The federal bank regulatory agencies Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Federal Reserve Board, Office of Thrift Supervision (the Agencies or the Regulators) have issued final guidance addressing Correspondent Concentration Risks (the Guidance). The Guidance sets forth regulatory guidelines for the identification, monitoring and management of credit and funding (liability) concentrations to other institutions, both on a stand alone and organization-wide basis. The Regulators intend the Guidance to facilitate appropriate due diligence and risk management by banks and savings associations (including their subsidiaries) and bank and savings and loan holding companies (including their nonbanking subsidiaries) with respect to credit exposure to and funding transactions with their correspondent organizations (including correspondents’ affiliates).

The Guidance defines “credit concentration risk” as arising when an institution advances or commits a significant volume of funds to a correspondent. The Guidance notes that the advancing institution’s assets are at risk if the correspondent fails to repay. According to the Guidance, credit concentrations can arise from a variety of correspondent activities. Those include due from bank accounts, federal funds sold as principal, over-collateralized repurchase agreements (or under-collateralized reverse repos), direct or indirect loans to or for the benefit of the correspondent, and investments in the correspondent, including trust preferred securities, subordinated debt and stock purchases. The Guidance indicates that the Agencies generally consider credit exposures of greater than 25 percent of total risk-based capital to be concentrations.

The Guidance defines a funding or liability concentration as a situation in which an institution depends on one or a few correspondents for a disproportionate share of funding. The primary risk of a funding concentration is that the institution could have to replace the funding on short notice if the correspondent abruptly limits the availability of access to liquid funds. The Guidance notes that, depending upon its size and characteristics, a concentration of credit for a lending institution may also be a funding exposure to the correspondent. The Guidance indicates that a specific funding concentration standard has not been established; however, it emphasizes that the Regulators have seen exposures as low as 5 percent of an institution’s total liabilities as presenting an elevated liquidity risk to the recipient institution.

The Guidance provides examples as to how correspondent concentration risk can arise. In the examples, Institution A has $400 million in total assets and is well capitalized with $40 million (10 percent) of total capital. Institution A maintains $10 million in its due from an account at Correspondent Bank (CB) and sells $20 million in unsecured overnight federal funds to CB. Together, the transactions reflect that Institution A has an aggregate risk exposure of $30 million (75 percent) of its total capital to CB. CB, which the example posits has $2 billion in total assets, $1.8 billion in total liabilities, and is well capitalized with $200 million (10 percent) of total capital, has a total of 20 Respondent Banks (RB) with the same credit exposures to CB as Institution A has to CB. The 20 RBs’ $600 million aggregate relationship represents 33 percent of CB’s total liabilities. The Guidance indicates that these relationships create significant funding risk for CB if a number of the RBs withdraw their funds over a short time frame.

The Guidance points out that the relationships could also threaten the viability of the 20 RBs. The loss of all or a significant portion of the RBs’ due from balances and unsecured federal funds sold to CB could substantially deplete their capital bases, resulting in multiple failures. According to the Guidance, the RB could be jeopardized if CB, in turn, had sold a significant portion of the federal funds from the RBs to another financial institution were it to fail abruptly. Further, financial institutions that rely on CB for account clearing services may find it difficult to transfer processing services to another provider quickly.

The Guidance recognizes that some concentrations meet business needs, such as the maintenance of large due balances from a correspondent to facilitate clearing activities. However, the Guidance indicates that the lack of diversification resulting from concentrations represents a risk that should be considered by management when creating strategic plans and internal risk limits.

The Guidance outlines the Regulators’ expectations regarding the measurement and monitoring of correspondent concentrations.

  • When identifying credit and funding concentrations for risk management purposes, gross and net exposures to the correspondent should be calculated both on a stand-alone and a correspondent organization-wide basis. The Guidance contains examples of proper calculation of exposures.
  • Prudent management of concentration risks requires written policies and procedures to prevent excessive exposure to any correspondent, particularly with reference to the correspondent’s financial condition. Thus, internal parameters should be established, commensurate with the nature, size and risk of the exposure, as to the information that will be periodically reviewed and documented for each correspondent on an ongoing basis. Pertinent analysis includes, but is not limited to, capital ratios, level of problem assets, earnings, deteriorating trends in capital or asset quality, levels of other real estate owned, credit rating downgrades and regulatory enforcement actions. The frequency of reviews should be adjusted as appropriate given the condition of the correspondent and general economic conditions.
  • Reviews should be comprehensive assessments of correspondents in the context of the internal parameters. Institutions should establish prudent internal concentration limits, as well as ranges or tolerances, for each factor being monitored for each correspondent. Plans should be developed for managing risk when the internal limits, ranges or tolerances are met or exceeded, either on an individual or collective basis. They should include procedures that provide for orderly and timely reductions of correspondent concentrations that exceed internal parameters. Such procedures could include reducing the volume of uncollateralized/uninsured funds, transferring excess funds to other correspondents after conducting appropriate reviews of their financial condition, requiring the correspondent to serve as agent instead of principal for federal funds sold, establishing limits on asset and liability purchases from and investments in correspondents and specifying reasonable timeframes to meet targeted reduction goals for different types of exposures.
  • An institution that maintains or contemplates entering into any credit or funding transaction with another financial institution should have written investment, lending and funding policies and procedures, including appropriate limits, that govern the relationship. Those procedures should ensure that the institution conducts an independent analysis of credit transactions prior to committing to engage in the transaction. The terms for all credit and funding transactions should strictly be on an arm’s length basis, conform to sound investment, lending and funding practices and avoid potential conflicts of interest.

The Guidance asserts that the specified levels of credit and funding concentration exposures are not firm limits but rather indicative of a concentration risk with the correspondent. According to the Guidance, such relationships warrant robust risk management practices, particularly when aggregated with other similarly-sized concentrations. The Guidance emphasizes that examiners will review correspondent relationships to determine whether appropriate policies and procedures have been established to identify and monitor concentrations. Examiners will also review the adequacy of contingency plans to address correspondent concentrations. Although the Guidance says that the referenced concentration levels are not firm limits, any institution that maintains correspondent exposures meeting or exceeding the specified levels should expect vigorous scrutiny by the examiners.

Of note, the Guidance makes clear that it does not replace applicable regulations such as the Federal Reserve Board’s Regulation F, governing interbank liabilities. Rather, the Guidance indicates that institutions should take action beyond the minimum requirements in Regulation F to identify, monitor and manage correspondent concentration risk.