transactions, and currency derivatives (for example, currency options, forwards, futures, and swaps) 
  equity-based products and activities including equity options, warrants, and swaps 
  commodity-based products and activities including commodity futures, options, and forwards 

Other capital-markets activities, such as asset securitization or secondary-market credit activities may be assessed by specific activity, function, or product. To prepare examiners for their assignments, the following initial procedures should be followed to achieve the required scope and coverage of the institution's activities. 

  Determine the extent of work performed during the past year by auditors and regulatory agencies (these would include, but not be limited to, the institution's internal auditors, the various exchanges, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the National Association of Securities Dealers, the National Futures Association, and the Internal Revenue Service). 
  Review deficiencies identified by audit reports and reports of examination. 
  Obtain a listing of the names, qualifications, functions, and positions of key trading and front- and back-office personnel, and a current organizational chart. This material should be available in prior examination and inspection reports. 
  Evaluate the volume of transactions and the dollar value of positions held in each trading product and activity. These data may be found in various regulatory reports. 
  Using the audit findings on the effectiveness of controls over capital-markets and trading activities, evaluate the examination scope to assess organizational and reporting changes, identify perceived weaknesses, and highlight patterns of error. 

BACKGROUND REVIEW 

Specific items which should be reviewed during the pre-examination process for capital-markets and trading activities include the following: 

  Regulatory reports. During the planning stages of an examination, the examiners may estimate activity volumes and diversity of instruments and activities from periodical regulatory reports. This information will help in the development of an examination scope and objective, as well as in the determination of staffing and resource requirements. 
  Prior report of examination. The findings and conclusions of the prior examination are invaluable to the preparation of the scope and objectives of the current examination. Examination reports provide insight into bank management's policies and practices in measuring and managing risk, the extent of risk exposure in a given product and/or activity, and the overall adequacy of the trading-activity control environment. 
  Audit reports. Internal and external audits are often focused on the activities of individual business units and may not encompass aggregate exposures and controls. Nevertheless, they are useful in identifying exceptions to internal policies and specific violations such as limit exceptions. Management's responses to audit findings are also useful in identifying corrective actions and the direction of the unit. 
  Correspondence since the last examination. An additional resource that should be reviewed before an examination is the correspondence file. This will contain important information such as management's response to the prior examination findings, any applications submitted to the Federal Reserve (for additional powers, mergers, and acquisitions), and any supervisory action or agreement that may exist. 
  Outstanding applications. The examiner-in-charge should inquire about the status of any outstanding applications before the Federal Reserve Board that may suggest expansion in the capital-markets and trading activities of the banking institution. 

FIRST-DAY LETTER 

In preparation for an on-site examination, examiners will often need to customize the first-day letter questionnaire to reflect the specific focus of the capital-markets review. The focus will reflect the range of products and activities of the institution as well as management's approach to risk control. The following is a brief list of core requests to be made in the first-day letter: 

  a copy of the organization charts (including name and title of managers) for the capital markets or global-trading operations to be assessed, including functional and legal-entity organization 
  a copy of the institution's written risk-management policies and procedures that outline the instruments traded, their associated risks, and the monitoring of the risks 
  a copy of established limits for each principal type of risk as well as documentation indicating periodic approval by the board of directors 
  general-ledger and subsidiary-ledger accounts identifying the range and level of activity as of the examination date 
  management information reports used in the global, functional, or legal-entity oversight of market- and credit-risk management 
  detailed information on transactions that are unique or uncommon 
  copies of management reports issued in connection with the bank's new financial products that were put in place since the last examination indicating the office at which such activity is conducted, the lines and limits established for each activity, and the perceived risks associated with each activity 
  a description of the scope and frequency of internal and external audits of the institution's capital-markets and trading activities and copies of audits, including working papers, conducted of capital-markets operations since the last examination 

The first-day letter to an institution that engages in capital-markets or trading activities and the use of derivatives usually will be much more precise and comprehensive than this list, depending on the institution's range of products and activities. Significantly more detail should be requested relative to the objectives of the trading operations, the activities in which the institution engages, the products it uses, and the risk-management methods and reports it relies on. The first-day letter should also include requests for detailed information related to the areas highlighted in the market, credit, liquidity, and operational risk sections of this manual.

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