[Federal Register Volume 77, Number 114 (Wednesday, June 13, 2012)]
[Rules and Regulations]
[Pages 35259-35263]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-14168]


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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Parts 1 and 160

[Docket ID OCC-2012-0006]
RIN 1557-AD36


Guidance on Due Diligence Requirements in Determining Whether 
Securities Are Eligible for Investment

AGENCY: Office of the Comptroller of the Currency, Treasury (OCC).

ACTION: Final guidance.

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SUMMARY: On November 29, 2011, the Office of the Comptroller of the 
Currency (OCC) proposed guidance to assist national banks and Federal 
savings associations in meeting due diligence requirements in assessing 
credit risk for portfolio investments. Today, the OCC is issuing final 
guidance that clarifies regulatory expectations with respect to 
investment purchase decisions and ongoing portfolio due diligence 
processes.

DATES: This guidance is effective January 1, 2013.

FOR FURTHER INFORMATION CONTACT: Kerri Corn, Director for Market Risk, 
or Michael Drennan, Senior Advisor, Credit and Market Risk Division, 
(202) 874-4660; or Carl Kaminski, Senior Attorney, or Kevin 
Korzeniewski, Attorney, Legislative and Regulatory Activities Division, 
(202) 874-5090; or Eugene H. Cantor, Counsel, Securities and Corporate 
Practices Division, (202) 874-5202, Office of the Comptroller of the 
Currency, 250 E Street SW., Washington, DC 20219.

SUPPLEMENTARY INFORMATION: Section 939A of the Dodd-Frank Wall Street 
Reform and Consumer Protection Act \1\ requires each Federal agency, 
within one year of enactment, to review: (1) Any regulations that 
require the use of an assessment of the creditworthiness of a security 
or money market instrument and (2) any references to or requirements in 
those regulations regarding credit ratings. Section 939A then requires 
the Federal agencies to modify the regulations identified during the 
review to substitute any references to or requirements of reliance on 
credit ratings with such standards of creditworthiness that each agency 
determines to be appropriate. The statute provides that the agencies 
shall seek to establish, to the extent feasible, uniform standards of 
creditworthiness, taking into account the entities the agencies 
regulate and the purposes for which those entities would rely on such 
standards.
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    \1\ Public Law 111-203, 939A (July 21, 2010) (Dodd-Frank Act).
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    On November 29, 2011 (76 FR 73777), the OCC issued proposed 
guidance together with a notice of proposed rulemaking (NPRM) to remove 
references to credit ratings in the OCC's non-capital regulations. In 
particular, the OCC proposed to amend the definition of ``investment 
grade'' in 12 CFR part 1 to no longer reference credit ratings. 
Instead, ``investment grade'' securities would be those where the 
issuer has an adequate capacity to meet the financial commitments under 
the security for the projected life of the investment. An issuer has an 
adequate capacity to meet financial commitments if the risk of default 
by the obligor is low and the full and timely repayment of principal 
and interest is expected. Generally, securities with good to very 
strong credit quality will meet this standard. National banks will have 
to meet this new standard before purchasing investment securities. In 
addition, national banks and Federal savings associations should 
continue to maintain appropriate ongoing reviews of their investment 
portfolios to verify that their portfolios meet safety and soundness 
requirements that are appropriate for the institution's risk profile 
and for the size and complexity of their portfolios.
    The OCC received 11 comments on the proposed rules and guidance 
from banks, bank trade groups, individuals, and bank service providers. 
The majority of the commenters generally supported the proposed rules 
and stated that the proposal presented a workable alternative to the 
use of credit ratings.

[[Page 35260]]

A few commenters raised specific issues, which are addressed in more 
detail in the preamble to the final rules published in today's Federal 
Register.

Text of Final Supervisory Guidance

    The text of the final supervisory guidance on due diligence that 
national banks and Federal savings associations should conduct in 
assessing credit risk for portfolio investments as required by 12 CFR 
part 1 and 12 CFR part 160 (specifically, 12 CFR 1.5 and 12 CFR 
160.1(b) and 160.40(c)) follows:

Purpose

    The OCC has issued final rules to revise the definition of 
``investment grade,'' as that term is used in 12 CFR parts 1 and 160 in 
order to comply with section 939A of the Dodd-Frank Act. Institutions 
have until January 1, 2013, to ensure that existing investments comply 
with the revised ``investment grade'' standard, as applicable based on 
investment type, and safety and soundness practices described in 12 CFR 
1.5 and this guidance. This implementation period also will provide 
management with time to evaluate and amend existing policies and 
practices to ensure new purchases comply with the final rules and 
guidance. National banks and Federal savings associations that have 
established due diligence review processes as described in previous 
guidance, and that have not relied exclusively on external credit 
ratings, should not have difficulty establishing compliance with the 
new standard.
    The OCC is issuing this guidance (``Guidance'') to clarify steps 
national banks ordinarily are expected to take to demonstrate they have 
properly verified their investments meet the newly established credit 
quality standards under 12 CFR Part 1 and steps national banks and 
Federal savings associations are expected to take to demonstrate they 
are in compliance with due diligence requirements when purchasing 
investment securities and conducting ongoing reviews of their 
investment portfolios. Federal savings associations will need to follow 
FDIC requirements when that agency promulgates credit quality standards 
under 12 U.S.C. 1831e. The standards below describe how national banks 
may purchase, sell, deal in, underwrite, and hold securities consistent 
with the authority contained in 12 U.S.C. 24(Seventh), and how Federal 
saving associations may invest in, sell, or otherwise deal in 
securities consistent with the authority contained in 12 U.S.C. 
1464(c). The activities of national banks and Federal savings 
associations also must be consistent with safe and sound banking 
practices, and this Guidance reminds national banks and Federal savings 
associations of the supervisory risk management expectations associated 
with permissible investment portfolio holdings under Part 1 and Part 
160.

Background

    Parts 1 and 160 provide standards for determining whether 
securities have appropriate credit quality and marketability 
characteristics to be purchased and held by national banks or Federal 
savings associations. These requirements also establish limits on the 
amount of investment securities an institution may hold for its own 
account. As defined in 12 CFR Part 1, an ``investment security'' must 
be ``investment grade.'' For the purpose of Part 1, ``investment 
grade'' securities are those where the issuer has an adequate capacity 
to meet the financial commitments under the security for the projected 
life of the investment. An issuer has an adequate capacity to meet 
financial commitments if the risk of default by the obligor is low and 
the full and timely repayment of principal and interest is expected. 
Generally, securities with good to very strong credit quality will meet 
this standard. In the case of a structured security (that is, a 
security that relies primarily on the cash flows and performance of 
underlying collateral for repayment, rather than the credit of the 
entity that is the issuer), the determination that full and timely 
repayment of principal and interest is expected may be influenced more 
by the quality of the underlying collateral, the cash flow rules, and 
the structure of the security itself than by the condition of the 
issuer.
    National banks and Federal savings associations must be able to 
demonstrate that their investment securities meet applicable credit 
quality standards. This Guidance provides criteria that national banks 
can use in meeting Part 1 credit quality standards and that national 
banks and Federal savings associations can use in meeting due diligence 
requirements.

Determining Whether Securities Are Permissible Prior to Purchase

    The OCC's elimination of references to credit ratings in its 
regulations, in accordance with the Dodd-Frank Act, does not 
substantively change the standards institutions should use when 
deciding whether securities are eligible for purchase under Part 1. The 
OCC's investment securities regulations generally require a national 
bank or Federal savings association to determine whether or not a 
security is ``investment grade'' in order to determine whether 
purchasing the security is permissible. Investments are considered 
``investment grade'' if they meet the regulatory standard for credit 
quality. To meet this standard, a national bank must be able to 
determine that the security has (1) low risk of default by the obligor, 
and (2) the full and timely repayment of principal and interest is 
expected over the expected life of the investment.\2\ A Federal savings 
association must meet the same standard when purchasing certain 
municipal revenue bonds pursuant to 12 CFR 160.24 and must meet the 
standards in 12 U.S.C. 1831e when purchasing corporate debt securities.
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    \2\ Federal savings associations may invest in and hold 
investment securities under section 5(c) of the Home Owners' Loan 
Act (HOLA), to the extent specified in regulations of the OCC. While 
OCC regulations imposing investment limitations generally apply to 
Federal savings associations, the Federal Deposit Insurance Act 
(FDIA), 12 U.S.C. 1831e(d)(1) also applies. Under this provision, 
savings associations currently are prohibited from investing in 
corporate debt securities unless they are rated ``investment 
grade.'' However, the Dodd-Frank Act provides that on July 21, 2012, 
this statutory requirement will be replaced by standards of 
creditworthiness established by the FDIC. Pub. L. 111-203, Section 
939(a)(2) (July 21, 2010).
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    For national banks, Type I securities, as defined in Part 1, 
generally are government obligations and are not subject to investment 
grade criteria for determining eligibility to purchase. Typical Type I 
obligations include U.S. Treasuries, agencies, municipal government 
general obligations, and for well-capitalized institutions, municipal 
revenue bonds. While Type I obligations do not have to meet the 
investment grade criteria to be eligible for purchase, all investment 
activities should comply with safe and sound banking practices as 
stated in 12 CFR 1.5 and in previous regulatory guidance. Under OCC 
rules, Treasury and agency obligations do not require individual credit 
analysis, but bank management should consider how those securities fit 
into the overall purpose, plans, and risk and concentration limitations 
of the investment policies established by the board of directors. 
Municipal bonds should be subject to an initial credit assessment and 
then ongoing review consistent with the risk characteristics of the 
bonds and the overall risk of the portfolio.
    Financial institutions should be well acquainted with fundamental 
credit analysis as this is central to a well-managed loan portfolio. 
The foundation of a fundamental credit analysis--character, capacity, 
collateral, and covenants--applies to investment securities just as it 
does to the loan portfolio. Accordingly, the OCC expects national banks 
and Federal savings

[[Page 35261]]

associations to conduct an appropriate level of due diligence to 
understand the inherent risks and determine that a security is a 
permissible investment. The extent of the due diligence should be 
sufficient to support the institution's conclusion that a security 
meets the investment grade standards. This may include consideration of 
internal analyses, third party research and analytics including 
external credit ratings, internal risk ratings, default statistics, and 
other sources of information as appropriate for the particular 
security. Some institutions may have the resources to do most or all of 
the analytical work internally. Some, however, may choose to rely on 
third parties for much of the analytical work. While analytical support 
may be delegated to third parties, management may not delegate its 
responsibility for decision-making and should ensure that prospective 
third parties are independent, reliable, and qualified. The board of 
directors should oversee management to assure that an appropriate 
decision-making process is in place.
    The depth of the due diligence should be a function of the 
security's credit quality, the complexity of the structure, and the 
size of the investment. The more complex a security's structure, the 
more credit-related due diligence an institution should perform, even 
when the credit quality is perceived to be very high. Management should 
ensure it understands the security's structure and how the security may 
perform in different default environments, and should be particularly 
diligent when purchasing structured securities.\3\ The OCC expects 
national banks and Federal savings associations to consider a variety 
of factors relevant to the particular security when determining whether 
a security is a permissible and sound investment. The range and type of 
specific factors an institution should consider will vary depending on 
the particular type and nature of the securities. As a general matter, 
a national bank or Federal savings association will have a greater 
burden to support its determination if one factor is contradicted by a 
finding under another factor.
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    \3\ For example, a national bank or Federal savings association 
should be able to demonstrate an understanding of the effects on 
cash flows of a structured security assuming varying default levels 
in the underlying assets.
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    The following matrix provides examples of factors for national 
banks and Federal savings associations to consider as part of a robust 
credit risk assessment framework for designated types of instruments. 
The types of securities included in the matrix require a credit-focused 
pre-purchase analysis to meet the investment grade standard or safety 
and soundness standards. Again, the matrix is provided as a guide to 
better inform the credit risk assessment process. Individual purchases 
may require more or less analysis dependent on the security's risk 
characteristics, as previously described.

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                                                                  Municipal
                                                                  government                        Structured
                 Key factors                  Corporate bonds      general       Revenue bonds      securities
                                                                 obligations
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Confirm spread to U.S. Treasuries is                       X                X                X                X
 consistent with bonds of similar credit
 quality....................................
Confirm risk of default is low and                         X                X                X                X
 consistent with bonds of similar credit
 quality....................................
Confirm capacity to pay and assess operating               X                X                X                X
 and financial performance levels and trends
 through internal credit analysis and/or
 other third party analytics, as appropriate
 for the particular security................
Evaluate the soundness of a municipal's       ...............               X   ...............  ...............
 budgetary position and stability of its tax
 revenues. Consider debt profile and level
 of unfunded liabilities, diversity of
 revenue sources, taxing authority, and
 management experience......................
Understand local demographics/economics.      ...............               X                X   ...............
 Consider unemployment data, local
 employers, income indices, and home values.
Assess the source and strength of revenue     ...............  ...............               X   ...............
 structure for municipal authorities.
 Consider obligor's financial condition and
 reserve levels, annual debt service and
 debt coverage ratio, credit enhancement,
 legal covenants, and nature of project.....
Understand the class or tranche and its       ...............  ...............  ...............               X
 relative position in the securitization
 structure..................................
Assess the position in the cash flow          ...............  ...............  ...............               X
 waterfall..................................
Understand loss allocation rules, specific    ...............  ...............  ...............               X
 definition of default, the potential impact
 of performance and market value triggers,
 and support provided by credit and/or
 liquidity enhancements.....................
Evaluate and understand the quality of the    ...............  ...............  ...............               X
 underwriting of the underlying collateral
 as well as any risk concentrations.........
Determine whether current underwriting is     ...............  ...............  ...............               X
 consistent with the original underwriting
 underlying the historical performance of
 the collateral and consider the affect of
 any changes................................
Assess the structural subordination and       ...............  ...............  ...............               X
 determine if adequate given current
 underwriting standards.....................
Analyze and understand the impact of          ...............  ...............  ...............               X
 collateral deterioration on tranche
 performance and potential credit losses
 under adverse economic conditions..........
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[[Page 35262]]

Additional Guidance on Structured Securities Analysis

    The creditworthiness assessment for an investment security that 
relies on the cash flows and collateral of the underlying assets for 
repayment (i.e., a structured security) is inherently different from a 
security that relies on the financial capacity of the issuer for 
repayment. Therefore, a financial institution should demonstrate an 
understanding of the features of a structured security that would 
materially affect its performance and that its risk of loss is low even 
under adverse economic conditions. Management's assessment of key 
factors, such as those provided in this guidance, will be considered a 
critical component of any structured security evaluation. Existing OCC 
guidance, including OCC Bulletin 2002-19, ``Supplemental Guidance, 
Unsafe and Unsound Investment Portfolio Practices,'' states that it is 
unsafe and unsound to purchase a complex high-yield security without an 
understanding of the security's structure and performing a scenario 
analysis that evaluates how the security will perform in different 
default environments. Policies that specifically permit this type of 
investment should establish appropriate limits, and pre-purchase due 
diligence processes should consider the impact of such purchases on 
capital and earnings under a variety of possible scenarios. The OCC 
expects institutions to understand the effect economic stresses may 
have on an investment's cash flows. Various factors can be used to 
define the stress scenarios. For example, an institution could evaluate 
the potential impact of changes in economic growth, stock market 
movements, unemployment, and home values on default and recovery rates. 
Some institutions have the resources to perform this type of analytical 
work internally. Generally, analyses of the application of various 
stress scenarios to a structured security's cash flow are widely 
available from third parties. Many of these analyses evaluate the 
performance of the security in a base case and a moderate and severe 
stress case environment. Even under severe stress conditions, the 
stress scenario analysis should determine that the risk of loss is low 
and full and timely repayment of principal and interest is expected.

Maintaining an Appropriate and Effective Portfolio Risk Management 
Framework

    The OCC has had a long-standing expectation that national banks 
implement a risk management process to ensure credit risk, including 
credit risk in the investment portfolio, is effectively identified, 
measured, monitored, and controlled. The 1998 Interagency Supervisory 
Policy Statement on Investment Securities and End-User Derivatives 
Activities (Policy Statement) contains risk management standards for 
the investment activities of banks and savings associations.\4\ The 
Policy Statement emphasizes the importance of establishing and 
maintaining risk processes to manage the market, credit, liquidity, 
legal, operational, and other risks of investment securities. Other 
previously issued guidance that supplements OCC investment standards 
are OCC 2009-15, ``Risk Management and Lessons Learned'' (which 
highlights lessons learned during the market disruption and re-
emphasizes the key principles discussed in previously issued OCC 
guidance on portfolio risk management); OCC 2004-25, ``Uniform 
Agreement on the Classification of Securities'' (which describes the 
importance of management's credit risk analysis and its use in examiner 
decisions concerning investment security risk ratings and 
classifications); and OCC 2002-19, ``Supplemental Guidance, Unsafe and 
Unsound Investment Portfolio Practices'' (which alerts banks to the 
potential risk to future earnings and capital from poor investment 
decisions made during periods of low levels of interest rates and 
emphasizes the importance of maintaining prudent credit, interest rate, 
and liquidity risk management practices to control risk in the 
investment portfolio).\5\
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    \4\ On April 23, 1998, the FRB, FDIC, NCUA, OCC, and OTS issued 
the ``Supervisory Policy Statement on Investment Securities and End-
User Derivatives Activities.'' As issued by the OTS, the Policy 
Statement applied to both state and Federal savings associations.
    \5\ Similar requirements also apply to Federal savings 
associations as set forth in OTS Examination Handbook Section 540, 
Investment Securities (January 2010).
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    National banks and Federal savings associations must have in place 
an appropriate risk management framework for the level of risk in their 
investment portfolios. Failure to maintain an adequate investment 
portfolio risk management process, which includes understanding key 
portfolio risks, is considered an unsafe and unsound practice.
    Having a strong and robust risk management framework appropriate 
for the level of risk in an institution's investment portfolio is 
particularly critical for managing portfolio credit risk. A key role 
for management in the oversight process is to translate the board of 
directors' tolerance for risk into a set of internal operating policies 
and procedures that govern the institution's investment activities. 
Policies should be consistent with the organization's broader business 
strategies, capital adequacy, technical expertise, and risk tolerance. 
Institutions should ensure that they identify and measure the risks 
associated with individual transactions prior to acquisition and 
periodically after purchase. This can be done at the institutional, 
portfolio, or individual instrument level. Investment policies also 
should provide credit risk concentration limits. Such limits may apply 
to concentrations relating to a single or related issuer, a 
geographical area, and obligations with similar characteristics. Safety 
and soundness principles warrant effective concentration risk 
management programs to ensure that credit exposures do not reach an 
excessive level.
    The aforementioned risk management policies, principles, and due 
diligence processes should be commensurate with the complexity of the 
investment portfolio and the materiality of the portfolio to the 
financial performance and capital position of the institution. 
Investment review processes, following the pre-purchase analysis, may 
vary from institution to institution based on the individual 
characteristics of the portfolio, the nature and level of risk 
involved, and how that risk fits into the overall risk profile and 
operation of the institution. Investment portfolio reviews may be risk-
based and focus on material positions or specific groups of investments 
or stratifications to enable analysis and review of similar risk 
positions.
    As with pre-purchase analytics, some institutions may have the 
resources necessary to do most or all of their portfolio reviews 
internally. However, some may choose to rely on third parties for much 
of the analytical work. Third party vendors offer risk analysis and 
data benchmarks that could be periodically reviewed against existing 
portfolio holdings to assess credit quality changes over time. Holdings 
where current financial information or other key analytical data is 
unavailable should warrant more frequent analysis. High quality 
investments generally will not require the same level of review as 
investments further down the credit quality spectrum. However, any 
material positions or concentrations should be identified and assessed 
in more depth and more frequently, and any system should ensure an 
accurate and timely risk assessment and reporting process that informs 
the board of material changes to the risk profile

[[Page 35263]]

and prompts action when needed. National banks and Federal savings 
associations should have investment portfolio review processes that 
effectively assess and manage the risks in the portfolio and ensure 
compliance with policies and risk limits. Institutions should reference 
existing regulatory guidance for additional supervisory expectations 
for investment portfolio risk management practices.

    Dated: June 4, 2012.
Thomas J. Curry,
Comptroller of the Currency.
[FR Doc. 2012-14168 Filed 6-12-12; 8:45 am]
BILLING CODE 4810-33-P