This section of the FEDERAL REGISTER

contains regulatory documents having general

applicability and legal effect, most of which

are keyed to and codified in the Code of

Federal Regulations, which is published under

50 titles pursuant to 44 U.S.C. 1510.

The Code of Federal Regulations is sold by

the Superintendent of Documents. Prices of

new books are listed in the first FEDERAL

REGISTER issue of each week.

Rules and Regulations Federal Register

24097

Vol. 63, No. 84

Friday, May 1, 1998

1The only exceptions granted were for those high

risk securities that either reduced interest rate risk

or were placed in a trading account. Federal credit

unions were not permitted these exceptions.

2Average Life: Weighted average life of no more

than 10 years; Average Life Sensitivity: (a) weighted

average life extends by not more than 4 years (300

basis point parallel shift in rates), (b) weighted

average life shortens by no more than 6 years (300

basis point parallel shift in rates); Price Sensitivity:

price does not change by more than 17 percent

(increase or decrease) for a 300 basis point parallel

shift in rates.

NATIONAL CREDIT UNION

ADMINISTRATION

12 CFR Chapter VII

Investment Securities and End-User

Derivatives; Interpretive Ruling and

Policy Statement

AGENCY: National Credit Union

Administration (NCUA).

ACTION: Final Interpretive Ruling and

Policy Statement No. 98–2—

Supervisory Policy Statement on

Investment Securities and End-User

Derivatives Activities and Withdrawal

of Interpretive Ruling and Policy

Statement No. 92–1—Supervisory

Policy Statement on Securities

Activities.

SUMMARY: The National Credit Union

Administration (NCUA), the Board of

Governors of the Federal Reserve

System (FRB), the Federal Deposit

Insurance Corporation (FDIC), the Office

of the Comptroller of the Currency

(OCC), and the Office of Thrift

Supervision (OTS), (collectively referred

to as the agencies) under the auspices of

the Federal Financial Institutions

Examination Council (FFIEC) have

approved the Supervisory Policy

Statement on Investment Securities and

End-User Derivatives Activities (1998

Statement) which provides guidance on

sound practices for managing the risks

of investment activities. This statement

replaces the Supervisory Policy

Statement on Securities Activities

published on February 3, 1992 (1992

Statement). NCUA adopted the 1992

Statement as Interpretive Ruling and

Policy Statement No. 92–1 (IRPS No.

92–1). Many elements of the prior

statement are retained in the 1998

Statement, while other elements have

been revised or eliminated. In adopting

the 1998 Statement, the agencies are

removing the specific constraints in the

1992 Statement concerning investments

by insured depository institutions in

‘‘high risk’’ mortgage derivative

products. The agencies believe that it is

a sound practice for institutions to

understand the risks related to all their

investment holdings. Accordingly, the

1998 Statement substitutes broader

guidance than the specific pass/fail

requirements contained in the 1992

Statement. Other than for the

supervisory guidance contained in the

1992 Statement, the 1998 Statement

does not supersede any other

requirements of the agencies’ statutory

rules, regulations, policies, or

supervisory guidance. Because the 1998

Statement does not retain the elements

of the 1992 Statement addressing the

reporting of securities activities (Section

II of the 1992 Statement), the agencies

intend to separately issue supervisory

guidance on the reporting of investment

securities and end-user derivatives

activities. Each agency may issue

additional guidance to assist institutions

in the implementation of this statement.

DATES: The Interpretive Ruling and

Policy Statement is effective October 1,

1998.

ADDRESSES: National Credit Union

Administration, 1775 Duke Street,

Alexandria, Virginia 22314–3428.

FOR FURTHER INFORMATION CONTACT:

Daniel Gordon, Senior Investment

Officer, Office of Investment Services,

(703) 518–6620 or Kim Iverson, Program

Officer, Office of Examination and

Insurance (703) 518–6360, or at the

above address.

SUPPLEMENTARY INFORMATION: In 1992,

the agencies implemented the FFIEC’s

Supervisory Policy Statement on

Securities Activities (57 FR 4028,

February 3, 1992). The 1992 Statement

addressed: (1) selection of securities

dealers, (2) portfolio policy and

strategies (including unsuitable

investment practices), and (3)

residential mortgage derivative products

(MDPs).

The final section of the 1992

Statement directed institutions to

subject MDPs to supervisory tests to

determine the degree of risk and the

investment portfolio eligibility of these

instruments. At that time, the agencies

believed that many institutions had

demonstrated an insufficient

understanding of the risks associated

with investments in MDPs. This

occurred, in part, because most MDPs

were issued or backed by collateral

guaranteed by government sponsored

enterprises. The agencies were

concerned that the absence of

significant credit risk on most MDPs

had allowed institutions to overlook the

significant interest rate risk present in

certain structures of these instruments.

In an effort to enhance the investment

decision making process at financial

institutions, and to emphasize the

interest rate risk of highly price

sensitive instruments, the agencies

implemented supervisory tests designed

to identify those MDPs with price and

average life risks greater than a newly

issued residential mortgage passthrough security.

These supervisory tests provided a

discipline that helped institutions to

better understand the risks of MDPs

prior to purchase. The 1992 Statement

generally provided that institutions

should not hold high risk MDPs in their

investment portfolios.1 A high risk MDP

was defined as a mortgage derivative

security that failed any of three

supervisory tests. The three tests

included: an average life test, an average

life sensitivity test, and a price

sensitivity test.2

These supervisory tests, commonly

referred to as the ‘‘high risk tests,’’

successfully protected institutions from

significant losses in MDPs. By requiring

a pre-purchase price sensitivity analysis

that helped institutions to better

understand the interest rate risk of

MDPs, the high risk tests effectively

precluded institutions from investing in

many types of MDPs that resulted in

large losses for other investors.

However, the high risk tests may have

created unintended distortions of the

investment decision making process.

Many institutions eliminated all MDPs

from their investment choices,

regardless of the risk versus return

merits of such instruments. These

reactions were due, in part, to concerns

about regulatory burden, such as higher

than normal examiner review of MDPs.
24098 Federal Register / Vol. 63, No. 84 / Friday, May 1, 1998 /Rules and Regulations

By focusing only on MDPs, the test and

its accompanying burden indirectly

provided incentives for institutions to

acquire other types of securities with

complex cash flows, often with price

sensitivities similar to high risk MDPs.

The emergence of the structured note

market is just one example. The test

may have also created the impression

that supervisors were more concerned

with the type of instrument involved

(i.e., residential mortgage products),

rather than the risk characteristics of the

instrument, since only MDPs were

subject to the high risk test. The

specification of tests on individual

securities may have removed the

incentive for some institutions to apply

more comprehensive analytical

techniques at the portfolio and

institutional level.

As a result, the agencies no longer

believe that the pass/fail criteria of the

high risk tests as applied to specific

instruments constitutes effective

supervision of investment activities.

The agencies believe that an effective

risk management program, through

which an institution identifies,

measures, monitors, and controls the

risks of investment activities, provides a

better framework. Hence, the agencies

are eliminating the high risk tests as

binding constraints on MDP purchases

in the 1998 Statement.

Effective risk management addresses

risks across all types of instruments on

an investment portfolio basis and

ideally, across the entire institution. The

complexity of many financial products,

both on and off the balance sheet, has

increased the need for a more

comprehensive approach to the risk

management of investment activities.

The rescission of the high risk tests as

a constraint on an institution’s

investment activities does not signal

that MDPs with high levels of price risk

are either appropriate or inappropriate

investments for an institution. Whether

a security, MDP or otherwise, is an

appropriate investment depends upon a

variety of factors, including the

institution’s capital level, the security’s

impact on the aggregate risk of the

portfolio, and management’s ability to

measure and manage risk. The agencies

continue to believe that the stress

testing of MDP investments, as well as

other investments, has significant value

for risk management purposes.

Institutions should employ valuation

methodologies that take into account all

of the risk elements necessary to price

these investments. The 1998 Statement

states that the agencies believe, as a

matter of sound practice, institutions

should know the value and price

sensitivity of their investments prior to

purchase and on an ongoing basis.

Summary of Comments

The 1998 Statement was published by

the FFIEC for comment in the Federal

Register of October 3, 1997 (62 FR

51862). The FFIEC received twenty-one

comment letters from a variety of

insured depository institutions, trade

associations, Federal Reserve Banks,

and financial services organizations.

Overall, the comments were supportive

of the 1998 Statement. The comments

generally approved of: (i) The rescission

of the high risk test as a constraint on

investment choices in the 1992

Statement; (ii) the establishment by

institutions of programs to manage

market, credit, liquidity, legal,

operational, and other risks of

investment securities and end-user

derivatives activities; (iii) the

implementation of sound risk

management programs that would

include certain board and senior

management oversight and a

comprehensive risk management

process that effectively identifies,

measures, monitors, and controls risks;

and (iv) the evaluation of investment

decisions at the portfolio or institution

level, instead of the focus of the 1992

Statement on limiting an institution’s

investment decisions concerning

specific securities instruments.

The following discussion provides a

summary of significant concerns or

requests for clarifications that were

presented in the aforementioned

comments.

1. Scope

The guidance covers a broad range of

instruments including all securities in

held-to-maturity and available-for-sale

accounts as defined in the Statement of

Financial Accounting Standards No. 115

(FAS 115), certificates of deposit held

for investment purposes, and end-user

derivative contracts not held in trading

accounts.

Some comments focused on the 1998

Statement’s coverage of ‘‘end-user

derivative contracts not held in trading

accounts.’’ According to these

comments, the 1998 Statement appears

to cover derivative contracts not

traditionally viewed as investments

including: (i) swap contracts entered

into when the depository institution

makes a fixed rate loan but intends to

change the income stream from a fixed

to floating rate, (ii) swap contracts that

convert the interest rates on certificates

of deposit from fixed to floating rates of

interest, and (iii) swap contracts used

for other asset-liability management

purposes. Those commenters objected to

the necessity of additional guidance for

end-user derivatives contracts given

current regulatory guidance issued by

the agencies with respect to derivative

contracts.

The guidance contained in the 1998

Statement is consistent with existing

agency guidance. The agencies believe

that institutions should have programs

to manage the market, credit, liquidity,

legal, operational, and other risks of

both investment securities and end-user

derivative activities. Given the

similarity of the risks in those activities

and the similarity of the programs

needed to manage those risks, especially

when end-user derivatives are used as

investment vehicles, the agencies

believe that covering both activities

within the scope of the 1998 Statement

is appropriate.

2. Board Oversight

Some commenters stated that the

1998 Statement places excessive

obligations on the board of directors.

Specifically, comments indicated that it

is unnecessary for an institution’s board

of directors to: (i) Set limits on the

amounts and types of transactions

authorized for each securities firm with

whom the institution deals, or (ii)

review and reconfirm the institution’s

list of authorized dealers, investment

bankers, and brokers at least annually.

These commenters suggested that it may

be unnecessary for the board—

particularly for larger institutions—to

review and specifically authorize each

dealer. They indicated that it should be

sufficient for senior management to

ensure that the selection of securities

firms is consistent with board approved

policies, and that establishment of

limits for each dealer is a credit decision

that should be issued pursuant to credit

policies.

The agencies believe that the board of

directors is responsible for supervision

and oversight of investment portfolio

and end-user derivatives activities,

including the approval and periodic

review of policies that govern

relationships with securities dealers.

Especially with respect to the

management of the credit risk of

securities settlements, the agencies

encourage the board of directors or a

subcommittee chaired by a director to

actively participate in the credit

decision process. The agencies

understand that institutions will have

various approaches to the credit

decision process, and therefore that the

board of directors may delegate the

authority for selecting dealers and

establishing dealer limits to senior

management. The text of the 1998
Federal Register / Vol. 63, No. 84 / Friday, May 1, 1998 /Rules and Regulations 24099

Statement has been amended to clarify

the obligation of the board of directors.

3. Pre-Purchase Analysis

The majority of the commenters were

in full support of eliminating the

specific constraints on investing in

‘‘high risk’’ MDPs. Some commenters

expressed opposition with respect to the

1998 Statement’s guidance concerning

pre-purchase analysis by institutions of

their investment securities. Those

commenters felt that neither preacquisition stress testing nor any

specific stress testing methodology

should be required for individual

investment decisions. Some

commenters involved in the use of

securities for collateral purposes

emphasized the benefits of pre- and

post-purchase stress testing of

individual securities.

The agencies wish to stress that

institutions should have policies

designed to meet the business needs of

the institution. These policies should

specify the types of market risk analyses

that should be conducted for various

types of instruments, including that

conducted prior to their acquisition and

on an ongoing basis. In addition,

policies should specify any required

documentation needed to verify the

analysis. Such analyses will vary with

the type of investment instrument.

As stated in Section V of the 1998

Statement, not all investment

instruments need to be subjected to a

pre-purchase analysis. Relatively simple

or standardized instruments, the risks of

which are well known to the institution,

would likely require no or significantly

less analysis than would more volatile,

complex instruments. For relatively

more complex instruments, less familiar

instruments, and potentially volatile

instruments, institutions should fully

address pre-purchase analysis in their

policies. In valuing such investments,

institutions should ensure that the

pricing methodologies used

appropriately consider all risks (for

example, caps and floors in adjustablerate instruments). Moreover, the

agencies do not believe that an

institution should be prohibited from

making an investment based solely on

whether that instrument has a high

price sensitivity.

4. Identification, Measurement, and

Reporting of Risks

Some commenters questioned

whether proposed changes by the

agencies concerning Schedule RC–B of

the Consolidated Reports of Condition

and Income (‘‘Call Reports’’) conflicted

with the 1998 Statement’s elimination

of the high risk test for mortgage

derivative products. The proposed

changes to the Call Reports would

require the disclosure of mortgagebacked and other securities whose price

volatility in response to specific interest

rate changes exceeds a specified

threshold level. (See 62 FR 51715,

October 2, 1997.)

The banking agencies have addressed

the concerns presented in these

comments within the normal process for

changing the Call Reports. For the 1998

Call report cycle, there will be no

changes to the high risk test reporting

requirement in the Call Reports. (The

above discussion is not applicable for

federal credit unions. Any changes to

the Call Report for credit unions will be

made through the normal process for

changing Call Reports.)

5. Market Risk

One commenter suggested that the

agencies enhance the 1998 Statement by

discussing and endorsing the concept of

total return. The agencies agree that the

concept of total return can be a useful

way to analyze the risk and return

tradeoffs for an investment. This is

because the analysis does not focus

exclusively on the stated yield to

maturity. Total return analysis, which

includes income and price changes over

a specified investment horizon, is

similar to stress test analysis since both

examine a security under various

interest rate scenarios. The agencies’

supervisory emphasis on stress testing

securities has, in fact, implicitly

considered total return. Therefore, the

agencies endorse the use of total return

analysis as a useful supplement to price

sensitivity analysis for evaluating the

returns for an individual security, the

investment portfolio, or the entire

institution.

6. Measurement System

One respondent stated that the

complexity and sophistication of the

risk measurement system should not be

a factor in determining whether pre-and

post-acquisition measurement of

interest rate risk should be performed at

the individual investment level or on an

institutional or portfolio basis. The

agencies agree that this statement may

be confusing and are amending the

Market Risk section.

Regulatory Procedures

Regulatory Flexibility Act

The Regulatory Flexibility Act

requires NCUA to prepare an analysis to

describe any significant economic

impact any final regulation may have on

a substantial number of small credit

unions, defined as those having less

than $1 million in assets. The NCUA

Board has determined and certifies that

the final rule will not have a significant

economic impact on a substantial

number of small credit unions.

Paperwork Reduction Act

NCUA has determined that the final

Interpretive Ruling and Policy

Statement does not increase paperwork

requirements under the Paperwork

Reduction Act of 1995 and regulations

of the Office of Management and Budget

(OMB).

Executive Order 12612

Executive Order 12612 requires

NCUA to consider the effect of its

actions on state interests. The final

Interpretive Ruling and Policy

Statement applies directly only to

federal credit unions. NCUA has

determined that the final Interpretive

Ruling and Policy Statement does not

constitute a ‘‘significant regulatory

action’’ for purposes of the Executive

Order.

Small Business Regulatory Enforcement

Fairness Act

The Small Business Regulatory

Enforcement Fairness Act of 1996 (Pub.

L. 104–121) provides generally for

Congressional review of agency rules.

The reporting requirement is triggered

in instances where NCUA issues a final

rule as defined by Section 551 of the

Administrative Procedure Act, 5 U.S.C.

551. NCUA is currently awaiting the

Office of Management and Budget’s

(OMB) decision on whether this is a

major rule.

By the National Credit Union

Administration Board on April 16, 1998.

Becky Baker,

Secretary of the Board.

Accordingly, Interpretive Ruling and

Policy Statement No. 98–2 is issued as

follows:

1. Authority: 12 U.S.C. 1757(7), 1757(8),

1757(15).

2. Interpretive Ruling and Policy

Statement No. 92–1 (57 FR 22157, May

27, 1992) is withdrawn.

3. Interpretive Ruling and Policy

Statement No. 98–2 is issued to read as

follows:

Note: The text of the Interpretive Ruling

and Policy Statement (IRPS 98–2) will not

appear in the Code of Federal Regulations.

Interpretive Ruling and Policy

Statement No. 98–2–Supervisory Policy

Statement on Investment Securities and

End-User Derivatives Activities

I. Purpose

This policy statement (Statement)

provides guidance to financial
24100 Federal Register / Vol. 63, No. 84 / Friday, May 1, 1998 /Rules and Regulations

1The FFIEC’s 1998 Statement (63 FR 20191, April

23, 1998) does not supersede any other

requirements of the respective agencies’ statutory

rules, regulations, policies, or supervisory guidance.

2Natural person federal credit unions are not

permitted to purchase non-residential mortgage

asset-backed securities and may participate in

derivative programs only if authorized by the

NCLA.

institutions (institutions) on sound

practices for managing the risks of

investment securities and end-user

derivatives activities.1 The FFIEC

agencies—the Board of Governors of the

Federal Reserve System, the Federal

Deposit Insurance Corporation, the

Office of the Comptroller of the

Currency, the Office of Thrift

Supervision, and the National Credit

Union Administration—believe that

effective management of the risks

associated with securities and derivative

instruments represents an essential

component of safe and sound practices.

This guidance describes the practices

that a prudent manager normally would

follow and is not intended to be a

checklist. Management should establish

practices and maintain documentation

appropriate to the institution’s

individual circumstances, consistent

with this Statement.

II. Scope

This guidance applies to all securities

in held-to-maturity and available-forsale accounts as defined in the

Statement of Financial Accounting

Standards No.115 (FAS 115), certificates

of deposit held for investment purposes,

and end-user derivative contracts not

held in trading accounts. This guidance

covers all securities used for investment

purposes, including: money market

instruments, fixed-rate and floating-rate

notes and bonds, structured notes,

mortgage pass-through and other assetbacked securities, and mortgagederivative products. Similarly, this

guidance covers all end-user derivative

instruments used for nontrading

purposes, such as swaps, futures, and

options.2 This Statement applies to all

federally-insured commercial banks,

savings banks, savings associations, and

federally chartered credit unions.

As a matter of sound practice,

institutions should have programs to

manage the market, credit, liquidity,

legal, operational and other risks of

investment securities and end-user

derivatives activities (investment

activities). While risk management

programs will differ among institutions,

there are certain elements that are

fundamental to all sound risk

management programs. These elements

include board and senior management

oversight and a comprehensive risk

management process that effectively

identifies, measures, monitors, and

controls risk. This Statement describes

sound principles and practices for

managing and controlling the risks

associated with investment activities.

Institutions should fully understand

and effectively manage the risks

inherent in their investment activities.

Failure to understand and adequately

manage the risks in these areas

constitutes an unsafe and unsound

practice.

III. Board and Senior Management

Oversight

Board of director and senior

management oversight is an integral part

of an effective risk management

program. The board of directors is

responsible for approving major policies

for conducting investment activities,

including the establishment of risk

limits. The board should ensure that

management has the requisite skills to

manage the risks associated with such

activities. To properly discharge its

oversight responsibilities, the board

should review portfolio activity and risk

levels, and require management to

demonstrate compliance with approved

risk limits. Boards should have an

adequate understanding of investment

activities. Boards that do not, should

obtain professional advice to enhance

its understanding of investment activity

oversight, so as to enable it to meet its

responsibilities under this Statement.

Senior management is responsible for

the daily management of an institution’s

investments. Management should

establish and enforce policies and

procedures for conducting investment

activities. Senior management should

have an understanding of the nature and

level of various risks involved in the

institution’s investments and how such

risks fit within the institution’s overall

business strategies. Management should

ensure that the risk management process

is commensurate with the size, scope,

and complexity of the institution’s

holdings. Management should also

ensure that the responsibilities for

managing investment activities are

properly segregated to maintain

operational integrity. Institutions with

significant investment activities should

ensure that back-office, settlement, and

transaction reconciliation

responsibilities are conducted and

managed by personnel who are

independent of those initiating risk

taking positions.

IV. Risk Management Process

An effective risk management process

for investment activities includes: (1)

policies, procedures, and limits; (2) the

identification, measurement, and

reporting of risk exposures; and (3) a

system of internal controls.

Policies, Procedures, and Limits

Investment policies, procedures, and

limits provide the structure to

effectively manage investment activities.

Policies should be consistent with the

organization’s broader business

strategies, capital adequacy, technical

expertise, and risk tolerance. Policies

should identify relevant investment

objectives, constraints, and guidelines

for the acquisition and ongoing

management of securities and derivative

instruments. Potential investment

objectives include: generating earnings,

providing liquidity, hedging risk

exposures, taking risk positions,

modifying and managing risk profiles,

managing tax liabilities, and meeting

pledging requirements, if applicable.

Policies should also identify the risk

characteristics of permissible

investments and should delineate clear

lines of responsibility and authority for

investment activities.

An institution’s management should

understand the risks and cashflow

characteristics of its investments. This is

particularly important for products that

have unusual, leveraged, or highly

variable cashflows. An institution

should not acquire a material position

in an instrument until senior

management and all relevant personnel

understand and can manage the risks

associated with the product.

An institution’s investment activities

should be fully integrated into any

institution-wide risk limits. In so doing,

some institutions rely only on the

institution-wide limits, while others

may apply limits at the investment

portfolio, sub-portfolio, or individual

instrument level.

The board and senior management

should review, at least annually, the

appropriateness of its investment

strategies, policies, procedures, and

limits.

Risk Identification, Measurement and

Reporting

Institutions should ensure that they

identify and measure the risks

associated with individual transactions

prior to acquisition and periodically

after purchase. This can be done at the

institutional, portfolio, or individual

instrument level. Prudent management

of investment activities entails

examination of the risk profile of a

particular investment in light of its

impact on the risk profile of the

institution. To the extent practicable,

institutions should measure exposures

to each type of risk and these
Federal Register / Vol. 63, No. 84 / Friday, May 1, 1998 /Rules and Regulations 24101

3Federal credit unions must comply with the

investment monitoring requirements of 12 CFR

703.90. See 62 FR 32989 (June 18, 1997).

measurements should be aggregated and

integrated with similar exposures

arising from other business activities to

obtain the institution’s overall risk

profile.

In measuring risks, institutions

should conduct their own in-house preacquisition analyses, or to the extent

possible, make use of specific third

party analyses that are independent of

the seller or counterparty. Irrespective

of any responsibility, legal or otherwise,

assumed by a dealer, counterparty, or

financial advisor regarding a

transaction, the acquiring institution is

ultimately responsible for the

appropriate personnel understanding

and managing the risks of the

transaction.

Reports to the board of directors and

senior management should summarize

the risks related to the institution’s

investment activities and should

address compliance with the investment

policy’s objectives, constraints, and

legal requirements, including any

exceptions to established policies,

procedures, and limits. Reports to

management should generally reflect

more detail than reports to the board of

the institution. Reporting should be

frequent enough to provide timely and

adequate information to judge the

changing nature of the institution’s risk

profile and to evaluate compliance with

stated policy objectives and constraints.

Internal Controls

An institution’s internal control

structure is critical to the safe and

sound functioning of the organization

generally and the management of

investment activities in particular. A

system of internal controls promotes

efficient operations, reliable financial

and regulatory reporting, and

compliance with relevant laws,

regulations, and institutional policies.

An effective system of internal controls

includes enforcing official lines of

authority, maintaining appropriate

separation of duties, and conducting

independent reviews of investment

activities.

For institutions with significant

investment activities, internal and

external audits are integral to the

implementation of a risk management

process to control risks in investment

activities. An institution should conduct

periodic independent reviews of its risk

management program to ensure its

integrity, accuracy, and reasonableness.

Items that should be reviewed include:

(1) Compliance with and the

appropriateness of investment policies,

procedures, and limits;

(2) The appropriateness of the

institution’s risk measurement system

given the nature, scope, and complexity

of its activities;

(3) The timeliness, integrity, and

usefulness of reports to the board of

directors and senior management.

The review should note exceptions to

policies, procedures, and limits and

suggest corrective actions. The findings

of such reviews should be reported to

the board and corrective actions taken

on a timely basis.

The accounting systems and

procedures used for public and

regulatory reporting purposes are

critically important to the evaluation of

an organization’s risk profile and the

assessment of its financial condition

and capital adequacy. Accordingly, an

institution’s policies should provide

clear guidelines regarding the reporting

treatment for all securities and

derivatives holdings. This treatment

should be consistent with the

organization’s business objectives,

generally accepted accounting

principles (GAAP), and regulatory

reporting standards.

V. The Risks of Investment Activities

The following discussion identifies

particular sound practices for managing

the specific risks involved in investment

activities. In addition to these sound

practices, institutions should follow any

specific guidance or requirements from

their primary supervisor related to these

activities.

Market Risk

Market risk is the risk to an

institution’s financial condition

resulting from adverse changes in the

value of its holdings arising from

movements in interest rates, foreign

exchange rates, equity prices, or

commodity prices. An institution’s

exposure to market risk can be

measured by assessing the effect of

changing rates and prices on either the

earnings or economic value of an

individual instrument, a portfolio, or

the entire institution. For most

institutions, the most significant market

risk of investment activities is interest

rate risk.

Investment activities may represent a

significant component of an institution’s

overall interest rate risk profile. It is a

sound practice for institutions to

manage interest rate risk on an

institution-wide basis. This sound

practice includes monitoring the price

sensitivity of the institution’s

investment portfolio (changes in the

investment portfolio’s value over

different interest rate/yield curve

scenarios). Consistent with agency

guidance, institutions should specify

institution-wide interest rate risk limits

that appropriately account for these

activities and the strength of the

institution’s capital position. These

limits are generally established for

economic value or earnings exposures.

Institutions may find it useful to

establish price sensitivity limits on their

investment portfolio or on individual

securities. These sub-institution limits,

if established, should also be consistent

with agency guidance.

It is a sound practice for an

institution’s management to fully

understand the market risks associated

with investment securities and

derivative instruments prior to

acquisition and on an ongoing basis.

Accordingly, institutions should have

appropriate policies to ensure such

understanding. In particular,

institutions should have policies that

specify the types of market risk analyses

that should be conducted for various

types or classes of instruments,

including that conducted prior to their

acquisition (pre-purchase analysis) and

on an ongoing basis. Policies should

also specify any required

documentation needed to verify the

analysis.

It is expected that the substance and

form of such analyses will vary with the

type of instrument. Not all investment

instruments may need to be subjected to

a pre-purchase analysis. Relatively

simple or standardized instruments, the

risks of which are well known to the

institution, would likely require no or

significantly less analysis than would

more volatile, complex instruments.3

For relatively more complex

instruments, less familiar instruments,

and potentially volatile instruments,

institutions should fully address prepurchase analyses in their policies.

Price sensitivity analysis is an effective

way to perform the pre-purchase

analysis of individual instruments. For

example, a pre-purchase analysis should

show the impact of an immediate

parallel shift in the yield curve of plus

and minus 100, 200, and 300 basis

points. Where appropriate, such

analysis should encompass a wider

range of scenarios, including nonparallel changes in the yield curve. A

comprehensive analysis may also take

into account other relevant factors, such

as changes in interest rate volatility and

changes in credit spreads.

When the incremental effect of an

investment position is likely to have a

significant effect on the risk profile of

the institution, it is a sound practice to

analyze the effect of such a position on
24102 Federal Register / Vol. 63, No. 84 / Friday, May 1, 1998 /Rules and Regulations

the overall financial condition of the

institution.

Accurately measuring an institution’s

market risk requires timely information

about the current carrying and market

values of its investments. Accordingly,

institutions should have market risk

measurement systems commensurate

with the size and nature of these

investments. Institutions with

significant holdings of highly complex

instruments should ensure that they

have the means to value their positions.

Institutions employing internal models

should have adequate procedures to

validate the models and to periodically

review all elements of the modeling

process, including its assumptions and

risk measurement techniques.

Management relying on third parties for

market risk measurement systems and

analyses should ensure that they fully

understand the assumptions and

techniques used.

Institutions should provide reports to

their boards on the market risk

exposures of their investments on a

regular basis. To do so, the institution

may report the market risk exposure of

the whole institution. Alternatively,

reports should contain evaluations that

assess trends in aggregate market risk

exposure and the performance of

portfolios in terms of established

objectives and risk constraints. They

also should identify compliance with

board approved limits and identify any

exceptions to established standards.

Institutions should have mechanisms to

detect and adequately address

exceptions to limits and guidelines.

Management reports on market risk

should appropriately address potential

exposures to yield curve changes and

other factors pertinent to the

institution’s holdings.

Credit Risk

Broadly defined, credit risk is the risk

that an issuer or counterparty will fail

to perform on an obligation to the

institution. For many financial

institutions, credit risk in the

investment portfolio may be low relative

to other areas, such as lending.

However, this risk, as with any other

risk, should be effectively identified,

measured, monitored, and controlled.

An institution should not acquire

investments or enter into derivative

contracts without assessing the

creditworthiness of the issuer or

counterparty. The credit risk arising

from these positions should be

incorporated into the overall credit risk

profile of the institution as

comprehensively as practicable.

Institutions are legally required to meet

certain quality standards (i.e.,

investment grade) for security

purchases. Many institutions maintain

and update ratings reports from one of

the major rating services. For non-rated

securities, institutions should establish

guidelines to ensure that the securities

meet legal requirements and that the

institution fully understands the risk

involved. Institutions should establish

limits on individual counterparty

exposures. Policies should also provide

credit risk and concentration limits.

Such limits may define concentrations

relating to a single or related issuer or

counterparty, a geographical area, or

obligations with similar characteristics.

In managing credit risk, institutions

should consider settlement and presettlement credit risk. These risks are

the possibility that a counterparty will

fail to honor its obligation at or before

the time of settlement. The selection of

dealers, investment bankers, and

brokers is particularly important in

effectively managing these risks. The

approval process should include a

review of each firm’s financial

statements and an evaluation of its

ability to honor its commitments. An

inquiry into the general reputation of

the dealer is also appropriate. This

includes review of information from

state or federal securities regulators and

industry self-regulatory organizations

such as the National Association of

Securities Dealers concerning any

formal enforcement actions against the

dealer, its affiliates, or associated

personnel.

The board of directors is responsible

for supervision and oversight of

investment portfolio and end-user

derivatives activities, including the

approval and periodic review of policies

that govern relationships with securities

dealers.

Sound credit risk management

requires that credit limits be developed

by personnel who are as independent as

practicable of the acquisition function.

In authorizing issuer and counterparty

credit lines, these personnel should use

standards that are consistent with those

used for other activities conducted

within the institution and with the

organization’s over-all policies and

consolidated exposures.

Liquidity Risk

Liquidity risk is the risk that an

institution cannot easily sell, unwind,

or offset a particular position at a fair

price because of inadequate market

depth. In specifying permissible

instruments for accomplishing

established objectives, institutions

should ensure that they take into

account the liquidity of the market for

those instruments and the effect that

such characteristics have on achieving

their objectives. The liquidity of certain

types of instruments may make them

inappropriate for certain objectives.

Institutions should ensure that they

consider the effects that market risk can

have on the liquidity of different types

of instruments under various scenarios.

Accordingly, institutions should

articulate clearly the liquidity

characteristics of instruments to be used

in accomplishing institutional

objectives.

Complex and illiquid instruments can

often involve greater risk than actively

traded, more liquid securities.

Oftentimes, this higher potential risk

arising from illiquidity is not captured

by standardized financial modeling

techniques. Such risk is particularly

acute for instruments that are highly

leveraged or that are designed to benefit

from specific, narrowly defined market

shifts. If market prices or rates do not

move as expected, the demand for such

instruments can evaporate, decreasing

the market value of the instrument

below the modeled value.

Operational (Transaction) Risk

Operational (transaction) risk is the

risk that deficiencies in information

systems or internal controls will result

in unexpected loss. Sources of operating

risk include inadequate procedures,

human error, system failure, or fraud.

Inaccurately assessing or controlling

operating risks is one of the more likely

sources of problems facing institutions

involved in investment activities.

Effective internal controls are the first

line of defense in controlling the

operating risks involved in an

institution’s investment activities. Of

particular importance are internal

controls that ensure the separation of

duties and supervision of persons

executing transactions from those

responsible for processing contracts,

confirming transactions, controlling

various clearing accounts, preparing or

posting the accounting entries,

approving the accounting methodology

or entries, and performing revaluations.

Consistent with the operational

support of other activities within the

financial institution, securities

operations should be as independent as

practicable from business units.

Adequate resources should be devoted,

such that systems and capacity are

commensurate with the size and

complexity of the institution’s

investment activities. Effective risk

management should also include, at

least, the following:

Valuation. Procedures should ensure

independent portfolio pricing. For

thinly traded or illiquid securities,
Federal Register / Vol. 63, No. 84 / Friday, May 1, 1998 /Rules and Regulations 24103

completely independent pricing may be

difficult to obtain. In such cases,

operational units may need to use prices

provided by the portfolio manager. For

unique instruments where the pricing is

being provided by a single source (e.g.,

the dealer providing the instrument),

the institution should review and

understand the assumptions used to

price the instrument.

Personnel. The increasingly complex

nature of securities available in the

marketplace makes it important that

operational personnel have strong

technical skills. This will enable them

to better understand the complex

financial structures of some investment

instruments.

Documentation. Institutions should

clearly define documentation

requirements for securities transactions,

saving and safeguarding important

documents, as well as maintaining

possession and control of instruments

purchased.

An institution’s policies should also

provide guidelines for conflicts of

interest for employees who are directly

involved in purchasing and selling

securities for the institution from

securities dealers. These guidelines

should ensure that all directors, officers,

and employees act in the best interest of

the institution. The board may wish to

adopt policies prohibiting these

employees from engaging in personal

securities transactions with these same

securities firms without specific prior

board approval. The board may also

wish to adopt a policy applicable to

directors, officers, and employees

restricting or prohibiting the receipt of

gifts, gratuities, or travel expenses from

approved securities dealer firms and

their representatives.

Legal Risk

Legal risk is the risk that contracts are

not legally enforceable or documented

correctly. Institutions should adequately

evaluate the enforceability of its

agreements before individual

transactions are consummated.

Institutions should also ensure that the

counterparty has authority to enter into

the transaction and that the terms of the

agreement are legally enforceable.

Institutions should further ascertain that

netting agreements are adequately

documented, executed properly, and are

enforceable in all relevant jurisdictions.

Institutions should have knowledge of

relevant tax laws and interpretations

governing the use of these instruments.

[FR Doc. 98–11451 Filed 4–30–98; 8:45 am]

BILLING CODE 7535–01–U

NATIONAL CREDIT UNION

ADMINISTRATION

12 CFR Parts 703 and 704

Investment and Deposit Activities;

Corporate Credit Unions

AGENCY: National Credit Union

Administration (NCUA).

ACTION: Final rule.

SUMMARY: NCUA is adopting as final the

interim final amendments to the

investment regulation as issued last

year. The final amendments revise the

broker-dealer and safekeeping

provisions. NCUA is also deleting the

references to the High Risk Securities

Test for CMOs/REMICs in its regulations

on investments and corporate credit

unions. These amendments will clarify

certain procedures related to credit

unions’ involvement with brokerdealers and safekeeping of securities.

DATES: The interim final amendments

published at 62 FR 64146 are adopted

as final effective May 1, 1998.

Amendments in this rule to part 703 are

effective October 1, 1998. Amendments

in this rule to part 704 are effective May

1, 1998.

ADDRESSES: National Credit Union

Administration, 1775 Duke Street,

Alexandria, Virginia 22314–3428.

FOR FURTHER INFORMATION CONTACT:

Daniel Gordon, Senior Investment

Officer, Office of Investment Services,

(703) 518–6620 or Kim Iverson (Program

Officer), Office of Examination and

Insurance (703) 518–6360, or at the

above address.

SUPPLEMENTARY INFORMATION:

A. Interim Final Rule

On November 24, 1997, NCUA issued

an interim final rule that made

substantive revisions and technical

changes to part 703. 62 FR 64146,

December 4, 1997. NCUA received

eleven comment letters, three from trade

associations, two from credit union

leagues, three from federal credit

unions, two from corporate credit

unions, and one from a state-chartered

credit union. Five commenters

supported the technical changes and

offered no other comments. The

remaining six had specific comments, as

discussed below.

The interim final rule amended

§ 703.50 to state that a federal credit

union may use a third party that is not

rregistered with the Securities and

Exchange Commission (SEC) or is not a

federally regulated depository

institution to purchase a certificate of

deposit (CD) as long as the credit union

purchases the CD directly from a bank,

credit union, or other depository

institution. One commenter requested

clarification that wiring funds to a

correspondent bank for further credit to

the issuing institution is an acceptable

practice. Another suggested that the rule

should simply state whether credit

unions are prohibited from using thirdparties, passing their funds through

third parties, or passing funds through

unregistered brokers. Another

commenter suggested the reason for the

amendment was that entities that sell

only CDs are not usually subject to

comprehensive regulatory oversight,

and NCUA should not inadvertently

force credit unions to stop buying CDs

from legitimate, regulated CD brokers

(banks and registered broker-dealers).

NCUA wishes to clarify that it is

permissible to send funds to an agent

depository institution either of the

credit union (credit union’s

correspondent) or of the issuing

depository institution (issuer’s

correspondent) for credit to an issuing

depository institution (issuer). For

example, a credit union can send its

funds directly to the issuer’s

correspondent. Alternatively, it is

permissible for a credit union to send

funds to its correspondent and this

correspondent can send those funds to

the issuer’s correspondent or the issuer.

A federal credit union may not wire, or

send in any manner, funds to an agent

depository institution of an unregistered

entity to purchase a CD. The account

relationship must be directly with the

issuer unless the credit union is using

a broker-dealer that is SEC-registered or

is a federally regulated depository

institution. NCUA believes that the

amendment made by the interim final

rule is sufficiently clear in this area and

is not making additional changes to the

provision in this final rule.

This interim final rule also

established that a credit union may

safekeep securities with a selling brokerdealer as long as the safekeeper used by

the broker-dealer is regulated by the

SEC. Two commenters suggested that

the preamble recommend that a

safekeeping agreement prohibit a third

party from pledging or lending the

credit union’s securities without notice

of each specific transaction. Without

notice of each specific transaction, the

credit union would have an unknown

counterparty exposure. The NCUA

Board agrees it is a sound business

practice for every credit union to

carefully read and understand the

details of any agreement it enters into

and encourages credit unions to do so.

In the absence of a delegation of

authority, a credit union must

specifically authorize any actions its