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November 1993




News and Views
for the Eighth District


FASB 115 Affects Investment Strategies
As Eighth District banks

implement FASB 115 - the
new accounting standard for
debt and equity securities each institution should consider
carefully how its investment
portfolio is structured. Because
the standard limits a bank's
flexibility in managing its
portfolio, each institution
should carefully evaluate its
intent when investing in a
debt or equity instrument. Bank
management must assure that
the portfolio, as a whole, meets
policy objectives for managing
liquidity and interest rate risk.
The new standard, which
becomes effective January 1,
1994, establishes three securities

Small BHCs
Federal Reserve Bank of St. Louis

ed examiners report that
field inspections of small
bank holding companies
continue to reflect inadequate
financial record keeping.
While retaining an independent
accountant and seeking advice
is appropriate, responsibility
for maintaining a complete
record-keeping system and
preparing financial statements remains with company


classifications that more accurately reflect the intent behind
management's investment
activities. The new classifications are as follow:

only if isolated, unusual or
non-recurring circumstances
arise that could not have been
anticipated when the securities
(continued 011 llext page)

Held to Maturity
Securities designated as "held
to maturity" are reported at
unamortized cost, and gains
and losses are recognized on
the income statement only
upon the sale of the security.
Securities are eligible for this
classification only if bankers
have the positive intent and
ability to hold these securities
to maturity.
Securities in this category
may be sold or reclassified

What Do Companies
It is important to remember
that all BHCs are financial
institutions under existing laws
and regulations. Fed examiners,
therefore, expect the management of each holding company
to understand and maintain
an adequate on-site financial
record-keeping system.
The system must account for
both cash and accrual entries,


maintain adequate information about the entries, and
allow for accurate preparation
of financial statements and
reports. Dual signature
requirements and independent
reviewof entries should be
(continued on nerl page)

FASB 115
(continued from front page)

were purchased. Bankers may
not use such securities to meet
liquidity needs, transfer them
to other inve tment accounts
or hedge them against interest
rate risk. If securities classified
as held to maturity are sold
or reclassified, the intent
underlying the classifications
of the remaining securities
may be questioned.

Securities purchased for the
purpose of taking advantage
of short-term movements
in price are designated as

"trading" and reported at fair
value. Any changes in fair
value regardless of whether
the securities are sold, are
recognized as realized gains
and losses on the income statement. There are no restrictions
on selling trading securities.

Available for Sale
Securities classified as
"available for sale" are reported
at fair value, with changes in
fair value recognized (net of
tax) as unrealized gains and
losses in a new equity account.
Upon sale, gain and lo

are recognized through
income. Available-for-sale
securitie may not be held
for short-term ale.
Call report in tructions will
be changed to reflect FASB 115
beginning with the quarter
ending March 31, 1994.
The federal banking agencies will request comments
on whether the new equity
account - which captures
changes in the fair value of
available-for-sale securities should be included in measures
of capital adequacy.

Bankers reviewing the structur
of their investment portfolios
may wi h to consult an independent accountant for fmther
information on how the new
standard will affect investment

Record Keeping
(continuedfrom front page)

implemented as an internal
control procedure.
Acomplete set of records
includes a cash receipts/disbursements journal, general
ledger and general journal.
Records must show that transactions are promptly recorded,
clearly detailed and supported
by original receipts or workpapers. Financial statements
must be prepared according to
generally accepted accounting
principles (GMP) and reconciled with regulatory reports.

What Are the
Benefits of a
Good System?
Agood financial recordkeeping system will result
in the following benefits:
• Management will have
accurate financial information with which to make
informed decisions.
• Outside accounting and
auditing costs will decline
since billings are directly
Federal Reserve Bank of St. Louis

Financial statements
must be prepared
according to GAAP
and reconciled with
regulatory reports.


proportional to the time
spent reconciling the
records and preparing
the financial tatements.
• Examiners will be able to
complete on-site inspections more quickly.
• Ongoing Fed monitoring
of the company's financial
condition will be more

What Are Examiners
The following record keeping
exceptions are commonly
noted in inspection reports:
• Acheckbook is maintained
as the only record for cash
entries and a sufficient


written explanation is
not provided for each entry.
Accrual entrie are recorded
as of the financial reporting
date without adequate
documentation or understanding of the basis of
the entry.
Entries are not in compliance with GMP.
Transactions are either
recorded late or omitted.
Important financial documents and related records
are maintained off-site in
an accountant's office.

These exceptions indicate that
company management has
inadequate knowledge and
control of the records; therefore, management may not
be able to fulfill its corporate
and fiduciary responsibilities
to manage the company's
financial affairs. In addition,
such record keeping inevitably results in errors in the
FR Y-6Annual Report for
Bank Holding Companies

and FR Y-9 Financial Statementsfor Bank Holding

What Can Manage•
ment Expect?
During each on-site inspection, examiners will ask
management to research
and correct any record keeping
exception . Deficiencies in
the sy tern will be cited in
the Report of Bank Holding
Company Inspection. In
addition, if examiners determine that regulatory reports
are materially misstated,
management must amend
and resubmit the reports.
The Fed's staff closely checks
all regulatory reports, and
repeated errors that result
from an inadequate financial
record-keeping system may
lead to supervisory action.

Section 23A: Questions and Answers
xamination and
inspection reports
frequently reflect
violations of
Section 23A of the
Federal Reserve Act. Section
23Ais designed to prevent the
misuse of a bank's resources
resultingfrom credit extensions
and asset purchases between
a bank and its affiliate . These
"covered transaction " are
limited in amount and may
be ubject to pecific collateral

The loan from the
subsidiary bank to
the stockholder is a
covered transaction
because the parent
holding company
received the loan
proceeds. The loan,
therefore, must be
appropriately collateralized and be less
than 10 percent
of the bank's


amount and collateral limitations apply to tran actions
between a bank and the ESOP.

Are transactions between
a bank and its parent
holding company covered
by Section 23A?

Are all transactions
between "sister banks,"
which are banks and
thrifts that are 80 percent
or more owned by the
same company, exempt
from Section 23A?

Yes. Because the parent company is an affiliate of the bank,
exten ions of credit to the parent are limited to 10 percent
of bank capital and must be
properly secured. For example,
an overdraft in the parent
company's demand account
held at its subsidiary bank is
a violation of Section 23A if
it i not adequately secured
by qualifying collateral.
Are expenses that a bank
prepays to its parent
company considered
extensions of credit?
Only when the prepayment
ignificantly precede the
bank's receipt of the service
for which payment is being
made. Examiners closely
review the amount and timing
of management fee and tax
benefit payments to ensure the
bank i not di advantaged by
its affiliation with the parent
holding company.

Federal Reserve Bank of St. Louis

Following are questions and
answers addressing common
violations of Section 23A.


Is an Employee Stock
Ownership Plan {ESOP)
that owns stock in its
parent holding company
an affiliate of a bank
within the same holding
Yes. The term "affiliate"
includes any compan either
pon ored or advised by the
bank or any ubsidiary or
affiliate of the bank. Both

o. Abank may not pm~
chase low-quality assets from
a sister bank. Low quality assets
include examiner-classified
assets, past-due and nonperforming loans and other real
estate. In addition tran action
between sister banks mu t
be on terms and conditions
consistent with safe and sound
banking practices.
How is capital defined
for the purposes of
Section 23A amount
Capital i the sum of a bank's
or thrift's common tock,
surplus, retained earnings
(collectively reported as equity),
plu the unallocated portion
of the loan loss reserve.
How is the 10 percent
capital limit applied when
a bank periodically buys
loans from a nonbank
affiliate, such as loans
originated and initially
funded by an affiliated
mortgage company?
The dollar value of loans
that can be purchased in any
transaction would be limited
to 10 percent of capital minu
(continued on next page)

the remaining balance of
mortgage loans previously
purchased. For example, if
10 percent of bank capital is
$10 million and the remaining
balance of loans which the
bank previously purchased is
$6 million, then the bank may
buy no more than $4 million
of loans in this transaction.
Is a loan for the purpose
of purchasing securities
of the bank's parent company a "covered transaction" under Section 23A?

Flood Claims

Other Affected
District States
Federal Reserve Bank of St. Louis

Yes. If the proceeds of the loan
benefit the parent company
by funding payment for newly
is-sued or Treasury shares, then
the loan must comply with
all provisions of Section 23A
in the same manner as if the
extension of credit were made
directly to the holding company.
Furthermore, the parent company's stock does not qualify as
acceptable collateral. If, however, the loan proceeds fund
the purchase of stock from an
unaffiliated third party, then
the individual and aggregate


nitial insurance claims
on losses from the Great
Flood of '93 suggest that many
lenders may be underinsured.
As of October 20, 1993, a total
of 11 ,399 claims had been
filed with the National Flood
Insurance Program. 1\vo
Eighth District states, Missouri
and Illinois, filed 8,259 of
those claims. In Missouri,
the average claim is $30,827;
in Illinois it is $22,128.
Historically, compliance
with the mandatory purchase
of flood insurance guidelines
has averaged 20 percent. Early
reports from affected regions
cause program administrators
to estimate, however, that only
10 percent of those required to
purchase flood insurance complied with the guidelines. The
low claims rate and the past
payment experience indicate
that bankers should review
loan administration programs
to ensure that loan review
procedures test for adequate
flood insurance coverage.
Under the National Flood
Insurance Program, bankers
who extend credit in special
flood hazard areas must require

quantitative limits apply to
the transaction.
Bankers with additional
questions about Section 23A
are encouraged to review the
statute (12 USC 371c) found
at Paragraph 3-1110 of the
Federal Reserve Regulatory
Service. If further assistance
is needed, call Timothy A.
Bosch, Assistant Vice President - Western Region
(Arkansas, Mississippi, and
Missouri) at (314) 444-8440
or Kim D. elson, Assistant

flood insurance as a condition
of any new, increased, extended
or renewed loan secured by
improved real estate or a mobile
In special flood hazard areas,
which are areas with a 1 percent
probability of having a flood
that either equals or exceeds
the last flood, the insurance
must at least be equal to the
loan's outstanding principal
balance or up to the maximum
limit of the available coverage,
whichever is less.
If a financial institution fails
to require an initial insurance
purchase or the borrower fails
to maintain adequate insurance, lenders may require the
borrower to purchase insurance
at any time during the life of
the loan. To ensure that the
banker is fully protected, the
loan agreement should include
a provision that allows the
banker to obtain insurance
and charge either the escrow
account or the borrower for
the cost.
Additionally, lenders that
are regulated by the Fed must
require flood insurance on
property located in communities

Vice President - Eastern
Region (Illinois, Indiana,
Kentucky, and Tennessee)
at (314) 444-8735.

that participate in the ational
Flood Insurance Program,
even if the property securing
the loan is located outside of
a special flood hazard area.
For example, additional caution may be warranted in area
that undergo flooding as a
result of storm water and in
remote areas where the Federal
Emergency Management Ag~ncy
(FEMA) has not designated
any flood hazard areas. The
National Flood Insurance
Program offers a low cost
"preferred risk" policy to
facilitate the purchase of
flood insurance outside special
flood hazard areas.
Safe lending in flood-prone
areas can be achieved when
institutions are aware of their
rights and obligations. A
comprehensive handbook,
Manda,tory Purchase ofFlood
Insurance Guidelines, can be
obtained by calling FEMA at
1-800-638- 6620.

Large Reserves Reflect Industry

lthough industry
and supervisory
attention has
focused on lower
short-term interest
rates, wider net interest margins, and record earnings,
other indicators of improved
banking conditions have not
gone unnoticed. During the
past year and a half, the ratio
of loan loss reserves to nonperforming loans has increased
to record levels. As of June 30,
1993, the aggregate coverage
ratio for District banks reached
167 percent. This ratio is 50
percentage points ahead of
U.S. peer banks with total
assets less than $15 billion.
(See chart at right.)
The increase in this ratio
suggests that reserves have


Loan Loss Provisions vs.
Net Loan Losses
District Banks
Billions of dollars


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0.6 ; - - --


0.5 +---1----~


~ ~-rii~-::_-




~ =--- - - _:::~ ~ ----l

0.4-+---- - - - - -- - - - - - - ' -~ 0.3-+-- - - - - - - - - - - -- --- 0.2 - - - - - - - - - - - - - - -------0.1- + - - - - - - - - - - - - - --



0 _,__....---~---.----~--~--.,........

Loan Loss Provisions
Federal Reserve Bank of St. Louis


Net Loan Losses

Loan Loss Reserve/
Nonperforming Loans



District Banks






U.S. Peer Banks

exceeded an appropriate level.
An analysis of changes in the

reserve for both District and
U.S. peer banks, however, indicates that declines in provision
expense have generallyfollowed
declines in nonperforming
loans. Since year-end 1990,
nonperforming loans have
decreased by 34.1 percent
among District banks and by
38.6 percent nationally. These
sizable decreases are primarily
responsible for the increase in
the coverage ratio.
Provision expense has declined
in tandem with lower loan
losses for District banks since
year-end 1991, as illustrated
in the chart to the left. However 1993 has brought about
the most significant decline
in recent years with provision
expense 26.5 percent lower

than the comparable period
in 1992. If these significant
declines remain constant in
the second half of this year, the
provision expense for the entire
year will be at its lowest point
in five years.

Agencies Warn Against Questionable Instruments
he enforcement staffs of the
federal banking agencies
have noted an increase in the
use of questionable financial
instruments - "Prime Bank"
notes, guarantees and letters
of credit - in complex and
potentially illegal schemes
aimed at defrauding borrowers,
investors and banks.
Since the agencies are unaware
of any legitimate use for such
documents, institutions should
be alert to the possible dangers
associated with any "Prime
Bank" - type instrument.
Institutions should also be
attentive to the attempted use
of any traditional type of
financial instrument - such



Post Office Box 442
St. Louis, Missouri 63166

Supervisory 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 S) tern or the Federal
Reserve Bank of St. Louis. Questions
regarding this publication should
be directed to Amy A. Helean,
editor, 314-444-4634.
Federal Reserve Bank of St. Louis

as a standby, performance or
commercial letter of credit in a manner that may be
In the event that any such
transaction becomes apparent,
please advise the appropriate
federal regulator:

Federal Reserve Board
of Governors
(202) 452-2620
National Credit Union
(703) 518-6540
Federal Deposit
Insurance Corporation
(202) 898-6750

Office of the Comptroller
of the Currency
(202) 874-4800
Office of Thrift
(202) 906-6853
In keeping with the applicable
criminal referral regulations,
suspected criminal offenses
require a prompt criminal
referral to the appropriate law
enforcement agencies.
Future notices of fraud activity
that may affect District institutions will be communicated
over the administrative wire.

The Office of Management
and Budget (0MB) issued
new metropolitan statistical area (MSA) designations on June 30, 1993,
that replace the designations that the 0MB issued
on December 28, 1992.
The new MSAs, which take
effect on January 1, 1994,
will be used to determine
coverage and collect 1994