Trading and Capital-Markets Activities Manual
Activities: Investment Securities and End-User Activities (Continue)
UNSUITABLE INVESTMENT PRACTICES
Institutions should categorize each of their security activities as trading, available-for-sale, or held-to-maturity consistent with GAAP (that is, Statement of Financial Accounting Standards No. 115, ''Accounting for Certain Investments in Debt and Equity Securities,'' as amended) and regulatory reporting standards. Management should reassess the categorizations of its securities periodically to ensure that they remain appropriate.
Securities that are intended to be held principally for the purpose of selling in the near term should be classified as trading assets. Trading activity includes the active and frequent buying and selling of securities for the purpose of generating profits on short-term fluctuations in price. Securities held for trading purposes must be reported at fair value, with unrealized gains and losses recognized in current earnings and regulatory capital. The proper categorization of securities is important to ensure that trading gains and losses are promptly recognized- which will not occur when securities intended to be held for trading purposes are categorized as held-to-maturity or available-for-sale.
It is an unsafe and unsound practice to report securities held for trading purposes as available-for-sale or held-to-maturity securities. A close examination of an institution's actual securities activities will determine whether securities it reported as available-for-sale or held-to-maturity are, in reality, held for trading. When the following securities activities are conducted in available-for-sale or held-to-maturity accounts, they should raise supervisory concerns. The first five practices below are considered trading activities and should not occur in available-for-sale or held-to-maturity securities portfolios, and the sixth practice is wholly unacceptable under all circumstances.
Gains trading is the purchase of a security and the subsequent sale of that security at a profit after a short holding period. However, at the same time, securities acquired for gains trading that cannot be sold at a profit are retained in the available-for-sale or held-to-maturity portfolio; unrealized losses on debt securities in these two categories do not directly affect regulatory capital and are not reported in income until the security is sold. Examiners should note institutions that exhibit a pattern or practice of reporting significant amounts of realized gains on sales of non-trading securities (typically, available-for-sale securities) after short holding periods, while continuing to hold other non-trading securities with significant amounts of unrealized losses. In these situations, examiners may designate some or all of the securities reported outside of the trading category as trading assets.
When-Issued Securities Trading
When-issued securities trading is the buying and selling of securities in the period between the announcement of an offering and the issuance and payment date of the securities. A purchaser of a when-issued security acquires all of the risks and rewards of owning a security and may sell this security at a profit before having to take delivery and pay for it. These transactions should be regarded as trading activities.
Pair-offs are security purchases that are closed out or sold at or before settlement date. In a pair-off, an institution commits to purchase a security. Then before the predetermined settlement date, the institution will pair off the purchase with a sale of the same security. Pair-offs are settled net when one party to the transaction remits the difference between the purchase and sale price to the counterparty. Other pair-off transactions may involve the same sequence of events using swaps, options on swaps, forward commitments, options on forward commitments, or other off-balance-sheet derivative contracts.
Regular-way settlement for U.S. government and federal-agency securities (except mortgage-backed securities and derivative contracts) is one business day after the trade date. Regular-way settlement for corporate and municipal securities is three business days after the trade date, and settlement for mortgage-backed securities can be up to 60 days or more after the trade date. Using a settlement period that exceeds the regular-way settlement periods to facilitate speculation is considered a trading activity.
A short sale is the sale of a security that is not owned. Generally, the purpose of a short sale is to speculate on a fall in the price of the security. Short sales should be conducted in the trading portfolio. A short sale that involves the delivery of the security sold short by borrowing it from the depository institution's available-for-sale or held-to-maturity portfolio should not be reported as a short sale. Instead, it should be reported as a sale of the underlying security with gain or loss recognized. Short sales are not permitted for federal credit unions.
Adjusted trading involves the sale of a security to a broker or dealer at a price above the prevailing market value and the simultaneous purchase and booking of a different security, frequently a lower-grade issue or one with a longer maturity, at a price above its market value. Thus, the dealer is reimbursed for its losses on the initial purchase from the institution and ensured a profit. Adjusted-trading transactions inappropriately defer the recognition of losses on the security sold and establish an excessive reported value for the newly acquired security. Consequently, these transactions are prohibited and may be in violation of 18 USC 1001 (False Statements or Entries) and 1005 (False Entries).
Investment Securities and End-User Activities
1. To determine if policies, practices, procedures, and internal controls for investments are adequate.
2. To determine if bank officers are operating in conformance with the established guidelines.
3. To determine the scope and adequacy of the audit function.
4. To determine the overall quality of the investment portfolio and how that quality relates to the soundness of the bank.
5. To determine compliance with laws and regulations.
6. To initiate corrective action when policies, practices, procedures, or internal controls are deficient or when violations of laws or regulations have been noted.
Investment Securities and End-User Activities
These procedures represent a list of processes and activities that may be reviewed during a full-scope examination. The examiner-in-charge will establish the general scope of examination and work with the examination staff to tailor specific areas for review as circumstances warrant. As part of this process, the examiner reviewing a function or product will analyze and evaluate internal audit comments and previous examination work papers to assist in designing the scope of examination. In addition, after a general review of a particular area to be examined, the examiner should use these procedures, to the extent they are applicable, for further guidance. Ultimately, it is the seasoned judgment of the examiner and the examiner-in-charge as to which procedures are warranted in examining any particular activity.
1. Based on the evaluation of internal controls and the work performed by internal and external auditors, determine the scope of the examination.
2. Test for compliance with policies, practices, procedures, and internal controls in conjunction with performing the examination procedures. Also, obtain a listing of any deficiencies noted in the latest review conducted by internal and external auditors and determine if corrections have been accomplished. Determine the extent and effectiveness of investment-policy supervision by-
a. reviewing the abstracted minutes of board
of directors meetings and minutes of appropriate committee meetings;
3. Obtain the following:
4. Using updated data available from reports of condition, UBPR printouts, and investment advisor and correspondent bank portfolio analysis reports, obtain or prepare an analysis of investment, money market, and end-user derivative holdings that includes-
a. a month-by-month schedule of par, book,
and market values of issues maEagle Tradersg in one year;
• descriptions of securities held
(par, book, and market values),
5. Review the reconcilement of the trial balances investment and money market accounts to general-ledger control accounts.
6. Using either an appropriate sampling technique or the asset-coverage method, select from the trial balances the international investments, municipal investments, and money market and derivative holdings for examination. If transaction volume permits, include in the population of items to be reviewed all securities purchased since the last general examination.
7. Perform the following procedures for
each investment and money market holding selected in step 6.
• published quotations, if available
c. For investments and money market obligations in the sample that are rated, compare the ratings provided to the most recent published ratings.
Before continuing, refer to steps 15 through 17. They should be performed in conjunction with steps 8 through 14. International-division holdings should be reviewed with domestic holdings to ensure compliance, when combined, with applicable legal requirements.
8. To the extent practicable under the circumstances,
test that the institution has analyzed the following:
• compare the schedule to the foreign
securities trial balance obtained in step 3 to ascertain which foreign
securities are to be included in Interagency Country Exposure Review Committee
- amount (and U.S. dollar equivalent if
a foreign currency) to include par, book, and market values
9. Review the most recent reports of examination of the bank's Edge Act and agreement corporation affiliates and foreign subsidiaries to determine their overall conditions. Also, compile data on Edge Act and agreement corporations and foreign subsidiaries that are necessary for the commercial report of examination (such as asset criticisms, transfer risk, and other material examination findings).
10. Classify speculative and defaulted issues according to the following standards (except those securities in the Interagency Country Exposure Review and other securities on which special instructions have been issued):
a. The entire book value of speculative
grade municipal general obligation securities which are not in default
will be classified substandard. Market depreciation on other speculative
issues should be classified doubtful. The remaining book value usually
is classified substandard.
• description of issue
11. Review the bank's maturity program.
• comparing book and market values
and, after considering the gain or loss on year-to-date sales, determine
if the costs of selling intermediate and long-term issues appear prohibitive,
b. Review the pledged-asset and secured-liability
schedules and isolate pledged securities by maturity segment, then determine
the market value of securities pledged in excess of net secured liabilities.
• if financing for securities purchases
is provided via repurchase agreement by the securities dealer who originally
sold the security to the bank,
d. Review the list of open purchase-and-sale
commitments and determine the effect of their completion on maturity scheduling.
12. Consult with the examiner responsible for the asset/liability management analysis to determine what information is needed to assess the bank's sensitivity to interest-rate fluctuations and its ability to meet short-term funding requirements. If requested, compile the information using bank records or other appropriate sources. (See the Instructions for the Report of Examination section of this manual for factors to be taken into account when compiling this information.) Information which may be required to be furnished includes-
a. the market value of un-pledged government
and federal-agency securities maEagle Tradersg within one year;
13. Determine whether the bank's investment
policies and practices are balancing earnings and risk satisfactorily.
• Compare results to peer-group statistics.
b. Calculate current market depreciation as a percentage of gross capital funds. c. Review the analysis of municipal and corporate issues by rating classification.
• Determine the total in each rating
class and the total of non-rated issues.
d. Review coupon rates or yields (when available)
and compare those recently acquired investments and money market holdings
with coupon rates or yields that appear high or low to similarly acquired
instruments of analogous types, ratings, and maturity characteristics.
Discuss significant rate or yield variances with management.
14. Review the bank's federal income tax
15. Determine that proper risk diversification
exists within the portfolio.
• Detail, as concentrations, all holdings
equaling 25 percent or more of capital funds.
b. Perform a credit analysis of all non-rated holdings determined to be a concentration (if not performed in step 8).
16. If the bank is engaged in financial
futures, exchange-traded puts and calls, forward placements, or standby
contracts, determine the following.
• the type and amount of each contract,
17. If the bank is engaged in financial
futures, forward placement, options, or standby contracts, determine if
the contracts have a reasonable correlation to the bank's business needs
(including gap position) and if the bank fulfills its obligations under
18. On the basis of the pricings, ratings,
and credit analyses performed above, and using the investments selected
in step 6 or from lists previously obtained, test for compliance with
applicable laws and regulations.
• determine if the book value has
been written down to an amount that represents the investment value of
the security, independent of the conversion or warrant provision (12 CFR
d. Review pledge agreements and secured
liabilities and determine that-
(Information needed to perform the above steps will be in the pledge agreement; Treasury circulars 92 and 176, as amended.)
e. Review accounting procedures to determine that-
• investment premiums are being extinguished
by maturity or call dates (12 CFR 1.11);
f. Determine if securities purchased under
agreement to resell are in fact securities (not loans), are eligible for
investment by the bank, and are within prescribed limits (12 USC 24 and
12 CFR 1). If not, determine whether the transaction is within applicable
legal lending limits in the state.
• acquiring and holding securities
(section 211.3(b)(3)) and
(Further considerations relating to the above are in other sections of Regulation K. Also review any applicable sections of Regulation T-Credit by Brokers and Dealers (12 CFR 220), Regulation X-Borrowers of Securities Credit (12 CFR 224), and Board interpretations 6150 (regarding securities issued or guaranteed by the International Bank for Reconstruction and Development) and 6200 (regarding borrowing by a domestic broker from a foreign broker). Edge Act and agreement corporations are discussed in the bank-related organizations section.
i. Determine that the bank's equity investments in foreign banks comply with the provisions of section 25 of the Federal Reserve Act and section 211.5 of Regulation K as to-
• investment limitations (section
19. Test for compliance with other laws
and regulations as follows. a. Review lists of affiliate relationships
and lists of directors and principal officers and their interests.
b. Determine if Federal Reserve stock equals
3 percent of the subject bank's booked capital and surplus accounts (Regulation
I and 12 CFR 209).
20. With regard to potential unsafe and
unsound investment practices and possible violations of the Securities
Exchange Act of 1934, review the list of securities purchased and/or sold
since the last examination.
• evaluate the reasonableness of the
relationship on the basis of the dealer's location and reputation and
b. Determine if investment-account securities have been purchased from the bank's own trading department. If so-
• independently establish the market
price as of trade date,
c. Determine if the volume of trading activity in the investment portfolio appears unwarranted. If so-
• review investment-account daily
ledgers and transaction invoices to determine if sales were matched by
a like amount of purchases,
21. Discuss with appropriate officers and
prepare report comments on-
22. The following guidelines are to be implemented
while reviewing securities participations, purchases and sales, swaps,
or other transfers. The guidelines are designed to ensure that securities
transfers involving state member banks, bank holding companies, and non-bank
affiliates are carefully evaluated to determine if they were carried out
to avoid classification and to determine the effect of the transfer on
the condition of the institution. In addition, the guidelines are designed
to ensure that the primary regulator of the other financial institution
involved in the transfer is notified.
• names of originating and receiving
23. Evaluate the quality of department management. Communicate your conclusion to the examiner who is assigned to management assessment and the examiner responsible for the international examination, if applicable.
24. Update work-papers with any information that will facilitate future examinations. If the bank has overseas branches, indicate those securities that will require review during the next overseas examination and the reasons for the review.
Investment Securities and End-User Activities
Internal Control Questionnaire
Review the bank's internal controls, policies, practices, and procedures regarding purchases, sales, and servicing of the investment portfolio. The bank's system should be documented completely and concisely, and should include, where appropriate, narrative descriptions, flow charts, copies of forms used, and other pertinent information. Items in the questionnaire marked with an asterisk require substantiation by observation or testing.
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