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May 1994




News and Views
for the Eighth District


Nondeposit Investment Risk Must be Clear
Federal Reserve Bank of St. Louis

Recently issued uniform
guidelines on retail sales of
nondeposit investment products
are intended to ensure that
bank customers understand
that these products carry investment risk. The guidelines apply
to mutual fund, annuity and
other nondeposit investment
product retail sales programs,
whether offered directly by
employees of the institution
or indirectly through employees
of a third party. They apply to
sales occurring on the premises
of the institution and sales
through referral of retail customers to off-premises third
parties when the institution

receives a benefit for the referral.
The guideline generally do not
apply to sales of such products
to non-retail customers such
as fiduciary accounts administered by the institution.

Advertising and sales practices
for nondeposit investment
products must be accompanied
by certain disclosures to ensure
that these products are clearly
differentiated from insured
deposits. Disclo ures must
be clear and conspicuous and,
at a minimum specify that
the product is:
• not insured by the FDIC;
• not a deposit or other obligation of, or guaranteed by, the
depository institution; and
• subject to investment risk,
including possible loss of the
principal amount invested.
These minimum disclosures
should be provided:
• in advertisements and other
promotional materials·
• orally during any sales

• orally when investment
advice concerning nondeposi t investment products
is provided; and
• orally and in writing prior
to or at the time an investment account is opened to
purchase these products.
Astatement, signed by the
customer, should be obtained
at the time such an account is
opened, acknowledging that
the customer has received and
understands the disclosures.
Confirmations and account
tatements should contain at
least the minimum disclosures
if the confirmations or account
statements display the name or
logo of the bank or an affiliate.
If a customer's periodic deposit
account statement includes
information concerning the
customer's nondeposit investment products, the information
must be clearly separate from
deposit account information
and should be introduced
with the minimum disclosures
(wntinued on next page)

Investment Risk
(continuedfrom front page)

and the identity of the entity
conducting the nondeposit

institution has an increased
responsibility to ensure that
appropriate measures are in
place to minimize customer
Tellers and other employees
located in the routine deposittaking areas, such as the teller
window, may not make general
or specific investment recommendations regarding nondeposit investment products,
qualify a customer as eligible
to purchase such products, or
accept orders for such products,
even if unsolicited. Tellers
may refer customers to individuals who are authorized to
assist in the purchase
of such

Separation of Deposit
and Nondeposit
To minimize customer confusion with deposit products,
sales or recommendations of
nondeposit investment products on the premises of a bank
should be conducted in a physical location distinct from the
area where retail deposits are
taken. Signs or other means
should be used to distinguish
the investment sales area from
the retail deposit-taking area
of the institution. If physical
considerations prevent
separation of the


• ,.-









Federal Reserve Bank of St. Louis



products. Bank employees,
including tellers, may receive
a one-time nominal fee in a
fixed dollar amount for each
Advertising and
sales practices must
be accompanied
by disclosures to
ensure that products are clearly
differentiated from
insured deposits.

customer referral for nondeposit investment products. The
payment of this fee should not
depend on whether the referral
results in a transaction.

Sales Practices and
Employees authorized to
recommend or sell nondeposit investment products or to
provide investment advice
must be adequately
trained and supervised.
Training should impart a
thorough knowledge of
the products, applicable
legal restrictions on
purchase and sale, and
customer protection
requirements. Employees
recommending or selling
securities must have training
which is the substantive equivalent of that required for individuals selling securities as
registered representatives.
In addition, employees
who recommend nondeposit
investment products must
have reasonable grounds for
believing the specific product
is suitable for the customer.
Employees should make
reasonable efforts to obtain

directly from the customer
information which includes,
at a minimum, the customer's
financial and tax status,
investment objectives and
other information that may
be useful or reasonable in
making investment recommendations to that customer.
This information should be
documented and updated
Personnel authorized to
sell products may receive
incentive compensation,
such as commissions, for
sales transactions. These
programs, however, must not
be structured in a way which
results in unsuitable recommendations or sales being
made to customers.
Compliance and audit
personnel should not receive
incentive compensation directly
related to the results of nondeposit investment sales programs.

Abank engaged in these
activities should develop a
written policy, formally adopted
by its directors, that addresses
the risks involved with the
sales program. The statement
should contain procedures
addressing, at a minimum,
the concerns addressed in
the guidelines. The Federal
Reserve is testing examination
procedures which measure compliance with these guidelines.

Revised Regulation OIntended to Reduce
Regulatory Burden
Federal Reserve Bank of St. Louis

egulation 0,
which limits loans
by a bank to its
insiders and executive officers, has
been recently revised to reduce
the burden and complexity
of its provisions. The revision
narrows the definition of "extension of credit" and provides


additional exemptions for
calculating the limits on insider
credit and loans to executive
officers. In addition, it reduces
recordkeeping requirements
and makes permanent the
interim rule increasing the
aggregate insider loan limit
for small banks to 200 percent
of capital and surplus.

Revisions to the
Definition of
"Extension of Credit"
First, the "tangible economic
benefit" rule was clarified to
clearly exempt arm~ length
extensions of credit by a bank
to a third party where the proceeds of the credit were used to
finance a bona fide acquisition
of property, goods or services

from an insider or an insider's
related interest. For example, a
home improvement loan to a
bank customer is not subject to
Regulation Orestrictions even
if the loan proceeds are paid to
an insider's construction company for performing the work.
The "tangible economic benefit" rule, however, does cover
extensions of credit to an insider's nominee and transactions
in which the proceeds of the
credit are loaned to an insider.
Secondly, a bank's purchase
of loans, conditional sales
contracts and similar paper
from an insider without
recourse is no longer
an extension of credit.
Lastly, the threshold
above which credit
card loans to insiders
are considered extensions of credit has
been raised from
$5,000 to $15,000. The threshold for extensions of credit
through overdraft plans,
however, has not been raised.
As a result, loans to insiders
under overdraft protection
plans in excess of $5,000 are
still considered "extensions
of credit."

loans to Executive
Loans to executive officers
that are fully secured by: (a)
obligations of the United States
or other obligations fully guaranteed as to principal and
interest by the United States;
(b) commitments or guarantees of a department or agency
of the United States; or (c) a
segregated deposit account

with the lending bank are now
exempt from the general purpose lending limit to executive
officers. This limit provides that
lending to executive officers is
generally limited to the greater
of $25,000 or 2.5 percent of its
equity capital plus its reserve
for loan losses, but in any case
may not exceed $100,000.
Loans to executive officers for
the purposes of purchasing,
constructing, maintaining or
improving their principal
residences, or to finance the
education of their children,
however, are not counted
toward this limit.
Revisions were also made
to clarify that a refinancing of
a mortgage loan was included
Revisions narrow
the definition
of "extension of
credit" and allow
additional exemptions for calculating
the limits on insider
credit and loans to
executive officers.

in the exception to the extent
that the proceeds are used
. to pay off a prior home mortgage loan or for purchasing,
constructing, maintaining
or improving an executive
officer's residence. evertheless,
loans to executive officers for
(amtinued on next page)

such purposes must be
approved in advance by the
bank's board of directors.

Record keeping
Recordkeeping requirements
for banks have been reduced.
Banks still must survey annually their own officers and directors, but are no longer required
to survey officers and directors
of affiliates in a holding company organization. To monitor
the limits on credit to insiders
of the bank's affiliates, the
bank may either 1) identify,

Every bank should
have a monitoring
system which
tracks individual
and aggregate
borrowing limits.

through an annual survey,
each insider of each affiliate or
2) require that each borrower
identify whether or not he or
she is an insider of an affiliate
of the bank. In either case, the
bank must continue to maintain records that identify the

amount and terms of each
extension of credit by the member bank to individuals and
companies identified under
either approach. While the
regulation permits other
recordkeeping methods, a
bank electing a different
method must establish to the
satisfaction of the examiner
that the different method is
equally effective.
Of importance to examiners
is that every bank has a monitoring system which tracks
individual and aggregate
borrowing limits, and that

board minutes properly record
the required approvals. During
each examination, it is normal
practice for all insider loans to
be reviewed for credit quality and
compliance with Regulation 0.

Revised Policy Statement on Securities Activities
Federal Reserve Bank of St. Louis

he FFIEC has issued
interim revisions to the
interagency policy statement
on securities activities of banks.
The revisions address the
section of the policy statement
relating to mortgage derivative
products to assure consistency
with the new FASB ll5. The
major revisions are:


• Mortgage derivative products
that are "non-high risk"
when purchased but later
become 'high-risk' do not
have to be redesignated as
available-for-sale or as trading assets. Examiners are
further instructed to consider
any unrecognized net depreciation in held-to-maturity
high-risk securities when
they evaluate the adequacy
of an institution's capital.
• High-risk mortgage securities acquired to reduce
interest rate risk, but which
no longer serve this purpose

due to changes in interest
rate positions, may not be
reported as held-to-maturity
securities at amortized cost.
In addition, examiners may
require that such securities
be sold, if they determine
that the continued ownership of the high-risk mortgage securities represents an
undue safety and soundness
risk to the institution. This
risk can arise from the size
of the institution's holdings
of high-risk mortgage securities in relation to its capital

and earnings, management's
inability to demonstrate an
understanding of the risks
inherent in such securities
and to manage overall
interest rate risk, inadequate
internal monitoring systems
and other internal controls
to measure market and cash
flow risks, in addition to
other factors.
These revisions will remain
in effect until the entire policy
statement is revised to conform
to FASB llS.

District Banks Earned Record
Profits. in '93
istrict banks
earned a record
$1.9 billion in
1993, a 16.8 percent increase over
earnings reported for 1992.
With the exception of a few
billion dollar banks and those
under $25 million, banks
across the District generated
aggregate returns on average
assets (ROM) in excess of
1 percent, leading to an aggregate ROM of 1.27 percent for
the entire District. U.S. peer
banks less than $15 billion
reported a 22 percent increase
in 1993 earnings, matching
for the first time the District's
1.27 percent aggregate return
on average assets.
Lower provision ·expense for
loan losses was the primary
contributor to earnings.


Provision Expense as
a Component of ROAA






Provision Expense

Federal Reserve Bank of St. Louis

Return on Average Assets


Noninterest Income and Expense
Percent of Average Assets


















198S 1986 1987 1988 1989 1990 1991 1992 1993


Expense US Peer
Income US Peer



Provision expense has been
declining since 1990, but the
deep cuts made in 1993 added
an average 17 basis points to
the aggregate pre-tax ROMs
for District banks. The cuts
in provision expense follow
significant improvements in
asset quality. Net loan losses
were reduced by half over the
past two years and aggregated
.36 percent of total loans for
the District. Although U.S. peer
banks reported net loan losses
twice that amount, their levels
of past due and nonaccrual
loans continued to decline.
Past due and nonaccruals
equalled a moderate 3.02 percent of total loans at year-end,
and loan loss reserves now
provide $1.22 for every dollar
in noncurrent loans, defined

Expense Eighth District
Income Eighth District

as loans past due 90 days or
more or on nonaccrual status.
As usual, District banks
retained high asset quality,
reporting aggregate past
due and nonaccrual loans at
2.08 percent of total loans and
$2.06 in loan loss reserves for
every dollar in noncurrent loans.
In addition, banks sharply
reduced their holdings of other
real estate during the year.
An additional $264 million
earned in the District through
various sources of noninterest
income also contributed to
earnings growth. Banks
reported aggregate noninterest
income of 1.29 percent of
average assets compared to
(amtinued on back page)

Bank Performance
(continuedfrom page 5)

1.17 percent in 1992. Half
of the additional revenue was
derived from other fee income,
with increases also reported for
all other noninterest income,
service charges and net trading
gains; income from fiduciary
activities declined 6percent.
Increases in all categories
of overhead, however, largely
mitigated the gains previously
noted for most District banks.
Conversely, most U.S. peer banks
and approximately one-third
of all District banks did report
improvements in their net

noninterest expense/average
assets ratio. On an aggregate
basis, improvement in the net
overhead ratio added 5 basis
points to the pre-tax ROAAs for
banks under $15 billion.
All banks experienced stronger
net interest margins in 1992;
however, only District banks
over 1 billion benefitted from
a stronger margin in 1993.
In fact, these banks' margins
were augmented an average
22 basis points due to declines
in in.terest expense, more than
offsetting declines in interest

income. U.S. peer banks and
all other District banks realized
no change or a slight squeeze
in their margins for the opposite reason; declines in interest
income moved in tandem with
or more than offset declines in
interest expense.
District interest income continued to be limited by declining
yields on loans and notably
securities; even so the District
reported aggregate loan growth
of 9.6 percent. Loan growth was
funded primarily by deposits
and other borrowings, and to a

les.5er extent profits. This greatly
exceeded loan growth by U.S.
peer banks of 2.7 percent.
Overall, the District's assets
grew a moderate 5.0 percent,
compared to a flat .8 percent
growth by U.S. peer banks.
Certainly, both District and
U.S. peer banks are well-positioned for 1994, with the past
two years of declining interest
rates strengthening margins
and balance sheets.

FFIEC Offers

hree, one-day fair lending
seminars are scheduled
to be held throughout the
country in 1994 for presidents,
chief executive officers and
directors of financial institutions. The seminars are
intended to assist top management to better understand fair
lending issues and institute
policies that ensure corporate

commitment to nondiscriminatory lending practices.
Each seminar will emphasize
the fair lending priorities of
the agency principals and the
initiatives underway to carry
them out, the role of the Justice
Department and the Department of Housing and Urban
Development in enforcing the
fair lending laws, secondary

market standards and their
effect on institutional fair
lending, and successful ways
lenders have improved their
fair lending practices.
Complete the enclosed application form to register. Early
registration is recommended
because space is limited.



Post Office Box 442
St. Louis, Missouri 63166

Supermsory Issues is published bimonthly by the Banking Supervision
and Regulation Division of the
Federal Reserve Bank of St. Louis.
Views expressed are not necessarily
official opinions of the Federal
Reserve System or the Federal
Reserve Bank of St. Louis. Questions
regarding this publication should
be directed to Kathleen Y. Poniewaz,
editor, 314-444-4634.
Federal Reserve Bank of St. Louis