View original document

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

Federal Reserve Bank of St. Louis

September 1994



News and Views
for the Eighth District


Risk Management Is Essential When
Purchasing Structured Notes
The Federal Reserve recently
advised banking organizations
of the risks associated with debt
securities known as structured
notes. The Fed reiterated that
risk management policies and
practices must be in place to
assure that use of these securities
is consistent with safe and sound
banking practices.

Characteristics of
Structured Notes
Structured notes are typically
medium-term debt securities,
most of which are issued by
U.S. government agencies and
other government-sponsored
entities. These notes are
"structured" in that a form of
embedded swap and/oroption
is incorporated into the debt
instrument. Coupon and principal payment levels are tied
to one or more indices either
directly or by formulas which
may change during the term
of the note. These formulas
may have various reset periods
and either periodic or lifetime
caps and floors.
Among the primary issuers
of structured notes are the
Federal Home Loan Banks.
Most notes issued by the banks
have either callable structures
or floating rate structures. A
callable structured note includes
an index amortizing note with
a principal payment level that
is tied to an index such as
LIBOR. Afloating rate structured note will carry a coupon

rate tied to an index. If the
coupon rate moves as the index
moves, the instrument is called
a "floater." If the rate resets
based on a formula that includes a multiple or variation
of the index, it is a "leveraged
floater." If the rate resets based
on the difference between a
set rate and the index, it is an
"inverse floater." There are
many other structured note
types, and new products are
continuing to be developed.
Because interest rate and
cash-flow characteristics vary
widely, these notes may offer
advantages over other instruments used to manage market
risk. In particular, they may
reduce couriterparty credit risk,
offer operating efficiencies,and
lower transaction costs, require
fewer transactions and address
more specifically an institution's

(wntinued on next page)

Structured Notes
(continuedfrom front page)

risk exposures. Risk to principal is typically small, and
yields are generally high to
compensate the investor for
the embedded option risk.
Accordingly, when analyzed
and managed properly, structured notes can be acceptable
investments for banks.

Price Volatility and
Liquidity Risk
Despite potential benefits,
the customized features and
embedded option characteristics
of structured notes make them
hard to price, increase their
price volatility and may result
in difficulties for an institution
that elects to liquidate its position in the secondary market.
The notes also reflect high
amounts of leverage when
compared with fixed income
instruments with comparable

Must Be
With Fair
Federal Reserve Bank of St. Louis

face values. Accordingly,
institutions considering the
purchase of such instruments
must look beyond the low credit
risk and initially favorable
yields, and evaluate the market
and liquidity risks associated
with the note structures under
a broad range of possible
market conditions.

amount of funds that may
be committed to them.
• Management must demonstrate that it understands
fully the risks these instruments present, including
the potentially reduced
liquidity in secondary
markets and the price
volatility that any embedded
options, leveraging or other
Appropriate Risk
characteristics can create.
Management Practices • Adequate information sysInstitutions must demonstrate
terns and internal controls
the following risk management
must exist for regularly
practices to assure that the
evaluating compliance
purchase of structured notes is •
with policies and managing
consistent with safe and sound
risks under changing marbanking practices:
ket conditions.
• There must be clear lines
• Policies must be approved
of authority for making inby the board of directors,
vestment decisions, and for
and address the goals and
evaluating and managing
objectives for these products,
the institution's securities
as well as set limits on the

Examiners will evaluate
whether these instruments
are appropriate investments
for each institution. In that
evaluation, they will consider
the ability of management to
understand and manage in a
safe and sound manner the
risks inherent in these instruments. In addition, they may
review management's ability to
conduct appropriate stress tests.
Supervisory risk management
standards for these instruments
reflect standards already
articulated for asset-backed
securities and standards in the
trading activities examination
manual issued by the Federal
Reserve System earlier this year.

he Federal Reserve, in
consultation with the
Departments of Justice and
Housing and Urban Development, is advising lenders that
certain mortgage origination
practices may result in examiner
review for compliance with the
Equal Credit Opportunity and
Fair Housing acts.
The mortgage origination
practice which permits lenders
to charge different interest
rates, origination fees and
higher points or other fees to
different borrowers during the
same period is called overages.
This practice gives the broker
or loan originator an incentive
to bring in more business, and
permits the broker to receive
additional compensation for
originating small balance
loans compared with large
balance loans. Overages also

amounts, it may have a
disparate impact because it
results in a disproportionate
number of minority borrowers
who receive loans under that
threshold and pay overages.
In that case, the lender must
demonstrate that the policy
has been applied impartially,
serves a necessary business
objective and that no other,
less discriminatory, method
is available.
The interagency fair lending
task force is currently considering more formal guidance on
the use of overages. Lenders
who permit overages are urged
to review carefullytheir policies
and practices to ensure that
they are applied in a nondiscriminatory manner and
without a discriminatory effect.


increase the value of loan
servicing rights.
This practice is not inherently
discriminatory but may result
in apparent disparate treatment
or have a disparate impact.
Alender who provides loan
officers with discretion in setting the price of a loan should
review its lending performance
to ensure that discretion is
exercised fairly and without
regard to-prohibited factors
such as race or gender. If a
lender finds, for example, that
overages were charged more
often to minorities than to
of loan type or amount-the
lender must demonstrate a
nondiscriminatory business
reason for this apparently
disparate 'treatment.
Even if the overage policy is
limited to loans under certain

Examiners Find Common Exceptions to
Regulation DD
ust over a year has
passed since the
implementation of
Regulation DD (Truth
in Savings), and
examiners report that
overall compliance
with the regulation is good.
There have been.a few common
exceptions, however, noted
during examinations.

New Accounts
Though new account disclosures generally meet regulatory
requirements, the following
disclosures are often omitted:
•For fixed rate accounts-the
period that the interest rate will
be in effect.
For variable rate accounts• the fact that the rate and
annual percentage yield
may change, how the rate
is determined, the frequency
with which it may change
and any limitation on the
amount rates may change;
• the frequency with which
interest is compounded
and credited, and whether
consumers will forfeit
interest if the account
is closed before accrued
interest is credited; and
• the minimum balance
required to open and
maintain the account to
avoid being charged a fee.
For time accountS'-the
maturity date and early withdrawal penalties; and how
withdrawing interest before
maturity will affect the annual
percentage yield.
Federal Reserve Bank of St. Louis

Periodic Statements
Regulation DD does not
require banks to provide periodic statements. If, however,
a bank does send statements
to con~umers regularly and at
least four times a year, certain
disclosures must be made.
Examples of information frequently missing from periodic
statements include the annual
percentage y1eld earned, the
number of days in the statement
cycle, and the beginning and
ending dates of the statement

Renewable Time
An automatically renewable

time account's maturity determines the timing and content
of disclosures.
Regarding timing, notices
must be mailed within the
periods specified in the regulation even if the interest rate
and annual percentage yield
have not yet been determined.
If this is the case, the disclosure
should explain that the information is not yet available.
It should also provide the date
that the information will be
available and include a telephone number consumers

may call to obtain interest rate
and an,nual percentage yield
Disclosures for accounts
which require advance notice
must be sent either 30 calendar
days before the scheduled
maturity date or 20 calendar
days before the end of a grace
period, as long as the grace
period is at least five days. If
the account has a maturity of
one month or less, disclosures
must be sent within a reasonable time after maturity.
In terms of content, disclosures will vary as follows:

• Longer than one yearNotices must include the
maturity date for the existing account as well as all
disclosures required for
a new account.
• Longer than one month)
but one year or lessNotices must provide either
the disclosures required for
accounts with maturities
longer than one year or the
maturity dates for both the
new and maturing accounts
combined with a description
of any differences in the
terms between the new
and maturing accounts.

• One month or lessNdtices must describe any
term that has changed for
the new account, other
than the annual percentage
yield and interest rate.

Rates and Yields
Examiners frequently noted
that banks are not disclosing
the annual percentage yield
(used for account disclosures
and advertising) and the
annual percentage yield earned
(used in periodic statements)
within the allowed tolerances
described in the appendix to
the regulation'. Both must be
shown to two decimal places /
and rounded to the nearest
one-hundredth of 1percent.
In addition, neither percentage
is considered accurate if it is
more than 0.05 of 1 percent
above or below the actual yield.
The interagency procedures,
objectives and checklist used
by Fed examiners are found
in the Federal Reserve System's
Consumer Compliance
Handbook. To order a copy,
send $20 to: Publications
Services, Mail Stop 138, Board
of Governors of the Federal
Reserve System, Washington,
D.C. 20551.

How to Prepare for an Electronic
Imaging Environment
he term electronic
technology used to
capturei store and
retrieve electronic
images of paper documentsis becoming commonplace in
financial institutions.
For most, the technology of
storing images electronically is
a welcome substitute for handling, distributing and storing
paper documents. Launching
a new imaging system, however,
will significantly affect how an
institution conducts
=::=;;;~=----..... usiness. New
udit and


Federal Reserve Bank of St. Louis

for example,
must be developed and
designed into the automated
process to ensure that information in image files cannot be
altered, erased or stolen. Some
potential areas for risk include:
Planning - Careful planning
is essential when launching an
imaging system. The lack of
planning in selecting and
converting paper systems to
document imaging systems, for
example, can result in excessive
installation costs, the destruction
of original documents, and
the failure to achieve expected
benefits. Critical issues such
as converting existing paper
storage files, integrating the
imaging system into the
organization's workflow,
and establishing processes
for equipment backup and

recovery should be addressed to
avoid reduced customer service
and business interruptions.
Auditing - Imaging systems
change the traditional controls
inherent in paper-based systems.
Redesign of audit procedures
and implementation of new
controls is essential.
Workflow Redesign - When
introducing imaging systems,
institutions generally redesign
workflow to benefit from the
new technology. New jobs are
often identified and others are
eliminated. Traditional control
functions such as time stamps,
control numbers and review
signatures must be addressed
in the-automated system to
prevent any increased risk to
the institution.
Scanning Devices - These
are the entry points for image
documents and introduce significant risk in imaging systems.
Factors that should be considered are quality control over
the scanning and indexing
process, the scanning rate of
the equipment, the storage of
images, equipment backup and
repair times, and the experience
of the personnel performing
the scanning function.
Indexing - The organization
and integrity of the indexing
system ensures access to documents and protects them from
unauthorized modification.
Institutions should keep automated journals and audit trails
of the access and modification
to customer records.
Software Security - The
integrity and reliability of
the imaging system is directly
related to the control quality
over access to the system.

Software and administrative
security functions are essential
to protect information from
unauthorized access and
Contingency Planning Because a large number of
documents-more than
100,000---can be stored on a
single optical disk, contingency
planning is crucial. The loss of
electronic image files or storage
media can, in fact, severely
affect business operations if
back-up electronic or paper
files are not readily available.
Contingency planning and
back-up storage procedures for
imaging system documents
should follow generally accepted
practices for data processing
and management information
Training - Personnel must
be adequately trained not only
to ensure quality control over
the scanning and storage of
imaged documents, but also to
maximize the benefits of converting to an imaging system.
Inadequate training of personnel
can result in poor quality document images and indexes as
well as a premature destruction
of original documents.
Legal Issues - Although a
precedent has been established
on electronically captured
documents such as facsimile,
microfilm and photocopies,
courts have not yet addressed
the authenticity of imaged
documents. Institutions with
imaging systems should
consider the legal implications
of converting original documents to images as well as
the subsequent destruction
of the original documents.

Reporting Inconsistencies Complicate
Interpretation of Mutual Funds Sales
ccording to data
collected from
the June 1994 call
report, 16 percent
of the 1,150
District banks reported mutual
fund sales and annuities, an
increase of 17 percent from
the previous quarter.
As the chart below indicates,
money market sales account
for 56 percent of mutual fund
sales-due largely to daily
sweep account activity. Banks
report that fee income from
the sale of mutual funds and
annuities accounts for 2.4
percent of total noninterest
Although this data may provide some long-awaited insight
into mutual fund activity,
reporting inconsistencies make


it premature to begin a comprehensive analysis of bank
mutual fund sales and related
fee income.
Instructions provided for
the March 1994 call report, for
example, resulted in differing
interpretations of reportable
data by banks. Some institutions
reported gross sales-which
included transfers between
funds-while others reported
net sales. In addition, the
instructions do not exempt
fiduciary sales; current data
appears to include a substantial
number of sales to trust funds.
On the other hand, retail
sales may be understated
because sales by nonbank
subsidiaries and affiliates
are not included if there is
no contractual relationship

Mutual Funds Held by Eigh~h District Banks By Type
Federal Reserve Bank of St. Louis

As of June 30, 1994

with the reporting bank.
Interpretation of mutual
fund activity is further complicated because we were unable
to fully analyze the data since
fee income is lumped into one
total and is not segregated by
type of mutual fund or annuity.
Revised instructions which
address many of these shortcomings will be issued to
banks next year; a similar
data collection effort will begin
for bank holding companies.
In the meantime, banks can
help improve the quality of
information several ways:

• When sales are made by
an off-site entity, the sales
should be reported if a
contractual arrangement
exists, and if the entity's
activity is dependent on
customer referrals.
• For sweep account activity,
report the average amount
of depositors' funds swept
into money market funds
each day during the quarter.
For more information about
mutual fund reporting, contact
Frank Bufe at (314) 444-87 50
or Jim Mack at (314) 444:.8599.

Equity Securities

Rieker Retires, Fed Makes Reassignments
fter 38 years with the
_St. Louis Fed-26 years
of those with the Banking
Supervision and Regulation
Division-Assistant Vice President Harold Rieker has retired.
Effective Sept. -19, Assistant
Vice President Lynn Barry
assumed responsibility for
consumer affairs supervision.
She continues to oversee bank

and holding company regulato- .
ry reporting and data collection:
call reports, the Y-9 (Bank
Holding Company) series and
HMDA. Lynn can be reached
at (314) 444-8565.
Ed Hqpkins, assistant vice
president, has assumed responsibility for all remaining reports,
including FR2900 (Report of
Transaction Accounts, Other

Deposits and Vault Cash). Ed's region. Tim's phone number
telephone number is (314)
remains the same-(314)
Also effective Sept. 19, Tim
Bosch, assistant vice president,
assumed respon~i~ility,for
EDP, trust and related spec!aJty _
supervision. Tim retains his
current responsibilities for safety
and soundness supervision in
the Eighth District's western

Oct. 23 through 29 is
National Consumers Week.
The 1994 theme, "Know Your
Consumer Rights," is designed
to increase consumer awareness
and promote positive action in

the'marketplace. Your institution should receive more
information soon.



' Post Office Box 442
St. Louis, Missouri /63166


Supen;isory Issues is published '
bi-monthly 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
Sue Gerker, 314-444-8758. ·
Federal Reserve Bank of St. Louis

ank holdi~g comp