INTERBANK LIABILITIES

12 CFR Part 206

\[Regulation F; Docket No. R-0769\]

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Final rule.

SUMMARY: The Board is publishing in final a new Regulation F, Interbank
Liabilities. The final rule implements section 308 of the Federal
Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), which
requires the Board to prescribe standards to limit the risks posed by
exposure of insured depository institutions to other depository
institutions. The final rule applies to banks, savings associations, and
branches of foreign banks with deposits insured by the Federal Deposit
Insurance Corporation (FDIC).

The final rule generally requires insured banks, savings associations,
and branches of foreign banks, referred to collectively as \"banks,\" to
develop and implement internal prudential policies and procedures to
evaluate and control exposure to the depository institutions with which
they do business, referred to as \"correspondents.\"

The rule also establishes a general \"limit\" stated in terms of the
exposed bank\'s capital, for overnight \"credit exposure\" to an
individual correspondent, as defined by the rule. Under the rule, a bank
ordinarily should limit its credit exposure to an individual
correspondent to an amount equal to not more than 25 percent of the
exposed bank\'s total capital, unless the bank can demonstrate that its
correspondent is at least \"adequately capitalized.\" No limit is
specified by the rule for credit exposure to correspondents that are at
least \"adequately capitalized,\" but a bank is required to establish
and follow its own internal policies and procedures with regard to
exposure to all correspondents, regardless of capital level.

The final rule provides for a thirty-month transition period after the
effective date for full implementation of the rule. Banks must have in
place the internal policies and procedures required by the rule on June
19, 1993. The regulatory limit on credit exposure to correspondents that
a bank cannot demonstrate are at least \"adequately capitalized\" will
be phased in, with the limit set at 50 percent of the exposed bank\'s
capital for a one-year period beginning on June 19, 1994, and reduced to
25 percent as of June 19, 1995.

EFFECTIVE DATE: December 19, 1992.

FOR FURTHER INFORMATION CONTACT: Oliver Ireland, Associate General
Counsel (202/452-3625), Lawranne Stewart, Attorney (202/452-3513), or
Manley Williams-Stander, Legal Assistant (202/452-5565), Legal Division;
or Stephen Lovette, Manager (202/452-3622), or Derek L. Young,
Supervisory Financial Analyst (202/452-2960), Division of Banking
Supervision and Regulation, Board of Governors of the Federal Reserve
System. For the hearing impaired only, Telecommunications Device for the
Deaf (TDD), Dorothea Thompson (202/452-3544), Board of Governors of the
Federal Reserve System, 20th & C Streets, NW., Washington, DC 20551.

SUPPLEMENTARY INFORMATION: On July 20, 1992, the Board published for
comment a proposed Regulation F, Interbank Liabilities, to implement
section 308 of the Federal Deposit Insurance Corporation Improvement Act
of 1991 (FDICIA). 57 FR 31974, July 20, 1992. Section 308, which added a
new section 23 to the Federal Reserve Act (FRA), requires the Board to
prescribe standards, by regulation or order, that will have the effect
of limiting the risks posed by an insured depository institution\'s
exposure to another depository institution.

Summary of the Proposed Rule

The Board\'s proposed rule was designed to ensure that banks adopt
prudent limits on credit and liquidity risks in dealing with other
depository institutions. The proposed rule required banks to establish
limits on both credit and settlement exposure to each individual
correspondent. The proposed rule also established \"benchmark\"
guidelines on the overnight credit exposure to individual correspondents
that ordinarily should not be exceeded. The benchmark guidelines were
stated as percentages of the exposed bank\'s capital. The levels of
overnight credit exposure considered to be permissible under the
benchmarks were tiered based on the capital of the correspondent with
which the bank is dealing, so that higher levels of a bank\'s capital
may be exposed to better capitalized correspondents. The benchmark
guidelines under the proposed rule were intended to establish the
maximum credit exposure that ordinarily would be considered to be
prudent with respect to a correspondent with a particular level of
capital.

The benchmark guidelines, which were based on a measure of credit
exposure that excluded certain relatively low-risk transactions,
generally permitted a bank to have credit exposure to an individual
correspondent in an amount up to 25 percent of the exposed bank\'s total
capital. For a correspondent that a bank could demonstrate is
\"adequately capitalized,\" the bank could have credit exposure under
the proposed rule equal to 50 percent of the bank\'s total capital, but
no more than 25 percent of the bank\'s capital could be exposed through
transactions with a term to maturity of more than thirty days. No
specific benchmark guideline was provided under the proposed rule for
credit exposure to a correspondent that the bank could demonstrate was
\"well capitalized.\"

Summary of Final Rule

The final rule continues to require that a bank adopt internal policies
and procedures to address exposure to correspondents, and includes a
\"regulatory limit\" for exposure to correspondents that are less than
adequately capitalized. As with the proposed rule, \"correspondent\"
includes both domestically chartered depository institutions that are
federally insured and foreign banks. The Board has made several
significant modifications to the proposed rule, however, in order to
improve the effectiveness of the rule and to reduce burdens identified
by the comments.

Prudential Standards

The final rule provides greater detail concerning the prudential
standards in order to clarify the rule\'s requirements for internal
policies and procedures to identify and control risk. Under the final
rule, a bank is required to adopt internal policies and procedures to
address the risk arising from exposure to a correspondent, taking into
account the financial condition of the correspondent and the size, form,
and maturity of the exposure. The final rule allows banks to adopt
flexible policies and procedures to meet this requirement in order to
permit banks to allocate resources in a manner that will result in real
reductions in risk, while minimizing the burden of compliance with the
rule.

The final rule requires a bank to maintain written policies and
procedures to prevent excessive exposure to any individual correspondent
in relation to the financial condition of the correspondent. Under the
final rule, a bank\'s board of directors must review annually the
bank\'s policies and procedures concerning correspondents, but need not
approve individual correspondent relationships. The policies and
procedures adopted by the board must provide for consideration of credit
and liquidity risks, including operational risks, in establishing and
maintaining relationships with correspondents. Where a bank\'s exposure
to a correspondent is significant, considering the size and maturity of
the exposure and the condition of the correspondent, the bank must
periodically review the financial condition of the correspondent. The
final rule does not require periodic review of the financial condition
of all correspondents. For example, the final rule does not require
periodic review of the financial condition of a correspondent to which
the bank has only insignificant levels of exposure, such as small
balances maintained for clearing purposes.

The final rule requires that a bank take into account any deterioration
in the condition of a correspondent in evaluating the creditworthiness
of the correspondent, and lists other factors that have a bearing on the
financial condition of the correspondent. A bank may base its review of
the financial condition of a correspondent on publicly available
information, such as call reports, Thrift Financial Reports, Uniform
Bank Performance Reports, or annual reports.[^1] The final rule
generally does not require a bank to obtain non-public information on
which to base its analysis of the financial condition of a
correspondent.[^2]

The final rule provides that a bank may rely on another party, such as
its bank holding company, a bank rating agency, or another
correspondent, to provide financial analysis of a correspondent, as long
as the bank has reviewed the assessment criteria used by that party.
Additionally, a bank may rely on its bank holding company to select and
monitor correspondents, or on a correspondent, such as a bankers\' bank,
to choose other correspondents with which to place the bank\'s federal
funds, as long as the bank has reviewed and approved the selection
criteria used.

The final rule requires that a bank establish internal limits on
exposure only where the financial condition of the correspondent and the
form or maturity of the exposure create a significant risk that payments
will not be made as contemplated. Limits must be consistent with the
risk undertaken, but may be flexible, based on factors such as the level
of monitoring of the exposure and the condition of the correspondent.
The final rule also provides that a bank need not set one overall limit
on exposure to a correspondent, but may instead set separate limits for
different forms of exposure, products, or maturities.

The final rule provides that, for the significant sources of exposure
for which internal limits are required, the bank either should monitor
its exposure or structure transactions with the correspondent in order
to ensure that the exposure ordinarily remains within the internal
limits established by the bank.[^3] Where monitoring is used, the final
rule indicates that the appropriate level of monitoring will depend on
the type and volatility of the exposure, on the extent to which the
exposure approaches the bank\'s internal limits, and on the condition of
the correspondent. The final rule also indicates that ex post monitoring
generally is sufficient.

The final rule continues to require that a bank\'s internal policies and
procedures address intraday exposure. As with other exposure of longer
maturities, however, the final rule does not necessarily require that
limits be established on intraday exposure. Such limits would be
required only if the size of the intraday exposure and the condition of
the correspondent indicated that there is a significant risk that
payments will not be made as contemplated.

Limit on Credit Exposure to Certain Correspondents

The final rule provides that a bank\'s internal policies and procedures
should limit overnight credit exposure to a correspondent to 25 percent
of the exposed bank\'s capital, unless the bank can demonstrate that its
correspondent is at least \"adequately capitalized,\" as defined by the
rule. The final rule does not specify limits for credit exposure to
adequately or well-capitalized correspondents.[^4]

The benchmark guideline included in the proposed rule for exposure to
adequately capitalized correspondents served largely as a transition
from the unrestricted exposure permitted for well-capitalized
correspondents to the 25 percent benchmark for correspondents that are
less than adequately capitalized. The final rule requires banks to take
into account the maturity of exposure and changes in the financial
condition of the correspondent in establishing internal prudential
limits and monitoring, and therefore decreases the need for formal
limits on credit exposure to adequately capitalized correspondents.
Additionally, because existing exposure above the 25 percent limit for
credit exposure to a less than adequately capitalized correspondent is
not \"grandfathered\" under the rule if the correspondent slips below
adequately capitalized, the existence of this limit will encourage banks
to shorten the maturity of exposure to correspondents that are at risk
of dropping below the capital levels required to be adequately
capitalized.

This regulatory \"limit\" requires that a bank\'s internal policies and
procedures limit \"credit exposure\" to a correspondent to 25 percent or
less of the exposed bank\'s capital, unless the bank can demonstrate
that the correspondent is at least \"adequately capitalized,\" as
defined in the rule. As in the proposed rule, this limit should be
viewed as a maximum level for credit exposure, rather than as a safe
harbor. Formal limits on credit exposure to such a correspondent would
not be necessary where the banks\' policies and procedures effectively
limit credit exposure to an amount below the 25 percent limit, such as
where only small balances are maintained with the correspondent, or
where the correspondent has only been approved for a limited
relationship. Although in many cases it will be necessary for a bank to
establish formal internal limits to meet the regulatory limit, the
provisions of Sec. 206.3 of the final rule concerning excesses over
internal limits also apply to limits established for the purpose of
controlling \"credit exposure\" under Sec. 206.4 of this rule.

As in the proposed rule, the \"credit exposure\" that is limited under
the final rule is based on the assets and off-balance sheet transactions
against which the bank must maintain capital under the risk-based
capital guidelines, with the same exclusions of lower-risk transactions
permitted. The final rule clarifies that \"credit exposure\" does not
include settlement exposure, transactions in which the bank acts as
agent, and other forms of exposure that are not covered by the capital
adequacy guidelines.

Transition Provisions

To mitigate the need for a bank to reduce exposure rapidly to a
correspondent whose capital has slipped below the levels needed to be
considered adequately capitalized, the final rule increases the
transition period for application of the 25 percent limit on credit
exposure to 120 days. The longer transition period will avoid undue
disruptions in correspondent relationships due to temporary declines in
capital ratios by allowing the correspondent an opportunity to bring its
capital ratios back above the relevant levels before the end of the next
quarterly report. The extended period will also provide the exposed bank
more time to implement any monitoring required to demonstrate compliance
with the limit on credit exposure and to adjust the maturities or level
of its exposure to the correspondent.

Initial Implementation Period

The proposed rule required that banks have internal policies and
procedures in place by December 19, 1992, with the benchmark guidelines
to be phased in over a two-year period. The final rule provides a
transition period of six months before the prudential standards become
effective, with the remaining limit on credit exposure phased in over a
two-year period after that date. The longer initial implementation
period will enable banks that have not made credit assessments of their
correspondents to do so, and will provide an opportunity for banks to
review and, where appropriate, improve their monitoring procedures.

Additional modifications to the proposed rule are detailed in the
discussion below.

Summary of Comments

The Board received 321 comment letters on the proposed rule. Two hundred
fourteen commenters opposed the rule. Five commenters supported the
regulation\'s implementation of section 308. An additional seventeen
commenters offered qualified support for the rule, urging the Board to
modify implementation to make it less burdensome, by, for example,
eliminating the guidelines based on capital. The others expressed no
opinion or offered detailed comments. The comments included
seventy-three \"form letters,\" forty-one of which focused on the effect
of the proposed rule on bankers\' banks and sixty-one of which addressed
the competition between Federal Reserve Banks and private sector
correspondents. All of the form letters were from small banks.[^5] The
321 commenters by category included 233 commercial banks, 41 bank
holding companies, 16 bankers\' banks, 13 trade associations, 5
clearinghouses, 6 savings associations, 1 Federal Home Loan Bank, and 6
others.

General Comments

Cost. One hundred fifty-one commenters expressed concern over the
additional cost burden the proposed rule would impose. The Board has
attempted to minimize costs to banks of implementing the final rule, but
some costs are inherent in any new rule that results in changes in bank
practices.

Excessive regulation. One hundred sixty-six commenters believed the
proposed rule created excessive regulation. While the Board recognizes
the regulatory burden associated with the new rule, the Board believes
that the provisions of the final rule are necessary to carry out the
intent of section 308.

Federal Reserve Bank and Federal Home Loan Bank competition. One hundred
seventy-nine commenters expressed concern that the proposed rule would
divert business from the private sector to the Federal Reserve Banks and
Federal Home Loan Banks. Two commenters suggested that the Board reduce
the competitive impact by including Federal Reserve Banks in the
definition of correspondent. Another commenter suggested the Board
require banks to conduct the same analysis of Federal Reserve Banks that
would be required for a private correspondent. Because exposure to a
Federal Reserve Bank or Federal Home Loan Bank poses minimal risk to a
respondent, the Board does not believe that Federal Reserve Banks and
Federal Home Loan Banks should be included in the definition of
correspondent in the final rule. To treat Federal Reserve Banks and
Federal Home Loan Banks as correspondents under the final rule would
impose unnecessary costs and burdens on banks, with no appreciable
reduction in risk.

Five commenters proposed that the Board rectify the competitive effect
of the rule by changing the private-sector adjustment factor or the
prices charged for check collection.[^6] The Board will review the
calculation of the private-sector adjustment factor to determine if
modifications are appropriate.

Disruption of the federal funds market. Twenty-four commenters expressed
concern that the proposed rule would disrupt the federal funds market by
preventing banks from selling all of their federal funds to a single
correspondent, and stated that the need to diversify federal funds sales
among a number of purchasers could result in higher transaction costs.
In addition, commenters expressed concern that the need to evaluate the
financial condition of correspondents could lead banks that are members
of the Federal Home Loan Banks to deposit funds in those banks rather
than selling them to correspondents.

While the Board recognizes that there may be some initial restructuring
of the channels for federal funds sales, the Board does not believe that
the regulation will result in a material or lasting disruption of the
federal funds market or to a material reduction in the availability of
federal funds. The federal funds market is competitive, and the Board
believes that creditworthy correspondents that are buyers of federal
funds will continue to be able to fund profitable business utilizing
this market. The Board also believes that modifications incorporated in
the final rule, including elimination of the regulatory limit on credit
exposure to adequately capitalized correspondents, will reduce the
effect of the rule on the federal funds market.

Availability of credit. Fifty-six commenters asserted that the proposed
rule would exacerbate the \"credit crunch,\" generally either because of
disruption in the federal funds markets or because of diversion of funds
to Federal Reserve Banks or Federal Home Loan Banks. Twenty-two of these
commenters claimed that this effect would be particularly pronounced in
small communities. As discussed above, the Board believes that the
modifications incorporated in the final rule have significantly reduced
the likelihood of any reduction in the availability of funds for
lending.

Effect on the FDIC funds. Thirty-eight commenters, nine of whom
submitted a substantially similar letter, expressed concern that the
proposed rule would weaken the Federal Deposit Insurance funds. Another
commenter, however, asserted that the proposed rule would actually
strengthen the funds. To the degree that the proposed rule diverts
deposits, generally in the form of compensating balances, from
depository institutions to Federal Reserve Banks or Federal Home Loan
Banks, it may reduce FDIC insurance assessments. However, the Board
believes that the overall effect of the final rule will be to strengthen
the funds by reducing losses.

Repeal. Forty-six commenters urged the repeal of the statute and one
commenter asserted that similar limits at the state level have failed.
The power to repeal the statute, however, rests with the Congress rather
than the Board.

Miscellaneous. Thirteen commenters suggested that, as an alternative to
regulating respondents, the federal regulators supervise the
correspondent banking business by restricting which banks could engage
in such business, notifying respondents that do business with unsound
correspondents, setting limits on the amount of exposure a correspondent
can accept, or automatically transferring balances from weak
correspondents to strong ones and notifying respondents later. Seven
other commenters noted that it is inefficient for a thousand banks to
monitor the same correspondent, which is also being monitored by a
regulator. The Board does not believe that it would be appropriate to
endorse specific correspondents, as such a practice could perpetuate the
\"too big to fail\" concept that section 308 was designed to address.

One commenter urged the Board to create a new instrument for Treasury
obligations for which the Federal Reserve Banks would be the broker and
administrator. The Board does not believe that the creation of such an
instrument is necessary, as the government securities market is broad
and deep, offering many opportunities for investment. Another commenter
suggested that the Board permit banks to sell federal funds to Federal
Reserve Banks. The Board does not believe that such a practice would be
appropriate because it would interfere with the conduct of monetary
policy.

Another commenter suggested that the Board change Regulation D and the
FDIC insurance calculation to encourage fee payment. The final rule
increases the incentives for respondents to compensate correspondents by
fees, and the Board believes that the market will make appropriate
adjustments to this change.

One commenter suggested that the Board expand legal lending limits to
include off-balance sheet items. The Board does not have the authority
to effect such a change, however, as these limits are administered by
the Comptroller of the Currency under the National Bank Act and by state
banking regulators under state law.

One commenter urged the Board to tailor the rule to the strength of the
respondent on the assumption that well-capitalized respondents would be
managed wisely. The final rule places greater emphasis on a bank\'s
internal policies and procedures.

Section-by-Section Comments

The section and paragraph numbers in the headings refer to the numbering
of the proposed rule. Where a provision has been renumbered or moved,
the appropriate cite in the final rule is provided in brackets.

Section 206.2 Definitions

Section 206.2(a) Bank

The proposed rule defined \"bank\" as an insured depository institution
as defined under section 3 of the Federal Deposit Insurance Act (12
U.S.C. 1813). Banks covered by this definition must control their
exposure to correspondents under this rule. The Board received
twenty-seven comments on this section.

Exclusion of Small Banks

Fourteen commenters proposed that the Board exclude small or community
banks, defined by some commenters as banks with assets under \$1
billion, or hold such banks to a more lenient standard, especially in
their correspondents are well or adequately capitalized. Another
thirteen commenters, nine of whom submitted a substantially similar
letter, asserted that the current rule violated Congressional intent, as
Congress did not intend to harm small banks with this regulation.

Section 308 states that the Board should address the risk posed to an
insured depository institution by the failure of another depository
institution. It does not restrict that mandate to risks posed to large
institutions. Section 308 is designed to limit bank failures
attributable to losses due to the failure of a correspondent. An
exemption for small bank exposure to correspondents would be contrary to
this design, as the failure of a correspondent would continue to
precipitate the failure of small banks.

Coverage of Definition

One commenter urged that the Board clarify that a nonbank credit card
company is excluded from the definition of \"bank.\" Nonbank credit card
companies are not considered to be banks for the purposes of this rule.
However, bank users of credit card or other payment services may,
depending upon the terms of their services, incur exposure to other
banks by virtue of use of such services.

The definition in the final rule has been redrafted for clarity.

Section 206.2(b) Correspondent \[Final Rule \-- Section 206.2(c)\]

The proposed rule defined \"correspondent\" as a U.S. depository
institution or a foreign bank, as defined in the proposed rule, to which
a bank had exposure. The Board received 134 comments on this section.

Exclusion of Bankers\' Banks

One hundred twenty-two commenters urged exclusion of bankers\' banks
from the definition of correspondent. Forty-seven commenters, twenty-six
of whom submitted substantially similar letters, argued that bankers\'
banks pose no systemic risk, either because the bankers\' banks are
themselves small, or because they serve only small banks. Thirteen
commenters, nine of whom submitted a substantially similar letter,
asserted that bankers\' banks reduce systemic risk by providing
alternative correspondent services. Twenty-seven commenters, eighteen of
whom submitted a substantially similar letter, argued that a bankers\'
bank may be less risky because it is a local institution, it is
chartered to serve only banks, and its board includes officers of its
respondent banks, who are therefore in a position to monitor its
financial condition more closely.

Forty-six commenters, twenty-nine of whom submitted a substantially
similar letter, pointed out that bankers\' banks rely exclusively on
interbank liabilities and are thus uniquely vulnerable to the interbank
liability limits. Sixty-three commenters, including twenty-eight form
letters and a number of bankers\' banks, argued that Congress did not
intend bankers\' banks to be targeted. Many of these commenters
concluded that the rule should create special provisions for bankers\'
banks. Thirty-two commenters, nine of whom submitted a substantially
similar letter, argued that Congress recognized the unique role of
bankers\' banks in the Depository Institutions Deregulation and Monetary
Control Act of 1980. One commenter argued that it was unfair to subject
bankers\' banks to the rule when central liquidity facilities, which
provide services to credit unions, are not covered. Another commenter
argued that bankers\' banks are not commercial banks and that the
deserve the same treatment as Federal Reserve Banks. Eleven commenters
argued that bankers\' banks should be excluded from the scope of the
rule because banks would otherwise be forced to obtain correspondent
services from their competitors.

In contrast, two commenters argued that exclusion of bankers\' banks
would unfairly restructure the market for correspondent services, and
another commenter noted that exemptions for some providers of
correspondent services would erode competition.

The Board recognizes that bankers\' banks are providing important
services to respondents and are meeting a market need, and that Congress
has given special status to bankers\' banks in other statutes.
Nonetheless, the Board does not believe that other legislation or the
statutory language or legislative history of section 308 demonstrate a
Congressional intent to exclude bankers\' banks from the coverage of
section 308. Nor does the Board believe the Congress intended for
bankers\' banks to be targeted by the rule. Accordingly, the final rule
treats bankers\' banks no differently than other correspondents.

The Board does not believe that bankers\' banks will be unduly harmed by
being treated as correspondents under the rule. Bankers\' banks
generally are at least adequately capitalized and there is no regulatory
limit on credit exposure to an adequately capitalized correspondent
under the final rule. Although respondents will need to obtain
information on correspondents\' capital ratios in order to demonstrate
that correspondents are at least adequately capitalized, bankers\' banks
can reduce this burden by providing the information to their respondents
directly. To the extent that bankers\' banks are concerned that the
burden of meeting the requirements of the rule\'s prudential standards
will cause banks to transfer business from a bankers\' bank to a Federal
Reserve Bank or Federal Home Loan Bank, the Board believes that the more
extensive guidance provided in the language of the final rule will
reduce this effect.

The Board believes that including bankers\' banks within the scope of
the rule is appropriate. Bankers\' banks represent a concentration of
interbank risk because they rely exclusively on interbank liabilities
and because their assets subject them to the same risks as other banks.
Further, an exception for bankers\' banks could alter the market for
correspondent services, possibly increasing risk as correspondent
business moves to such special purpose banks. With regard to arguments
that including bankers\' banks as correspondents under the rule will
force banks to obtain services from their competitors, the Board notes
that banks often do business with competitors.

Sixteen commenters asserted that the rule would result in a reduction in
deposits at bankers\' banks which, in turn, would reduce the capacity of
bankers\' banks to provide \"overline\" loan and participation
arrangements and other correspondent services. The Board believes that
the demand for these services will provide incentives for banks to
continue to do business with bankers\' banks rather than shifting to
Federal Reserve Banks or Federal Home Loan Bands, which provide only
limited services.

Six commenters stated that the proposed rule would preclude a bankers\'
bank from raising capital when it is most needed because banks could not
increase exposure to the bankers\' bank through stock investments.
Although most bankers\' banks are well or adequately capitalized, the
Board recognizes that the capital of bankers\' banks generally
represents exposure of the owner-customers of the bankers\' bank. The
Board notes, however, that capital ratios may be increased by other
means, such as by reducing certain assets of the bankers\' bank.

Restriction of Coverage to Large, Weak Banks

Fifty-nine commenters concerned with the regulatory burden imposed by
the proposed rule urged that the rule focus exclusively on banks that
might be considered \"too big to fail.\" Thirty-five of these
commenters, twenty-eight of whom submitted a substantially similar
letter, suggested that the Congressional intent was to focus on the risk
caused by the failure of a large depository institution, and that small
banks were not to be affected by the regulation. In addition,
thirty-five commenters, thirty of whom submitted a substantially similar
letter, urged the Board to exempt exposure to well-capitalized
correspondents from the regulation or at least to treat exposure to them
no differently than exposure to a Federal Reserve Bank.

Although the introductory language in section 308 refers to the failure
of a large depository institution, the text of the statute directs the
Board to limit risks posed by exposure to \"any other depository
institution.\" Further, excluding exposure to small correspondents from
the rule could cause correspondent business to shift to small
correspondents, regardless of their financial condition, thereby
increasing the risk that the failure of a small correspondent would
cause the failure of other banks. Finally, entirely excluding exposure
to well-capitalized correspondents could encourage banks to take
exposure to a well-capitalized correspondent that may be excessive in
relation to the overall financial condition of the correspondent. Thus,
the Board believes that the definition of \"correspondent\" should not
exclude depository institutions on the basis of size or capitalization.

Expansion of the Definition of Correspondent

Nine commenters expressed concern about competition in the correspondent
business from nonbanks and credit unions. Three of these commenters
proposed that the definition of correspondent encompass all providers of
correspondent services, including nonbanks. One commenter pointed out
that Edge Act companies are not defined as correspondents but are
included as subsidiaries.

The Board notes that the interbank liability provisions of section 308
concern exposure to depository institutions, not to financial service
providers generally. The definition of \"correspondent\" in the proposed
rule was limited to institutions that receive special treatment under
the capital adequacy guidelines, which provide that claims against
certain foreign banks and federally insured domestic depository
institutions generally are given a 20 percent risk weight.[^7]
Furthermore, the Board does not believe that nonbank providers of
correspondent services, including credit unions, provide a full range of
correspondent services in competition with traditional correspondents or
that risk to banks will increase materially through migration to
providers of services that are not covered by the rule. Finally, the
failure of financial institutions that are not insured by the Federal
Deposit Insurance Corporation would not pose a threat to the Federal
Deposit Insurance funds through invocation of \"too big to fail.\"

Final Rule

The definition of correspondent has been amended to exclude commonly
controlled correspondents that are subject to cross-guarantees under the
Federal Deposit Insurance Act. The proposed rule excluded commonly
controlled correspondents from the limits on credit exposure, but not
from the prudential standards. In the final rule this exclusion has been
extended to the prudential standards for consistency. This exclusion
does not affect the applicability of other statutory provisions
governing transactions with affiliated institutions, such as section 23A
of the Federal Reserve Act (12 U.S.C. 371c).

Section 206.2(c) Exposure \[Final Rule \-- Section 206.2(d)\]

The proposed rule defined \"exposure\" as the risk that payment to
complete a transaction will not be made in a timely manner or that an
obligation will not be paid in full. The definition further provided
that \"exposure\" includes the operational and liquidity risks related
to the settlement of transactions and risk related to the
creditworthiness of a correspondent. Both overnight and intraday
exposure were covered by the definition. The proposed rule required
exposure to be monitored under the prudential standards. The Board
received twenty comments on this section.

Scope of the Definition

Ten commenters urged that the scope of the definition be restricted.
Nine commenters suggested that the definition of exposure include only
significant exposure measured by the amount at risk and the product line
at issue to a particular correspondent. Four of these commenters
suggested that the Board provide guidance, such as that in the payments
system risk policy, as to what constitutes significant exposure. One
commenter urged that the definition exclude items covered by FDIC
insurance. Another commenter suggested that the purchase and sale of
Treasury securities be excluded. One commenter suggested that the Board
exclude settlement risk from the definition of exposure. Another
commenter suggested that the settlement risk in delivery-versus-payment
systems be excluded. Two commenters, clearinghouses, suggested that the
settlement risk attendant to a clearing and settlement system that
includes settlement finality should be excluded from the definition of
exposure because it is insignificant. One commenter asked the Board to
exclude collateralized interest rate swaps from the definition of
exposure. Another commenter questioned whether other exposures like
payroll, pending ATM, and coin and currency settlements should be
included in exposure. One commenter suggested that the definition of
exposure distinguish exposure due to capital market transactions from
exposure due to correspondent banking activity. In addition, four
commenters urged the exclusion of short-term exposure. One commenter
suggested that the rule exclude all exposure with a maturity of less
than 14 days, two others urged the exclusion of demand deposits, and the
fourth called for the exclusion of federal funds transactions. Three
commenters expressed concern that regulators would unreasonably expand
the definition.

The final rule excludes certain lower-risk transactions from the
definition of \"credit exposure,\" which is the measure of exposure
subject to a specific regulatory limit under the rule. The general
definition of \"exposure\" used in the final rule, however, covers all
types of transactions that create a risk of nonpayment or delayed
payment. The Board believes that banks should consider all types of
financial exposure in establishing prudential policies and procedures.
As discussed in the summary of the final rule, however, the prudential
standards in the final rule have been amended to clarify that a bank is
not required to treat all types of exposure in the same manner, and that
a bank\'s internal policies and procedures may provide for differential
treatment of exposure based on the form, maturity, and size of the
exposure, as well as on the condition of the correspondent.

Clarification of the Definition

Seven commenters found the definition of exposure too vague. Two
commenters sought clarification of the definition of settlement risk.
One commenter asked for clarification of how settlement risk relates to
automated clearinghouse (ACH) transactions. One commenter urged that
exposure arising out of credit card transactions should be excluded from
the definition of exposure because a bank cannot control the banks to
which it has this exposure. In this regard, the Board notes that
exposure arising from the following transactions generally is
insignificant because the exposed bank usually has prompt recourse to
other parties or because the amounts involved are not significant: (1) A
collecting bank\'s risk that a check will be returned, (2) an
originating bank\'s risk that an ACH debit transfer will be returned or
its settlement reversed, (3) a receiving bank\'s risk that settlement
for an ACH credit transfer will be reversed, or (4) a credit card
transaction. Under the final rule, a bank is not required to conduct
periodic reviews of the financial condition of a correspondent where the
amount of the exposure is insignificant and would not be required to
limit exposure unless there is a significant risk that payment will not
be made as contemplated.

Another commenter requested clarification of the terms \"liquidity
risk\" and \"operational risk\" used in the definition of exposure.
Liquidity risk is the risk that payment will be delayed for some period
of time. For example, a bank is subject to the liquidity risk that a
payment due from a failed correspondent will not be made on time; the
bank\'s credit risk may be a lesser amount due to later distributions
from the correspondent\'s receiver. Liquidity risk is included in the
definition of exposure in the final rule. Operational risk if the risk
that operational problems at a correspondent, such as computer failure,
may prevent it from making payments, thereby creating liquidity risks
for other banks, and is also included in the definition of exposure in
the final rule.

One commenter asked if correspondent obligations that a bank holds in a
fiduciary capacity are excluded. Because obligations held in a fiduciary
capacity do not expose the bank itself to loss due to credit, liquidity,
or operational problems, such obligations are not included in the
definition of exposure.

One commenter argued that depository institution equity securities taken
as collateral or in satisfaction of a debt should be excluded from the
definition of \"exposure\" because they are not payment obligations.
Such transactions are covered by the definition of \"exposure,\" in the
final rule, as they create a credit risk to the bank should the
depository institution fail. The definition in the final rule has been
redrafted for clarity.

Section 206.2(d) Foreign Banks \[Final Rule \-- Section 206.2(e)\]

The proposed rule defined a \"foreign bank\" as an institution that is
organized under the laws of a country other than the United States,
engages in the business of banking, is recognized as a bank by the bank
supervisory or monetary authorities of the country of the bank\'s
organization, receives deposits to a substantial extent in the regular
course of business, and has the power to accept demand deposits. Foreign
banks were included in the definition of correspondent in the proposed
rule. The Board received seven comments on this section.

Exclusion of Foreign banks

Two commenters urged that the rule exclude foreign banks because of the
cost and difficulty in obtaining necessary information, such as capital
information, and because the proposed rule would harm the
competitiveness of U.S. banks in foreign correspondent markets. These
commenters also argued that foreign banks do not pose a risk to the
deposit insurance fund, or to the U.S. banking system as a whole. An
additional two commenters, focusing on the lack of current risk-based
capital ratio information and on the decreased risk posed by foreign
banks, suggested that exposure to foreign banks be excluded from
application of the benchmark guidelines and subjected only to the
prudential standards. Two other commenters, however, strongly supported
the coverage of foreign banks in the rule, arguing that exclusion would
grant such banks a competitive advantage over domestic banks. One
commenter, a clearinghouse, noted that its members were divided on this
issue.

Foreign banks were included as correspondents under the proposed rule
because failure to cover foreign banks could encourage a migration of
correspondent and interbank business to foreign banks irrespective of
their condition, thereby potentially increasing risk to insured
depository institutions. Consequently, the Board does not believe that
foreign banks should be excluded from coverage of the limits on credit
exposure or the prudential standards. To address problems with obtaining
adequate information concerning foreign banks, however, the final rule
provides greater flexibility as to the timing and frequency with which a
bank must obtain information on the capital levels of its foreign bank
correspondents.

Clarification of the Definition

Two commenters called for recognition of the decreased risk posed by a
foreign central bank or a bank guaranteed by a foreign government, and
perhaps even exclusion of these institutions from coverage as
\"correspondents\" under this rule. The definition of \"foreign bank\"
is based on the criteria used in the risk-based capital guidelines. As
those guidelines exclude the central bank of a foreign country, such
institutions would be excluded for the purposes of this rule as well.
The Board believes, however, that banks guaranteed by foreign central
governments may pose risks and should be included as correspondents for
the purposes of this rule.

The definition remains unchanged in the final rule.

Section 206.2(e) Primary Federal Supervisor \[Final Rule \-- Section
206.2(f)\]

No comments were received on this section, and the definition remains
unchanged in the final rule.

Section 206.2(f) Quality Asset \[Final Rule \-- Section 206.4(f)(3)\]

The proposed rule defined a \"quality asset\" as an asset that is not in
a nonaccrual status, on which principal or interest is not more than
thirty days past due, and whose terms have not been renegotiated or
compromised due to the deteriorating financial condition of the primary
obligor. Furthermore, under the proposed rule an asset would not be
considered to be a \"quality asset\" if any other loans to the primary
obligor on the asset have been classified as \"substandard,\"
\"doubtful,\" or \"loss\" or treated as \"other loans specially
mentioned\" in the most recent report of examination or inspection of
the bank or an affiliate prepared by either a federal or a state
supervisory agency. Under the proposed rule, a transaction for which a
correspondent is only secondarily liable could be excluded from a
bank\'s \"credit exposure\" to the correspondent as long as the
transaction could be considered a \"quality asset.\"

The Board received one comment, which criticized this definition as too
restrictive. The commenter urged that the definition include assets on
which principal or interest is not more that 90 days past due, as is the
standard in SEC Guide 3 Section III C.1. This SEC standard is used for
reporting and disclosure purposes and does not appear to be appropriate
for the purposes of this rule. The Board believes that the proposed
definition, which was derived from section 23A of the Federal Reserve
Act (12 U.S.C. 371c), permits a more accurate measure of actual credit
exposure. In the final rule the definition of \"quality asset\" has been
incorporated into the section concerning \"credit exposure\" (Sec.
206.4).

Section 206.2(g) Subsidiary \[Final Rule \-- Section 206.4(e)\]

Under the proposed rule, the term \"subsidiary\" was given the same
meaning as that term under section 23A of the Federal Reserve Act, and
therefore included any company in which a bank owns or control 25
percent or more of any class of voting securities. This definition in
the final rule has been modified and incorporated into Sec. 206.4, and
is discussed below in the description of comments on that section.

Section 206.2(i) Total Capital \[Final Rule \-- Section 206.2(g)\]

The proposed rule defined total capital as the total of a bank\'s Tier 1
and Tier 2 capital under the risk-based capital guidelines provided by
the bank\'s primary federal supervisor. For an insured branch of a
foreign bank organized under the laws of a country that subscribes to
the principles of the Basle Capital Accord, \"total capital\" means
total Tier 1 and Tier 2 capital as calculated under the standards of
that country. For an insured branch of a foreign bank organized under
the laws of a country that does not subscribe to the principles of the
Basle Capital Accord, \"total capital\" means total Tier 1 and Tier 2
capital as calculated under the provisions of the Accord. The Board
received two comments on this section.

Two commenters requested clarification that the benchmark guidelines
would be based on the total capital of a foreign bank, rather than only
on the capital of the branch. The limit on credit exposure of the
insured branch of a foreign bank is based on the foreign bank\'s total
capital, as defined in this section, not on the imputed capital of the
branch.

The definition remains unchanged in the final rule.

Section 206.2(j) U.S. depository Institution \[Final Rule \-- Section
206.2(h)\]

The proposed rule defined \"U.S. depository institution\" as a federally
insured depository institution chartered in the United States under
federal or state law, and included an insured national bank, state bank,
District bank, or savings association, as those terms are defined under
section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813), but did
not include an insured branch of a foreign bank. U.S. depository
institutions were included in the definition of \"correspondent\" in the
proposed rule. The Board received eight comments on this section, two of
which supported the definition as written.

Scope of the Definition

Three commenters urged the inclusion of credit unions, asserting that
they poses risks to the financial system through the large
inter-institution liabilities of credit union corporate centrals. Credit
unions do not offer a full range of correspondent services to
FDIC-insured banks and are not insured by the FDIC. Therefore, the Board
does not believe that exposure to credit unions poses risks to insured
banks and to the FDIC insurance funds of the type that section 308 was
designed to address.

Clarification of the Definition

Three commenters suggested that the final rule include specific language
excluding Federal Home Loan Banks. The Board believes that the
definition excludes Federal Home Loan Banks and that a specific
exclusion for Federal Home Loan Banks is unnecessary. The definition in
the final rule has been redrafted for clarity.

Section 206.3 Prudential Standards

Section 206.3(a) Internal limits. \[Final Rule \-- Section 206.3(c)\]

The proposed rule required that a bank establish and maintain policies
and procedures to limit exposure to the correspondents with which it
does business. The rule further required that banks establish and
periodically review and revise, as necessary, limits on exposure to
individual correspondents based on an evaluation of the overall
financial condition and other factors being on the creditworthiness of
each correspondent. Finally, it required that a bank structure these
limits to avoid undue concentration of settlement or credit risk with
respect to any individual correspondent. Most of the comments received
addressed the prudential standards, and 110 of those comments addressed
Sec. 206.3(a) on internal limits.

Appropriateness of Internal Prudential Standards

Twenty-four commenters agreed that the prudential standards reflect
prudent banking and general industry practice, and twenty-eight
commenters indicated that they had already established prudential
standards for interbank exposure. Moreover, twenty-four commenters
suggested that this provision, supplemented by examination, be the heart
of the regulation. On the other hand, forty-two commenters, including
five who indicated that they already conduct similar prudential
analyses, disagreed with the Board\'s approach to the problem of
interbank liabilities. These commenters argued that the examination
process can adequately address the problem, both because adequate
controls already exist in the safety and soundness criteria and because
the examination and consultative process is superior to regulation.
These commenters concluded, therefore, that the rule would impose
increased costs without achieving a commensurate reduction in risk.
Three of these commenters suggested that the Board conduct an empirical
study of the risks associated with interbank liabilities and the cost of
controlling those risks.

Thirty-two commenters offered alternatives to the prudential standards.
Three suggested approval of correspondent relationships by vote of the
bank\'s board of directors. Eighteen commenters, submitting an identical
letter, suggested that the prudential standards require only that a bank
obtain information from its correspondents once a year to demonstrate
that the correspondents meet appropriate capital standards. One
commenter suggested that banks be permitted to tier their prudential
standards in a similar fashion as the capital guidelines. Six commenters
favored a simple statement that the risks must be addressed, while
another suggested that the standard be the same due diligence standard
applied to any loan. One commenter urged the Board to require specific,
detailed lending policies, similar to those for highly leveraged
transactions, while another commenter asserted that only on-site
examinations offer a true measure of risk. One commenter suggested that
the rule require an annual review of capital, management experience, and
income trends.

Implementation of the Requirement

Twelve commenters expressed a desire for greater specificity regarding
the preparation and review of the internal limits. Six requested
specificity as to the factors that a bank should evaluate or argued that
the factors be limited. One commenter sought clarification of whether
internal standards could ever be breached. Four commenters indicated
that respondents may lack the expertise to analyze the financial
condition and risk of larger correspondent banks, particularly where the
correspondent has significant off-balance sheet activities. Six
commenters expressed concern about the availability of the information.
One of these commenters stated that correspondents that compete on other
fronts may be unwilling to divulge non-public information. One commenter
asked whether banks could rely on information from correspondents. Two
commenters expressed concern that call and audit reports do not address
overall conditions and operations, although both are mentioned as
factors in the proposed rule. Five commenters expressed concern that the
proposed rule failed to encourage banks to improve continuously their
risk management programs and may encourage banks to abandon a more
sophisticated system for one which tracks the guidelines. One of those
commenters urged that the Board adopt uniform examination guidelines
that reflect to the greatest degree possible existing risk monitoring
and control practices.

Final Rule

The primary focus of the final rule is on a bank\'s analysis of the
creditworthiness of its correspondents. Many of the concerns raised by
these commenters are addressed by the more extensive guidance in the
final rule as to the standards that a bank\'s internal policies and
procedures would be expected to meet. The final rule states that
internal procedures should be directed at preventing excessive exposure
to a correspondent in relation to the financial condition of the
correspondent, and allows banks to adopt flexible policies and
procedures to meet this standard. The final rule does not require the
same procedures to be used for all correspondents or all types of
exposure.

Under the final rule, a bank\'s internal policies and procedures must
provide for periodic reviews of a correspondent\'s financial condition
only where exposure to the correspondents is significant. Periodic
review of the financial condition of correspondents to which the bank
has only insignificant levels of exposure, such as small balances
maintained for clearing purposes, would not be required under the final
rule. While the bank\'s board of directors would be required to review
the bank\'s policies and procedures concerning correspondents on an
annual basis, the board would not be required to approve individual
correspondent relationships. The final rule also does not require the
bank to obtain non-public information on which to base its analysis of
the financial condition of a correspondent, but permits use of publicly
available information, such as call reports, Uniform Bank Performance
Reports, and annual reports.[^8]

Additionally, the final rule requires the establishment of internal
limits only where the financial condition of the correspondent and the
form or maturity of the exposure create a significant risk that payments
will not be made as contemplated. The rule does not require a particular
structure or method of maintaining such limits, but permits the bank
flexibility to structure limits in a manner that will meet the needs of
the bank. For example, in appropriate circumstances a bank may establish
limits for longer term exposure to a correspondent, while not setting
limits for overnight or intraday exposure.

Clarification of the Requirement

Eight commenters inquired whether the Board would permit a lead bank or
bank holding company to conduct the prudential analysis for affiliated
banks. The final rule clarifies that a bank may rely on its bank holding
company, a bank rating agency, or another party to provide financial
analysis of correspondents or to select correspondents, as long as the
board of directors of the bank has reviewed the assessment or selection
criteria used by that party.

Section 206.3(b) Monitoring. \[Final Rule \-- Sec. 206.3(c)\]

The proposed rule required that a bank structure transactions with a
correspondent or monitor exposure to a correspondent to ensure that its
exposure does not exceed its internal limits established under Sec.
206.3(a) and that its credit exposure ordinarily not exceed any
applicable guidelines on credit exposure specified in Sec. 206.4. The
Board received 160 comments on this section.

One hundred fourteen commenters, thirty of whom submitted a
substantially similar letter, protested the cost burden implicit in the
monitoring requirements. Sixteen commenters argued that the costs of the
monitoring provisions of the proposed rule outweigh the benefits.
Fifty-nine commenters argued that these costs will be exacerbated if
banks must spread their correspondent business among a number of banks.
Two commenters complained that the cost burden would fall
disproportionately. One asserted that small community banks would bear
the brunt of it and another asserted it would fall inequitably on the
adequately and well-capitalized banks of the Midwest. Seven commenters
pointed out that even well-capitalized private correspondents and
respondents will have to bear these costs.

Clarification of the Requirement

Six commenters requested clarification as to whether the requirement of
the rule would be satisfied by structuring relations so that the limits
are not exceeded, such as through agency sales policies. Five commenters
urged the Board to consider permitting a lead or parent bank in a bank
holding company to monitor exposure for its affiliated banks. Two
commenters urged that the monitoring requirements distinguish between
significant and insignificant exposure. Another urged that the final
rule permit systems consistent with the institution\'s business,
internal systems operations, and personnel. Seven commenters expressed
concern that examiners might unduly restrict the regulatory flexibility
that was designed to permit the use of diverse existing monitoring and
risk control practices. They urged the Board to adopt uniform
examination guidelines that would accommodate existing systems. Two
commenters suggested as a model the guidelines for self-assessments on
payment system risk.

Frequency of Monitoring

Twelve commenters argued that daily monitoring is excessive if not
impossible. One commenter asserted that a banker cannot know the balance
on a pass-through account. Two other commenters stated that global
monitoring of outstanding exposures on a daily basis in products such as
interest rate swaps, letters of credit, and other transactions would be
extremely difficult, and that banks should be permitted to use their
prudential limits as proxies for actual exposure where these limits are
below the benchmarks. One commenter urged that the final rule match the
frequency of review with the risk, while another urged the Board to
permit banks to monitor exposure in arrears and take corrective action
should exposure exceed prearranged levels. One commenter urged the Board
to permit banks to monitor weekly or monthly averages. Two commenters
expressed approval of the proposed rule\'s acceptance of ex post
monitoring.

Monitoring Overnight Exposure

Fourteen commenters urged the Board to clarify the requirements for
monitoring overnight interbank transactions and to consider eliminating
monitoring of these transactions. Four of these commenters stated that
the likelihood of a bank failing solely on the basis of its overnight
exposure is very remote, and two argued that market factors weed out
weak correspondent banks. Five other commenters argued that the
regulatory burden on small banks in monitoring and controlling overnight
interbank transactions is unreasonable and costly, and could force small
banks to transfer their business to Reserve Banks. Another commenter
urged the exclusion of overnight federal funds sales from the exposure
that must be monitored as long as the sales were made under a
preauthorized line to an approved list of correspondents, on the grounds
that it may be difficult to determine other exposure to a correspondent
at the time of a federal funds transaction.

Monitoring Credit Exposure

Fifteen commenters addressed the issue of monitoring credit exposure.
Five of these commenters urged that the proposed rule\'s acceptance of
occasional or inadvertent excesses be maintained and broadened
sufficiently that small banks with unexpected large deposits or late
incoming wire transfers be permitted to adjust their balances within a
day or two. Six commenters expressed concern that the guidelines would
be viewed as rigid limits. Another commenter asserted that the proposed
rule\'s acceptance of occasional excesses would be where the trouble
spots would arise. Three other commenters requested clarification as to
how often and under what circumstances a bank may exceed the guidelines.
One commenter suggested that the final rule grant banks time to bring
combined credit exposures due to mergers or other acquisitions into
compliance with the benchmark guidelines.[^9]

Monitoring Intraday Exposure

Eleven commenters urged the Board to eliminate any requirement for
intraday monitoring. Three of these commenters stated that most banks,
and especially smaller banks, would find it difficult or impossible to
monitor and manage intraday exposure. Another commenter expressed
concern that banks\' attempts to limit intraday exposure by delaying
settlements pending receipt of offsetting funds could lead to system
gridlock. Two commenters argued that intraday exposure was similar to
cash items in the process of collection and should be excluded from the
rule. Four additional commenters sought clarification as to whether
daylight overdrafts would be violations of the rule.

The Final Rule

The final rule allows a bank to adopt monitoring policies and procedures
that are appropriate for the bank\'s particular situation. The final
rule does not require the establishment of limits or monitoring for all
sources of exposure to all correspondents. The final rule provides that,
for the significant sources of exposure for which internal limits are
required, a bank may either monitor exposure or structure transactions
to ensure that internal limits generally are not exceeded. A bank could
accomplish this either by monitoring actual overall exposure, or by
establishing individual lines for significant sources of exposure, such
as federal funds sales, and establishing procedures to ensure that
exposure generally remained within the established lines. A bank could
also maintain limits on exposure by establishing limits with
correspondents, such as for federal funds sold on an agency basis.

Under the final rule, banks are not expected to monitor exposure to
correspondents on a real-time basis. Monitoring generally may be done
retrospectively, and the required frequency depends on the extent to
which exposure approaches the bank\'s internal limits, on the volatility
of the exposure, and on the condition of the correspondent.

Although the purpose of requiring monitoring or structuring of
transactions is to ensure that exposure generally remains within
established limits, the final rule recognizes that occasional excesses
may occur. The final rule provides that a bank should structure
transactions or monitor exposure to a correspondent to ensure that
exposure ordinarily does not exceed internal limits, except for
occasional excesses resulting from factors such as unusual market
disturbances, market movements favorable to the bank, operational
problems, or increases in activity. Unusual late incoming wires or
unusually large cash letters would be considered examples of the types
of activities that could lead to excesses over internal limits that
would not be considered impermissible under the final rule. The final
rule requires the bank to establish appropriate procedures to address
excesses over internal limits.

With respect to intraday monitoring, the Board recognizes that intraday
exposure may be difficult for a bank to actively monitor and limit.
Under the final rule, intraday exposure, like interday exposure, may be
monitored retrospectively. Further, where the risk resulting from
intraday exposure is low, taking into account the condition of the
correspondent and the size of the exposure, specific limits and
monitoring to those limits would not be required under the final rule.

Additionally, to ease monitoring in the case of mergers or acquisitions,
the final rule excludes exposure resulting from the merger or
acquisition of a bank from the calculation of \"credit exposure,\" for
the purposes of the limit on credit exposure for one year after the
merger or acquisition.

Under the final rule, a bank\'s internal policies and procedures are
required to limit credit exposure to a less than adequately capitalized
correspondent to not more than 25 percent of the exposed bank\'s
capital. Therefore, these monitoring requirements for exposure would
also apply to monitoring credit exposure limits.

Section 206.4 Guidelines for Credit Exposure

The proposed rule provided that, in addition to the prudential limits on
exposure established by a bank under Sec. 206.3, a bank ordinarily would
be expected to maintain credit exposure to an individual correspondent,
as calculated under Sec. 206.5, within certain guidelines or limits
unless the exposure is to a commonly controlled insured depository
institution, as provided in paragraph (b) of that section. The proposed
guidelines or limits were structured as \"benchmarks\" that would be
considered prudent outside limits on credit exposure and were not
intended to endorse levels of credit exposure that otherwise would not
be considered prudent based on the condition and operations of the
correspondent. The Board received 112 comments addressing this section
specifically.

Elimination of the Guidelines

Forty-three commenters, primarily large banks, opposed the requirement
that banks adhere to these limits. Forty commenters argued that the
Board should eliminate the guidelines, and three commenters urged that
the guidelines be merged into the prudential standards to retain
responsibility in management for the safe and sound management of
exposure. One commenter proposed that where banks have appropriate
internal prudential policies, they need not demonstrate that they are
within the guidelines. Seven commenters argued that the proposed rule
would require the creation of a comprehensive system to monitor credit
exposure, as measured by the rule, simply to demonstrate that credit
exposure is substantially within the guidelines. Ten other commenters
argued that the benchmarks are crudely calibrated and that compliance
with them would divert resources within banks away from activities
designed to achieve real reductions in risks. Eight other commenters
stated that the guidelines would create costly inefficiencies and reduce
interbank liquidity, as banks would reduce exposure to an individual
correspondent solely to avoid monitoring costs. One commenter contended
that the guidelines would, in effect, penalize banks with existing
internal controls. One commenter asserted that many banks lack the
information technology that would permit on-line access to information
on credit exposure to a specific correspondent, and that purchasing such
a system would cost \$1 million. Two commenters argued that it is
impossible to monitor and therefor to limit global exposure daily.

The Level of the Guidelines

The board received fifty-seven comments concerning the amount of
permissible exposure under the guidelines, two of which specifically
endorsed the guidelines. Two commenters urged that banks in a bank
holding company be permitted to aggregate their credit exposure to
individual correspondents in measuring compliance with the guidelines.
One commenter argued that the limits were too high and suggested that
they not exceed the legal lending limits, which are themselves too high
in the opinion of the commenter. The remainder of the commenters argued
that the guidelines were too restrictive.

The commenters presented a number of arguments for relaxing the
guidelines. Seventeen commenters noted that the benchmarks could force a
bank to reduce its exposure to a well-managed, adequately capitalized
correspondent while taking more exposure to other correspondents that
the bank may not believe are as creditworthy. Eight commenters stated
that small banks\' federal funds sales can fluctuate dramatically,
making continuous compliance costly and difficult. Six commenters
expressed concern that cash letter fluctuations would make compliance
with the guidelines difficult. Two commenters expressed concern that the
guidelines would make it difficult to fund their correspondent to cover
payments system transactions. One commenter argued that the guidelines
would force inexperienced banks to engage in securities trading in order
to avoid federal funds sales.

Sixty-two commenters emphasized the difficulty of diversifying
correspondent business in order to comply with the guidelines.
Fifty-nine of these commenters focused on the costs of establishing and
maintaining additional correspondent relationships, and many argued that
the expense of diversification exceeds the reduction in risk. Four
commenters asserted that mergers and acquisitions have reduced the
number of suitable correspondents. One commenter argued that larger
correspondents were not interested in providing services to smaller
banks. Five correspondents argued that concentrating correspondent
business is beneficial because a close relationship covering multiple
services is important and brings such benefits as preferred customer
status. One commenter argued that only by concentrating its
correspondent business can a small bank engage in a broad range of
transactions, such as settling trades in Treasury bills in an amount
large enough to obtain the maximum yield. Six other commenters argued
that concentrating correspondent business may reduce systemic risk by
facilitating closer monitoring.

Eight commenters contended that reducing exposure by selling federal
funds through an agent is more expensive. Four commenters asserted that
reducing exposure by shifting from compensating balances to fees reduces
profitability because compensating balances often provide a higher
return than short-term investments. Another commenter argued that fees
created a risk to the correspondent of nonpayment.

Three commenters proposed modifications to the guidelines. One urged an
exemption for well-managed banks and two others suggested that the tiers
be altered to permit a minimum percentage or dollar amount of acceptable
exposure without regard to capitalization.

The Final Rule

The final rule places greater emphasis on analysis of the
creditworthiness of correspondents and decreases the emphasis on
across-the-board limits. The limit on credit exposure to adequately
capitalized correspondents has been eliminated. The limit on credit
exposure to correspondents that a bank cannot demonstrate are at least
adequately capitalized remains, however. The Board believes that the
elimination of the limit for adequately capitalized correspondents will
significantly reduce the problems associated with the limits. Because
fewer correspondents would be subject to the limits, monitoring to
ensure compliance should be less costly.

Additionally, because the remaining limit on credit exposure would be
implemented as part of the bank\'s normal policies and procedures, the
final rule permits a bank to choose to implement the limit through
structuring of relationships or monitoring.

Section 206.4(a)(1) Well-Capitalized Correspondents \[Final Rule \--
Included With Adequately Capitalized Correspondents Under Section
206.4(a)(1)\]

The proposed rule stated that, except as otherwise provided in Sec.
206.3, a bank need not limit its credit exposure to a correspondent that
the bank can demonstrate is well capitalized, as defined in Sec. 206.6
of the proposed rule. The Board received three comments on this section,
two of which strongly endorsed the rule as written.

One commenter expressed concern that regulators will restrict
respondent\'s discretion in creating exposure to well-capitalized banks
and that respondents, fearing that, will themselves restrict their
exposure, reducing liquidity and fragmenting correspondent
relationships. The final rule continues to provide that, while
prudential limits to well-capitalized correspondents may be appropriate,
these limits are not bounded by an express limit in the rule.

Section 206.4(a)(2) Adequately Capitalized Correspondents \[Final Rule
\-- Included in Section 206.4(a)(1)\]

The proposed rule provided that a bank ordinarily should limit its daily
interday credit exposure to a correspondent that the bank can
demonstrate is adequately capitalized, as defined in Sec. 206.6 of the
proposed rule, to an amount equal to not more than 50 percent of the
bank\'s total capital. The proposed rule also provided that, for such a
correspondent, the bank ordinarily should limit its daily inter-day
credit exposure with a remaining term to maturity of more than thirty
days to an amount equal to not more than 25 percent of the bank\'s total
capital. Twenty-three commenters specifically addressed this section.

Elimination of Limit

Eighteen commenters suggested that the final rule eliminate the
distinction between adequately and well-capitalized correspondents
altogether.

A number of banks argued that this provision would have an adverse
effect on adequately capitalized banks or that the difference between
adequately and well-capitalized banks was not meaningful. One commenter
argued that the rule would interfere with an adequately capitalized
bank\'s ability to compete in international funding markets. Three
commenters pointed out that, although the difference between a
well-capitalized bank and an adequately capitalized bank is
insignificant at the margin, the rule imposes a significant monitoring
burden on respondents dealing with an adequately capitalized
correspondent. Two other commenters asserted that the burden of
complying with the rule would lead respondents to cease to do business
with adequately capitalized banks. Three commenters argued that it would
be very difficult for banks to regain market share if they drop, even
temporarily, from well to adequately capitalized. Two commenters
suggested that the rule may exacerbate systemic risk by restricting
credit to a bank when that bank\'s capital declines by an arbitrary
amount.

Two commenters complained that, in effect, the rule would force banks to
restrict their exposure to transactions with maturities shorter than 30
days, leading banks to concentrate bank funding in shorter maturities,
rather than balancing short- and long-term exposure. These commenters
also argued that the rule would force banks to buy securities, reducing
liquidity and exacerbating the credit crunch. In addition, two
commenters expressed concern that misunderstanding of the purpose of the
capital classifications could lead to a retreat from institutions that
do not pose a risk to the banking system or to their customers, but that
do not meet the standards to be considered \"well capitalized.\"

Proposed Changes

Six commenters proposed changes to the guidelines concerning adequately
capitalized banks. Two commenters suggested that the 25 percent limit
only apply to exposures with a maturity of over 90 days. One suggested
that the only restriction on banks dealing with adequately capitalized
correspondents be a limit of 50 percent of capital on exposure with
maturities of 90 days or more. Two other commenters suggested that the
exposure limit be increased to 100 percent of capital with a 50 percent
limit for 30 day maturities. Conversely, one commenter suggested that
the Board eliminate limits on credit exposure with maturities longer
than 30 days, asserting that tracking exposure by maturity is expensive,
especially for small banks, and that as a result banks will eliminate
exposure to adequately capitalized banks.

The Final Rule

The final rule does not include a regulatory limit on credit exposure to
adequately capitalized institutions. The Board believes that this change
will reduce monitoring costs and avoid unwarranted reductions in the
business of adequately capitalized banks due to the implementation of
section 308. Elimination of this limit also reflects the difficulty in
setting an appropriate exposure limit that reflects the actual credit
and liquidity effects of a correspondent\'s failure in light of prompt
partial payment by the FDIC.

Further, the proposed limit on credit exposure for adequately
capitalized correspondents served largely as a transition from the
unrestricted credit exposure permitted for well-capitalized
correspondents to the 25 percent limit for less than adequately
capitalized correspondents. The prudential standards of the proposed
final rule have been modified to address this issue more directly by
emphasizing analysis of the creditworthiness of a correspondent and
requiring a bank to take into account any deterioration in the financial
condition of its correspondent.

Finally, credit exposure in excess of 25 percent of the bank\'s total
capital would not be \"grandfathered\" under the proposed final rule,
thus encouraging a bank with significant credit exposure to a
correspondent that is in danger of slipping below adequately capitalized
to limit the maturity of any credit exposure in excess of the 25 percent
guideline.

The final rule also reduces the need for a rapid reduction in exposure
to a correspondent that has slipped below adequately capitalized by
extending the transition provision to 120 days, allowing the bank more
time to evaluate exposure and restructure activities.

Section 206.4(a)(3) Other Correspondents \[Final

Rule \-- Incorporated in Section 206.4(a)(1)\]

The proposed rule provided that a bank ordinarily should limit its daily
interday credit exposure to a correspondent that the bank cannot
demonstrate is well or adequately capitalized to an amount equal to not
more than 25 percent of the bank\'s total capital. The Board received
nine comments on this section, one of which supported the regulation as
written.

Three commenters proposed that the rule increase permissible exposure to
50 percent of capital. One of these commenters suggested that this
increase be contingent upon the respondent conducting due diligence
quarterly. Another commenter argued that restricting exposure to less
than adequately capitalized banks would increase the likelihood of their
failure. Three commenters suggested that the final rule be more
stringent. Two suggested that the rule prohibit any uninsured exposure
to a significantly or critically undercapitalized correspondent, and the
other suggested that the rule prevent significantly undercapitalized
banks from purchasing federal funds or certificates of deposit with
maturities over seven days. Finally, one commenter questioned why the
proposed rule did not distinguish between undercapitalized,
significantly undercapitalized, and critically undercapitalized banks.

As discussed above, the limit on credit exposure to correspondents that
a bank cannot demonstrate are at least adequately capitalized has been
retained in the final rule. Greater credit exposure to such
correspondents would generally create undue risk to banks. However, the
Board does not believe that additional guidelines to address more
significantly impaired correspondents are warranted. Banks\' prudential
policies and procedures should address exposure to particularly troubled
correspondents.

Section 206.4(b) Commonly Controlled Insured Depository

Institutions \[Final Rule \-- Section 206.2(b) and (c)\]

The proposed rule provided that, except for the general prudential
standards in Sec. 206.3, a bank need not limit its credit exposure to a
correspondent that is commonly controlled with the bank and for which
the bank is subject to liability under section 5(e) of the Federal
Deposit Insurance Act.

The proposed rule defined a correspondent as commonly controlled with
the bank if 25 percent or more of any class of voting securities of the
bank and the correspondent were owned, directly or indirectly, by the
same depository institution or company; or, either the bank or the
correspondent owns 25 percent or more of any class of voting securities
of the other. Exposure to a commonly controlled depository institution
was excluded from the limits on credit exposure because there is no
effective way for an insured bank to limit its credit exposure to an
FDIC-insured depository institution that is commonly controlled with the
bank. The cross-guarantee provisions of the Federal Deposit Insurance
Act make an insured depository institution potentially liable to the
FDIC for losses resulting from the failure of a commonly controlled
insured depository institution. The Board received fourteen comments on
this section, three of which supported the section as written.

Substantive Comments

Eleven commenters criticized the exemption for commonly controlled
institutions. Eight of them, submitting a substantially similar letter,
argued that this provision would permit big banks to evade the purpose
of the statute by shifting funds among commonly controlled institutions.
Another commenter argued that depositor risk is measured by institutions
and that risk to the deposit insurance system is not reduced because of
bank consolidation. The commenter questioned whether the rule reflects a
regulatory bias towards consolidation. In contrast, two other commenters
argued that the Board should exclude inter-affiliate transactions from
the rule entirely.

The provisions of the proposed rule reflected the authority of the FDIC
to invoke cross-guarantees and thereby override any efforts of a bank to
limit exposure to a commonly controlled correspondent, as well as
current inter-affiliate funding arrangements within bank holding
companies. Because of the cross-guarantees, disruption of these
arrangements would not yield a commensurate reduction in risk to the
FDIC insurance funds or to the banking system. The Board believes that
exposure to commonly controlled correspondents should not be covered by
either the limits on credit exposure or the prudential standards
provisions of the final rule, as a bank cannot effectively limit its
exposure to such correspondents under either provision. However, the
Board notes that section 23A(a)(4) of the Federal Reserve Act would
continue to apply to transactions with affiliates, including commonly
controlled insured depository institutions.

One commenter suggested that the exclusion apply to banks that own
shares in bankers\' banks. The Board does not believe that it is
appropriate to apply the exclusion to owners of a bankers\' bank because
the failure of the bankers\' bank would not subject the owners to the
cross-guarantee provisions of section 5(e) of the Federal Deposit
Insurance Act.

Drafting

Two commenters suggested that the exception include banks subject to the
provisions of section 23A of the Holding Company Act. This portion of
the rule reflects those banks subject to the cross-guarantee provisions,
which will cover virtually all those covered by section 23A.

This provision has been retained in the final rule but has been moved to
the definitions section with conforming drafting changes.

Section 206.4(c) Exposure of Subsidiaries \[Final Rule \-- Section
206.4(e)\]

The proposed rule provided that, in calculating credit exposure to a
correspondent under this part, a bank must include the credit exposure
of the bank\'s subsidiaries to the correspondent. If the bank did not
own 100 percent of the shares of the subsidiary, the proposed rule
required the bank\'s credit exposure to include a pro rata portion of
the subsidiary\'s exposure, based on the percentage ownership of the
bank in the subsidiary. The purpose of this section was to capture the
full exposure of a bank to a correspondent. The Board received five
comments on this section.

Four commenters argued for restricting the scope of the regulation to
subsidiaries of which the bank owns a majority of the voting stock. Two
commenters argued that where a bank owns only a minority position, it
may be unable to obtain daily exposure figures. Three commenters stated
that the parent bank is unlikely to have consolidated systems for
calculating exposure for minority-owned subsidiaries, and one noted that
the percentage ownership may not justify the expense to the subsidiary
of establishing an information reporting system for the shareholder
bank. One of the commenters argued a bank cannot cause a subsidiary that
the bank does not control to reduce its exposure, and the bank therefore
could ensure compliance with the limits only by selling its interest in
the subsidiary or by reducing its own exposure to the counterparty.
Finally, three commenters argued that where the subsidiary is not
included in the bank\'s consolidated financial statements, but is only
reported as an investment, the parent\'s exposure is not the
subsidiary\'s exposure but is limited to the bank\'s investment.

One commenter queried how the pro rata portion should be determined if a
bank holds different classes of stock in the subsidiary. This commenter
suggested that the provision only apply to banks holding common stock
because the same credit exposure does not exist if the bank holds
preferred stock, and proposed that where a bank holds a different class
of stock, it should be permitted to use any reasonable method to
calculate exposure.

In formulating the proposed rule, the Board noted that banks may assume
obligations to support a subsidiary beyond their actual investment.
However, the Board has modified the final rule to require a bank to
include with the bank\'s own credit exposure 100 percent of the credit
exposure of any subsidiary that the bank is required to consolidate on
its Report of Condition and Income or Thrift Financial Report. This
provision generally captures the credit exposure of any majority-owned
subsidiary of the bank. Under the final rule, therefore, none of a
minority-owned subsidiary\'s exposure and all of a majority-owned
subsidiary\'s exposure would be included in the parent bank\'s exposure
calculation.

Section 206.4(d) Transition Provisions \[Final Rule \-- Section
206.4(a)(2)\]

The proposed rule required that, where a bank is no longer able to
demonstrate that a correspondent is adequately capitalized or well
capitalized for the purposes of Sec. 206.4(a)(1) or (2), including where
the bank cannot obtain adequate information concerning the capital
ratios of the correspondent, the bank should reduce its credit exposure
to the appropriate level under Sec. 206.4(a) within 30 days after the
date when current call report or other relevant financial data normally
would be available. The Board received forty-seven comments on this
section.

Extension of the Transition Period

Forty-five commenters expressed concern about the increase in monitoring
requirements when a correspondent drops from well to adequately
capitalized, the competitive impact on the correspondent, and compliance
burdens. These commenters urged the Board to avoid overreaction to
temporary dips in capital and to extend the transition period. Thirty of
these commenters, submitting a substantially similar letter, proposed
that banks be given one year to resume well-capitalized status. Eight
commenters recommended transition periods ranging from 90 to 120 days.
Four commenters noted that a variety of factors, such as regulatory
changes, increases in reserves, asset revaluation, or acquisitions,
could cause a bank\'s capitalization ratio to change abruptly without
necessarily signifying significantly increased risk. Another commenter
argued that the proposed rule, as written, would require a swift, abrupt
adjustment to temporary swings in capital, resulting in a market bias
for banks with capital less subject to fluctuations. Five commenters
argued that where the credit exposure consists of off-balance sheet
items or instruments with maturities of longer than 30 days, judicious
reductions in credit exposure may not be possible within the rule\'s
time frame. Three others stated that delays in financial reporting,
especially where the respondent relies on a reporting service, may make
compliance with the transition provisions extremely difficult.

One commenter inquired whether a respondent must adjust its exposure if
the correspondent provides assurances that it will reacquire its former
status within the next reporting period.

The Board believes that a longer transition period of at least a
calendar quarter will avoid undue disruptions in correspondent
relationship for temporary declines in capital ratios by allowing the
correspondent an opportunity to bring its capital ratios back the
relevant levels before the next quarterly report. The extended period
will also provide the exposed bank more time to implement any monitoring
required to demonstrate compliance with the regulatory limit and to
adjust the maturities or level of exposure to the correspondent.
Accordingly, the final rule would permit a bank 120 days to reduce its
credit exposure to a correspondent.

If a bank has been relying on information from call reports or from a
bank rating service for a correspondent\'s capital ratios, the 120-day
period would run from the date when the call report or bank rating
reflecting the correspondent\'s reduced capital ratios was received, or
from the date that the information normally would be received. If a bank
has been relying on information received from the correspondent to
demonstrate that the correspondent is at least adequately capitalized,
and the correspondent is no longer providing such information, the
120-day period would run from the date when the bank ordinarily would
have received the information from the correspondent.

Section 206.5 Credit Exposure \[Final Rule Consolidated in Section
206.4\]

Section 206.5(a) Scope of Credit Exposure \[Final Rule \-- Section
206.4(b)\]

The proposed rule defined the credit exposure of a bank to a
correspondent as the bank\'s assets and off-balance sheet items that are
subject to capital requirements under the capital adequacy guidelines of
the bank\'s primary federal supervisor and that involve claims on the
correspondent. The proposed rule excluded certain relatively lower-risk
items. In addition, for the purposes of this section, the rule provided
that off-balance sheet items were to be valued on the basis of current
exposure. Under the proposed rule, \"credit exposure\" was subject to
the numerical benchmark guidelines or limits. In addition to the
comments concerning the definition of exposure, addressed in Sec.
206.2(c) above, the Board received ten comments on the definition of
credit exposure.

One commenter noted that credit exposure is difficult to measure and
criticized the proposed rule\'s emphasis on it. The proposed final rule
deemphasizes credit exposure by eliminating the regulatory limit on
credit exposure to adequately capitalized correspondents. While most of
the commenters addressed the specific exclusions from the calculation of
credit exposure, one commenter expressed concern about the inclusion of
derivative instruments, such as swaps, in the calculation of interbank
exposures, especially in light of the fact that non-bank correspondents
or parties to derivative instruments are excluded. This commenter argued
that the rule would drive the derivative business to non-bank
counter-parties, weakening the safety protocols introduced into the
swaps and other derivative markets as a result of bank participation in
the markets. The Board believes that banks should have similar controls
on credit exposure to nonbanks as on credit exposure to banks. However,
exposure to nonbanks was not addressed by the statute. Further, the
Board believes that it is not appropriate to exclude credit exposure
from derivative instruments from the rule, as it represents a
significant source of interbank exposure in many cases.

One commenter argued that depository institution equity securities taken
as collateral or in satisfaction of a debt should be excluded from the
definition of \"credit exposure\" because these instruments are not
payment obligations. Such transactions give rise to a risk of loss if
the correspondent fails, and therefore are covered by the definition of
\"credit exposure.\" In some circumstances, however, obligations
collateralized by bank stock may qualify for exclusion under 206.4(d)(3)
of the final rule. The definition in the final rule has been redrafted
to clarify that capital instruments issued by the correspondent are
included in the definition of \"credit exposure.\"

Another commenter asked if the calculation of \"current replacement
value\" for interest rate and foreign exchange contracts means that
banks must make daily mark-to-market calculations on a counterparty by
counterparty basis. The rule provides that monitoring must be on a
mark-to-market basis. However, the marking need only be done at the
appropriate monitoring intervals, which depend on the factors listed in
the revised monitoring provision discussed above, not daily. One
commenter stated that it has a sophisticated system which measures
fractional rather than mark-to-market exposure, and inquired whether it
may use its own system rather than the proposed rules. As noted above in
the discussion of monitoring, alternative systems may be used where they
will effectively maintain exposure within the prescribed limits.

Six commenters urged that settlement exposure be specifically excluded
for the sake of clarity. Two commenters urged that intraday exposure be
specifically excluded. One commenter suggested that intraday exposure be
defined as exposure of less than 24 hours.

The proposed final rule has been redrafted for greater clarity,
specifying that intraday or settlement exposure and agented funds are
not included in \"credit exposure.\"

Section 206.5(b) Netting \[Final Rule \-- Section 206.4(c)\]

The proposed rule provided that transactions covered by netting
agreements that are valid and enforceable under all applicable laws may
be netted in calculating exposure. The Board received two comments on
this section.

One commenter urged the Board to permit mutual correspondents to deduct
the reciprocal \"due from\" balances from exposure limits because they
reduce exposure risk. Another commenter requested that the Board clarify
the requirements that a bank \"must have reasoned legal opinions\" that
netting contracts are valid and enforceable.

Under the final rule, the netting provision remains unchanged.
Reciprocal \"due from\" balances that do not result in legally binding
netting do not reduce credit risk to the same extent as legally binding
netting. Reasoned legal opinions that netting contracts are valid would
include opinions of counsel describing the legal reasoning that led to
the conclusions expressed in the opinions.

Section 206.5(c) Exclusions \[Final Rule \-- Section 206.4(d)\]

The proposed rule established four exclusions to the scope of credit
exposure.

Section 206.5(c)(1) Secured Transactions \[Final Rule \-- Section
206.4(d)(1)\]

The first exclusion involved transations, including reverse repurchase
agreements, that are fully secured by government securities or readily
marketable collateral having a current market value equal to 100 percent
of the credit exposure under the transaction. For the purpose of this
exclusion, \"government securities\" were defined as obligations of, or
obligations fully guaranteed as to principal and interest by, the United
States government or any department, agency, bureau, board, commission,
or establishment of the United States, or any corporation wholly owned
directly or indirectly by the United States. \"Readily marketable
collateral\" means financial instruments or bullion that may be sold in
ordinary circumstances with reasonable promptness at a fair market value
determined by quotations based on actual transactions on an auction or a
similarly available daily bid- and ask-price market. Both of these
definitions were taken from the Office of the Comptroller of the
Currency\'s lending limits on national banks. The Board received six
comments on this section.

Two commenters suggested that this exception cover transactions to the
extent that they are secured. The final rule has been redrafted to
exclude transactions to the extent that they are secured.

Two other commenters suggested that the definition of government
securities include those backed by the full faith and credit of a state
government as well. The definition of government securities has not been
changed, but the Board believes that most state securities would be
covered by the definition of \"readily marketable collateral.\"
Transactions secured by these securities, therefore, would be excluded
from credit exposure.

One commenter asked if letters of credit guaranteed by the Export-Import
Bank of the United States would be considered government securities. The
Board notes that, regardless of whether guaranteed letters of credit
would be considered to be government securities, such transactions
generally would qualify for exclusion from the calculation of credit
exposure provided under Sec. 206.4(d)(3) of the final rule (see
discussion under \"Quality assets\").

Another commenter expressed concern that the exclusion for transactions
secured by government-backed securities would lead to increased
investment in government securities and decreased loans. The Board
recognizes that the rule could encourage investment in government
securities, but investment in government securities reflects lower
credit risk than many other transactions and is consistent with the
capital guidelines.

Section 206.5(c)(2) Cash Items in the Process of Collection (CIPC)
\[Final Rule \-- Section 206.4(d)(2)\]

The second exclusion from the calculation of credit exposure covered the
proceeds of checks and other cash items deposited in an account at a
correspondent that are not yet available for withdrawal. The Board
received nine comments on this section, three of which supported the
section as written.

Three commenters expressed concern about the rule\'s treatment of when a
cash item becomes exposure. One asked if \"due from\" balances should be
measured by the actual available balance as reported by the bank on its
internal ledger balance. The final rule requires that such balances be
measured by the actual available balance. Two trade associations
commenting on the rule stated that current correspondent practice is to
make funds available as early in the day as possible, causing
respondents under the proposed rule to incur a measurable exposure for a
longer period of time and perhaps before collection of the underlying
item has actually taken place. The Board notes that the valuation of
cash items in the process of collection that would not be considered to
be deposits by the FDIC, acting as receiver of a failed bank, can only
be made after the fact. The Board believes, however, that the proposed
standard best approximates this value and has retained it in the final
rule.

Clarification

Six commenters asked what comparable items are included in \"checks and
other cash items.\" One commenter specifically suggested that credit
card and debit card transaction be covered by the exclusion. Two
commenters urged that it exclude all cash items, since the associated
risk tends to be relatively short in duration. While cash items that are
not treated as \"agency\" transactions by the FDIC clearly result in
credit risk and should be included in credit exposure, the Board
believes that it is appropriate to exclude from credit exposure any item
that the FDIC treats as being collected in an agency capacity rather
than as a deposit or claim. The Board does not believe, however, that
the FDIC has addressed whether the credit and debit card transactions
are collected in an agency capacity.

Miscellaneous

One commenter asked if the Board would provide systems support in
accounting for settlement exposure and cash items in the process of
collection. The Board believes that this support is better provided by
the market, and that correspondents may provide such support.

This exclusion remains unchanged in the final rule.

Section 206.5(c)(3) Quality Assets \[Final Rule \-- Section
206.4(d)(3)\]

The third exclusion covered \"quality assets\" on which the
correspondent is secondarily liable or that result in secondary exposure
to the correspondent, including loans to third parties secured by stock
or debt obligations of the correspondent, loans to third parties
purchased from the correspondent with recourse, and loans or obligations
of third parties backed by stand-by letters of credit issued by the
correspondent. The Board received three comments on this section.

One commenter expressed concern that the definition of \"quality asset\"
raises the possibility that a loan secured by the stock of a
correspondent may lose its status and be counted as exposure,
discouraging such loans. Another commenter suggested that the rule give
an exposed bank at least 30 days to adjust to a decline in the quality
of a quality asset. The third commenter argued that credit exposure
backed by a quality asset, such as a letter of credit, should be
excluded from the definition of credit exposure.

In the final rule the exclusion for quality assets has been broadened to
include direct exposure to a correspondent that is backed by a
creditworthy obligor as well as a correspondent\'s secondary exposure on
a quality asset. Additionally, under the final rule, the potential for
excesses in exposure is recognized and a bank is required to have
appropriate procedures to deal with such excesses.

Section 206.5(c)(4) FDIC-Insured Amounts \[Final Rule \-- Section
206.4(d)(5)\]

No comments were received on this section and it remains unchanged in
the final rule.

Mergers and Acquisitions \[Final Rule \-- Section 206.4(d)(4)\]

As noted above, one commenter suggested that banks be given time after a
merger to bring exposure within the guidelines for credit exposure. The
final rule excludes exposure that results from a merger or acquisition
of a bank from the definition of \"credit exposure\" for one year after
the merger or acquisition. This exclusion gives banks one year to merge
their systems for monitoring credit exposure.

Section 206.6 Capital Levels of Correspondents \[Final

Rule \-- Section 206.5\]

The proposed rule provided that, for the purpose of compliance with the
credit exposure guidelines, a correspondent would be considered \"well
capitalized\" if the correspondent has a total risk-based capital ratio
of 10.0 percent or greater, a Tier 1 risk-based capital ratio of 6.0
percent or greater, and a leverage ratio of 5.0 percent or greater. A
correspondent would be considered \"adequately capitalized\" if the
correspondent has a total risk-based capital ratio of 8.0 percent or
greater, a Tier 1 risk-based capital ratio of 4.0 percent or greater,
and a leverage ratio of 4.0 percent or greater. As used in the proposed
rule, the terms \"well capitalized\" and \"adequately capitalized\" were
similar but not identical to the definition of those terms as used for
the purposes of the prompt corrective action standards under section 38
of the Federal Deposit Insurance Act (12 U.S.C. 1831o) (\"prompt
corrective action standards\"). The proposed rule further provided that
a correspondent that is a foreign bank may be considered \"well
capitalized\" or \"adequately capitalized\" under this section without
regard to the minimum leverage ratios required under subparagraphs
(a)(1)(iii) and (a)(2)(iii) of this section of the proposed rule. The
Board received 137 comments on this section.

Criticism of the Emphasis on Capital

Sixteen commenters disagreed with the Board\'s approach to structuring
the limits on credit exposure. Ten commenters argued that the proposed
rule overemphasized capital relative to other creditworthiness
indicators such as liquidity, asset quality, earnings strength, regional
and product line portfolio diversity, and operating environment. These
commenters expressed concern that the proposed rule could encourage
banks to focus on capitalization rather than on their own, broader
based, prudential systems for analyzing correspondent credit or on the
efficiency or competitiveness of the correspondent\'s payments and
processing systems. In addition, seven commenters questioned the value
of capital as an indicator of strength. One commenter pointed out that
risk-based capital provides a numerical assessment of subjective risks.
Another commenter asserted that capital levels measured on a daily or
quarterly basis are notoriously inaccurate. A third commenter argued
that the limits on credit exposure should be based on the book value
rather than on the market value of a correspondent\'s assets. A bank
holding company argued that inadequate loan loss provisions can lead to
a misrepresentation of a bank\'s actual strength. Two commenters
suggested that if the proposed rule is seeking an objective measure it
should select one which is easy to measure and not subject to frequent
fluctuations. One commenter suggested that, as an alternative, the
guidelines be based on the financial markets. In contrast, two
commenters pointed out that the advantage of using capital is that it
will encourage large banks that are not well capitalized to strengthen
their capital position in order to maintain their interbank business.
The final rule has been amended to de-emphasize the capital of
correspondents by removing the limit on credit exposure to adequately
capitalized correspondents.

Monitoring Capital of Domestic Banks

Sixteen commenters argued that gathering and analyzing data to the
extent required by the rule is extremely difficult and unfairly
burdensome, and that small banks lack the technical capacity and
resources to conduct this analysis. Eight commenters objected to the
cost of monitoring capital. Another commenter claimed that large banks
may resist giving capitalization information to smaller banks seeking to
initiate a correspondent relationship. Moreover, this commenter pointed
out that prompt corrective action rules forbid advertizing capital
levels. One commenter argued that without access to its correspondent\'s
examination report, it would be unable to determine if the correspondent
was adequately capitalized. Four commenters noted that CAMEL ratings are
confidential.

Nineteen commenters suggested that regulatory agencies publish
capitalization ratings, lists of well and adequately capitalized
correspondents, or exposure limits for particular correspondents,
domestic and foreign. These commenters justified the request by arguing
that regulatory agencies have access to the information and have the
capacity to make a more complete evaluation of safety and soundness. One
commenter urged that the regulatory authorities release the data they
have available. Five others urged that call reports or financial reports
be altered to require banks to disclose capital adequacy.

Four commenters expressed concern that small banks will be unable to
analyze capitalization information from a call report due to the length
and complexity of the document. Four commenters urged that where federal
funds are sold on an agency basis, the respondent should be able to rely
on the capitalization information supplied by the agent. One commenter
expressed concern that although the regulation only required a ratio
analysis, respondents will ask for quarterly call reports. Moreover,
seven commenters complained of the cost of disseminating this
information. One of these commenters, for example, noted that it has 110
respondents to distribute the report to. Two other commenters expressed
concern that the compliance burden would increase the advantage enjoyed
by other financial service providers. One commenter proposed that the
Board draft a model form with only the essential information necessary
to comply with the rule.

Eight commenters urged the Board to shift the burden from respondents to
correspondents. Two commenters proposed that the rule require
correspondents to prepare uniform disclosure reports and to disclose
promptly any deterioration in capitalization. Two other commenters urged
that the rule permit respondents to base their credit assessment on a
correspondent\'s self-assessment of its capital adequacy classification
together with any supporting information it may provide. Twenty
commenters, nineteen of whom submitted a substantially similar letter,
urged the Board to permit respondents to rely on a correspondent\'s
annual documentation of its capital levels. Thirty-four commenters
suggested that quarterly submissions satisfy the requirement. One
commenter urged the Board to inform correspondents that the financial
information provided to other banks is subject to review by examiners
and should be consistent with the information provided to regulators.

The Board recognizes that it is currently difficult to obtain
information on the risk-based capital levels of a correspondent. Under
the final rule, this task is somewhat simplified, as a bank will be
required to demonstrate only that its correspondent\'s capital ratios
qualify it as at least adequately capitalized. While the call report for
correspondents that are not required to file a complete Schedule RC-R
currently does not provide sufficient information to calculate a
correspondent\'s precise capital ratios, it can be relied on to
demonstrate that a correspondent is at least adequately capitalized. /10
Further, the Board anticipates that most banks will receive information
on their correspondent\'s capital ratios either directly from the
correspondents or from a bank rating agency. Finally, the Board notes
that the standard used in the rule is based solely on capital ratios and
does not require disclosure of CAMEL ratings.

/10 Banks with assets of \$1 billion or less generally are required to
complete only Part I of the Schedule, which provides a rough estimate of
risk-based capital. A bank may assume that its correspondent is at least
adequately capitalized if the correspondent has completed only Part I of
Schedule RC-R. For correspondents that file a complete Schedule RC-R,
the call report does include sufficient information to calculate a
correspondent\'s risk-based capital. The Board expects that further
information to facilitate this calculation will be made available prior
to the implementation of the regulatory limit on credit exposure to less
than adequately capitalized correspondents.

Five commenters asked for clarification of permissible sources for
capitalization information. One claimed that the most accurate
information is informal information and sought acknowledgement of the
validity of it as a source. Another suggested that the rule explicitly
permit banks to rely on call reports in determining capitalization. Two
commenters requested that banks be permitted to rely on call reports
alone. Three commenters asked the Board to describe a publicly available
information base. The final rule does not limit a bank to a single
source of information for capital ratios, but indicates that a bank may
rely on capital information obtained from a correspondent, bank rating
agency, or other reliable source of information. The bank may also rely
on information contained in the call report for this purpose. While the
Board recognizes that informal information may be useful in evaluating
the overall condition of a correspondent, such information is not
sufficient to justify the higher levels of credit exposure permitted to
adequately or well-capitalized correspondents under the rule. As stated
in the summary of the final rule, the rule does not limit a bank to the
use of publicly available information, but merely provides that a bank
generally is not required to obtain non-public information.

Application of the Provision to Foreign Banks

Thirteen commenters expressed concern about the difficulty and cost of
monitoring capital levels of foreign banks. One commenter noted that
disclosure of capital information varies widely among foreign banks and
another noted that information is difficult to obtain from the
institution or from secondary sources. One requested that G-10 banks be
required to provide uniform information. Two other commenters suggested
that additional flexibility be granted to U.S. banks which deal with
non-Basle banks because of the added difficulty in obtaining capital
information. Two commenters requested that the Board develop a method to
determine the capital levels of foreign correspondents.

One commenter proposed that the rule permit respondents to rely on
annual data if that is the best available. Another commenter argued that
it is inequitable to require quarterly analysis of the capital of U.S.
banks while permitting banks to analyze the capitalization of foreign
banks semi-annually because information on foreign banks is unavailable
on a more frequent basis. A third commenter proposed that if information
is not available at least semi-annually, exposure to foreign banks
should be restricted to 25 percent.

As in the proposed rule, the final rule permits a foreign correspondent
to be considered \"adequately capitalized\" without regard to the level
of the foreign bank\'s leverage ratio. As indicated in the supplementary
information to the proposed rule, the Board believes that this treatment
of foreign banks is consistent with the findings of the Capital
Equivalency Report submitted by the Board and the Department of Treasury
to Congress earlier this year.

The Board recognizes that public sources of information on risk-based
capital ratios may not be available for many foreign bank
correspondents. As with domestic correspondents, however, the Board
anticipates that in most instances the correspondent will provide the
information to the banks with which it does business. As foreign banks
do not necessarily prepare financial statements on a quarterly basis, as
domestic banks do, the final rule would permit a bank to rely on the
foreign bank correspondent\'s most recent financial statements.

Clarification of the Provision

Eight commenters quoted the supplementary information to the proposed
rule, which stated that banks should not rely on capitalization alone
and that weakness in a correspondent\'s management, operations, or loan
portfolio might lead a bank to restrict its exposure below the
permissible limits on credit exposure. These commenters pointed out that
these terms are subjective and that their interpretation by the various
federal bank regulators may lead to substantial and unevenly enforced
compliance burdens. Two of these commenters added that it may be
prohibitively expensive to judge any potential \"weakness\" in a
correspondent and, as a result, respondents may shift their
correspondent activities to the public sector. One commenter suggested
that to facilitate compliance, the final rule eliminate references which
cut back on what is permissible under the guidelines and leave other
considerations for the prudential analysis section.

The Board continues to believe that the remaining limit on credit
exposure should be viewed as a maximum level for credit exposure rather
than a safe harbor. To the extent that a bank\'s prudential policies and
procedures suggest a lower level of credit exposure to a correspondent,
the bank should adhere to the lower level.

Frequency of Monitoring

Twenty-six commenters sought clarification of the frequency with which
capital must be monitored and the way it must be measured. Two
commenters suggested that quarterly monitoring is too frequent and
another proposed that capital be monitored annually. Twenty-three
commenters, nineteen of whom submitted a substantially similar letter,
urged that capital be measured over a period of time, rather than at a
point in time. Three commenters urged that the capitalization of a
correspondent in a multibank holding company be based on the capital of
the bank holding company.

Under the final rule for domestic correspondents, capital should be
monitored quarterly to pick up information based on the correspondent\'s
most recent call report, financial statement, or bank rating report. For
foreign bank correspondents, monitoring frequency should be related to
the frequency with which financial statements or other regular reports
are available. Although such information is available quarterly for some
foreign banks, for many foreign banks financial statements generally
will be available only on a semi-annual basis. Further, quarterly
monitoring of capital is only required for correspondents to which a
bank\'s potential credit exposure is more than 25 percent of its own
capital. If the internal systems of a bank ordinarily limit credit
exposure to a correspondent to less than 25 percent of the exposed
bank\'s capital, no monitoring of the correspondent\'s capital would be
necessary, although periodic reviews of the correspondent\'s financial
condition may be required under Sec. 206.3(a)(2) if exposure to the
correspondent is significant.

Six commenters expressed concerns about the timeliness of the required
information. Three noted substantial delays before generally published
reports become available and another noted that this information is more
expensive if it is obtained before it is commercially available. Two
commenters requested guidelines on the requisite freshness of this data.
Because information in risk-based capital ratios is generally based on
the call report, a bank would be justified in relying on the most
recently available reports based on call report data. While there may be
a significant lag in such data, the Board believes that where the
information in such reports is followed by the bank on a continuing
basis, the reports remain a useful monitor of trends in the conditions
of the correspondent.

Definition of \"Adequately Capitalized\"

Several commenters criticized the definition of \"adequately
capitalized.\" One suggested that the definition include all banks with
a leverage ratio of 4 percent or greater and a total risk based capital
ratio in excess of 8 percent. One suggested it include all banks with a
tier 1 ratio of at least 5 percent. Another argued that the definition
of adequately capitalized is unjustifiably more restrictive than the
definition in the prompt corrective action standards and suggested that
the definition include correspondents with a capital ratio of 3 percent
and a 1 CAMEL rating. While acknowledging that a bank cannot disclose
its CAMEL rating, the commenter suggested that it could disclose if it
is adequately capitalized under this standard. Another bank suggested
that the leverage ratio be excluded because it is not applied to foreign
banks. Commenters also addressed the definition of \"well capitalized,\"
which has been deleted. One commenter suggested that the rule be written
to state clearly the capital requirements imposed upon correspondents.
Another commenter supported the capital definitions.

The definition of adequately capitalized in the proposed rule was based
on, but not identical to, the definition used for prompt corrective
action. The difference between the definitions is to enable banks to
determine, from publicly available information, a correspondent\'s
capital for the purpose of this rule. The Board believes that it would
be confusing to make further changes in this rule\'s definition of
\"adequately capitalized\" and the definition in the final rule remains
unchanged.

Section 206.7 Waiver \[Final Rule \-- Section 206.6\]

The proposed rule provided that the Board may waive the application of
Sec. 206.4(a) to a bank if the primary federal supervisor of the bank
advises the Board that the bank is not reasonably able to obtain
necessary services, including payment-related services and placement of
funds, without incurring exposure to a correspondent in excess of
otherwise applicable limits. The Board received three comments on this
section.

Two commenters suggested that if the guidelines are not relaxed, small
rural banks with seasonal cash flows should receive waivers. As noted
above, the proposed final rule would eliminate the regulatory limit on
credit exposure for adequately capitalized banks, substantially easing
this constraint. To the extent that seasonal cash flows require rural
banks to sell federal funds or engage in other transactions in excess of
25 percent of their capital, the Board believes that they should deal
with banks that are adequately capitalized or better or diversify their
credit exposure.

Another commenter suggested that the Board use its waiver authority
liberally when the exposure is of a length or a type that extrication
within 30 days is quite difficult. The Board does not believe that this
use of the waiver authority is appropriate. The waiver is designed for
low capital banks that need payment services and would not be able to
obtain them otherwise. Rather than liberalize the waiver provisions, the
Board has extended to 120 days the transition period for compliance with
the limit on credit exposure to a correspondent that is less than
adequately capitalized. This extension should permit banks to reduce
exposure judiciously to a bank whose capital has been reduced. Under the
final rule, the waiver provision remains unchanged.

Section 206.8 Record Retention \[Deleted in Final Rule\]

The proposed rule required that banks establish recordkeeping reasonably
designed to demonstrate compliance with the provisions of Secs. 206.3
and 206.4. The Board received forty-seven letters that commented on this
section specifically and one hundred eight letters that complained of
excessive paperwork generally.

Concerns With Cost Burdens

All of the forty-seven comments on this section complained of the cost
and burden of these requirements. A trade association pointed out that
banks already confront substantial compliance and recordkeeping
requirements and that the requirements in the proposed rule may exceed
banks\' compliance capacity and ability. Two commenters asserted that
requiring documentation of every closed transaction would substantially
increase compliance costs. These commenters stated that records of
closed transactions generally are not retained. Rather, limits are set
for specific products and maturities, and internal limits are monitored
to ensure they are not exceeded without specific credit approval. The
commenters proposed that rather than requiring that records of closed
transactions be available for review, the final rule should focus on the
adequacy of a bank\'s establishment and monitoring of limits, including
any reported overages.

Clarification of the Requirement

Three commenters requested that the final rule articulate what
documentation must be maintained on file, in what format, and for how
long, both to assist banks in maintaining reasonable records and to
provide examiners with guidelines to effect uniform enforcement.

Proposals of Modification

Thirty-eight commenters offered specific suggestions for reducing the
burden. Two commenters suggested that the requirements should not apply
to exposure covered by FDIC insurance and that the requirements should
be reduced for smaller amounts of exposure regardless of the
correspondent\'s capitalization. Another commenter suggested an
exception when exposure is less than 25% of capital.

Thirty-two commenters urged a reduction in recordkeeping requirements
for respondents dealing with well-capitalized banks. Thirty of them sent
an identical letter urging that the recordkeeping requirement be the
same for a well-capitalized bank as it is for a Federal Reserve Bank.
One commenter suggested that if a respondent selects a well-capitalized
correspondent the recordkeeping burden should be restricted to
maintaining on file the correspondent\'s quarterly disclosure and
certification of its capitalization.

Other commenters urged a generalized reduction in the burden. One
commenter suggested that the prudential standards requirement be limited
to documenting an annual review. Two commenters suggested that the
capital monitoring requirement be satisfied by documentation of an
annual review of capital.

One commenter urged that the requirement be eliminated altogether,
proposing that examiners rely on the adequacy of the prudential policies
and that the burden be on the examiners to prove a violation of the
regulation rather than on banks to prove compliance.

Final Rule

The specific record retention requirement has been deleted from the
final rule. Examiners will use examiner guidance to determine compliance
with the rule.

Section 206.9 Transition Provisions \[Final Rule \-- Section 206.7\]

The proposed rule provided that for a period of one year beginning on
December 19, 1992, a bank would be required to comply with the
prudential standards required under Sec. 206.3(a), and under Sec.
206.3(b) would be required to structure transactions with a
correspondent or monitor exposure to a correspondent to ensure that its
exposure did not exceed its internal limits established under Sec.
206.3(a). During this period, the proposed rule did not require the bank
to meet the guidelines for credit exposure established under Sec. 206.4
or monitor credit exposure under Sec. 206.3(b).

The proposed rule further provided that for a period of one year
beginning on December 19, 1993, the overall guideline for credit
exposure to an adequately capitalized correspondent contained in Sec.
206.4(b)(ii) would be 100 percent of the bank\'s total capital, with the
guideline for credit exposure having a remaining term to maturity of
more than 30 days at 50 percent of the bank\'s capital. The proposed
rule set the interim guideline on credit exposure to an individual
correspondent contained in Sec. 206.4(a)(iii) at 50 percent of the
exposed institution\'s total capital. This section was designed to allow
banks adequate time to rearrange their correspondent banking
relationship to meet the new requirements. The Board received twelve
comments on this section, one of which supported the provision as
written and another of which supported the idea of a transition period.

Proposed Extension of the Transition Period.

Nine commenters urged the Board to extent the initial transition period,
i.e. the period before the prudential guidelines become effective, to
permit banks to prepare new policies or review and revise existing
policies, to establish procedures to monitor and control interbank
exposures, and to restructure correspondent relationships. Two
commenters suggested that the proposed implementation date would not
allow bank regulatory agencies sufficient time to train examiners.

The Board believes that a longer initial transition period will enable
banks that have not made credit assessments of their correspondents to
do so and for banks to review and, where appropriate, improve their
monitoring procedures. An extended initial transition period also will
enable the Board to develop examination guidelines related to the rule.
Therefore, the final rule provides for a six-month transition period
before the prudential standards become effective, with the regulatory
limit on credit exposure phased in over a two year period after that
date.

Competitive Analysis

The proposed rule included a competitive impact analysis discussing the
effects of the proposed rule on the ability of private sector
correspondent banks to compete effectively with the Federal Reserve
Banks in providing similar services. The proposed rule did not limit
credit exposure of a bank to Federal Reserve Banks or to \"well
capitalized\" correspondents because such exposure would not pose a risk
to the bank. However, the proposed rule did impose three substantive
requirements on a bank\'s exposure to a well capitalized correspondent
that are not imposed on a bank\'s exposure to a Federal Reserve Bank,
requiring a bank to have internal policies and procedures to limit
exposure to a well capitalized correspondent, to structure transactions
or monitor exposure to ensure that exposure ordinarily remains within
the internal limits established, and to obtain sufficient information to
demonstrate that the correspondent is well capitalized. Additionally,
for adequately-capitalized correspondents, the proposed rule required a
bank to limit overall credit exposure to an amount equal to not more
than 50 percent of the exposed bank\'s capital, and to limit credit
exposure with a term to maturity of greater than thirty days to an
amount equal to not more than 25 percent of the exposed bank\'s capital.

The analysis included with the proposed rule indicated that the rule
could have a direct and material adverse effect on the ability of
correspondents to compete effectively with the Federal Reserve Banks in
providing payment services, particularly in the area of check
collection. The analysis concluded that this adverse effect was due to
the differing legal powers of the Federal Reserve Banks. In assessing
whether the objective of the proposed rule, to limit the risks that the
failure of a correspondent would pose to exposed banks, could be
reasonably achieved with a lesser or no adverse competitive impact, the
Board concluded that the structure of the proposed rule minimized any
adverse competitive effects on correspondents by not imposing rigid
limits on credit exposure, by permitting higher levels of credit
exposure to correspondents with higher capital levels, and by excluding
cash items in the process of collection from the calculation of credit
exposure to a correspondent.

In light of comments received on the proposed rule, however, the Board
has made a number of modifications to the final rule to reduce further
any adverse competitive effect on private sector correspondents. These
modifications, described in detail above, include removing the limit on
credit exposure to adequately capitalized correspondents, requiring
internal limits on exposure to a correspondent only where there is a
significant risk that payments will not be made as contemplated, and
requiring monitoring or structuring of transactions to remain within
limits only where limits are required by the final rule. Additionally,
the final rule affords a longer initial implementation period in order
to provide banks adequate time to review existing internal policies and
procedures. The Board believes that the extended implementation period,
along with the other modifications to the final rule, will reduce the
likelihood that a bank will conclude that it must transfer activities to
a Federal Reserve Bank.

While the Board recognizes that the modifications to the final rule do
not completely remove the adverse competitive effects of the rule, the
Board believes that the provisions of the final rule are necessary to
fulfill the statutory objectives. Additionally, the Board will consider
whether modifications should be made to the private-sector adjustment
factor (PSAF) used to calculate the prices of Reserve Bank services to
address disparities in capital ratios between the Reserve Banks and
private correspondents resulting from the rule.

Regulatory Flexibility Analysis

Pursuant to section 603 of the Regulatory Flexibility Act (Pub. L.
96-354, U.S.C. 601 et seq.), the Board published for comment an initial
regulatory flexibility analysis analyzing the provisions of its proposed
Regulation F. Section 604 of the Regulatory Flexibility Act requires the
Board to publish a final regulatory flexibility analysis with the final
rule containing: (1) A statement of the need for, and objectives of, the
rule; (2) a summary of the issues raised by the public comment in
response to the initial regulatory flexibility statement, a summary of
the assessment of such comments, and a statement of changes made in the
proposed rule in response to comments; (3) a description of each of the
significant alternatives to the rule consistent with the stated
objectives of applicable statutes and designed to minimize any
significant economic impact of the rule on small entities, and a
statement of why these alternatives were rejected.

Each of these items are discussed in detail in the Supplementary
Information above. The Board believes that the modifications included in
the final rule significantly reduce the recordkeeping and regulatory
burden imposed by the rule. The final rule places greater emphasis on
the general internal policies and procedures of the bank, and does not
require internal limits for all exposure to correspondents. The proposed
rule also had been clarified to reduce the burden of monitoring such
exposure. Additionally, the limit on credit exposure to adequately
capitalized correspondents has been removed, significantly reducing the
regulatory burden on banks in complying with the rule. This change
lessens the probability that a bank will be required to diversify its
exposure to a correspondent as a result of the rule, and eliminates the
need for banks to monitor credit exposure to an adequately capitalized
correspondent. Although a bank will continue to be required to monitor
the capital levels of correspondents to which it has significant
exposure, the final rule clarifies that a bank may rely on information
obtained from its bank holding company, correspondent, or other party,
significantly reducing the burden of obtaining the information.

Notice of Final Rule

A final rule is generally required to be published at least thirty days
prior to its effective date. 5 U.S.C. 553(d). An exception is provided,
however, where the agency has found good cause and provided the basis
for the finding in the publication of the rule. 5 U.S.C. 553(d)(3). The
final rule has been made effective as of December 19, 1992, in order to
comply with the requirements of section 308 of FDICIA, which becomes
effective on December 19, 1992. Further, although less than thirty
days\' notice has been provided before the effective date of the final
rule, the rule contains transition provisions for actual compliance with
the provisions of the regulation. Depository institutions covered by the
rule will have six months after the effective date before actual
compliance with any of the provisions of the rule is required. The Board
therefore finds that there is good cause for the final rule to be made
effective with less than a thirty-day notice period.

List of Subjects in 12 CFR Part 206

Banks, Banking, Interbank liability, Lending limits, Savings
associations.

For the reasons set forth in the preamble, and pursuant to the Board\'s
authority under section 23 of the Federal Reserve Act, 12 U.S.C. 371b-2,
the Board is adding 12 CFR Part 206 to read as follows:

Part 206 \-- Limitations On Interbank Liabilities

Sec.

206.1 Authority, purpose, and scope.

206.2 Definitions.

206.3 Prudential standards.

206.4 Credit exposure.

206.5 Capital levels of correspondents.

206.6 Waiver.

206.7 Transition provisions.

Authority: Section 308 of Public Law 102-242, 105 Stat. 2236, 12 U.S.C.
371b-2.

§ 206.1 Authority, purpose, and scope.

\(a\) Authority and purpose. This part (Regulation F, 12 CFR part 206)
is issued by the Board of Governors of the Federal Reserve System
(Board) to implement section 308 of the Federal Deposit Insurance
Corporation Improvements Act of 1991 (Act), 12 U.S.C. 371b-2. The
purpose of this part is to limit the risks that the failure of a
depository institution would pose to insured depository institutions.

\(b\) Scope. This part applies to all depository institutions insured by
the Federal Deposit Insurance Corporation.

§ 206.2 Definitions.

As used in this part, unless the context requires otherwise:

\(a\) Bank means an insured depository institution, as defined in
section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813), and
includes an insured national bank, state bank, District bank, or savings
association, and an insured branch of a foreign bank.

\(b\) Commonly-controlled correspondent means a correspondent that is
commonly controlled with the bank and for which the bank is subject to
liability under section 5(e) of the Federal Deposit Insurance Act. A
correspondent is considered to be commonly controlled with the bank if:

\(1\) 25 percent or more of any class of voting securities of the bank
and the correspondent are owned, directly or indirectly, by the same
depository institution or company; or

\(2\) Either the bank or the correspondent owns 25 percent or more of
any class of voting securities of the other.

\(c\) Correspondent means a U.S. depository institution or a foreign
bank, as defined in this part, to which a bank has exposure, but does
not include a commonly controlled correspondent.

\(d\) Exposure means the potential that an obligation will not be paid
in a timely manner or in full. \"Exposure\" includes credit and
liquidity risks, including operational risks, related to intraday and
interday transactions.

\(e\) Foreign bank means an institution that: (1) Is organized under the
laws of a country other than the United States;

\(2\) Engages in the business of banking;

\(3\) Is recognized as a bank by the bank supervisory or monetary
authorities of the country of the bank\'s organization;

\(4\) Receives deposits to a substantial extent in the regular course of
business; and

\(5\) Has the power to accept demand deposits.

\(f\) Primary federal supervisor has the same meaning as the term
\"appropriate Federal banking agency\" in section 3(q) of the Federal
Deposit Insurance Act (12 U.S.C. 1813(q)).

\(g\) Total capital means the total of a bank\'s Tier 1 and Tier 2
capital under the risk-based capital guidelines provided by the bank\'s
primary federal supervisor. For an insured branch of a foreign bank
organized under the laws of a country that subscribes to the principles
of the Basle Capital Accord, \"total capital\" means total Tier 1 and
Tier 2 capital as calculated under the standards of that country. For an
insured branch of a foreign bank organized under the laws of a country
that does not subscribe to the principles of the Basle Capital Accord,
\"total capital\" means total Tier 1 and Tier 2 capital as calculated
under the provisions of the Accord.

\(h\) U.S. depository institution means a bank, as defined in Sec.
206.2(a) of this part, other than an insured branch of a foreign bank.

§ 206.3 Prudential standards.

\(a\) General. A bank shall establish and maintain written policies and
procedures to prevent excessive exposure to any individual correspondent
in relation to the condition of the correspondent.

\(b\) Standards for selecting correspondents. (1) A bank shall establish
policies and procedures that take into account credit and liquidity
risks, including operational risks, in selecting correspondents and
terminating those relationships.

\(2\) Where exposure to a correspondent is significant, the policies and
procedures shall require periodic reviews of the financial condition of
the correspondent and shall take into account any deterioration in the
correspondent\'s financial condition. Factors bearing on the financial
condition of the correspondent include the capital level of the
correspondent, level of nonaccrual and past due loans and leases, level
of earnings, and other factors affecting the financial condition of the
correspondent. Where public information on the financial condition of
the correspondent is available, a bank may base its review of the
financial condition of a correspondent on such information, and is not
required to obtain non-public information for its review. However, for
those foreign banks for which there is no public source of financial
information, a bank will be required to obtain information for its
review.

\(3\) A bank may rely on another party, such as a bank rating agency or
the bank\'s holding company, to assess the financial condition of or
select a correspondent, provided that the bank\'s board of directors has
reviewed and approved the general assessment or selection criteria used
by that party.

\(c\) Internal limits on exposure. (1) Where the financial condition of
the correspondent and the form of maturity of the exposure create a
significant risk that payments will not be made in full or in a timely
manner, a bank\'s policies and procedures shall limit the bank\'s
exposure to the correspondent, either by the establishment of internal
limits or by other means. Limits shall be consistent with the risk
undertaken, considering the financial condition and the form and
maturity of exposure to the correspondent. Limits may be fixed as to
amount of flexible, based on such factors as the monitoring of exposure
and the financial condition of the correspondent. Different limits may
be set for different forms of exposure, different products, and
different maturities.

\(2\) A bank shall structure transactions with a correspondent or
monitor exposure to a correspondent, directly or through another party,
to ensure that its exposure ordinarily does not exceed the bank\'s
internal limits, including limits established for credit exposure,
except for occasional excesses resulting from unusual market
disturbances, market movements favorable to the bank, increases in
activity, operational problems, or other unusual circumstances.
Generally, monitoring may be done on a retrospective basis. The level of
monitoring required depends on:

\(i\) The extent to which exposure approaches the bank\'s internal
limits;

\(ii\) The volatility of the exposure; and

\(iii\) The financial condition of the correspondent.

\(3\) A bank shall establish appropriate procedures to address excesses
over its internal limits.

\(d\) Review by board of directors. The policies and procedures
established under this section shall be reviewed and approved by the
bank\'s board of directors at least annually.

§ 206.4 Credit exposure.

\(a\) Limits on credit exposure. (1) The policies and procedures on
exposure established by a bank under Sec. 206.3(c) of this part shall
limit a bank\'s interday credit exposure to an individual correspondent
to not more than 25 percent of the bank\'s total capital, unless the
bank can demonstrate that its correspondent is at least adequately
capitalized, as defined in Sec. 206.5(a) of this part.

\(2\) Where a bank is no longer able to demonstrate that a correspondent
is at least adequately capitalized for the purposes of Sec. 206.4(a) of
this part, including where the bank cannot obtain adequate information
concerning the capital ratios of the correspondent, the bank shall
reduce its credit exposure to comply with the requirements of Sec.
206.4(a)(1) of this part within 120 days after the date when the current
Report of Condition and Income or other relevant report normally would
be available.

\(b\) Calculation of credit exposure. Except as provided in Secs. 206.4
(c) and (d) of this part, the credit exposure of a bank to a
correspondent shall consist of the bank\'s assets and off-balance sheet
items that are subject to capital requirements under the capital
adequacy guidelines of the bank\'s primary federal supervisor, and that
involve claims on the correspondent or capital instruments issued by the
correspondent. For this purpose, off-balance sheet items shall be valued
on the basis of current exposure. The term \"credit exposure\" does not
include exposure related to the settlement of transactions, intraday
exposure, transactions in an agency or similar capacity where losses
will be passed back to the principal of other party, or other sources of
exposure that are not covered by the capital adequacy guidelines.

\(c\) Netting. Transactions covered by netting agreements that are valid
and enforceable under all applicable laws may be netted in calculating
credit exposure.

\(d\) Exclusions. A bank may exclude the following from the calculation
of credit exposure to a correspondent:

\(1\) Transactions, including reverse repurchase agreements, to the
extent that the transactions are secured by government securities or
readily marketable collateral, as defined in paragraph (f) of this
section, based on the current market value of the collateral;

\(2\) The proceeds of checks and other cash items deposited in an
account at a correspondent that are not yet available for withdrawal;

\(3\) Quality assets, as defined in paragraph (f) of this section, on
which the correspondent is secondarily liable, or obligations of the
correspondent on which a creditworthy obligor in addition to the
correspondent is available, including but not limited to:

\(i\) Loans to third parties secured by stock or debt obligations of the
correspondent;

\(ii\) Loans to third parties purchased from the correspondent with
recourse;

\(iii\) Loans or obligations of third parties backed by stand-by letters
of credit issued by the correspondent; or

\(iv\) Obligations of the correspondent backed by stand-by letters of
credit issued by a creditworthy third party;

\(4\) exposure that results from the merger with or acquisition of
another bank for one year after that merger or acquisition is
consummated; and

\(5\) The portion of the bank\'s exposure to the correspondent that is
covered by federal deposit insurance.

\(e\) Credit exposure of subsidiaries. In calculating credit exposure to
a correspondent under this part, a bank shall include credit exposure to
the correspondent of any entity that the bank is required to consolidate
on its Report of Condition and Income or Thrift Financial Report.

\(f\) Definitions. As used in this section:

\(1\) Government securities means obligations of, or obligations fully
guaranteed as to principal and interest by, the United States government
or any department, agency, bureau, board, commission, or establishment
of the United States, or any corporation wholly owned, directly or
indirectly, by the United States.

\(2\) Readily marketable collateral means financial instruments or
bullion that may be sold in ordinary circumstances with reasonable
promptness at a fair market value determined by quotations based on
actual transactions on an auction or a similarly available daily
bid-ask-price market.

(3)(i) Quality asset means an asset:

\(A\) That is not in a nonaccrual status;

\(B\) On which principal or interest is not more than thirty days past
due; and

\(C\) Whose terms have not been renegotiated or compromised due to the
deteriorating financial conditions of the additional obligor.

\(ii\) An asset is not considered a \"quality asset\" if any other loans
to the primary obligor on the asset have been classified as
\"substandard,\" \"doubtful,\" or \"loss,\" or treated as \"other loans
specially mentioned\" in the most recent report of examination or
inspection of the bank or an affiliate prepared by either a federal or a
state supervisory agency.

§ 206.5 Capital levels of correspondents.

\(a\) Adequately capitalized correspondents.[^10] For the purpose of
this part, a correspondent is considered adequately capitalized if the
correspondent has:

\(1\) A total risk-based capital ratio, as defined in paragraph (e)(1)
of this section, of 8.0 percent or greater;

\(2\) A Tier 1 risk-based capital ratio, as defined in paragraph (e)(2)
of this section, of 4.0 percent or greater; and

\(3\) A leverage ratio, as defined in paragraph (e)(3) of this section,
of 4.0 percent or greater.

\(b\) Frequency of monitoring capital levels. A bank shall obtain
information to demonstrate that a correspondent is at least adequately
capitalized on a quarterly basis, either from the most recently
available Report of Condition and Income, Thrift Financial Report,
financial statement, or bank rating report for the correspondent. For a
foreign bank correspondent for which quarterly financial statements or
reports are not available, a bank shall obtain such information on as
frequent a basis as such information is available. Information obtained
directly from a correspondent for the purpose of this section should be
based on the most recently available Report of Condition and Income,
Thrift Financial Report, or financial statement of the correspondent.

\(c\) Foreign banks. A correspondent that is a foreign bank may be
considered adequately capitalized under this section without regard to
the minimum leverage ratio required under paragraph (a)(3) of this
section.

\(d\) Reliance on information. A bank may rely on information as to the
capital levels of a correspondent obtained from the correspondent, a
bank rating agency, or other party that it reasonably believes to be
accurate.

\(e\) Definitions. For the purposes of this section:

\(1\) Total risk-based capital ratio means the ratio of qualifying total
capital to weighted risk assets.

\(2\) Tier 1 risk-based capital ratio means the ratio of Tier 1 capital
to weighted risk assets.

\(3\) Leverage ratio means the ratio of Tier 1 capital to average total
consolidated assets, as calculated in accordance with the capital
adequacy guidelines of the correspondent\'s primary federal supervisor.

\(f\) Calculation of capital ratios. (i) For a correspondent that is a
U.S. depository institution, the ratios shall be calculated in
accordance with the capital adequacy guidelines of the correspondent\'s
primary federal supervisor.

\(ii\) For a correspondent that is a foreign bank organized in a country
that has adopted the risk-based framework of the Basle Capital Accord,
the ratios shall be calculated in accordance with the capital adequacy
guidelines of the appropriate supervisory authority of the country in
which the correspondent is chartered.

\(iii\) For a correspondent that is a foreign bank organized in a
country that has not adopted the risk-based framework of the Basle
Capital Accord, the ratios shall be calculated in accordance with the
provisions of the Basle Capital Accord.

§ 206.6 Waiver.

The Board may waive the application of Sec. 206.4(a) of this part to a
bank if the primary Federal supervisor of the bank advises the Board
that the bank is not reasonably able to obtain necessary services,
including payment-related services and placement of funds, without
incurring exposure to a correspondent in excess of the otherwise
applicable limit.

§ 206.7 Transition provisions.

\(a\) Beginning on June 19, 1993, a bank shall comply with the
prudential standards prescribed under Sec. 206.3 of this part.

\(b\) Beginning on June 19, 1994, a bank shall comply with the limit on
credit exposure to an individual correspondent required under Sec.
206.4(a) of this part, but for a period of one year after this date the
limit shall be 50 percent of the bank\'s total capital.

By order of the Board of Governors of the Federal Reserve System,
December 11, 1992.

William W. Wiles,

Secretary of the Board.

\[FR Doc. 92-30587 Filed 12-17-92; 8:45 am\]

[^1]: For significant correspondent banking relationships, the Board
    believes that banks generally have considerable non-public
    information concerning their correspondents, such as information on
    the quality of management, general portfolio composition, and
    similar information. The limitation of the rule to financial
    analysis based on publicly available information is intended to
    recognize that access to non-public information is not always
    available, and is not intended to discourage the use of more
    extensive information, where available.

[^2]: A bank is required to obtain non-public information to evaluate a
    correspondent\'s condition only for those foreign banks for which no
    public financial statements are available. In these limited
    circumstances, the bank would need to obtain financial information
    directly from the correspondent.

[^3]: A bank could meet the requirements of the rule by monitoring
    actual overall exposure, or by establishing individual lines for
    significant sources of exposure, such as federal funds sales, and
    establishing procedures to ensure that exposure generally remained
    within the established lines. A bank could also maintain limits on
    exposure by establishing limits monitored by a correspondent , such
    as for sales of federal funds through the correspondent as agent.

    Although the purpose of requiring monitoring or structuring of
    transactions to which limits apply is to ensure that exposure
    generally remains within established limits, the final rule
    recognizes that occasional excesses over limits may result from
    factors such as unusual market disturbances, unusual favorable
    market moves, or other unusual increases in activity or operational
    problems. The final rule requires the bank to establish appropriate
    procedures to address excesses over internal limits.

[^4]: While the proposed rule referred to \"benchmark guidelines\" to
    reflect that the numerical limits were subject to exceptions, the
    successor provision in final rule refers to \"limits\" to reflect
    that this \"limit\" is an outside limit on the bank\'s own internal
    limits. This limit, as well as the bank\'s internal limits, are
    subject to exceptions noted in the final rule. Thus, the nature of
    this limit is substantially the same as the benchmark guidelines in
    the proposed rule.

[^5]: For example: 30 commercial banks and bank holding companies sent
    identical letters which focused on competition from Federal Reserve
    Banks; 19 bankers\' banks and their customers sent an identical
    resolution on the effect of the proposed rule on bankers\' banks and
    competition from Federal Reserve Banks; 10 commercial banks,
    customers and shareholders of a bankers\' bank, sent identical
    letters concerning the proposal\'s effect on bankers\' banks; and 9
    commercial banks sent substantially similar letters on bankers\'
    banks and Reserve Bank competition.

[^6]: Two commenters noted that, in addition to the cost of maintaining
    capital, correspondents generally would have to bear the cost of
    disseminating call reports in order to provide their respondents
    with information on their capital ratios, and that Reserve Banks
    would not have to bear this cost.

[^7]: Claims against other types of financial institutions generally are
    given a 100 percent risk-weighting under the capital adequacy
    guidelines.

[^8]: A bank would be required to obtain non-public financial
    information only in the limited circumstances where no publicly
    available source of information existed, such as for certain
    privately owned foreign banks.

[^9]: Other comments on monitoring credit exposure are addressed in the
    discussion of the guidelines on credit exposure.

[^10]: ^1^ As used in this part, the term \"adequately capitalized\" is
    similar but not identical to the definition of that term as used for
    the purposes of the prompt corrective action standards. See, e.g. 12
    CFR part 208, subpart B.