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Federal R eserve Bank
OF DALLAS
WILLIAM H. W ALLACE

DALLAS, TEXAS 7 5 2 2 2

FIR S T VICE P R E S ID E N T

December 13, 1985
Circular 85-147

TO:

The Chief Executive Officer of all
member banks, state member banks and
others concerned in the Eleventh
Federal Reserve District
SUBJECT
Policy statement, supervisory guidelines on repurchase agreements
DETAILS

The Board of Governors of the Federal Reserve System has announced
the adoption of a supervisory policy on repurchase agreement transactions.
The adoption of this policy was approved by the Federal Financial Institutions
Examination Council (FFIEC) on October 21, 1985. The Board adopted this
policy on October 31, 1985 and was effective November 15, 1985. The policy
statement is intended to provide financial institutions with minimum safety
and soundness guidelines for managing credit risk exposure. It also provides
guidance related to the possession or control of securities involved in
repurchase agreement transactions.
ATTACHMENTS
The Board's press release and the material as published in the
Federal Register are attached.
MORE INFORMATION
For further information, please contact Marvin C. McCoy at (214)
651-6657; William C. Reddick, Jr. at (214) 651-6652 or David Dixon at (214)
651-6228.
Sincerely yours,

For additional copies of any circular please contact the Public Affairs Department at (214) 651-6289. Banks and others are
encouraged to use the following incoming WATS numbers in contacting this Bank (800) 442-7140 (intrastate) and (800)
527-9200 (interstate).

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)

FEDERAL RESERVE press release
* • ? R t ' . •*
.*'

For immediate release

November 1, 1985

The Federal Reserve Board today announced the adoption of a supervisory
policy on repurchase agreement transactions.

The adoption of this policy had been

recommended by the Federal Financial Institutions Examination Council.
The policy statement is intended to provide financial institutions with
minimum safety and soundness guidelines for managing credit risk exposure.

It also

provides guidance related to the possession or control of securities involved in
repurchase agreement transactions.

In addition, the policy points out the need

for full collateralization, maintenance of agreed upon collateral margins and
frequent mark-to-market procedures.
Depository institutions doing business with unregulated government
securities dealers are urged to verify that these dealers are complying with the
Federal Reserve Bank of New York's minimum capital guidelines.
Depository institutions should contact their District Federal Reserve
Banks with questions concerning the procedures for obtaining control of U.S.
Treasury securities and certain agency obligations through the Federal Reserve's
book-entry system.
A copy of the policy statement is attached.
-

Attachment

0-

FEDERAL RESERVE SYSTEM
Supervisory Policy Statement on
Repurchase Agreement Transactions
AGENCY:

Board of Governors of the Federal Reserve System

ACTION:

Policy Statement.

SUMMARY:

On October 21, 1985, the Federal Financial Insti­

tutions Financial Council approved detailed supervisory
guidelines on repurchase agreement transactions and recom­
mended their adoption by federal regulatory authorities.
The Board of Governors adopted these guidelines on
October 31, 1985.

The policy statement is intended to provide

financial institutions with minimum safety and soundness
guidelines for managing credit risk exposure.

It also provides

guidance related to the possession or control of securities
involved in repurchase agreement transactions.
EFFECTIVE DATE:

November 15, 1985.

FOR FURTHER INFORMATION CONTACT:

Robert S. Plotkin, Assistant

Director, or Michael J. Schoenfeld, Senior Securities Regula­
tions Analyst (202) 452-2782, Division of Banking Supervision
and Regulation, or Joy W. O'Connell, Telecommunication Device
for the Deaf (TDD)

(202) 452-3244, Board of Governors of the

Federal Reserve System, Washington, D. C.
SUPPLEMENTAL INFORMATION:

20551.

Certain financial institutions

engaging in repurchase agreement transactions have failed to
adopt appropriate prudential policies and procedures to

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prevent or minimize losses when repurchase agreement counter­
parties become insolvent.

Following the collapse of a Florida

based government securities firm in early 1985, the Federal
Reserve Bank of New York, on behalf of the System, initiated
a program of educating market participants as to prudent
practices and pitfalls in the repo market.

Seminars have

been and are being held throughout the country at each of the
Federal Reserve Banks.

Voluntary capital adequacy guidelines

for unregulated nonbank government dealers, developed by the
Federal Reserve Bank of New York, were adopted in May 1985.
The policy statement is intended to provide fina­
ncial institutions with minimum safety and soundness guide­
lines for managing credit risk exposure to counterparties
and providing for the appropriate control of securities in­
volved in repurchase agreement transactions.

Federal exami­

ners will review written policies and procedures of depository
institutions to determine their adequacy in light of these
minimum guidelines and the scope of each depository institu­
tion's repurchase agreement transactions.
Financial institutions are advised to develop
written policies addressing key factors related to repurchase
agreements, such as prior approval and the periodic credit
evaluations of repurchase agreement counterparties, maximum
position and temporary exposure limits, and specific identifi­
cation of authorized counterparties

(e.g., regulated affiliate

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or unregulated government security dealer).

Depository insti­

tutions doing business with unregulated government securities
dealers are urged to request verification that such dealers
voluntarily comply with the Federal Reserve Bank of New
York's minimum capital guidelines.

The policy statement discusses the need for full
collateralization,

frequent mark-to-market procedures and the

need for maintaining agreed upon collateral margins.

Deposi­

tory institutions are cautioned that failure to obtain control
of collateral when lending cash may be considered an unsecured
extension of credit subject to lending restrictions, and that
substantial losses are likely to be incurred in the event of
insolvency of the counterparty.

State-chartered banks are

encouraged to consult with their counsel or state banking
authorities as to the applicability of state lending restric­
tions to repurchase agreements.

Finally, depository institu­

tions are advised to consult their counsel about state law
governing control of securities and custodial agreements, and
to contact their District Federal Reserve Banks with questions
concerning the procedures for obtaining control of repurchase
agreement securities through the book-entry system.
Acting pursuant to its supervisory's authority over
State member banks contained in Section 9 (12 U.S.C. § 321,
et se q .) and Section 11 (12 U.S.C. § 248) of the Federal

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Reserve Act and the Financial Institutions Supervisory Act of
1966 (12 U.S.C. § 1818(b)) and related provisions of law, the
Board of Governors adopted the following policy statement:
Statement of Supervisory Policy
Concerning Repurchase Agreements of
Depository Institutions with
Securities Dealers and Others

Purpose
Depository institutions and others involved with the
purchase of United States Government and Agency obligations
under agreements to resell (reverse repurchase agreement) t±y
have sometimes incurred significant losses.
The most important
factors causing these heavy losses have been inadequate credit
risk management and the failure to exercise effective control
over securities collateralizing the transactions.
The following minimum guidelines address the need for managing
credit risk exposure to counterparties under securities
repurchase agreements and for controlling the securities in
those transactions, and should be followed by depository
institutions that enter into repurchase agreements with
securities dealers and others.
Depository institutions that actively engage in repurchase
agreements are encouraged to have more comprehensive policies
and controls to suit their particular circumstances.
The
examining staffs of the Federal bank, thrift and credit union
supervisory agencies will review written policies and
procedures of depository institutions to determine their
adequacy in light of these minimum guidelines and the scope of
each depository's operations.

1/ In order to avoid confusion among market participants who
sometimes use the same term to describe different sides of the
same transaction, the term "repurchase agreement” will be used
in the balance of this statement to refer to both repurchase
and reverse repurchase agreements.
A repurchase agreement is
one in which a party that owns securities acquires funds by
transferring the securities to another party under an agreement
to repurchase the securities at an agreed upon future date.
A
reverse repurchase (resale) agreement is one in which a party
provides funds by acquiring securities pursuant to an agreement
to resell them at an agreed upon future date.
2/ Throughout this document repurchase agreements are
generally discussed in terms of secured credit transactions.
This usage should not be deemed to be based upon a legal
determination.

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I.

5-

Credit Policy Guidelines

The apparent safety of short-term repurchase agreements
which are collateralized by highly liquid, U.S. Government and
Federal agency obligations has contributed to an attitude of
complacency.
Some portfolio managers have underestimated the
credit risk associated with the performance of the counterparty
to the transaction, and have not taken adequate steps to assure
control of the securities covered by the agreement.
All depository institutions that engage in securities
repurchase agreement transactions should establish written
credit policies and procedures governing these activities.
At
a minimum, those policies and procedures should cover the
following:
A.
Written policies should establish "know your
counterparty" principles.
Engaging in repurchase agreement
transactions in volume and in large dollar amounts frequently
requires the services of a counterparty who is a dealer in the
underlying securities.
Some firms which deal in the markets
for U.S. Government and Federal agency securities are
subsidiaries of, or related to, financially stronger and better
known firms.
However, these stronger firms may be independent
of their .U.S. Government securities subsidiaries and affiliates
and may not be legally obligated to stand behind the
transactions of related companies.
Without an express
guarantee, the stronger firm's financial position cannot be
relied upon in assessing the creditworthiness of a counterparty.
It is important to know the legal entity that is the
actual counterparty to each repurchase agreement transaction.
A depository institution should know about the actual
counterparty's character, integrity of management, activities,
and the financial markets in which it deals.
Depository
institutions should be particularly careful in conducting
repurchase agreements with any firm that offers terms that are
significantly more favorable than those currently prevailing in
the market.
In certain situations depository institutions may use,
or serve as, brokers or finders in order to locate repurchase
agreement counterparties or particular securities.
When using
or acting as this type of agent the names of each counterparty
should be fully disclosed.
Depository institutions should not
enter into undisclosed agency or "blind brokerage" repurchase
transactions in which the counterparty's name is not disclosed.
B.
Dealings with unregulated securities dealers.
A
dealer in U.S. Government and Federal agency obligations is not
necessarily a Federally insured bank or thrift, or a
broker/dealer registered with the Securities and Exchange
Commission.
Therefore, the dealer firm may not be subject to
any Federal regulatory oversight.

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A depository institution doing business with an
unregulated securities dealer should be certain that the dealer
voluntarily complies with the Federal Reserve Bank of New
York's minimum capital guideline, which currently calls for
liquid capital to exceed measured risk by 20 percent (that is,
the ratio of a dealer's liquid capital to risk of 1.2:1).
This
ratio
can be calculated by a dealer using either the Securities
and Exchange Commission's Net Capital Rule for Brokers and
Dealers (Rule 15c3-l) or the Federal Reserve Bank of New York's
Capital Adequacy Guideline for United States Government
Securities Dealers.
To ensure that an unregulated dealer
complies with either of those capital standards, it should
certify its compliance with the capital standard and provide
the following three forms of certification:
(1)

A letter of certification from the
dealer will adhere on a continuous
capital adequacy standard;

dealer that the
basis to the

(2)

audited financial statements which demonstrate that
as of the audit date the dealer was in compliance
with the standard and the amount of liquid capital;
and

(3)

a copy of a letter from the firm's certified public
accountant stating that it found no material
weaknesses in the dealer's internal systems and
controls incident to adherence to the standard.A

C.
Periodic evaluations of counterparty
creditworthiness should be conducted by individuals who
routinely make credit decisions and who are not involved in
the execution of repurchase agreement transactions.
Prior to engaging in initial transactions with a new
counterparty, depository institutions should obtain audited
financial statements and regulatory filings (if any) from its
counterparties, and should insist that similar information be
provided on a periodic and timely basis in the future.
Recent
failures of government securities dealers have typically been
foreshadowed by delays in producing these statements.
Many
firms are registered with the Securities and Exchange
Commission as broker/dealers and have to file financial
statements and should be willing to provide a copy of these
filings.

3/ This letter should be similar to that which must be given
to the SEC by registered broker/dealers.

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The counterparty credit analysis should consider the
financial statements of the entity that is to be the depository
institution's counterparty as well as those of any related
companies that could have an impact on the financial condition
of the counterparty.
When transacting business with a
subsidiary, consolidated financial statements of a parent are
not adequate.
Repurchase agreements should not be entered into
with any counterparty that is unwilling to provide complete and
timely disclosure of its financial condition.
As part of this
analysis, the depository institution should make inquiry about
the counterparty's general reputation and whether there have
been any formal enforcement actions against the counterparty or
its affiliates by State or Federal securities regulators.
D.
Maximum position and temporary exposure limits for
each approved counterparty should be established based upon
credit analysis performed.
Periodic reviews and updates of
those limits are necessary.
Individual repurchase agreement counterparty limits
should consider overall exposure to the same or related
counterparty throughout the depository institution.
Repurchase
agreement counterparty limitations should include the overall
permissible dollar positions in repurchase agreements, maximum
repurchase agreement maturities and limits on temporary
exposure that may result from decreases in collateral values or
delays in receiving collateral.
E.
Lending Limitations. Federally-chartered savings
institutions and Federal credit unions are subject to all
Federal regulations in this area.
State-chartered banks or
savings institutions should consult with their counsel and/or
state banking or thrift authorities as to the applicability of
state lending restrictions to repurchase transactions.
Except as otherwise provided in applicable agency
regulations and State law, it should be assumed that unless the
depository institution's interest in securities held as
collateral under a repurchase agreement is assured, a
repurchase agreement transaction with any single counterparty
will be subject to the lending limitations applicable to that
institution.
Conversely, the market value of securities sold
under a repurchase agreement in excess of the amount of
proceeds received by the depository institution could be viewed
as an unsecured extension of credit to the repurchase agreement
counterparty subject to the depository institution's lending
limits.
The application of lending limitations on loans by national
banks to certain types of repurchase transactions is currently
under review by the Comptroller of the Currency.
Until this
review is completed, national banks as a matter of prudent
banking should treat repurchase agreements as if they are
subject to the lending limit unless the bank has control of the
underlying securities.

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II. Guidelines for Controlling Repurchase Agreement Collateral
Repurchase agreements can be a useful asset and
liability management tool, but repurchase agreements can expose
a depository institution to serious
risks if they are not
managed appropriately.
It is possible to reduce repurchase
agreement risk if the depository institution negotiates written
agreements with all repurchase agreement counterparties and
custodian banks.
Compliance with the terms of these written
agreements should be monitored on a daily basis.
If prudent
management control requirements of repurchase agreements are
too burdensome for a depository institution, other
asset/liability management tools should be used.
The marketplace perceives repurchase agreement
transactions as similar to lending transactions collateralized
by highly liquid Government securities.
However, experience
has shown that the collateral securities will probably not
serve as protection if the counterparty becomes insolvent or
fails, and the purchasing
institution does not have control
over the securities.
This policy statement provides general
guidance on the steps depository institutions should take to
protect their interest
in the securities underlying repurchase
agreement transactions (see "C. Control of Securities,"
page 6).
However, ultimate responsibility for establishing
adequate procedures rests with management of the institution.
Management should obtain a written legal opinion as to the
adequacy of the procedures utilized to establish and protect
the depository institution's interest in the underlying
collateral.
General Reguirements
A.
A written agreement specific to a repurchase agreement
transaction or master agreement governing all repurchase
agreement transactions should be entered into with each
counterparty.
The written agreement should specify all the
terms of the transaction and the duties of both the buyer and
seller.
Senior managers of depository institutions should
consult legal counsel regarding the content of the repurchase
and custodial agreements.
The repurchase and custodial
agreements should specify, but should not be limited to, the
following:
o acceptable types and maturities of collateral securities;
o

initial acceptable margin for collateral securities of
various types and maturities;

o

margin maintenance, call, default and sellout provisions;

o

rights to interest and principal payments;

o

rights to substitute collateral; and

o

the persons authorized to transact business on behalf of
the depository institution and its counterparty.

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B.
Confirmations. Some repurchase agreement
confirmations may contain terms that attempt to change the
depository institution's rights in the transaction. The
depository institution should obtain and compare written
confirmations for each repurchase agreement transaction to be
certain that the information on the confirmation is consistent
with the terms of the agreement.
The confirmation should
identify specific collateral securities.
C.
Control of Securities.
As a general rule, a
depository institution should obtain possession or control of
the underlying securities and take necessary steps to protect
its interest in the securities.
The legal steps necessary to
protect its interest may vary with applicable facts and law and
accordingly should be undertaken with the advice of counsel.
Additional prudential management controls may include:
(1)

Direct delivery of physical securities to the
institution, or of book-entry securities by
appropriate entry in an account maintained in the
name of the depository institution by a Federal
Reserve Bank which maintains a book-entry system
for U.S. Treasury securities and certain agency
obligations (for further information as to the
procedures to be followed, contact the Federal
Reserve Bank for the District in which the
depository institution is located);

(2)

delivery of either physical securities to, or in
the case of book entry securities, making
appropriate entries in the books of a third party
custodian designated by the depository institution
under a written custodial agreement which
explicitly recognizes the depository institution's
interest in the securities as superior to that of
any other person; or

(3)

appropriate entries on the books of a third party
custodian acting pursuant to a tripartite
agreement with the depository institution and the
counterparty, ensuring adequate segregation and
identification of either physical or book-entry
securities.

Where control of the underlying securities is not
established, the depository institution may be regarded only as
an unsecured general creditor of the insolvent counterparty.
In such instance, substantial losses are likely to be
incurred. Accordingly, a depository institution should not
enter into a repurchase agreement without obtaining control of
the securities unless all of the following minimum procedures
are observed:
(1) it is completely satisfied as to the
creditworthiness of the counterparty; (2) the transaction is
within credit limitations that have been pre-approved by the
board of directors, or a committee of the board, for unsecured
transactions with the counterparty;

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(3) periodic credit evaluations of the counterparty are
conducted; and (4) the depository institution has ascertained
that collateral segregation procedures of the counterparty are
adequate.
Unless prudential internal procedures of these types
are instituted and observed, the depository institution may be
cited by its financial supervisory agency for engaging in
unsafe or unsound practices.
All receipts and deliveries of either physical or
book-entry securities should be made according to written
procedures, and third party deliveries should be confirmed in
writing directly by the custodian.
It is not acceptable to
receive confirmation from the counterparty that the securities
are segregated in a depository institution's name with a
custodian; the depository institution should, however, obtain a
copy of the advice of the counterparty to the custodian
requesting transfer of the securities to the depository
institution.
Where securities are to be delivered, payment for
securities should not be made until the securities are actually
delivered to the depository institution or its agent.
The
custodial contract should provide that the custodian takes
delivery of the securities subject to the exclusive direction
of the depository institution.
Substitution of securities should not be allowed without
the prior consent of a depository institution.
The depository
institution should give its consent before the delivery of the
substitute securities to the depository institution or a third
party custodian.
Any substitution of securities should take
into consideration the following discussion of "margin
requirements."
D.
Margin Requirements.
The amount paid by a
depository institution under the repurchase agreement should be
less than the market value of the securities, including the
amount of any accrued interest, with the difference
representing a predetermined margin.
Factors to be considered
in establishing an appropriate margin include the size and
maturity of the repurchase transaction, the type and maturity
of the underlying securities, and the creditworthiness of the
counterparty.
Margin requirements on U.S. Government and
Federal agency obligations underlying repurchase agreements
should allow for the anticipated price volatility of the
security until the maturity of the repurchase agreement.
Less
marketable securities may require additional margin to
compensate for less liquid market conditions.
Written
repurchase agreement policies and procedures should require
daily mark-to-market of repurchase agreement securities to the
bid side of the market.
Repurchase agreements should provide
for additional securities or cash to be placed with the
depository institution or its custodian bank to maintain the
margin within the predetermined level.

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Margin calculations should also consider accrued interest
on underlying securities and the anticipated amount of accrued
interest over the term of the repurchase agreement, the date of
interest payment and which party is entitled to receive the
payment.
In the case of pass-through securities, anticipated
principal reductions should also be considered when determining
margin adequacy.
E.
Prudent management procedures should be followed in
the administration of any repurchase agreement.
Longer term
repurchase agreements require management’s daily attention to
the effects of securities substitutions, margin maintenance
requirements (including consideration of any coupon interest or
principal payments) and possible changes in the financial
condition of the counterparty.
Engaging in open repurchase
agreement transactions without maturity dates may be regarded
as an unsafe and unsound practice unless the depository
institution has retained rights to terminate the transaction
quickly to protect itself against changed circumstances.
Similarly, automatic renewal of short-term repurchase agreement
transactions without reviewing collateral values and adjusting
collateral margin may be regarded as an unsafe and unsound
practice.
If additional margin is not deposited when required,
the depository institution's rights to sell securities or
otherwise liquidate the repurchase agreement should be
exercised without hesitation.
F.
Overcollateralization. A depository institution
should use current market values, including the amount of any
accrued interest, to determine the price of securities that are
sold under repurchase agreements.
Counterparties should not be
provided with excessive margin.
Thus, the written repurchase
agreement contract should provide that the counterparty must
make additional payment or return securities if the margin
exceeds agreed upon levels.
When acquiring funds under
repurchase agreements it is prudent business practice to keep
at a reasonable margin the difference between the market value
of the securities delivered to the counterparty and the amount
borrowed.
The excess market value of securities sold by a
depository institution may be viewed as an unsecured loan to
the counterparty subject to the unsecured prudential
limitations for the depository institution and should be
treated accordingly for credit policy and control purposes.

By order of the Board of Governors, this 12th day of
November, 1985.
(signed)

William

A.

William W. Wiles
Secretary of the Board

Wiles

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