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From Banking and Finance Law Daily, June 6, 2013

Banks Provided Supervisory Expectations for Credit-Risk Due Diligence

By John M. Pachkowski, J.D.

In its latest issue of Supervisory Insight, the Federal Deposit Insurance Corporation discusses the new standards of creditworthiness banks now must apply to investment portfolios. These standards reinforce the importance of effective credit risk due diligence by financial institutions.

The FDIC’s article “Credit Risk Assessment of Bank Investment Portfolios,” which was written by Eric W. Reither, Senior Capital Markets Specialist at the agency’s Division of Risk Management Supervision, provides banks with supervisory expectations for credit risk due diligence of their investment portfolios, offers examples of how to conduct due diligence, and lists questions examiners may consider when assessing an institution's credit risk management practices.

The article was a response to queries by banks seeking clarification of a final rule and guidance issued by the Office of the Comptroller of the Currency to implement Section 939A of the Dodd-Frank Act. Section 939A was the Congressional response to the financial crisis, which exposed deficiencies in credit ratings assigned by nationally recognized statistical rating organizations for certain fixed-income securities, such as structured products tied to the residential real estate market. Pursuant to Section 939A, the federal banking agencies were required to remove language in banking regulations that called for reliance on external credit ratings to form judgments about a fixed-income obligor’s repayment capacity. The FDIC noted that although the “OCC rule was directed to nationally chartered financial institutions, state-chartered institutions should also adhere to the rule and guidance since state banks are generally prohibited from engaging in an investment activity not permissible for a national bank.”

Focus shifted. The FDIC noted that the actions taken by the agencies to implement Section 939A have not substantively changed the standards banks should consider when evaluating a fixed-income instrument’s creditworthiness, permissibility, and adverse classification. Going forward, examiners will focus less on credit ratings and more on the adequacy of pre-purchase analysis, integration of various credit factors other than credit ratings, and monitoring procedures. The depth of due diligence that examiners expect will depend in part on the size, complexity, and risk characteristics of the securities portfolio. For example, institutions with high concentrations of particular types of securities relative to capital would be expected to perform more comprehensive due diligence and ongoing monitoring.

Good-faith progress. The article states that as methods for measuring and monitoring credit risk in the investment portfolios will evolve, and best practices will emerge, FDIC examiners, at their initial examination reviews, will work with banks as they transition away from a ratings-centric bond selection and monitoring process, provided bank management demonstrates that it has made good-faith progress to comply with the OCC rule. Doreen R. Eberley, Director of the FDIC’s Division of Risk Management Supervision, noted, “We understand there will be a learning curve as bankers develop appropriate due diligence methodologies, and we are providing an example of the type of analysis a bank could perform.”

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