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Capital-Markets Activities Manual
Policy : Preparation for Examination
Source: Federal Reserve
(The complete Activities
Manual (pdf format) can be downloaded from the Federal Reserve's web
The globalization of markets, increased transaction
volume and volatility, and the introduction of complex products and trading
strategies have led capital-markets and trading activities to take on
an increasingly important role at financial institutions over the last
decade. These activities include the use of a range of financial products
and strategies, from the most liquid fixed income securities to complex
derivative instruments. The risk dimensions of these products and strategies
should be fully understood, monitored, and controlled by bank management.
Accordingly, adequate risk-management systems and controls at financial
institutions are essential to prevent losses and protect capital. The
role of regulators in supervising capital markets and trading activities
is to evaluate management's ability to identify, measure, monitor, and
control the risks involved in these activities and to ensure that institutions
have sufficient capital to support the risks they take. The level of risk
an institution may reasonably assume through capital-markets and trading
activities should be determined by the board of directors' stated tolerance
for risk, the ability of senior management to effectively govern these
operations, and the capital position of the institution.
OVERVIEW OF RISK
For capital-markets and trading activities,
risk is generally defined as the potential for loss on an instrument,
portfolio, or activity. Thus, the risks referred to in this manual will
be discussed in terms of the impact of some event on value (value-at-risk)
and income (earnings-at-risk) from the instrument, activity, or portfolio
Risk management is the process by which managers identify, assess, monitor,
and control all risks associated with a financial institution's activities.
The increasing complexity of the financial industry and the range of financial
instruments have made risk management more difficult to accomplish and
to evaluate. In more sophisticated institutions, the role of risk management
is to identify the risks associated with particular business activities
and to aggregate summary data into generic components, ultimately allowing
exposures to be evaluated on a common basis. This methodology enables
institutions to manage risks by portfolio and to consider exposures in
relationship to the institution's global strategy and risk tolerance.
A financial institution's risk-management process should not only be assessed
by business line, but also in the context of the global, consolidated
institution. A review of the global organization may reveal risk concentrations
not readily identifiable from the limited view of a branch, agency, Edge
Act institution, non-bank subsidiary, or head office on a stand-alone
basis. The consolidation of risk information also allows the institution
to identify, measure, and control its risks, while giving the necessary
consideration to the breakdown of exposure by legal entity. Sometimes,
if applicable rules and laws allow, identified risks at a branch or subsidiary
may be compensated for by offsetting exposures at another related institution.
However, this management of risks across separate entities must be done
in a way that is consistent with the authorities granted to each entity.
Some financial institutions and their subsidiaries may not be permitted
to hold, trade, deal, or underwrite certain types of financial instruments,
including some of those instruments discussed in the 4000 sections of
this manual, unless they have specifically received regulatory approval.
Furthermore, conditions and commitments may be attached to regulatory
approvals to engage in certain capital-markets activities. Examiners should
ensure that financial institutions have the proper regulatory authority
for the activities they engage in and that activities are conducted consistent
with their specific regulatory approvals.
Ideally, an institution should be able to identify the relevant generic
risks and should have measurement systems in place to conceptualize, quantify,
and control these risks on an institutional level using a common measurement
framework. However, it is recognized that not all institutions have an
integrated risk-management system that aggregates all business activities.
In addition, risk-management methodologies in the marketplace and an institution's
scope of business are continually evolving, making risk management a dynamic
process. Nonetheless, an institution's risk-management system should always
be able to identify, aggregate, and control all risks posed by capital-markets
and trading activities that could have a significant impact on capital
Examiners need to determine the ability of the institution's risk-management
system to measure and control risks. The assessment of risk-management
systems and controls should be performed by type of instrument and type
of risk. Some of the risks inherent in the trading process are described
• Market (price) risk is the risk that the value of a financial
instrument or a portfolio of financial instruments will change as a result
of a change in market conditions (for example, interest-rate movement).
• Funding-liquidity risk refers to the ability to meet investment
and funding requirements arising from cash-flow mismatches.
• Market-liquidity risk refers to the risk of being unable to close
out open positions quickly enough and in sufficient quantities at a reasonable
price to avoid adverse financial impacts.
• Counterparty credit risk is the risk that a counterparty to a
transaction will fail to perform according to the terms and conditions
of the contract, thus causing the holder of the claim to suffer a loss
in cash flow or market value.
• Clearing/settlement credit risk is (1) the risk that a counterparty
who has received a payment or delivery of assets defaults before delivery
of the asset or payment or (2) the risk that technical difficulties interrupt
delivery or settlement despite the counterparty's ability or willingness
• Operations and systems risk is the risk of human error or fraud
or the risk that systems will fail to adequately record, monitor, and
account for transactions or positions.
• Legal risk is the risk that a transaction cannot be consummated
because of some legal barrier, such as inadequate documentation, a regulatory
prohibition on a specific counterparty, and non-enforceability of bilateral
and multilateral close-out netting and collateral arrangements in bankruptcy.
• Reputational risk is the risk arising from negative public opinion
regarding an institution's products or activities.
The examiner must be prepared to identify and evaluate exposures that
arise out of any part of a capital-markets operation. To that end, the
examiner must become familiar with the institution's overall reporting
structure and segregation of duties, range of business activities, global
risk-management framework, risk-measurement models, and system of internal
controls. Furthermore, the examiner must assess the qualitative and quantitative
assumptions implicit in the overall risk-management system and the effectiveness
of the institution's approach to controlling risks. In addition, the examiner
must determine that the management information system and other forms
of communication are adequate for the institution's level of business
Banking supervision is a dynamic process and this is especially evident
in the oversight of capital-markets and trading activities. As capital
markets, financial instruments, and secondary market activities continue
to expand and develop, they have an increasingly significant impact on
the safety and soundness of financial institutions. Consequently, it has
become equally necessary for bank supervisors to focus their attention
on the capital-markets and trading activities arena. Policies and practices
for evaluating the exposures, management tools, and controls employed
by banking institutions have had to be constructed and adapted to keep
pace with changes in the industry. In this context, the manual encourages
the examiner to ask the following basic questions:
• Are the tools employed by management to measure and monitor risk
• Is the level of risk exposure appropriate given the financial
institution's size, sophistication, and financial condition?
• Are the risks in the institution's portfolio of products and
activities recognized, understood, measured, and managed?
• Are the activities conducted consistent with the goals and risk
tolerance of senior management and the board of directors?
To prepare for the on-site portion of the examination of any capital-markets
or trading activity, a preliminary overview of the range of products and
activities of the institution should be developed. This overview will
help examiners formulate a scope and objective for the upcoming exam that
is consistent with the types and levels of risk exposure assumed by the
The review of trading activities is generally
conducted on the basis of a financial institution's organizational structure.
These structures may vary widely depending on the size and sophistication
of the institution, the markets and geographies in which it competes,
and the objectives and strategies of its management and board of directors.
Many banks and bank holding companies have several subsidiaries that conduct
business independent of affiliated entities, and some branches and agencies
may operate autonomously. The overlap of business lines, sharing of information
and personnel, and transaction netting agreements that exist among affiliated
legal entities force examiners to go beyond the basic business-unit review
and focus on functional exposures within the global institution. It is
also important for an examiner to ensure that an institution respects
divisions between legal entities, such as firewall and bank/non-bank separations.
For example, while a bank holding company must be aware of the level of
its consolidated risk, it cannot ignore legal boundaries completely in
the management of that risk. Exposure in the bank is not automatically
hedged by offsetting positions in the bank holding company and vice versa.
In some cases, transactions may be offset by a transaction between these
affiliates which may, however, be subject to other regulatory requirements.
Bank holding companies should manage and control risk exposures on a consolidated
basis, while recognizing legal distinctions among subsidiaries. Examiners
should always maintain a view of the ''big picture'' impact of capital-markets
and trading activities on consolidated risk exposure.
The examiner team should meet before the examination begins to summarize
the institution's status and assign responsibilities for completing preparatory
work. Generally, examination assignments may be segregated based on products,
activities, or functions. For example, for trading operations, examiners
may be given administrative responsibility for the following areas of
• interest-rate products including fixed-income securities, swaps,
futures, forward-rate agreements (FRAs), options, caps, and floors
• currency-related activities including customer-driven and discretionary
foreign-exchange (FX) trading, cross-currency transactions, and currency
derivatives (for example, currency options, forwards, futures, and swaps)
• equity-based products and activities including equity options,
warrants, and swaps
• commodity-based products and activities including commodity futures,
options, and forwards
Other capital-markets activities, such
as asset securitization or secondary-market credit activities may be assessed
by specific activity, function, or product. To prepare examiners for their
assignments, the following initial procedures should be followed to achieve
the required scope and coverage of the institution's activities.
• Determine the extent of work performed during the past year by
auditors and regulatory agencies (these would include, but not be limited
to, the institution's internal auditors, the various exchanges, the Securities
and Exchange Commission, the Commodity Futures Trading Commission, the
National Association of Securities Dealers, the National Futures Association,
and the Internal Revenue Service).
• Review deficiencies identified by audit reports and reports of
• Obtain a listing of the names, qualifications, functions, and
positions of key trading and front- and back-office personnel, and a current
organizational chart. This material should be available in prior examination
and inspection reports.
• Evaluate the volume of transactions and the dollar value of positions
held in each trading product and activity. These data may be found in
various regulatory reports.
• Using the audit findings on the effectiveness of controls over
capital-markets and trading activities, evaluate the examination scope
to assess organizational and reporting changes, identify perceived weaknesses,
and highlight patterns of error.
Specific items which should be reviewed
during the pre-examination process for capital-markets and trading activities
include the following:
• Regulatory reports. During the planning stages of an examination,
the examiners may estimate activity volumes and diversity of instruments
and activities from periodical regulatory reports. This information will
help in the development of an examination scope and objective, as well
as in the determination of staffing and resource requirements.
• Prior report of examination. The findings and conclusions of
the prior examination are invaluable to the preparation of the scope and
objectives of the current examination. Examination reports provide insight
into bank management's policies and practices in measuring and managing
risk, the extent of risk exposure in a given product and/or activity,
and the overall adequacy of the trading-activity control environment.
• Audit reports. Internal and external audits are often focused
on the activities of individual business units and may not encompass aggregate
exposures and controls. Nevertheless, they are useful in identifying exceptions
to internal policies and specific violations such as limit exceptions.
Management's responses to audit findings are also useful in identifying
corrective actions and the direction of the unit.
• Correspondence since the last examination. An additional resource
that should be reviewed before an examination is the correspondence file.
This will contain important information such as management's response
to the prior examination findings, any applications submitted to the Federal
Reserve (for additional powers, mergers, and acquisitions), and any supervisory
action or agreement that may exist.
• Outstanding applications. The examiner-in-charge should inquire
about the status of any outstanding applications before the Federal Reserve
Board that may suggest expansion in the capital-markets and trading activities
of the banking institution.
In preparation for an on-site examination,
examiners will often need to customize the first-day letter questionnaire
to reflect the specific focus of the capital-markets review. The focus
will reflect the range of products and activities of the institution as
well as management's approach to risk control. The following is a brief
list of core requests to be made in the first-day letter:
• a copy of the organization charts (including name and title of
managers) for the capital markets or global-trading operations to be assessed,
including functional and legal-entity organization
• a copy of the institution's written risk-management policies
and procedures that outline the instruments traded, their associated risks,
and the monitoring of the risks
• a copy of established limits for each principal type of risk
as well as documentation indicating periodic approval by the board of
• general-ledger and subsidiary-ledger accounts identifying the
range and level of activity as of the examination date
• management information reports used in the global, functional,
or legal-entity oversight of market- and credit-risk management
• detailed information on transactions that are unique or uncommon
• copies of management reports issued in connection with the bank's
new financial products that were put in place since the last examination
indicating the office at which such activity is conducted, the lines and
limits established for each activity, and the perceived risks associated
with each activity
• a description of the scope and frequency of internal and external
audits of the institution's capital-markets and trading activities and
copies of audits, including working papers, conducted of capital-markets
operations since the last examination
The first-day letter to an institution that engages in capital-markets
or trading activities and the use of derivatives usually will be much
more precise and comprehensive than this list, depending on the institution's
range of products and activities. Significantly more detail should be
requested relative to the objectives of the trading operations, the activities
in which the institution engages, the products it uses, and the risk-management
methods and reports it relies on. The first-day letter should also include
requests for detailed information related to the areas highlighted in
the market, credit, liquidity, and operational risk sections of this manual.
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