The office of the Comptroller of the Currency, Treasury (“OCC”), Office of Thrift Supervision, Treasury (“OTS”), Federal Reserve Board (“FRB”), Federal Deposit Insurance Corporation (“FDIC”) and Securities and Exchange Commission (“SEC”) have adopted an interagency final statement on sound practices for national banks, state banks, banking holding companies (excluding foreign banks), federal and state savings associations, savings and loan holding companies, U.S. branches and agencies of foreign banks, and SEC-registered broker-dealers and investment advisers (“financial institutions”) that engage in complex structured finance transactions (“CSFTs”). Effective Jan. 11, 2007, the final statement was adopted as supervisory guidance by the OCC, OTS, FRB and FDIC, and as a policy statement by the SEC, and is intended to describe internal controls and risk management procedures which can assist financial institutions in identifying, managing and addressing heightened reputational and legal risks that may arise from CSFTs that may be considered to have an “elevated risk.”
Characteristics of Elevated Risk CSFTs
Elevated risk CSFTs are identified as those that may create heightened levels of legal or reputational risks for a participating financial institution. The final statement recognizes that CSFTs cover a wide range of products with varying levels of complexity. Many structured finance transactions, such as standard public mortgage-backed securities and hedging-type transactions involving derivatives or collateralized debt obligations are well-known to market participants, have long and well-established track records, and have easily identifiable business purposes or economic substance. Elevated risk CSFTs can be distinguished by their lack of economic substance or business purpose, and on the basis that they may have been designed or are used primarily for questionable accounting, regulatory or tax objectives. In addition, such transactions may be identified because they raise concerns that a client will report or disclose such a transaction in a manner that is materially misleading, or inconsistent with the substance of the transaction or applicable regulatory or accounting requirements.
Establishment of Formal, Written, Firmwide Procedures and Policies by Financial Institutions Engaging in Elevated Risk CSFTs
Financial institutions that are engaging in or contemplating engaging in CSFTs that could be classified as elevated risk should establish a clear framework for the review and approval of CSFTs. Such policies and procedures should provide clear guidance for all personnel involved in organization, structuring, trading, review, approval, documentation, verification and execution of these kinds of transactions. It may be helpful for financial institutions to incorporate these policies into existing new product policies. Financial institutions should develop procedures for identifying what constitutes a new CSFT. In determining whether a CSFT is new, financial institutions may take into account structural or pricing variations from existing products; who is the targeted customer and whether the targeted customer is new to such transactions; and whether the product raises new legal, compliance or regulatory issues.
Elevated risk CSFTs should be subject to heightened security and should be reviewed by representatives from the relevant business lines and management, as well as by appropriate control areas that are independent of any business lines that are involved in the transaction. The final statement emphasizes that a financial institution should not conclude that a transaction which is identified as being an elevated risk CSFT would nevertheless be acceptable solely because of the fact that other financial institutions will participate in the transaction or because of the size or sophistication of the customer or counterparty.