View PDF

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

l l★K

Federal Reserve Bank of Dallas
2200 N. PEARL ST.
DALLAS, TX 75201-2272

February 3, 2004

Notice 04-05

TO: The Chief Executive Officer of each
financial institution and foreign agency
in the Eleventh Federal Reserve District
SUBJECT
Interagency Policy on Banks/Thrifts Providing Financial Support
to Funds Advised by the Banking Organization
DETAILS
The Board of Governors of the Federal Reserve System, Federal Deposit Insurance
Corporation, Office of the Comptroller of the Currency, and Office of Thrift Supervision have
issued a statement titled Interagency Policy on Banks/Thrifts Providing Financial Support to
Funds Advised by the Banking Organization or its Affiliates. The statement sets forth the
collective views of the agencies concerning the safety and soundness implications of a bank
providing financial support to investment funds advised by the bank or its affiliates (i.e.,
affiliated investment fund).
ATTACHMENTS
A copy of the Board’s SR letter and the interagency statement are attached.
MORE INFORMATION
For more information, please contact Gayle Teague, Banking Supervision
Department, at (214) 922-6151. Paper copies of this notice or previous Federal Reserve Bank
notices can be printed from our web site at www.dallasfed.org/banking/notices/index.html.

For additional copies, bankers and others are encouraged to use one of the following toll-free numbers in contacting the Federal
Reserve Bank of Dallas: Dallas Office (800) 333-4460; El Paso Branch Intrastate (800) 592-1631, Interstate (800) 351-1012;
Houston Branch Intrastate (800) 392-4162, Interstate (800) 221-0363; San Antonio Branch Intrastate (800) 292-5810.

BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551
DIVISION OF BANKING
SUPERVISION AND REGULATION

SR 04-1
January 5, 2004

TO THE OFFICER IN CHARGE OF SUPERVISION AND APPROPRIATE
SUPERVISORY AND EXAMINATION STAFF AT EACH FEDERAL
RESERVE BANK AND TO EACH DOMESTIC AND FOREIGN BANKING
ORGANIZATION SUPERVISED BY THE FEDERAL RESERVE
SUBJECT: Interagency Policy on Banks/Thrifts Providing Financial
Support to Funds Advised by the Banking Organization
The Board of Governors of the Federal Reserve System,
Federal Deposit Insurance Corporation, Office of the Comptroller of the
Currency, and Office of Thrift Supervision (the agencies) have issued the
attached Interagency Policy on Banks/Thrifts Providing Financial Support to
Funds Advised by the Banking Organization or its Affiliates . This interagency
policy statement sets forth the collective views of the agencies concerning the
safety and soundness implications of a bank providing financial support to
investment funds advised by the bank or its affiliates (i.e., affiliated investment
fund).
The three core principles contained in the interagency policy
statement emphasize that a bank should not:
inappropriately place its resources and
reputation at risk for the benefit of
affiliated investment funds' investors and
creditors;
violate the limits and requirements
contained in sections 23A and 23B of
the Federal Reserve Act and
Regulation W, other applicable legal
requirements, or any special supervisory
condition imposed by the agencies; or
create an expectation that the bank will
prop up the advised fund(s).
In addition, bank affiliated investment advisers are

encouraged to establish alternate sources of financial support to avoid
seeking support from affiliated banks. Finally, bank management is expected
to notify and consult with its appropriate federal banking agency prior to (or
immediately after, in the event of an emergency) providing material financial
support to an affiliated investment fund.1
The guidance contained in the interagency policy statement
is consistent with the Board's existing guidance issued in 1994 through SR
letters 94-53, Investment Adviser Activities , and 94-54, Contributions by
Banking Organizations to Mutual Funds and Common Investment Funds .
With the issuance of this interagency policy statement, SR letter 94-54 is
rescinded. However, the sound practices for management and oversight of
investment adviser activities recommended in SR letter 94-53 remain valid.
As with certain other supervisory guidance issued prior to
passage of the Gramm-Leach-Bliley Act (GLBA), examiners are reminded of
the necessary modifications in the implementation of that guidance in the
context of functional regulation. Under GLBA the SEC, as the functional
regulator of the investment advisory activities of registered investment
advisors, has primary rulemaking and supervisory responsibility for those
advisers. Accordingly, the guidance advanced in SR letter 94-53 as it
pertains to the examination of investment advisers to mutual funds should
now be viewed principally as guidance applicable to the parent bank or bank
holding company in its oversight and control of functionally regulated
entities.2 All other advisory activities, such as trust departments operating
collective investment funds, remain subject to the guidance contained in
SR letter 94-53 as well as the new interagency guidance on providing
financial support to funds advised by banking organizations.
Reserve Banks are requested to send a copy of this SR letter
and the interagency policy statement to senior management at domestic and
foreign banking organizations supervised by the Federal Reserve. If you
have any questions or are notified of actual or pending material financial
support by a state member bank, or branch or agency subject to Federal
Reserve supervision, please contact Jim Embersit, Deputy Associate Director
(202-452-5249), or Mike Schoenfeld, Senior Supervisory Financial Analyst
(202-452-2836), Market and Liquidity Risk Section.
Richard Spillenkothen
Director
Attachment

Cross reference:

SR letters 94-53, SR 94-54, and SR 00-13

Modifies:

SR letter 94-53

Supersedes:

SR letter 94-54

Notes:
1. The deferral or waiver of fees is not deemed to be material financial
support for this purpose.
2. Federal Reserve examiners no longer examine a registered
investment adviser that solely provides advice to a mutual fund
subject to SEC supervision, unless GLBA criteria are met (see
SR letter 00-13 for additional details).

______________________________________________________________________________

Office of the Comptroller of the Currency
Federal Deposit Insurance Corporation
Board of Governors of the Federal Reserve System
Office of Thrift Supervision
______________________________________________________________________________
January 5, 2004

Interagency Policy on Banks/Thrifts Providing Financial Support to Funds
Advised by the Banking Organization or its Affiliates
Purpose and Scope
This interagency policy is issued jointly by the federal banking agencies, including the Office of
the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the
Board of Governors of the Federal Reserve System (Board), and the Office of Thrift Supervision
(OTS) (the agencies) to alert banking organizations, including their boards of directors and
senior management, of the safety and soundness implications of and the legal impediments to a
bank providing financial support to investment funds1 advised by the bank, its subsidiaries, or
affiliates. A banking organization’s investment advisory services can pose material risks to the
bank’s liquidity, earnings, capital, and reputation, and can harm investors, if the associated risks
are not effectively controlled. The agencies have concluded that recent market developments,
including market volatility, the continued low interest rate environment, and operational and
corporate governance weaknesses, warrant the issuance of this guidance.
Banks are under no statutory requirement to provide financial support to the funds they advise;
however, circumstances may motivate banks to do so for reasons of reputation risk and liability
mitigation. This type of support by banking organizations to funds they advise has included
credit extensions, cash infusions, asset purchases, and acquisition of fund shares. In very limited
circumstances, certain arrangements between banks and funds they advise have been expressly
determined to be legally permissible and safe and sound when properly conducted and managed.
However, the agencies are concerned about other occasions when emergency liquidity needs
may prompt banks to support their advised funds in ways that raise prudential and legal
concerns.
Federal laws and regulations place significant restrictions on transactions between banks and
their advised funds. In particular, sections 23A and 23B of the Federal Reserve Act and the
Board’s Regulation W (12 CFR 223) place quantitative limits and collateral and market terms
requirements on many transactions between a bank and certain of its advised funds.
1

Bank advised investment funds include mutual funds, alternative strategy funds, collective investment funds, and
other funds where the bank, its subsidiaries, or affiliates is the investment adviser and receives a fee for its
investment advice. For purposes of this guidance, “banks” includes banks and savings associations regulated by the
federal banking or thrift agencies.

Additionally, the OCC’s fiduciary activities regulation (12 CFR 9) may restrict transactions
between a bank and its advised funds.2
Policy
To avoid engaging in unsafe and unsound banking practices, banks should adopt appropriate
policies and procedures governing routine or emergency transactions with bank advised
investment funds. Such policies and procedures should be designed to ensure that the bank will
not (1) inappropriately place its resources and reputation at risk for the benefit of the funds’
investors and creditors; (2) violate the limits and requirements contained in sections 23A and
23B of the Federal Reserve Act and Regulation W, other applicable legal requirements, or any
special supervisory condition imposed by the agencies; or (3) create an expectation that the bank
will prop up the advised fund. Further, the agencies expect banking organizations to maintain
appropriate controls over investment advisory activities3 that include:
•

Establishing alternative sources of emergency support from the parent holding company,
non-bank affiliates or external third parties prior to seeking support from the bank.

•

Instituting effective policies and procedures for identifying potential circumstances triggering
the need for financial support and the process for obtaining such support. In the limited
instances that the bank provides financial support, the bank’s procedures should include an
oversight process that requires formal approval from the bank’s board of directors, or an
appropriate board designated committee, independent of the investment advisory function.
The bank’s audit committee also should review the transaction to ensure that appropriate
policies and procedures were followed.

•

Implementing an effective risk management system for controlling and monitoring risks
posed to the bank by the organization’s investment advisory activities. Risk controls should
include establishing appropriate risk limits, liquidity planning, performance measurement
systems, stress testing, compliance reviews, and management reporting to mitigate the need
for significant bank support.

•

Implementing policies and procedures that ensure that the bank is in compliance with
existing disclosure and advertising requirements to clearly differentiate the investments in
advised funds from obligations of the bank or insured deposits.

•

Ensuring proper regulatory reporting of contingent liabilities arising out of its investment
advisory activities in the banking organization’s published financial statements in accordance
with FAS 5, and fiduciary settlements, surcharges, and other losses arising out of its

2

Banks should be aware that other legal requirements may also restrict or prohibit transactions between a bank and
its advised funds, including the Investment Company Act of 1940, the Investment Advisers Act of 1940, and the
Employee Retirement Income Security Act of 1974 (ERISA).
3

The agencies acknowledge the SEC’s functional regulatory authority over the investment advisory activities of
SEC registered investment advisers. However, the agencies remain responsible for evaluating the consolidated risk
profiles of banking organizations, which may include assessing the risks posed to the bank from the activities and
obligations of any subsidiary or affiliate.

Date: January 5, 2004

Page 2 of 3

investment advisory activities in accordance with the instructions for completing Call Report
Schedule RC-T – Fiduciary and Related Services.
Notification
Because of the potential risks posed by the provision of financial support to advised funds, bank
management should notify and consult with its appropriate federal banking agency prior to (or
immediately after, in the event of an emergency) the bank providing material financial support to
its advised funds. The appropriate federal banking agency will closely scrutinize the
circumstances surrounding the transaction and will address situations that raise supervisory
concerns.

Date: January 5, 2004

Page 3 of 3

BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551

DIVISION OF BANKING
SUPERVISION AND REGULATION

SR 94-53 (FIS)
October 25, 1994
TO THE OFFICER IN CHARGE OF SUPERVISION
AT EACH FEDERAL RESERVE BANK
SUBJECT: Investment Adviser Activities
Within the last several months, some bank holding companies whose subsidiaries act as
investment advisers to proprietary money market mutual funds have provided financial support to their
respective funds to offset declines in portfolio values resulting from reductions in the market value of complex
investment products such as high risk CMOs and structured securities.1 A few state member banks have had to
address similar circumstances with respect to their trust departments' common investment funds (CIFs) that are
advised by the bank.
These events underscore the importance to banking organizations acting as investment advisers
of having appropriate policies and procedures that address the management and operations of investment
adviser activities. These policies and procedures should assure that the adviser is aware of the risks
associated with the investment products it recommends to its client funds, particularly with respect to complex
derivative products, structured notes, and other high risk investments. Further, the adviser should determine
that investment products are appropriate and consistent with the funds' prospectuses and stated objectives.2
Banking organizations that engage in investment adviser activities should have policies and
procedures for addressing, monitoring, and controlling all significant risks associated with the advisory activity,
including legal, operating, reputational, fiduciary, and financial risks. The latter includes the possible exposure
associated with providing direct financial support to advised funds. Losses incurred by the advised fund could
also pose an indirect financial risk to the advising banking organization if depositors or other providers of funds
were to lose confidence in the organization, leading to possible deposit withdrawals or the termination of credit
lines. Before commencing the activity of acting as investment adviser, banking organizations should assess all
significant risks associated with the activity and should establish policies and systems to monitor and control
such risks. In addition, all major policies and procedures pertaining to advisory activities should be reviewed
periodically and approved by the organizations' boards of directors.
As a result of recent events, it is appropriate to reiterate the importance of the Federal Reserve's
established bank and bank holding company3 supervision policies and examination procedures that address
the risks associated with acting as an investment adviser. Reserve Banks are instructed to continue to monitor
carefully investment adviser activities and, where necessary, to enhance their review and assessment of bank
and bank holding company policies, procedures and internal controls in the investment adviser function during
the examination of banks, bank holding companies, or nonbank subsidiaries that act as investment advisers to
mutual funds or CIFs.
Review of Investment Adviser Activities
Examiners should give special attention to the organization's policies and procedures pertaining

to investment adviser activities and to contingencies that could arise with this activity. The Federal Reserve's
examination guidelines and related procedures pertaining to investment advisory activities of bank holding
companies and their nonbank subsidiaries and state member banks' trust departments are contained in the
Bank Holding Company Supervision Manual (Section 3130)4 and the Trust Examination Manual (Sections 4
and 5), respectively. These examination procedures indicate that an adviser is obligated to provide advice that
is consistent with the stated investment objectives as set forth in the prospectus and with the liquidity needs
applicable to a fund or account.
In addition, a recent supervisory letter on structured securities5 which focused on the use of these
instruments by banking organizations in trading, investment, or trust operations, emphasized that failure of
management to understand adequately the dimensions of the risks in complex derivative products can
constitute an unsafe and unsound practice. Similarly, an investment adviser is expected to understand fully the
risks involved in any investment product recommended to its client funds and how these risks relate to the
funds' stated investment objectives.
In this regard, examiners should determine whether an investment adviser has policies and
procedures to ensure that the fund portfolios it advises are operated in a manner fully consistent with the funds'
objectives or, if applicable, SEC requirements. Investment advisers should have policies and procedures that
subject advised funds to appropriate "stress testing" or contingency planning on a periodic basis in an effort to
determine whether the investments will continue to conform to the funds' objectives in periods of market
uncertainty and volatility.
Examiners should also determine that the investment adviser has policies and procedures in
place that ensure compliance with applicable laws and SEC requirements such as those pertaining to the
permissibility of certain high risk investments for money market mutual funds. Further, the adviser should have
procedures to ensure that management of advised funds is fully informed of the risk character of the overall
portfolio, including the presence of any complex investment products or other high risk investments. This is
necessary to ensure that the funds' management and their distributors are able to make any necessary
disclosures to investors in conformance with SEC requirements.
With regard to the inspection of the parent bank holding company, examiners should determine
that the holding company's senior management and its board of directors have policies and procedures in
place to monitor the activities of investment adviser subsidiaries to ensure that the risks associated with the
conduct of this activity are not in conflict with the parent company's overall risk tolerance parameters. The
parent should be able to assess at all times the extent of its exposure to financial, litigation, or reputational risk,
if any, that stems from the investment advisory activities conducted by subsidiaries, and whether any such
exposure would have a material adverse effect on the parent company's ability to act as a source of strength to
its banks. In addition, the parent bank holding company should assure that the internal audit function monitors
the activities of the investment adviser for compliance with any limits or internal controls that are intended to
restrict its activities.
The examination frequency of investment adviser activities historically has been dependent on
the volume and scope of advisory activities and the results of previous Reserve Bank (or SEC)
examinations. Given the significance of investment advisory activities and the potential for off-balance sheet
risk, such activities should generally be examined as part of the bank holding company's or bank's annual
safety and soundness or trust examination. Particular attention should be focused on an investment adviser
that places orders directly on behalf of a fund, or provides other portfolio management services such as
safekeeping of securities or recordkeeping. As in the past, Reserve Banks should consider using trust
examiners to conduct or participate in examinations and inspections of investment advisory activities because
of their familiarity with the subject.6
It is requested that you distribute a copy of this letter to bank holding companies, state member
banks, and state-licensed U.S. branches and agencies of foreign banks in your district that are engaged or
intend to engage in the activity of providing investment advisory services to mutual funds or trust department

CIFs. Should you have any questions regarding this letter or the examination of investment advisory activities,
please contact either Howard Amer (x2958) or Angela Desmond (x3497).
Richard Spillenkothen
Director
Cross Reference: SR 81-216
SR 88-11
SR 91-4
SR 94-45

Footnotes
1. Some bank holding companies have chosen, for business reasons, to provide the financial support
necessary to maintain the $1.00 per share net asset value of proprietary money market mutual funds even
though the companies were under no legal obligation, barring a breach of fiduciary responsibility, to do so. In
general, the support provided was treated as an expense by the bank holding companies.
2. In a June 16, 1994 letter to the CEOs of large money market funds, the Chairman of the SEC strongly
encouraged the management of every fund that holds derivative instruments to take steps that will ensure the
proper understanding and effective management of derivatives risk. He also indicated that fund managers
must implement policies to ensure that use of derivatives is fully consistent with the fund's investment
objectives. In a June 30, 1994 follow-up letter to the ICI, SEC staff advised that funds should dispose of five
types of structured securities, specifically, inverse floaters, cost-of-funds index floaters, constant-maturity
Treasury floaters, dual-index floaters and range floaters.
3. This supervisory letter is applicable throughout to foreign banking organizations and their U.S. branches
and agencies.
4. See SR 91-4 (SA), dated February 8, 1991, which also incorporated previously issued supervisory policy
and procedures contained in earlier supervisory letters.
5. SR 94-45, dated August 5, 1994.
6. See Section 3130.1.3 of the Bank Holding Company Supervision Manual and SR 88-11, dated April 28,
1988.

BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551

DIVISION OF BANKING
SUPERVISION AND REGULATION

SR 94-54 (FIS)
October 27, 1994
TO THE OFFICER IN CHARGE OF SUPERVISION
AT EACH FEDERAL RESERVE BANK
SUBJECT: Contributions by Banking Organizations to Mutual Funds and Common Investment Funds
(CIFs)
In order to stay informed regarding contributions of funds by banks, bank holding companies and
foreign banking organizations to mutual funds or trust department CIFs they advise, and to aid in determining
the appropriate supervisory response with regard to a specific situation as well as industry practices in general,
Reserve Banks are requested to notify Board staff on a timely basis of proposed or actual instances of such
contributions. As was the case with the specific transactions that have already occurred, Reserve Banks also
are requested to provide us with a written review of the transaction.
The review should be thorough and include, at a minimum, the following information:
the names and relationships of the legal entities concerned
the underlying cause of the losses sustained by the fund and the amount and nature of the specific
investment products that declined in value
the amount and form of the contribution or support provided by the banking organization to the fund
the degree of financial effect the contribution has on the banking organization
any proposed supervisory response
Please forward your notices and reviews directly to me. Should you have any questions, please
contact Howard Amer (x2958).
James I. Garner
Deputy Associate Director
Cross Reference:

SR 94-53

BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551
DIVISION OF BANKING
SUPERVISION AND REGULATION

SR 00-13 (SUP)
August 15, 2000

TO THE OFFICER IN CHARGE OF SUPERVISION AND APPROPRIATE
SUPERVISORY STAFF AT EACH FEDERAL RESERVE BANK AND TO
FINANCIAL HOLDING COMPANIES
SUBJECT: Framework for Financial Holding Company
Supervision
Introduction
The Gramm-Leach-Bliley Act ("GLB Act") repeals those provisions
of the Glass-Steagall Act and the Bank Holding Company Act that restrict the
ability of bank holding companies ("BHCs") to affiliate with securities firms
and insurance companies. The GLB Act authorizes qualifying BHCs to
operate as financial holding companies ("FHCs") and to engage in a
diversified range of financial activities. In addition to controlling depository
institutions, permissible activities for FHCs include conducting securities
underwriting and dealing, serving as an insurance agent and insurance
underwriter, acting as a futures commission merchant, and engaging in
merchant banking. Permissible activities also include those that the Board
and the Secretary of the Treasury jointly determine to be financial in nature or
incidental to financial activities, or that the Board determines is
complementary to a financial activity and does not pose a substantial risk to
the safety and soundness of depository institutions or the financial system
generally.
Under the GLB Act, the Federal Reserve has supervisory
oversight authority and responsibility for BHCs, including BHCs that operate
as FHCs. The statute includes provisions that streamline various aspects of
the Federal Reserve's supervision for all BHCs and sets forth parameters for
the relationship between the Federal Reserve and other regulators. The
statute differentiates between the Federal Reserve's relations with regulators
of depository institutions and functional regulators, which include insurance,
securities and commodities regulators. There should be minimal, if any,
noticeable change in the well-established relationships between the Federal
Reserve as BHC (including FHC) supervisor and bank and thrift supervisors

(federal and state). The Federal Reserve's relationships with functional
regulators will, in practice, depend upon the extent to which an FHC is
engaged in functionally regulated activities and also will be influenced by
already established working arrangements.
This SR letter provides guidance concerning the purpose and
scope of the Federal Reserve's supervision of FHCs, with particular focus on
the legislation's requirements for working with functional regulators. The
framework should be used by Federal Reserve staff in supervising FHCs and
coordinating activities with the appropriate primary supervisors of an FHC's
banking, insurance, and securities subsidiaries.
The Federal Reserve's supervisory oversight role is that of an
umbrella supervisor concentrating on a consolidated or group-wide analysis
of an organization. Umbrella supervision is not viewed as an extension of
more traditional bank-like supervision throughout an FHC. The FHC
framework set forth in this letter is consistent with and incorporates principles
that are well established for BHCs. Because the GLB Act does not require
significant changes in supervisory practice for non-FHC BHCs, this document
focuses on addressing supervisory practice for, and relationships with, FHCs,
particularly those that are engaged in securities or insurance activities.

Roles of Supervisors
The Federal Reserve is responsible for the consolidated
supervision of FHCs. In this regard, the Federal Reserve will assess the
holding company on a consolidated or group-wide basis with the objective of
ensuring that the holding company does not threaten the viability of its
depository institution subsidiaries. The manner in which the Federal Reserve
fulfills this role will likely evolve along with the activities and structure of FHCs
and may differ depending on the mix of banking, securities, and insurance
activities of an FHC.
Depository institution subsidiaries of FHCs are supervised by their
appropriate primary bank or thrift supervisor (federal and state). The GLB Act
did not alter the role of the Federal Reserve, as holding company supervisor,
vis-a-vis the primary supervisors of FHC-associated bank and thrift
subsidiaries because the Federal Reserve has traditionally relied to the
fullest extent possible on those supervisors.
Nonbank (or nonthrift) subsidiaries engaged in securities,
commodities or insurance activities are supervised by their appropriate
functional regulators. Such functionally regulated subsidiaries include a
broker, dealer, investment adviser, and investment company registered with
and regulated by the SEC (or, in the case of an investment adviser, registered

with any state); an insurance company or insurance agent subject to
supervision by a state insurance regulator; and a nonbank subsidiary
engaged in CFTC-regulated activities.

Objectives of Financial Holding Company Supervision
The Federal Reserve, as umbrella supervisor, will seek to
determine that FHCs are operated in a safe and sound manner so that their
financial condition does not threaten the viability of affiliated depository
institutions. Oversight of FHCs (particularly those engaged in a broad range
of financial activities) at the consolidated level is important because the risks
associated with those activities can cut across legal entities and business
lines. The purpose of FHC supervision is to identify and evaluate, on a
consolidated or group-wide basis, the significant risks that exist in a
diversified holding company in order to assess how these risks might affect
the safety and soundness of depository institution subsidiaries.
Accordingly, the Federal Reserve will focus on the financial
strength and stability of FHCs, their consolidated risk-management
processes, and overall capital adequacy. The Federal Reserve will review
and assess the internal policies, reports, and procedures and effectiveness of
the FHC consolidated risk management process. The appropriate bank, thrift,
or functional regulator will continue to have primary responsibility for
evaluating risks, hedging, and risk management at the legal-entity level for
the entity or entities that it supervises.
As noted above, financial holding company supervision is not
intended to impose bank-like supervision on FHCs, nor is it intended to
duplicate or replace supervision by the primary bank, thrift, or functional
regulators of FHC subsidiaries. Rather, it seeks, on the one hand, to balance
the objective of protecting the depository institution subsidiaries of
increasingly complex organizations with significant inter-related activities and
risks, against, on the other, the objective of not imposing an unduly
duplicative or onerous burden on the subsidiaries of the organization.
Effective financial holding company supervision requires:
Strong, cooperative relationships between the Federal
Reserve and primary bank, thrift, and functional
regulators and foreign supervisors. These relationships
respect the individual statutory authorities and
responsibilities of the respective supervisors, but at the
same time, allow for enhanced information flows and
coordination so that individual responsibilities can be
carried out effectively without creating duplication or
excessive burden;

Substantial reliance by the Federal Reserve on reports
filed with, or prepared by, bank, thrift, and functional
regulators, as well as on publicly available information
for both regulated and non-regulated subsidiaries; and
Continued reliance on the risk-focused supervision and
examination process and on market discipline.

Financial Holding Company Supervision in Practice
The supervisory activities of the Federal Reserve fall into three
broad categories: information gathering, assessments and supervisory
cooperation; ongoing supervision; and promotion of sound practices and
improved disclosure.
Information gathering, assessments, and supervisory cooperation
To fulfill its responsibilities, the Federal Reserve needs to interact
closely and exchange information with the primary bank, thrift, and functional
regulators. It is also important that the Federal Reserve develop strong
relationships with senior management and boards of directors of FHCs, and
have access to timely information from FHCs. In order to understand how risk
management and internal control policies and procedures established at the
consolidated level are being implemented and assessed, these relationships
will need to include heads of significant business lines and key internal audit,
control, and risk management officials.
To achieve these objectives, Federal Reserve supervisory staff
will:
Regularly assess an FHC's centralized risk
management and control processes. Such
assessments are necessary to understand an
organization's overall risk profile, to identify material
contributions to core risks, and to determine how such
risks are being managed and controlled on a
consolidated basis.
Perform limited targeted transaction testing, where
appropriate, to verify that risk management systems of
the FHC are adequately and appropriately measuring
and managing areas of risk for the organization, and to
confirm that laws and regulations applicable to the FHC
and within the jurisdiction of the Federal Reserve are

being followed.
Have periodic discussions with FHC senior
management and boards of directors. Such
discussions will enable the Federal Reserve to build
relationships with key personnel and to understand
changing activities and the evolving risk profile of the
consolidated organization. Periodic discussions also
will provide a forum for supervisory staff to present any
findings or concerns related to the activities of the
group as a whole or to business lines that cut across
legal entities.
Have periodic discussions with key personnel
responsible for corporate management and control
functions, such as heads of business lines, risk
management, internal audit and internal control.
In performing the tasks described above, Federal Reserve
supervisory staff, to the extent possible, should coordinate their actions with
those of the primary bank, thrift, and functional regulators of the FHC's
subsidiaries. For example, in order to understand the risks and
risk-management systems of an FHC at the consolidated level, the Federal
Reserve will need information concerning assets or liabilities booked in
significant bank, thrift, and functionally regulated subsidiaries within the FHC
group. The primary bank, thrift, and functional regulators of such subsidiaries
also may have a need for information from the FHC, consistent with their
respective statutory mandates. To assist in sharing needed information,
Federal Reserve supervisory staff should:
Have periodic meetings with the primary bank, thrift
and functional regulators of an FHC's subsidiaries to
develop an understanding of the risk profiles of the
individual regulated legal entities and their relation to
the FHC's overall risk profile. These meetings also
should be used, where appropriate, to share
information regarding supervisory plans and
coordinate supervisory activities and follow-up, as
needed.
Review the examination findings of primary bank, thrift
and functional regulators (and their self-regulatory
organizations) together with other relevant information
in order to develop a consolidated picture of the FHC's
financial condition and risk profile, the effectiveness of
risk management and internal control policies, and the

implications for the affiliated depository institutions.
Make available to primary bank, thrift and functional
regulators, to the extent permissible, pertinent
information regarding the financial condition, risk
management policies, and operations of an FHC that
may have a material impact on individual regulated
subsidiaries, as well as information concerning
transactions or relationships between the regulated
subsidiaries and other subsidiaries within the FHC
group. This process will assist supervisors in
performing their statutory and supervisory
responsibilities over regulated subsidiaries.
Participate in the sharing of information among
international supervisors, consistent with applicable
law, to ensure that an FHC's global activities are
supervised on a consolidated basis and to minimize
material gaps in supervision.
Review internal audit and management reports and
publicly available information (including market
information on equity and debt prices of the
consolidated organization), as well as reports and
statistics collected by other regulators, including those
of depository institution subsidiaries. To limit regulatory
burden, this information should be obtained, to the
fullest extent possible, from the parent organization,
from primary bank, thrift, and functional regulators of
the FHC's regulated subsidiaries, and from publicly
available sources, such as externally audited financial
statements.
Ongoing supervision
FHC structure, management, and the applications process
The Federal Reserve is responsible for understanding the
consolidated organization's legal, organizational, and risk management
structure, major business activities, and risk exposures and risk management
systems. The Federal Reserve needs to understand the nature and degree of
involvement of the board of directors at the consolidated group level in
overseeing the risk management and control process of the organization.
The Federal Reserve, when considering any formal application, declaration,
certification, or notification process at the FHC level, will coordinate, as
appropriate, with primary bank, thrift, and functional regulators.

Reporting and examination
The Federal Reserve will rely, to the fullest extent possible, on
reports that an FHC or its subsidiaries are required to file with, or are
prepared by, federal or state authorities (or self-regulatory organizations).
The Federal Reserve will rely on routinely prepared management reports,
publicly reported information, and externally audited financial statements.
The Federal Reserve also will rely to the fullest extent possible on the
examination of an FHC's bank and nonbank subsidiaries by their appropriate
primary bank, thrift, and functional regulators (and their self-regulatory
organizations).
If supervisory staff requires a specialized report from a functionally
regulated subsidiary of an FHC, staff first will request it from the subsidiary's
appropriate functional regulator. In the event that the report is not made
available to the Federal Reserve, supervisory staff may obtain the report
directly from the functionally regulated subsidiary if it is necessary to assess
(i) a material risk to the FHC or any of its depository institution subsidiaries, (ii)
compliance with any federal law that the Federal Reserve has specific
jurisdiction to enforce against the FHC or a subsidiary, or (iii) the FHC's
systems for monitoring and controlling financial and operational risks that
may pose a safety and soundness threat to a depository institution subsidiary.
The Federal Reserve may examine a functionally regulated
subsidiary when it has reasonable cause to believe (or reasonably
determines) that (i) the subsidiary is engaged in an activity that poses a
material risk to an affiliated depository institution, (ii) the examination is
necessary to be adequately informed about the FHC's systems for monitoring
and controlling the financial and operational risks that may pose a safety and
soundness risk to a depository institution subsidiary, or (iii) the subsidiary is
not in compliance with any federal law that the Board has specific jurisdiction
to enforce (and the Board cannot determine compliance by examining the
FHC or its affiliated depository institutions). Before examining a functionally
regulated subsidiary, supervisory staff should first seek to obtain the
necessary information from the appropriate functional regulator. If an
examination is determined to be necessary, the Federal Reserve should
coordinate its actions with the appropriate functional regulator.
Consistent with current practice, the Federal Reserve will
continue to rely to the fullest extent possible on the work performed by bank,
thrift, and functional regulators to validate that material risks are measured
and managed adequately at the regulated subsidiary level. Where
necessary and appropriate, and consistent with (i) through (iii) above, the
Federal Reserve may conduct or participate in reviews at banks, thrifts, or
functionally regulated subsidiaries to validate that risk management and

internal control policies established at the consolidated level are being
implemented effectively.
For a subsidiary of an FHC that is not supervised by a bank, thrift,
or functional regulator, the Federal Reserve will obtain information from the
subsidiary, as appropriate and necessary, to assess the financial condition of
the FHC as a whole. In addition, the Federal Reserve will conduct
examinations of such subsidiaries, if necessary, to be informed as to the
nature of the subsidiary's operations and financial condition, as well as the
subsidiary's financial and operational risks that may pose a threat to the
safety and soundness of any depository institution subsidiary of the FHC and
the systems for monitoring and controlling such risks. Under the GLB Act, the
Federal Reserve may not examine any subsidiary of an FHC that is an
investment company registered with the SEC and that is not itself a BHC.
Capital adequacy
The Federal Reserve is responsible for assessing consolidated
capital adequacy for FHCs with the ultimate objective of protecting the
insured depository subsidiaries from the effects of disruptions in the nonbank
portions of the organization. Capital adequacy will be assessed in relation to
the risk profile of the consolidated organization. The Federal Reserve will
review the FHC's internal risk assessment and related capital analysis
process for determining the adequacy of its overall capital position. Such a
review will include consideration of present and future economic conditions,
future business development plans, possible stress scenarios, and internal
risk control and audit procedures. As BHCs, FHCs are subject to the Federal
Reserve's holding company capital guidelines, which set forth minimum
capital ratios that serve as tripwires for additional supervisory scrutiny and
corrective action. The Federal Reserve will review these requirements as
they apply to FHCs and may, if warranted, adapt the manner in which they
apply to FHCs that engage in a broad range of financial activities.
Although the Federal Reserve is responsible for assessing the
consolidated capital adequacy of FHCs, the primary bank, thrift, or functional
regulators of FHC subsidiaries will continue to set and enforce applicable
capital requirements for the regulated entities within their jurisdiction. Under
the GLB Act, the Federal Reserve may not establish separate capital
adequacy requirements for an FHC subsidiary that is in compliance with the
capital requirements of its functional regulator.
Consistent with current practice, the Federal Reserve will
continue to place significant reliance on the primary bank, thrift, or functional
regulator's analysis of the capital adequacy of a regulated subsidiary and use
that analysis as significant input in assessing an FHC's consolidated capital
adequacy. This is especially true where a securities broker-dealer or

insurance company comprises a predominant part of an FHC.
When assessing consolidated capital adequacy for FHCs with
functionally regulated subsidiaries, several issues take on particular
prominence. Capital adequacy requirements that have been established for
banking, securities, and insurance entities by their respective regulators
reflect varying definitions of the elements of capital and varying approaches
to asset and liability valuations. Techniques for assessing capital adequacy
must be sufficiently robust to identify situations such as double or multiple
leverage or double gearing, because in such cases the actual capital
protection may be overstated.
Intra-group exposures and concentrations
Intra-group exposures, including servicing arrangements and risk
concentrations, have the potential to threaten the condition of regulated
entities. Intra-group exposures may be significant at large, complex FHCs,
especially those that operate their businesses on global lines that cut across
legal entities within the firm. The focus of the Federal Reserve in this area is
on the potential impact of intra-group exposures and concentrations on
insured depository institution subsidiaries of an FHC.
Risk concentrations can take many forms, including exposures to
one or more counterparties or related entities, industry sectors, and
geographic regions. For risk concentrations, the holding company supervisor
is uniquely positioned to understand the combinations of exposures within an
organization across all legal entities. This understanding is critical at the
group level -- risk concentrations that are prudent on a legal entity basis may
aggregate to an unsafe level for the consolidated organization.
The Federal Reserve will monitor intra-group exposures and risk
concentrations as follows:
The appropriate primary bank and thrift regulators will
continue to monitor and enforce section 23A and 23B
restrictions at the bank or thrift level. The Federal
Reserve will focus on assessing whether the FHC
monitors and ensures compliance with these statutory
requirements. The Federal Reserve plans to begin
collecting data from each depository institution
subsidiary of BHCs, including FHCs, on their covered
transactions with affiliates that are subject to sections
23A and 23B and will share that data with primary bank
and thrift regulators.
Functional regulators will continue to monitor and

enforce any intra-group exposure restrictions that may
apply to the regulated entities under their jurisdictions.
The Federal Reserve will focus on understanding and
monitoring related-party exposures at the group level,
including areas such as servicing agreements,
derivatives exposures, and payments system
exposures, with an important focus on the extent to
which a depository institution subsidiary's risk
management is dependant on transactions with
affiliates.
The Federal Reserve also will focus on management's
effectiveness in monitoring and controlling intra-group
exposures and risk concentrations. The Federal
Reserve will consider how an organization's risk
management processes measure and manage
group-wide risk concentrations.
Enforcement powers
The Federal Reserve generally is authorized to take enforcement
action against FHCs and their nonbank subsidiaries. The primary bank and
thrift supervisors have the authority to take enforcement action against the
banks and thrifts under their jurisdictions. Under the GLB Act, the Federal
Reserve may take enforcement action against a functionally regulated
subsidiary of an FHC, but only when such action is necessary to prevent or
redress an unsafe or unsound practice or breach of fiduciary duty that poses
a material risk either to the financial safety, soundness or stability of an
affiliated depository institution, or to the domestic or international payments
system. In such circumstances, the Federal Reserve may only take the action
if it is not reasonably possible to protect effectively against the material risk
through an action directed at or against an affiliated depository institution.
Under any circumstances, the Board may take enforcement action
against a functionally regulated subsidiary to enforce compliance with any
federal law that the Federal Reserve has specific jurisdiction to enforce
against the subsidiary. In the event the Federal Reserve believes that an
enforcement action by the Federal Reserve against a functionally regulated
entity is necessary, the Federal Reserve will notify the entity's appropriate
functional regulator and will coordinate such an action with any taken by the
functional regulator wherever practical. It is expected that the Federal
Reserve will not take an enforcement action against a functionally regulated
subsidiary (or a person associated with the subsidiary) if the problem involves
factors and statutes that are the primary responsibility of the functional
regulator.

Under the existing bank holding company framework, the Federal
Reserve coordinates enforcement actions with the primary bank and thrift
regulators, possibly with some adaptation of the action for the holding
company context (such as limitations on parent company debt or dividends).
The Federal Reserve will continue to coordinate enforcement actions with
those regulators. In a similar fashion, the Federal Reserve will coordinate
with functional regulators when formulating and issuing enforcement actions
that involve or may have an impact on functionally regulated subsidiaries.
Promotion of sound practices and improved disclosure
The Federal Reserve can promote sound practices in a number of
ways, such as by monitoring trends in risk exposures and risk management
practices across the FHC population through a combination of efforts. These
include regular discussions, centered on specific issues and emerging risks,
with FHC management; regular meetings with primary bank, thrift, and
functional regulators to explore and discuss issues of mutual interest and/or
concern; interagency working groups or specialty teams to gain early insight
into risks that cut across the various entities of a conglomerate or groups of
conglomerates; and industry conferences on relevant topics of interest.
These initiatives will contribute to the development of sound
practices that the Federal Reserve and other primary bank, thrift, and
functional regulators can communicate to the senior management and board
of directors of the FHCs, as well as to the senior management of their bank
and nonbank subsidiaries.
Improved transparency and public disclosure can meaningfully
supplement the efforts of supervisors to monitor the increasingly complex and
global activities of diversified banking organizations. The Federal Reserve
will, consistent with sound accounting principles and practices, and with
considerations of depository institution safety and soundness, participate in
efforts to enhance disclosures that illuminate group-wide activities, risk
exposures, risk management, controls, and intra-group exposures.
Ongoing challenges
Most of the concepts discussed in this framework are already
being applied by the Federal Reserve in the context of the consolidated
supervision of BHCs.1 Examples include greater reliance on risk-focused
supervision; strengthening relationships with senior management; improving
coordination with other federal, state and international regulatory and
supervisory authorities; greater reliance on specialty teams, sound practices
papers and public disclosures; and simplification of the applications process.

Still, supervision of more diversified FHCs presents new
challenges. To address these challenges, the Federal Reserve will continue
its efforts to strengthen (i) cooperative arrangements with bank and thrift
regulators, the SEC, CFTC, state insurance and securities regulators, and
foreign supervisors; (ii) relationships with FHC management and personnel
responsible for significant risk management functions and, where necessary,
the management of the organization's nonbank subsidiaries; (iii) information
flows that provide supervisors with relevant, up-to-date information without
imposing unwarranted burden on financial organizations; (iv) techniques for
evaluating capital adequacy for FHCs engaged in an expanded range of
nonbank financial activities; (v) public disclosures and market discipline; (vi)
techniques for assessing the overall risk profile of FHCs and the implications
for affiliated depository institutions; and (vii) incentives for FHCs to continually
review and improve their risk management processes, internal controls, and
audit practices.
The Federal Reserve is committed to continuing to work in a
constructive and cooperative fashion with all regulators involved in
overseeing the activities of FHCs and their bank and nonbank subsidiaries.
Reserve Banks are asked to distribute this SR letter to FHCs as
well as to the state banking agencies and functional regulators in their
districts. Questions pertaining to this framework should be directed to Roger
Cole, Associate Director, at (202) 452-2618, Michael Martinson, Deputy
Associate Director, at (202) 452-3640, or Barbara Bouchard, Manager, Policy
Development, at (202) 452-3072.

Richard Spillenkothen
Director

Cross Reference: SR 99-15

Notes:
1. The Federal Reserve’s framework for supervising large complex banking
organizations (LCBOs) is described in SR letter 99-15.


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102