The Federal Reserve has issued guidance to banking organizations and examiners on the potential impact of high-cost credit risk mitigation techniques on a banking organization’s overall capital adequacy. Supervision and Regulation Letter SR 11-1 released on January 25 advises that, in some instances, the high premiums or fees paid for certain credit protection transactions, combined with other terms and conditions, call into question the degree of risk transfer involved in the transaction and may be inconsistent with safety and soundness. According to the Federal Reserve, the primary effect of such high-cost credit protection transactions is to embed a high percentage of expected losses into the premiums and fees paid by a banking institution rather than contribute to a prudent risk-management strategy. SR 11-1 also advises that examiners will scrutinize these transactions and, based on the factors and analysis described in the guidance, examiners may determine that a credit protection transaction should be discounted in the assessment of the banking organization’s management of its risk profile and capital needs, or that the cost of the transaction should be judged as having a negative impact on the banking organization’s earnings and capital.

Notes: The Federal Reserve recommends that banking organizations analyze and document the economic substance of credit protection transactions that have unusually high-cost or innovative features to assess the degree of risk transfer and the associated impact on the organization’s overall capital adequacy. According to the guidance, the analysis should also specify how the transaction aligns with the banking organization’s overall risk-management strategy. In evaluating the degree of risk transfer involved in a transaction, banking organizations should consider, and examiners will assess, factors that include a comparison of the present value of premiums relative to expected losses over a variety of stress scenarios, the pricing of the transaction relative to market prices, and the timing of payments under the transaction relative to the timing of provisioning or write downs and payments by the counterparty. Other relevant assessment factors may include a review of applicable call dates to assess the likely duration of the credit protection relative to the potential timing of future credit losses, an analysis of whether certain circumstances could lead to the banking organization’s increased reliance on the counterparty while the counterparty’s ability to meet its obligations is weakened, and an analysis of whether the banking organization can prudently afford the premiums given its earnings, capital, and overall financial condition.