I. INTRODUCTION
The Federal Reserve Board (FRB) adopted a final rule relating to interbank liabilities as prescribed by Section 308 of the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA).
The final rule requires banks to develop and implement written policies and procedures to effectively evaluate and control significant risk exposure to correspondent banks. The rule also establishes a general “limit” stated in terms of the exposed bank’s capital for overnight credit exposure to an individual correspondent. Under the rule, a bank ordinarily should limit its credit exposure to an individual correspondent to an amount equal to not more than 25 percent of the exposed bank’s total capital, unless the bank can demonstrate that its correspondent is at least “adequately capitalized.” While no limit is specified by the rule for credit exposure to correspondents that are at least “adequately capitalized,” a bank is required to establish and follow its own internal policies and procedures with regard to exposure to all correspondents, regardless of capital level.
The effective date of the final rule was in December of 1992. Banks were required to have the internal policies and procedures, as required by the rule, in place during June of 1993.
II. PRUDENTIAL STANDARDS
During 1993, a bank was required to adopt internal policies and procedures to address the risk arising from exposure to a correspondent, taking into account the financial condition of the correspondent and the size, form and maturity of the exposure. For purposes of the rule, “correspondent” includes both domestically chartered depository institutions that are federally insured and foreign banks, but does not include a commonly controlled correspondent. The final rule allows banks to adopt flexible policies and procedures to meet this requirement in order to permit banks to allocate resources in a manner that will result in real reductions in risk, while minimizing the burden of compliance with the rule.
III. STANDARDS FOR SELECTING CORRESPONDENTS
The policies and procedures established by a bank in selecting correspondents and terminating those relationships, must take into account credit and liquidity risks, including operational risks. Where a bank’s exposure to a correspondent is significant, considering the size and maturity of the exposure and the condition of the correspondent, the bank must periodically review the financial condition of the correspondent. In determining if the bank’s exposure is significant, the bank may wish to utilize a formula based upon a percentage of the bank’s annual earnings or a percentage of the bank’s total risk-based capital. In reviewing the financial condition of the correspondent, the bank should review a number of factors, such as the capital level, level of non-accrual and past due loans, level of earnings, and other factors affecting the financial condition of the correspondent, and should take into account any deterioration in the condition of the correspondent.
IV. INTERNAL LIMITS
Where the financial condition of the correspondent and the form of maturity of the exposure create a significant risk that payments will not be made in full, or in a timely manner, a bank’s policies and procedures must limit the bank’s exposure to the correspondent, either by the establishment of internal limits or by other means. The internal limits established by a bank must be consistent with the risk undertaken, considering the financial condition and the form and maturity of exposure to the correspondent. A bank need not set one overall limit on exposure to a correspondent, but may instead set separate limits for different forms of exposure, products or maturities.
For significant sources of exposure for which the establishment of internal limits are required, a bank may either structure transactions with a correspondent or monitor exposure to a correspondent to ensure that its exposure ordinarily remains within the internal limits established by the bank. Where monitoring is employed, the level of monitoring required is dependent upon: (1) the extent to which exposure approaches the bank’s internal limits; (2) the volatility of the exposure; and (3) the financial condition of the correspondent. If it is determined that there is a “significant” risk that your correspondent will not pay in full, or on time, it would be prudent to close out the exposure as quickly as possible, consistent with safe and sound banking practices.
While the requirement of monitoring or structuring of transactions to which limits apply is intended to ensure that exposure generally remains within the established limits, the final rule recognizes that occasional excesses over limits may result from factors such as unusual market disturbances, market movements favorable to the bank, increases in activity, operational problems, or other unusual circumstances. However, the regulation requires a bank to establish appropriate procedures to address excesses over its internal limits.
The rule also requires that the policies and procedures established by a bank must be reviewed and approved by the bank’s board of directors at least annually.
V. LIMITS ON CREDIT EXPOSURE
Subject to the transitional rules established by the regulation, a bank’s overnight credit exposure to an individual correspondent must be limited to not more than 25 percent of the bank’s total capital, unless the bank can demonstrate that its correspondent is at least adequately capitalized. To maintain status as “adequately capitalized” the correspondent must have: (1) a total risk-based capital ratio of 8 percent or greater; (2) a Tier one risk-based capital ratio of 4 percent or greater; and (3) a leverage ratio of 4 percent or greater. The rule does not specify limits for credit exposure to adequately or well-capitalized correspondence.
VI. CALCULATION OF CREDIT EXPOSURE
Credit exposure of a bank to a correspondent is based on the assets and off-balance sheet transactions against which the bank must maintain capital under the risk-based capital guidelines. Credit exposure specifically excludes settlement exposure, transactions in which the bank acts as agent and other forms of exposure that are not covered by the capital adequacy guidelines.
There are five exclusions from the scope of credit exposure, which are as follows:
A. Transactions that are fully secured by government securities or readily marketable collateral having a current market value equal to 100 percent of the credit exposure under the transaction. This would include reverse repurchase agreements;
B. The proceeds of checks and other cash items deposited in an account at a correspondent that are not yet available for withdrawal;
C. “Quality assets” on which the correspondent is secondarily liable or that result in secondary exposure to the correspondent. This would include loans to third parties secured by stock or debt obligations of the correspondent, loans to third parties purchased from the correspondent with recourse, and loans or obligations of third parties backed by stand-by letters of credit issued by the correspondent;
D. Exposure that results from the merger with or acquisition of another bank for one year after that merger or acquisition is consummated; and
E. The portion of the bank’s exposure to the correspondent that is covered by federal deposit insurance.
The supplemental information also states that correspondent obligations held by a bank in a fiduciary capacity are excluded because they do not expose the bank itself to loss due to credit liquidity or operational problems and thus do not meet the definition of exposure.
VII. CONCLUSION
Under the regulation, as of June 19, 1993, banks were required to document internal policies and procedures for monitoring credit exposure to other banks. By June 19, 1995, the limit on credit exposure to correspondents that a bank was unable to demonstrate were at least “adequately capitalized,” were required to be permanently established at 25 percent of the exposed bank’s capital.