OCC 2002-39	
OCC BULLETIN	

Subject:  Investment Portfolio Credit Risks: Safekeeping Arrangements
Description:  Supplemental Guidance

Date:  September 5, 2002

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

PURPOSE

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

BACKGROUND

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

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

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

DEPOSIT BROKERS

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

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

Unregistered Deposit Brokers.  When assessing the creditworthiness of a
deposit broker, banks should first determine whether the deposit brokers
activities are limited to deposit brokerage only, or are part of a larger
broker/dealer function.  Many deposit brokers that are not registered with
the SEC have little (or no) capital.  Such firms may be subject to no
external supervision and often will not be creditworthy counterparties.
Because unregistered deposit brokers are agents and frequently have little
capital strength, national banks generally should use them as "finders"
only.  The unregistered deposit broker can identify an issuing institution
offering to pay a certain rate, but investing banks generally should wire
funds directly to the issuer when purchasing the CD.  It is an unsafe and
unsound practice for banks to wire funds to purchase deposits to an
unregistered deposit broker, or to allow that deposit broker to act as
custodian for insured CDs, unless the deposit brokers financial strength
and reputation warrants an unsecured credit facility in the cumulative
amount of the investments a bank has purchased.
 
Deposit Brokers Registered As Broker/Dealers.  Some deposit brokers are
registered with the SEC as securities broker/dealers and are subject to
that agency's minimum capital requirements.  Capital requirements vary
significantly among broker/dealers, depending on whether the broker/dealer
clears or carries customer accounts, or does not carry accounts and,
instead, clears its brokerage transactions through a full-service broker.
Therefore, banks should not assume that a deposit broker is a creditworthy
counterparty simply because it is registered with the SEC.

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

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

DEPOSIT BROKER FAILURES

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

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

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

2) Registered Broker/Dealer Failure:  In another recent case, banks have
suffered losses following the failure of a broker/dealer custodian whose
subsidiary broker/dealer had brokered insured CDs into bank portfolios.
The broker/dealer subsidiary also sold banks other non-CD investments.
Banks have suffered losses even though the broker/dealer, unlike in the
case of the unregistered deposit broker above, purchased (and, through its
parent, held for customers) insured CDs with the identical terms it had
confirmed to its customers.  The trustee for the  broker/dealers
liquidation, in accordance with the Securities Investor Protection Act
(SIPA), has withheld CDs and other investments registered in "street
name."   [Note 1:  "Street name" registration means that the investments
are not registered in the customer's name; they are registered in the
broker/dealer's name.  Street name registration is also used by banks and
other intermediaries and enhances liquidity by making the investments
easily transferable.]

When a broker/dealer fails, if there are losses involving customer assets,
[Note 2:  "Losses involving customer assets" refers to losses resulting
from fraud, operational error, and market transactions, such as securities
lending, when a broker/dealer fails.  When a broker/dealer loans a
customer's security, a loss can occur if, for example, the broker/
dealer's counterparty (i.e., the securities borrower) sells the borrowed
assets to cover the failed broker/dealer's inability to meet a margin
call.   The phrase "losses involving customer assets" does not refer to
market value changes that cause security values to fall below the
customer's cost.] investments of customers that the broker/dealer holds in
"street name" become "customer property," which is segregated from the
broker/dealer's other assets and is distributed to all of the firm's
customers.  Banks are customers of a broker/dealer for purposes of the
SIPA and have a claim on these assets.  But, under the terms of the SIPA,
banks are not entitled to the Securities Investor Protection Corporation
(SIPC) protection that generally covers $500,000 in property for other
investors.  Under SIPC procedures, the trustee for the failed
broker/dealer first returns property to customers, if that property is
registered in a specific customer's name ("customer name" securities).
Second, the trustee calculates, and then distributes to customers, their
pro rata share of customer property held in "street name."  The pro rata
distribution reflects the trustees recovery of customer assets.  As the
trustee recovers more property for the estate, it seeks court approval to
make additional distributions of that property to customers.  Finally,
customers entitled to SIPC protection receive up to $500,000 to cover any
remaining shortfall in what is due to the customer following the pro rata
distribution.  Banks are not entitled to receive SIPC protection and thus
receive only their pro rata distributions from the estate.

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

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

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

MEASURES TO REDUCE CUSTODIAL RISK

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

1. Purchase insured CDs directly from the issuing institution.

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

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

Investors can suffer losses if either a bank or broker/dealer custodian
fails and has committed fraud, or had an operational error, with respect
to customer security holdings.  Investors should recognize, however, that
they incur a unique risk when dealing with a broker/dealer, because failed
broker/dealers, unlike failed banks, subject investors to the
SIPA-mandated pro rata distribution process.  [Note 3:  As noted above, an
investor bank that holds assets with a failed broker/dealer in street name
will have that asset labeled "customer property" and used in a pro rata
distribution to all of the firm's customers.  On the other hand, when a
bank fails, client assets it holds as custodian are generally not subject
to a pro rata distribution.  The FDIC will return the assets to the
client.  This is true even if the assets were held in the failed banks
name.  Only those clients with losses in their accounts will sustain a
loss.  For example, if fraud is involved (e.g., the assets dont exist or
were never purchased), or, in the absence of fraud, the FDIC determines
that the assets legally belong to the failed bank, clients then become
general creditors of the bank and would receive a pro rata distribution
upon liquidation.  This issuance only provides a summary of FDIC
treatment.  Additional information is available at the FDIC's Web site at
< http://www.fdic.gov >.]  But, that unique risk does not dictate that
banks should safekeep investment assets only with another commercial bank
simply because there is a more limited risk of a pro rata distribution.  A
well- capitalized broker/dealer with an excellent market reputation may
represent a low risk comparable to that of a well-run commercial bank.
National banks evaluating custody options should carefully consider the
risks of insolvency and market reputations for both banks and
broker/dealers.

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

*  Having the assets registered in the investing banks name.  Since the
trustee for the SIPC in a broker/dealer liquidation returns "customer
name" assets to their owners prior to the pro-rata distribution process,
registration reduces risk.  This strategy does not eliminate risk,
however, because even "customer name securities may disappear (e.g., in
the case of fraud) in connection with a broker/dealers insolvency.  When
a broker/dealer fails, the investing bank will have to file a claim
promptly to recover the registered assets.  Failure to file the
appropriate claim in a timely manner may result in significant delays in
recovering the asset or, worse, denial of the claim in its entirety.
Registration may, however, reduce the practical liquidity of the
investments because the bank will have to re-register the assets, and
incur related expenses, in order to sell them.  Banks should carefully
evaluate the costs and benefits of this risk-reducing strategy, including
an assessment of coverage available under the custodian's insurance
policy.  The stronger the reputation and capital position of the
broker/dealer, the less likely the benefits of this risk reduction
technique will exceed the costs.  Moreover, for some assets, such as
insured CDs, registration may not be practical.  [Note 4:  Broker/dealers
and banks typically hold CDs under arrangements that preclude registering
the CDs in any individual customers name.  For example, most CDs sold
through broker/dealers and banks are issued in denominations of $1,000 and
are evidenced by large-denomination physical certificates representing
multiple $1,000 deposits.  The large-denomination certificates may be held
by the broker/dealer or bank, or safekept for it by one or more
intermediaries such as a bank, a clearing broker/dealer or a securities
depository such as the Depository Trust Company.  In any of these
instances, the CDs cannot be registered in the name of the customer unless
the broker/dealer or bank arranges for the customers CDs to be registered
with the issuing bank in the customers name.]

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

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

OBTAINING PASS-THROUGH DEPOSIT INSURANCE

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

A deposit placed by an agent (such as broker/dealer) on behalf of a
principal (such as the purchaser), is considered insured by the FDIC to
the same extent as if the investor purchased the CD directly from the
issuer, provided certain conditions are met.  Typically, the custodian or
its agent holds a large-denomination CD evidencing a number of $1,000
deposits owned by various depositors for which the custodian acts as
agent.  [Note 5:  In some instances, a deposit broker will purchase a
large-denomination CD that does not evidence multiple $1,000 CDs and will
sell participations in the large-denomination CD.  In such cases, the
insurance coverage will "pass through" the broker to the customers if the
FDIC's requirements have been satisfied.  Apart from the insurance,
however, banks should be cautious about these arrangements because the
large-denomination CD is not divisible into $1,000 CDs and, hence,
liquidity may be poor.  The only potential buyers for the CD may be the
deposit broker's own customer base.]  National banks purchasing CDs
through deposit brokers should consider the following FDIC requirements in
order to determine whether FDIC insurance passes through to their holding:
[Note 6:  This issuance only provides a summary of FDIC requirements to
obtain pass- through insurance.  If a bank has any question about the
applicability of FDIC insurance to an investment, the bank should contact
the FDIC directly for guidance or consult the FDIC's Web site at <
http://www.fdic.gov/deposit/index.html >, where information on deposit
insurance is located.]

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

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

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

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

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

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

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

RESPONSIBLE OFFICE

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



Kathryn E. Dick Deputy Comptroller for Risk Evaluation