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Board of Governors of the Federal Reserve System
Federal Deposit Insurance Corporation
National Credit Union Administration
Office of the Comptroller of the Currency
Interagency Supervisory Guidance on Allowance for Loan and Lease Losses Estimation Practices for
Loans and Lines of Credit Secured by Junior Liens on 1-4 Family Residential Properties
January 31, 2012
Purpose
This document provides guidance related to allowance for loan and lease losses (ALLL)
estimation practices associated with loans and lines of credit secured by junior liens on
1-4 family residential properties (junior liens).
Background
Amidst continued uncertainty in the economy and the housing market, federally regulated
financial institutions are reminded to monitor all credit quality indicators relevant to credit
portfolios, including junior liens. While the following guidance specifically addresses junior
liens, it contains principles that apply to estimating the ALLL for all types of loans. This
guidance reiterates key concepts included in generally accepted accounting principles (GAAP)
and existing ALLL supervisory guidance related to the ALLL and loss estimation practices.
Institutions also are reminded to follow appropriate risk management principles in managing
junior lien loans and lines of credit, including those in the May 2005 Interagency Credit Risk
Management Guidance for Home Equity Lending.
Financial Accounting Standards Board Accounting Standards Codification (ASC)
Section 450-20-25, Contingencies – Loss Contingencies – Recognition,1 states: “An estimated
loss from a loss contingency shall be accrued by a charge to income if both of the following
conditions are met:
a. Information available before the financial statements are issued or are available to be
issued indicates that it is probable that an asset had been impaired or a liability had been
incurred at the date of the financial statements.
b. The amount of loss can be reasonably estimated.”
1 Formerly Statement of Financial Accounting Standards No. 5, Accounting for Contingencies.
Page 1 of 6
The December 2006 Interagency Policy Statement on the Allowance for Loan and Lease
Losses (IPS) states: “Estimates of credit losses should reflect consideration of all significant
factors that affect the collectibility of the portfolio as of the evaluation date.”
The Interagency Credit Risk Management Guidance for Home Equity Lending states:
“Financial institutions should establish an appropriate ALLL and hold capital commensurate
with the riskiness of portfolios. In determining the ALLL adequacy, an institution should
consider how the interest-only and draw features of HELOCs during the lines’ revolving period
could affect the loss curves for the HELOC portfolio. Those institutions engaging in
programmatic subprime home equity lending or institutions that have higher risk products are
expected to recognize the elevated risk of the activity when assessing capital and ALLL
adequacy.”
Responsibilities of Management
Consideration of All Significant Factors
Institutions should ensure that during the ALLL estimation process sufficient information
is gathered to adequately assess the probable loss incurred within junior lien portfolios.
Generally, this information should include the delinquency status of senior liens associated with
the institution’s junior liens and whether the senior lien loan has been modified. Institutions with
significant holdings of junior liens should gather and analyze data on the associated senior lien
loans it owns or services. When an institution does not own or service the associated senior lien
loans, it should use reasonably available tools to determine the payment status of the senior lien
loans. Such tools include obtaining credit reports or data from third-party services to assist in
matching an institution’s junior liens with its associated senior liens. Additionally, an institution
may, as a proxy, use the relevant performance data on similar senior liens it owns or services.
An institution with an insignificant volume of junior lien loans and lines of credit may use
judgment when determining what information about associated senior liens not owned or
serviced is reasonably available.
Institutions with significant holdings of junior liens should also periodically refresh other
credit quality indicators the organization has deemed relevant about the collectibility of its junior
liens, such as borrower credit scores and combined loan-to-value ratios (CLTVs), which include
both the senior and junior liens. Institutions should refresh relevant credit quality indicators as
often as necessary considering economic and housing market conditions that affect the
institution’s junior lien portfolio. As noted in the December 2006 IPS, “changes in the level of
the ALLL should be directionally consistent with changes in the factors, taken as a whole, that
evidence credit losses.” For example, if declining credit quality trends in the factors relevant to
either junior liens or their associated senior lien loans are evident, the ALLL level as a
percentage of the junior lien portfolio should generally increase, barring unusual charge-off
Page 2 of 6
activity. Similarly, if improving credit quality trends are evident, the ALLL level as a percentage
of the junior lien portfolio should generally decrease.
Institutions routinely gather information for credit risk management purposes, but some
may not fully use that information in the allowance estimation process. Institutions should
consider all reasonably available and relevant information in the allowance estimation process,
including information obtained for credit risk management purposes. As noted above,
ASC Topic 450 states that losses should be accrued by a charge to income if information
available prior to issuance of the financial statements indicates that it is probable that an asset has
been impaired. The December 2006 IPS states that “estimates of credit losses should reflect
consideration of all significant factors.” Consequently, it is considered inconsistent with both
GAAP and supervisory guidance to fail to gather and consider reasonably available and relevant
information that would significantly affect management’s judgment about the collectibility of the
portfolio.2
Adequate Segmentation
Institutions normally segment their loan portfolio into groups of loans based on risk
characteristics as part of the ALLL estimation process. Institutions with significant holdings of
junior liens should ensure adequate segmentation within their junior lien portfolio to
appropriately estimate the allowance for high-risk segments within this portfolio. A lack of
segmentation can result in an allowance established for the entire junior lien portfolio that is
lower than what the allowance would be if high-risk loans were segregated and grouped together
for evaluation in one or more separate segments. The following credit quality indicators may be
appropriate for use in identifying high-risk junior lien portfolio segments:
Delinquency and modification status of an institution’s junior liens, Delinquency and modification status of senior lien loans associated with an institution’s
junior liens,
Current borrower credit score, Current CLTV, Origination channel,
Documentation type, Property type (for example, investor owned or owner-occupied),
2 “Portfolio” refers to loans collectively evaluated for impairment under ASC Topic 450; this supervisory
guidance may also be applicable to junior lien loans that are subject to measurement for impairment under
ASC Subtopic 310-10, Receivables – Overall (formerly Statement of Financial Accounting Standards No. 114,
Accounting by Creditors for Impairment of a Loan) and ASC Subtopic 310-30, Loans and Debt Securities Acquired
with Deteriorated Credit Quality (formerly AICPA Statement of Position 03-3, Accounting for Certain Loans or
Debt Securities Acquired in a Transfer).
Page 3 of 6
Geographic location of property,
Origination vintage,
Home equity lines of credit (HELOCs) where the borrower is making only the minimum
payment due, and
HELOCs where current information and conditions indicate that the borrower will be
subject to payment shock.
In particular, institutions should ensure their ALLL methodology adequately incorporates
the elevated borrower default risk associated with payment shocks due to (1) rising interest rates
for adjustable rate junior liens, including HELOCs,3
or (2) HELOCs converting from interest-
only to amortizing loans. If the default rate of junior liens that have experienced payment shock
is higher than the default rate of junior liens that have not experienced payment shock, an
institution should determine whether it has a significant amount of junior liens approaching their
conversion to amortizing loans or approaching an interest rate adjustment date. If so, to ensure
the institution’s estimate of credit losses is not understated, it would be necessary to adjust
historical default rates on these junior liens to incorporate the effect of payment shocks that,
based on current information and conditions, are likely to occur.
Adequate segmentation of the junior lien portfolio by risk factors should facilitate an
institution’s ability to track default rates and loss severity for high-risk segments and its ability to
appropriately incorporate these data into the allowance estimation process.
Qualitative or Environmental Factor Adjustments
As noted in the December 2006 IPS, institutions should adjust a loan group’s historical
loss rate for the effect of qualitative or environmental factors that are likely to cause estimated
credit losses as of the evaluation date to differ from the group’s historical loss experience.
Institutions typically reflect the overall effect of these factors on a loan group as an adjustment
that, as appropriate, increases or decreases the historical loss rate applied to the loan group.
Alternatively, the effect of these factors may be reflected through separate standalone
adjustments within the ASC Subtopic 450-20 component of the ALLL.
When an institution uses qualitative or environmental factors to estimate probable losses
related to individual high-risk segments within the junior lien portfolio, any adjustment to the
historical loss rate or any separate standalone adjustment should be supported by an analysis that
relates the adjustment to the characteristics of and trends in the individual risk segments. In
addition, changes in the allowance allocation for junior liens should be directionally consistent
3 Forecasts of future interest rate increases should not be included in the determination of the ALLL. However, if
rates have risen since the last rate adjustment, the effect of the increase on the amount of the payment at the next rate
adjustment should be considered.
Page 4 of 6
with changes in the factors taken as a whole that evidence credit losses on junior liens, keeping
in mind the characteristics of the institution’s junior lien portfolio.
Charge-off and Nonaccrual Policies
Banking institutions should ensure that their charge-off policy on junior liens is in
accordance with the June 2000 Uniform Retail Credit Classification and Account Management
Policy.4 As stated in the December 2006 IPS, “when available information confirms that specific
loans, or portions thereof, are uncollectible, these amounts should be promptly charged off
against the ALLL.”
Institutions also should ensure that income recognition practices related to junior liens are
appropriate. Consistent with GAAP and regulatory guidance, institutions are expected to have
revenue recognition practices that do not result in overstating income. Placing a junior lien on
nonaccrual, including a current junior lien, when payment of principal or interest in full is not
expected is one appropriate method to ensure that income is not overstated. An institution’s
income recognition policy should incorporate management’s consideration of all reasonably
available information including, for junior liens, the performance of the associated senior liens as
well as trends in other credit quality indicators. The policy should require that consideration of
these factors takes place before foreclosure on the senior lien or delinquency of the junior lien.
The policy should also explain how management’s consideration of these factors affects income
recognition prior to foreclosure on the senior lien or delinquency of the junior lien to ensure
income is not overstated.
Responsibilities of Examiners
To the extent an institution has significant holdings of junior liens, examiners should
assess the appropriateness of the institution’s ALLL methodology and documentation related
to these loans, and the appropriateness of the level of the ALLL established for this portfolio.
As noted in the December 2006 IPS, for analytical purposes, an institution should attribute
portions of the ALLL to loans that it individually evaluates and determines to be impaired
under ASC Subtopic 310-10 and to groups of loans that it evaluates collectively under
ASC Subtopic 450-20. However, the ALLL is available to cover all charge-offs that arise
from the loan portfolio.
Consistent with the December 2006 IPS, in their review of the junior lien portfolio,
examiners should consider all significant factors that affect the collectibility of the portfolio. In
4 Charge-off policy guidance for credit unions is set forth in NCUA Letter to Credit Unions 03-CU-01, dated
January 2003, Loan Charge-off Guidance.
Page 5 of 6
reviewing the appropriateness of an institution’s allowance established for junior liens,
examiners should:
Evaluate the institution’s ALLL policies and procedures and assess the methodology that management uses to arrive at an overall estimate of the ALLL for junior liens. This
should include whether all significant qualitative or environmental factors that affect the
collectibility of the portfolio (including those factors previously discussed) have been
appropriately considered in accordance with GAAP.
Review management’s use of loss estimation models or other loss estimation tools to
ensure that the resulting estimated credit losses are in conformity with GAAP.
Review management’s support for any qualitative or environmental factor adjustments to the allowance related to junior liens. Examiners should ensure that all relevant
qualitative or environmental factors were considered and adjustments to historical loss
rates for specific risk segments within the junior lien portfolio are supported by an
analysis that relates the adjustment to the characteristics of and trends in the individual
risk segments.
Review the interest income accounts associated with junior liens to ensure that the
institution’s net income is not overstated.
If the examiner concludes that the reported ALLL for junior liens is not appropriate or
determines that the ALLL evaluation process is deficient, recommendations for correcting these
deficiencies, including any examiner concerns regarding an appropriate level for the ALLL,
should be noted in the report of examination. Examiners should cite any departures from GAAP
and regulatory guidance, as applicable. Additional supervisory action may also be taken based
on the magnitude of the observed shortcomings in the ALLL process.
Page 6 of 6
Page 1 of 2
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM WASHINGTON, D.C. 20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 12-3
January 31, 2012
TO THE OFFICER IN CHARGE OF SUPERVISION AT EACH FEDERAL RESERVE BANK AND TO EACH DOMESTIC BANKING ORGANIZATION SUPERVISED BY THE FEDERAL RESERVE SUBJECT: Interagency Guidance on Allowance Estimation Practices for Junior Lien Loans and Lines of Credit Applicability to Community Banking Organizations: This guidance applies to all banking organizations with junior lien loans, including those with $10 billion or less in consolidated assets.
The Board of Governors of the Federal Reserve System, together with the Federal Deposit Insurance Corporation, the National Credit Union Administration, and the Office of the Comptroller of the Currency, has issued the attached guidance addressing allowance estimation practices for junior lien loans and lines of credit (collectively, junior liens).
Domestic banking organizations supervised by the Federal Reserve are reminded to consider all credit quality indicators relevant to their junior liens. Generally, this information should include the delinquency status of senior liens associated with the institution’s junior liens and whether the senior lien has been modified. Institutions should ensure that during the allowance for loan and lease loss (ALLL) estimation process sufficient information is gathered to adequately assess the probable loss incurred within junior lien portfolios.
In addition, based on the rapid growth in home equity lending during the 2003-2007
timeframe, a significant volume of home equity lines of credit (HELOCs) will be approaching the end of their draw periods in the next several years and will either convert to amortizing loans or have principal due as a balloon payment. An institution with a significant number of HELOCs should ensure that its ALLL methodology appropriately captures the elevated borrower default risk associated with any upcoming payment shocks.
Page 2 of 2
This guidance applies to institutions of all sizes. The guidance states that an institution should use reasonably available tools to determine the payment status of senior liens associated with its junior liens, such as credit reports, third party services or in certain cases, a proxy. It is expected that large, complex institutions would find most tools reasonably available and would use proxies in limited circumstances.
The guidance does not add to or modify existing regulatory reporting requirements issued by the agencies or current generally accepted accounting principles (GAAP). This guidance reiterates key concepts included in GAAP and existing supervisory guidance related to the ALLL. Institutions also are reminded to follow appropriate risk management principles in managing junior lien loans and lines of credit, including the May 2005 Interagency Credit Risk Management Guidance for Home Equity Lending.
Reserve Banks are asked to distribute this letter to financial institutions supervised by the Federal Reserve in their districts, as well as to their own application, supervisory, and examination staff. Questions regarding the attached guidance should be addressed to Joanne Wakim, Senior Accounting Policy Analyst, Accounting Policy and Disclosure, at (202) 912-4302; Laurie F. Priest, Manager, Accounting Policy and Disclosure, at (202) 452-2750; or Steven P. Merriett, Assistant Director and Chief Accountant, at (202) 452-2531. In addition, questions may be sent via the Board’s public website.1
Michael S. Gibson Director
Attachment:
• Interagency Supervisory Guidance on Allowance for Loan and Lease Losses Estimation Practices for Loans and Lines of Credit Secured by Junior liens on 1-4 Family Residential Properties
Cross references to:
• SR letter 06-17, “Interagency Policy Statement on the Allowance for Loan and Lease Losses”
• SR letter 05-11, “Interagency Credit Risk Management Guidance for Home Equity Lending”
• SR letter 00-8, “Revised Uniform Retail Credit Classification and Account Management Policy”
1 See http://www.federalreserve.gov/apps/contactus/feedback.aspx.
Board of Governors of the Federal Reserve System
Federal Deposit Insurance Corporation
National Credit Union Administration
Office of the Comptroller of the Currency
Interagency Supervisory Guidance on Allowance for Loan and Lease Losses Estimation Practices for
Loans and Lines of Credit Secured by Junior Liens on 1-4 Family Residential Properties
January 31, 2012
Purpose
This document provides guidance related to allowance for loan and lease losses (ALLL)
estimation practices associated with loans and lines of credit secured by junior liens on
1-4 family residential properties (junior liens).
Background
Amidst continued uncertainty in the economy and the housing market, federally regulated
financial institutions are reminded to monitor all credit quality indicators relevant to credit
portfolios, including junior liens. While the following guidance specifically addresses junior
liens, it contains principles that apply to estimating the ALLL for all types of loans. This
guidance reiterates key concepts included in generally accepted accounting principles (GAAP)
and existing ALLL supervisory guidance related to the ALLL and loss estimation practices.
Institutions also are reminded to follow appropriate risk management principles in managing
junior lien loans and lines of credit, including those in the May 2005 Interagency Credit Risk
Management Guidance for Home Equity Lending.
Financial Accounting Standards Board Accounting Standards Codification (ASC)
Section 450-20-25, Contingencies – Loss Contingencies – Recognition,1 states: “An estimated
loss from a loss contingency shall be accrued by a charge to income if both of the following
conditions are met:
a. Information available before the financial statements are issued or are available to be
issued indicates that it is probable that an asset had been impaired or a liability had been
incurred at the date of the financial statements.
b. The amount of loss can be reasonably estimated.”
1 Formerly Statement of Financial Accounting Standards No. 5, Accounting for Contingencies.
Page 1 of 6
The December 2006 Interagency Policy Statement on the Allowance for Loan and Lease
Losses (IPS) states: “Estimates of credit losses should reflect consideration of all significant
factors that affect the collectibility of the portfolio as of the evaluation date.”
The Interagency Credit Risk Management Guidance for Home Equity Lending states:
“Financial institutions should establish an appropriate ALLL and hold capital commensurate
with the riskiness of portfolios. In determining the ALLL adequacy, an institution should
consider how the interest-only and draw features of HELOCs during the lines’ revolving period
could affect the loss curves for the HELOC portfolio. Those institutions engaging in
programmatic subprime home equity lending or institutions that have higher risk products are
expected to recognize the elevated risk of the activity when assessing capital and ALLL
adequacy.”
Responsibilities of Management
Consideration of All Significant Factors
Institutions should ensure that during the ALLL estimation process sufficient information
is gathered to adequately assess the probable loss incurred within junior lien portfolios.
Generally, this information should include the delinquency status of senior liens associated with
the institution’s junior liens and whether the senior lien loan has been modified. Institutions with
significant holdings of junior liens should gather and analyze data on the associated senior lien
loans it owns or services. When an institution does not own or service the associated senior lien
loans, it should use reasonably available tools to determine the payment status of the senior lien
loans. Such tools include obtaining credit reports or data from third-party services to assist in
matching an institution’s junior liens with its associated senior liens. Additionally, an institution
may, as a proxy, use the relevant performance data on similar senior liens it owns or services.
An institution with an insignificant volume of junior lien loans and lines of credit may use
judgment when determining what information about associated senior liens not owned or
serviced is reasonably available.
Institutions with significant holdings of junior liens should also periodically refresh other
credit quality indicators the organization has deemed relevant about the collectibility of its junior
liens, such as borrower credit scores and combined loan-to-value ratios (CLTVs), which include
both the senior and junior liens. Institutions should refresh relevant credit quality indicators as
often as necessary considering economic and housing market conditions that affect the
institution’s junior lien portfolio. As noted in the December 2006 IPS, “changes in the level of
the ALLL should be directionally consistent with changes in the factors, taken as a whole, that
evidence credit losses.” For example, if declining credit quality trends in the factors relevant to
either junior liens or their associated senior lien loans are evident, the ALLL level as a
percentage of the junior lien portfolio should generally increase, barring unusual charge-off
Page 2 of 6
activity. Similarly, if improving credit quality trends are evident, the ALLL level as a percentage
of the junior lien portfolio should generally decrease.
Institutions routinely gather information for credit risk management purposes, but some
may not fully use that information in the allowance estimation process. Institutions should
consider all reasonably available and relevant information in the allowance estimation process,
including information obtained for credit risk management purposes. As noted above,
ASC Topic 450 states that losses should be accrued by a charge to income if information
available prior to issuance of the financial statements indicates that it is probable that an asset has
been impaired. The December 2006 IPS states that “estimates of credit losses should reflect
consideration of all significant factors.” Consequently, it is considered inconsistent with both
GAAP and supervisory guidance to fail to gather and consider reasonably available and relevant
information that would significantly affect management’s judgment about the collectibility of the
portfolio.2
Adequate Segmentation
Institutions normally segment their loan portfolio into groups of loans based on risk
characteristics as part of the ALLL estimation process. Institutions with significant holdings of
junior liens should ensure adequate segmentation within their junior lien portfolio to
appropriately estimate the allowance for high-risk segments within this portfolio. A lack of
segmentation can result in an allowance established for the entire junior lien portfolio that is
lower than what the allowance would be if high-risk loans were segregated and grouped together
for evaluation in one or more separate segments. The following credit quality indicators may be
appropriate for use in identifying high-risk junior lien portfolio segments:
Delinquency and modification status of an institution’s junior liens, Delinquency and modification status of senior lien loans associated with an institution’s
junior liens,
Current borrower credit score, Current CLTV, Origination channel,
Documentation type, Property type (for example, investor owned or owner-occupied),
2 “Portfolio” refers to loans collectively evaluated for impairment under ASC Topic 450; this supervisory
guidance may also be applicable to junior lien loans that are subject to measurement for impairment under
ASC Subtopic 310-10, Receivables – Overall (formerly Statement of Financial Accounting Standards No. 114,
Accounting by Creditors for Impairment of a Loan) and ASC Subtopic 310-30, Loans and Debt Securities Acquired
with Deteriorated Credit Quality (formerly AICPA Statement of Position 03-3, Accounting for Certain Loans or
Debt Securities Acquired in a Transfer).
Page 3 of 6
Geographic location of property,
Origination vintage,
Home equity lines of credit (HELOCs) where the borrower is making only the minimum
payment due, and
HELOCs where current information and conditions indicate that the borrower will be
subject to payment shock.
In particular, institutions should ensure their ALLL methodology adequately incorporates
the elevated borrower default risk associated with payment shocks due to (1) rising interest rates
for adjustable rate junior liens, including HELOCs,3
or (2) HELOCs converting from interest-
only to amortizing loans. If the default rate of junior liens that have experienced payment shock
is higher than the default rate of junior liens that have not experienced payment shock, an
institution should determine whether it has a significant amount of junior liens approaching their
conversion to amortizing loans or approaching an interest rate adjustment date. If so, to ensure
the institution’s estimate of credit losses is not understated, it would be necessary to adjust
historical default rates on these junior liens to incorporate the effect of payment shocks that,
based on current information and conditions, are likely to occur.
Adequate segmentation of the junior lien portfolio by risk factors should facilitate an
institution’s ability to track default rates and loss severity for high-risk segments and its ability to
appropriately incorporate these data into the allowance estimation process.
Qualitative or Environmental Factor Adjustments
As noted in the December 2006 IPS, institutions should adjust a loan group’s historical
loss rate for the effect of qualitative or environmental factors that are likely to cause estimated
credit losses as of the evaluation date to differ from the group’s historical loss experience.
Institutions typically reflect the overall effect of these factors on a loan group as an adjustment
that, as appropriate, increases or decreases the historical loss rate applied to the loan group.
Alternatively, the effect of these factors may be reflected through separate standalone
adjustments within the ASC Subtopic 450-20 component of the ALLL.
When an institution uses qualitative or environmental factors to estimate probable losses
related to individual high-risk segments within the junior lien portfolio, any adjustment to the
historical loss rate or any separate standalone adjustment should be supported by an analysis that
relates the adjustment to the characteristics of and trends in the individual risk segments. In
addition, changes in the allowance allocation for junior liens should be directionally consistent
3 Forecasts of future interest rate increases should not be included in the determination of the ALLL. However, if
rates have risen since the last rate adjustment, the effect of the increase on the amount of the payment at the next rate
adjustment should be considered.
Page 4 of 6
with changes in the factors taken as a whole that evidence credit losses on junior liens, keeping
in mind the characteristics of the institution’s junior lien portfolio.
Charge-off and Nonaccrual Policies
Banking institutions should ensure that their charge-off policy on junior liens is in
accordance with the June 2000 Uniform Retail Credit Classification and Account Management
Policy.4 As stated in the December 2006 IPS, “when available information confirms that specific
loans, or portions thereof, are uncollectible, these amounts should be promptly charged off
against the ALLL.”
Institutions also should ensure that income recognition practices related to junior liens are
appropriate. Consistent with GAAP and regulatory guidance, institutions are expected to have
revenue recognition practices that do not result in overstating income. Placing a junior lien on
nonaccrual, including a current junior lien, when payment of principal or interest in full is not
expected is one appropriate method to ensure that income is not overstated. An institution’s
income recognition policy should incorporate management’s consideration of all reasonably
available information including, for junior liens, the performance of the associated senior liens as
well as trends in other credit quality indicators. The policy should require that consideration of
these factors takes place before foreclosure on the senior lien or delinquency of the junior lien.
The policy should also explain how management’s consideration of these factors affects income
recognition prior to foreclosure on the senior lien or delinquency of the junior lien to ensure
income is not overstated.
Responsibilities of Examiners
To the extent an institution has significant holdings of junior liens, examiners should
assess the appropriateness of the institution’s ALLL methodology and documentation related
to these loans, and the appropriateness of the level of the ALLL established for this portfolio.
As noted in the December 2006 IPS, for analytical purposes, an institution should attribute
portions of the ALLL to loans that it individually evaluates and determines to be impaired
under ASC Subtopic 310-10 and to groups of loans that it evaluates collectively under
ASC Subtopic 450-20. However, the ALLL is available to cover all charge-offs that arise
from the loan portfolio.
Consistent with the December 2006 IPS, in their review of the junior lien portfolio,
examiners should consider all significant factors that affect the collectibility of the portfolio. In
4 Charge-off policy guidance for credit unions is set forth in NCUA Letter to Credit Unions 03-CU-01, dated
January 2003, Loan Charge-off Guidance.
Page 5 of 6
reviewing the appropriateness of an institution’s allowance established for junior liens,
examiners should:
Evaluate the institution’s ALLL policies and procedures and assess the methodology that management uses to arrive at an overall estimate of the ALLL for junior liens. This
should include whether all significant qualitative or environmental factors that affect the
collectibility of the portfolio (including those factors previously discussed) have been
appropriately considered in accordance with GAAP.
Review management’s use of loss estimation models or other loss estimation tools to
ensure that the resulting estimated credit losses are in conformity with GAAP.
Review management’s support for any qualitative or environmental factor adjustments to the allowance related to junior liens. Examiners should ensure that all relevant
qualitative or environmental factors were considered and adjustments to historical loss
rates for specific risk segments within the junior lien portfolio are supported by an
analysis that relates the adjustment to the characteristics of and trends in the individual
risk segments.
Review the interest income accounts associated with junior liens to ensure that the
institution’s net income is not overstated.
If the examiner concludes that the reported ALLL for junior liens is not appropriate or
determines that the ALLL evaluation process is deficient, recommendations for correcting these
deficiencies, including any examiner concerns regarding an appropriate level for the ALLL,
should be noted in the report of examination. Examiners should cite any departures from GAAP
and regulatory guidance, as applicable. Additional supervisory action may also be taken based
on the magnitude of the observed shortcomings in the ALLL process.
Page 6 of 6
Page 1 of 3
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM WASHINGTON, D.C. 20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
DIVISION OF CONSUMER AND
COMMUNITY AFFAIRS
SR 12-10
CA 12-9
June 28, 2012 TO THE OFFICERS IN CHARGE OF SUPERVISION AND APPROPRIATE
SUPERVISORY AND EXAMINATION STAFF AT THE FEDERAL RESERVE BANKS AND FINANCIAL INSTITUTIONS SUPERVISED BY THE FEDERAL RESERVE
SUBJECT: Questions and Answers for Federal Reserve-Regulated Institutions Related to the Management of Other Real Estate Owned (OREO) Applicability to Community Banking Organizations: This guidance applies to all institutions regulated by the Federal Reserve with OREO, including those with $10 billion or less in consolidated assets.
This letter conveys various questions and answers regarding the management of OREO by institutions regulated by the Federal Reserve. During the recent financial crisis, financial institutions have experienced a rise in OREO caused by general weaknesses in the housing market, including increases in delinquencies and defaults, house price declines, and weaknesses in the structure of a number of commercial real estate financings. The attached Questions and Answers for Federal Reserve-Regulated Institutions Related to the Management of Other Real Estate Owned (OREO) Assets document (Q&A document) is intended to clarify existing policies and promote prudent practices for the management of an institution’s OREO assets, addressing both safety-and-soundness policies and consumer compliance issues.
The Federal Reserve’s longstanding guidance for the management and financial reporting
of OREO assets is set forth in Section 2200 of the Commercial Bank Examination Manual and the instructions to regulatory reporting forms for banks and bank holding companies.1 However,
1 See, for example, Instructions for Preparation of Consolidated Reports of Condition and Income (FFIEC 031 and 041) and Instructions for Preparation of Consolidated Financial Statements for Bank Holding Companies
Page 2 of 3
given the increase in OREO on financial institutions’ balance sheets, the Federal Reserve is issuing the attached Q&A document to reiterate this longstanding guidance and to highlight key concepts on the financial reporting, loss recognition, and management of OREO assets. Topics covered in the Q&A document include:
• Transferring an Asset to OREO
• Reporting Treatment and Classification
• Appraisal Concepts
• Ongoing Property Management
• Operational and Legal Issues
• Sale and Transfer of OREO
Reserve Banks are asked to distribute this letter and the attached Q&A document to state member banks, bank holding companies, and savings and loan holding companies, as well as to supervisory and examination staff. Questions regarding this letter should be directed to the following individuals:
• Division of Banking Supervision and Regulation: Mary Aiken, Manager, at (202)
452-4534; Donald Gabbai, Senior Supervisory Financial Analyst, at (202) 452-3358; or Carmen Holly, Supervisory Financial Analyst, at (202) 973-6122, in Credit, Market, and Liquidity Risk Policy; and Matthew Kincaid, Senior Accounting Policy Analyst, at (202) 452-2028, in Accounting Policy; or
• Division of Consumer and Community Affairs: Timothy Robertson, Senior Supervisory Consumer Financial Services Analyst, RB Oversight/CBO Supervision, at (202) 452-2565.
In addition, institutions may send questions via the Board’s public website.2
Michael S. Gibson Director
Division of Banking Supervision and Regulation
Sandra F. Braunstein Director
Division of Consumer and Community Affairs
(FR Y-9C). Refer to the Federal Reserve’s public website under the tab “Reporting Forms” for reporting instructions. http://www.federalreserve.gov/reportforms/default.cfm 2 See http://www.federalreserve.gov/apps/contactus/feedback.aspx.
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Attachment: • Questions and Answers for Federal Reserve-Regulated Institutions Related to the
Management of Other Real Estate Owned (OREO) Assets Cross-references to:
• SR letter 12-5/CA letter 12-3, “Policy Statement on Rental of Residential Other Real Estate Owned (OREO) Properties
• SR letter 10-16, “Interagency Appraisal and Evaluation Guidelines”
• CA letter 09-5, “Information and Examination Procedures for the “Protecting Tenants at Foreclosure Act of 2009”
• CA letter 05-3, “Servicemembers Civil Relief Act of 2003”
• SR letter 03-5, “Amended Interagency Guidance on the Internal Audit Function and its Outsourcing”
• SR letter 00-17, “Guidance on the Risk Management of Outsourced Technology Service”
• SR letter 95-16, “Real Estate Appraisal Requirements for Other Real Estate Owned (OREO)
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Questions and Answers For Federal Reserve-Regulated Institutions1
Related to the Management of Other Real Estate Owned (OREO) Assets
June 28, 2012
TABLE OF CONTENTS
I. TRANSFERING AN ASSET TO OREO ................................................................................. 2
II. REPORTING TREATMENT AND CLASSIFICATION ........................................................ 3
III. APPRAISAL CONCEPTS ....................................................................................................... 5
IV. ONGOING PROPERTY MANAGEMENT ............................................................................ 7
V. OPERATIONAL AND LEGAL ISSUES............................................................................... 10
VI. SALE AND TRANSFER OF OREO ..................................................................................... 12
1 For purposes of this Q&A document, “institution” refers to a financial institution regulated by the Federal Reserve, including state member banks, bank holding companies, and savings and loan holding companies.
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I. TRANSFERING AN ASSET TO OREO 1. Q: When should an institution re-categorize its asset from “Loans and lease financing
receivables” to “Other real estate owned” on the Consolidated Reports of Condition and Income (Call Report)?2 A: In accordance with Call Report instructions, an institution should re-categorize its asset from “Loans and lease financing receivables” to “Other real estate owned” on the Call Report when the institution takes physical possession of the property, regardless of whether formal foreclosure proceedings have taken place.
2. Q: At what value should an institution initially report an OREO asset?
A: In accordance with Call Report instructions, when an institution receives an asset, such as real estate, from a borrower in full satisfaction of a loan, the institution initially reports the asset at its fair value less cost to sell.3 Similarly, a real estate asset received in partial satisfaction of a loan should be initially reported as described above and the carrying amount of the loan should be reduced by the fair value less cost to sell of the asset at the time of foreclosure.4 The fair value less cost to sell becomes the “cost” of the OREO asset. The amount, if any, by which the carrying amount of the loan plus recorded accrued interest (that is, the recorded loan amount) exceeds the fair value less cost to sell of the OREO asset is a loss that must be charged to the allowance for loan and lease losses (ALLL) at the time of foreclosure or repossession. If the fair value less cost to sell of the OREO asset when taken into possession is greater than the recorded loan amount, the excess should be reported either as “Other noninterest income” on the Call Report or as “Recoveries on loans and leases” if there had been a prior charge-off of the loan. In a situation when the OREO asset appears to be worth more than the balance of the loan, the appraisal or other information on the property’s value should be reviewed to understand why the borrower would risk losing the equity in the property. Additionally, in some states, lenders are required to return recovered amounts, in excess of the amount owed, to the borrower.
3. Q: Do Call Report requirements differ when a borrower has the ability to redeem a property after foreclosure?
A: Reporting requirements will depend on who has physical possession of the property after foreclosure. If state law allows the borrower to live in the property during the redemption
2 While the Q&As reference the schedule and line item (shown in italics) on the Call Report, a holding company should refer to the corresponding schedule and line item in the Consolidated Financial Statements for Bank Holding Companies (FR Y-9C). 3 For financial reporting purposes, fair value reflects the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date (that is, the financial reporting date). 4 In accordance with Call Report instructions, if an institution sells the OREO asset shortly after foreclosure or repossession, it is generally appropriate to substitute the value received in the sale (net of cost to sell) for the asset’s fair value (less cost to sell) which had been estimated at the time of foreclosure or repossession.
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period, then the asset would remain in “Loans and lease financing receivables” on the Call Report until expiration of the redemption period and the institution takes physical possession of the property. However, if the institution has physical possession of the property during the redemption period (that is, the borrower has vacated the property or has been evicted from the property), then the asset would be moved to “Other real estate owned” on the Call Report.
II. REPORTING TREATMENT AND CLASSIFICATION 4. Q: When an institution forecloses on its subordinate lien position, how are the
outstanding senior liens on the OREO asset treated for financial reporting purposes? A: In accordance with Call Report instructions, the amount of any senior debt (principal and accrued interest) to which an OREO asset is subject at the time of foreclosure is reported as a liability in “Other borrowed money” on the Call Report.
5. Q: What are the reporting consequences when the value of an OREO asset changes?
A: In accordance with Call Report instructions, an OREO asset is carried at the lower of (1) the fair value of the asset less the estimated cost to sell the asset or (2) the cost of the asset (that is, the OREO asset’s fair value less cost to sell recorded at the time of foreclosure, as discussed in Question 2). Changes in fair value must be determined on each OREO asset individually. In subsequent periods, if the fair value of the OREO asset minus the estimated cost to sell is less than the cost of the asset, the deficiency must be recognized as a valuation allowance against the asset, which is created through a charge to expense. This valuation allowance is increased or decreased (but not below zero) through charges or credits to expense for changes in the OREO asset’s fair value or estimated selling cost. On the Call Report, the balance reported for the OREO asset is net of any valuation allowances.
6. Q: Should an OREO asset be adversely classified? A: As discussed in the “Classification of OREO,” subsection of section 2200.1 “Other Real Estate Owned” of the Commercial Bank Examination Manual, an OREO asset is generally considered an adversely classified asset. For purposes of classification, any carrying value of the OREO asset in excess of its fair value, less cost to sell, should be classified as Loss, net of any applicable valuation allowance. The institution should periodically evaluate the OREO asset’s carrying value and factors affecting potential recovery that may require classification of the asset’s remaining book value. In determining the classification of the remaining book value, an institution may consider a pending sale of the OREO asset or rental income from the OREO asset. If the institution has a sales contract to sell the OREO asset to a third party and the net sale proceeds are expected to cover the carrying value, the institution may not need to classify the asset. The institution should be able to demonstrate that the purchaser has the financial resources to complete the
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purchase and that the institution has no contingent liability to repurchase the property or guarantee the property’s financial performance. With regard to residential rental OREO properties, a property with a lease in place and demonstrated rental cash flow sufficient to generate a reasonable rate of return would generally not be adversely classified. For further guidance, refer to SR letter 12-5/CA letter 12-3, “Policy Statement on Rental of Residential Other Real Estate Owned (OREO) Properties.”
7. Q: How should an institution report the operating income and expenses for an OREO
asset on the Call Report?
A: Operating income related to an OREO asset (for example, gross rental income) is recognized as “Other noninterest income” on the Call Report, while expenses are reported as “Other noninterest expense.” Operating expenses include, but are not limited to, legal fees and direct costs incurred for foreclosure, property maintenance, and state and local government assessments.
8. Q: How does an institution account for real estate taxes and insurance on an OREO asset?
A: In accordance with generally accepted accounting principles (GAAP), real estate taxes and insurance would be expensed if the institution is merely holding the property for future sale. If an institution forecloses on an incomplete project and decides to complete construction, costs incurred for real estate taxes and insurance are capitalized during the construction period until it is substantially complete and ready for its intended use. Once the OREO asset is substantially complete and ready for its intended use, those costs are expensed.
9. Q: If an OREO asset is partially completed and the institution decides to complete construction, how should the institution report these capital improvement expenses? A: In accordance with GAAP, capital improvement expenses clearly associated with the construction of the project should be capitalized as part of the cost of the OREO asset and reported on the balance sheet as part of the fair value less cost to sell of the asset. Once the property is ready for its intended purpose, subsequent carrying costs should be expensed as incurred. As noted in Question 5, each OREO asset must be carried at the lower of (1) the fair value of the asset less the estimated cost to sell the asset or (2) the cost of the asset. Therefore, while the capital improvements will increase the cost of the asset, the capitalized expenses may not increase the OREO asset’s recorded value to an amount greater than the asset’s fair value after improvements and less cost to sell.
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III. APPRAISAL CONCEPTS5 10. Q: What are the Federal Reserve’s supervisory expectations for a regulated
institution’s practices to obtain an appraisal upon a property’s transfer to OREO?
A: In accordance with the regulatory appraisal exemption for an existing extension of credit in the Federal Reserve Board’s appraisal regulation,6 a regulated institution is required at minimum to obtain an evaluation when a property is transferred to OREO through foreclosure or a deed in lieu of foreclosure. Although the appraisal regulation’s minimum requirement is an evaluation, the regulated institution may decide to obtain an appraisal, considering the type, complexity, use, and location of the property, as well as current market conditions. Refer to SR letter 10-16, “Interagency Appraisal and Evaluation Guidelines,” for a discussion of the development and content of an evaluation. While the Federal Reserve Board’s regulation may not require an appraisal, a state member bank also needs to consider whether state banking laws and regulations require an appraisal at the time the state member bank forecloses or takes possession of the property. Refer to SR letter 95-16, “Real Estate Appraisal Requirements for Other Real Estate Owned (OREO).”
11. Q: What are the supervisory expectations for an institution’s practices to determine the value of a property upon transfer to OREO? A: In accordance with the Board’s appraisal regulation, an institution must, at a minimum, have an evaluation or may elect to obtain an appraisal to determine the value of a property upon transfer to OREO. The evaluation or appraisal should reflect an opinion of the property’s market value as defined in the Board’s appraisal regulation (12 CFR 225.62 (g)). Market value is defined as:
The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition are the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby: (1) Buyer and seller are typically motivated; (2) Both parties are well informed or well advised, and acting in what they consider their
own best interests; (3) A reasonable time is allowed for exposure in the open market;
5 In this Q&A document, unless the discussion pertains to the Board’s appraisal regulation, “appraisal” refers to both an appraisal and evaluation. The Board’s appraisal regulation (12 CFR 225.62(a)) defines an “appraisal” as a written statement independently and impartially prepared by a qualified appraiser setting forth an opinion as to the market value of an adequately described property as of a specific date(s), supported by the presentation and analysis of relevant market information. An evaluation must comply with the requirements outlined in the attachment to SR letter 10-16, “Interagency Appraisal and Evaluation Guidelines.” 6 See the Board’s Regulation H for state member banks (12 CFR 208, subpart E) and the Board’s Regulation Y for holding companies (12 CFR 225, subpart G).
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(4) Payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and
(5) The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.
The term “market value” that is defined in the Board’s appraisal regulation is based on similar valuation concepts as “fair value” for accounting purposes under GAAP. In accordance with GAAP, the term “fair value” reflects the price that would be received to sell an asset in an orderly transaction between market participants at the measurement date. Therefore, to comply with GAAP, an institution must initially report the fair value of the property less cost to sell on its financial statements, as discussed in Question 2.
12. Q: How should an institution assess the adequacy of an appraisal (or an evaluation if
permitted) to support its valuation of a particular OREO property? A: The appraisal should fully support the market value opinion of the OREO asset with sufficient information and analysis of the property’s current “as is” condition (considering the property’s highest and best use) and other relevant risk and market factors affecting the property’s market value. This includes an assessment as to whether the appraisal’s assumptions on market conditions, events, and trends are reasonable and supportable. Refer to SR 10-16 for further supervisory expectations for an institution’s appraisal process. An institution should consider whether:
• The appraisal addresses the current condition of the property and reflects any deferred maintenance.
• For a property under construction, construction costs are reasonable and are adequate to cover completion of the project in accordance with plans and any possible contingencies.
• The assumptions support any anticipated change in the permissible use of the property, supported by information on market conditions.
• For a special-purpose property, the appraisal considers the value of the property under more conventional use and identifies the value of any special-purpose features and fixtures.
• The sources of data are current and timely, recognizing that there are data lags when public records are used.
• If there are few comparable sales, the appraisal addresses supply and demand factors, and identifies recently closed sales and not just properties listed for sale.
• For an income-producing property, the appraisal provides information on and consideration of typical rental concessions.
• The holding and absorption period to achieve stabilized occupancy or to sell-out the project are reasonable and supportable by current market conditions and trends.
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• Terms and conditions of lease renewals consider the current market and rental rates and not just historical trends.
• On an existing property, the appraisal explains whether contract rents differ from market rents and discloses the effect on the property’s market value.
• Capitalization and discount rates are realistic and reflective of current investor expectations.
13. Q: What are the supervisory expectations for an institution’s practices to monitor the
value of OREO, including obtaining a new appraisal? A: While the Federal Reserve has no regulatory requirement governing when and how often to obtain a new appraisal for an OREO asset, SR 10-16 provides supervisory expectations that an institution should have policies and procedures for the monitoring of collateral values. Further, current market value information of an OREO asset is necessary to determine the property’s fair value and support the carrying value of the OREO asset on the institution’s financial statements. Therefore, a regulated institution should have a policy establishing procedures for monitoring the market value of the OREO property over the holding period. The institution’s policy should consider whether the existing appraisal or collateral valuation information is still current. The policy should consider procedures for determining the validity of an existing appraisal or collateral valuation information, with which to determine whether the appraisal or collateral valuation reflect current market conditions, based on factors such as: the property type, current market supply and demand, current use of the property, and the passage of time since the most recent appraisal. Updated collateral valuation information is particularly important during rapidly changing market conditions (including both declining and improving markets), and when there are changes in project plans. A state member bank also needs to consider whether state banking laws and regulations require the state member bank to update the property’s market value on an annual or periodic basis. These requirements vary by state and are addressed in state regulations on the booking and holding of other real estate or bank-owned real estate.
IV. ONGOING PROPERTY MANAGEMENT 14. Q: How long may a Federal Reserve-regulated institution hold an OREO asset on its
books?
A: Generally, the Federal Reserve allows bank holding companies to hold an OREO asset for up to five years, with an additional five-year extension subject to certain circumstances.7 Regardless of the allowable holding period, the Federal Reserve generally expects bank holding companies, their nonbank subsidiaries, and state member banks to seek to dispose of
7 Refer to the Board’s Regulation Y (12 CFR 225.22(d)(1)).
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OREO assets as soon as prudent and reasonable, taking into account market conditions.8 Under difficult market conditions, Federal Reserve regulations and policies permit the rental of OREO properties to third-party tenants as part of an orderly disposition strategy within statutory and regulatory limits. For further guidance on this matter, refer to SR 12-5/CA 12-3. Savings and loan holding companies generally may acquire real estate for rental and are not subject to the same statutory and regulatory restrictions as bank holding companies.9 State member banks and licensed branches of foreign banks are subject to the holding periods and other limitations on OREO activity established by their licensing authority, which vary on initial holding period, extensions of holding period, and total length of the holding period, as well as requirements for the write-down of the OREO carrying value.
15. Q: If an institution decides to enter into an agreement with a third party to manage or
maintain an OREO asset, what due diligence should the institution’s management consider before entering into a management agreement, and what are sound practices for entering into and managing outsourcing arrangements for OREO activities?
A: To manage the cost and to supplement its own resources, an institution may use a third-party service provider for property management, maintenance or improvements, compliance with local laws and regulations, or other services. However, the outsourcing of all or part of the OREO management function poses risks that an institution needs to address, as is the case with any outsourced function. Therefore, the supervisory guidance for managing the risks associated with other types of outsourcing arrangements10 may be used as guidance for sound risk management practices for the selection, contract review, and monitoring of a third-party provider. In entering into these third-party arrangements, an institution should:
• Identify, assess, and monitor the risk of the outsourcing arrangement.
• Implement policies and procedures for monitoring and managing the risk of outsourcing OREO activities, consistent with the institution’s OREO policies and procedures.
• Perform due diligence and evaluate vendors, considering such factors as competence, expertise, management quality, financial strength (for example, the ability to obtain insurance and bonding), and professional accreditation. Other considerations include the vendor’s experience with a particular property type or in a particular geographic market, and presence of, or access to, specialized legal expertise.
8 See Commercial Bank Examination Manual, Section 2200.1, “Other Real Estate Owned,” and Bank Holding Company Supervision Manual, Section 3030.0, “Section 4(c)(2) and (3) of the BHC Act (Acquisition of DPC Shares, Assets, or Real Estate).” 9 See 12 U.S.C. 1467a(c)(2) and 12 CFR 238.53(b). 10 See Federal Financial Institutions Examination Council IT Examination Handbook, “Outsourcing Technology Services Booklet;” SR letter 03-5, “Amended Interagency Guidance on the Internal Audit Function and its Outsourcing;” and SR letter 00-17, “Guidance on the Risk Management of Outsourced Technology Services.”
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A contractual arrangement may address the following items:
• Expectations and responsibilities under the contract for both parties. Among other things, vendor responsibilities should include providing information related to the work performed, expenses, compliance with all applicable laws and regulations, and other relevant activity or risk-exposure information necessary for sound risk management by senior management and directors;
• The scope and frequency of, and the fees to be paid for, the work to be performed by the vendor;
• The process for changing the terms of the contract or agreement, especially for expansion of work if significant repair or maintenance issues are found, and conditions of default and causes for contract termination;
• The location(s) where OREO activity documentation will be maintained by the vendor, the length of time documents will be archived by the vendor, and provisions for the institution to have reasonable and timely access to the documents;
• Audit and regulatory review of the vendor’s services, including stipulations that examiners have access to records or documents prepared or maintained by the vendor; and
• A process (for example, arbitration, mediation, or other means) for resolving disputes and for determining who bears the cost of consequential damages arising from errors, omissions, and negligence.
16. Q: When an institution forecloses on a partially completed real estate project, what
factors should be considered before deciding to finish the project or sell the project in its “as is” condition?
A: While each situation presents varying challenges and risks, an institution should analyze the economic cost and risk before deciding to complete a project, considering the feasibility of the project under current market conditions. The institution should also consider whether it has the skill and management resources to manage a construction project. Furthermore, an institution should evaluate whether investing additional funds to complete the project will minimize its losses as compared to marketing and selling the property in its “as is” condition.
17. Q: What steps should institutions take to ensure that a property is appropriately maintained after a notice of foreclosure is issued to the current homeowner but prior to the foreclosure being completed? A: Institutions are expected to have controls to ensure compliance with state and local laws related to entering properties during a foreclosure redemption period. Furthermore, institutions should secure properties to the best of their ability during the foreclosure process.
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V. OPERATIONAL AND LEGAL ISSUES
18. Q: What ownership risks or liabilities arise when an institution takes title to OREO, and what are the sound risk management practices associated with the ownership of foreclosed property (both occupied and vacant properties)?
A: Based on its risk assessment, an institution should consider seeking legal advice on the risks posed by taking possession of the property. The risk assessment should be performed before the institution takes title to the property and should consider local market conditions and any local and state government requirements governing the institution’s ownership, maintenance, and sale or disposal of the property. If the property is located outside of the institution’s market footprint, the institution may need to retain experts with knowledge of local legal requirements and market conditions.
Ownership risks and potential liability exposures include:
• Obligations under property governing documents, tenant lease agreements, or contracts;
• Requirements to provide a safe and secure environment to tenants;
• Requirements to maintain or operate the property in conformance with federal, state, and local laws, including those addressing health and safety standards;
• Payment of property taxes; and
• Obligations to address possible environmental risks. Examples of risk management practices for vacant properties include:
• Remediating obvious hazards to health and safety;
• Securing exterior openings to the property and all exterior mechanical systems;
• Adjusting utility services to a level appropriate to preserve the property;
• Scheduling the property for periodic field inspection and maintenance;
• Posting emergency contact information and ownership information on the main entrance door to the property, on a laminated waterproof notice;
• Posting and executing “No Trespassing” signage at the front and rear of the property, and executing all required “No Trespass” documents in accordance with local law enforcement agencies; and
• Analyzing the potential environmental liability to the institution and the implications for the property’s value.
19. Q: What are some potentially useful measures for monitoring and managing OREO
risk? A: An institution should develop measures to assess and monitor the risk in its OREO assets that are consistent with the nature, extent, and complexity of its OREO portfolio.
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Management should have an information system to monitor and analyze OREO properties that is appropriate for the institution’s OREO portfolio size and complexity. The following are examples of performance ratios that the institution may choose to monitor:
• Net disposition proceeds as a percentage of original book value of the property
• Valuation reserve as a percentage of OREO values
• Volume and dollar amount of former OREO currently being financed
• OREO holding and management costs as a percentage of OREO
• Legal expense (since foreclosure) related to OREO as a percentage of OREO
• OREO as a percentage of internally criticized assets (which include special mention and classified assets) plus past due
• OREO (by type) as a percentage of corresponding loan type
20. Q: What controls and processes should institutions have in place to ensure that properties in the OREO inventory are properly maintained and meet local code-enforcement ordinances and other laws? A: Institutions should have policies and procedures in place to ensure that properties are maintained in compliance with federal, state, and local laws, including laws governing health and safety, property preservation, fair housing, and property registration. An institution’s failure to adhere to these legal requirements can result in fines, litigation, and reputational damage. Further, institutions engaging third-party vendors to carry out functions related to these requirements should ensure that vendors maintain appropriate compliance controls. Reliance on third-party vendors does not relieve an institution of its compliance responsibilities or liability.
21. Q: In addition to considerations regarding health and safety violations, how should institutions determine which repairs to make before disposition? A: Expending funds to repair a property is one strategy for an institution to consider for improving potential recovery on the sale of OREO assets. For instance, repairs may be necessary for the property to qualify for a Federal Housing Administration (FHA)-insured loan, which in turn may attract a greater number of qualified buyers. Institutions should have controls in place to comply with all federal, state, and local laws, including fair housing laws. For example, institutions may not avoid or delay the maintenance or repairs of dwellings based on the racial or ethnic composition of the geographic area where they are located.
22. Q: What steps should an institution take to comply with existing laws protecting tenants? A: Institutions should have controls in place to comply with all federal, state, and local laws related to protecting the rights of tenants, including the federal Protecting Tenants at Foreclosure Act of 2009 (CA letter 09-5), Servicemembers Civil Relief Act (CA letter 05-3),
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the Fair Housing Act, and the Americans with Disabilities Act. For example, an institution or its agent should have consistent processes in place to provide proper and timely notice of the institution’s ownership of the foreclosed property and provide the tenant with the allowable timeframes, as established under law, to remain in the foreclosed property before eviction proceedings commence. Institutions that lack experience as a landlord may wish to engage the services of a property management firm. However, as previously stated, reliance on third-party vendors does not relieve an institution of its compliance responsibilities or liability.
VI. SALE AND TRANSFER OF OREO 23. Q: What is the primary source of accounting guidance for sales of OREO?
A: The primary accounting guidance for sales of real estate (including foreclosed real estate) is Accounting Standards Codification Subtopic 360-20, “Property, Plant, and Equipment – Real Estate Sales” (formerly FASB Statement No. 66, “Accounting for Sales of Real Estate”) (ASC 360-20). This standard, which applies to all transactions in which the seller provides financing to the buyer of the real estate, establishes several methods (discussed in questions 25 to 27) to account for the disposition of real estate. The methods established in ASC 360-20 are the full accrual, installment, cost recovery, reduced-profit, and deposit methods. Each of these methods is also summarized in the Call Report Glossary entry titled “Foreclosed Assets.”
While the methods established in ASC 360-20 are briefly described in the questions below, this document does not contain a comprehensive list of all considerations that need to be made when analyzing sales of real estate. This area of GAAP is very complex and requires significant judgment; therefore, a thorough review of ASC 360-20 is usually required when analyzing sales of real estate because it provides detailed guidance necessary to determine the appropriate accounting for these transactions. As a result, it is not possible to cover all of the details of this area of GAAP in this document.
24. Q: When an institution sells an OREO asset, how is a gain or loss on the sale reported on the Call Report? A: Any loss on the sale of an OREO asset should be recognized immediately and reported as “Net gains (losses) on sales of other real estate owned” on the Call Report. A gain on the sale of an OREO asset is also reported on the same line; however, recognition of a gain depends on the accounting method used in the transaction, as noted in Questions 25-26.
25. Q: When may an institution immediately recognize the gain on an institution-financed
sale of OREO? A: Under GAAP, when the transaction meets the qualifications for the full accrual method of sale accounting, the following applies: (1) a sale is recognized, (2) the asset resulting from the institution’s financing of the transaction is reported as a loan, (3) the gain or loss on the
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sale is recognized immediately, and (4) interest income is accrued on the new loan. This method may be used when all of the following conditions have been met:
• A sale has been consummated,11
• The buyer’s initial investment (for example, a cash down payment) and continuing investment (periodic payments) are adequate to demonstrate a commitment to pay for the property,
• The receivable is not subject to future subordination, and
• The usual risks and rewards of ownership have been transferred. Further details regarding the minimum initial investment, including detailed guidance regarding what must be included or excluded in this amount, can be found in ASC 360-20. The Appendix to this Q&A document contains guidance on the minimum initial investment for various types of real estate that is provided in ASC 360-20-55. To meet the continuing investment (periodic payment) requirement, the contractual loan payments must be sufficient to repay the loan in level annual payments over the customary term for the type of property involved. In order for the usual risks and rewards of ownership to be transferred, the institution cannot have substantial continuing involvement with the property. ASC 360-20 provides detailed guidance on the forms of continuing involvement that result in prohibition on the use of the full accrual method.
26. Q: What other accounting methods could apply to an institution-financed sale of OREO? How are gains on sales and interest income recognized under those methods?
A: The following methods are used when a sale has been consummated as prescribed by GAAP, but the conditions for full accrual have not been met:
• Installment method: For use when the buyer’s initial investment is not adequate for full accrual, but recovery of the cost of the OREO asset is reasonably assured if the buyer defaults. This method recognizes a sale of the OREO asset and the corresponding new loan. Any gain on the sale is recognized as payments are received and interest income may be accrued, when appropriate.
• Cost recovery method: For use when the disposition does not qualify for full accrual or installment methods. This method recognizes a sale of the OREO asset and the corresponding new loan on nonaccrual status, and all income recognition is deferred. Principal payments reduce the loan balance and interest increases unrecognized gross profit. No gain or interest income is recognized until either the aggregate payments exceed the recorded amount of the loan, or a change to another accounting method is appropriate.
11 Under GAAP, a sale has been consummated when all of the following conditions are met: (1) the parties are bound by the terms of a contract, (2) all consideration has been exchanged, (3) any permanent financing for which the seller is responsible has been arranged, and (4) all conditions precedent to closing have been performed. Usually, these four conditions are met at the time of closing or after closing, not when an agreement to sell is signed or at a preclosing.
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• Reduced-profit method: For use when the down payment is adequate, but the amortization schedule does not meet full accrual method requirements. This method recognizes a sale of the OREO asset and a corresponding new loan. However, only a portion of the gain on the sale is recognized as payments are received based on the present value of the lowest level of periodic payments required under the loan agreement.
If the transaction eventually meets the requirements for the full accrual method, the institution may switch to that method at that time and recognize any unrecognized gain on the sale. As stated in Question 24, any loss on the sale of the OREO asset is recognized immediately under all methods.
27. Q: Under what circumstances would an institution-financed sale of OREO not result in a sale for accounting and reporting purposes, and what method of accounting would be appropriate for the transaction?
A: Under GAAP, certain conditions exist for a sale to be consummated for accounting purposes (see Question 25). If a sale is not consummated for accounting purposes, the transaction is accounted for under the deposit method. Because there is no sale for accounting purposes, the asset remains reported as an OREO asset and no gain on sale or interest income for the new loan is recognized. If, however, the net carrying amount of the OREO asset exceeds the sum of the deposit received, the fair value of the unrecorded note receivable, and the debt assumed by the buyer, the institution must recognize the loss on the date the agreement to sell is signed. Payments received from the borrower are reported as a liability until sufficient payments have been received to qualify for a different accounting method. The deposit method may also be used if a sale is consummated for accounting purposes, but the initial investment is inadequate and recovery of the cost of the property is not assured.
Finally, certain forms of continuing involvement in the OREO asset by the institution may limit its ability to recognize a sale. One example is when the institution may be required to initiate or support operations for an extended period of time, which results in accounting for the transaction as a financing, leasing, or profit-sharing arrangement. One common type of condition that indicates a presumption of support is when the institution holds a receivable from the buyer for a significant part of the sales price and collection of the receivable depends on the operation of the property. ASC 360-20 includes detailed guidance on the types of continuing involvement that should be considered when determining whether a sale has occurred for accounting and reporting purposes.
28. Q: May an institution sell or transfer an OREO asset to a related party (such as the bank holding company or a non-bank affiliate)?
A: The Federal Reserve does not have a regulation prohibiting the sale of an OREO asset to a related party. When a transaction with a related party occurs, an institution should verify that the asset is recorded at fair value. The sale of an asset to an affiliate must comply with the market terms requirement of the Board’s Regulation W (12 CFR 223.51). The terms must be substantially the same, or at least as favorable to the institution, as those to nonaffiliates for
Page 15 of 19
comparable transactions. Similarly, if an insider purchases an OREO asset, the transaction must be recorded at fair value in accordance with GAAP and not create a disadvantage to the institution by an artificially low sales price. Additionally, the Board’s Regulation O (12 CFR 215) limitations apply when an institution finances an OREO asset sale to an insider. Moreover, transfers of an OREO asset within a holding company do not extend any period for the required divestiture of the property. Refer to the Board’s Regulation Y (12 CFR 225.22(d)(1)(iii)).
29. Q: What procedures and internal controls should an institution have in place to assess the reasonableness of an offer to purchase an OREO asset and to support the decision to sell the property? A: The institution’s procedures should ensure that the sale of an OREO asset maximizes recovery and adheres to applicable federal and state laws and regulations. The procedures should also address the approval process for the sale of a particular property, including the level of management required to approve a sale. Moreover, the procedures should address whether the institution will consider an offer to purchase an OREO asset from a related party (for example, a member of the board of directors, an employee, or a relative of an employee). Procedures should address documentation requirements for the institution’s plans to market and sell the property, the approval of the sale, and, if applicable, the approval of a loan to finance the purchase of an OREO asset. Such documentation should include:
• A plan for the marketing and sale of the property in accordance with applicable federal and state laws, including the Fair Housing Act. The plan should be revised as needed to reflect changes in market conditions;
• A record of inquiries and purchase offers made by potential buyers, including reasons for rejecting an offer or accepting an offer. Acceptance of an offer should include confirmation that the potential buyer has the financial ability and motivation to close the sale;
• Methods used to market, advertise, and sell the property, whether by the institution or its agent (for example, documentation should address the method of sale, including bulk sales or auction);
• The establishment of the property’s sales listing price and any changes to the listing price;
• An assessment of market conditions affecting the ability of the institution to sell the property, including regular updates;
• Listing and sales agreements with the institution’s agent, including terms of sales commissions;
• The purchase agreement and the terms of sale, including any representations and warrants made by the institution, transaction closing costs to be paid by the institution, and documentation on the transfer of ownership and recordation of the title;
Page 16 of 19
• Legal review of the sale transaction documents;
• Approval of the sale by the appropriate level of management and, if applicable, the approval of the institution’s loan to the purchaser of the property and executed loan documents;
• Confirmation of the institution’s receipt of the funds from the purchaser of the property; and
• Other documentation related to the sale and transfer of ownership, including cancellation or assignment of a property management agreement, transfer of property management documents (for example, lease agreements) to the new owner, and notification to the institution’s insurance company of the sale.
30. Q: What incentives exist to encourage institutions to sell residential OREO properties
to owner-occupants and groups involved in neighborhood stabilization efforts, before considering selling to investors? A: Many institutions have implemented “first look” programs that give prospective homeowners brief exclusive opportunity to purchase bank-owned properties in certain neighborhoods so these homes can either be rehabilitated, rented, resold, or demolished. Giving prospective homeowners and communities a “first look” can help to limit neighborhood blight, stabilize property values, maximize recovery, and mitigate reputational risk for a financial institution. Under the Community Reinvestment Act (CRA) and the Neighborhood Stabilization Program rules, institutions can receive investment credit for OREO donations made in U.S. Department of Housing and Urban Development-designated Neighborhood Stabilization Areas, in line with this provision of CRA.
31. Q: What legal requirements should institutions consider when deciding how to market and sell residential properties, including whether to sell residential properties (or pools of properties) to investors or at auction? A: An institution should ensure that its policies and procedures governing the marketing, sale, and disposition of OREO properties comply with applicable laws, including the Fair Housing Act and the Equal Credit Opportunity Act (if the institution makes or facilitates credit). For example, an institution’s marketing and sales strategies may not be based on the racial or ethnic composition of the geographies where the properties are located. Additionally, when selling to investors, an institution should conduct proper due diligence to ensure they have no prior criminal history and do not engage in practices that could have an adverse impact on property values. Institutions may also consider implementing controls to evaluate purchaser actions following the sale of OREO property to an investor. Some institutions now evaluate bulk purchasers to determine whether properties are resold to responsible buyers or are contributing to neighborhood blight due to negligence. Robust oversight of investor purchase transactions of OREO properties can reduce an institution’s financial, legal, and reputational risks.
Page 17 of 19
Appendix GAAP Guidance on Minimum Initial Investment Requirements
As noted in ASC 360-20-40, a buyer’s initial investment shall be adequate to demonstrate
the buyer’s commitment to pay for the property and shall indicate a reasonable likelihood that the seller will collect the receivable. The minimum initial investment requirements for various types of real estate are provided in ASC 360-20-55 (see the following table). The minimum initial investment is expressed as a percentage of sales value. Although the table does not cover every type of real estate property, an institution may make analogies to the types and associated risks of properties specified in this table to evaluate initial investments for other property types.
Further, institutions need to consider the other requirements in ASC 360-20-55 to
determine whether the institution needs to modify the minimum initial investment requirement. If a recently placed permanent loan or firm permanent loan commitment for maximum financing of the property exists with an independent, established lending institution, the minimum initial investment should be whichever of the following is greater:
a. The minimum percentage of sales value of the property specified in the ASC 360-20-55 table, or
b. The lesser of:
1. The amount of the sales value of the property in excess of 115% of the amount of a newly placed permanent loan or firm permanent loan commitment from a primary lender that is an independent established lending institution; or
2. 25% of the sales value.
Page 18 of 19
Table from ASC 360-20-55
Minimum Initial Investment
Expressed as a Percentage of Sales
Value Land Held for commercial, industrial, or residential development to commence within two years after sale 20 Held for commercial, industrial, or residential development to commence after two years 25 Commercial and Industrial Property Office and industrial buildings, shopping centers, and so forth:
Properties subject to lease on a long-term lease basis to parties with satisfactory credit rating; cash flow currently sufficient to service all indebtedness 10 Single-tenancy properties sold to a buyer with a satisfactory credit rating 15 All other 20
Other income-producing properties (hotels, motels, marinas, mobile home parks, and so forth):
Cash flow currently sufficient to service all indebtedness 15 Start-up situations or current deficiencies in cash flow 25
Multifamily Residential Property Primary residence:
Cash flow currently sufficient to service all indebtedness 10 Start-up situations or current deficiencies in cash flow 15
Secondary or recreational residence: Cash flow currently sufficient to service all indebtedness 15 Start-up situations or current deficiencies in cash flow 25
Single-Family Residential Property (including condominium or cooperative housing) Primary residence of the buyer 5(a) Secondary or recreational residence 10(a)
Note (a): If collectibility of the remaining portion of the sales price cannot be supported by reliable evidence of collection experience, the minimum initial investment shall be at least 60 percent of the difference between the sales value and the financing available from loans guaranteed by regulatory bodies such as the Federal Housing Authority (FHA) or the Veterans Administration (VA), or from independent, established lending institutions. This 60 percent test applies when independent first-mortgage financing is not utilized and the seller takes a receivable from the buyer for the difference between the sales value and the initial investment. If independent first mortgage financing is utilized, the adequacy of the initial investment on sales of single-family residential property should be determined in accordance with ASC 360-20-55-1.
Page 19 of 19
A seller of owner-occupied single-family residential homes that finances a sale under an
FHA or VA government-insured program may use the normal down payment requirements or loan limits established under those programs as a surrogate for the down payment criteria set forth above and may record profit under the full accrual method, provided that the mortgage receivable is fully insured from loss under the FHA or VA program. In that specific circumstance, departure from the minimum initial investment criteria above is justified because all of the credit risk associated with the receivable from the sale is transferred to the governmental agency. However, in all other circumstances (for example, FHA or VA programs that provide for less than full insurance or seller financing using private mortgage insurance), the minimum initial investment criteria set forth above shall be followed.
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cred
it d
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s.
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s an
d A
nsw
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(Q
&A
s)
on
th
e M
anag
em
en
t o
f O
the
r R
eal
Est
ate
Ow
ne
d (
OR
EO)
Gu
est
Sp
eak
ers
:
Do
nal
d G
abb
ai, F
eder
al R
eser
ve B
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Car
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n H
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eral
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of
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vern
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Mat
thew
Kin
caid
, Fed
eral
Res
erve
Bo
ard
of
Go
vern
ors
Tim
Ro
be
rtso
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eder
al R
eser
ve B
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d o
f G
ove
rno
rs
Fed
era
l Re
serv
e S
yste
m
Sep
tem
be
r 2
7, 2
01
2
We
lco
me
eve
ryo
ne
•To
day
’s s
ess
ion
•Q
ue
stio
ns:
–Em
ail y
ou
r q
ue
stio
n t
o:
askt
he
fed
@st
ls.f
rb.o
rg
or
–U
se t
he
“A
sk a
Qu
est
ion
” fe
atu
re o
n t
he
Ask
th
e F
ed
® w
eb
site
: w
ww
.ask
thef
ed
.org
•Th
is c
all i
s b
ein
g re
cord
ed
an
d w
ill b
e a
vaila
ble
imm
ed
iate
ly
follo
win
g th
e s
ess
ion
.
•A
su
rve
y w
ill b
e d
eliv
ere
d v
ia e
mai
l fo
llow
ing
the
cal
l. L
et
us
kno
w y
ou
r th
ou
ghts
or
ide
as f
or
futu
re s
ess
ion
s.
2
Julie
Sta
ckh
ou
se
Fed
eral
Res
erve
B
ank
of
St. L
ou
is
Fed
eral
Res
erve
B
oar
d o
f G
ove
rno
rs
Fed
eral
Res
erve
B
oar
d o
f G
ove
rno
rs
Fed
eral
Res
erve
B
oar
d o
f G
ove
rno
rs
Mat
t K
inca
id
Car
me
n H
olly
Ti
m R
ob
ert
son
Ou
r P
rese
nte
rs a
nd
Ho
st T
od
ay
Fed
eral
Res
erve
B
oar
d o
f G
ove
rno
rs
Do
nal
d G
abb
ai
3
Age
nd
a
•B
ackg
rou
nd
–W
hy
the
Bo
ard
issu
ed
Q&
As
on
OR
EO
•R
ep
ort
ing
tre
atm
en
t
–Tr
ansf
err
ing
asse
ts t
o O
REO
–R
ep
ort
ing
tre
atm
en
t
–Sa
le a
nd
tra
nsf
er
of
OR
EO
•C
lass
ific
atio
n
•A
pp
rais
al c
on
cep
ts
•C
om
mu
nit
y is
sue
s
•Q
ue
stio
ns
4
Bac
kgro
un
d
5
•O
ver
the
last
se
vera
l ye
ars,
ban
ks h
ave
e
xpe
rie
nce
d a
ris
e in
OR
EO a
s a
resu
lt o
f:
–G
en
era
l we
akn
ess
es
in t
he
ho
usi
ng
mar
ket
–In
cre
ase
s in
de
linq
ue
nci
es
and
de
fau
lts
–D
ecl
ine
s in
ho
usi
ng
pri
ces
–W
eak
ne
sse
s in
th
e s
tru
ctu
re o
f a
nu
mb
er
of
com
me
rcia
l re
al e
stat
e f
inan
cin
gs
Bac
kgro
un
d:
Wh
y th
e B
oar
d
Issu
ed
OR
EO Q
&A
s
6
Sou
rce:
Fo
r fo
recl
osu
re in
ven
tory
, sta
ff e
stim
ate
fro
m M
ort
gage
Ban
kers
Ass
oci
atio
n;
for
REO
, Co
reLo
gic
Bac
kgro
un
d:
Wh
y th
e B
oar
d
Issu
ed
OR
EO Q
&A
s (c
on
tin
ue
d)
7
•Q
A is
inte
nd
ed
to
ad
dre
ss b
oth
saf
ety
an
d s
ou
nd
ne
ss a
nd
co
nsu
me
r co
mp
lian
ce is
sue
s.
•To
pic
s co
vere
d in
th
e Q
A d
ocu
me
nt:
– F
inan
cial
re
po
rtin
g
– L
oss
re
cogn
itio
n
– M
anag
em
en
t o
f O
REO
ass
ets
– C
on
sum
er
pro
tect
ion
issu
es
•Se
e S
R le
tte
r 1
2-1
0/C
A le
tte
r 1
2-9
, “Q
ue
stio
ns
and
A
nsw
ers
fo
r Fe
de
ral-
Re
serv
e R
egu
late
d In
stit
uti
on
s R
ela
ted
to
th
e M
anag
em
en
t o
f O
the
r R
eal
Est
ate
Ow
ne
d
(OR
EO)”
Bac
kgro
un
d:
Wh
y th
e B
oar
d
Issu
ed
OR
EO Q
&A
s (c
on
tin
ue
d)
8
Re
po
rtin
g Tr
eat
me
nt
and
C
lass
ific
atio
n
9
Acc
ou
nti
ng
and
R
ep
ort
ing
Gu
idan
ce
Acc
ou
nti
ng
guid
ance
•A
SC S
ub
top
ic 3
10
-40
, R
ecei
vab
les:
Tro
ub
led
Deb
t R
estr
uct
uri
ng
s b
y C
red
ito
rs
(fo
rmer
ly F
AS
15
)
•A
SC S
ub
top
ic 3
60
-10
, Pro
per
ty,
Pla
nt,
an
d E
qu
ipm
ent:
Ove
rall
(fo
rmer
ly F
AS
14
4)
•A
SC S
ub
top
ic 3
60
-20
, Pro
per
ty,
Pla
nt,
an
d E
qu
ipm
ent:
Rea
l Es
tate
Sa
les
(fo
rmer
ly F
AS
66
)
Reg
ula
tory
gu
idan
ce
•FR
Y-9
C in
stru
ctio
ns,
glo
ssar
y en
try
for
Fore
clo
sed
Ass
ets
•C
all R
epo
rt in
stru
ctio
ns,
gl
oss
ary
entr
y fo
r Fo
recl
ose
d
Ass
ets
10
Tran
sfe
rrin
g an
Ass
et
to O
REO
•A
n a
sse
t is
re
-cat
ego
rize
d f
rom
a lo
an t
o O
REO
on
th
e C
all
Re
po
rt w
he
n a
n in
stit
uti
on
tak
es
ph
ysic
al p
oss
ess
ion
, re
gard
less
of
wh
eth
er
form
al f
ore
clo
sure
pro
cee
din
gs
hav
e ta
ken
pla
ce.
•A
n O
REO
ass
et
is m
eas
ure
d a
nd
re
po
rte
d a
t fa
ir v
alu
e (
FV)
less
co
st t
o s
ell
at t
he
tim
e o
f fo
recl
osu
re (
it b
eco
me
s a
ne
w “
cost
” o
f O
REO
ass
et)
.
•Th
is d
ete
rmin
atio
n m
ust
be
mad
e o
n a
n a
sse
t-b
y-as
set
bas
is.
11
Acc
ou
nti
ng
for
OR
EO
•A
fte
r ta
kin
g p
oss
ess
ion
, eac
h O
REO
ass
et
mu
st b
e
carr
ied
at
the
low
er
of:
–
The
FV
of
the
ass
et
min
us
est
imat
ed
co
sts
to s
ell
the
ass
et
–Th
e “
cost
” o
f th
e a
sse
t (d
esc
rib
ed o
n s
lide
11
)
•Th
e w
rite
-do
wn
can
be
re
cogn
ize
d a
s a
valu
atio
n
allo
wan
ce a
gain
st t
he
ass
et,
cre
ate
d t
hro
ugh
a
char
ge t
o e
xpe
nse
: –
Op
tio
nal
use
of
a va
luat
ion
allo
wan
ce
–Su
bse
qu
entl
y, in
crea
se o
r d
ecr
eas
e o
f va
luat
ion
allo
wan
ce
(bu
t n
ot
be
low
ze
ro)
for
chan
ges
in t
he
ass
et’
s FV
or
cost
to
se
ll
12
Acc
ou
nti
ng
for
OR
EO (
con
tin
ue
d)
•In
th
e C
all R
ep
ort
, op
era
tin
g in
com
e r
ela
ted
to
O
REO
(e
.g.,
gro
ss r
en
tals
) is
re
po
rte
d a
s o
the
r n
on
inte
rest
inco
me
, wh
ile o
pe
rati
ng
exp
en
ses
(e.g
., p
rop
ert
y ta
xes,
insu
ran
ce, m
ain
ten
ance
co
sts)
are
re
po
rte
d a
s o
the
r n
on
inte
rest
e
xpe
nse
s.
13
Exam
ple
of
Acc
ou
nti
ng
for
OR
EO
1/1
5/1
2
3/3
1/1
2
6/3
0/1
2
9/3
0/1
2
Assu
mp
tio
ns:
Loan
1
50
,00
0
FV
of co
llate
ral
11
0,0
00
1
00
,00
0
10
5,0
00
1
20
,00
0
Estim
ate
d c
ost to
se
ll (1
0,0
00
) (1
0,0
00
) (1
0,0
00
) (1
0,0
00
)
FV
le
ss c
ost to
se
ll 1
00
,00
0
90
,00
0
95
,00
0
11
0,0
00
Fin
an
cia
l S
tate
me
nt Im
pa
ct:
Loan
0
Lo
ss
(5
0,0
00
)
OR
EO
1
00
,00
0
10
0,0
00
1
00
,00
0
10
0,0
00
Va
lua
tio
n a
llow
an
ce
N/A
(1
0,0
00
) (5
,00
0)
0
Ne
t ca
rryin
g v
alu
e o
f
OR
EO
1
00
,00
0
90
,00
0
95
,00
0
10
0,0
00
14
Acc
ou
nti
ng
for
Sale
of
OR
EO
•A
pp
lies
to a
ll tr
ansa
ctio
ns
in w
hic
h t
he
se
ller
pro
vid
es
fin
anci
ng
to t
he
bu
yer
of
the
re
al e
stat
e.
•Es
tab
lish
es
five
met
ho
ds
to a
cco
un
t fo
r th
e d
isp
osi
tio
n o
f re
al e
stat
e (
de
scri
be
d
in m
ore
det
ail i
n t
he
Cal
l Re
po
rt
glo
ssar
y e
ntr
y, F
ore
clo
sed
Ass
ets)
:
•Fu
ll ac
cru
al
•In
stal
lmen
t
•C
ost
rec
ove
ry
•R
edu
ced
pro
fit
•D
epo
sit
ASC
36
0-2
0
15
Acc
ou
nti
ng
for
Sale
of
OR
EO
(co
nti
nu
ed
)
•Th
is a
rea
of
gen
era
lly a
cce
pta
ble
acc
ou
nti
ng
pri
nci
ple
s (G
AA
P)
is v
ery
co
mp
lex
and
re
qu
ire
s si
gnif
ican
t ju
dgm
en
t.
–Th
oro
ugh
re
vie
w o
f A
SC 3
60
-20
is u
sual
ly r
eq
uir
ed
w
he
n a
nal
yzin
g sa
les
of
real
est
ate
be
cau
se it
incl
ud
es
de
taile
d g
uid
ance
ne
cess
ary
to d
ete
rmin
e a
pp
rop
riat
e
acco
un
tin
g fo
r th
ese
tra
nsa
ctio
ns.
16
Acc
ou
nti
ng
for
Sale
of
OR
EO
(co
nti
nu
ed
)
•Sa
le f
inan
ced
by
ano
the
r in
stit
uti
on
re
sult
s in
im
me
dia
te r
eco
gnit
ion
of
gain
or
loss
.
•Sa
le f
inan
ced
by
the
ban
k as
ow
ne
r o
f O
REO
: –
Loss
on
sal
e o
f an
OR
EO a
sse
t ar
e r
eco
gniz
ed
im
me
dia
tely
–R
eco
gnit
ion
of
gain
on
sal
e o
f an
OR
EO a
sse
t d
ep
en
ds
on
th
e a
cco
un
tin
g m
eth
od
use
d in
th
e t
ran
sact
ion
(e
.g.,
th
e f
ive
me
tho
ds
fro
m s
lide
15
)
17
Acc
ou
nti
ng
for
Sale
of
OR
EO
(co
nti
nu
ed
)
•Ex
amp
les
of
circ
um
stan
ces
wh
ere
th
e s
ale
of
OR
EO
do
es
no
t re
sult
in a
sal
e f
or
acco
un
tin
g an
d r
ep
ort
ing
pu
rpo
ses
incl
ud
e, b
ut
are
no
t lim
ite
d t
o, t
he
fo
llow
ing:
–
Init
ial i
nve
stm
en
t is
inad
eq
uat
e a
nd
re
cove
ry o
f th
e
cost
of
the
pro
pe
rty
is n
ot
assu
red
–C
on
tin
uin
g in
volv
em
en
t in
th
e O
REO
ass
et
•Th
e s
ale
of
OR
EO t
o a
re
late
d p
arty
mu
st b
e
reco
rde
d a
t FV
: –
Mu
st a
lso
co
mp
ly w
ith
th
e m
arke
t te
rms
req
uir
em
en
t o
f R
egu
lati
on
W
18
Cla
ssif
icat
ion
of
OR
EO A
sse
ts
•Ti
me
of
tran
sfe
r
–V
alu
atio
n o
f O
REO
ass
et
–Lo
ss is
re
cogn
ize
d t
hro
ugh
th
e a
llow
ance
fo
r lo
an a
nd
le
ase
loss
es
(ALL
L)
–O
REO
ass
et,
giv
en
its
we
ll-d
efi
ne
d w
eak
ne
sse
s, s
ho
uld
b
e a
dve
rse
ly c
lass
ifie
d
•H
old
ing
pe
rio
d
–D
ecr
eas
e in
th
e O
REO
ass
et’
s FV
less
co
st t
o s
ell
is
con
sid
ere
d a
loss
–O
REO
ass
et
wo
uld
co
nti
nu
e t
o b
e a
dve
rse
ly c
lass
ifie
d
19
Cla
ssif
icat
ion
of
OR
EO A
sse
ts
(co
nti
nu
ed
) •
Pe
nd
ing
sale
–O
REO
ass
et
may
be
cla
ssif
ied
“p
ass”
un
de
r ce
rtai
n
con
dit
ion
s:
•A
fir
m c
on
trac
t is
in p
lace
th
at c
on
tem
pla
tes
a sa
le in
th
e r
eas
on
ably
ne
ar f
utu
re
•Sa
le p
roce
eds
cove
r ca
rryi
ng
valu
e
•P
urc
has
er
has
th
e f
inan
cial
re
sou
rce
s to
co
mp
lete
th
e p
urc
has
e
•B
ank
has
no
co
nti
nge
nt
liab
ility
•O
the
r co
nsi
de
rati
on
s
–O
REO
re
sid
enti
al r
en
tal a
sse
t cl
assi
fie
d “
pas
s” w
he
n t
he
le
ase
re
fle
cts
a re
aso
nab
le r
ate
of
retu
rn (
refe
r to
SR
lett
er
12
-5/C
A le
tte
r 1
2-3
, “P
olic
y St
ate
me
nt
on
Re
nta
l of
Re
sid
enti
al O
REO
Pro
pe
rtie
s”)
2
0
Ap
pra
isal
Co
nce
pts
21
Ap
pra
isal
Co
nce
pts
•A
t a
min
imu
m, a
n e
valu
atio
n is
re
qu
ire
d w
he
n a
pro
pe
rty
is t
ran
sfe
rre
d t
o O
REO
th
rou
gh f
ore
clo
sure
or
de
ed
in li
eu
o
f fo
recl
osu
re. R
efe
r to
SR
lett
er
95
-16
“R
eal
Est
ate
A
pp
rais
al R
eq
uir
em
en
ts f
or
Oth
er
Re
al E
stat
e O
wn
ed
(O
REO
).”
•St
ate
ban
kin
g la
ws
or
the
inte
rnal
po
licie
s o
f an
inst
itu
tio
n
may
re
qu
ire
an
ap
pra
isal
up
on
tra
nsf
er
to O
REO
.
•In
tera
gen
cy A
pp
rais
al a
nd
Eva
luat
ion
Gu
ide
line
s p
rovi
de
gu
idan
ce o
n a
pp
rais
al s
tan
dar
ds
and
eva
luat
ion
co
nte
nt.
R
efe
r to
SR
lett
er
10
-16
“In
tera
gen
cy A
pp
rais
al a
nd
Ev
alu
atio
n G
uid
elin
es.
”
22
Ap
pra
isal
Co
nce
pts
(co
nti
nu
ed
)
•Th
e a
pp
rais
al o
r e
valu
atio
n o
f O
REO
pro
pe
rty
sho
uld
re
fle
ct t
he
mar
ket
valu
e o
f th
e p
rop
ert
y as
de
fin
ed
in t
he
B
oar
d’s
ap
pra
isal
re
gula
tio
n (
12
CFR
22
5.6
2 (
g)).
•D
efi
nit
ion
of
“mar
ket
valu
e”
in t
he
ap
pra
isal
re
gula
tio
n
and
th
e c
on
cep
t o
f FV
un
de
r G
AA
P a
re b
ase
d o
n s
imila
r co
nce
pts
.
•A
n e
valu
atio
n a
nd
ap
pra
isal
sh
ou
ld a
dd
ress
th
e “
as-i
s”
con
dit
ion
of
the
OR
EO a
sse
t in
arr
ivin
g at
th
e p
rop
ert
y’s
mar
ket
valu
e, c
on
sid
eri
ng:
–P
rop
ert
y’s
hig
he
st a
nd
be
st u
se
–R
ele
van
t ri
sk a
nd
mar
ket
fact
ors
23
Ap
pra
isal
Co
nce
pts
(co
nti
nu
ed
)
•Fa
cto
rs t
o c
on
sid
er
in r
evi
ew
ing
an a
pp
rais
al o
r e
valu
atio
n in
clu
de
: –
Co
nd
itio
n o
f th
e p
rop
ert
y
–U
se o
f th
e p
rop
ert
y
–St
abili
ty o
f th
e p
rop
ert
y
24
Ap
pra
isal
Co
nce
pts
(co
nti
nu
ed
)
•Th
e in
stit
uti
on
sh
ou
ld h
ave
po
licie
s an
d p
roce
du
res
for
mo
nit
ori
ng
the
mar
ket
valu
e o
f th
e O
REO
ass
et
ove
r th
e h
old
ing
pe
rio
d a
nd
de
term
inin
g w
he
the
r an
e
xist
ing
app
rais
al o
r e
valu
atio
n is
sti
ll va
lid,
con
sid
erin
g:
–P
rop
ert
y ty
pe
–C
urr
en
t m
arke
t su
pp
ly a
nd
de
man
d f
or
sim
ilar
pro
pe
rtie
s
–C
urr
en
t u
se o
f th
e p
rop
ert
y o
r ch
ange
in u
se
–Th
e p
assa
ge o
f ti
me
25
Ap
pra
isal
Co
nce
pts
(co
nti
nu
ed
)
Key
Ref
eren
ces
and
Do
cum
ents
• Th
e B
oar
d’s
ap
pra
isal
reg
ula
tio
ns:
—
Ban
k h
old
ing
com
pan
ies:
Reg
ula
tio
n Y
(1
2 C
FR 2
25
su
bp
art
G)
—
Sta
te m
emb
er
ban
ks: R
egu
lati
on
H (
12
CFR
20
8 s
ub
par
t E)
•
Inte
rage
ncy
Ap
pra
isal
an
d E
valu
atio
n G
uid
elin
es (
SR le
tter
10
-16
) •
Sta
te b
anki
ng
law
s •
Un
ifo
rm S
tan
dar
ds
of
Pro
fess
ion
al A
pp
rais
al P
ract
ice
•
Inte
rnal
ban
k p
olic
ies
and
pro
ced
ure
s
26
Co
mm
un
ity
Issu
es
27
Ge
ne
ral C
om
mu
nit
y D
eve
lop
men
t Ex
pe
ctat
ion
s: M
anag
ing
and
D
isp
osi
ng
of
OR
EO
•O
REO
ass
et
ho
lde
rs s
ho
uld
hav
e a
cle
ar a
nd
e
ffe
ctiv
e a
pp
roac
h f
or
man
age
me
nt
and
d
isp
osi
tio
n o
f O
REO
, in
clu
din
g:
–C
om
ply
ing
wit
h a
ll fe
de
ral,
sta
te, a
nd
loca
l law
s an
d
regu
lati
on
s
–Im
ple
me
nti
ng
eff
ect
ive
pro
pe
rty
mai
nte
nan
ce
stan
dar
ds
and
th
ird
-par
ty v
en
do
r o
vers
igh
t
–C
on
sid
eri
ng
pra
ctic
es
that
su
pp
ort
ne
igh
bo
rho
od
st
abili
zati
on
28
Ge
ne
ral C
om
mu
nit
y D
eve
lop
men
t Ex
pe
ctat
ion
s: M
anag
ing
and
D
isp
osi
ng
of
OR
EO (
con
tin
ue
d)
•Se
llin
g O
REO
pro
pe
rtie
s to
ow
ne
r/o
ccu
pan
ts o
r d
on
atin
g th
em
to
gro
up
s in
volv
ed
in
ne
igh
bo
rho
od
sta
bili
zati
on
eff
ort
s ca
n h
elp
fi
nan
cial
inst
itu
tio
ns
rece
ive
cre
dit
un
de
r th
e
Co
mm
un
ity
Re
inve
stm
en
t A
ct.
29
Ge
ne
ral C
om
mu
nit
y D
eve
lop
men
t Ex
pe
ctat
ion
s: M
anag
ing
and
D
isp
osi
ng
of
OR
EO (
con
tin
ue
d)
•If
OR
EO is
re
nte
d, a
sse
t h
old
ers
sh
ou
ld f
ollo
w t
he
p
rovi
sio
ns
of
the
Fe
de
ral R
ese
rve
Po
licy
Stat
em
en
t o
n
Re
nta
l of
Re
sid
en
tial
OR
EO P
rop
ert
ies
(SR
lett
er
12
-5/C
A
lett
er
12
-3).
•In
stit
uti
on
s sh
ou
ld h
ave
con
tro
ls in
pla
ce t
o c
om
ply
wit
h
law
s re
late
d t
o p
rote
ctin
g th
e r
igh
ts o
f te
nan
ts, i
ncl
ud
ing:
–Th
e P
rote
ctin
g Te
nan
ts a
t Fo
recl
osu
re A
ct o
f 2
00
9
(CA
lett
er
09
-5)
–Th
e S
erv
ice
mem
ber
s C
ivil
Re
lief
Act
(C
A le
tte
r 0
5-3
)
–Th
e F
air
Ho
usi
ng
Act
–Th
e A
me
rica
ns
wit
h D
isab
iliti
es
Act
30
To a
sk a
qu
est
ion
:
•Em
ail y
ou
r q
ue
stio
n t
o:
askt
he
fed
@st
ls.f
rb.o
rg
•U
se t
he
“A
sk a
Qu
est
ion
” fe
atu
re o
n t
he
A
sk t
he
Fe
d®
we
bsi
te:
w
ww
.ask
thef
ed
.org
31
Ad
dit
ion
al S
ess
ion
Re
sou
rce
s
SR L
ette
rs
•S
R L
ett
er
12
-10
/CA
Le
tte
r 1
2-9
, Q
ue
stio
ns a
nd
An
sw
ers
fo
r F
ed
era
l R
ese
rve
-R
eg
ula
ted
In
stitu
tio
ns R
ela
ted
to
th
e M
an
ag
em
en
t o
f O
the
r R
ea
l E
sta
te
Ow
ne
d (
OR
EO
)
•S
R L
ett
er
12
-5/ C
A L
ett
er
12
-3, P
olic
y S
tate
me
nt o
n R
en
tal o
f R
esid
en
tial
Oth
er
Rea
l E
sta
te O
wn
ed
(O
RE
O)
Pro
pe
rtie
s
•S
R L
ett
er
10
-16
, In
tera
gen
cy A
pp
rais
al a
nd
Eva
lua
tio
n G
uid
elin
es
•C
A L
ett
er
09
-5, In
form
atio
n a
nd
Exa
min
atio
n P
roce
du
res fo
r th
e “
Pro
tecting
Te
na
nts
at F
ore
clo
su
re A
ct o
f 2
00
9”
•S
R L
ett
er
05
-3, S
erv
ice
me
mb
ers
Civ
il R
elie
f A
ct o
f 2
00
3
•S
R L
ett
er
03
-5, A
me
nd
ed
In
tera
gen
cy G
uid
an
ce
on
th
e In
tern
al A
ud
it
Fu
nctio
n a
nd
its
Outs
ou
rcin
g
•S
R L
ett
er
00
-17
,Guid
an
ce
on
th
e R
isk M
an
ag
em
ent o
f O
uts
ou
rced
Te
ch
no
logy S
erv
ice
•S
R L
ett
er
95
-16
, R
ea
l E
sta
te A
pp
rais
al R
eq
uir
em
ents
fo
r O
the
r R
ea
l E
sta
te
Ow
ne
d (
OR
EO
)
32
Than
ks f
or
join
ing
us.
ww
w.a
skth
efe
d.o
rg
33
2011-230
Comment Letter No. 342
2011-230
Comment Letter No. 342
2011-230
Comment Letter No. 342
Page 1 of 2
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM WASHINGTON, D.C. 20551
DIVISION OF BANKING
SUPERVISION AND REGULATION
DIVISION OF CONSUMER AND
COMMUNITY AFFAIRS
SR 12-5 CA 12-3 April 5, 2012
TO THE OFFICER IN CHARGE OF SUPERVISION AT EACH FEDERAL RESERVE BANK AND TO EACH BANKING ORGANIZATION SUPERVISED BY THE FEDERAL RESERVE SUBJECT: Policy Statement on Rental of Residential Other Real Estate Owned (OREO) Properties Applicability to Community Banking Organizations: While this guidance applies to all institutions supervised by the Federal Reserve, the statement is particularly relevant to large banking organizations with significant portfolios of residential OREO properties.
The Federal Reserve is issuing the attached Policy Statement on Rental of Residential OREO Properties (policy statement) to remind banking organizations and examiners that the Federal Reserve’s regulations and policies permit the rental of OREO properties as part of an orderly disposition strategy within statutory and regulatory limits.
In light of the current extraordinary conditions in housing markets, the policy statement
indicates that banking organizations may rent one- to four-family residential OREO properties without having to demonstrate continuous active marketing of the properties, provided suitable policies and procedures are followed. The policy statement applies to state member banks, bank holding companies, nonbank subsidiaries of bank holding companies, savings and loan holding companies, non-thrift subsidiaries of savings and loan holding companies, and U.S. branches and agencies of foreign banking organizations (collectively, banking organizations).1
The policy statement describes key risk management considerations for banking organizations that engage in the rental of residential OREO, including compliance with holding-period requirements for OREO, compliance with landlord-tenant and associated requirements,
1 This policy statement supplements other relevant Federal Reserve guidance, including the Board’s policy statement on the disposition of property acquired in satisfaction of debts previously contracted. See 12 CFR 225.140.
Page 2 of 2
and accounting according to generally accepted accounting principles. Rental OREO properties with leases in place and demonstrated cash flow from rental operations sufficient to generate a reasonable rate of return should generally not be classified.
The policy statement also establishes specific supervisory expectations for banking
organizations that undertake large-scale residential OREO rentals (generally, 50 properties or more available for rent). Such organizations should have formal policies and procedures governing the operation and administration of OREO rental activities, including property-specific rental plans, policies and procedures for compliance with applicable laws and regulations, a risk management framework, and oversight of third-party property managers.
Federal Reserve Banks are asked to distribute this letter to the banking organizations in their districts, as well as to supervisory and examination staff. For questions related to this guidance, please contact William Treacy, Adviser, Division of Banking Supervision and Regulation, at (202) 452-3859; or Tim Robertson, Senior Supervisory Consumer Financial Services Analyst, Division of Consumer and Community Affairs, at (202) 452-2565. In addition, questions may be sent via the Board’s public website.2
Michael S. Gibson Director
Division of Banking Supervision and Regulation
Sandra F. Braunstein Director
Division of Consumer and Community Affairs
Attachment:
• Federal Reserve Policy Statement on Rental of Residential Other Real Estate Owned Properties
Cross References to:
• SR letter 10-16, “Interagency Appraisal and Evaluation Guidelines” • SR letter 00-17, “Guidance on the Risk Management of Outsourced Technology
Services” • SR letter 95-16, “Real Estate Appraisal Requirements for Other Real Estate Owned
(OREO)” • CA letter 09-5, “Information and Examination Procedures for the ‘Protecting Tenants at
Foreclosure Act of 2009” • CA letter 05-3, “Servicemembers Civil Relief Act of 2003”
2 See http://www.federalreserve.gov/apps/contactus/feedback.aspx.
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Federal Reserve Policy Statement on Rental of Residential Other Real Estate Owned Properties
April 5, 2012
In light of the large volume of distressed residential properties and the indications of higher demand for rental housing in many markets, some banking organizations may choose to make greater use of rental activities in their disposition strategies than in the past. This policy statement reminds banking organizations and examiners that the Federal Reserve’s regulations and policies permit the rental of residential other real estate owned (OREO) properties to third-party tenants as part of an orderly disposition strategy within statutory and regulatory limits.1 This policy statement applies to state member banks, bank holding companies, nonbank subsidiaries of bank holding companies, savings and loan holding companies, non-thrift subsidiaries of savings and loan holding companies, and U.S. branches and agencies of foreign banking organizations (collectively, banking organizations).2
The general policy of the Federal Reserve is that banking organizations should make
good-faith efforts to dispose of OREO properties at the earliest practicable date. Consistent with this policy, in light of the extraordinary market conditions that currently prevail, banking organizations may rent residential OREO properties (within statutory and regulatory holding-period limits) without having to demonstrate continuous active marketing of the property, provided that suitable policies and procedures are followed. Under these conditions and circumstances, banking organizations would not contravene supervisory expectations that they show “good-faith efforts” to dispose of OREO by renting the property within the applicable holding period. Moreover, to the extent that OREO rental properties meet the definition of community development under the Community Reinvestment Act (CRA) regulations, they would receive favorable CRA consideration.3 In all respects, banking organizations that rent OREO properties are expected to comply with all applicable federal, state, and local statutes and regulations. Background
Home prices have been under considerable downward pressure since the financial crisis began, in part due to the large volume of houses for sale by creditors, whether acquired through foreclosure or voluntary surrender of the property by a seriously delinquent borrower (distressed sales). Creditors, in turn, often seek to liquidate their inventories of such properties quickly. Since 2008, it is estimated that millions of residential properties have passed through lender
1 The term “residential properties” in this policy statement encompasses all one-to-four family properties and does not include multi-family residential or commercial properties. 2 This policy statement supplements other relevant Federal Reserve guidance, including the Board’s policy statement on disposition of property acquired in satisfaction of debts previously contracted (see 12 CFR 225.140). 3 The Federal Reserve’s CRA regulations define community development to include activities that provide affordable housing to low- and moderate-income individuals as well as those activities that revitalize or stabilize low- and moderate-income areas (see 12 CFR 228.12(g)(1) and (4)).
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inventories. These distressed sales represent a significant proportion of all home sales transactions, despite some ebb and flow, and thus are a contributing element to the downward pressure on home prices. With mortgage delinquency rates remaining stubbornly high, the continued inflow of new real estate owned properties to the market--expected to be millions more over the coming years--will continue to weigh on house prices for some time.4
Banking organizations include their holdings of such properties in OREO on regulatory
reports and other financial statements.5 Existing federal and state laws and regulations limit the amount of time banking organizations may hold OREO property.6 In addition, there are established supervisory expectations for management of OREO properties and the nature of the efforts banking organizations should make to dispose of these properties during that period.
Risk Management Considerations for Residential OREO Property Rentals
In all circumstances, the Federal Reserve expects a banking organization considering
such rentals to evaluate the overall costs, benefits, and risks of renting. The banking organization’s decision to rent OREO might depend significantly on the condition of individual properties, local market conditions for rental and owner-occupied housing, and its capacity to engage in rental activity in a safe and sound manner and consistent with applicable laws and regulations.
Banking organizations should have an operational framework for their residential OREO rental activities that is appropriate to the extent to which they rent OREO properties. In general, banking organizations with relatively small holdings of residential OREO properties--fewer than 50 individual properties rented or available for rent--should use a framework that appropriately records the organizations’ rental decisions and transactions as they take place, preserves key documents, and is otherwise sufficient to safeguard and manage the individual OREO assets.7 In contrast, banking organizations with large inventories of residential OREO properties8-- 50 or
4 For further discussion of housing market conditions and the obstacles to conversions of OREO properties to rental, see “The U.S. Housing Market: Current Conditions and Policy Considerations,” Federal Reserve staff white paper, January 4, 2012 (housing white paper), available at http://www.federalreserve.gov/publications/other-reports/files/housing-white-paper-20120104.pdf. 5 “Other real estate owned” is comprised of all real estate other than (1) bank premises owned or controlled by the bank and its consolidated subsidiaries and (2) direct and indirect investments in real estate ventures. 6 Generally, the Federal Reserve allows bank holding companies to hold OREO property for up to five years, with an additional five-year extension subject to certain circumstances (see 12 CFR 225.140). National banks are subject to similar restrictions. State member banks and licensed branches of foreign banks are subject to the holding periods and other limitations on OREO activity established by their respective licensing authorities, which vary. Savings and loan holding companies generally may acquire real estate for rental (see 12 USC 1467a(c)(2) and 12 CFR 238.53(b)). 7 A preliminary analysis of Call Report data suggests that roughly ninety-eight percent of community banks held 50 or fewer residential OREO properties. 8 For purposes of this guidance, the supervisory expectations for OREO rentals and the number of properties available for rent should include those properties for which tenants were already in place at the time of foreclosure or transfer of ownership, and for which tenants are afforded certain protections under the Protecting Tenants at
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more individual properties available for rent or rented--should utilize a framework that systematically documents how they meet the supervisory expectations described in the next section. All banking organizations that rent OREO properties, irrespective of the size of their holdings, should adhere to the guidance set forth in this section.
Compliance with maximum OREO holding-period requirements
Banking organizations should pursue a clear and credible approach for ultimate sale of
the rental OREO property within the applicable holding-period limitations. Exit strategies in some cases may include special transaction features to facilitate the sale of OREO, potentially including prudent use of seller-assisted financing or rent-to-own arrangements with tenants. Compliance with landlord-tenant and other associated requirements
Banking organizations’ residential property rental activities are expected to comply with
all applicable federal, state, and local laws and regulations, including: landlord-tenant laws; landlord licensing or registration requirements; property maintenance standards; eviction protections (such as under the Protecting Tenants at Foreclosure Act); protections under the Servicemembers Civil Relief Act;9 and anti-discrimination laws, including the applicable provisions of the Fair Housing Act and the Americans with Disabilities Act. Prior to undertaking the rental of OREO properties, banking organizations should determine whether such activities are legally permissible under applicable laws, including state laws. When applicable, banking organizations should review homeowner and condominium association bylaws and local zoning laws for prohibitions on renting a property. Banking organizations may use third-party vendors to manage properties but should provide necessary oversight to ensure that property managers fully understand and comply with these federal, state, and local requirements.
Other considerations
Banking organizations should account for OREO assets in accordance with generally
accepted accounting principles and applicable regulatory reporting instructions.10 Banking organizations should also provide the appropriate classification treatment for their residential OREO holdings. Residential OREO is typically treated as a substandard asset, as defined by the interagency classification guidelines.11 However, residential properties with leases in place and
Foreclosure Act of 2009. See Federal Reserve Consumer Compliance Handbook, Section IV for further information at http://www.federalreserve.gov/boarddocs/supmanual/cch/i-v.pdf 9 See CA letter 09-5, “Information and Examination Procedures for the ‘Protecting Tenants at Foreclosure Act of 2009,’” July 30, 2009, and CA letter 05-3, “Servicemembers Civil Relief Act of 2003,” May 6, 2005. 10 See the instructions for the Consolidated Reports of Condition and Income (Call Report) as to the reporting of OREO transactions and to the Consolidated Financial Statements for Bank Holding Companies (FR Y-9C). See more generally the Federal Reserve’s Commercial Bank Examination Manual (CBEM) section 2200.1, “Other Real Estate Owned.” 11 The interagency classification guidelines are summarized in CBEM section 2060.1, “Classification of Credits.”
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demonstrated cash flow from rental operations sufficient to generate a reasonable rate of return12 should generally not be classified.
Specific Expectations for Large-Scale Residential OREO Rentals
Banking organizations with large inventories of residential OREO properties that decide
to engage in rental activities should have in place a documented rental strategy, including formal policies and procedures for OREO rental activities, and a documented operational framework. Policies and procedures should clearly describe how the banking organization will comply with all applicable laws and regulations. Policies and procedures should include processes for determining whether the properties meet local building code requirements and are otherwise habitable, and whether improvements to the properties are needed in order to market them for rent. In addition, policies and procedures should establish operational standards for the banking organization’s rental activities, including that adequate insurance policies are in place, that property and other tax obligations are met on a timely basis, and that expenditures on improvements are appropriate to the value of the property and to prevailing norms in the local market.
Policies and procedures should also require plans for rental of residential OREO
properties, down to the individual property level, that cover the full holding period from the time the bank received title to ultimate sale by the bank. Plans should identify which properties would be eligible for rental. Plans also should establish criteria by which properties are chosen for marketing as rental properties, and the process by which rental decisions should be made and implemented. Plans should describe the general conditions under which the organization believes a rental approach is likely to be successful, including appropriate consideration of rental market and economic conditions in respective local markets.
Finally, policies and procedures should address all risk management issues that arise in renting residential OREO properties. Some risk elements parallel those found in other banking activities, for example, the credit risk associated with tenants’ potential failure to make timely rent payments, or potential conflict of interest issues such as the use of a firm by a banking organization to both provide information on a property’s value and list that property for sale on behalf of the banking organization. Other risks unique to such rental include:
12 Whether a rate of return is reasonable depends on a number of considerations including local market conditions, the time horizon of the rental, and the nature of the property. Commonly used measures include a capitalization rate (known as a “cap rate,” which generally is the expected annual cash flows from renting the property relative to the price at which the property holder could expect to sell it in the owner-occupied market), as discussed in the housing white paper, or other measures of internal rate of return. Depending on the circumstances and risks associated with the property, valid indications that a level of return is reasonable could include (but would not be limited to) comparisons with normal returns for single-family rentals in the relevant local market; rates of return on other similar local real estate investments; or cap rates or other measures of internal rate of return on investments with similar risk profiles. For example, in many markets a cap rate above 8 percent would likely represent a reasonable rate of return. Large one-time expenditures that are idiosyncratic to a given year but are normal to residential properties over their lifetime, such as replacement cost for worn-out appliances, should generally not be the reason that a property would be classified. Costs of improvement should be treated as capital expenditures with a corresponding effect on properties’ carrying value to the extent the improvements improve the properties’ values.
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• Dealing with vacancy, marketing, and re-rental of previously occupied properties;13
• Liability risk arising from rental activities, along with the use and management of liability insurance or other approaches to mitigate that liability and risk; and
• Legal requirements arising from the potential need to take action against tenants for rent delinquency, potentially including eviction. Such requirements may include notice periods.
Banking organizations may need to develop new policies and risk management processes to address properly these categories of risk.
In many cases, banking organizations will use third-party vendors (for example, real
estate agents or professional property managers) to manage their OREO properties. Policies and procedures should provide that such individuals or organizations have appropriate expertise in property management, be in sound financial condition, and have a good track record in managing similar properties. Policies and procedures should also call for contracts with such vendors to carry appropriate terms and provide, among other key elements, for adequate management information systems and reporting to the banking organization, including rent rolls (along with actual lease agreements), maintenance logs, and security deposits and charges to these deposits. Banking organizations should provide for adequate oversight of vendors.14
Additional Materials for Reference15
• The Board’s Policy Statement on Disposition of Property Acquired in Satisfaction of Debts Previously Contracted, July 28, 1980. See 12 CFR 225.140.
• Instructions for Preparation of Consolidated Reports of Condition and Income (Call Report, FFIEC 031 and 041), Schedule RC-M item 3, available at http://www.ffiec.gov/PDF/FFIEC_forms/FFIEC031_FFIEC041_201109_i.pdf.
• Instructions for Preparation of the Consolidated Financial Statements for Bank Holding Companies (FR Y-9C), available at http://www.federalreserve.gov/reportforms/.
• Accounting Standards Codification (ASC) 310-40, Receivables-Troubled Debt Restructurings by Creditors (formerly known as FAS 15, “Accounting by Debtors and Creditors for Troubled Debt Restructurings”).
• ASC 360-10-30, Property, Plant and Equipment-Initial Measurement (formerly included in FAS 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”).
13 Various jurisdictions may apply specific requirements to landlords in their marketing and re-rental activities (for example, an obligation to offer potential tenants an initial lease term of two years). 14 See Federal Financial Institutions Examination Council statement on Risk Management of Outsourced Technology Services (November 28, 2000, SR letter 00-17), which provides illustrative guidance on constructing outsourcing risk assessments, due diligence in selecting a service provider, contract review, and monitoring a third party that provides services to a regulated institution. 15 Referenced Federal Reserve regulations and guidance documents may be found on the Board’s public website under “Banking Information and Regulation” available at http://www.federalreserve.gov/
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• ASC 360-10-35, Property, Plant and Equipment-Subsequent Measurement.
• The disposition of other real estate is addressed in ASC 360-20-40, Property, Plant and Equipment-Real Estate Sales-Derecognition (formerly within FAS 66, “Accounting for Sales of Real Estate”), which includes specific criteria for the recognition of profit.
• Commercial Bank Examination Manual section 2200.1, “Other Real Estate Owned” available at http://www.federalreserve.gov/boarddocs/supmanual/cbem/2000.pdf.
• SR letter 10-16, “Interagency Appraisal and Evaluation Guidelines,” December 2, 2010. For the sale of OREO property with a value of $250,000 or less, a bank holding company or state member bank may obtain an evaluation in lieu of an appraisal.
• SR letter 00-17, “Statement on Risk Management of Outsourced Technology Services,” November 28, 2000.
• SR letter 95-16, “Real Estate Appraisal Requirements for Other Real Estate Owned (OREO),” March 28, 1995.
• CA letter 09-5, “Information and Examination Procedures for the ‘Protecting Tenants at Foreclosure Act of 2009,’” July 30, 2009.
• CA letter 05-3, “Servicemembers Civil Relief Act of 2003,” May 6, 2005.
BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM WASHINGTON, D. C. 20551
TO THE OFFICER IN CHARGE OF SUPERVISION AND APPROPRIATE SUPERVISORY AND EXAMINATION STAFF AT EACH FEDERAL RESERVE BANK AND TO DOMESTIC AND FOREIGN BANKING ORGANIZATIONS SUPERVISED BY THE FEDERAL RESERVE
SUBJECT: Amended Interagency Guidance on the Internal Audit Function and its Outsourcing
The Federal Reserve Board, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision have issued the attached, amended policy statement, Internal Audit Function and its Outsourcing. The amended policy statement supersedes the interagency policy statement on this subject that was issued December 22, 1997 (SR letter 97-35). The amendments to the 1997 policy statement provide more guidance to institutions seeking to enhance the independence and effectiveness of their internal audit function.
The 1997 policy statement was amended to bring supervisory policy regarding the external auditor in concordance with the prohibition on internal audit outsourcing imposed by the Sarbanes-Oxley Act of 2002 and pertinent regulations of the U.S. Securities and Exchange Commission. The FDIC guidelines implementing Section 36 of the Federal Deposit Insurance Act refer to SEC auditor independence regulations for the purpose of meeting Section 36's audit requirements. As a result, banking organizations subject to Section 36 -- essentially those with $500 million or more in assets -- should comply with the Sarbanes-Oxley Act prohibition on internal audit outsourcing to their external auditor. Institutions that are neither subject to Section 36 nor SEC registrants are encouraged in the amended policy statement not to use their external auditor to perform internal audit services.
In explaining the prohibitions on non-audit services, the Sarbanes-Oxley Act describes three broad principles that define potential conflicts of interest for an external auditor. The principles are that an external auditor should not: (i) audit his or her own work; (ii) perform management functions; or (iii) act in an advocacy role for the client. Institutions should use these principles as a framework for analyzing existing or proposed non-audit services in order to avoid potential conflicts of interest for the external auditor.
Other issues besides outsourcing internal audit to the external auditor can significantly
Note: This letter was cross referenced by SR 12-10 / CA 12-9.
DIVISION OF BANKING SUPERVISION AND REGULATION
SR 03-5 April 22, 2003
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10/15/2012
affect the internal audit function. Management reporting and corporate governance issues have an important bearing on the independence of the internal audit function. Staff competence and resources are key determinants in the effectiveness of the internal audit function.
This guidance is effective immediately for all bank holding companies, state member banks, and the U.S. operations of foreign banking organizations. Reserve Banks are asked to send a copy of this SR letter and the amended interagency statement to senior management at domestic and foreign banking organizations supervised by the Federal Reserve.
If you have any questions, please call Gerald A. Edwards, Jr., Associate Director and Chief Accountant - Supervision (202/452-2741), Charles Holm, Assistant Director (202/452-3502), or Gregory Eller, Project Manager (202/452-5277).
Herbert A. Biern Senior Associate Director
Interagency Policy Statement on the Internal Audit Function and its Outsourcing (1,199 KB PDF)
SR letter 97-35
Attachment:
Supersede:
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10/15/2012
BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM FEDERAL DEPOSIT INSURANCE CORPORATION OFFICE OF THE COMPTROLLER OF THE CURRENCY OFFICE OF THRIFT SUPERVISION
INTERAGENCY POLICY STATEMENT ON THE INTERNAL AUDIT
FUNCTION AND ITS OUTSOURCING
March 17, 2003
INTRODUCTION
Effective internal control[See Footnote 1] is a foundation for the safe and sound operation of a financial institution (institution).[See Footnote 2] The board of directors and senior management of an institution are responsible for ensuring that the system of internal control operates effectively. Their responsibility cannot be delegated to others within the institution or to outside parties. An important element in assessing the effectiveness of the internal control system is an internal audit function. When properly structured and conducted, internal audit provides directors and senior management with vital information about weaknesses in the system of internal control so that management can take prompt, remedial action. The federal banking agencies’[See Footnote 3] (agencies) long-standing examination policies call for examiners to review an institution’s internal audit function and recommend improvements, if needed. In addition, pursuant to Section 39 of the Federal Deposit Insurance Act (FDI Act) (12 U.S.C. 1831p-1), the agencies have adopted Interagency Guidelines Establishing Standards for Safety and Soundness that apply to insured
Footnote 1 -- In summary, internal control is a process designed to provide reasonable assurance that the institution will achieve the following internal control objectives: efficient and effective operations, including safeguarding of assets; reliable financial reporting; and, compliance with applicable laws and regulations. Internal control consists of five components that are a part of the management process: control environment, risk assessment, control activities, information and communication, and monitoring activities. The effective functioning of these components, which is brought about by an institution’s board of directors, management, and other personnel, is essential to achieving the internal control objectives. This description of internal control is consistent with the Committee of Sponsoring Organizations of the Treadway Commission (COSO) report Internal Control—Integrated Framework. In addition, under the COSO framework, financial reporting is defined in terms of published financial statements, which, for purposes of this policy statement, encompasses both financial statements prepared in accordance with generally accepted accounting principles and regulatory reports (such as the Reports of Condition and Income and the Thrift Financial Report). Institutions are encouraged to evaluate their internal control against the COSO framework if they are not already doing so.[End of Footnote 1]
Footnote 2 -- The term “institution” includes depository institutions insured by the Federal Deposit Insurance Corporation (FDIC), U.S. financial holding companies and bank holding companies supervised by the Federal Reserve System, thrift holding companies supervised by the Office of Thrift Supervision (OTS), and the U.S. operations of foreign banking organizations.[End of Footnote 2]
Footnote 3 -- Board of Governors of the Federal Reserve System, FDIC, Office of the Comptroller of the Currency, and OTS.[End of Footnote 3]
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depository institutions.[See Footnote 4] Under these guidelines and policies, each institution should have an internal audit function that is appropriate to its size and the nature and scope of its activities.
In addressing various quality and resource issues, many institutions have been engaging independent public accounting firms and other outside professionals (outsourcing vendors) in recent years to perform work that traditionally has been done by internal auditors. These arrangements are often called “internal audit outsourcing,” “internal audit assistance,” “audit co-sourcing,” and “extended audit services” (hereafter collectively referred to as outsourcing). Typical outsourcing arrangements are more fully illustrated in Part II below.
Outsourcing may be beneficial to an institution if it is properly structured, carefully conducted, and prudently managed. However, the agencies have concerns that the structure, scope, and management of some internal audit outsourcing arrangements do not contribute to the institution’s safety and soundness. Furthermore, the agencies want to ensure that these arrangements with outsourcing vendors do not leave directors and senior management with the erroneous impression that they have been relieved of their responsibility for maintaining an effective system of internal control and for overseeing the internal audit function.
This policy statement sets forth key characteristics of the internal audit function in Part I. Sound practices concerning the use of outsourcing vendors are discussed in Part II. Part III discusses the effect outsourcing arrangements have on the independence of an external auditor who also provides internal audit services to an institution. Part III also discusses the prohibition on internal audit outsourcing to a public company’s external auditor under the Sarbanes-Oxley Act of 2002,[See Footnote 5] the effect of this prohibition on insured depository institutions subject to the annual audit and reporting requirements of Section 36 of the FDI Act (12 U.S.C. 1831m), and the agencies’ views on compliance with this provision of the Sarbanes-Oxley Act by institutions not subject to Section 36 (including smaller depository institutions) that are not publicly-held. Finally, Part IV of this statement provides guidance to examiners concerning their reviews of internal audit functions and related matters.
PART I — THE INTERNAL AUDIT FUNCTION
Board and Senior Management Responsibilities
The board of directors and senior management are responsible for having an effective system of internal control and an effective internal audit function in place at their institution. They are also responsible for ensuring that the importance of internal control is understood and respected throughout the institution. This overall responsibility cannot be delegated to anyone else. They may, however, delegate the design, implementation and monitoring of specific internal controls
Footnote 4 -- For national banks, Appendix A to Part 30; for state member banks, Appendix D-1 to Part 208; for insured state nonmember banks and insured state-licensed branches of foreign banks, Appendix A to Part 364; for savings associations, Appendix A to Part 570.[End of Footnote 4]
Footnote 5 -- Pub. L. 107-204, 116 Stat. 745 (2002).[End of Footnote 5]
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to lower-level management and the testing and assessment of internal controls to others. Accordingly, directors and senior management should have reasonable assurance that the system of internal control prevents or detects significant inaccurate, incomplete, or unauthorized transactions; deficiencies in the safeguarding of assets; unreliable financial reporting (which includes regulatory reporting); and deviations from laws, regulations, and the institution’s policies.[See Footnote 6]
Some institutions have chosen to rely on so-called “management self-assessments” or “control self-assessments,” wherein business line managers and their staff evaluate the performance of internal controls within their purview. Such reviews help to underscore management’s responsibility for internal control, but they are not impartial. Directors and members of senior management who rely too much on these reviews may not learn of control weaknesses until they have become costly problems, particularly if directors are not intimately familiar with the institution’s operations. Therefore, institutions generally should also have their internal controls tested and evaluated by units without business-line responsibilities, such as internal audit groups.
Directors should be confident that the internal audit function addresses the risks and meets the demands posed by the institution’s current and planned activities. To accomplish this objective, directors should consider whether their institution’s internal audit activities are conducted in accordance with professional standards, such as the Institute of Internal Auditors’ (IIA) Standards for the Professional Practice of Internal Auditing. These standards address independence, professional proficiency, scope of work, performance of audit work, management of internal audit, and quality assurance reviews. Furthermore, directors and senior management should ensure that the following matters are reflected in their institution’s internal audit function.
Structure. Careful thought should be given to the placement of the audit function in the institution’s management structure. The internal audit function should be positioned so that the board has confidence that the internal audit function will perform its duties with impartiality and not be unduly influenced by managers of day-to-day operations. The audit committee,[See Footnote 7] using objective criteria it has established, should oversee the internal audit function and evaluate its
Footnote 6 -- Under Section 36 of the FDI Act, as implemented by Part 363 of the FDIC’s regulations (12 CFR 363), FDIC-insured depository institutions with total assets of $500 million or more must submit an annual management report signed by the chief executive officer (CEO) and chief accounting or chief financial officer. This report must discuss management’s responsibility for financial reporting controls and assess the effectiveness of those controls as well as the institution’s compliance with designated laws and regulations.[End of Footnote 6]
Footnote 7 -- Depository institutions subject to Section 36 of the FDI Act and Part 363 of the FDIC’s regulations must maintain independent audit committees (i.e., comprised of directors who are not members of management). Consistent with the 1999 Interagency Policy Statement on External Auditing Programs of Banks and Savings Associations, the agencies also encourage the board of directors of each depository institution that is not otherwise required to do so to establish an audit committee consisting entirely of outside directors. Where the term “audit committee” is used in this policy statement, the board of directors may fulfill the audit committee responsibilities if the institution is not subject to an audit committee requirement.[End of Footnote 7]
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performance.[See Footnote 8] The audit committee should assign responsibility for the internal audit function to a member of management (hereafter referred to as the manager of internal audit or internal audit manager) who understands the function and has no responsibility for operating the system of internal control. The ideal organizational arrangement is for this manager to report directly and solely to the audit committee regarding both audit issues and administrative matters, e.g., resources, budget, appraisals, and compensation. Institutions are encouraged to consider the IIA’s Practice Advisory 2060-2: Relationship with the Audit Committee, which provides more guidance on the roles and relationships between the audit committee and the internal audit manager.
Many institutions place the manager of internal audit under a dual reporting arrangement: functionally accountable to the audit committee on issues discovered by the internal audit function, while reporting to another senior manager on administrative matters. Under a dual reporting relationship, the board should consider the potential for diminished objectivity on the part of the internal audit manager with respect to audits concerning the executive to whom he or she reports. For example, a manager of internal audit who reports to the chief financial officer (CFO) for performance appraisal, salary, and approval of department budgets may approach audits of the accounting and treasury operations controlled by the CFO with less objectivity than if the manager were to report to the chief executive officer. Thus, the chief financial officer, controller, or other similar officer should ideally be excluded from overseeing the internal audit activities even in a dual role. The objectivity and organizational stature of the internal audit function are best served under such a dual arrangement if the internal audit manager reports administratively to the CEO.
Some institutions seek to coordinate the internal audit function with several risk monitoring functions (e.g., loan review, market risk assessment, and legal compliance departments) by establishing an administrative arrangement under one senior executive. Coordination of these other monitoring activities with the internal audit function can facilitate the reporting of material risk and control issues to the audit committee, increase the overall effectiveness of these monitoring functions, better utilize available resources, and enhance the institution’s ability to comprehensively manage risk. Such an administrative reporting relationship should be designed so as to not interfere with or hinder the manager of internal audit’s functional reporting to and ability to directly communicate with the institution’s audit committee. In addition, the audit committee should ensure that efforts to coordinate these monitoring functions do not result in the manager of internal audit conducting control activities nor diminish his or her independence with respect to the other risk monitoring functions. Furthermore, the internal audit manager should have the ability to independently audit these other monitoring functions.
In structuring the reporting hierarchy, the board should weigh the risk of diminished independence against the benefit of reduced administrative burden in adopting a dual reporting organizational structure. The audit committee should document its consideration of this risk and
Footnote 8 -- For example, the performance criteria could include the timeliness of each completed audit, comparison of overall performance to plan, and other measures.[End of Footnote 8]
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mitigating controls. The IIA’s Practice Advisory 1110-2: Chief Audit Executive Reporting Lines provides additional guidance regarding functional and administrative reporting lines.
Management, staffing, and audit quality. In managing the internal audit function, the manager of internal audit is responsible for control risk assessments, audit plans, audit programs, and audit reports.
A control risk assessment (or risk assessment methodology) documents the internal auditor’s understanding of the institution’s significant business activities and their associated risks. These assessments typically analyze the risks inherent in a given business line, the mitigating control processes, and the resulting residual risk exposure of the institution. They should be updated regularly to reflect changes to the system of internal control or work processes, and to incorporate new lines of business.
An internal audit plan is based on the control risk assessment and typically includes a summary of key internal controls within each significant business activity, the timing and frequency of planned internal audit work, and a resource budget.
An internal audit program describes the objectives of the audit work and lists the procedures that will be performed during each internal audit review.
An audit report generally presents the purpose, scope, and results of the audit, including findings, conclusions, and recommendations. Workpapers that document the work performed and support the audit report should be maintained.
Ideally, the internal audit function’s only role should be to independently and objectively evaluate and report on the effectiveness of an institution’s risk management, control, and governance processes. Internal auditors increasingly have taken a consulting role within institutions on new products and services and on mergers, acquisitions, and other corporate reorganizations. This role typically includes helping design controls and participating in the implementation of changes to the institution’s control activities. The audit committee, in its oversight of the internal audit staff, should ensure that the function’s consulting activities do not interfere or conflict with the objectivity it should have with respect to monitoring the institution’s system of internal control. In order to maintain its independence, the internal audit function should not assume a business-line management role over control activities, such as approving or implementing operating policies or procedures, including those it has helped design in connection with its consulting activities. The agencies encourage internal auditors to follow the IIA’s standards, including guidance related to the internal audit function acting in an advisory capacity.
The internal audit function should be competently supervised and staffed by people with sufficient expertise and resources to identify the risks inherent in the institution’s operations and assess whether internal controls are effective. The manager of internal audit should oversee the staff assigned to perform the internal audit work and should establish policies and procedures to guide the audit staff. The form and content of these policies and procedures should be consistent
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with the size and complexity of the department and the institution. Many policies and procedures may be communicated informally in small internal audit departments, while larger departments would normally require more formal and comprehensive written guidance.
Scope. The frequency and extent of internal audit review and testing should be consistent with the nature, complexity, and risk of the institution’s on- and off-balance-sheet activities. At least annually, the audit committee should review and approve internal audit’s control risk assessment and the scope of the audit plan, including how much the manager relies on the work of an outsourcing vendor. It should also periodically review internal audit’s adherence to the audit plan. The audit committee should consider requests for expansion of basic internal audit work when significant issues arise or when significant changes occur in the institution’s environment, structure, activities, risk exposures, or systems.9
Communication. To properly carry out their responsibility for internal control, directors and senior management should foster forthright communications and critical examination of issues to better understand the importance and severity of internal control weaknesses identified by the internal auditor and operating management’s solutions to these weaknesses. Internal auditors should report internal control deficiencies to the appropriate level of management as soon as they are identified. Significant matters should be promptly reported directly to the board of directors (or its audit committee) and senior management. In periodic meetings with management and the manager of internal audit, the audit committee should assess whether management is expeditiously resolving internal control weaknesses and other exceptions. Moreover, the audit committee should give the manager of internal audit the opportunity to discuss his or her findings without management being present.
Furthermore, each audit committee should establish and maintain procedures for employees of their institution to submit confidentially and anonymously concerns to the committee about questionable accounting, internal accounting control, or auditing matters.10 In addition, the audit committee should set up procedures for the timely investigation of complaints received and the retention for a reasonable time period of documentation concerning the complaint and its subsequent resolution.
Contingency Planning. As with any other function, the institution should have a contingency plan to mitigate any significant discontinuity in audit coverage, particularly for high-risk areas. Lack of contingency planning for continuing internal audit coverage may increase the institution’s level of operational risk.
Footnote 9 -- Major changes in an institution’s environment and conditions may compel changes to the internal control system and also warrant additional internal audit work. These include: (a) new management; (b) areas or activities experiencing rapid growth or rapid decline; (c) new lines of business, products, or technologies or disposals thereof; (d) corporate restructurings, mergers, and acquisitions; and (e) expansion or acquisition of foreign operations (including the impact of changes in the related economic and regulatory environments).[End of Footnote 9]
Footnote 1 0 -- Where the board of directors fulfills the audit committee responsibilities, the procedures should provide for the submission of employee concerns to an outside director.[End of Footnote 10]
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Small Institutions
An effective system of internal control and an independent internal audit function form the foundation for safe and sound operations, regardless of an institution’s size. As noted in the Introduction, each institution should have an internal audit function that is appropriate to its size and the nature and scope of its activities. The procedures assigned to this function should include adequate testing and review of internal controls and information systems.
It is the responsibility of the audit committee and management to carefully consider the extent of auditing that will effectively monitor the internal control system after taking into account the internal audit function’s costs and benefits. For institutions that are large or have complex operations, the benefits derived from a full-time manager of internal audit or an auditing staff likely outweigh the cost. For small institutions with few employees and less complex operations, however, these costs may outweigh the benefits. Nevertheless, a small institution without an internal auditor can ensure that it maintains an objective internal audit function by implementing a comprehensive set of independent reviews of significant internal controls. The key characteristic of such reviews is that the person(s) directing and/or performing the review of internal controls is not also responsible for managing or operating those controls. A person who is competent in evaluating a system of internal control should design the review procedures and arrange for their implementation. The person responsible for reviewing the system of internal control should report findings directly to the audit committee. The audit committee should evaluate the findings and ensure that senior management has or will take appropriate action to correct the control deficiencies.
U.S. Operations of Foreign Banking Organizations
The internal audit function of a foreign banking organization (FBO) should cover its U.S. operations in its risk assessments, audit plans, and audit programs. Its U.S. domiciled audit function, head-office internal audit staff, or some combination thereof normally performs the internal audit of the U.S. operations. Internal audit findings (including internal control deficiencies) should be reported to the senior management of the U.S. operations of the FBO and the audit department of the head office. Significant adverse findings also should be reported to the head office’s senior management and the board of directors or its audit committee.
PART II — INTERNAL AUDIT OUTSOURCING ARRANGEMENTS
Examples of Arrangements
An outsourcing arrangement is a contract between an institution and an outsourcing vendor to provide internal audit services. Outsourcing arrangements take many forms and are used by institutions of all sizes. Some institutions consider entering into these arrangements to enhance the quality of their control environment by obtaining the services of a vendor with the knowledge and skills to critically assess, and recommend improvements to, their internal control systems.
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The internal audit services under contract can be limited to helping internal audit staff in an assignment for which they lack expertise. Such an arrangement is typically under the control of the institution’s manager of internal audit, and the outsourcing vendor reports to him or her. Institutions often use outsourcing vendors for audits of areas requiring more technical expertise, such as electronic data processing and capital markets activities. Such uses are often referred to as “internal audit assistance” or “audit co-sourcing.”
Some outsourcing arrangements are structured so that an outsourcing vendor performs virtually all the procedures or tests of the system of internal control. Under such an arrangement, a designated manager of internal audit oversees the activities of the outsourcing vendor and typically is supported by internal audit staff. The outsourcing vendor may assist the audit staff in determining risks to be reviewed and may recommend testing procedures, but the internal audit manager is responsible for approving the audit scope, plan, and procedures to be performed. Furthermore, the internal audit manager is responsible for the results of the outsourced audit work, including findings, conclusions, and recommendations. The outsourcing vendor may report these results jointly with the internal audit manager to the audit committee.
Additional Considerations for Internal Audit Outsourcing Arrangements
Even when outsourcing vendors provide internal audit services, the board of directors and senior management of an institution are responsible for ensuring that both the system of internal control and the internal audit function operate effectively. In any outsourced internal audit arrangement, the institution’s board of directors and senior management must maintain ownership of the internal audit function and provide active oversight of outsourced activities. When negotiating the outsourcing arrangement with an outsourcing vendor, an institution should carefully consider its current and anticipated business risks in setting each party’s internal audit responsibilities. The outsourcing arrangement should not increase the risk that a breakdown of internal control will go undetected.
To clearly distinguish its duties from those of the outsourcing vendor, the institution should have a written contract, often taking the form of an engagement letter.[See Footnote 11] Contracts between the institution and the vendor typically include provisions that:
Define the expectations and responsibilities under the contract for both parties;
Set the scope and frequency of, and the fees to be paid for, the work to be performed by the vendor;
Footnote 1 1 -- The engagement letter provisions described are comparable to those outlined by the American Institute of Certified Public Accountants (AICPA) for financial statement audits (see AICPA Professional Standards, AU section 310). These provisions are consistent with the provisions customarily included in contracts for other outsourcing arrangements, such as those involving data processing and information technology. Therefore, the federal banking agencies consider these provisions to be usual and customary business practices.[End of Footnote 11]
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Set the responsibilities for providing and receiving information, such as the type and frequency of reporting to senior management and directors about the status of contract work;
Establish the process for changing the terms of the service contract, especially for expansion of audit work if significant issues are found, and stipulations for default and termination of the contract;
State that internal audit reports are the property of the institution, that the institution will be provided with any copies of the related workpapers it deems necessary, and that employees authorized by the institution will have reasonable and timely access to the workpapers prepared by the outsourcing vendor;
Specify the locations of internal audit reports and the related workpapers;
Specify the period of time (for example, seven years) that vendors must maintain the workpapers;[See Footnote 12]
State that outsourced internal audit services provided by the vendor are subject to regulatory review and that examiners will be granted full and timely access to the internal audit reports and related workpapers prepared by the outsourcing vendor;
Prescribe a process (arbitration, mediation, or other means) for resolving disputes and for determining who bears the cost of consequential damages arising from errors, omissions, and negligence; and
State that the outsourcing vendor will not perform management functions, make management decisions, or act or appear to act in a capacity equivalent to that of a member of management or an employee and, if applicable, will comply with AICPA, U.S. Securities and Exchange Commission (SEC), Public Company Accounting Oversight Board (PCAOB), or regulatory independence guidance.
Vendor Competence. Before entering an outsourcing arrangement, the institution should perform due diligence to satisfy itself that the outsourcing vendor has sufficient staff qualified to perform the contracted work. The staff’s qualifications may be demonstrated, for example, through prior experience with financial institutions. Because the outsourcing arrangement is a personal-services contract, the institution’s internal audit manager should have confidence in the competence of the staff assigned by the outsourcing vendor and receive timely notice of key staffing changes. Throughout the outsourcing arrangement, management should ensure that the outsourcing vendor maintains sufficient expertise to effectively perform its contractual obligations.
Footnote 1 2 -- If the workpapers are in electronic format, contracts often call for the vendor to maintain proprietary software that enables the bank and examiners to access the electronic workpapers for a specified time period.[End of Footnote 12]
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Management. Directors and senior management should ensure that the outsourced internal audit function is competently managed. For example, larger institutions should employ sufficient competent staff members in the internal audit department to assist the manager of internal audit in overseeing the outsourcing vendor. Small institutions that do not employ a full-time audit manager should appoint a competent employee who ideally has no managerial responsibility for the areas being audited to oversee the outsourcing vendor’s performance under the contract. This person should report directly to the audit committee for purposes of communicating internal audit issues.
Communication. Communication between the internal audit function and the audit committee and senior management should not diminish because the institution engages an outsourcing vendor. All work by the outsourcing vendor should be well documented and all findings of control weaknesses should be promptly reported to the institution’s manager of internal audit. Decisions not to report the outsourcing vendor’s findings to directors and senior management should be the mutual decision of the internal audit manager and the outsourcing vendor. In deciding what issues should be brought to the board’s attention, the concept of “materiality,” as the term is used in financial statement audits, is generally not a good indicator of which control weakness to report. For example, when evaluating an institution’s compliance with laws and regulations, any exception may be important.
Contingency Planning. When an institution enters into an outsourcing arrangement (or significantly changes the mix of internal and external resources used by internal audit), it may increase its operational risk. Because the arrangement may be terminated suddenly, the institution should have a contingency plan to mitigate any significant discontinuity in audit coverage, particularly for high-risk areas.
PART III — INDEPENDENCE OF THE INDEPENDENT PUBLIC ACCOUNTANT
This part of the policy statement relates only to an outsourcing vendor who is a public accountant and is considering providing both external audit and internal audit services to an institution.
When one accounting firm performs both the external audit and the outsourced internal audit function, the firm risks compromising its independence. These concerns arise because, rather than having two separate functions, this outsourcing arrangement places the independent public accounting firm in the position of appearing to audit, or actually auditing, its own work. For example, in auditing an institution’s financial statements, the accounting firm will consider the extent to which it may rely on the internal control system, including the internal audit function, in designing audit procedures.
The next three sections outline the applicability of the SEC’s auditor independence requirements to public companies, insured depository institutions subject to Section 36 of the FDI Act, and non-public institutions that are not subject to Section 36. They are followed by information on the AICPA’s independence guidance.
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Institutions that are Public Companies
To strengthen auditor independence, Congress passed the Sarbanes-Oxley Act of 2002. Title II of this act applies to any company that has a class of securities registered with the SEC or the appropriate federal banking agency under Section 12 of the Securities Exchange Act of 1934 or that is required to file reports with the SEC under Section 15(d) of that act,[See Footnote 13] i.e., a public company. Within Title II, Section 201(a) prohibits an accounting firm from acting as the external auditor of a public company during the same period that the firm provides internal audit outsourcing services to the company.[See Footnote 14] In addition, if a public company’s external auditor will be providing auditing services and non-audit services, such as tax services, that are not otherwise prohibited by Section 201(a) of the Sarbanes-Oxley Act, Title II also provides that the company’s audit committee must pre-approve each of these services.
The SEC adopted final rules implementing the non-audit service prohibitions and audit committee pre-approval requirements of Title II on January 22, 2003.[See Footnote 15] According to these rules, an accountant is not independent if, at any point during the audit and professional engagement period, the accountant provides internal audit outsourcing or other prohibited non-audit services to a public company audit client. These rules generally become effective on May 6, 2003, although a one-year transition period is provided for contractual arrangements in place as of that date. Under this transition rule, an external auditor’s independence will not be deemed to be impaired until May 6, 2004, if the auditor is performing internal audit outsourcing and other prohibited non-audit services for a public company audit client pursuant to a contract in existence on May 6, 2003. However, the services being provided must not have impaired the auditor’s independence under the pre-existing independence requirements of the SEC, the Independence Standards Board, and the AICPA.
The SEC’s pre-existing auditor independence requirements are contained in regulations that were adopted in November 2000 and became fully effective in August 2002.[See Footnote 16] Although the SEC’s
Footnote 1 3 -- 15 U.S.C. 78l and 78o(d).[End of Footnote 13]
Footnote 1 4 -- In addition to prohibiting internal audit outsourcing, Section 201(a) of the Sarbanes-Oxley Act also identifies other non-audit services that an external auditor is prohibited from providing to a public company whose financial statements it audits. The legislative history of Section 201(a) indicates that three broad principles should be considered when determining whether an auditor should be prohibited from providing a non-audit service to an audit client. These principles are that an auditor should not (1) audit his or her own work, (2) perform management functions for the client, or (3) serve in an advocacy role for the client. To do so would impair the auditor’s independence. Based on these three broad principles, the other non-audit services that Section 201(a) prohibits an auditor from providing for a public company audit client include bookkeeping or other services related to the client’s accounting records or financial statements; financial information systems design and implementation; appraisal or valuation services, fairness opinions, or contribution-in-kind reports; actuarial services; management functions or human resources; broker or dealer, investment adviser, or investment banking services; legal services and expert services unrelated to the audit; and any other service determined to be impermissible by the PCAOB.[End of Footnote 14]
Footnote 1 5 -- 68 Fed. Reg. 6006, February 5, 2003.[End of Footnote 15]
Footnote 1 6 -- 65 Fed. Reg. 76007, December 5, 2000.[End of Footnote 16]
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November 2000 regulations do not prohibit the outsourcing of internal audit services to a public company’s independent public accountant, they place conditions and limitations on internal audit outsourcing.
Depository Institutions Subject to the Annual Audit and Reporting Requirements of Section 36 of the FDI Act
Under Section 36 as implemented by Part 363 of the FDIC’s regulations, each FDIC-insured depository institution with total assets of $500 million or more is required to have an annual audit performed by an independent public accountant.[See Footnote 17] The Part 363 guidelines address the qualifications of an independent public accountant engaged by such an institution by stating that “[t]he independent public accountant should also be in compliance with the AICPA’s Code of Professional Conduct and meet the independence requirements and interpretations of the SEC and its staff.”[See Footnote 18]
Thus, the guidelines provide for each FDIC-insured depository institution with $500 million or more in total assets, whether or not it is a public company, and its external auditor to comply with the SEC’s auditor independence requirements that are in effect during the period covered by the audit. These requirements include the non-audit service prohibitions and audit committee pre-approval requirements implemented by the SEC’s January 2003 auditor independence rules once they take effect May 6, 2003, subject to the transition rule for internal audit outsourcing and other contracts in existence on that date described in the preceding section. That transition rule provides that such outsourcing arrangements will not impair an auditor’s independence until May 6, 2004, provided certain conditions are met.[See Footnote 19]
Institutions Not Subject to Section 36 of the FDI Act that are Neither Public Companies nor Subsidiaries of Public Companies
The agencies have long encouraged each institution not subject to Section 36 of the FDI Act[See Footnote 20]
that is neither a public company nor a subsidiary of a public company to have its financial
Footnote 1 7 -- 12 CFR 363.3(a).[End of Footnote 17]
Footnote 1 8 -- Appendix A to Part 363—Guidelines and Interpretations, Paragraph 14. Independence.[End of Footnote 18]
Footnote 1 9 -- If a depository institution subject to Section 36 and Part 363 satisfies the annual independent audit requirement by relying on the independent audit of its parent holding company, once the SEC’s January 2003 regulations prohibiting an external auditor from performing internal audit outsourcing services for an audit client take effect May 6, 2003, or May 6, 2004, depending on the circumstances, the holding company’s external auditor cannot perform internal audit outsourcing work for that holding company or the subsidiary institution.[End of Footnote 19]
Footnote 2 0 -- FDIC-insured depository institutions with less than $500 million in total assets are not subject to Section 36 of the FDI Act. Section 36 does not apply directly to holding companies, but it provides that, for an insured depository institution that is a subsidiary of a holding company, its audited financial statements requirement and certain of its other requirements may be satisfied by the holding company.[End of Footnote 20]
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statements audited by an independent public accountant.[See Footnote 21] The agencies also encourage each such non-public institution to follow the internal audit outsourcing prohibition in Section 201(a) of the Sarbanes-Oxley Act when the SEC’s January 2003 regulations implementing this prohibition take effect, as discussed above for institutions that are public companies.
As previously mentioned, some institutions seek to enhance the quality of their control environment by obtaining the services of an outsourcing vendor who can critically assess their internal control system and recommend improvements. The agencies believe that a small non-public institution with less complex operations and limited staff can, in certain circumstances, use the same accounting firm to perform both an external audit and some or all of the institution’s internal audit activities. These circumstances include, but are not limited to, situations where:
Splitting the audit activities poses significant costs or burden;
Persons with the appropriate specialized knowledge and skills are difficult to locate and obtain;
The institution is closely held and investors are not solely reliant on the audited financial statements to understand the financial position and performance of the institution; and
The outsourced internal audit services are limited in either scope or frequency.
In circumstances such as these, the agencies view an internal audit outsourcing arrangement between a small non-public institution and its external auditor as not being inconsistent with their safety and soundness objectives for the institution.
When a small non-public institution decides to hire the same firm to perform internal and external audit work, the audit committee and the external auditor should pay particular attention to preserving the independence of both the internal and external audit functions. Furthermore, the audit committee should document both that it has pre-approved the internal audit outsourcing to its external auditor and has considered the independence issues associated with this arrangement.[See Footnote 22] In this regard, the audit committee should consider the independence standards described in Parts I and II of this policy statement, the AICPA guidance discussed in the following section, and the broad principles that the auditor should not perform management functions or serve in an advocacy role for the client.
Footnote 2 1 -- See, for example, the 1999 Interagency Policy Statement on External Auditing Programs of Banks and Savings Institutions.[End of Footnote 21]
Footnote 2 2 -- If a small non-public institution is considering having its external auditor perform other non-audit services (see footnote 14 for examples of such services), its audit committee may wish to discuss the implications of the performance of these services on the auditor’s independence.[End of Footnote 22]
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Accordingly, the agencies will not consider an auditor who performs internal audit outsourcing services for a small non-public audit client to be independent unless the institution and its auditor have adequately addressed the associated independence issues. In addition, the institution’s board of directors and management must retain ownership of and accountability for the internal audit function and provide active oversight of the outsourced internal audit relationship.
A small non-public institution may be required by another law or regulation, an order, or another supervisory action to have its financial statements audited by an independent public accountant. In this situation, if warranted for safety and soundness reasons, the institution’s primary federal regulator may require that the institution and its independent public accountant comply with the auditor independence requirements of Section 201(a) of the Sarbanes-Oxley Act.[See Footnote 23]
AICPA Guidance
As noted above, the independent public accountant for a depository institution subject to Section 36 of the FDI Act also should be in compliance with the AICPA’s Code of Professional Conduct. This code includes professional ethics standards, rules, and interpretations that are binding on all certified public accountants (CPAs) who are members of the AICPA in order for the member to remain in good standing. Therefore, this code applies to each member CPA who provides audit services to an institution, regardless of whether the institution is subject to Section 36 or is a public company.
The AICPA has issued guidance indicating that a member CPA would be deemed not independent of his or her client when the CPA acts or appears to act in a capacity equivalent to a member of the client’s management or as a client employee. The AICPA’s guidance includes illustrations of activities that would be considered to compromise a CPA’s independence. Among these are activities that involve the CPA authorizing, executing, or consummating transactions or otherwise exercising authority on behalf of the client. For additional details, refer to Interpretation 101-3 – Performance of Other Services and Interpretation 101-13 – Extended Audit Services in the AICPA’s Code of Professional Conduct.
PART I V — EXAMINATION GUIDANCE
Review of the Internal Audit Function and Outsourcing Arrangements
Examiners should have full and timely access to an institution’s internal audit resources, including personnel, workpapers, risk assessments, work plans, programs, reports, and budgets. A delay may require examiners to widen the scope of their examination work and may subject the institution to follow-up supervisory actions.
Footnote 2 3 -- For OTS-required audits under 12 CFR 562.4, independent public accountants performing such audits must meet the independence requirements and interpretations of the SEC and its staff.[End of Footnote 23]
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Examiners will assess the quality and scope of an institution’s internal audit function, regardless of whether it is performed by the institution’s employees or by an outsourcing vendor. Specifically, examiners will consider whether:
The internal audit function’s control risk assessment, audit plans, and audit programs are appropriate for the institution’s activities;
The internal audit activities have been adjusted for significant changes in the institution’s environment, structure, activities, risk exposures, or systems;
The internal audit activities are consistent with the long-range goals and strategic direction of the institution and are responsive to its internal control needs;
The audit committee promotes the internal audit manager’s impartiality and independence by having him or her directly report audit findings to it;
The internal audit manager is placed in the management structure in such a way that the independence of the function is not impaired;
The institution has promptly responded to significant identified internal control weaknesses;
The internal audit function is adequately managed to ensure that audit plans are met, programs are carried out, and results of audits are promptly communicated to senior management and members of the audit committee and board of directors;
Workpapers adequately document the internal audit work performed and support the audit reports;
Management and the board of directors use reasonable standards, such as the IIA’s Standards for the Professional Practice of Internal Auditing, when assessing the performance of internal audit; and
The audit function provides high-quality advice and counsel to management and the board of directors on current developments in risk management, internal control, and regulatory compliance.
The examiner should assess the competence of the institution’s internal audit staff and management by considering the education, professional background, and experience of the principal internal auditors.
In addition, when reviewing outsourcing arrangements, examiners should determine whether:
The arrangement maintains or improves the quality of the internal audit function and the institution’s internal control;
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. Key employees of the institution and the outsourcing vendor clearly understand the lines of communication and how any internal control problems or other matters noted by the outsourcing vendor are to be addressed;
. The scope of the outsourced work is revised appropriately when the institution’s environment, structure, activities, risk exposures, or systems change significantly;
. The directors have ensured that the outsourced internal audit activities are effectively managed by the institution;
. The arrangement with the outsourcing vendor satisfies the independence standards described in this policy statement and thereby preserves the independence of the internal audit function, whether or not the vendor is also the institution’s independent public accountant; and
. The institution has performed sufficient due diligence to satisfy itself of the vendor’s competence before entering into the outsourcing arrangement and has adequate procedures for ensuring that the vendor maintains sufficient expertise to perform effectively throughout the arrangement.
Concerns about the Adequacy of the Internal Audit Function
If the examiner concludes that the institution’s internal audit function, whether or not it is outsourced, does not sufficiently meet the institution’s internal audit needs, does not satisfy the Interagency Guidelines Establishing Standards for Safety and Soundness, if applicable[See Footnote 24] or is otherwise inadequate, he or she should consider adjusting the scope of the examination. The examiner should also discuss his or her concerns with the internal audit manager or other person responsible for reviewing the system of internal control. If these discussions do not resolve the examiner’s concerns, he or she should bring these matters to the attention of senior management and the board of directors or audit committee. Should the examiner find material weaknesses in the internal audit function or the internal control system, he or she should discuss them with appropriate agency staff in order to determine the appropriate actions the agency should take to ensure that the institution corrects the deficiencies. These actions may include formal and informal enforcement actions.
The institution’s management and composite ratings should reflect the examiner’s conclusions regarding the institution’s internal audit function. The report of examination should contain comments concerning the adequacy of this function, significant issues or concerns, and recommended corrective actions.
Concerns about the Independence of the Outsourcing Vendor
An examiner’s initial review of an internal audit outsourcing arrangement, including the actions of the outsourcing vendor, may raise questions about the institution’s and its vendor’s adherence
Footnote 24 -- See footnote 4.[End of Footnote 24]
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to the independence standards described in Parts I and II of this policy statement, whether or not the vendor is an accounting firm, and in Part III if the vendor provides both external and internal audit services to the institution. In such cases, the examiner first should ask the institution and the outsourcing vendor how the audit committee determined that the vendor was independent. If the vendor is an accounting firm, the audit committee should be asked to demonstrate how it assessed that the arrangement has not compromised applicable SEC, PCAOB, AICPA, or other regulatory standards concerning auditor independence. If the examiner’s concerns are not adequately addressed, the examiner should discuss the matter with appropriate agency staff prior to taking any further action.
If the agency staff concurs that the independence of the external auditor or other vendor appears to be compromised, the examiner will discuss his or her findings and the actions the agency may take with the institution’s senior management, board of directors (or audit committee), and the external auditor or other vendor. In addition, the agency may refer the external auditor to the state board of accountancy, the AICPA, the SEC, the PCAOB, or other authorities for possible violations of applicable independence standards. Moreover, the agency may conclude that the institution’s external auditing program is inadequate and that it does not comply with auditing and reporting requirements, including Sections 36 and 39 of the FDI Act and related guidance and regulations, if applicable.
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Basel Committee on Banking Supervision
The internal audit function in banks June 2012
This publication is available on the BIS website (www.bis.org).
© Bank for International Settlements 2012. All rights reserved. Brief excerpts may be reproduced or translated provided the source is cited.
ISBN 92-9131- 140-5 (print)
ISBN 92-9197- 140-5 (online)
The internal audit function in banks i
Contents
Introduction ............................................................................................................................... 1
Overview of the principles ......................................................................................................... 2
A. Supervisory expectations relevant to the internal audit function ..................................... 3 1. The internal audit function ...................................................................................... 4 2. Key features of the internal audit function .............................................................. 4 3. The internal audit charter ....................................................................................... 7 4. Scope of activity ..................................................................................................... 7 5. Corporate governance considerations ................................................................... 9 6. Internal audit within a group or holding company structure .................................. 13 7. Outsourcing of internal audit activities ................................................................. 14
B. The relationship of the supervisory authority with the internal audit function ................ 14 1. Benefits of enhanced communication between the supervisory authority and the
internal audit function ........................................................................................... 15 2. Potential topics for discussion between supervisors and internal audit ............... 16
C. Supervisory assessment of the internal audit function .................................................. 17 1. Assessment of the internal audit function ............................................................ 17 2. Actions to be undertaken by the supervisory authority ........................................ 18
Annex 1: Internal audit function's communication channels ................................................... 19
Annex 2: Responsibilities of a bank's audit committee ........................................................... 21
ii The internal audit function in banks
Members of the Accounting Task Force’s Audit Subgroup of the Basel Committee on Banking Supervision
Chairman: Mr Marc Pickeur
National Bank of Belgium
Representatives in italics provided drafting support
Office of the Superintendent of Financial Institutions, Canada Ms Laural Ross
Ms Ruby Garg
Bank of France Ms Nathalie Boutin
Prudential Supervisory Authority, France Ms Sylvie Marchal
Deutsche Bundesbank, Germany
Bundesanstalt für Finanzdienstleistungsaufsicht, Germany Ms Dragomira Berberova
Ms Stefanie Jessen
Banca d’Italia, Italy Ms Lidja Schiavo
Bank of Japan Mr Hiroyuki Yoshida
Ms Keiko Sumida
Financial Services Agency, Japan Mr Tadashi Tsumori
Commission de Surveillance du Secteur Financier, Luxembourg
Ms Martine Wagner
De Nederlandsche Bank, The Netherlands Mr Nic van der Ende
Banco de España, Spain Ms Barbara Olivares
Financial Services Authority, United Kingdom Ms Patricia Sucher
Mr Robert Konowalchuk
Ms Veenu Mittal
Board of Governors of the Federal Reserve System, United States
Mr Terrill Garrison
Office of the Comptroller of the Currency, United States Mr Robert Riordan
Federal Deposit Insurance Corporation, United States Mr Harrison Greene
Secretariat Secretariat of the Basel Committee on Banking Supervision Mr Xavier-Yves Zanota
The internal audit function in banks 1
Introduction
1. The Basel Committee on Banking Supervision (the Committee) is issuing this revised supervisory guidance for assessing the effectiveness of the internal audit function in banks, which forms part of the Committee’s ongoing efforts to address bank supervisory issues and enhance supervision through guidance that encourages sound practices within banks. The document replaces the 2001 document Internal audit in banks and the supervisor’s relationship with auditors. It takes into account developments in supervisory practices and in banking organisations and incorporates lessons drawn from the recent financial crisis.
2. The Committee’s Principles for Enhancing Corporate Governance1 states that banks should have an internal audit function with sufficient authority, stature, independence, resources and access to the board of directors. Independent, competent and qualified internal auditors are vital to sound corporate governance.
3. A strong internal control system, including an independent and effective internal audit function, is part of sound corporate governance. Banking supervisors must be satisfied as to the effectiveness of a bank's internal audit function, that policies and practices are followed and that management takes appropriate and timely corrective action in response to internal control weaknesses identified by internal auditors. An internal audit function provides vital assurance to a bank’s board of directors and senior management (and bank supervisors) as to the quality of the bank’s internal control system. In doing so, the function helps reduce the risk of loss and reputational damage to the bank.
4. This document addresses supervisory expectations for the internal audit function in banking organisations, the relationship of the supervisory authority with the internal audit function and the supervisory assessment of that function. This document seeks to promote a strong internal audit function within banking organisations and to provide guidance for the supervisory assessment of this function.
5. This document also encourages bank internal auditors to comply with and to contribute to the development of national and international professional standards, such as those issued by The Institute of Internal Auditors, and it promotes due consideration of prudential issues in the development of internal audit standards and practices.
6. This document refers to a management structure comprised of a board of directors2 and senior management. The Committee recognises that significant differences exist in legislative and regulatory frameworks between countries. These national frameworks shape the role and function of management and governance structures. In some countries the board of directors has the main, if not exclusive, function of overseeing the executive body, often referred to as senior management, and ensuring that it fulfils its responsibilities. For this reason it is sometimes known as a supervisory board that has no executive functions. In contrast, in other countries the board has a broader remit in that it lays down the general framework for the management of the bank. Owing to these differences, the concepts of the board of directors and senior management are used in this document not to identify legal constructs but rather to label two decision-making functions within a bank.
1 BCBS website: http://www.bis.org/publ/bcbs176.pdf 2 In this document, the terms “board of directors” and “board” are both used and have the same meaning.
2 The internal audit function in banks
7. The principles set out in this document should be applied in accordance with the national legislation and corporate governance structures applicable in each country.
8. For large banks and internationally active banks, an audit committee (or its equivalent) is typically responsible for providing oversight of the bank’s internal auditors. Such a committee is established within the board of directors. Annex 2 of this document provides more details about the responsibilities of audit committees. In this document, references to the board of directors presume appropriate involvement of its audit committee, when one exists. In line with the Committee's Principles for Enhancing Corporate Governance, paragraph 50, this document assumes that large and internationally active banks have an audit committee or its equivalent. Other banks are strongly encouraged to establish such a committee.
9. This guidance applies to all banks, including those within a banking group, and to holding companies whose subsidiaries are predominantly banks and to those holding companies subject to prudential supervision whose subsidiaries are predominantly banks. All of these structures are referred to as banks or banking organisations in this document. The extent of application of this guidance should be commensurate with the significance, complexity and international presence of the bank (principle of proportionality).
Overview of the principles
Principles relating to the supervisory expectations relevant to the internal audit function Principle 1: An effective internal audit function provides independent assurance to the board of directors and senior management on the quality and effectiveness of a bank’s internal control, risk management and governance systems and processes, thereby helping the board and senior management protect their organisation and its reputation.
Principle 2: The bank's internal audit function must be independent of the audited activities, which requires the internal audit function to have sufficient standing and authority within the bank, thereby enabling internal auditors to carry out their assignments with objectivity.
Principle 3: Professional competence, including the knowledge and experience of each internal auditor and of internal auditors collectively, is essential to the effectiveness of the bank’s internal audit function.
Principle 4: Internal auditors must act with integrity.
Principle 5: Each bank should have an internal audit charter that articulates the purpose, standing and authority of the internal audit function within the bank in a manner that promotes an effective internal audit function as described in Principle 1.
Principle 6: Every activity (including outsourced activities) and every entity of the bank should fall within the overall scope of the internal audit function.
Principle 7: The scope of the internal audit function’s activities should ensure adequate coverage of matters of regulatory interest within the audit plan.
Principle 8: Each bank should have a permanent internal audit function, which should be structured consistent with Principle 14 when the bank is within a banking group or holding company.
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Principle 9: The bank’s board of directors has the ultimate responsibility for ensuring that senior management establishes and maintains an adequate, effective and efficient internal control system and, accordingly, the board should support the internal audit function in discharging its duties effectively.
Principle 10: The audit committee, or its equivalent, should oversee the bank’s internal audit function.
Principle 11: The head of the internal audit department should be responsible for ensuring that the department complies with sound internal auditing standards and with a relevant code of ethics.
Principle 12: The internal audit function should be accountable to the board, or its audit committee, on all matters related to the performance of its mandate as described in the internal audit charter.
Principle 13: The internal audit function should independently assess the effectiveness and efficiency of the internal control, risk management and governance systems and processes created by the business units and support functions and provide assurance on these systems and processes.
Principle 14: To facilitate a consistent approach to internal audit across all the banks within a banking organisation, the board of directors of each bank within a banking group or holding company structure should ensure that either:
(i) the bank has its own internal audit function, which should be accountable to the bank’s board and should report to the banking group or holding company's head of internal audit; or
(ii) the banking group or holding company's internal audit function performs internal audit activities of sufficient scope at the bank to enable the board to satisfy its fiduciary and legal responsibilities.
Principle 15: Regardless of whether internal audit activities are outsourced, the board of directors remains ultimately responsible for the internal audit function.
Principle relating to the relationship of the supervisory authority with the internal audit function Principle 16: Supervisors should have regular communication with the bank’s internal auditors to (i) discuss the risk areas identified by both parties, (ii) understand the risk mitigation measures taken by the bank, and (iii) understand weaknesses identified and monitor the bank’s responses to these weaknesses.
Principles relating to the supervisory assessment of the internal audit function Principle 17: Bank supervisors should regularly assess whether the internal audit function has sufficient standing and authority within the bank and operates according to sound principles.
Principle 18: Supervisors should formally report all weaknesses they identify in the internal audit function to the board of directors and require timely remedial actions.
4 The internal audit function in banks
Principle 19: The supervisory authority should consider the impact of its assessment of the internal audit function on its evaluation of the bank's risk profile and on its own supervisory work.
Principle 20: The supervisory authority should be prepared to take informal or formal supervisory actions requiring the board and senior management to remedy any identified deficiencies related to the internal audit function within a specified timeframe and to provide the supervisor with periodic written progress reports.
A. Supervisory expectations relevant to the internal audit function
Principle 1: An effective internal audit function provides independent assurance to the board of directors and senior management on the quality and effectiveness of a bank’s internal control, risk management and governance systems and processes, thereby helping the board and senior management protect their organisation and its reputation.
1. The internal audit function 10. The internal audit function plays a crucial role in the ongoing maintenance and assessment of a bank’s internal control, risk management and governance systems and processes – areas in which supervisory authorities have a keen interest. Furthermore, both internal auditors and supervisors use risk based approaches to determine their respective work plans and actions. While internal auditors and supervisors each have a different mandate and are responsible for their own judgments and assessments, they may identify the same or similar/related risks.
11. The internal audit function should develop an independent and informed view of the risks faced by the bank based on their access to all bank records and data, their enquiries, and their professional competence. The internal audit function should be able to discuss their views, findings and conclusions directly with the audit committee and the board of directors, thereby helping the board to oversee senior management.
2. Key features of the internal audit function 12. The key features described below are essential for the effective operation of an internal audit function.
(a) Independence and objectivity3 Principle 2: The bank's internal audit function must be independent of the audited activities, which requires the internal audit function to have sufficient standing and
3 Both “independence” and “objectivity” have a specific meaning in an internal audit environment. The Glossary
of The Institute of Internal Auditors refers to independence as the freedom from conditions that threaten the ability of the internal audit activity to carry out internal audit responsibilities in an unbiased manner. Objectivity is referred to in the Glossary as an unbiased mental attitude that allows internal auditors to perform engagements in such a manner that they believe in their work product and that no quality compromises are made. Objectivity requires that internal auditors do not subordinate their judgement on audit matters to others.
The internal audit function in banks 5
authority within the bank, thereby enabling internal auditors to carry out their assignments with objectivity.
13. On the basis of the audit plan established by the head of the internal audit function and approved by the board of directors, the internal audit function must be able to perform its assignments on its own initiative in all areas and functions of the bank. It must be free to report its findings and assessments internally through clear reporting lines. The head of internal audit should demonstrate appropriate leadership and have the necessary skills to fulfil his or her responsibility for maintaining the function’s independence and objectivity.
14. The internal audit function should not be involved in designing, selecting, implementing or operating specific internal control measures. However, the independence of the internal audit function should not prevent senior management from requesting input from internal audit on matters related to risk and internal controls. Nevertheless, the development and implementation of internal controls should remain the responsibility of management.
15. Continuously performing similar tasks or routine jobs may negatively affect an individual internal auditor’s capacity for critical judgement because of possible loss of objectivity. It is therefore a sound practice, whenever practicable and without jeopardising competence and expertise, to periodically rotate internal audit staff within the internal audit function. In addition, a bank may rotate staff from other functional areas of the bank to the internal audit function or from the internal audit function to other functional areas of the bank. Staff rotations within the internal audit function and staff rotations to and from the internal audit function should be governed by and conducted in accordance with a sound written policy. The policy should be designed to avoid conflicts of interest, including the observance of an appropriate “cooling-off” period following an individual's return to the internal audit staff before that individual audits activities in the functional area of the bank where his/her rotation had been served.
16. The independence and objectivity of the internal audit function may be undermined if the internal audit staff’s remuneration is linked to the financial performance of the business lines for which they exercise internal audit responsibilities. The remuneration of the head of the internal audit function should be determined in accordance with the remuneration policies and practices of the bank. Remuneration to reward the performance of the head of internal audit or internal audit staff members should be structured to avoid creating conflicts of interest and compromising independence and objectivity.
(b) Professional competence and due professional care Principle 3: Professional competence, including the knowledge and experience of each internal auditor and of internal auditors collectively, is essential to the effectiveness of the bank’s internal audit function.
17. Professional competence depends on the auditor’s capacity to collect and understand information, to examine and evaluate audit evidence and to communicate with the stakeholders of the internal audit function. This should be combined with suitable methodologies and tools and sufficient knowledge of auditing techniques.
18. The head of internal audit should be responsible for acquiring human resources with sufficient qualifications and skills to effectively deliver on the mandate for professional competence and to audit to the required level. He/she should continually assess and monitor the skills necessary to do so. The skills required for senior internal auditors should include the abilities to judge outcomes and make an impact at the highest level of the organisation.
6 The internal audit function in banks
19. The head of internal audit should ensure that the internal audit staff acquires appropriate ongoing training in order to meet the growing technical complexity of banks’ activities and the increasing diversity of tasks that need to be undertaken as a result of the introduction of new products and processes within banks and other developments in the financial sector.
20. Internal auditors collectively should be competent to examine all areas in which the bank operates. Alternatively, when outsourcing4 arrangements are in place, it is the responsibility of the head of internal audit to maintain adequate oversight and to ensure adequate transfer of knowledge from external experts to the bank’s internal audit staff. The head of internal audit should ensure that the use of those experts does not compromise the independence and objectivity of the internal audit function.5
21. Internal auditors must apply the care and skills expected of a reasonably prudent and competent professional. Due professional care does not imply infallibility; however, internal auditors having limited competence and experience in a particular area should be supervised by more experienced internal auditors.
(c) Professional ethics Principle 4: Internal auditors must act with integrity.
22. Integrity establishes trust as it requires the internal auditor to be straightforward, honest and truthful. This provides the basis for reliance on the internal auditor's professional judgement.
23. Internal auditors should respect the confidentiality of information acquired in the course of their duties. They should not use that information for personal gain or malicious action and should be diligent in the protection of information acquired.
24. The head of the internal audit function and all internal auditors should avoid conflicts of interest. Internally recruited internal auditors should not engage in auditing activities for which they have had previous responsibility before a sufficiently long “cooling off” period has elapsed. Moreover, compensation arrangements should not provide incentives for internal auditors to act contrary to the attributes and objectives of the internal audit function.
25. Internal auditors should apply the bank’s code of ethics (when there is one) or should adhere to an established international code of ethics for internal auditors, such as that of The Institute of Internal Auditors.6 A code of ethics should at a minimum address the principles of objectivity, competence, confidentiality and integrity.
4 Outsourcing is the engagement of experts from outside the banking organisation to perform internal audit
activities to support the internal audit function. 5 If internal experts from within the bank (so-called guest auditors) are used in lieu of or in addition to external
experts, the head of internal audit has the same responsibilities for oversight, knowledge transfer, independence and objectivity.
6 The Institute of Internal Auditors (The IIA) and the International Ethics Standards Board for Accountants (IESBA) have each issued a code of ethics. Both codes emphasise the importance of the principle of integrity.
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3. The internal audit charter Principle 5: Each bank should have an internal audit charter that articulates the purpose, standing and authority of the internal audit function within the bank in a manner that promotes an effective internal audit function as described in Principle 1.
26. The charter should be drawn up and reviewed periodically by the head of internal audit and approved by the board of directors. It should be available to all internal stakeholders of the organisation and, in certain circumstances, such as listed entities, to external stakeholders.
27. At a minimum, an internal audit charter should establish:
• The internal audit function’s standing within the bank, its authority, its responsibilities and its relations with other control functions in a manner that promotes the effectiveness of the function as described in Principle 1 of this guidance;
• The purpose and scope of the internal audit function;
• The key features of the internal audit function described under Section A.2 above;
• The obligation of the internal auditors to communicate the results of their engagements and a description of how and to whom this should be done (reporting line);
• The criteria for when and how the internal audit function may outsource some of its engagements to external experts;
• The terms and conditions according to which the internal audit function can be called upon to provide consulting or advisory services or to carry out other special tasks;
• The responsibility and accountability of the head of internal audit;
• A requirement to comply with sound internal auditing standards;
• Procedures for the coordination of the internal audit function with the statutory or external auditor.
28. The charter should empower the internal audit function, whenever relevant to the performance of its assignments, to initiate direct communication with any member of staff, to examine any activity or entity of the bank, and to have full and unconditional access to any records, files, data and physical properties of the bank. This includes access to management information systems and records and the minutes of all consultative and decision-making bodies.
4. Scope of activity Principle 6: Every activity (including outsourced activities) and every entity of the bank should fall within the overall scope of the internal audit function.
29. The scope of internal audit activities should include the examination and evaluation of the effectiveness of the internal control, risk management and governance systems and processes of the entire bank, including the organisation’s outsourced activities and its subsidiaries and branches.
8 The internal audit function in banks
30. The internal audit function should independently evaluate the:
• Effectiveness and efficiency of internal control, risk management and governance systems in the context of both current and potential future risks;
• Reliability, effectiveness and integrity of management information systems and processes (including relevance, accuracy, completeness, availability, confidentiality and comprehensiveness of data);
• Monitoring of compliance with laws and regulations, including any requirements from supervisors (see the following sub-section for more details); and
• Safeguarding of assets.
31. The head of internal audit is responsible for establishing an annual internal audit plan that can be part of a multi-year plan. The plan should be based on a robust risk assessment (including input from senior management and the board) and should be updated at least annually (or more frequently to enable an ongoing real-time assessment of where significant risks lie). The board’s approval of the audit plan implies that an appropriate budget will be available to support the internal audit function’s activities. The budget should be sufficiently flexible to adapt to variations in the internal audit plan in response to changes in the bank’s risk profile.
Principle 7: The scope of the internal audit function’s activities should ensure adequate coverage of matters of regulatory interest within the audit plan.
32. Internal audit should have the appropriate capability regarding matters of regulatory interest and undertake regular reviews of such areas based on the results of its robust risk assessment. These include policies, processes and governance measures established in response to various regulatory principles, rules and guidance established by the relevant authorities. In particular, the internal audit function of a bank should have the capacity to review key risk management functions, regulatory capital adequacy and liquidity control functions, regulatory and internal reporting functions, the regulatory compliance function and the finance function.
(a) Risk management 33. A bank’s risk management processes support and reflect its adherence to regulatory provisions and safe and sound banking practices. Therefore, internal audit should include in its scope the following aspects of risk management:
• the organisation and mandates of the risk management function including market, credit, liquidity, interest rate, operational, and legal risks;
• evaluation of risk appetite, escalation and reporting of issues and decisions taken by the risk management function;
• the adequacy of risk management systems and processes for identifying, measuring, assessing, controlling, responding to, and reporting on all the risks resulting from the bank’s activities;
• the integrity of the risk management information systems, including the accuracy, reliability and completeness of the data used; and
• the approval and maintenance of risk models including verification of the consistency, timeliness, independence and reliability of data sources used in such models.
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When the risk management function has not informed the board of directors about the existence of a significant divergence of views between senior management and the risk management function regarding the level of risk faced by the bank, the head of internal audit should inform the board about this divergence.
(b) Capital adequacy and liquidity 34. Banks are subject to the global regulatory framework for capital and liquidity as approved by the Committee and implemented in national regulation. This framework contains measures to strengthen regulatory capital and global liquidity. The scope of internal audit should include all provisions of this regulatory framework and in particular the bank’s system for identifying and measuring its regulatory capital and assessing the adequacy of its capital resources in relation to the bank’s risk exposures and established minimum ratios.
35. Internal audit should review management’s process for stress testing its capital levels, taking into account the frequency of such exercises, their purpose (e.g., internal monitoring vs. regulator imposed), the reasonableness of scenarios and the underlying assumptions employed, and the reliability of the processes used.
36. Additionally, the bank’s systems and processes for measuring and monitoring its liquidity positions in relation to its risk profile, external environment, and minimum regulatory requirements, should fall within the audit universe.
(c) Regulatory and internal reporting 37. In addition to the matters identified above, internal auditors should regularly evaluate the effectiveness of the process by which the risk and reporting functions interact to produce timely, accurate, reliable and relevant reports for both internal management and the supervisor.
38. This includes standardised reports which record the bank’s calculation of its capital resources, requirements and ratios. It may also include public disclosures intended to facilitate transparency and market discipline such as the Pillar 3 disclosures and the reporting of regulatory matters in the bank’s public reports.
(d) Compliance7 39. The scope of the activities of the compliance function should be subject to periodic review by the internal audit function.
40. Compliance laws, rules and standards include primary legislation, rules and standards issued by legislators and supervisors, market conventions, codes of practice promoted by industry associations, and internal codes of conduct applicable to the staff members of the bank.
41. The audit of the compliance function should include an assessment of how effectively it fulfils its responsibilities.
7 To be read in conjunction with the Committee's Compliance and the compliance function in banks, April 2005.
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(e) Finance 42. A bank’s finance function8 is responsible for the integrity and accuracy of financial data and reporting. Key aspects of Finance’s activities (e.g. calculations, profit and loss valuations and reserves) have an impact on the level of a bank’s capital resources and therefore associated controls should be robust and consistently applied across similar risks and businesses. As such, it is important that these controls are subject to periodic internal audit review, using resources and expertise to provide an effective evaluation of bank practices.
43. Internal audit should devote sufficient resources to evaluate the valuation control environment, availability and reliability of information or evidence used in the valuation process and the reliability of estimated fair values. This is achieved through reviewing the independent price verification processes and testing valuations of significant transactions.
44. Internal audit should also include in its scope (the list is not intended to be exhaustive):
• The organisation and mandate of the finance function;
• The adequacy and integrity of underlying financial data and finance systems and processes for completely identifying, capturing, measuring and reporting key data such as profit or loss, valuations of financial instruments and impairment allowances;
• The approval and maintenance of pricing models including verification of the consistency, timeliness, independence and reliability of data sources used in such models;
• Controls in place to prevent and detect trading irregularities;
• Balance sheet controls including key reconciliations performed and actions taken (e.g. adjustments).
5. Corporate governance considerations 45. Annex 1 provides an illustrative overview of relevant principles and standards with respect to the internal audit function, corporate governance structure, and communication channels within a generic bank’s governance model.
(a) Permanency of the internal audit function Principle 8: Each bank should have a permanent internal audit function, which should be structured consistent with Principle 14 when the bank is within a banking group or holding company.
46. In fulfilling its duties and responsibilities, senior management and the board should take all the necessary measures to ensure that the bank has a permanent internal audit function commensurate with its size, the nature of its operations and the complexity of its organisation.
8 Finance includes valuation, modelling, product control and financial control.
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47. Internal audit activities should normally be conducted by the bank's own internal audit staff. When internal audit activities are partially or fully outsourced, the board of directors remains ultimately responsible for these activities and for maintaining an internal audit function within the bank. Outsourcing of internal audit activities is further addressed in principle 15 and related paragraphs.
(b) Responsibilities of the board of directors and senior management Principle 9: The bank’s board of directors has the ultimate responsibility for ensuring that senior management establishes and maintains an adequate, effective and efficient internal control system and, accordingly, the board should support the internal audit function in discharging its duties effectively.
48. At least once a year, the board of directors should review the effectiveness and efficiency of the internal control system based, in part, on information provided by the internal audit function. Moreover, as part of their oversight responsibilities, the board of directors should review the performance of the internal audit function. From time to time, the board of directors should consider commissioning an independent external quality assurance review of the internal audit function.
49. Senior management is responsible for developing an internal control framework that identifies, measures, monitors and controls all risks faced by the bank. It should maintain an organisational structure that clearly assigns responsibility, authority and reporting relationships and ensures that delegated responsibilities are effectively carried out. It is an established practice for senior management to report to the board of directors on the scope and performance of the internal control framework.
50. Senior management should inform the internal audit function of new developments, initiatives, projects, products and operational changes and ensure that all associated risks, known and anticipated, are identified and communicated at an early stage.
51. Senior management should be accountable for ensuring that timely and appropriate actions are taken on all internal audit findings and recommendations.
52. Senior management should ensure that the head of internal audit has the necessary resources, financial and otherwise, available to carry out his or her duties commensurate with the annual internal audit plan, scope and budget approved by the audit committee.
(c) Responsibilities of the audit committee in relation to the internal audit function
Principle 10: The audit committee, or its equivalent, should oversee the bank’s internal audit function.
53. This principle applies when the board of directors has established an audit committee. In cases where no audit committee exists, the responsibilities described below should be assumed by the board itself. As explained in paragraph 50 of the Committee's Principles for Enhancing Corporate Governance, large banks and internationally active banks should have an audit committee or its equivalent. Other banks are encouraged to establish an audit committee.
54. The oversight function of the audit committee includes ensuring that the internal audit function is able to discharge its responsibilities in an independent manner, congruent with principle 2. It also includes reviewing and approving the audit plan, its scope, and the
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budget of the internal audit function. It reviews key audit reports and ensures that senior management is taking necessary and timely corrective actions to address control weaknesses, compliance issues with policies, laws and regulations and other concerns identified and reported by the internal audit function.
55. Annex 2 of this document gives an overview of the responsibilities of an audit committee.
(d) Management of the internal audit department Principle 11: The head of the internal audit department should be responsible for ensuring that the department complies with sound internal auditing standards and with a relevant code of ethics.
56. The head of the internal audit department should ensure compliance with sound internal auditing standards, such as The Institute of Internal Auditors’ International Standards for the Professional Practice of Internal Auditing. In addition, auditors should adhere to a relevant code of ethics (see paragraph 25).
57. The audit committee should ensure that the head of the internal audit function is a person of integrity. This means that he or she will be able to perform his or her work with honesty, diligence and responsibility. It also implies that this person observes the law and has not been a party to any illegal activity. The head of internal audit should also ensure that the members of internal audit staff are persons of integrity.
(e) Reporting lines of the internal audit function Principle 12: The internal audit function should be accountable to the board, or its audit committee, on all matters related to the performance of its mandate as described in the internal audit charter.
58. The Internal audit function should be accountable to the board of directors or its audit committee. It should also promptly inform senior management about its findings.
59. Senior management is responsible for implementing and maintaining an adequate and effective internal control system and processes. Therefore, the internal audit function should inform senior management of all significant findings so that timely corrective actions can be taken. Subsequently, the internal audit function should follow up with senior management on the outcome of these corrective measures. The head of the internal audit function should report to the board, or its audit committee, the status of findings that have not (yet) been rectified by senior management.
(f) The relationship between the internal audit, compliance and risk management functions
Principle 13: The internal audit function should independently assess the effectiveness and efficiency of the internal control, risk management and governance systems and processes created by the business units and support functions and provide assurance on these systems and processes. 60. The relationship between a bank’s business units, the support functions and the internal audit function can be explained using the three lines of defence model. The business units are the first line of defence. They undertake risks within assigned limits of risk exposure and are responsible and accountable for identifying, assessing and controlling the risks of their business. The second line of defence includes the support functions, such as risk
The internal audit function in banks 13
management, compliance, legal, human resources, finance, operations, and technology. Each of these functions, in close relationship with the business units, ensures that risks in the business units have been appropriately identified and managed. The business support functions work closely to help define strategy, implement bank policies and procedures, and collect information to create a bank-wide view of risks. The third line of defence is the internal audit function that independently assesses the effectiveness of the processes created in the first and second lines of defence and provides assurance on these processes.
Line of defence Examples Approach
First line Front Office, any client-facing activity
Transaction-based, ongoing
Second line
Risk Management, Compliance, Legal, Human Resources, Finance, Operations, and Technology
Risk-based, ongoing or periodic
Third line Internal Audit Risk-based, periodic
61. The responsibility for internal control does not transfer from one line of defence to the next line.
6. Internal audit within a group or holding company structure Principle 14: To facilitate a consistent approach to internal audit across all the banks within a banking organisation, the board of directors of each bank within a banking group or holding company structure should ensure that either: (i) the bank has its own internal audit function, which should be accountable to
the bank’s board and should report to the banking group or holding company's head of internal audit; or
(ii) the banking group or holding company's internal audit function performs internal audit activities of sufficient scope at the bank to enable the board to satisfy its fiduciary and legal responsibilities.
62. The board of directors of each bank in a group or holding company structure remains responsible for ensuring that the bank’s senior management establishes and maintains an adequate, effective and efficient internal control system and processes. The board also should ensure that internal audit activities are conducted effectively at the bank according to the principles of this document. The internal auditors who perform the internal audit work at the bank should report to the bank’s audit committee, or its equivalent, and to the group or holding company’s head of internal audit.
63. The board of directors and senior management of the parent company have the overall responsibility for ensuring that an adequate and effective internal audit function is established across the banking organisation and for ensuring that internal audit policies and mechanisms are appropriate to the structure, business activities and risks of all of the components of the group or holding company.
64. The head of internal audit at the level of the parent company should define the group or holding company’s internal audit strategy, determine the organisation of the internal audit function both at the parent and subsidiary bank levels (in consultation with these entities’ respective boards of directors and in accordance with local laws) and formulate the
14 The internal audit function in banks
internal audit principles, which include the audit methodology and quality assurance measures.
65. The group or holding company’s internal audit function should determine the audit scope for the banking organisation. In doing so, it should comply with local legal and regulatory provisions and incorporate local knowledge and experience.
7. Outsourcing of internal audit activities Principle 15: Regardless of whether internal audit activities are outsourced, the board of directors remains ultimately responsible for the internal audit function.
66. It is recommended that large banks and internationally active banks perform internal audit activities using their own staff. However, outsourcing of internal audit activities, but not the function, on a limited and targeted basis can bring benefits to banks such as access to specialised expertise and knowledge for an internal audit engagement where the expertise is not available within the internal audit function. Outsourcing could also alleviate temporary resourcing constraints which might otherwise jeopardise the execution of the audit plan. Banks should be able to explain the reasons for outsourcing specific internal audit activities.
67. The head of internal audit should ensure that outsourcing suppliers comply with the principles of the bank’s internal audit charter. To preserve independence, it is important to ensure that the supplier has not been previously engaged in a consulting engagement in the same area within the bank unless a reasonably long “cooling-off” period has elapsed. Subsequently, those experts who participated in an internal audit engagement should not provide consulting services to a function of the bank they recently audited. Additionally, as a sound practice, banks should not outsource internal audit activities to their own external audit firm.9
68. The head of internal audit should ensure that, whenever practical, the relevant knowledge input from an expert is assimilated into the organisation. This may be possible by having one or more members of the bank’s internal audit staff participate in the external expert’s work.
B. The relationship of the supervisory authority with the internal audit function
69. The supervisory authority will benefit from effective communication about topics of mutual interest with the internal audit function of a bank. When establishing a relationship with the internal audit function of a bank, the supervisory authority should obtain an understanding of the organisation and operation of the internal audit function, including its position and remit within the bank.
70. Supervisors and internal auditors should each ensure that enhanced communication does not undermine their respective perceived and actual independence and status, as the supervisory authority and the internal audit function each have different roles and
9 Any departure from this best practice should be limited to small banks and should remain within the bounds of
the applicable ethical standards for the statutory or external auditor.
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responsibilities. Regardless of the supervisor’s assessment of the internal audit function, the supervisor should be able to challenge the work of the internal auditors through their continuous supervision process, including through on-site supervision.
71. The relationship between the supervisor and the internal audit function should be established in a structured and transparent way. In principle, the supervisor will initiate this relationship.
1. Benefits of enhanced communication between the supervisory authority and the internal audit function
Principle 16: Supervisors should have regular communication with the bank’s internal auditors to (i) discuss the risk areas identified by both parties, (ii) understand the risk mitigation measures taken by the bank, and (iii) monitor the bank’s response to weaknesses identified.
72. The internal audit function is a key building block of the internal control system because it provides an independent assessment of the adequacy of, and compliance with, the bank’s established policies and procedures. Therefore, supervisory authorities have an interest in engaging in a constructive and formalised dialogue with the internal audit function. This dialogue could be a valuable source of information on the quality of the internal control system.
73. The extent to which the work of internal auditors is factored into the supervisory course of action for a bank will depend on the supervisory approach, the supervisor's assessment of the internal audit function, and the circumstances relating to the issues at hand.
74. In addition to meetings with senior management, supervisory authorities should meet periodically with the bank’s internal auditors to discuss their risk analysis, findings, recommendations and the audit plan. Supervisors should decide on a case per case approach whether senior management should or should not be present at these meetings. These meetings can also facilitate the understanding of how and to what extent the recommendations made by supervisors (including those made during on-site reviews) and internal auditors have been implemented. These meetings should be sufficiently frequent to enable the supervisor to ensure the effectiveness of the actions taken by the bank to carry out these recommendations. The frequency of these meetings and other communication between supervisors and internal auditors should be commensurate with the bank's size, the nature and risks of its operations and the complexity of its organisation. Supervisors may also request the internal audit reports from time to time. The analysis of these internal audit reports and information may contribute to the supervisor’s assessment of the internal control system of the bank.
75. The relationship between supervisors and internal auditors is also two-way. Supervisory authorities may consider sharing relevant information with the internal audit function when this could increase the effectiveness of its internal audit work. Also, supervisory authorities should make specific recommendations for strengthening the internal audit function and the control environment.
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2. Potential topics for discussion between supervisors and internal audit 76. Although all matters covered by the internal audit function are potentially of value to supervisors, some topics are closely related to supervisory requirements and are therefore of particular interest to banking supervisors.
77. A bank’s capital and liquidity positions and its processes and methods for determining, monitoring, controlling and reporting on material risks are directly relevant and important to supervisors. Therefore, supervisors and internal auditors should discuss the areas described in Section A - Principle 7 and related paragraphs.
78. Internal audit is well placed to provide the supervisor with insight on the institution’s business model including risks in the institution’s business activities, processes and functions and the adequacy of the control and oversight of these risks such as:
(i) Application and effectiveness of risk management procedures and risk assessment methodologies, as applied to credit risk, market risk, liquidity risk, operational risk (including information technology and business continuity management), and other risks relevant to the Basel capital adequacy Pillar 2 requirements;
(ii) Contingency planning;
(iii) Outsourcing arrangements; and
(iv) Fraud risk.
79. To the extent that accounting data drives certain regulatory measures or is included in regulatory reporting, supervisors should seek to understand and benefit from work performed by internal audit relating to:
(i) Measurement (including fair values) and impairment of financial instruments;
(ii) Significant transactions in financial instruments with a regulatory impact; and
(iii) Other judgemental accounting areas, including estimates.
80. Supervisors may also have an interest in business or market conduct issues as identified through the audit of the compliance function, for example:
(i) Transaction reporting;
(ii) Adherence to rules for dealing with client assets;
(iii) Anti-money laundering processes and controls; and
(iv) Management of conflicts of interest.
81. The board of directors and senior management are responsible for establishing the bank’s strategy and business models. However, changes therein may have consequences for the bank’s internal control, risk management and governance systems and processes. Although internal audit does not set the bank’s policies and should not interfere in its business decisions, it can be in a position to influence them by challenging management. Both the internal audit function and banking supervisors have an interest in the following:
(i) Processes for objective setting and strategic decision making; and,
(ii) Quality and substance of management and governance structure and processes.
The internal audit function in banks 17
C. Supervisory assessment of the internal audit function
82. Because of the crucial role played by internal audit in assessing the effectiveness of a bank’s overall control systems and processes, supervisors should assess the internal audit function. This will influence their overall assessment of the bank and enable them to determine the extent to which they will use the work of the internal audit function.
1. Assessment of the internal audit function Principle 17: Bank supervisors should regularly assess whether the internal audit function has sufficient standing and authority within the bank and operates according to sound principles.
83. The supervisory authority should consider the extent to which the board of directors, its audit committee and senior management promote a strong internal control environment supported and assessed by a sound internal audit function.
84. The assessment of the internal audit function should be based on the supervisory expectations as set out in section A of this guidance. This includes:
• The basic features of the internal audit function;
• The internal audit function’s standing and authority within the bank;
• The existence and content of the internal audit charter;
• The scope of the internal audit function's work and its output;
• The corporate governance arrangements that apply to the internal audit function;
• The organisation of the function within a group or holding company;
• The professional competence, experience and expertise within the internal audit function;
• The remuneration structure of the head of the internal audit function and the key internal auditors; and
• Outsourced internal audit activities, if any.
85. In order to promote consistency and comparability over time and across banks and to identify industry best practices, the supervisory authority may benefit from using a grading system to perform its assessment of the internal audit function.
86. Weaknesses identified in the internal audit function may affect the supervisor’s assessment of the bank’s risk profile.
87. Although the supervisory authority should independently assess the quality of the internal audit function, the audit committee or its equivalent and the internal audit function should develop and maintain their own tools to assess the quality of the internal audit function.
88. The appointment and replacement of the head of the internal audit function is relevant to the supervisory assessment of the bank. Therefore, the supervisory authority should be promptly informed by the audit committee (or its equivalent) or senior management of the appointment of a new head of the internal audit function, including relevant qualifications and previous experience. Similarly, whenever the head of the internal audit function ceases to act in this capacity, the supervisory authority should be informed of this
18 The internal audit function in banks
fact and its circumstances. The supervisory authority should consider meeting with the former head of internal audit to discuss the reasons for his or her departure.
2. Actions to be undertaken by the supervisory authority Principle 18: Supervisors should formally report all weaknesses they identify in the internal audit function to the board of directors and require remedial actions.
89. When the supervisory authority concludes that a bank's internal audit function is inadequate or ineffective, it should require the board of directors to develop an appropriate written remediation plan that addresses the identified weaknesses on a timely basis. The written plan should be submitted to the supervisory authority for review. If the supervisor is not satisfied, it should require changes or additional measures to be included in the plan. The supervisor should monitor the implementation of the plan.
90. In addition to measures relating to the performance and standing of the internal audit function, the supervisor may also recommend enhancements to the governance of the bank including the functioning of the audit committee.
91. The audit committee and board of directors should not conclude that the internal audit function is functioning well solely because the supervisory authority has not identified any weaknesses. The supervisory review process is not a substitute for the audit committee's assessment, or an external assessment of the internal audit function.
Principle 19: The supervisory authority should consider the impact of its assessment of the internal audit function on its evaluation of the bank's risk profile and on its own supervisory work.
92. The assessment of the internal audit function may have consequences for the supervisor's evaluation of the bank's risk profile, the allocation of supervisory resources and the activities envisaged by the authority.
93. Where remedial actions cannot be agreed upon or where the bank faces ongoing delays in remediating the identified weaknesses, the supervisory authority should consider the impact of this on the bank’s risk profile.
94. In cases where a bank belongs to an international group, the supervisor should consider sharing its concerns with the other relevant authorities, for example within the supervisory college.
Principle 20: The supervisory authority should be prepared to take informal or formal supervisory actions requiring the board and senior management to remedy any identified deficiencies related to the internal audit function within a specified timeframe and to provide the supervisor with periodic written progress reports.
95. While supervisors expect banks to have a strong and robust internal audit function, there may be certain circumstances in which deficiencies exist and warrant specific supervisory actions aimed at remedying the deficiencies. Supervisory action may be of a public or non-public nature.
The internal audit function in banks 19
Annex 1
Internal audit function’s communication channels
References to support these communication channels for the internal audit function are provided in the Committee’s Core Principles and other relevant guidance issued by the Committee, International Standards on Auditing (ISAs) issued by the International Auditing and Assurance Standards Board, and the standards of The Institute of Internal Auditors (The IIA) as indicated. The diagram does not reflect all of the communication channels for parties other than the internal audit function.
• Basel Committee on Banking Supervision:
– Core Principles for Effective Banking Supervision
– Principles for Enhancing Corporate Governance
– The Internal Audit Function in Banks
• IIA: International Standards for the Professional Practice of Internal Auditing. Standards starting at 1xxx are Attribute Standards and Standards starting at 2xxx are Performance Standards. See International Professional Practices Framework (IPPF), The Institute of Internal Auditors, Altamonte Springs, Florida, USA, 2011.
– IIA 1000 - Purpose, Authority, and Responsibility
– IIA 1100 - Independence and Objectivity
Board and Audit Committee
Senior management
Supervisor
Internal audit function
External auditors
IIA 1000, 1110, 1111, 2440 C2
BCBS Core Principles
BCBS Corporate Governance
BCBS Core Principles
ISA 260
IIA 1100 IIA 2440 C2
ISA 315 and 610
BCBS Corporate Governance
BCBS Core Principles
BCBS Internal Audit in Banks
20 The internal audit function in banks
– IIA 1110 - Organizational Independence
– IIA 1111 - Direct Interaction with the Board
– IIA 2440 - Disseminating Results
• ISA: International Standards on Auditing. Standards starting at 2xx deal with the overall objectives and responsibilities of the external auditor, standards starting at 3xx deal with risk assessment and response to assessed risk by the external auditor and standards starting at 6xx deal with the external auditor's use of the work of others. See Handbook of International Quality Control, Auditing, Review, Other Assurance, and related Services Pronouncements, 2010 Edition Part 1, International Federation of Accountants, New York, New York, USA.
– ISA 260 - Communication with Those Charged with Governance
– ISA 315 - Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment
– ISA 610 - Using the Work of Internal Auditors
The internal audit function in banks 21
Annex 2
Responsibilities of a bank's audit committee
The audit committee is a specialised committee within the board of directors. As such, it prepares the work of, and reports to the board of directors in specific areas for which it has designated responsibility. The board of directors assumes final responsibility.
The audit committee may invite the head of internal audit, the head of compliance, senior management, in particular the chief executive officer and other officials deemed relevant for the purpose of fulfilling its responsibilities to attend meetings of the committee. It is a sound practice that the head of internal audit and members of the audit committee have a private session, i.e. in the absence of management, to discuss issues of interest.
The main areas of responsibility of the audit committee are listed below by broad categories. The list provides a summary of sound practices for the audit committee of a bank. This list may vary according to local regulations and practices. For example, the responsibilities of an audit committee may be assumed directly by the board of directors in some banks or in some countries.
Financial reporting, including disclosures
(a) monitoring the financial reporting process and its output;
(b) overseeing the establishment of accounting policies and practices by the bank and reviewing the significant qualitative aspects of the bank's accounting practices, including accounting estimates and financial statement disclosures;
(c) monitoring the integrity of the bank’s financial statements and any formal announcements relating to the bank’s financial performance;
(d) reviewing significant financial reporting judgments contained in the financial statements; and
(e) reviewing arrangements by which staff of the bank may confidentially raise concerns about possible improprieties in matters of financial reporting.
Internal control
(f) ensuring that senior management establishes and maintains an adequate and effective internal control system and processes. The system and processes should be designed to provide assurance in areas including reporting (financial, operational, risk), monitoring compliance with laws, regulations and internal policies, efficiency and effectiveness of operations and safeguarding of assets.
22 The internal audit function in banks
Internal audit
(g) monitoring and reviewing the effectiveness of the bank’s internal audit function;
(h) approving the internal audit plan, scope and budget;
(i) reviewing and discussing internal audit reports;
(j) ensuring that the internal audit function maintains open communication with senior management, external auditors, the supervisory authority, and the audit committee;
(k) reviewing discoveries of fraud and violations of laws and regulations as raised by the head of the internal audit function;
(l) approving the audit charter and the code of ethics of the internal audit function;
(m) approving, or recommending to the board for its approval, the annual remuneration of the internal audit function as a whole, including performance awards;
(n) assessing the performance of the head of the internal audit function; and,
(o) approving, or recommending to the board for its approval, the appointment, re-appointment or removal of the head of the internal audit function and the key internal auditors.
The statutory or external auditor
Appointment, reappointment, dismissal and remuneration (p) approving a set of appropriate objective criteria for approving the statutory auditor or
external audit firm of the bank;
(q) approving, or recommending to the board or shareholders for their approval, the appointment, re-appointment and removal of the statutory auditor or external audit firm;
(r) approving the remuneration and terms of engagement of the statutory auditor or external audit firm.
Compliance with relevant ethical requirements, in particular independence and objectivity (s) reviewing and monitoring the independence of the statutory auditor or external audit
firm, and in particular the provision of additional services to the bank, including the related safeguards that have been applied to eliminate identified threats to independence or reduce them to an acceptable level;
(t) reviewing and monitoring the statutory auditor's objectivity and the effectiveness of the audit process;
(u) developing and implementing a policy on the engagement of the statutory auditor or external audit firm for the supply of non-audit services, taking into account relevant ethical guidelines on the provision of non-audit services by the external audit firm; and,
(v) Approving the total fees charged for the audit of the financial statements and for non-audit services provided by the external audit firm and external audit network firms to the entity and its components controlled by the entity.
The internal audit function in banks 23
The statutory audit or external audit (w) overseeing the statutory audit of the annual and consolidated accounts;
(x) discussing with the statutory auditor or external audit firm key matters arising from the statutory audit or external audit, and in particular any identified material weaknesses in internal control in relation to the financial reporting process; and,
(y) discussing the written representations the statutory auditor or external audit firm is requesting from senior management and, where appropriate, those charged with governance;
Remedial actions (z) ensuring that senior management is taking necessary corrective actions to address
the findings and recommendations of internal auditors and external auditors in a timely manner;
(aa) addressing control weaknesses, non-compliance with policies, laws and regulations and other problems identified by internal auditors and external auditors, and
(bb) ensuring that deficiencies identified by supervisory authorities related to the internal audit function are remedied within an appropriate time frame and that progress of necessary corrective actions are reported to the board of directors.
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Trou
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Deb
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R)A
gend
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Gui
danc
e•
TDR
iden
tific
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Acc
rual
, im
pair
men
t, a
nd re
port
ing
Cons
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atio
ns in
TD
R ac
coun
ting
and
repo
rtin
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Tria
l mod
ifica
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•Re
venu
e re
cogn
ition
–ac
crua
l/no
nacc
rual
•A
/B n
ote
split
s•
TDR
repo
rtin
g•
Iden
tifyi
ng w
heth
er a
rate
is a
mar
ket r
ate
•Lo
ss m
easu
rem
ent m
etho
ds
Que
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nd a
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4
TDR
Iden
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n an
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SB A
ccou
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310-
40Pr
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of
TDR
GA
AP
guid
ance
•A
loan
rest
ruct
urin
g or
mod
ifica
tion
of te
rms
is a
TD
R “i
f th
e cr
edito
r for
eco
nom
ic o
r le
gal r
easo
ns r
elat
ed to
the
debt
or’s
fina
ncia
l diff
icul
ties
gran
ts a
con
cess
ion
to th
e de
btor
that
it w
ould
not
oth
erw
ise
cons
ider
.”
A T
DR
is d
efin
ed a
s:
•A
bor
row
er is
exp
erie
ncin
g fin
anci
al d
iffic
ultie
s an
d•
An
inst
itutio
n ha
s gr
ante
d a
conc
essi
on th
at it
wou
ld n
ot
have
oth
erw
ise
cons
ider
ed if
not
for
the
borr
ower
’s
finan
cial
diff
icul
ties.
A T
DR
dete
rmin
atio
n re
quir
es ju
dgm
ent
to a
sses
s if:
5
TDR
Iden
tific
atio
n
6
Two-
step
Pro
cess
:St
ep 1
:
Det
erm
ine
whe
ther
the
borr
ower
is
expe
rien
cing
fina
ncia
l diff
icul
ties
.
Indi
cato
rs in
clud
e th
e fo
llow
ing:
•Cu
rren
t or p
roba
ble
defa
ult i
n fo
rese
eabl
e fu
ture
on
any
debt
•H
eade
d to
war
d, o
r is
in, b
ankr
uptc
y•
Dou
bt a
bout
abi
lity
to re
mai
n a
goin
g co
ncer
n•
Una
ble
to s
ervi
ce d
ebt b
ased
on
curr
ent
capa
bilit
ies
for t
he fo
rese
eabl
e fu
ture
•In
abili
ty to
obt
ain
take
out f
inan
cing
•D
ebt-
spec
ific
wea
knes
s (in
abili
ty to
m
aint
ain
tena
nts,
rent
s, o
r los
s of
key
le
ader
ship
)
Step
2:
Det
erm
ine
whe
ther
mod
ifica
tion
is
a co
nces
sion
.
Exam
ples
incl
ude
the
follo
win
g:•
Forg
ivin
g pr
inci
pal o
r int
eres
t•
Mod
ifyin
g in
tere
st ra
te to
a b
elow
-mar
ket
ra
te•
Def
erri
ng p
rinc
ipal
pay
men
ts (e
.g.,
inte
rest
on
ly)
•Ex
tend
ing
the
mat
urity
dat
e
TDR
Iden
tific
atio
n:N
ew G
uida
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FASB
-issu
ed A
ccou
ntin
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anda
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Upd
ate
2011
-02
in A
pril
2011
•
Prov
ides
cla
rify
ing
guid
ance
inte
nded
to n
arro
w d
iver
sity
in p
ract
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of T
DR
iden
tific
atio
n•
Did
not
cha
nge
the
TDR
defin
ition
Key
poin
ts:
•A
n in
crea
se in
a b
orro
wer
’s in
tere
st ra
te d
oes
not p
recl
ude
a re
stru
ctur
ing
from
bei
ng c
onsi
dere
d a
TDR
(incr
ease
in ra
te m
ight
repr
esen
t a c
once
ssio
n)•
In a
sses
sing
fina
ncia
l diff
icul
ty, c
onsi
der w
heth
er b
orro
wer
mig
ht d
efau
lt in
the
fore
seea
ble
futu
re•
An
insi
gnifi
cant
del
ay in
pay
men
t is
not a
con
cess
ion
•A
ddin
g co
llate
ral o
r gu
aran
tees
in e
xcha
nge
for
a m
odifi
catio
n m
ay b
e a
conc
essi
on if
not
ade
quat
e co
mpe
nsat
ion
7
TDR
Iden
tific
atio
n:In
sign
ifica
nt D
elay
Mod
ifica
tion
s or
rest
ruct
urin
gs th
at re
sult
in a
n in
sign
ifica
nt d
elay
in
paym
ent a
re n
ot c
once
ssio
ns
Conc
ept o
f in
sign
ifica
nt d
elay
in im
pair
men
t gui
danc
e ad
ded
to T
DR
guid
ance
Insi
gnifi
cant
del
ay c
once
pt re
quir
es a
n as
sess
men
t of b
oth
the
am
ount
and
tim
ing
of c
ash
flow
s
•A
mou
nt o
f the
rest
ruct
ured
pay
men
ts s
ubje
ct to
the
dela
y is
insi
gnifi
cant
rela
tive
to
the
unpa
id p
rinc
ipal
bal
ance
or c
olla
tera
l val
ue o
f the
deb
t and
will
resu
lt in
an
insi
gnifi
cant
sho
rtfa
ll•
The
dela
y in
tim
ing
of th
e re
stru
ctur
ed p
aym
ents
is in
sign
ifica
nt re
lativ
e to
any
one
of
the
follo
win
g:•
Freq
uenc
y of
pay
men
ts d
ue,
•D
ebt’s
ori
gina
l con
trac
tual
mat
urity
, or
•D
ebt’s
ori
gina
l exp
ecte
d du
ratio
n.
8
App
lyin
g th
e G
uida
nce:
Colla
tera
l/G
uara
ntee
s
A b
ank
may
res
truc
ture
a d
ebt i
n ex
chan
ge fo
r ad
diti
onal
co
llate
ral o
r gu
aran
tees
. In
that
sit
uati
on, a
ban
k ha
s gr
ante
d a
conc
essi
on w
hen
the
natu
re a
nd a
mou
nt o
f tha
t add
itio
nal
colla
tera
l or
guar
ante
es r
ecei
ved
as p
art o
f a r
estr
uctu
ring
do
not s
erve
as
adeq
uate
com
pens
atio
n fo
r ot
her
term
s of
the
rest
ruct
urin
g.
9
Impl
icat
ions
for I
nter
est A
ccru
al
•Ba
nk s
houl
d no
t m
ater
ially
ove
rsta
te
inco
me.
•D
ecis
ion
to re
turn
a lo
an
to a
ccru
al s
tatu
s sh
ould
be
bas
ed o
n a
sust
aine
d pe
riod
of p
erfo
rman
ce a
t th
e re
vise
d te
rms
(e.g
., si
x m
onth
s).
•A
ll am
ount
s du
e (b
oth
prin
cipa
l and
inte
rest
) are
re
ason
ably
ass
ured
of
colle
ctio
n.
Allo
wan
ce fo
r Loa
n an
d Le
ase
Loss
es (A
LLL)
•Lo
ans
that
are
repo
rted
as
TD
Rs a
re d
eem
ed to
be
impa
ired
and
shou
ld
gene
rally
be
eval
uate
d ba
sed
on th
e pr
esen
t va
lue
of e
xpec
ted
cash
flo
ws.
•H
owev
er, i
f the
loan
is
colla
tera
l dep
ende
nt, t
he
impa
irm
ent s
houl
d be
m
easu
red
base
d up
on
the
fair
val
ue o
f the
co
llate
ral l
ess
cost
s to
se
ll.
Call
Repo
rt
(Sch
edul
e RC
-C P
art I
m
emor
anda
item
1b)
•Re
stru
ctur
ed lo
ans
are
repo
rted
as
rest
ruct
ured
un
til p
aid
in fu
ll.
How
ever
, a re
stru
ctur
ed
loan
that
is in
com
plia
nce
with
its
mod
ified
term
s an
d yi
elds
a m
arke
t rat
e ne
ed n
ot c
ontin
ue to
be
repo
rted
as
a tr
oubl
ed
debt
rest
ruct
urin
g af
ter
the
year
in w
hich
the
rest
ruct
urin
g to
ok p
lace
.
Acc
rual
, Im
pair
men
t, a
nd
Repo
rtin
g
10
Cons
ider
atio
ns in
TD
R:A
ccou
ntin
g an
d Re
port
ing
App
lyin
g th
e gu
idan
ce r
equi
res
judg
men
t
•Q
ualit
ativ
e an
d qu
antit
ativ
e•
No
brig
ht li
nes
Polic
y el
ecti
ons
•In
sign
ifica
nt d
elay
eva
luat
ions
•Su
ffic
ient
ly g
ranu
lar (
e.g.
, by
prod
uct t
ype)
•Co
nsis
tent
app
licat
ion
TDR
asse
ssm
ent
proc
ess
shou
ld b
e re
ason
able
, do
cum
ente
d, a
nd w
ell-s
uppo
rted
11
App
lyin
g th
e G
uida
nce:
Tria
l Mod
ifica
tion
s
•Th
ere
may
be
dive
rsit
y in
pra
ctic
e w
ith
resp
ect t
o th
e id
enti
ficat
ion
of a
tri
al m
odifi
cati
on a
s a
rest
ruct
urin
g th
at
wou
ld b
e w
ithi
n th
e sc
ope
of T
DR
acco
unti
ng.
•Tr
ial m
odifi
cati
ons
are
not a
utom
atic
ally
sco
ped
out o
f TD
R ac
coun
ting
.
•Se
vera
l lar
ge b
anks
are
cur
rent
ly d
iscu
ssin
g th
is is
sue
wit
h th
e Se
curi
ties
and
Exc
hang
e Co
mm
issi
on (S
EC).
12
App
lyin
g th
e G
uida
nce:
A/B
Not
e St
ruct
ures
A fo
rmal
rest
ruct
urin
g m
ay in
volv
e a
mul
tipl
e no
te
stru
ctur
e in
whi
ch, f
or e
xam
ple,
a tr
oubl
ed lo
an is
re
stru
ctur
ed in
to t
wo
note
s.
•Th
e fir
st, o
r "A
" no
te, r
epre
sent
s th
e po
rtio
n of
the
orig
inal
loan
pri
ncip
al a
mou
nt th
at is
exp
ecte
d to
be
fully
col
lect
ed a
long
with
con
trac
tual
inte
rest
. •
The
seco
nd, o
r "B
" no
te, r
epre
sent
s th
e po
rtio
n of
th
e or
igin
al lo
an th
at h
as b
een
char
ged
off.
13
App
lyin
g th
e G
uida
nce:
A/B
Not
e St
ruct
ures
(con
tinu
ed)
The
"A"
note
may
be
retu
rned
to a
ccru
al s
tatu
s pr
ovid
ed th
e co
ndit
ions
in th
e pr
eced
ing
sect
ion
on re
turn
ing
TDRs
to a
ccru
al s
tatu
s ar
e m
et a
nd:
•Th
ere
is e
cono
mic
sub
stan
ce to
the
rest
ruct
urin
g,
•Th
e po
rtio
n of
the
orig
inal
loan
repr
esen
ted
by th
e "B
“ no
te h
as
been
cha
rged
off
bef
ore
or a
t the
tim
e of
the
rest
ruct
urin
g, a
nd•
The
"A"
note
is re
ason
ably
ass
ured
of r
epay
men
t.
The
“A”
note
mus
t be
repo
rted
as
a TD
R fo
r th
e re
mai
nder
of t
he c
alen
dar
year
but
nee
d no
t be
re
port
ed a
s a
TDR
in s
ubse
quen
t yea
rs.
14
App
lyin
g th
e G
uida
nce:
TDR
Repo
rtin
g Is
sues
Gen
eral
ly, o
nce
a TD
R, a
lway
s a
TDR
Nar
row
TD
R re
port
ing
exce
ptio
n•
For a
TD
R w
ith a
n in
tere
st ra
te a
t or
grea
ter
than
a
mar
ket r
ate
of in
tere
st fo
r th
at b
orro
wer
at t
he ti
me
of th
e m
odifi
catio
n, a
nd th
at is
per
form
ing
in
com
plia
nce
with
the
rest
ruct
ured
term
s•
The
loan
is n
ot re
quire
d to
be
repo
rted
in
cale
ndar
yea
rs a
fter
the
rest
ruct
urin
g if
both
co
nditi
ons
are
pres
ent
15
App
lyin
g th
e G
uida
nce:
Whe
n M
arke
ts C
ontr
act
If a
bor
row
er d
oes
not o
ther
wis
e ha
ve a
cces
s to
fund
s at
a
mar
ket r
ate
for
loan
s w
ith
sim
ilar r
isk
char
acte
rist
ics
as th
e re
stru
ctur
ed lo
an b
ecau
se n
o ba
nk is
off
erin
g th
at lo
an
prod
uct i
n th
e m
arke
t, th
e re
stru
ctur
ing
wou
ld b
e co
nsid
ered
to
be
at a
bel
ow-m
arke
t rat
e, w
hich
wou
ld li
kely
indi
cate
that
th
e ba
nk h
as g
rant
ed a
con
cess
ion.
16
App
lyin
g th
e G
uida
nce:
Mar
ket R
ate
of In
tere
st E
valu
atio
n
•Ca
ll Re
port
Sup
plem
enta
l Ins
truc
tions
indi
cate
that
in
dete
rmin
ing
whe
ther
a lo
an h
as b
een
mod
ified
at a
mar
ket
inte
rest
rat
e, a
n in
stitu
tion
shou
ld:
–A
naly
ze th
e bo
rrow
er’s
cur
rent
fina
ncia
l con
ditio
n an
d
–Co
mpa
re th
e ra
te o
n th
e m
odifi
ed lo
an to
rat
es th
e in
stitu
tion
wou
ld c
harg
e cu
stom
ers
with
sim
ilar
finan
cial
ch
arac
teri
stic
s on
sim
ilar
type
s of
loan
s.
•Th
is d
eter
min
atio
n re
quir
es th
e us
e of
judg
men
t and
sho
uld
incl
ude
an a
naly
sis
of c
redi
t hi
stor
y an
d sc
ores
, loa
n-to
-val
ue
ratio
s or
oth
er c
olla
tera
l pro
tect
ion,
the
borr
ower
’s a
bilit
y to
ge
nera
te c
ash
flow
suf
ficie
nt to
mee
t the
rep
aym
ent t
erm
s, a
nd
othe
r fa
ctor
s no
rmal
ly c
onsi
dere
d w
hen
unde
rwri
ting
and
pric
ing
loan
s.
17
App
lyin
g th
e G
uida
nce:
Loss
Mea
sure
men
t
•A
loan
res
truc
ture
d in
a T
DR
is a
n im
pair
ed lo
an.
•A
ll TD
Rs m
ust b
e m
easu
red
for i
mpa
irm
ent
in a
ccor
danc
e w
ith A
SC S
ubto
pic
310-
10, R
ecei
vabl
es –
Ove
rall
(for
mer
ly
FAS
114,
“A
ccou
ntin
g by
Cre
dito
rs fo
r Im
pair
men
t of a
Lo
an,”
as
amen
ded)
.
•TD
Rs th
at a
re m
odifi
catio
ns o
f ter
ms,
whe
re re
paym
ent i
s ex
pect
ed fr
om th
e bo
rrow
er, a
re g
ener
ally
mea
sure
d fo
r lo
ss b
ased
upo
n th
e pr
esen
t val
ue o
f cas
h flo
ws,
dis
coun
ted
at th
e lo
an’s
ori
gina
l eff
ectiv
e in
tere
st r
ate.
18
App
lyin
g th
e G
uida
nce:
Loss
Mea
sure
men
t (c
onti
nued
)
•Re
gula
tory
repo
rtin
g in
stru
ctio
ns re
quir
e th
at T
DRs
that
ar
e co
llate
ral d
epen
dent
be
mea
sure
d fo
r lo
ss, b
ased
on
the
fair
val
ue o
f the
col
late
ral,
less
cos
ts to
sel
l.–
Loan
s th
at a
re c
olla
tera
l dep
ende
nt a
re d
efin
ed in
ASC
310
-30
as lo
ans
“for
whi
ch t
he r
epay
men
t is
expe
cted
to b
e pr
ovid
ed
sole
ly b
y th
e un
derl
ying
col
late
ral.”
–If
a lo
an is
rep
aid
thro
ugh
oper
atio
n or
sal
e of
the
colla
tera
l, th
at lo
an is
col
late
ral d
epen
dent
and
sho
uld
be m
easu
red
for
loss
, bas
ed u
pon
the
fair
val
ue (F
V) o
f the
col
late
ral.
19
Que
stio
n an
d A
nsw
er
Is a
con
cess
ion
gran
ted
if th
e ba
nk
rest
ruct
ures
the
loan
from
an
amor
tizi
ng lo
an
to a
n in
tere
st-o
nly
loan
?
•U
nles
s th
e de
ferr
al o
f pri
ncip
al p
aym
ent i
s co
nsid
ered
an
insi
gnifi
cant
del
ay, y
es, i
t is
a co
nces
sion
.
20
Que
stio
n an
d A
nsw
er
A le
nder
ren
ews
a co
mm
erci
al re
al e
stat
e (C
RE) l
oan
(land
acq
uisi
tion
and
de
velo
pmen
t) in
a m
arke
t whe
re n
o le
nder
s ar
e or
igin
atin
g th
at ty
pe o
f loa
n. I
s th
is a
TD
R?•
It d
epen
ds o
n fa
cts
and
circ
umst
ance
s.•
Is th
e lo
an b
eing
rene
wed
bec
ause
the
orig
inal
exi
t str
ateg
y ha
s fa
iled
and
the
borr
ower
can
not p
ay th
e lo
an?
•H
ow d
o op
erat
ions
com
pare
to o
rigi
nal e
xpec
tatio
ns?
•Ba
sed
upon
cur
rent
fore
cast
s, w
ill th
e bo
rrow
er’s
cas
h flo
ws
be
suff
icie
nt to
ser
vice
the
debt
(bot
h in
tere
st a
nd
prin
cipa
l) in
acc
orda
nce
with
the
cont
ract
ual t
erm
s of
the
exis
ting
agre
emen
t for
the
fore
seea
ble
futu
re?
21
Que
stio
n an
d A
nsw
er
A 5
-yea
r ba
lloon
loan
wit
h pa
ymen
ts b
ased
upo
n a
20-y
ear
amor
tiza
tion
was
rest
ruct
ured
at
mat
urit
y to
a 3
-yea
r ba
lloon
loan
wit
h pa
ymen
ts
base
d up
on a
20-
year
am
orti
zati
on a
nd a
75
bpin
crea
se in
the
inte
rest
rate
. Is
the
new
inte
rest
ra
te a
con
cess
ion?
•To
det
erm
ine
whe
ther
the
mod
ifica
tion
is a
con
cess
ion,
the
bank
sho
uld
perf
orm
a c
redi
t rev
iew
of t
he b
orro
wer
.•
Is th
e ra
te a
mar
ket r
ate
of in
tere
st?
•Is
the
new
rate
com
men
sura
te w
ith th
e ri
sk p
rofil
e of
th
e bo
rrow
er?
•Ju
st b
ecau
se th
e ra
te w
as in
crea
sed
does
not
mea
n it
is n
ot a
con
cess
ion.
22
Que
stio
n an
d A
nsw
er
Shou
ld a
loan
be
rem
oved
from
TD
R re
port
ing
if th
e bo
rrow
er d
efau
lts
unde
r th
e m
odifi
ed
term
s?
•A
s no
ted
abov
e, th
e on
ly e
xcep
tion
for T
DR
repo
rtin
g is
w
hen
the
TDR
had
a m
arke
t rat
e of
inte
rest
at t
he ti
me
of
the
rest
ruct
urin
g an
d is
per
form
ing
in c
ompl
ianc
e w
ith th
e re
stru
ctur
ed te
rms.
•A
TD
R in
def
ault
wou
ld n
ot m
eet t
hat e
xcep
tion
and
wou
ld
ther
efor
e co
ntin
ue to
be
repo
rted
as
a TD
R. (P
ast d
ue T
DRs
sh
ould
be
repo
rted
on
RC-N
Mem
oran
da).
23
Que
stio
n an
d A
nsw
er
A C
RE lo
an is
rene
wed
wit
h an
inte
rest
rate
con
cess
ion.
The
bo
rrow
er p
erfo
rms
unde
r th
e ne
w te
rms
for
a ye
ar. T
he
mod
ified
rate
is n
ow a
mar
ket r
ate
of in
tere
st (m
arke
t ra
tes
have
dec
lined
). T
he lo
an is
fully
sec
ured
, bas
ed u
pon
a re
cent
ap
prai
sal.
Whi
le t
he p
rope
rty
does
n’t
serv
ice
the
debt
, the
bo
rrow
er’s
and
gua
rant
or’s
glo
bal c
ash
flow
s pr
ovid
e 1.
1x d
ebt
serv
ice
cove
rage
. Can
this
loan
be
rem
oved
from
TD
R st
atus
an
d re
turn
ed to
acc
rual
sta
tus?
•Th
e lo
an d
oesn
’t m
eet t
he e
xcep
tion
and
cann
ot b
e re
mov
ed fr
om T
DR
repo
rtin
g be
caus
e it
was
not
at a
mar
ket r
ate
of in
tere
st a
t the
tim
e of
the
mod
ifica
tion.
•Th
e lo
an c
an b
e re
turn
ed to
acc
rual
sta
tus
once
the
borr
ower
has
de
mon
stra
ted
sust
aine
d pa
ymen
t per
form
ance
(gen
eral
ly c
onsi
dere
d to
be
6 m
onth
s).
24
Que
stio
n an
d A
nsw
er
A lo
an h
as b
een
rest
ruct
ured
(i.e
., pa
rtia
l for
give
ness
of
debt
, red
uced
inte
rest
rate
, ext
ende
d m
atur
ity)
wit
h th
e bo
rrow
er p
ayin
g th
e re
cord
ed b
alan
ce a
ccor
ding
to t
he
mod
ified
term
s, w
ith
no in
dica
tion
of i
nher
ent
loss
. A
t w
hat t
ime
wou
ld it
be
reas
onab
le to
con
side
r up
grad
ing
the
loan
cla
ssifi
cati
on?
•N
eed
to c
onsi
der:
•A
ny u
ncer
tain
ty s
urro
undi
ng th
e co
llect
ion
of th
e re
mai
ning
bal
ance
•Ex
pect
atio
ns o
f the
bor
row
er’s
abi
lity
to c
ontin
ue to
mak
e co
ntra
ctua
l pa
ymen
ts (p
rofit
abili
ty a
nd d
ebt s
ervi
ce c
over
age)
•Le
ngth
of t
ime
borr
ower
has
com
plie
d w
ith m
odifi
ed te
rms
•Co
mpl
ianc
e w
ith b
ank’
s un
derw
ritin
g st
anda
rds
(A/B
not
e sp
lit)
25
26
To a
sk a
que
stio
n:
• E
mai
l you
r qu
esti
on t
o:
askt
hefe
d@st
ls.f
rb.o
rg
• U
se t
he “
Ask
a Q
uest
ion”
feat
ure
on th
e A
sk th
e Fe
d® w
ebsi
te:
ww
w.s
tlou
isfe
d.or
g/as
kthe
fed
Than
ks fo
r jo
inin
g us
.
ww
w.s
tlou
isfe
d.or
g/as
kthe
fed
27
