SECURITIES AND DERIVATIVES
Investment activities can provide banks with earnings, liquidity, and capital appreciation, but can also increase risk exposure, such as:
- Market risk
- Credit risk
- Liquidity risk
- Operating risk
- Legal risk
- Settlement risk
- Interconnection risk
Policy Statement
Provides guidance and sound principles for managing investment risks. The policy covers all securities used for investment purposes and all end-user derivative instruments used for non-trading purposes. The policy statement:
- Underscores the importance of Board oversight and management supervision
- Emphasizes effective risk management
- Contains no specific constraints on holding “high risk” mortgage derivative products
- Eliminates the requirement to obtain the specific regulatory volatility test for mortgage derivative products
- Applies to all permissible investment securities and end-user derivatives
Policy statements suggest that banks implement programs to management investment risk. Adequate programs identify, measure, monitor, and control these risk
- Failure to understand and adequately manage investment activity risks is an unsafe and unsound practice
Risk Management Process
Effective risk management program should include:
- Board adopts policies that establish clear goals and risk limits
- Board should review and act upon management’s reports
- Board should establish an independent review function and review its reports
- Management should develop investment strategies to achieve the Board’s goals
- Management should analyze and select investments consistent with its strategies
- Management should maintain an effective internal control program
- Management should regularly measure the portfolios risk levels and performance
- Management should provide reports to the Board
- Board and management should periodically evaluate and, when warranted, modify the program
Banks are permitted to manage risk on an:
- Individual instrument basis
- Aggregate portfolio basis
- Whole bank basis
Individual Basis
- Each instrument’s risk and return is evaluated independently
- For banks engaged in less complex activities
Aggregate Portfolio Basis/Whole Bank Basis
- Management evaluates an instrument’s contribution to overall portfolio risk and return
- For banks with complex or extensive investment activities
Advantages for using the aggregate portfolio or whole bank basis over individual:
- Integrated management of risk and return
- Understanding of each instrument’s contribution to overall risk and return
- Increased flexibility when selecting instruments
POLICIES, PROCEDURES, AND RISK LIMITS
Board is responsible for adopting comprehensive, written investment policies that clearly express the Board’s investment goals and risk tolerance. Policy should address:
- Boards investment goals
- Authorized activities and instruments
- Internal controls and independent review
- Selecting broker/dealers
- Risk limits
- Risk and performance measurement
- Reporting
- Accounting and taxation
- More specifically, policy should:
- Articulate the investment portfolio’s purpose, risk limits, and return goals
- Describe all authorized investment activities
- Detail characteristics of authorized instruments
- Delegate investment authority
- Establish guidelines for selecting securities broker/dealers and limit credit exposure to them
- Establish when/which investments are necessary to perform pre-purchase analysis
Management should analyze the risks in an instrument that has not been authorized and should seek the Board’s permission to alter the list of authorized instruments before purchase
Risk Limits
Board approves risk limits; management should set these limits.
- Risk limits should be expressed relative to meaningful standards (such as capital or earnings). Can be expressed in terms of bank-wide risk, investment portfolio risk, portfolio segment risk, or individual instrument risk
- Limits should be placed on:
- Market risk
- Credit risk
- Liquidity risk
- Asset types
- Maturities
- Market Risk
- Quantify maximum price sensitivity as percentage of capital or earnings
- Credit Risk
- Restrict management to investment grade instruments or non-rated instruments consistent with investment grade standards
- Liquidity Risk
- Restrict positions in less marketable instruments – generally obscure issues, complex instruments, defaulted securities, and instruments with thin markets
- Asset Type
- Limit concentrations
- Diversify
- Maturity
- Restrictions on the maximum stated maturity, weighted average maturity, or duration of investments
Establish a standard risk measurement methodology that captures all risk mentioned above
Internal Controls
- Internal controls provide the first line of defense against operating risk
- Separation of duties between individuals who execute, settle, and account for transactions should exit
- Internal control program should include procedures for the following:
- Portfolio valuation
- Personnel
- Settlement
- Physical control and documentation
- Conflict of interest
- Accounting
- Reporting
- Independent review
- Internal controls should promote efficiency, reliable internal/regulatory reporting/compliance with policies and laws
- Portfolio Valuation
- Independent portfolio pricing
- Personnel
- Sufficient staffing resources and expertise
- Settlement
- Physical Control and Documentation
- Possessing and controlling purchased instruments
- Saving and safeguarding important documents
- Invoice review
- Invoices and confirmations display each instrument’s original purchase price
- Review can also be used when determining if the bank is involved in any of the following inappropriate activities:
- Engaging one dealer for all transactions
- Purchasing from or selling to the bank’s trading department
- Inaccurate reporting
- Conflict of Interest
- Guidelines should govern all employees authorized to purchase and sell securities
- Guidelines should ensure that all employees act in the bank’s best interest
- Describe circumstances and limits for accepting gifts, gratuities, or travel expenses from brokers/dealers
- Accounting
- Reporting
- Independent Review
- Independent review may encompass external audits or an internal audit program
- Evaluation by personnel independent of the portfolio management function is ok
- Independent review should assess:
- Adherence to policies and risk limits
- Risk measurement system’s adequacy and accuracy
- Reporting system’s timeliness, accuracy, and usefulness
- Personnel resources and capabilities
- Compliance with regulatory standards
- Internal control environment
- Accounting and documentation practices
- Conflicts of interest
- Independent review findings should be reported directly to the Board at least annually
Unsuitable Investment Activities
Trading activity within the HTM or AFS portfolio is unsuitable and may be considered unsafe and unsound
- Bank’s internal controls should be designed to prevent the following:
- Gains Trading – the purchase and subsequent sale of a security at a profit after a short holding period, while securities acquired for this purpose that cannot be sold at a profit are retained in the AFS or HTM portfolio. (Look for banks with high realized gains and high unrealized losses)
- When-Issued Security Trading – the buying and selling of securities in the period between the announcement of an offering and the issuance and payment date of the securities. (Happens before the delivery and payment of the securities)
- Pair-offs – security purchase transactions that are closed-out or sold at or before the settlement date. An institution commits to purchase a security and then, before the predetermined settlement date, the bank pairs-off the purchase with a sale of the same security. (Settled net)
- Extended Settlement – the use of a securities trade settlement period in excess of the regular-way settlement period. The use of a settlement period in excess of the regular-way settlement period to facilitate speculation is considered a trading activity
- Repositioning Repurchase Agreement – offered by a dealer to allow an institution that has entered into a when-issued trade or a pair-off that cannot be closed out at a profit on the payment or settlement date to hold its speculative position until the security can be sold at a gain.
- Short sale – the sale of a security that is not owned. Purpose is to speculate on a fall in the price of a security. Should be conducted in the trading portfolio. A short sale that involves the delivery of a the security sold short by borrowing it from the bank’s AFS or HTM portfolio should be reported as a sale of the security, not as a short sale.
- Adjusted Trading – the sale of a security to a broker or dealer at a price above the prevailing market value and the simultaneous purchase and booking of a different security, frequently a lower rate or quality issue or one with a longer maturity, at a price above its market value. These types of transactions are prohibited and may be a violation
RISK IDENTIFICATION, MEASUREMENT, AND REPORTING
Market Risk
Possibility that an instrument will lose value due to a change in price of an underlying instrument, change in the value of an index, or change in interest rates
- Three types of market risk:
- Price Risk – possibility that an instrument’s price fluctuation will unfavorably affect income, capital, or risk reduction strategies. Usually influenced by other risk.
- Interest Rate Risk - changes in value due to changes in interest rates
- Yield Curve – change in value due to a non-parallel yield curve shift
- Basis Risk – possibility that an instrument’s value will fluctuate at a rate that differs from the change in value of a related instrument
Credit Risk
Possibility of loss due to a counterparty’s or issuer’s default, or inability to meet contractual payment terms.
- The amount of credit risk equals replacement cost of an identical instrument (assess market value)
- Exchange traded derivatives contain minimal credit risk
- Credit risk can also involves the selecting of a broker/dealer. Management should at a minimum:
- Review each firms most current financial statements and evaluate its ability to honor its commitments
- Inquire into the reputation of the firm by contacting previous or current customers
- Review state/federal information on the firm and broker/dealer
Liquidity Risk
Possibility that an instrument cannot be obtained, closed out, or sold at its economic value
Operational Risk
Possibility that inadequate internal controls or procedures, human error, system failure or fraud can cause losses
Legal Risk
Possibility that legal action will preclude a counterparty’s contractual performance. Occurs when a contract or instrument violates laws or regulations.
Settlement Risk
Possibility of loss from a counterparty that does not perform after the investor has delivered funds or assets.
Interconnection Risk
Possibility of loss due to changes in interest rates, indices or other instrument values that may or may not be held by the investor.
Risk Measurement
- Authorized investment instruments should be segregated into groups of like risk characteristics
- Pre-purchase analysis on instruments that are not relatively simple or standard and the risk are not fully known by the bank
- On-going analysis of risk
- Risk should be measured
Risk Reporting
- Board must review periodic investment activity reports
- Management’s reports to the Board should:
- Summarize all investment activity
- Clearly illustrate investment portfolio risk and return
- Evaluate management’s compliance with policies and limits
- List exceptions to policy and regulatory requirements
- Management should:
- Ensure compliance with policies and regulatory requirements
- Evaluate portfolio performance
- Present exceptions for approval before engaging in an unauthorized activity
- Board may consider changing its policies to permit an activity
BOARD AND SENIOR MANAGEMENT OVERSIGHT
Board Oversight
Board should adopt policies that establish guidelines for management and periodically review management’s performance. The Board should:
- Approve broad goals and risk limits
- Adopt major investment and risk management policies
- Understand the approved investment activities
- Ensure competent investment management
- Periodically review investment activity
- Require management to demonstrate compliance with policies and risk limits
- Mandate an independent review program and review its findings
Management Oversight
Management is responsible for daily oversight of all investment activity. Management should:
- Establish policies, procedures, and risk limits to achieve the Board’s goals
- Implement strong internal control environment
- Understand all approved investment activities and related risk
- Identify, measure, monitor, and control investment activity risk
- Report investment activity and risk to the Board
- Ensure that staff is competent and adequately trained
- Adhere to securities broker/dealer selection policies
Board and management may obtain professional advice for investment activities; however, their responsibilities can not be transferred to another party
Delegation of Investment Authority
- Investment authority may be delegated to a third party
- Board and management must understand every investment’s risk, return, and cash flow characteristics even if third party has investment authority
- If management does not understand an investment’s risk characteristics, the bank should not engage in that activity until it possesses the necessary knowledge
- Third party arrangements should be governed by a formal written agreement that specifies:
- Compensation
- Approved broker/dealers
- Investment goals
- Approved activities and investments
- Risk limits
- Risk and performance measurement
- Reporting requirements
- Settlement practices
- Independent review
- Written agreements should require that all trade invoices, safekeeping receipts, and investment analysis are readily available to the bank
Program Evaluation
- Evaluations should be performed annually, quarterly in larger/more complex banks
- For Evaluation Board should:
- Review management reports, including investment activity summary, portfolio risk and performance measures, and independent review findings to determine if:
- Stated goals accurately represent the Board’s objectives
- Risk limits reflect Board’s risk tolerances
- Risk limits protect bank’s safety and soundness
- Management pursues Board’s goals
- Internal controls remain adequate
- Any new activities warranted
- Policies provide sufficient guidance for management
- Management’s responsibilities include:
- Measuring portfolio risk and performance
- Validating risk measurement systems adequacy and accuracy