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| ## Co |   |                            |       |                 |   |
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+-------+---+----------------------------+-------+-----------------+---+
| #     |   | ## Investm                 | ## De | ## Supple       |   |
| # Sub |   | ent Portfolio Credit Risks | scrip | mental Guidance |   |
| ject: |   | : Safekeeping Arrangements | tion: |                 |   |
+-------+---+----------------------------+-------+-----------------+---+

**TO:** Chief Executive Officers of All National Banks, Federal Branches
and Agencies, Department and Division Heads, and All Examining Personnel

##### PURPOSE

The following guidance alerts banks to the potentially significant
credits risks they incur when safekeeping investment portfolio assets
with third parties, such as brokers, broker/dealer firms and banks. It
supplements the bulletin, OCC 98-20, "Supervisory Policy Statement on
Investment Securities and End-User Derivatives Activities," dated April
27, 1998.

##### BACKGROUND

When purchasing investment assets for their own portfolios, banks
typically use a third party to act as safekeeping agent or custodian.
Such third parties may include registered broker-dealers, commercial
banks, or unregulated entities. Each of these entities presents certain
safekeeping, or "custodial" risks. A number of financial institutions
have suffered losses following the insolvency of two custodian deposit
brokers that had sold insured certificates of deposit (CDs) to, and
safekept them for, these institutions. While this bulletin will use
these recent incidents involving CDs to illustrate custodial risks,
national banks should strongly consider the precautions set forth herein
with regard to [all]{.underline} investment assets purchased and held
through third parties.

With market yields at historically low levels, many banks have purchased
insured CDs as a low-risk alternative to longer maturity investments.
When done properly, this strategy can produce some incremental yield
with minimal credit and interest rate risks. However, banks must
recognize that the credit risk for investment transactions extends
beyond the issuer of the instrument; it also includes the actions and
judgment of the safekeeping agent (custodian).

Banks frequently buy insured CDs from *[deposit brokers]{.underline}*
(i.e., entities that broker CDs). National banks should be aware of the
credit quality and external supervision distinctions among deposit
brokers, and the implications these distinctions have on the credit
risks banks face when dealing with these entities. A deposit broker is
not required to obtain any type of certification, or to be registered
with any government agency. However, in some cases, a deposit broker may
be a broker/dealer registered with the Securities and Exchange
Commission (SEC), or it may be a bank or other deposit institution. If a
deposit broker is SEC-registered, it will be subject to certain
requirements and to regulation by that agency as well as by a
self-regulatory organization (e.g., the National Association of
Securities Dealers, Inc.). The legal requirements applicable to a
registered broker/dealer include minimum capital requirements, but
capital requirements may vary significantly among broker/dealers. A bank
or other depository institution will be subject to federal or state
banking regulation, or both, as well as minimum leverage and risk-based
capital requirements.

##### DEPOSIT BROKERS

A deposit broker typically acts as an agent for both the issuer and the
investor. After purchasing insured CDs from a deposit broker, investing
banks generally allow the deposit broker to act as custodian
(safekeeping agent) for the assets. Many banks have not considered the
credit risk associated with custody relationships for insured CDs and
other types of investments. If the custodian fails, banks can lose, and
have lost, some of their investment assets. Therefore, banks must
carefully evaluate the creditworthiness and market reputation of the
investment organizations through which they purchase, and then safekeep,
both insured CDs *and other investment assets*.

Deposit brokers generally fall into the following categories: 1)
unregistered entities, activities of which are limited to deposit
brokerage; 2) broker/dealers registered with the SEC that also engage in
deposit brokerage; and 3) commercial banks.

[Unregistered Deposit Brokers]{.underline}. When assessing the
creditworthiness of a deposit broker, banks should first determine
whether the deposit broker's activities are limited to deposit brokerage
only, or are part of a larger broker/dealer function. Many deposit
brokers that are not registered with the SEC have little (or no)
capital. Such firms may be subject to no external supervision and often
will not be creditworthy counterparties. Because unregistered deposit
brokers are agents and frequently have little capital strength, national
banks generally should use them as "finders" only. The unregistered
deposit broker can identify an issuing institution offering to pay a
certain rate, but investing banks generally should wire funds directly
to the issuer when purchasing the CD. *It is an unsafe and unsound
practice for banks to wire funds to purchase deposits to an unregistered
deposit broker, or to allow that deposit broker to act as custodian for
insured CDs, unless the deposit broker's financial strength and
reputation warrants an unsecured credit facility in the cumulative
amount of the investments a bank has purchased.*

[Deposit Brokers Registered As Broker/Dealers]{.underline}. Some deposit
brokers are registered with the SEC as securities broker/dealers and are
subject to that agency's minimum capital requirements. Capital
requirements vary significantly among broker/dealers, depending on
whether the broker/dealer clears or carries customer accounts, or does
not carry accounts and, instead, clears its brokerage transactions
through a full-service broker. *Therefore, banks should not assume that
a deposit broker is a creditworthy counterparty simply because it is
registered with the SEC*.

[Commercial Banks]{.underline}. Bank deposit brokers do not register
with the SEC, but they are subject to supervision from federal and/or
state banking regulatory agencies. Bank deposit brokers may have strong
capital bases and, therefore, represent creditworthy custodians.
However, investing banks should not assume that another commercial bank
is a creditworthy custodian simply because it is subject to minimum
risk-based capital requirements and external supervision.

It is not uncommon for banks that have accounts with other banks and
registered broker/dealers that act as deposit brokers to wire funds to
these entities for CD purchases and to allow them to serve as custodian
for the assets. *The risk of loss from the failure of a custodian can
potentially be very significant; therefore,* *as in any relationship
that involves credit risk, banks should conduct a thorough credit review
of the financial strength of potential custodians before initiating a
custodial relationship.* The credit review should assess the custodian's
operating performance, market reputation, insurance coverage maintained,
registration status (if applicable), as well as its commitment to, and
experience in, the custody business.

##### DEPOSIT BROKER FAILURES

Recently, there have been two failures of custodians with deposit
brokerage activity. One of the failed custodians was a deposit broker
not registered with the SEC; the other was an SEC- registered
broker/dealer with a subsidiary (also a registered broker/dealer)
engaging in deposit brokerage activities.

1\) [Unregistered Deposit Broker Failure]{.underline}: Rather than wire
funds for CD purchases to issuing institutions, as is appropriate when
doing business through a thinly capitalized, unregistered, deposit
broker, a number of banks inappropriately wired funds to the deposit
broker for the purchase of CDs. These banks then further allowed the
deposit broker to serve as custodian. The deposit broker did not invest
the funds according to the terms it had confirmed to its clients.
Instead, the deposit broker took investor funds and invested them in its
name and for its own terms. As a result, when the deposit broker failed,
its actual CD investments did not correspond to the terms of the
transactions that it had confirmed to its investing clients. Investors
now have uninsured obligations of the failed firm. Despite the low risk
of insured CD investments, banks now face losses because they failed to
assess the credit risk of advancing funds to an unregistered deposit
broker, and allowing the broker to act as custodian.

Some institutions exposed to losses from transactions with this deposit
broker had dealt with the firm on a satisfactory basis for a number of
years. The loss exposure on otherwise low-risk assets underscores the
important credit principle that *banks must understand, on an ongoing
basis, the creditworthiness and reputation of firms to which they
advance funds.*

2\) [Registered Broker/Dealer Failure]{.underline}: In another recent
case, banks have suffered losses following the failure of a
broker/dealer custodian whose subsidiary broker/dealer had brokered
insured CDs into bank portfolios. The broker/dealer subsidiary also sold
banks other non-CD investments. Banks have suffered losses even though
the broker/dealer, unlike in the case of the unregistered deposit broker
above, purchased (and, through its parent, held for customers) insured
CDs with the identical terms it had confirmed to its customers. The
trustee for the broker/dealer's liquidation, in accordance with the
Securities Investor Protection Act (SIPA), has withheld CDs and other
investments registered in "street name." [^1]

When a broker/dealer fails, *if there are losses involving customer
assets*,[^2] investments of customers that the broker/dealer holds in
"street name" become "customer property," which is segregated from the
broker/dealer's other assets and is distributed to all of the firm's
customers.

Banks are customers of a broker/dealer for purposes of the SIPA and have
a claim on these assets. But, under the terms of the SIPA, banks are
[not]{.underline} entitled to the Securities Investor Protection
Corporation (SIPC) protection that generally covers \$500,000 in
property for other investors. Under SIPC procedures, the trustee for the
failed broker/dealer first returns property to customers, *if that
property is registered in a specific customer's name* ("customer name"
securities). Second, the trustee calculates, and then distributes to
customers, their *pro rata* share of customer property held in "street
name." The *pro rata* distribution reflects the trustee's recovery of
customer assets. As the trustee recovers more property for the estate,
it seeks court approval to make additional distributions of that
property to customers. Finally, customers entitled to SIPC protection
receive up to \$500,000 to cover any remaining shortfall in what is due
to the customer following the *pro rata* distribution. Banks are not
entitled to receive SIPC protection and thus receive only their *pro
rata* distributions from the estate.

The SIPC trustee in this particular broker/dealer failure made an
initial 90 percent pro rata distribution of customer property, an
unusually large amount compared to other broker/dealer failures. As a
result, banks that used the broker/dealer as a custodian had 10 percent
of their investment assets withheld to pay for losses on other
customers' assets. A smaller distribution, more in line with past
experience, would have resulted in considerably more losses and
underscores the magnitude of potential losses in custody relationships.
A subsequent 6 percent distribution in this case has reduced losses to 4
percent of the property safekept at the failed firm.

In contrast to a broker/dealer failure, if an insured bank custodian
fails, the FDIC, as receiver, would determine whether a custodial CD or
other investment asset legally belongs to particular customers or to the
failed bank. This determination would depend upon whether the bank
accepted the funds in an agency or custodial capacity and whether the
bank segregated the funds from its own assets. If the FDIC determines
that the CD or other securities do not belong to the failed bank, then
the FDIC would release the assets to the actual owners (or continue to
hold them for the benefit of those owners).

The practical difference between the failure of an insured bank and
broker/dealer custodian involves the distribution of losses. With a
broker/dealer failure, if there are losses on customer securities,
[all]{.underline} customers share those losses equally, regardless of
whether any particular customer had a loss in his or her account. With
an insured bank custodian failure, a customer incurs a loss only if
there is a shortfall in his or her account.

##### MEASURES TO REDUCE CUSTODIAL RISK

To minimize custodian risk with respect to the purchase of insured
certificates of deposit*, and other investments*, banks should consider
the following strategies:

1.  Purchase insured CDs directly from the issuing institution.

This is a prudent practice for nearly all transactions arranged by
unregistered deposit brokers and can also be followed in the case of
registered broker/dealers and banks. The CD will have applicable FDIC
deposit insurance. This strategy may, however, result in some reduction
in yield relative to brokered CDs.

2.  Purchase insured CDs and other investment assets from, and safekeep
    them with, a well-capitalized and reputable commercial bank or
    broker/dealer.

> Investors can suffer losses if either a bank or broker/dealer
> custodian fails and has committed fraud, or had an operational error,
> with respect to customer security holdings. Investors should
> recognize, however, that they incur a unique risk when dealing with a
> broker/dealer, because failed broker/dealers, unlike failed banks,
> subject investors to the SIPA-mandated *pro rata* distribution
> process.[^3] But, that unique risk does not dictate that banks should
> safekeep investment assets only with another commercial bank simply
> because there is a more limited risk of a *pro rata* distribution. A
> well-capitalized broker/dealer with an excellent market reputation may
> represent a low risk comparable to that of a well-run commercial bank.
> National banks evaluating custody options should carefully consider
> the risks of insolvency and market reputations for both banks and
> broker/dealers.

3.  When using broker/dealers as custodians, banks may reduce the risk
    of a pro rata distribution by:

-   *Having the assets registered in the investing bank's name.* Since
    the trustee for the SIPC in a broker/dealer liquidation returns
    "customer name" assets to their owners *prior to* the pro rata
    distribution process, registration reduces risk. This strategy does
    not eliminate risk, however, because even "customer name" securities
    may disappear (e.g., in the case of fraud) in connection with a
    broker/dealer's insolvency. When a broker/dealer fails, the
    investing bank will have to file a claim promptly to recover the
    registered assets. Failure to file the appropriate claim in a timely
    manner may result in significant delays in recovering the asset or,
    worse, denial of the claim in its entirety. Registration may,
    however, reduce the practical liquidity of the investments because
    the bank will have to re-register the assets, and incur related
    expenses, in order to sell them. Banks should carefully evaluate the
    costs and benefits of this risk-reducing strategy, including an
    assessment of coverage available under the custodian's insurance
    policy. The stronger the reputation and capital position of the
    broker/dealer, the less likely the benefits of this risk reduction
    technique will exceed the costs. Moreover, for some assets, such as
    insured CDs, registration may not be practical.[^4]

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-   *Diversifying custodian relationships.* Rigorous credit analysis and
    a thorough inquiry into a custodian's market reputation are critical
    steps to demonstrate prudence in selecting, and continuing, a
    custodian relationship. These steps can reduce, but not eliminate,
    the likelihood that a custodian fails. In the case of the failure of
    the registered broker/dealer referred to above, sound credit due
    diligence may not have prevented loss exposure because the firm
    failed so suddenly that a review of its financial statements may not
    have provided an early warning of financial troubles. As a result,
    banks can reduce the impact of a pro rata distribution when
    safekeeping "street name" investments with broker/dealers by
    diversifying custodian relationships. Banks should consider
    safekeeping assets at more than one broker/dealer custodian so that
    a sudden failure of any one firm does not expose an excessive level
    of assets to the *pro rata* distribution process. This principle
    applies to [all investments]{.underline}, not only to CDs.

*National banks should immediately evaluate the creditworthiness of
their custodians, carefully consider their market reputation, and reduce
unwarranted exposures or concentrations.*

##### OBTAINING PASS-THROUGH DEPOSIT INSURANCE

For deposit insurance to pass through to the investor on an insured CD
held by a third party, the deposit broker must observe certain record
keeping conventions.

A deposit placed by an agent (such as broker/dealer) on behalf of a
principal (such as the purchaser), is considered insured by the FDIC to
the same extent as if the investor purchased the CD directly from the
issuer, *provided* certain conditions are met. Typically, the custodian
or its agent holds a large-denomination CD evidencing a number of
\$1,000 deposits owned by various depositors for which the custodian
acts as agent.[^5] National banks purchasing CDs through deposit brokers
should consider the following FDIC requirements in order to determine
whether FDIC insurance passes through to their holding: [^6]

-   The issuing bank's records of the CD's ownership must disclose the
    existence of the fiduciary or agency relationship under which the
    deposit broker holds the CD. Examples:

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-   "ABC Broker/Dealer Co. as Agent for Customers" when the deposit
    broker is the only agent acting for a customer; and

-   "ABC Broker/Dealer Co. as Agent for Customers, Who May, in Turn, Be
    Acting as Agents for Others" when the CD is held for the customer
    through multiple levels of agents.

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-   The interest of each owner of the CD must be ascertainable from the
    deposit accounts records of the CD issuer or records maintained in
    the regular course of business by the agent. If a CD is held for an
    owner through multiple levels of agents, the records of each agent
    must identify the interest of that agent\'s principal(s).

-   The CD must belong to the customer and not to the agent or to
    another customer. This means that the agent must not have sold to
    the purchasing bank and others more CDs than the agent has recorded
    in its name or the name of its agent.

-   Finally, when the CD is fractionalized, its terms generally must
    remain the same through the various levels of ownership. For
    example, a change in the CD's maturity date will likely cut off the
    insurance pass-through, whereas a change in the CD's interest rate
    may or may not, depending on the nature of the change. The FDIC has
    not articulated the extent to which changes are permitted without
    cutting off pass-through insurance, and a bank considering the
    purchase of a fractionalized interest in a CD, where the interest
    being purchased is different from the original CD, should consider
    contacting the FDIC for guidance.

    Investors, including banks, are generally not in a position to
    review the details of a custodian's compliance with the record
    keeping conventions necessary to assure the availability of deposit
    insurance pass-through. However, registered broker/dealers and banks
    active in marketing CDs typically have established programs that
    incorporate the requisite record keeping arrangements. These deposit
    brokers adhere to a number of conventions, including: (i) providing
    a detailed information statement that outlines the operation of the
    CD program and discusses the availability of pass-through deposit
    insurance; (ii) delivering a confirmation in connection with each
    sale of a CD; and (iii) providing periodic statements of account to
    customers showing transactions in CDs and positions held at the end
    of the period. In addition, each of these broker/dealers and banks
    is able to provide, if requested, samples of the forms of CDs,
    including large-denomination CDs, and ownership registrations used
    in the deposit broker's CD program.

    The insured CD investor must ultimately rely upon the integrity,
    creditworthiness, and competence of any deposit broker used as a
    custodian for CDs. A deposit broker's failure to adhere to one or
    more of the conventions described above, or an inability or
    unwillingness to provide samples of the forms of CDs used in the
    deposit broker's program, should raise issues about the soundness of
    the CD program.

    **RESPONSIBLE OFFICE**

Questions or concerns regarding this guidance should be directed to Kurt
Wilhelm in the Treasury and Market Risk Division at (202) 874-5670, or
Eugene Cantor in the Securities and Corporate Practices Division at
(202) 874-5210.

Kathryn E. Dick

Deputy Comptroller for Risk Evaluation

[^1]: "Street name" registration means that the investments are not
    registered in the customer's name; they are registered in the
    broker/dealer's name. Street name registration is also used by banks
    and other intermediaries and enhances liquidity by making the
    investments easily transferable.

[^2]: "Losses involving customer assets" refers to losses resulting from
    fraud, operational error, and market transactions, such as
    securities lending, when a broker/dealer fails. When a broker/dealer
    loans a customer's security, a loss can occur if, for example, the
    broker/dealer's counterparty (i.e., the securities borrower) sells
    the borrowed assets to cover the failed broker/dealer's inability to
    meet a margin call. The phrase "losses involving customer assets"
    does [not]{.underline} refer to market value changes that cause
    security values to fall below the customer's cost.

[^3]: As noted above, an investor bank that holds assets with a failed
    broker/dealer in street name will have that asset labeled "customer
    property" and used in a *pro rata* distribution to all of the firm's
    customers. On the other hand, when a bank fails, client assets it
    holds as custodian are generally [not]{.underline} subject to a *pro
    rata* distribution. The FDIC will return the assets to the client.
    This is true even if the assets were held in the failed bank's name.
    Only those clients with losses in their accounts will sustain a
    loss. For example, if fraud is involved (e.g., the assets don't
    exist or were never purchased), or, in the absence of fraud, the
    FDIC determines that the assets legally belong to the failed bank,
    clients then become general creditors of the bank and would receive
    a pro rata distribution upon liquidation. This issuance only
    provides a summary of FDIC treatment. Additional information is
    available at the FDIC's Web site at \< http://www.fdic.gov \>.

[^4]: Broker/dealers and banks typically hold CDs under arrangements
    that preclude registering the CDs in any individual customer's name.
    For example, most CDs sold through broker/dealers and banks are
    issued in denominations of \$1,000 and are evidenced by
    large-denomination physical certificates representing multiple
    \$1,000 deposits. The large-denomination certificates may be held by
    the broker/dealer or bank, or safekept for it by one or more
    intermediaries such as a bank, a clearing broker/dealer or a
    securities depository such as the Depository Trust Company. In any
    of these instances, the CDs cannot be registered in the name of the
    customer unless the broker/dealer or bank arranges for the
    customer's CDs to be registered with the issuing bank in the
    customer's name.

[^5]: In some instances, a deposit broker will purchase a
    large-denomination CD that does not evidence multiple \$1,000 CDs
    and will sell participations in the large-denomination CD. In such
    cases, the insurance coverage will "pass through" the broker to the
    customers if the FDIC's requirements have been satisfied. Apart from
    the insurance, however, banks should be cautious about these
    arrangements because the large-denomination CD is not divisible into
    \$1,000 CDs and, hence, liquidity may be poor. The only potential
    buyers for the CD may be the deposit broker's own customer base.

[^6]: This issuance only provides a summary of FDIC requirements to
    obtain pass-through insurance. If a bank has any question about the
    applicability of FDIC insurance to an investment, the bank should
    contact the FDIC directly for guidance or consult the FDIC's Web
    site at \< http://www.fdic.gov/deposit/index.html \>, where
    information on deposit insurance is located.