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FDIC, FRB, OCC, OTS: Proposed Statement on Complex Structured Finance Transactions

ABA Contact: Paul Smith, (202) 663-5331
                          Gwen Ritter, (202) 663-4986
Published: 69 Federal Register 28980; May 19, 2004
Comments Due: July 19, 2004
Disposition: Filed

The Agencies has proposed a statement on risk management of complex structured finance transactions (CSFT).  Preliminary discussion with some bankers has tentatively identified these issues as important to comment upon:

1.  The guidance appears to place too much responsibility on the bank for the customers that buy and want structured deals, their accounting, their business purpose for doing the deal, whether it makes good economic sense for the customer to do the deal or are they trying to avoid financial reporting, tax, or compliance issues.

2.  A concern that the definition of what is a structured product is woefully too broad.

3.  Concern over how to assess "reputational" risk to the bank to sell to any customer.

4.  Concern about all the information and analysis that would be required including to be kept in a "binder" that is reported to the Board of Directors, as well as possible overload on the directors.

5.  Concern that the broad scope of the proposal will impose a very significant burden on small banks (of which we have a great many more than the U.K.)

6.   Concern that the proposal goes well beyond current industry practice on handling these financings and would require major changes in internal controls and reporting.

Summary of the Proposed Statement

The Statement defines a CSFT as one that exposes a financial institution to elevated levels of market, credit, operational, legal or reputational risks. They usually:

a.  result in a final product that is often non-standard and structured to meet the specific financial objectives of a customer;

b.  often involve professionals from multiple disciplines within the financial institution and may have significant fees or high returns in relation to the market and credit risks associated with the transaction; and

c.  may be associated with the creation or use of one or more special purpose entities designed to address the economic, legal, tax or accounting objectives of the customer and/or the combination of cash and derivative products.

The statement sets out a number of standards of practice for the Board of Directors and senior management, including that the Board should establish the institution's threshold for risks in CSFT and ensure a strong risk control framework for CSFT is in place.

Senior management should implement a risk control framework for CSFTs that includes comprehensive policies, defined roles and responsibilities and approval authorities, detailed management reporting, required documentation, and ongoing independent monitoring and testing of policy compliance. The Agencies suggest that management might create a senior management risk-control committee to ensure that products that with higher levels of financial, legal and reputational risk are comprehensively and consistently managed and controlled on a firm-wide basis. One overriding theme of the statement is that an institution is expected to fully understand the customers' business objectives for entering into a complex structured financial transaction.

Board and senior management also should send a strong organizational message about the importance of integrity, compliance with the law, and overall good business ethics. Incentive plans are not structured in a way that encourages crossing ethical boundaries when executing CSFTs.

An institution's policies and procedures should define what constitutes a CSFT and, at a minimum, address the following subjects:

1.  Transaction Approval: The policies should define the process that financial institution personnel must follow to obtain approval for CSFTs. The approval process should involve both transactors, such as personnel from the sales, marketing and trading areas, and independent control staff, such as personnel from risk management, accounting and legal areas. Policies should clearly outline when third-party legal, accounting and/or tax professionals should be engaged to consult on the transactions.

2. New Product: The policies should establish a control process for the approval of all "new" complex structured finance products. In determining whether a product is "new," the institution should consider any structural variations from existing products; whether the product is targeted at a new class of customers; pricing variations from existing products; whether the product raises additional or new legal, compliance or regulatory issues; and deviations from standard market practices. The New Product policy should also address the roles and responsibilities of all relevant financial institution personnel.

3.  Reputational and Legal Risk Management: The policies should ensure that a financial institution identifies a CSFT that has elevated levels of reputational and legal risks and appropriately manages these risks. The policies should ensure that the customer understands the risk-return profile of a particular transaction and outline the responsibilities of financial institution personnel to analyze and document a

customer's objectives and customer-related accounting, regulatory and tax issues. The legal risk management policies should enable the financial institution to (i) assess a customer's business objectives for entering into a transaction; (ii) analyze the economic substance of a transaction; (iii) evaluate the appropriateness of the transaction; and (iv) prevent the institution from participating in inappropriate transactions.

4.  Accounting and Disclosure by Customers: The policies should ensure that financial institution staff appropriately reviews and documents the customers' proposed accounting treatment of complex structured finance transactions, financial disclosures relating to the transactions, and business objectives for entering into the transactions.

5.  Documentation Standards: The polices should provide for the generation, collection and retention of appropriate documentation relating to all complex structured finance transactions. The documents retained should include standard legal documents, as well as any ancillary documents, such as notes from customer meetings and third-party opinions. The Statement also specifically states that the documentation polices should seek to ensure that all counterparty obligations are reduced to legally enforceable written contracts. This should include the use of term sheets, confirmations, master agreements, netting agreements and collateral agreements.

6.  Reporting to the Board of Directors and Senior Management: The policies should ensure that the board of directors and senior management of the financial institution receive appropriate and timely reports concerning the complex structured finance activities of the institution.

7.  Independent Monitoring: The policies should provide for periodic independent reviews of the institution's complex structured finance activities to ensure that the institution's policies and controls are being implemented effectively and to identify potential compliance issues.

8.  Audit: The policies should ensure effective internal audit coverage of the institution's complex structured finance activities, which will require personnel that have the necessary skills and experience to understand the structured transactions and to identify and report on compliance with financial institution policy and procedures.  Outside consultants may be needed.

9.  Training: Financial institution personnel should receive appropriate training concerning the institution's policies and procedures governing its complex structured finance activities.

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