Clarification on the Responsibilities of the Board of Directors February 26, 2021: As

described in SR letter 21-4 / CA letter 21-2, “Inactive or Revised SR Letters Related to Federal

Reserve Expectations for Boards of Directors,” this SR letter was revised as of February 26,

2021 to better reflect the Federal Reserve's guidance for boards of directors in SR letter 21-3 /

CA letter 21-1, “Supervisory Guidance on Board of Directors' Effectiveness,” and SR letter 16­

11, “Supervisory Guidance for Assessing Risk Management at Supervised Institutions with Total 

Consolidated Assets Less than $100 Billion.” No other material changes were made to this

letter.

Attachment A

Disposal of Problem Assets through Exchanges

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Background

Deterioration in asset quality arising from weak economic conditions over the past

several years has led to an increase in the levels of nonperforming assets and other real estate

owned (OREO) (collectively, problem assets). In the recent past, examiners have encountered

situations where institutions, especially smaller institutions, were considering or structuring

transactionsto reduce the volume of problem assets.

In some instances, referred to in this guidance as “asset exchanges,” third parties or

marketing agents have offered to purchase problem assets from institutions and replace them

with performing assets, which would help institutions diversify their loan portfolios. Institutions

perceived that asset exchange transactions offered the potential to increase interest income,

reduce the level of real estate concentrations, enhance liquidity, and reduce the stress on capital. 

Nevertheless, these transactions may pose significant risks. In some of these transactions, sellers

have exchanged problem assets for purportedly performing assets (acquired assets) that were

recorded at values in excess of fair value.

Attachment B of this guidance offers a detailed example of such an asset exchange

transaction. The risks involved in these activities, the risk management considerations for

institutions, and the supervisory considerations for examiners when faced with these transactions

are outlined below.

Risk management considerations

Asset exchanges may expose institutions to significant risks, which management should

assess before entering into such transactions. Management should focus not only on the

immediate or short-term benefits of a transaction, but should determine its long-term effect on 

the institution's balance sheet and loss exposure. Management should also determine how these

risks align with the institution's overall risk management strategy.

In undertaking due diligence on these types of transactions, management should assess

the risks and provide evidence of its analysis, taking into account:
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• The reported benefits to the institution from the transfer. This assessment should address

whether the transaction would actually enable the institution to transfer significant risk

associated with the problem assets.

• The economic costs and benefits of the transaction. This should include the economic

benefits accruing to the marketing agent; the marketing agent's responsibilities and

liabilities; and the loss position, including recourse, of each participant if either the ceded

assets or acquired assets do not perform as anticipated.

• The servicing responsibilities attached to the acquired assets. If the institution assumes

servicing responsibilitiesfor the acquired assets, the institution should evaluate and show

evidence that it has the capacity and infrastructure in place, as well as appropriate risk

controls, to service the acquired assets.

• The transaction's compliance with the firm's risk tolerance and risk mitigation policies ,

including the overall strategy for managing or reducing problem assets.

• The appropriate accounting treatment in accordance with U.S. generally accepted

accounting principles(GAAP). Specific issues with regard to the appropriate accounting

treatment include, but are not limited to, the following:

o When specific loans are identified for inclusion in exchange transactions and the

institution decides to sell the loans, they should be transferred to a “held-for-sale”

account at the lower of cost or fair value with losses recognized through earnings.

Any reduction in value should be reflected as a write-down of the recorded

investment resulting in a new cost basis. The sale of these loans should occur at

an appropriate fair value.

o Newly acquired assets should be recorded at an appropriate fair value.

• A review of the marketing agent. This should include, but not be limited to, an

assessment of the agent's financial strength, including its ability to provide credit

enhancement if it is required in the transaction.

• The relationship between the marketing agent and any entity providing services for the

transaction, with particular attention paid to possible cross-ownership or other relatedparty relationships.

• An independent valuation by a reputable and experienced third-party valuation expert of

the assets being acquired. The party that performs the valuation should be independent of

the marketing agent and the institution selling the performing assets. The use of outside

resources does not relieve management of its responsibility to ensure that fair value

estimates are measured in accordance with GAAP. [Footnote 1

- Fair value measurements are determined based on assumptionsthat market participants would use in valuing the

assets. This should include a risk premium reflecting the amount market participants would demand because of the

risk (uncertainty) in the cash flows. End of Footnote 1.]

Management should sufficiently

understand the bases for the measurement and valuation techniques used by outside
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parties to determine the appropriateness of these techniques, the underlying inputs and

assumptions, and the resulting fair value measurements. [Footnote 2

- Examples of significant inputs and assumptionsinclude, but are not limited to, default probabilities, current loanto-value ratios, loss severities, and prepayment speeds. End of Footnote 2.]

• The acquiring institution's experience, skills, personnel, and risk management

capabilities to manage the newly acquired assets, especially if the assets are in business

segments or geographical areas that are different from the institution's own.

Supervisory responsibilities

While it is not necessary to scope a specific review of these transactionsinto routine

examination and inspection activities, particularly where there is no evidence that a bank has

engaged in such transactions, Reserve Banks nevertheless should be aware of indications of

possible asset exchange transactions as part of their routine monitoring of financial institutions

between examinations. Examiners should hold ongoing discussions with an institution's

management as part of the supervision process if examiners become aware that the institution is 

considering these types of transactions. Monitoring activities should focus on financial

statement changes commonly associated with asset exchanges, internal risk management reports,

and other documentsreceived on a routine basis. Indicators that asset exchanges might have

taken place include:

• Asset sales at (or very near) book values, with either no loss recognized, or a gain on 

recovery of a prior write-down recognized. It is unusual for a third party to buy problem

assets at higher than the selling institution's book value at the time of the sale.

• Board or management discussion of strategies designed to achieve material reductions in

problem assets.

• Material loan sales and purchases involving the same counterparty, on or around the same

date.

• Significant reductions in the institution's nonperforming loan totals without attendant

losses. The motivation for asset exchanges is to reduce problem assets, but this may be

difficult to do in the current economic environment without realizing significant losses.

• Purchase of a large portfolio of loans that are outside the institution'straditional markets

and/or are inconsistent with the institution's business strategies or lending and investment

policies.

• Purchase at (or near) par of a large portfolio of loans that, while currently performing,

have high-risk characteristics (e.g., are outside generally accepted underwriting standards

for this type of credit) that indicate they may not continue to perform in accordance with

their contractual terms.

• Large net loan or asset growth during a short period. Because asset exchanges nearly

always involve an institution purchasing more assets than it is selling, it is common for 

the balance sheet to grow rapidly as a result of the asset exchange transaction.
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Supervisory actions

If examiners observe an institution engaging in asset exchanges, they should determine

whether the appropriate risk management measures have been considered and management has

used appropriate valuations in accordance with GAAP. Important findings should be noted in

the examination/inspection report and, as appropriate, plans for remedial action discussed with

management. Given the concern regarding both safety-and-soundness issues as well as the

appropriate valuation practices, Reserve Banks should contact the appropriate Board staff analyst

to discuss the asset exchange transaction.