The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
Federal Reserve Bank of Dallas R O B ERT D. M cTEER , JR. DALLAS, TEXAS PRESIDENT AND CHIEF EXECUTIVE OFFICER 75265-5906 November 2, 1998 Notice 98-100 TO: The Chief Executive Officer of each financial institution and others concerned in the Eleventh Federal Reserve District SUBJECT Uniform Interagency Trust Rating System DETAILS The Federal Financial Institutions Examination Council (FFIEC) has revised the Uniform Interagency Trust Rating System, commonly referred to as the trust rating system. The revisions update the rating system to reflect changes that have occurred in the fiduciary services industry and in supervisory policies and procedures since the rating system was first adopted in 1978. The changes • revise the definitions for the numerical ratings to conform to the language and tone of the Uniform Financial Institutions Rating System rating definitions, commonly referred to as the CAMELS rating system; • reformat and clarify the component rating descriptions; • reorganize the account administration and conflicts of interest components into a new component addressing compliance; • emphasize the quality of risk management processes in each of the rating compo nents, particularly in the management component; • add language in composite rating definitions to parallel the changes in the compo nent rating descriptions; and • explicitly identify the types of risk that are considered in assigning component ratings. 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. This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org) ATTACHMENT A copy of the FFIEC’s notice as it appears on pages 54704-11, Vol. 63, No. 197 of the Federal Register dated October 13, 1998, is attached. MORE INFORMATION For more information, please contact Daniel Kirkland at (214) 922-6256. For addi tional copies of this Bank’s notice, contact the Public Affairs Department at (214) 922-5254. Sincerely yours, Federal Registe Tuesday October 13,1998 Federal Financial Institutions Examination Council Uniform Interagency Trust Rating System 54704 Federal Register/Vol. 63, No. 197/Tuesday, October 13, 1998/Notices The Federal Financial Institutions Examination Council (FFIEC) is revising the Uniform Interagency Trust Rating System (UITRS), commonly referred to as the trust rating system. The revisions update the rating system to reflect changes that have occurred in the fiduciary services industry and in supervisory policies and procedures since the rating system was first adopted in 1978. The changes revise the definitions for the num erical ratings to conform to the language and tone of the Uniform Financial Institutions Rating System (UFIRS) rating definitions, commonly referred to as the CAMELS rating system; reformat and clarify the com ponent rating descriptions; reorganize the account adm inistration and conflicts of interest components into a new com ponent addressing compliance; emphasize the quality of risk management processes in each of the rating components, particularly in the m anagement component; add language in composite rating definitions to parallel the changes in the com ponent rating descriptions; and explicitly identify the types of risk that are considered in assigning com ponent ratings. The term “financial institution” refers to those FDIC insured depository institutions w hose prim ary Federal supervisory agency is represented on the FFIEC. U ninsured trust companies that are chartered by the OCC, members of the Federal Reserve System, or subsidiaries of registered bank holding com panies or insured depository institutions are also covered by this notice. The Federal supervisory agencies participating in this notice are: 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). DATES: Effective October 13,1998. SUMMARY: FOR FURTHER INFORMATION CONTACT: FEDERAL FINANCIAL INSTITUTIONS EXAMINATION COUNCIL Uniform Interagency Trust Rating System Federal Financial Institutions Examination Council. a c t i o n : Notice. AGENCY: FRB: W illiam R. Stanley, Supervisory Trust Analyst, Specialized Activities, (202) 452-2744, Division of Banking Supervision and Regulation, Board of Governors of the Federal Reserve System, Mail Stop 175, 20th and C Streets, NW, W ashington, D.C. 20551 FDIC: John F. Harvey, Trust Review Examiner, (202) 898-6762, Division of Supervision, Federal Deposit Insurance Corporation, Room F2078, 550 17th Street, NW, W ashington, D.C. 20429. OCC: Laurie A. Edlund, National Bank Examiner, (202) 874-3828, Division of Asset Management, Office of the Comptroller of the Currency, 250 E Street, SW, Mail Stop 7-7, W ashington, D.C., 20219. OTS: Larry A. Clark, Senior Manager, Compliance and Trust Programs, (202) 906-5628, Gary C. Jackson, Program Analyst, (202) 906-5653, Compliance Policy, Office of Thrift Supervision, 1700 G Street, NW, W ashington, D.C. 20552. SUPPLEMENTARY INFORMATION: Background information On February 17, 1998, the FFIEC published a notice in the Federal Register (February Notice), 63 FR 7802, requesting comment on proposed revisions to the Uniform Interagency Trust Rating System (UITRS). The UITRS is an internal supervisory exam ination rating system used by the Federal supervisory agencies for evaluating the adm inistration of fiduciary activities of financial institutions and uninsured trust companies on a uniform basis and for identifying those institutions requiring special supervisory attention. The UITRS was adopted on September 21, 1978 by the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the Board of Governors of the Federal Reserve System (FRB), and in 1988 by the Federal Home Loan Bank Board, predecessor agency to the Office of Thrift Supervision (OTS). U nder the UITRS, each institution is assigned a composite rating based on an evaluation and rating of essential com ponents of an institution’s fiduciary activities. The composite rating reflects the overall condition of an institution’s fiduciary activities and is used by the Federal supervisory agencies to monitor aggregate trends in the overall adm inistration of fiduciary activities. U nder the former UITRS, each financial institution or trust com pany was assigned a composite rating based on an evaluation and rating of six essential com ponents of an institution’s fiduciary activities. These com ponents addressed: the capability of management; the adequacy of operations, controls and audits; the m anagement of fiduciary assets; the adequacy of account adm inistration practices; the adequacy of practices relating to self-dealing and conflicts of interest; and the quality and level of earnings. Both the composite and com ponent ratings are assigned on a 1 to 5 num erical scale. A 1 indicates the strongest performance and management practices, and the least degree of supervisory concern, while a 5 indicates the weakest performance and management practices and, Federal Register/Vol. 63, No. 197/Tuesday, October 13, 1998/Notices therefore, the highest degree of supervisory concern. The UITRS has proven to be an effective way for the Federal supervisory agencies to determ ine the condition of an institution’s fiduciary activities. A num ber of changes, however, have occurred in the fiduciary industry and in supervisory policies and procedures since the rating system was first adopted. As a result, the FFIEC is making certain enhancem ents to the rating system, b u t is retaining its basic framework. The UITRS enhancements: • Realign the UITRS rating definitions to bring them in line w ith UFIRS. • Reduce the com ponent rating categories from six to five, combining the Account A dm inistration and Conflicts of Interest com ponents into a new Compliance component. • Require Earnings to be rated only in institutions w ith more than $100 m illion in total trust assets, and in all non-deposit trust companies. An earnings rating is not required for the remaining institutions (those institutions not required to file Schedule E ■); however, each Federal supervisory agency has the option of requiring the earnings of these institutions to be rated using the alternate rating definitions where applicable. • Explicitly refer to the quality of risk management processes in the management component, and the identification of risk elements w ithin the composite and com ponent rating definitions. Comments Received and Changes Made The FFIEC received two public comments from industry trade associations regarding the proposed revisions to the UITRS. Both commenters generally favored the changes made, in particular the emphasis on risk management, the changes to the UITRS to conform to the language and tone of the UFIRS, and the considerations given to the earnings com ponent w hen evaluating a small trust department. Examiners field tested the revised rating system’during 61 bank and thrift fiduciary examinations conducted between February and May 1998. The examiners provided comments regarding the revised rating system. 1 Schedule E is the Trust Income Statem ent of the FFIEC A nnual Report of Trust Assets (FFIEC 001). Schedule E is required to be filed by each financial institution w ith total trust assets of more than $100 m illion as reported on line 18, colum n F of Schedule A, and by all non-deposit trust companies, w hether or not they report any assets on Schedule A. Examiner response was generally favorable, and no significant problems or unanticipated rating differences were encountered between the former and updated UITRS. Some of the examiner comments recom m ended clarifying changes to various aspects of the revised rating system. The FFIEC carefully considered each com ment and examiner response and m ade certain changes. The following discussion describes the comments received (both through public comment and agency field testing) and changes m ade to the UITRS in response to those comments. The updated UITRS is included at the end of this Notice. February Notice Specific Questions In addition to requesting general comments regarding the proposed system, the FFIEC invited comments on four specific questions: (1) Does the proposal capture the essential risk areas of the fiduciary services industry? The majority of the responses to this question were positive, and no changes were made. (2) Does the proposed management com ponent adequately assess the quality of the board of directors’ and m anagem ent’s oversight regarding its fiduciary responsibility and its ability to identify and manage all areas of risk involved in the exercise of its fiduciary powers? The majority of the responses to this question were positive, and no changes were made. (3) Are there any components w hich should be added to or deleted from the proposal? The majority of the responses received regarding the com ponents were favorable. A num ber of examiners recom m ended strengthening the conflict of interest section of the Compliance component. Several examiners also requested clarification of the application of the optional earnings rating to the Earnings component. These concerns are addressed later in this Notice. (4) Are the definitions for the individual com ponents and the composite num erical ratings in the proposal consistent w ith the language and tone of the UFIRS definitions? The majority of the responses to this question were positive. The agencies received several examiner comments recommending changes to address m inor inconsistencies in wording throughout the UITRS. M any of these m inor wording changes were m ade to improve the consistency of the rating system. 54705 Compliance Com ponent The February notice combined the former Account A dm inistration and Conflicts of Interest com ponents into a new Compliance component. The new com ponent assesses the institution’s compliance w ith the terms of governing instrum ents, applicable laws and regulations, sound fiduciary principles, and internal policies and procedures. In addition, the new com ponent addresses compliance w ith applicable laws, regulations, and internal policies and procedures on a broader, institutionw ide basis by focusing on compliance and strategic risk. Several examiners expressed concern that the new rating com ponent deemphasizes the seriousness of selfdealing and conflicts of interest. The FFIEC emphasizes that self-dealing and other conflicts of interest, and the associated risks to the institution, continue to be areas of great importance and concern. The intent of the new Compliance com ponent was not to deemphasize the seriousness or importance of self-dealing or other conflicts of interest. Accordingly, the description of the new com ponent and its rating definitions has been revised and expanded to clarify the importance of these issues. Earnings Com ponent Under the former UITRS, an Earnings rating was required for all institutions. The February notice proposed several changes to the Earnings component. An earnings rating w ould be required for institutions w ith more than $100 m illion in total trust assets (as reported on FFIEC 001 Schedule A, line 18, colum n F) and for non-deposit trust companies. An earnings rating would not be required for the remaining institutions (those institutions not required to file Schedule E of FFIEC 001); however, each Federal supervisory agency w ould have the option of requiring the earnings of these institutions to be rated using either the rating definitions designated for Schedule E filers or, in accordance w ith the agency’s im plem enting guidelines, the definitions for the alternate ratings. The majority of the comments received on the Earnings com ponent changes were positive; however, several examiners requested that the FFIEC clarify various aspects of this component. In response, the FFIEC added an evaluation factor section for the alternate earnings rating, and separated the two rating definitions. In addition, each agency w ill issue im plem enting guidance addressing the 54706 Federal Register/Vol. 63, No. 197/Tuesday, October 13, 1998/Notices applicability of the Earnings rating to its supervised institutions. Im plem entation Date The FFIEC recom mends that the Federal supervisory agencies im plem ent the updated UITRS January 1, 1999. This date ensures that institutions w ith examinations commenced in 1999 w ill be assessed under the updated UITRS. Text o f the Revised Uniform Interagency Trust Rating System Uniform Interagency Trust Rating System Introduction The Uniform Interagency Trust Rating System (UITRS) was adopted on September 21, 1978 by the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the Board of Governors of the Federal Reserve System (FRB), and in 1988 by the Federal Home Loan Bank Board, predecessor agency to the Office of Thrift Supervision (OTS). Over the years, the UITRS has proven to be an effective internal supervisory tool for evaluating the fiduciary activities of financial institutions on a uniform basis and for identifying those institutions requiring special attention. A num ber of changes have occurred in both the banking industry and the Federal supervisory agencies’ policies and procedures w hich prom pted a review and revision of the 1978 rating system. The revisions to the UITRS: • Realign the UITRS rating definitions to bring them in line with the Uniform Financial Institutions Rating System (UFIRS). • Reduce the com ponent rating categories from six to five, combining the A ccount A dm inistration and Conflicts of Interest com ponents into a new Compliance component. • Require Earnings to be rated only in institutions w ith more than $100 m illion in total trust assets, and in all non-deposit trust companies. An earnings rating is not required for the remaining institutions (those institutions not required to file FFIEC 001 Schedule E);2 however, each Federal supervisory agency has the option of requiring the earnings of these institutions to be rated using the 2 Schedule E is the T rust Income Statem ent of the FFIEC Annual Report of Trust Assets (FFIEC 001). Schedule E is required to be filed by each financial institution w ith total trust assets of more than $100 m illion as reported on line 18, colum n F of Schedule A, and by all non-deposit trust com panies, w hether or not they report any assets on Schedule A. of the factors comprising that alternate rating definitions where com ponent and its interrelationship applicable. • Explicitly refer to the quality of risk w ith the other components. W hen m anagem ent processes in the assigning a composite rating, some management component, and the com ponents may be given more weight identification of risk elements w ithin than others depending on the situation the composite and com ponent rating at the institution. In general, assignment definitions. of a composite rating may incorporate These revisions are intended to any factor that bears significantly on the promote and com plem ent efficient overall adm inistration of the financial examination processes. The revisions institution’s fiduciary activities. update the rating system but retain its Assigned composite and component basic framework. Consequently, the ratings are disclosed to the institution’s revised rating system w ill not result in board of directors and senior additional regulatory burden to management. institutions or require additional The ability of management to respond policies or processes. to changing circumstances and to The UITRS considers certain address the risks that m ay arise from managerial, operational, financial and changing business conditions, or the compliance factors that are common to initiation of new fiduciary activities or all institutions w ith fiduciary activities. products, is an im portant factor in U nder this system, the supervisory evaluating an institution’s overall agencies endeavor to ensure that all fiduciary risk profile and the level of institutions w ith fiduciary activities are supervisory attention warranted. For evaluated in a comprehensive and this reason, the m anagement com ponent uniform m anner, and that supervisory is given special consideration w hen attention is appropriately focused on assigning a composite rating. The ability of m anagement to identify, those institutions exhibiting weaknesses measure, monitor, and control the risks in their fiduciary operations. of its fiduciary operations is also taken Overview into account w hen assigning each Under the UITRS, the fiduciary com ponent rating. It is recognized, activities of financial institutions are however, that appropriate management assigned a composite rating based on an practices may vary considerably among evaluation and rating of five essential financial institutions, depending on the com ponents of an institution’s fiduciary size, complexity and risk profiles of activities. These components address their fiduciary activities. For less the following: the capability of complex institutions engaged solely in management; the adequacy of traditional fiduciary activities and operations, controls and audits; the w hose directors and senior managers are quality and level of earnings; actively involved in the oversight and compliance w ith governing instrum ents, m anagement of day-to-day operations, applicable law (including self-dealing relatively basic m anagement systems and conflicts of interest laws and and controls may be adequate. On the regulations), and sound fiduciary other hand, at more complex principles; and the management of institutions, detailed and formal fiduciary assets. management systems and controls are Composite and com ponent ratings are needed to address a broader range of assigned based on a 1 to 5 numerical activities and to provide senior scale. A 1 is the highest rating and managers and directors w ith the indicates the strongest performance and information they need to supervise dayrisk management practices and the least to-day activities. degree of supervisory concern. A 5 is All institutions are expected to the lowest rating and indicates the properly manage their risks. For less weakest performance and risk complex institutions engaging in less management practices and, therefore, risky activities, detailed or highly the highest degree of supervisory formalized management systems and concern. Evaluation of the composite controls are not required to receive and com ponents considers the size and strong or satisfactory com ponent or sophistication, the nature and composite ratings. complexity, and the risk profile of the The following two sections contain institution’s fiduciary activities. the composite rating definitions, and the The composite rating generally bears descriptions and definitions for the five a close relationship to the com ponent com ponent ratings. ratings assigned. However, the Composite Ratings composite rating is not derived by Composite ratings are based on a computing an arithmetic average of the careful evaluation of how an institution com ponent ratings. Each com ponent conducts its fiduciary activities. The rating is based on a qualitative analysis Federal Register/Vol. 63, No. 197/Tuesday, October 13, 1998/Notices review encompasses the capability of management, the soundness of policies and practices, the quality of service rendered to the public, and the effect of fiduciary activities upon the soundness of the institution. The five key com ponents used to assess an institution’s fiduciary activities are: the capability of management; the adequacy of operations, controls and audits; the quality and level of earnings; compliance w ith governing instrum ents, applicable law (including self-dealing and conflicts of interest laws and regulations), and sound fiduciary principles; and the management of fiduciary assets. The composite ratings are defined as follows: Composite 1. A dm inistration of fiduciary activities is sound in every respect. Generally all components are rated 1 or 2. Any weaknesses are m inor and can be h andled in a routine m anner by management. The institution is in substantial compliance w ith fiduciary laws and regulations. Risk management practices are strong relative to the size, complexity, and risk profile of the institution’s fiduciary activities. Fiduciary activities are conducted in accordance w ith sound fiduciary principles and give no cause for supervisory concern. Composite 2. A dm inistration of fiduciary activities is fundam entally sound. Generally no com ponent rating should be more severe than 3. Only moderate weaknesses are present and are w ell w ithin m anagem ent’s capabilities and willingness to correct. Fiduciary activities are conducted in substantial compliance w ith laws and regulations. Overall risk m anagement practices are satisfactory relative to the institution’s size, complexity, and risk profile. There are no material supervisory concerns and, as a result, the supervisory response is informal and limited. Composite 3. Adm inistration of fiduciary activities exhibits some degree of supervisory concern in one or more of the com ponent areas. A combination of weaknesses exists that may range from moderate to severe; however, the m agnitude of the deficiencies generally does not cause a com ponent to be rated more severely than 4. M anagement may lack the ability or willingness to effectively address weaknesses w ithin appropriate tim e frames. Additionally, fiduciary activities may reveal some significant noncom pliance w ith laws and regulations. Risk management practices may be less than satisfactory relative to the institution’s size, complexity, and risk profile. While problems of relative significance may exist, they are not of such im portance as to pose a threat to the trust beneficiaries generally, or to the soundness of the institution. The institution’s fiduciary activities require more than normal supervision and may include formal or informal enforcement actions. Composite 4. Fiduciary activities generally exhibit unsafe and unsound practices or conditions, resulting in unsatisfactory performance. The problems range from severe to critically deficient and may be centered around inexperienced or inattentive management, weak or dangerous operating practices, or an accum ulation of unsatisfactory features of lesser importance. The weaknesses and problems are not being satisfactorily addressed or resolved by the board of directors and management. There may be significant noncom pliance w ith laws and regulations. Risk management practices are generally unacceptable relative to the size, complexity, and risk profile of fiduciary activities. These problems pose a threat to the account beneficiaries generally and, if left unchecked, could evolve into conditions that could cause significant losses to the institution and ultim ately underm ine the public confidence in the institution. Close supervisory attention is required, w hich means, in m ost cases, formal enforcement action is necessary to address the problems. Composite 5. Fiduciary activities are conducted in an extremely unsafe and unsound manner. A dm inistration of fiduciary activities is critically deficient in num erous major respects, w ith problems resulting from incom petent or neglectful adm inistration, flagrant and/ or repeated disregard for laws and regulations, or a willful departure from sound fiduciary principles and practices. The volum e and severity of problems are beyond m anagem ent’s ability or willingness to control or correct. Such conditions evidence a flagrant disregard for the interests of the beneficiaries and may pose a serious threat to the soundness of the institution. Continuous close supervisory attention is w arranted and may include term ination of the institution’s fiduciary activities. Com ponent Ratings Each of the com ponent rating descriptions is divided into three sections: a narrative description of the component; a list of the principal factors used to evaluate that component; and a description of each num erical rating for that component. Some of the evaluation factors are reiterated under one or more of the other com ponents to reinforce the interrelationship among components. 54707 The listing of evaluation factors is in no particular order of importance. M anagement. This rating reflects the capability of the board of directors and management, in their respective roles, to identify, measure, monitor and control the risks of an institution’s fiduciary activities. It also reflects their ability to ensure that the institution’s fiduciary activities are conducted in a safe and sound m anner, and in compliance w ith applicable laws and regulations. Directors should provide clear guidance regarding acceptable risk exposure levels and ensure that appropriate policies, procedures and practices are established and followed. Seniorfiduciary management is responsible for developing and im plem enting policies, procedures and practices that translate the board’s objectives and risk limits into prudent operating standards. Depending on the nature and scope of an institution’s fiduciary activities, management practices may need to address some or all of the following risks: reputation, operating or transaction, strategic, compliance, legal, credit, market, liquidity and other risks. Sound management practices are dem onstrated by: active oversight by the board of directors and management; com petent personnel; adequate policies, processes, and controls th at consider the size and complexity of the institution’s fiduciary activities; and effective risk monitoring and management information systems. This rating should reflect the board’s and m anagem ent’s ability as it applies to all aspects of fiduciary activities in w hich the institution is involved. The management rating is based upon an assessment of the capability and performance of m anagem ent and the board of directors, including, but not lim ited to, the following evaluation factors: • The level and quality of oversight and support of fiduciary activities by the board of directors and m anagement, including com mittee structure and adequate docum entation of committee actions. • The ability of the board of directors and management, in their respective roles, to plan for, and respond to, risks that may arise from changing business conditions or the introduction of new activities or products. • The adequacy of, and conformance with, appropriate internal policies, practices and controls addressing the operations and risks of significant fiduciary activities. • The accuracy, timeliness, and effectiveness of managem ent inform ation and risk m onitoring systems appropriate for the in stitution’s size, complexity, and fiduciary risk profile. • The overall level of com pliance w ith laws, regulations, and sound fiduciary principles. 54708 Federal Register /Vol. 63, No. 197/Tuesday, October 13, 1998/Notices • Responsiveness to recom m endations from auditors and regulatory authorities. • Strategic planning for fiduciary products an d services. • The level of experience and com petence of fiduciary m anagem ent and staff, including issues relating to turnover and succession planning. • The adequacy of insurance coverage. • The availability of com petent legal counsel. • The extent and nature of pending litigation associated w ith fiduciary activities, and its potential im pact on earnings, capital, and the in stitution’s reputation. • The process for identifying and responding to fiduciary custom er complaints. Ratings. A rating of 1 indicates strong performance by managem ent and the board of directors and strong risk m anagem ent practices relative to the size, complexity and risk profile of the institution’s fiduciary activities. All significant risks are consistently and effectively identified, m easured, monitored, and controlled. M anagement and the board are proactive, and have dem onstrated the ability to prom ptly and successfully address existing and potential problems and risks. A rating of 2 indicates satisfactory management and board performance and risk management practices relative to the size, complexity and risk profile of the institution’s fiduciary activities. M oderate weaknesses m ay exist, b ut are not material to the sound adm inistration of fiduciary activities, and are being addressed. In general, significant risks and problems are effectively identified, m easured, monitored, and controlled. A rating of 3 indicates management and board performance that needs im provem ent or risk management practices that are less than satisfactory given the nature of the in stitu tio n’s fiduciary activities. The capabilities of management or the board of directors may be insufficient for the size, complexity, and risk profile of the institution’s fiduciary activities. Problems and significant risks may be inadequately identified, m easured, m onitored, or controlled. A rating of 4 indicates deficient management and board performance or risk managem ent practices that are inadequate considering the size, complexity, and risk profile of the institution’s fiduciary activities. The level of problems and risk exposure is excessive. Problems and significant risks are inadequately identified, measured, monitored, or controlled and require im m ediate action by the board and m anagement to protect the assets of account beneficiaries and to prevent erosion of public confidence in the institution. Replacing or strengthening management or the board may be necessary. A rating of 5 indicates critically deficient m anagement and board performance or risk management practices. Management and the board of directors have not dem onstrated the ability to correct problems and im plem ent appropriate risk management practices. Problems and significant risks are inadequately identified, m easured, monitored, or controlled and now threaten the continued viability of the institution or its adm inistration of fiduciary activities, and pose a threat to the safety of the assets of account beneficiaries. Replacing or strengthening management or the board of directors is necessary. Operations, Internal Controls &• Auditing. This rating reflects the adequacy of the institution’s fiduciary operating systems and internal controls in relation to the volume and character of business conducted. A udit coverage m ust assure the integrity of the financial records, the sufficiency of internal controls, and the adequacy of the compliance process. The institution’s fiduciary operating systems, internal controls, and audit function subject it prim arily to transaction and compliance risk. Other risks including reputation, strategic, and financial risk may also be present. The ability of management to identify, measure, m onitor and control these risks is reflected in this rating. The operations, internal controls and auditing rating is based upon, but not lim ited to, an assessment of the following evaluation factors: Operations and Internal Controls, including the adequacy of: • Staff, facilities and operating systems; • Records, accounting and data processing systems (including controls over systems access and such accounting procedures as aging, investigation and disposition of items in suspense accounts); • Trading functions and securities lending activities; • Vault controls and securities movement; • Segregation of duties; • Controls over disbursem ents (checks or electronic) and unissued securities; • Controls over income processing activities; • Reconciliation processes (depository, cash, vault, sub-custodians, suspense accounts, etc.); • Disaster and/or business recovery programs; • Hold-mail procedures and controls over returned mail; and, • Investigation and proper escheatm ent of funds in dorm ant accounts. Auditing, including: • The independence, frequency, quality and scope of the internal and external fiduciary audit function relative to the volume, character and risk profile of the institu tio n’s fiduciary activities; • The volum e and/or severity of internal control and audit exceptions and the extent to w hich these issues are tracked and resolved; and • The experience and com petence of the audit staff. Ratings. A rating of 1 indicates that operations, internal controls, and auditing are strong in relation to the volume and character of the institution’s fiduciary activities. All significant risks are consistently and effectively identified, measured, m onitored, and controlled. A rating of 2 indicates that operations, internal controls and auditing are satisfactory in relation to the volume and character of the institution’s fiduciary activities. Moderate weaknesses may exist, but are not material. Significant risks, in general, are effectively identified, measured, monitored, and controlled. A rating of 3 indicates that operations, internal controls or auditing need im provem ent in relation to the volume and character of the institution’s fiduciary activities. One or more of these areas are less than satisfactory. Problems and significant risks may be inadequately identified, measured, m onitored, or controlled. A rating of 4 indicates deficient operations, internal controls or audits. One or more of these areas are inadequate or the level of problems and risk exposure is excessive in relation to the volum e and character of the institution’s fiduciary activities. Problems and significant risks are inadequately identified, measured, m onitored, or controlled and require im m ediate action. Institutions w ith this level of deficiencies may make little provision for audits, or may evidence weak or potentially dangerous operating practices in combination w ith infrequent or inadequate audits. A rating of 5 indicates critically deficient operations, internal controls or audits. Operating practices, w ith or w ithout audits, pose a serious threat to the safety of assets of fiduciary accounts. Problems and significant risks are inadequately identified, measured, monitored, or controlled and now threaten the ability of the institution to continue engaging in fiduciary activities. Earnings. This rating reflects the profitability of an institution’s fiduciary activities and its effect on the financial condition of the institution. The use and adequacy of budgets and earnings projections by functions, product lines and clients are reviewed and evaluated. Federal Register/Vol. 63, No. 197/Tuesday, October 13, 1998/Notices Risk exposure that may lead to negative earnings is also evaluated. An evaluation of earnings is required for all institutions w ith fiduciary activities. An assignment of an earnings rating, however, is required only for institutions that, at the time of the examination, have total trust assets of more than $100 million, or are a non deposit trust com pany (those institutions that w ould be required to file Schedule E of FFIEC 001). For institutions where the assignment of an Earnings rating is not required by the UITRS, the Federal supervisory agency has the option to assign an earnings rating using an alternate set of ratings. A rating w ill be assigned in accordance with implementing guidelines adopted by the supervisory agency. The definitions for the alternate ratings are included in the revised UITRS and may be found in the section immediately following the definitions for the required ratings. The evaluation of earnings is based upon, but not lim ited to, an assessment of the following factors: • The profitability of fiduciary activities in relation to the size and scope of those activities and to the overall business of the institution. • The overall im portance to the institution of offering fiduciary services to its customers and local community. • The effectiveness of the institu tion ’s procedures for m onitoring fiduciary activity income and expense relative to the size and scope of these activities and their relative im portance to the institution, including the frequency and scope of profitability reviews and planning by the institutio n’s board of directors or a com mittee thereof. For those institutions for w hich a rating of earnings is mandatory, additional factors should include the following: • The level and consistency of profitability, or the lack thereof, generated by the in stitution’s fiduciary activities in relation to the volum e and character of the institution ’s business. • D ependence up on non-recurring fees and commissions, such as fees for court accounts. • The effects of charge-offs or compromise actions. • U nusual features regarding the com position of business and fee schedules. • Accounting practices that contain practices such as (1) unusual m ethods of allocating direct and indirect expenses and overhead, or (2) unusual m ethods of allocating fiduciary income and expense w here two or more fiduciary institutions w ithin the same holding com pany family share fiduciary services and/or processing functions. • The extent of m anagem ent’s use of budgets, projections and other cost analysis procedures. • Methods used for directors’ approval of financial budgets and/or projections. • M anagem ent’s attitude tow ard growth and new business development. • New business developm ent efforts, including types of business solicited, market potential, advertising, com petition, relationships w ith local organizations, and an evaluation by management of risk potential inherent in n ew business areas. Ratings. A rating of 1 indicates strong earnings. The institution consistently earns a rate of return on its fiduciary activities that is com m ensurate w ith the risk of those activities. This rating w ould norm ally be supported by a history of consistent profitability over tim e and a judgement that future earnings prospects are favorable. In addition, management techniques for evaluating and monitoring earnings performance are fully adequate and there is appropriate oversight by the institution’s board of directors or a committee thereof. M anagement makes effective use of budgets and cost analysis procedures. Methods used for reporting earnings inform ation to the board of directors, or a committee thereof, are comprehensive. A rating of 2 indicates satisfactory earnings. Although the earnings record may exhibit some weaknesses, earnings performance does not pose a risk to the overall institution nor to its ability to meet its fiduciary obligations. Generally, fiduciary earnings m eet management targets and appear to be at least sustainable. Management processes for evaluating and monitoring earnings are generally sufficient in relationship to the size and risk of fiduciary activities that exist, and any deficiencies can be addressed in the normal course of business. A rating of 2 may also be assigned to institutions w ith a history of profitable operations if there are indications that management is engaging in activities w ith w hich it is not familiar, or where there may be inordinately high levels of risk present that have not been adequately evaluated. Alternatively, an institution w ith otherwise strong earnings performance may also be assigned a 2 rating if there are significant deficiencies in its m ethods used to m onitor and evaluate earnings. A rating of 3 indicates less than satisfactory earnings. Earnings are not commensurate w ith the risk associated w ith the fiduciary activities undertaken. Earnings may be erratic or exhibit dow nw ard trends, and future prospects are unfavorable. This rating may also be assigned if m anagement processes for evaluating and monitoring earnings exhibit serious deficiencies, provided the deficiencies identified do not pose an im m ediate danger to either the overall financial condition of the 54709 institution or its ability to meet its fiduciary obligations. A rating of 4 indicates earnings that are seriously deficient. Fiduciary activities have a significant adverse effect on the overall income of the institution and its ability to generate adequate capital to support the continued operation of its fiduciary activities. The institution is characterized by fiduciary earnings performance that is poor historically, or faces the prospect of significant losses in the future. Management processes for m onitoring and evaluating earnings may be poor. The board of directors has not adopted appropriate measures to address significant deficiencies. A rating of 5 indicates critically deficient earnings. In general, an institution w ith this rating is experiencing losses from fiduciary activities that have a significant negative im pact on the overall institution, representing a distinct threat to its viability through the erosion of its capital. The board of directors has not im plem ented effective actions to address the situation. Alternate Rating o f Earnings. Alternate ratings are assigned based on the level of im plem entation of four m inim um standards by the board of directors and management. These standards are: • Standard No. 1—The institution has reasonable m ethods for m easuring income and expense com m ensurate w ith the volume and nature of the fiduciary services offered. • Standard No. 2—The level of profitability is reported to the board of directors, or a committee thereof, at least annually. • Standard No. 3—The board of directors periodically determ ines that the continued offering of fiduciary services provides an essential service to the institu tio n’s customers or to the local community. • Standard No. 4—The board of directors, or a committee thereof, reviews the justification for the institution to continue to offer fiduciary services even if the institution does not earn sufficient income to cover the expenses of providing those services. Ratings. A rating of 1 may be assigned where an institution has im plem ented all four m inim um standards. If fiduciary earnings are lacking, management views this as a cost of doing business as a full service institution and believes that the negative effects of not offering fiduciary services are more significant than the expense of adm inistrating those services. A rating of 2 m ay be assigned where an institution has im plem ented, at a m inim um , at least three of the four standards. This rating may be assigned if the institution is not generating positive earnings or where formal 54710 Federal Register/Vol. 63, No. 197/Tuesday, October 13, 1998/Notices earnings information may not be available. A rating of 3 may be assigned if the institution has im plem ented at least two of the four standards. While management may have attem pted to identify and quantify other revenue to be earned by offering fiduciary services, it has decided that these services should be offered as a service to customers, even if they cannot be operated profitably. A rating of 4 may be assigned if the institution has im plem ented only one of the four standards. Management has undertaken little or no effort to identify or quantify the collateral advantages, if any, to the institution from offering fiduciary services. A rating of 5 m ay be assigned if the institution has im plem ented none of the standards. Compliance. This rating reflects an institution’s overall compliance with applicable laws, regulations, accepted standards of fiduciary conduct, governing account instrum ents, duties associated w ith account adm inistration, and internally established policies and procedures. This com ponent specifically incorporates an assessment of a fiduciary’s duty of undivided loyalty and compliance w ith applicable laws, regulations, and accepted standards of fiduciary conduct related to self-dealing and other conflicts of interest. The compliance com ponent includes reviewing and evaluating the adequacy and soundness of adopted policies, procedures, and practices generally, and as they relate to specific transactions and accounts. It also includes reviewing policies, procedures, and practices to evaluate the sensitivity of management and the board of directors to refrain’ from self-dealing, m inim ize potential conflicts of interest, and resolve actual conflict situations in favor of the fiduciary account beneficiaries. Risks associated w ith account adm inistration are potentially unlim ited because each account is a separate contractual relationship that contains specific obligations. Risks associated w ith account adm inistration include: failure to comply w ith applicable laws, regulations or terms of the governing instrum ent; inadequate account adm inistration practices; and inexperienced managem ent or inadequately trained staff. Risks associated w ith a fiduciary’s duty of undivided loyalty generally stem from engaging in self-dealing or other conflict of interest transactions. An institution may be exposed to compliance, strategic, financial and reputation risk related to account adm inistration and conflicts of interest activities. The ability of management to identify, measure, m onitor and control these risks is reflected in this rating. Policies, procedures and practices pertaining to account adm inistration and conflicts of interest are evaluated in light of the size and character of an institution’s fiduciary business. The compliance rating is based upon, bu t not lim ited to, an assessm ent of the following evaluation factors: • Compliance w ith applicable federal and state statutes and regulations, including, but not lim ited to, federal and state fiduciary laws, the Employee Retirement Income Security Act of 1974, federal and state securities laws, state investm ent standards, state principal and income acts, and state probate codes; • Compliance w ith the terms of governing instrum ents; • The adequacy of overall policies, practices, and procedures governing com pliance, considering the size, complexity, and risk profile of the institution’s fiduciary activities; • The adequacy of policies and procedures addressing account adm inistration; • The adequacy of policies and procedures addressing conflicts of interest, including those designed to prevent the im proper use of “m aterial inside inform ation” ; • The effectiveness of systems and controls in place to identify actual and potential conflicts of interest; • The adequacy of securities trading policies and practices relating to the allocation of brokerage business, the paym ent of services w ith “soft dollars” and the combining, crossing, and timing of trades; • The extent and perm issibility of transactions w ith related parties, including, bu t not lim ited to, the volume of related commercial and fiduciary relationships and holdings of corporations in w hich directors, officers, or em ployees of the institution may be interested; • The decision making process used to accept, review, and terminate accounts; and, • The decision making process related to account adm inistration duties, including cash balances, overdrafts, and discretionary distributions. Ratings. A rating of 1 indicates strong compliance policies, procedures and practices. Policies and procedures covering conflicts of interest and account adm inistration are appropriate in relation to the size and complexity of the institution’s fiduciary activities. Accounts are adm inistered in accordance w ith governing instrum ents, applicable laws and regulations, sound fiduciary principles, and internal policies and procedures. Any violations are isolated, technical in nature and easily correctable. All significant risks are consistently and effectively identified, m easured, m onitored and controlled. A rating of 2 indicates fundam entally sound compliance policies, procedures and practices in relation to the size and complexity of the institution’s fiduciary activities. A ccount adm inistration may be flawed by moderate weaknesses in policies, procedures or practices. M anagement’s practices indicate a determ ination to m inim ize the instances of conflicts of interest. Fiduciary activities are conducted in substantial compliance w ith laws and regulations, and any violations are generally technical in nature. Management corrects violations in a timely m anner and w ithout loss to fiduciary accounts. Significant risks are effectively identified, m easured, monitored, and controlled. A rating of 3 indicates compliance practices that are less than satisfactory in relation to the size and complexity of the institution’s fiduciary activities. Policies, procedures and controls have not proven effective and require strengthening. Fiduciary activities may be in substantial noncom pliance w ith laws, regulations or governing instrum ents, but losses are no worse th an minimal. W hile management may have the ability to achieve compliance, the num ber of violations that exist, or the failure to correct prior violations, are indications that management has not devoted sufficient time and attention to its compliance responsibilities. Risk management practices generally need improvement. A rating of 4 indicates an institution w ith deficient compliance practices in relation to the size and complexity of its fiduciary activities. Account adm inistration is notably deficient. The institution makes little or no effort to m inim ize potential conflicts or refrain from self-dealing, and is confronted w ith a considerable num ber of potential or actual conflicts. Numerous substantive and technical violations of laws and regulations exist and many may rem ain uncorrected from previous examinations. Management has not exerted sufficient effort to effect compliance and m ay lack the ability to effectively adm inister fiduciary activities. The level of compliance problems is significant and, if left unchecked, may subject the institution to m onetary losses or reputation risk. Risks are inadequately identified, m easured, m onitored and controlled. A rating of 5 indicates critically deficient compliance practices. Account adm inistration is critically deficient or incom petent and there is a flagrant disregard for the terms of the governing instrum ents and interests of account beneficiaries. The institution frequently engages in transactions that compromise Federal Register/Vol. 63, No. 197/Tuesday, October 13, 1998/Notices its fundam ental duty of undivided loyalty to account beneficiaries. There are flagrant or repeated violations of laws and regulations and significant departures from sound fiduciary principles. Management is unw illing or unable to operate w ithin the scope of laws and regulations or w ithin the terms of governing instrum ents and efforts to obtain voluntary compliance have been unsuccessful. The severity of noncom pliance presents an im m inent monetary threat to account beneficiaries and creates significant legal and financial exposure to the institution. Problems and significant risks are inadequately identified, m easured, m onitored, or controlled and now threaten the ability of management to continue engaging in fiduciary activities. A sset M anagement. This rating reflects the risks associated with managing the assets (including cash) of others. Prudent portfolio management is based on an assessment of the needs and objectives of each account or portfolio. An evaluation of asset management should consider the adequacy of processes related to the investm ent of all discretionary accounts and portfolios, including collective investm ent funds, proprietary m utual funds, and investm ent advisory arrangements. The institution’s asset management activities subject it to reputation, compliance and strategic risks. In addition, each individual account or portfolio managed by the institution is subject to financial risks such as market, credit, liquidity, and interest rate risk, as well as transaction and compliance risk. The ability of managem ent to identify, measure, m onitor and control these risks is reflected in this rating. The asset management rating is based upon, but not lim ited to, an assessment of the following evaluation factors: • The adequacy of overall policies, practices and procedures governing asset management, considering the size, com plexity and risk profile of the institu tio n’s fiduciary activities. • The decision making processes used for selection, retention and preservation of discretionary assets including adequacy of docum entation, com mittee review and approval, and a system to review and approve exceptions. • The use of quantitative tools to measure the various financial risks in investm ent accounts and portfolios. • The existence of policies and procedures addressing the use of derivatives or other com plex investm ent products. • The adequacy of procedures related to the purchase or retention of miscellaneous assets including real estate, notes, closely held com panies, lim ited partnerships, m ineral interests, insurance and other unique assets. • The extent and adequacy of periodic reviews of investm ent performance, taking into consideration the needs and objectives of each account or portfolio. • The monitoring of changes in the com position of fiduciary assets for trends and related risk exposure. • The quality of investm ent research used in the decision-making process and docum entation of the research. • The due diligence process for evaluating investm ent advice received from vendors and/or brokers (including approved or focus lists of securities). • The due diligence process for reviewing and approving brokers and/or counter parties used by the institution. This rating may not be applicable for some institutions because their operations do not include activities involving the managem ent of any discretionary assets. Functions of this type w ould include, but not necessarily be lim ited to, directed agency relationships, securities clearing, non fiduciary custody relationships, transfer agent and registrar activities. In institutions of this type, the rating for Asset Management may be om itted by the examiner in accordance w ith the examining agency’s im plem enting guidelines. However, this com ponent should be assigned w hen the institution provides investm ent advice, even though it does not have discretion over the account assets. An example of this type of activity w ould be w here the institution selects or recom m ends the m enu of m utual funds offered to participant directed 401 (k) plans. Ratings. A rating of 1 indicates strong asset m anagement practices. Identified w eaknesses are m inor in nature. Risk exposure is m odest in relation to m anagem ent’s abilities and the size and complexity of the assets managed. A rating of 2 indicates satisfactory asset management practices. Moderate weaknesses are present and are well w ithin m anagem ent’s ability and w illingness to correct. Risk exposure is commensurate w ith m anagem ent’s abilities and the size and complexity of the assets managed. Supervisory response is limited. A rating of 3 indicates that asset m anagem ent practices are less than satisfactory in relation to the size and complexity of the assets managed. Weaknesses may range from moderate to severe; however, they are not of such significance as to generally pose a threat to the interests of account beneficiaries. Asset management and risk management practices generally need to be improved. An elevated level of supervision is norm ally required. 54711 A rating of 4 indicates deficient asset management practices in relation to the size and complexity of the assets managed. The levels of risk are significant and inadequately controlled. The problems pose a threat to account beneficiaries generally, and if left unchecked, may subject the institution to losses and could underm ine the reputation of the institution. A rating of 5 represents critically deficient asset management practices and a flagrant disregard of fiduciary duties. These practices jeopardize the interests of account beneficiaries, subject the institution to losses, and m ay pose a threat to the soundness of the institution. Dated: October 7, 1998 Keith J. Todd, Executive Secretary, Federal Financial Institutions Examination Council. [FR Doc. 98-27328 Filed 10-9-98; 8:45 am] BILLING CODE 6 2 1 0 -0 1 -P 25%, 6720-01- P 25%, 6 7 1 4 01- P 25%, 4810 -3 3 -P 25%
@FedFRASER