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Commercial LoansEffective date July 1997 Section 3050.1

Generally, commercial loans comprise the larg-est asset concentration of a branch, offer themost complexity, and require the greatest com-

mitment from branch management to monitorand control risks. Proper management of theseassets requires a clearly articulated credit policythat imposes discipline and sound loan admin-istration. Since lenders are subject to pressuresrelated to productivity and competition, theymay be tempted to relax prudent credit under-writing standards to remain competitive in themarketplace, thus increasing the potential forrisk. Examiners need to understand the uniquecharacteristics of the varying types of commer-

cial and industrial loans, as well as how toproperly analyze their quality.Commercial loans are extended on a secured

or unsecured basis with a wide range of pur-poses, terms, and maturities. While the types of commercial and industrial loans can vary widelydepending on the purpose of loans made andmarket characteristics where the branch oper-ates, most commercial and industrial loans willprimarily be made in the form of a working-capital loan, term loan, or loan to an individual

for a business purpose. This section will provideexaminers with a fundamental understanding of secured and unsecured transactions, the keyprinciples for assessing credit quality, and basicbankruptcy law. Other sections of this manualdiscuss more specific types of lending.

TYPES OF COMMERCIAL LOANS

Working Capital or Seasonal Loans

Working capital or seasonal loans provide abusiness with short-term financing for inven-tory, receivables, the purchase of supplies, orother operating needs during the business cycle.These types of loans are often appropriate forbusinesses that experience seasonal or short-term peaks in current assets and current liabili-ties, such as a retailer who relies heavily on aholiday season for sales or a manufacturingcompany that specializes in summer clothing.These types of loans are often structured in theform of an advised line of credit or a revolvingcredit. An advised line of credit is a revocablecommitment by the branch to lend funds up to aspecified period of time, usually one year. Lines

of credit are generally reviewed annually by thebranch, do not have a fixed repayment schedule,and may not require fees or compensating bal-

ances. In the case of unadvised lines of credit,the branch has more control over advances andmay terminate the facility at any time, depend-ing on state law or legal precedents. A revolvingline of credit is valid for a stated period of timeand does not have a fixed repayment schedule,but usually has a required fee. The lender hasless control over a revolving credit since there isan embedded guarantee (i.e. firm commitment)to make advances within the prescribed limits of the loan agreement. The borrower may receive

periodic advances under the line of credit or therevolving credit up to the agreed limit. Repay-ment is generally accomplished through theconversion or turnover of short-term assets,such as inventory or accounts receivable. Inter-est payments on working capital loans are usu-ally paid throughout the term of the loan, such asmonthly or quarterly.

Working-capital loans are intended to berepaid through the cash flow derived from con-verting the financed assets to cash. The structure

of the loans can vary, but they should be closelytied to the timing of the conversion of thefinanced assets. In most cases, working-capitalfacilities are renewable at maturity, are for aone-year term, and include a clean-up require-ment for a period sometime during the low pointor contraction phase of the business cycle. Theclean-up period is a specified period (usually 30days) during the term of the loan in which theborrower is required to pay off the loan. Whilethis requirement is becoming less common, it

provides the branch with proof that the borroweris not dependent on the lender for permanentfinancing. It is important to note, however, thatan expanding business may not be able to cleanup its facility since it may be increasing itscurrent assets.

Analysis of Working-Capital Loans

The analysis of a working-capital loan is bestaccomplished by a monthly or quarterly reviewof a company’s balance sheet and income state-ments to identify the peak and contraction phasesof the business cycle. The lender should knowwhen the peak and contraction phases are, and

Branch and Agency Examination Manual September 1997Page 1



the loan should be structured accordingly. Thelender’s primary objective is to determinewhether the advances are being used for theintended purposes (inventories or payables) andnot for the acquisition of fixed assets or pay-

ments on other debts. Repayments on the facil-ity should also be consistent with the conversionof assets. If the borrower has other loan facilitiesat the branch, all credit facilities should bereviewed at the same time to ensure that theactivity with the working-capital facility is notused to pay interest on other loans in the branch.Projections of sources and uses of funds are alsoa valuable tool for reviewing a working-capitalline of credit and determining the sales cycle.

Quarterly balance-sheet and income state-

ments are very helpful when a comparison ismade with the original projections. Other help-ful information can be obtained from a review of an aging of accounts receivable for delinquen-cies and concentrations, a current list of inven-tory, an accounts-payable aging, and accrualsmade during the quarter. This information canbe compared with the outstanding balance of thefacility to ensure that the loan is not overex-tended and that the collateral margins are con-sistent with borrowing-base parameters.

A borrowing base is the amount the lender iswilling to advance against a dollar value of pledged collateral; for example, a branch willonly lend up to a predetermined specified per-centage of total outstanding receivables less allaccounts more than a certain number of daysdelinquent. A borrowing-base certificate shouldbe compiled at least monthly or more oftenduring peak activity in the facility. When review-ing working-capital loans, examiners shouldremember that a branch relies heavily on inven-

tory as collateral in the beginning of a compa-ny’s business cycle and on receivables towardthe end of the business cycle. However, intraditional working-capital loans, greater empha-sis is usually placed on accounts receivable ascollateral throughout the loan’s tenure.

Normally, a branch is secured by a perfectedblanket security interest on accounts receivable,inventory, and equipment, and on the proceedsfrom the turnover of these assets. Well-capitalized companies with a good history of payout or cleanup may be exceptions and qualifyfor unsecured lending. An annual lien search,however, would be prudent under this type of lending relationship to detect any purchasemoney security interest that may have occurredduring the business cycle.

The following are potential problems associ-ated with working-capital loans:

• Working-capital advances used for fundinglosses. A business uses advances from a

revolving line of credit to fund business losses,including the funding of wages, businessexpenses, debt service, or any other cost notspecifically associated with the intended pur-pose of the facility.

• Working-capital advances funding long-term

assets. A business will use working-capitalfunds to purchase capital assets that are nor-mally acquired with term business loans.

• Trade creditors not paid out at end of businesscycle. While the branch may be paid out,

some trade creditors may not get full repay-ment. This can cause a strained relationship asunpaid trade creditors may be less willing toprovide financing or offer favorable creditterms in the future. In turn, the business willbecome more reliant on the branch to supportfunding needs that were previously financedby trade creditors.

• Overextension of collateral. The business doesnot have the collateral to support the extension

of credit, causing an out-of-borrowing-basesituation. Examiners should review borrowing-base certificates to verify that coverage meetsthe prescribed limitations established by thebranch’s credit policy for the specific assetsbeing financed.

• Value of inventory declines. When a businessdoes not pay back the branch after inventory isconverted to cash or accounts receivable, thevalue of the inventory declines. Other causesof inventory devaluation include obsoles-

cence, a general economic downturn, or in thecase of a commodity, market volatility.Declines in inventory value will commonlyput a working-capital facility in an out-of-borrowing-base situation and require theexcess debt to be amortized and repaid throughfuture profits of the business.

• Collectibility of accounts receivable declines.The increasingly past-due status of accountsreceivable or deteriorating credit quality of account customers both result in the noncol-

lection of receivables. This can also cause anout-of-borrowing-base situation for the lend-ing institution.

• Working-capital advances used to fund long-term capital. Funds may be inappropriatelyused to repurchase company stock, pay off

3050.1 Commercial Loans

September 1997 Branch and Agency Examination Manual

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subordinated debt holders, or even pay divi-dends on capital stock.

These situations may cause a loan balance tobe remaining at the end of the business cycle. If

this should occur, the branch generally has oneof three options: (1) Require the unpaid balanceto be amortized; This option is, however, depen-dent on the ability of the business to repay thedebt through future profits; (2) Request theborrower to find another lender or require aninfusion of capital by the borrower. This is notalways a feasible option because of the probableweakened financial condition of the businessand ownership under these circumstances; or(3) Liquidate the collateral. Foreclosing on the

collateral should only be executed when itbecomes obvious that the business can no longerfunction as a going concern. The problem withthis option is that once the branch discovers thatthe business is no longer a viable concern,realizing the full value of the collateral is in

jeopardy. The need to resort to any of theseoptions will usually prompt criticism of thecredit.

Term Loans

Term loans are generally granted at a fixed orvariable rate of interest, have a maturity inexcess of one year, and are intended to providean organization with the funds needed to acquirelong-term assets, such as physical plants andequipment, or finance the residual balance onlines of credit or long-term working capital.Term loans are repaid through the business’s

cash flow, according to a fixed-amortizationschedule, which can vary based on the cash-flowexpectations of the underlying asset financed orthe anticipated profitability or cash flow of thebusiness. Term loans involve greater risk thanshort-term advances because of the length of time the credit is extended. As a result of thisgreater risk, term loans are usually secured.Loan interest may be payable monthly, quar-terly, semiannually, or annually. Loan principalshould amortize with the same frequency in

order to fully pay off the loan at maturity.

In most cases, the terms of these loans aredetailed in formal loan agreements with affirma-tive and negative covenants that place certainconditions on the borrower throughout the termof the loan. In affirmative covenants, the bor-

rower pledges to fulfill certain requirements,such as maintain adequate insurance coverage,make timely loan repayments, or ensure thefinancial stability of the business. Negative orrestrictive covenants prohibit or require the

borrower to refrain from certain practices, suchas selling or transferring assets, defaulting, fall-ing below a minimum debt coverage ratio,exceeding a maximum debt-to-equity ratio, ortaking any action that may diminish the value of collateral or impair the collectibility of the loan.Covenants should not be written so restrictivelythat the borrower is constantly in default overtrivial issues; however, violations should bedealt with immediately to give credibility to theagreement. Violations of these covenants can

often result in acceleration of the debt maturityand payments. A formal loan agreement is mostoften associated with longer-term loans. If aformal agreement does not exist, the term loansshould be written with shorter maturities andballoon payments to allow more frequent reviewby branch management.

Analysis of Term Loans

While a working-capital loan analysis empha-sizes the balance sheet, the analysis of termloans will focus on both the balance sheet andthe income statement. Because a term loan isrepaid from excess cash flow, the long-termviability of the business is critical in determin-ing the overall quality of the credit. In evaluat-ing long-term earnings, the examiner mustdevelop a fundamental understanding of thecompany’s industry and competitive position in

the marketplace. Most of the analysis will beconducted based on the historical performanceof the business and its history of making pay-ments on its debt. Any historical record of inconsistencies or inability to perform on exist-ing debt should prompt an in-depth review todetermine the ability of the borrower to meet theloan’s contractual agreements. One of the mostcritical determinations that should be made whenevaluating term debt is whether the term of thedebt exceeds the useful life of the underlying

asset being financed.

While cash flow of the business is the primarysource of repayment for a term loan, a secondarysource would be the sale of the underlyingcollateral. Often, if circumstances warrant acollateral sale, the branch may face steep dis-

Commercial Loans 3050.1




counts and significant expenses related to thesale. Examiners should carefully consider theseissues when evaluating the underlying value of collateral under a liquidation scenario.

The following are potential problems associ-

ated with term loans:

• The term of the loan is not consistent with theuseful life of collateral.

• Cash flow from operations does not allow foradequate debt amortization, a fundamentalproblem that can be solved only by improvedperformance.

• The gross margin of the business is narrow-ing, which requires the business to sell moreproduct to produce the same gross profit.

Higher sales volume could require more cashfor expansion of current assets, leaving lesscash for debt amortization. This situation is acommon by-product of increased competition.

• Sales are lower than expected. In the face of lower sales, management is unable or unwill-ing to cut overhead expenses, straining cashflow and resulting in diminished debt servic-ing ability.

• Fixed assets that are financed by term loansbecome obsolete before the loans are retired,

likely causing the value of underlying collat-eral to deteriorate.

• The business’s excess cash is spent on highersalaries or other unnecessary expenses.

• The payments on term debt have put a strainon cash flow, and the business is unable toadequately operate or allow natural expan-sion.

• The balance sheet of the business is weaken-ing. The overall financial condition of the

business is deteriorating because of poor per-formance or unforeseen occurrences in theindustry.

Shared National Credits

Regulatory agencies participate in a program forthe uniform review of shared national credits(SNC). A SNC is defined as any loan, commit-ment, or group of loans or commitments aggre-gating $20 million or more at origination that is:

• Committed under a formal lendingarrangement.

• Shared at its inception by two or more super-vised institutions or sold to one or more

institutions with the purchasing entity assum-ing its pro rata share of the credit risk.

A single facility with different terms and/orparticipants for tranches should be reported as

separate credits. Loans sold to affiliate banks of the same holding company are not part of theSNC program.

If the outstanding balance or commitment of aSNC falls below $20 million after its inception,and it is not criticized, the credit will not bereviewed at the next review date. Therefore, theexaminer should conduct an individual reviewof the credit at the branch under examination.However, if the former SNC facility fell belowthe threshold through a charge-off, and was

classified or specially mentioned at the mostrecent SNC review, the credit relationship wouldcontinue to be reviewed under the SNC programuntil such time that the balance falls below$10 million. The Federal Deposit InsuranceCorporation (FDIC), the state agencies, and theOffice of the Comptroller of the Currency (OCC)also participate in this program. The FederalReserve carries out the examination of SNCs atthe lead or agent banks that are state-memberbanks, state-chartered foreign branches, and

credit-extending nonbank subsidiaries of domes-tic and foreign organizations. The FDIC isprimarily responsible for any SNC credits atstate non-member banks, and the OCC super-vises the review of those SNCs in which the leadbank is a national bank or an OCC-charteredforeign branch.

SNCs should not be analyzed or reviewedduring the examination of the individual partici-pating branch. If the examiner is uncertainwhether the credit was reviewed under the SNC

program, the respective Reserve Bank coordina-tor should be contacted. If credits eligible for theprogram are found but have not been reviewed(other than new SNCs since the time of the lastSNC program review), the examiner shouldsubmit a memorandum detailing those credits tothe respective Reserve Bank coordinator to beforwarded to the SNC coordinator at the FederalReserve Bank of New York.

The SNC program does not track subpartici-pations. A subparticipant is a banking organiza-tion that has purchased a share from either abank in the original syndicate or from a bank considered a first-tier participant. Therefore, if the bank is a subparticipant in a credit, it will notappear in the ‘‘Report of Lenders and theirBorrowers’’. However, the credit may have been



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reviewed by the SNC Program and examinerscan obtain the results of such a review by callingthe SNC coordinator for their agency.

SECURED AND UNSECUREDTRANSACTIONS

This subsection is intended to be a generalreference for an examiner’s review of a creditfile to determine whether the branch’s collateralposition is properly documented. Examinersshould be aware that secured transactionsencompass an extensive body of law that israther technical in nature. The following discus-sion contains general information for examinerson the basic laws that govern a branch’s securityinterest in property and on the documentationthat needs to be in a loan file to properlydocument a perfected security interest in aborrower’s assets.

Secured Transactions

Most secured transactions in personal propertyand fixtures are governed by article 9 of theUniform Commercial Code (UCC). The UCChas been adopted by all 50 states, the District of Columbia, and the Virgin Islands. Timing dif-ferences as well as filing locations differ fromstate to state. Failure to file a financing statementin a timely manner or in the proper location willcompromise a lender’s security interest in thecollateral.

Article 9 of the UCC applies to any transac-

tion that is intended to create a security interestin personal property. Mortgage transactions arenot covered, marine mortgages are filed with theCoast Guard, and aircraft liens are filed with theFederal Aviation Administration. A securityinterest is defined in the UCC as ‘‘an interest inpersonal property or fixtures which secures pay-ment or performance of an obligation.’’ Asecured transaction requires that there be anagreement between the parties indicating theparties’ intention to create a security interest forthe benefit of the creditor or secured party. Thisagreement is commonly referred to as a securityagreement.

Article 9 of the UCC refers to two differentconcepts related to security interests: attachmentand perfection. Attachment is the point in time at

which the security interest is created andbecomes enforceable against the debtor. Perfec-tion refers to the steps that must be taken inorder for the security interest to be enforceableagainst third parties who have claims against

collateral.

Attachment of Security Interest

The three requirements for the creation of asecurity interest are stated in UCC section9-203(1). Once the following requirements aremet, the security interest is attached.

• The collateral is in the possession of thesecured party pursuant to agreement, or thedebtor has signed a security agreement thatcontains a description of the collateral and,when the security interest covers crops nowgrowing or to be grown or timber to be cut, adescription of the land concerned.

• Value has been given to the debtor.

• The debtor has rights in the collateral.

Thus, unless the collateral is in the possessionof the secured party, there must be a writtensecurity agreement that describes the collateral.The description does not have to be very specificor detailed— ‘‘any description of personal prop-erty... is sufficient whether or not it is specific if it reasonably identifies what is described’’ (seeUCC section 9-110). The agreement must alsobe signed by the debtor. The creditor may signit, but its failure to do so does not affect the

agreement’s enforceability against the debtor.Giving value is any consideration that sup-

ports a contract. Value can be given by a directloan, a commitment to grant a loan in the future,the release of an existing security interest, or thesale of goods on contract.

While the debtor must have rights in thecollateral, he or she does not necessarily have tohave title to the property. For example, thedebtor may be the beneficiary of a trust (thetrustee has title of trust assets) or may lease thecollateral. The debtor, in such cases, has rightsin the collateral, but does not hold the title to thecollateral. The secured party, however, onlyobtains the debtor’s limited interest in the col-lateral on default if the debtor does not have fulltitle to the collateral.





Perfection of Security Interest inProperty

Perfection represents the legal process by whicha creditor secures an interest in property. Per-

fection provides the branch assurance that it hasa legal interest in the collateral. The category of collateral will dictate the method of perfectionto be used. The most common methods of perfection are: (1) automatic perfection whenthe security interest is attached (such as in thecase of purchase-money security interests appli-cable to consumer goods other than vehicles);(2) perfection by possession; (3) the filing of afinancing statement in one or more public filingoffices,1 and (4) compliance with a state certifi-

cate of title law or central filing under a statestatute other than the UCC, such as registrationof vehicles.

The most common method of perfecting asecurity interest is public filing. Public filingserves as a constructive notice to the rest of theworld that the branch claims a security interestin certain property of the debtor described inboth the security agreement and the financingstatement. Public filing is accomplished by fil-ing a financing statement (UCC-1) in a public

office, usually the county recorder or secretaryof state. The system of filing required by theUCC provides for a notice filing wherebypotential creditors can determine the existenceof any outstanding liens against the debtor’sproperty.

The form of the financing statement andwhere to file it varies from state to state. Whilethe filing of a nonstandard form will generallybe accepted, the failure to file in the properpublic office can jeopardize the priority of thelender’s security interest. The UCC providesthree alternative filing systems:

• Alternative System One. Liens on minerals,timber to be cut, and fixtures are filed in thecounty land records. All other liens are filed inthe office of the secretary of state.

• Alternative System Two. The majority of stateshave adopted this version. It is the same assystem one, except liens on consumer goods,

farm equipment, and farm products are filed inthe county where the debtor resides, or in the

county where the collateral is located if it isowned by a nonresident.

• Alternative System Three. In a few states,filings made with the secretary of state mustalso be filed in the county of the borrower’s

business (or residence if there is no place of business in that state). Otherwise, the require-ment in these states is the same as system two.

As each state may select any of the abovethree alternatives or a modified version of them,it is important that the examiner ascertain thefiling requirements of the state(s) where thebranch’s customer operates. Most importantly, itis the location of the borrower, not the branch,that determines where the financing statement

must be filed.

Evaluation of Security Interest inProperty

Key items to look for in evaluating a securityinterest in property include the following:

• Security agreement. There should be a propersecurity agreement, signed and dated by theborrower, that identifies the appropriate col-lateral to be secured. It should include adescription of the collateral and its location insufficient detail so the lender can identify it,and should assign to the lender the right to sellor dispose of the collateral if the borrower isunable to pay the obligation.

• Collateral possession. If the institution hastaken possession of the collateral to perfect itssecurity interest, management of the institu-

tion should have an adequate record-keepingsystem and proper dual control over theproperty.

• Financing statement. If the institution hasfiled a financing statement with the state orlocal authority to perfect its security interest inthe collateral, in general, it should contain thefollowing information:— names of the secured party and debtor— the debtor’s signature— the debtor’s mailing address

— the address of the secured party fromwhich information about the security inter-est may be obtained

— the types of the collateral and descriptionof the collateral21. The financing statement is good for five years, and the

lender must file for a continuation within the six-month periodbefore expiration of the original statement. 2. Substantial compliance with the requirements of UCC



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• Amendments. Not all amendments require theborrower’s signature, and branches may filean amendment for the following reasons:

— borrower’s change of address

— creditor’s change of address

— borrower’s name change— creditor’s name change

— correction of an inaccurate collateraldescription

— addition of a trade name for the borrowerthat was subsequently adopted

• Where to file a financing statement. In general,financing statements filed in good faith orfinancing statements not filed in all of therequired places are still effective. If a localfiling is required, the office of the recorder inthe county of the debtor’s residence is theplace to file. If state filing is required, theoffice of the secretary of state is the place tofile.

• Duration of effectiveness of a financing state-ment. Generally, effectiveness lapses five yearsafter filing date. If a continuation statement isfiled within six months before the lapse,effectiveness is extended five years after thelast date on which the filing was effective.

Succeeding continuation statements may befiled to further extend the period of effectiveness.

Perfection of Security Interest in RealEstate

As previously mentioned, real estate is expresslyexcluded from coverage under the UCC. A

separate body of state law covers such interests.However, for a real estate mortgage to beenforceable, the mortgage must be recorded inthe county where the real estate covered by themortgage is located.

Real estate mortgage/deed of trust. Whenobtaining a valid lien on real estate, only onedocument is used, the mortgage or deed of trust.The difference between a mortgage and a deedof trust varies from state to state; however, the

primary difference relates to the process of foreclosure. A mortgage generally requires a

judicial foreclosure, whereas, in some states, aforeclosure on a deed of trust may not. Nearlyall matters affecting the title to the real estate,including the ownership thereof, are recorded inthe recorder’s office.

When determining the enforceability of a realestate mortgage or deed of trust, the examinershould be aware of the following requirements:

• The mortgage must be in writing.

• To be recordable, the mortgage must beacknowledged. There are different forms of acknowledgments for various situationsdepending on whether individuals, corpora-tions, partnerships, or other entities are execut-ing the mortgage. Make sure that the form of

the acknowledgment used is in accordancewith the type of individual or entity executingthe mortgage.

• If a corporation is the mortgagor, its articles of incorporation or bylaws often will specificallystate which officers have authority to sign aninstrument affecting real estate. In theseinstances, the designated officer should berequired to sign. If the corporation has a seal,that also must be affixed. If the corporation

does not have a seal, this fact must be shownin the acknowledgment.

• As soon as possible after the mortgage isexecuted, it should be recorded in the office of the recorder for each county in which theproperty described in the mortgage is located.In most cases, the borrower signs an affidavitthat indicates, in part, that he or she will notattempt to encumber the property while thelender is waiting for the mortgage to berecorded. In any event, the lender should

conduct a title search after the mortgage isrecorded to ensure that his position has notbeen compromised.

• If the mortgagor is married, the spouse must join in the execution of the mortgage tosubject his or her interest to the lien of themortgage. If the mortgagor is single, themortgage should indicate that no spouse existswho might have a dower interest or homesteadinterest in the property.

• If the mortgagor is a partnership, it must bedetermined whether the title is in the name of the partnership or in the names of the indi-vidual partners. If the title is in the names of the individual partners, their spouses should

join in executing the mortgage. If the title is inthe name of the partnership, those partners

section 9-402 is sufficient if errors are only minor and notseriously misleading. Some states require the debtor’s tax IDnumber on the financing statement.





who are required to sign under the partnershipagreement should sign.

Unsecured Transactions

Unsecured transactions are granted based on theborrower’s financial capacity, credit history,earnings potential, and/or liquidity. Assignmentof the borrower’s collateral is not required, andrepayment is based on the terms and conditionsof the loan agreement. While unsecured loansoften represent the branch’s strongest borrow-ers, the unsecured loan portfolio can representits most significant risk. One of the primaryconcerns related to unsecured credit is that if theborrower’s financial condition deteriorates, thelender’s options to work out of the lendingrelationship deteriorate as well. In general, if acredit is unsecured, the file should containreliable and current financial information that issufficient to indicate that the borrower has thecapacity and can be reasonably expected torepay the debt.

Emerging Problem Loans

The following are key signals of an emergingproblem loan:

• Outdated or inaccurate financial information.The borrower is unwilling to provide thefinancial institution with a current, complete,and accurate financial statement at least annu-ally. Management also should request a per-sonal tax return (and all related schedules) on

the borrower. While borrowers will usuallypresent their personal financial statements inthe most favorable light, their income taxreturn provides a more conservative picture.

• The crisis borrower. The borrower needed themoney yesterday, so the branch advancedunsecured credit.

• No specific terms for repayment. The unse-cured loan has no structure for repayment, andit is commonly renewed or extended atmaturity.

• Undefined source of repayment. Repaymentsources are often not identified and are unpre-dictable. These types of loans are often repaidthrough excess cash flow of the borrower, saleof an asset(s), or loan proceeds from anotherfinancial institution.

REVIEWING CREDIT QUALITY

Importance of Cash Flow

Evaluating cash flow is the single most impor-tant element in determining whether a businesshas the ability to repay debt. Two principalmethods of calculating the cash flow available ina business to service debt are presented in thissubsection. The results of these methods shouldbe used to determine the adequacy of cash flowin each credit evaluated at an institution. Theaccrual conversion method is the preferredmethod because it is the most reliable. Thesecond and less reliable method is the supple-

mental or traditional cash-flow analysis; how-ever, the information needed for this analysis isusually more obtainable and easier to calculate.The traditional method can be used when cir-cumstances warrant, for example, when theborrower’s financial statements are not suffi-ciently detailed for the information requested inthe accrual conversion analysis or when histori-cal information is inadequate.

Analysis and Limitations of CashFlow

Cash-flow analysis uses the income statementand balance sheet to determine a borrower’soperational cash flow. Careful analysis of allinvestment and financing (borrowing) activitiesmust be made for an accurate assessment of cashflow. In reality, examiners face time constraintsthat often prevent them from performing the

complex mathematical calculations involved insophisticated cash-flow analysis. Therefore, thecash-flow methods presented below weredesigned to be reasonable and practical forexaminer use. However, examiners should becareful of conclusions reached using the tradi-tional cash-flow analysis, without considerationof balance-sheet changes or other activities thataffect cash flow. The traditional cash-flow analy-sis does not recognize growth in accountsreceivable or inventory, a slow-down in accountspayable, capital expenditures, or additional bor-rowings. If the credit file contains a CPA-prepared statement of cash flow or a statementprepared using the accrual conversion method,the examiner should concentrate efforts onreviewing and analyzing these statements rather



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than on preparing a traditional cash-flowstatement.

One critical issue to remember is that deficitcash flow does not always mean that the bor-rower is encountering serious financial difficul-

ties. In some cases, deficit cash flow is causedby a business’s experiencing significant growth,and there is a pronounced need for externalfinancing to accommodate this growth and elimi-nate the deficit cash-flow position. In this case,an adequate working-capital facility may not bein place to accommodate the need for additionalinventory. A comprehensive analysis of changesin the balance sheet from period to periodshould be made before the loan is criticized.

Components of the AccrualConversion Method of Cash Flow

Category Basis for Amount

Sales: Dollar amount of sales in period

+/ −change in

A/R, INV.,A/P: Represents the absolute differ-

ence of the current period fromthe corresponding period of theprevious year in accountsreceivable, inventory, andaccounts payable.

Formula: a) An increase in any currentasset is a use of cash and issubtracted from the calculation.

Conversely, a decrease in anycurrent asset is a source of cashand is added to the calculation.

b) An increase in any currentliability is a source of cash andis added to the calculation. Con-versely, a decrease in any cur-rent liability is a use of cashand is subtracted from thecalculation.

SGA: Subtract selling, general, andadministrative expenses.

InterestExpense: Add interest expense to the cal-

culation if SGA ‘‘expense’’includes interest expense.

Excess (Deficit)Cash Flow: Represents cash available before

debt service.

Calculation of Supplemental/Traditional Cash Flow

Net Income: Amount of net income reportedon most recent annual incomestatement before taxes.

InterestExpense: Add the total amount of interest

expense for the period.

Depreciation/ Amortization: Add all noncash depreciation

and principal amortization onoutstanding debt.

Cash FlowbeforeDebt Service: Indicates net Earnings Before

Interest, Taxes, Depreciation,and Amortization (EBITDA).

Amortization should includeboth principal and interest pay-ments required on debt.

Debt Service: Subtract scheduled principaland interest payments.

CapitalExpenditures: Subtract all capital expendi-

tures for the period.

EQUALS—

Excess (Deficit)Cash Flow: Total amount of excess or defi-

cit cash flow for the period afterdebt service.

CoverageRatio: Cash flow before debt service

divided by debt service (princi-pal and interest).

Importance of Financial Analysis

While cash-flow analysis is critical in reviewingwhether a borrower has the ability to repayindividual debt, a review of the borrower’s other





financial statements can offer information aboutother sources of repayment, as well as theborrower’s overall financial condition and futureprospects. The availability of historical balance-sheet and income information, which allow

declining trends to be identified, is critical. Also,it may be appropriate to compare the borrower’sfinancial ratios with the average for the industryoverall. Much of the financial information thatexaminers will review will not be audited;therefore, considerable understanding of generalaccounting principals is necessary to compe-tently review an unaudited financial statement.At a minimum, financial statements should beobtained annually; where appropriate, the branchalso should obtain monthly or quarterly

statements.When reviewing a credit file of a borrowing

customer of a branch, the following financialinformation should be available for review:income statement, balance sheet, reconciliationof equity, cash-flow statements, and applicablenotes to financial statements. The componentsfor a financial review can be segregated intothree areas: operations management, asset man-agement, and liability management. Operationsmanagement is derived from the income state-

ment and can be used to assess company sales,cost control, and profitability. Asset manage-ment involves the analysis of the quality andliquidity of assets, as well as the asset mix.Liability management covers the analysis of thecompany’s record of matching liabilities to theasset conversion cycle, such as long-term assetsbeing funded by long-term liabilities.

In studying these forms of management, vari-ous ratios will help the examiner form aninformed and educated conclusion about the

quality of the credit being reviewed. The ratioscan be divided into four main categories:

• Profitability ratios. These ratios measure man-agement’s efficiency in achieving a givenlevel of sales revenue and profits, as well asmanagement’s ability to control expenses andgenerate return on investment. Examples of these ratios include gross margin, operatingprofit margin, net profit margin, profit-to-salesratio, profit-to-total assets ratio, and directcost and expense ratios.

• Efficiency ratios. These ratios, which measuremanagement’s ability to manage and controlassets, include sales to assets, inventory dayson hand, accounts receivable days on hand,accounts payable days on hand, sales to net

fixed assets, return on assets, and return onequity.

• Leverage ratios. These ratios compare thefunds supplied by business owners with thefinancing supplied by creditors, and measure

debt capacity and ability to meet obligations.These ratios may include debt-to-assets, debt-to-net-worth, debt-to-tangible-net-worth, andinterest coverage.

• Liquidity ratios. Include ratios such as thecurrent ratio and quick ratio, which measurethe borrower’s ability to meet currentobligations.

Common ‘‘Red Flags’’

The symptoms listed below are included toprovide an understanding of the common prob-lems or weaknesses examiners encounter intheir review of financial information. While onesymptom may not justify criticizing a loan,when symptoms are considered in the aggregate,they may help the examiner detect near-termtrouble. This list is only a sampling of "redflags" that should prompt further review; exam-iners should also be able to identify issues that

may require further investigation from theircursory review of a borrower’s financialstatement.• A slowdown in the receivables collection

period. This symptom often reveals that theborrower has become more liberal in estab-lishing credit policies, has softened collectionpractices, or is encountering an increase inuncollected accounts.

• Noticeably rising inventory levels in bothdollar amount and percentage of total assets.

Increases in inventory levels are usually sup-ported by trade suppliers, and financing theseincreases can be extremely risky, particularlyif turnover ratios are declining. The increasein inventory levels or lower turnover ratiosmay also be related to the borrower’s naturalreluctance to liquidate excessive or obsoletegoods at a reduced price. Many businesses arewilling to sacrifice liquidity to maintain profitmargins.

• Slowdown in inventory turnover. This symp-tom may indicate overbuying or some otherimbalance in the company’s purchasing poli-cies, and it may indicate that inventory isslow-moving. If the inventory is undervalued,the actual turnover is even slower than thecalculated results.



Page 10



• Existence of heavy liens on assets. Evidenceof second and third mortgage holders is a signof greater-than-average risk. The cost of juniormoney is high. Most borrowers are reluctantto use this source of funds unless conventional

sources are unavailable.• Concentrations of noncurrent assets other than fixed assets. A company may put fundsinto affiliates or subsidiaries for which thebranch may not have a ready source of infor-mation on operations.

• High levels of intangible assets. Intangibleassets, which shrink or vanish much morequickly than hard assets, usually have veryuncertain values in the marketplace. In somecases, however, intangible assets such as pat-

ents or trademarks have significant value andshould be given considerable credit.

• Substantial increases in long-term debt. Thissymptom causes increasing dependence oncash flow and long-term profits to supportdebt repayment.

• A major gap between gross and net sales. Thisgap represents a rising level of returns andallowances, which could indicate lower qual-ity or inferior product lines. Customer dissat-isfaction can seriously affect future profitability.

• Rising cost percentages. These percentagescan indicate the business’s inability or unwill-ingness to pass higher costs to the customer orits inability to control overhead expenses.

• A rising level of total assets in relation to

sales. If a company does more business, it willtake more current assets in the form of inven-tory, receivables, and fixed assets. Examinersshould be concerned when assets are increas-ing faster than sales growth.

• Significant changes in the balance-sheet struc-ture. These changes may not be the customarychanges mentioned previously, but they arerepresented by marked changes spread acrossmany balance-sheet items and may not beconsistent with changes in the marketplace,profits or sales, product lines, or the generalnature of the business.

BANKRUPTCY LAW ANDCOMMERCIAL LOANS

This section provides examiners with an over-view of the United States Bankruptcy Code(code) chapters that affect commercial and indus-trial loans. Bankruptcy law is a significant body

of law; it would be difficult in this manual todiscuss all the issues necessary for comprehen-sive understanding of the code. This subsectionwill focus on basic issues that an examinerneeds to be familiar with relative to three

principal sections of the code, chapters 7, 11,and 13.

Creditors of a Bankrupt Business

A creditor in bankruptcy is anyone with a claimagainst a bankrupt business, even if a formalclaim is not filed in the bankruptcy case. Inbankruptcy court, a claim is defined very broadly.A claim may include a right to payment from abankrupt business, a promise to perform work,or a right to a disputed payment from the debtorthat is contingent on some other event. The twobasic types of creditors are secured and unse-cured. Secured creditors are those with perfectedsecurity interest in specific property, such asequipment, accounts receivable, or any otherasset pledged as collateral on a loan. Unsecuredcreditors are generally trade creditors and otherswho have not taken a specific interest in prop-

erty supplied to the bankrupt debtor.

Voluntary Versus InvoluntaryBankruptcy

When a debtor files a bankruptcy petition, it isdescribed as a voluntary bankruptcy filing. Theindividual or organization does not have to beinsolvent to file a voluntary case. Creditors may

also file a bankruptcy petition, in which case theproceeding is known as an involuntary bank-ruptcy. This form of petition can occur inchapters 7 and 11 bankruptcy cases, and thedebtor generally must be insolvent. To be deemedinsolvent, the debtor must be unable to pay debtsas they mature. However, the code does limitwho an involuntary action can be sought against.

Chapter 7—Liquidation Bankruptcy

A chapter 7 action may be filed by virtually anyperson or business organization that is eligibleto file bankruptcy. Chapter 7 bankruptcy can befiled by a sole proprietorship, partnership, cor-poration, joint stock company, or any other





business organization. Restrictions apply to onlya few highly regulated businesses, such asrailroads, insurance companies, banks, munici-palities, and other financial institutions. Thischapter is often referred to as ‘‘straight liquida-

tion’’ or the orderly liquidation of all assets of the entity. Generally, a debtor in a chapter 7bankruptcy case is released from obligations topay all dischargeable pre-bankruptcy debts inexchange for surrendering all nonexempt assetsto a bankruptcy trustee. The trustee liquidates allassets and distributes the net proceeds on a prorata basis against the allowed claims of unse-cured creditors. Secured creditor claims aregenerally satisfied by possession or sale of thedebtor’s assets. Depending on the circum-

stances, a secured creditor may receive thecollateral, the proceeds from the sale of thecollateral, or a reaffirmation of the debt from thedebtor. The reaffirmed debts are generallysecured by property that the debtor can exemptfrom the bankruptcy estate, such as a home orvehicle. The amount of the reaffirmation islimited to the value of the asset at the time of thebankruptcy filing.

Some characteristics of a chapter 7 bank-ruptcy are described below:

• A trustee is appointed in all chapter 7 bank-ruptcies and acts as an administrator of thebankruptcy estate. The bankruptcy estate thatis established when the petition is filedbecomes the legal owner of the property. Thetrustee acts to protect the interest of all partiesaffected by the bankruptcy.

• The trustee has control of all nonexempt

assets of the bankrupt debtor.• The trustee is required to liquidate the estate

quickly without jeopardizing the interests of the affected parties.

• The proceeds from the sale pay trustee’s feesand other creditors. Trustee fees are deter-mined according to the amount disbursed tothe creditors and are a priority claim.

• A chapter 7 bankruptcy is typically completedin 90 days, depending on the time needed to

liquidate collateral. In rare situations, otherchapter 7 bankruptcies may take years tocomplete.

• The court may allow the trustee to continue tooperate a business, if this is consistent withthe orderly liquidation of the estate.

Chapter 11—Reorganization

Most major or large businesses filing bank-ruptcy file a chapter 11 reorganization. As inchapter 7, virtually any business can file bank-

ruptcy under chapter 11. There are specializedchapter 11 reorganization procedures for certainbusinesses such as railroads, and chapter 11 isnot available to stockbrokers, commodity bro-kers, or a municipality. The basic concept behindchapter 11 is that a business gets temporaryrelief or a reprieve from paying all debts owedto creditors. This temporary relief gives thebusiness time to reorganize, reschedule its debts(at least partially), and successfully emerge frombankruptcy as a viable business. The basic

assumption underlying a chapter 11 bankruptcyis that the value of the enterprise as a goingconcern will usually exceed the liquidation valueof its assets.

Reorganization Plan

Generally, the debtor has an exclusive 120-dayperiod to prepare and file a reorganization plan.

If the debtor’s plan has not been confirmedwithin 180 days of the bankruptcy filing, acreditor may file a plan. A plan can provide forany treatment of creditor claims and equityinterest, as long as it meets the requirements setout in the code. For example, a plan mustdesignate substantially similar creditor claimsand equity interest into classes and provide forequal treatment of such class members. A planmust also identify those classes with impairedclaims and their proposed treatment. Finally, a

method of implementation must be provided.Although plans do not have to be filed by adeadline, the bankruptcy judge will generallyplace a deadline on the debtor or creditor autho-rized to prepare the plan.

Some characteristics of a chapter 11 bank-ruptcy are described below.

• The bankrupt debtor usually controls the busi-ness during the bankruptcy proceedings. Thisarrangement is referred to as ‘‘debtor in pos-

session.’’• The business continues to operate while in

bankruptcy.

• The debtor is charged with the duty of devel-oping a reorganization plan within the first120 days of the filing. After this period



Page 12



expires, the court may grant this authority to acreditors’ committee.

• Once the plan is approved by the bankruptcycourt, the debtor’s payment of debts is gener-ally limited to the schedule and amounts that

are detailed in the reorganization plan.• A chapter 11 proceeding can be complex andlengthy, depending on the number of credi-tors, amount of the debts, amount of theassets, and other factors that complicate theproceedings.

Chapter 13—Wage-Earner Bankruptcy

A chapter 13 bankruptcy is available to any

individual whose income is sufficiently stableand regular to enable him or her to makepayments under the plan. As long as the indi-vidual has regular wages or takes a regular drawfrom his or her business, the individual mayqualify under chapter 13 of the code. Underchapter 13, an individual or married couple canpay their debts over time without selling theirproperty. As a protection to creditors, the moneypaid to a creditor must equal or exceed the

amount that the creditor would get in a liquida-tion or chapter 7 bankruptcy. Chapter 13 may beused for a business bankruptcy, but only if thebusiness is a proprietorship. In most cases, thebusiness needs to be fairly small to qualify.

Some characteristics of a chapter 13 bank-ruptcy are described below:

• In most cases, only an individual can file achapter 13 bankruptcy.

• Secured debt may not exceed $350,000.• Unsecured debt may not exceed $100,000.• The debtor must propose a good-faith plan to

repay as many debts as possible from avail-able income.

• A debtor makes regular payments to a trustee,

who disburses the funds to creditors under theterms of the plan.

• The trustee does not control the debtor’sassets.

• A chapter 13 bankruptcy may include thedebts of a sole proprietorship. The businessmay continue to operate during the bank-ruptcy.

• After all payments are made under the plan,general discharge is granted.





Commercial LoansExamination ObjectivesEffective date July 1997 Section 3050.2

1. To determine if lending policies, practices,procedures, and internal controls regarding

commercial loans are adequate.2. To determine if branch officers are operatingin conformance with the establishedguidelines.

3. To evaluate the portfolio for credit quality,performance, collectibility, and collateralsufficiency.

4. To recommend corrective action when poli-cies, practices, procedures, or internal con-

trols are deficient or when violations of lawor regulations have been noted.




Commercial LoansExamination ProceduresEffective date July 1997 Section 3050.3

Refer to the Credit Risk Management examina-tion procedures for general procedures to assess

the risk of commercial lending activities. How-ever, if the branch conducts significant commer-cial lending activities, and additional informa-tion is needed, the examiner should perform thefollowing procedures.

1. If selected for implementation, complete orupdate the Internal Control Questionnaire forthis area.

2. Determine if deficiencies noted at previousexaminations and internal/external audits

have been addressed by management.

3. If the branch has any credits that should bereviewed under the Shared National Credit

program but were omitted (other than newcredits that originated since the previousreview) submit a memorandum to the SNCcoordinator detailing those credits to therespective Federal Reserve District. Do notinclude subparticipations, where the branchpurchased its share from either a bank in theoriginal syndicate, or from a bank considereda first-tier participant. Subparticipations shouldonly be tracked internally by the branch.




Commercial LoansInternal Control QuestionnaireEffective date July 1997 Section 3050.4

Refer to the Credit Risk Management internalcontrol questionnaire for a general review of the

branch’s internal controls, policies, practices,and procedures. If additional information isneeded, complete the following internal controlquestionnaire. For audit procedures, refer to theCredit Risk Management section 3010.5.

POLICIES

1. Has the head office adopted written com-mercial loan policies for the branch that:

a. Establish procedures for reviewing com-mercial loan applications?

b. Define qualified borrowers?c. Establish minimum standards for

documentation?2. Are policies reviewed, at least annually, to

determine if they are compatible with chang-ing market conditions?

3. Do loan records provide satisfactory audittrails that permit the tracing of transactionsfrom initiation to final disposition?

4. Has the branch instituted a system thatensures:a. Security agreements are filed?b. Collateral mortgages are properly

recorded?c. Title searches and property appraisals

are performed in connection with collat-eral mortgages?

d. Insurance coverage, including loss payeeclause, is in effect on property covered

by collateral mortgages?e. The borrower is in compliance with allthe covenants of the loan agreement?

5. Does the branch have an internal reviewsystem that:a. Ensures liens are perfected?

b. Checks collateral values when the loan ismade and at reasonable intervals

thereafter?c. Ensures that cash flow analyses are per-formed on appropriate borrowers in atimely manner?

d. Determines that loan payments arepromptly posted?

6. Do working capital loans require clean-upperiods?

7. Who is responsible for monitoring theclean-up period, the account officer or anindependent source?

8. What are the consequences if the borrowercannot clean-up the line?

9. Are different criteria used for loans toborrowers on an unsecured basis versus asecured basis (e.g. more stringent documen-tation requirements, more frequent creditreviews, or cashflow analyses)?

10. Is there any evidence that the branch isextending working capital loans to financethe acquisition of long-term assets or capital?

11. Do all term loans require meaningful prin-

cipal amortization (at least quarterly)?12. Does the term of the loan correspond to the

useful life of the underlying asset beingfinanced?

CONCLUSION

13. Is the information covered by this internalcontrol questionnaire adequate for evaluat-

ing internal controls in this area? If not,indicate any additional examination proce-dures deemed necessary.

14. Based on the information gathered, evaluateinternal controls in this area (i.e. strong,satisfactory, fair, marginal, unsatisfactory).




Financing Corporate RestructuringsEffective date July 1997 Section 3060.1

Corporate restructurings have become a tech-nique for financing acquisitions through lever-aged buyouts, resisting takeovers, and restruc-

turing corporate balance sheets. They encompasstraditional leveraged buyouts, management buy-outs, corporate mergers and acquisitions, andsignificant stock buybacks. Leveraged EmployeeStock Option Plans (ESOPs) may also be con-sidered as corporate restructurings if they areused to acquire or recapitalize an existingbusiness.

It is not considered inappropriate for branchesto lead and/or participate in loans to financecorporate restructurings so long as they are

conducted in a sound and prudent manner.However, booking of such credits could affectasset quality and increase overall levels of risk exposure.

Corporate restructurings involve many of thesame characteristics and risks that have tradi-tionally been evaluated during on-site examina-tions. These relate to the borrower’s income,cash flow, and general ability to pay interest andprincipal on outstanding debt; economic condi-tions and trends; the borrower’s management;

and the borrower’s ability to realize valuethrough the sale or liquidation of assets. Whatusually distinguishes corporate restructuringsfrom typical bank loans is the level of debt theborrower assumes in relation to standard mea-sures of financial capacity or ability to repay.Clearly, a high level of debt in relation to networth or total assets can place heavy demandson a borrower’s cash flow and reduce theborrower’s ability to absorb the effects of unan-ticipated financial shocks or economic adversity.

Branches may be involved in corporaterestructurings at a number of levels. First, they,together with other institutional lenders, mayprovide senior secured financing that typicallyrepresents the largest portion of a corporaterestructuring. In addition, branches may extendcredit on a subordinated basis. Bridge loans alsorepresent another type of financing, which maybe considered as senior debt or mezzaninefinancing, depending on its characteristics.

Because corporate restructurings traditionallyentail high leverage, they often increase thevulnerability of borrowers to adverse marketand financial developments and have the poten-tial to raise the level of risk in bank loanportfolios. For these reasons, bank supervisorshave actively urged bank management to exer-

cise caution and apply especially rigorous lend-ing and investing standards in participating inthese transactions.

WAYS TO FINANCE CORPORATERESTRUCTURINGS

Corporate restructurings are typically financedthrough a complex combination of debt andequity instruments. A general overview of thetypes of financings is provided as follows:

Senior Debt

This term refers to all loans and debt securitiessecured by first liens on assets or the stock of theborrower’s operating entities; and, any unse-cured loans and debt securities, which havepriority in repayment over all other creditors andequity investors in the event of liquidation. Themajority of senior debt generally consists of secured term loans; however, other types of debt, including revolving working capital loans,bridge loans, and debt securities may be consid-ered senior debt. To be considered as seniordebt, the loans must not be subordinated to anyother obligations in the event of liquidation.

Mezzanine Financing

Mezzanine financing consists of all layers of financing between senior debt and equity invest-

ments. These include all unsecured loans anddebt securities where payment is subordinated,loans or debt securities secured by liens inferiorto those of senior debt, fully subordinated debt,and any limited-life preferred stock with signifi-cant debt characteristics.

Bridge Loans

Bridge loans have varying characteristics andare considered as either senior debt or mezza-nine financing based upon the definitions above.Repayment of bridge loans is dependent on thesuccessful marketing of longer term securities orthe sale of assets for repayment. Bridge loansthat would be subordinated to other obligations




in the event of liquidation are considered mez-zanine financing.

Noninvestment Grade Bonds

These bonds consist of all noninvestment-grade,high-yield debt securities involved in corporate

restructurings (commonly referred to as junk bonds). This includes various types of high yieldissues, which have attributes of debt, such aszero-coupon or zero-slash bonds and pay-in-kind (PIK) bonds. Pay-in-kind preferred stock

and other issues with significant equity attributesare considered equity investments.

3060.1 Financing Corporate Restructurings


Page 2



Financing Corporate RestructuringsExamination ObjectivesEffective date July 1997 Section 3060.2

1. To determine if policies, practices, proce-dures, and internal controls regarding corpo-

rate restructurings are adequate.2. To determine if branch officers are oper-ating in conformance with the establishedguidelines.

3. To determine compliance with applicablelaws and regulations.

4. To recommend corrective action when poli-cies, practices, procedures, or internal con-trols are deficient or when violations of lawor regulations have been noted.




Financing Corporate RestructuringsExamination ProceduresEffective date July 1997 Section 3060.3

Determine if management performs thefollowing:

1. Evaluates the adequacy and stability of theborrower’s current and prospective cash flowunder varying economic scenarios, includingthe possibility of an economic decline.

2. Sets reasonable in-house limits regardingexposure to individual borrowers, total expo-sure to all corporate restructured borrowers,and industry concentrations resulting fromcorporate restructurings.

3. Establishes credit analysis, approval, and

review procedures that take account of thehigh levels of debt involved in thesetransactions.

4. Maintains internal systems, controls, andreporting procedures that track the perfor-

mance and condition of individual exposures,monitor the organization’s compliance withinternal procedures and limits and keep headoffice management adequately informed on atimely basis of the organization’s involve-ment in corporate restructurings.

5. Establishes pricing policies and practices thattake into account a prudent manner of thetrade-off between risk and return.

6. Avoids compromising sound banking prac-tices in an effort to broaden market share or

realize substantial fees.




Due From Nonrelated BanksEffective date July 1997 Section 3070.1

This section refers to deposit accounts withnonrelated banking organizations. These depositaccounts can be either noninterest-bearing settle-

ment accounts (demand) or interest-bearingdeposits and placements (time). For informationon accounts with related banking offices andaffiliates see the Due From/Due To RelatedOffices section of this manual. In addition, theinstructions for the FFIEC 002, Report of Assetsand Liabilities of U.S. Branches and Agencies of Foreign Banks, are an important source of information on accounts with nonrelated andrelated offices and institutions.

DEMAND DEPOSITS

Banks maintain deposits in other banks to facili-tate the transfer of funds. Those assets, knownas due from banks-demand, correspondent bank balances, or settlement accounts, are a part of the primary, uninvested funds of every bank. Atransfer of funds between banks may result, inpart, from the collection of cash items, thetransfer and settlement of securities transac-tions, the transfer of participating loan funds,and the purchase or sale of Federal funds.

Banks also utilize other banks to providecertain services that can be performed moreeconomically or efficiently by the other banksbecause of their size or geographic location.Such services include processing of cash letters,packaging loan agreements, funding overlineloan requests of customers, performing EDPservices, collecting out-of-area items, exchang-ing foreign currency, and providing financialadvice in specialized loan areas. When theservice is one-way, the bank receiving thatservice usually maintains a minimum balancethat acts as a compensating balance in full orpartial payment for the services received.

Some banks, particularly branches, must beprepared to make and receive payments inforeign currencies to meet the needs of theirinternational customers. This can be accom-plished by maintaining foreign currency duefrom banks-demand accounts with affiliates (nos-tro balances) or with other banks in foreigncountries.

TIME DEPOSITS

Branches also maintain interest-bearing time

deposits, known as due from banks-time, withother banks. Those assets may also be referredto as placements, placings, interbank placements(deposits), redeposits or even Federal funds, ininstances where their maturities are similar toFederal funds. These placements represent asource of primary liquidity to many branches.

All banks with which the branch has demandand time accounts shown on its books should besubject to an appropriate level of scrutiny forcreditworthiness, which should be documented

in the branch’s on-site credit files. In cases,where these credit evaluations are conducted bythe head office or another related office, branchmanagement should obtain copies of these evalu-ations for its files.

Due from banks-time deposit activities becameimportant with the growth of the Eurodollarmarket. The bulk of due from banks-time depos-its now consist of Eurodollars, with smalleramounts in other Eurocurrencies. Other foreigncurrency time deposits are placed in substan-

tially the same manner as Eurodollar deposits,subject to differing exchange control regulationsor local customs.

Eurodollar (interbank) deposits are some-times linked with foreign exchange transactions.As a result, the branch’s foreign exchange orEurocurrency deposit traders frequently work closely with the trader responsible for placingdue from banks-time deposits. Foreign exchangebrokers also may act as intermediaries if war-ranted by market conditions, local customers,

the size of the branch, or other factors.The practice of placing interbank deposits

(and takings on the liability side) originated inLondon because, under U.K. regulations, bankswere entitled to ‘‘accept’’ interbank depositswhereas interbank borrowings(i.e. loans) requiredauthorization by the Bank of England. There-fore, due from banks-time deposits are‘‘accepted’’ even though the receiving bank mayhave instructed its foreign exchange trader,directly or through brokers, to find a bank willing to offer it such deposits.

Due from banks-time deposits contain thesame credit and country risks as any extensionof credit to a bank. Consequently, a prudentlymanaged bank should place deposits with (i.e.lend to) only well-managed banks. The traders




should be provided with a list of approved bankswith which funds can be deposited up to pre-scribed limits for each bank. Due from bank-time deposits differ from other types of creditextensions because they often represent deposits

of relatively short maturity which normallyreceive first priority in case of insolvency. Nev-ertheless, the credit and country exposure exists,and customer limits must be established bycredit officers and not by foreign exchangetraders. Such limits must be reviewed regularlyby credit officers, particularly during periods of money market uncertainty or rapidly changingeconomic and political conditions.

The examiner also must recognize that creditrisks intensify when due from bank-time depos-

its are placed for longer periods. Furthermore,the credit risks for specialized or smaller banksthat have recently entered the interbank depositmarket can be far greater than that for larger,long-established banks. Banks which tradition-

ally utilized only regular lines of credit orspecial facilities also have entered the due frombanks-time deposit market to meet their externalneeds. Those banks could be the first to becaught in a market crunch.

Incoming confirmations from banks must bemeticulously checked by the bank to recordcopies in each instances to protect against fraudand errors. Similarly, a systematic follow-up onnon-receipt of incoming confirmations shouldbe carefully monitored by the bank.

3070.1 Due From Nonrelated Banks


Page 2



Due From Nonrelated BanksExamination ObjectivesEffective date July 1997 Section 3070.2

1. To determine if the policies, practices, pro-cedures, and internal controls regarding bal-

ances due from banks, both demand andtime, are adequate.2. To determine if branch officers and employ-

ees are operating in conformance with estab-lished guidelines.

3. To determine that all due from accounts arereasonably stated and represent funds ondeposit with other banks.

4. To determine whether the branch evaluatesthe credit quality of banks with which demand

and time accounts are maintained.5. To determine the scope and adequacy of theinternal and external audit coverage as itapplies to this area.

6. To recommend corrective action when poli-cies, practices, procedures, or internal con-trols are deficient or when violations of law,rulings, or regulations have been noted.




Due From Nonrelated BanksExamination ProceduresEffective date July 1997 Section 3070.3

1. If included in the scope of the examination,complete or update the Internal Control

Questionnaire.2. Test for compliance with policies, practices,procedures, and internal controls within theparameters of the established scope.

3. Scan the most recent bank-prepared recon-cilements for any unusual items and deter-mine that closing balances listed on recon-cilements agree with the general ledger andwith the balance shown on the cut-off state-ment if one has been obtained.

4. If the bank’s policy for charge-off of old

open items provides for exceptions inextenuating circumstances, review excepteditems and determine if charge-off isappropriate.

5. If the bank has no policy for charge-off of old open items, review any items which arelarge or unusual or which have been out-standing for over two months, along withrelated correspondence, and determine if charge-off is appropriate.

6. Obtain a trial balance of the due from banks

—time balances. Reconcile balances todepartment controls and general ledger.

7. Check a sample of confirmations. This willensure that the balances are indeed due frombank balances and not loans to banks (forCall Report purposes). If any transactions

are not confirmed as of the date of exami-nation, determine why incoming confirma-

tion is missing.8. The credit quality of placements is includedin the scope of the asset quality review.Using appropriate sampling techniques,select deposit customers for examinationand review the credit file maintained oneach bank. Ensure the bank has performed acredit analysis on all approved due frombank counterparties. If the credit analysishas been prepared by the head office, shadowfiles need to be maintained at the institution.

9. Check back office procedures, adequacy of separation of duties, and who monitorslimits.

10. If problems are detected concerning theinstitution’s policies or lack thereof, thedeficiencies should be discussed under Risk Management. If the institution is deficientin its operations and is not following itspolicies, the exception should be discussedunder Operational Controls.

11. Prepare comments on deficiencies or viola-

tions of law noted above for inclusion in theexamination report.

12. Assemble workpapers to support conclu-sions reached. Include any information thatwill facilitate future examinations.




Due From Nonrelated BanksInternal Control QuestionnaireEffective date July 1997 Section 3070.4

AUDIT COVERAGE

1. Does the scope of the branch’s internalaudit program include procedures covering:

a. Due from banks-demand accounts?

b. Due from banks-time accounts?

2. Do audit procedures include all of thefollowing to ascertain the effectiveness of internal controls:

a. Ensure that procedural manuals orinstructions covering the reconcilementfunction exist?

b. Ascertain if statements are not recon-ciled by an individual, who also:

• Has signing authority on the account?

• Approves entries?

• Posts the general ledger?

• Effects money transfers?

c. Ensure that statements are reconciledpromptly when received?

d. Check to see that reconcilements areprepared on preprinted forms?

e. Ensure that completed reconcilementsare properly stored to satisfy record-retention requirements?

f. Ensure that open items are promptlyreferred to and followed up by theappropriate operating department orresponsible officer?

g. Test that open entries outstanding beyonda reasonable length of time are:

• Referred to appropriate senior branch

management in writing?• Charged off to profit/loss accounts?

• Transferred to special suspenseaccounts, pending additional follow-upaction?

h. Ensure that reconciliation personnel areprohibited from preparing adjustingentries?

i. Spot check selected general ledger tick-ets and supporting documentation for:

• Adequate details of the transaction?• Proper officer approvals?

j. Test check on selected transactions thatinclude open, reconciled, adjusted, andcharged-off items to ascertain proprietyof disposition?

POLICIES FOR DUE FROMBANKS

3. Do current written policies and proceduresexist for due from banks-demand accountsthat:

a. Provide for periodic review and approvalof balances maintained in each suchaccount?

b. Indicate person(s) responsible for moni-toring balances and the application of approved procedures?

c. Establish levels of check-signing author-ity?

d. Indicate officers responsible for approvalof transfers between correspondent banksand procedures for documenting suchapproval?

e. Indicate the supervisor responsible forregular review of reconciliations and rec-onciling items?

f. Indicate that all entries to the accountsare to be approved by an officer or

appropriate supervisor and that suchapproval will be documented?

g. Establish time guidelines for charge off of old open items?

4. Do current written policies and proceduresexist for due from banks-time account that:

a. Establish maximum limits of the aggre-gate amount of due from banks-timedeposits for each:

• Bank?

• Currency of deposit?

• Country of deposit?

b. Restrict due from banks-time deposits toonly those customers for whom lineshave been established?

c. Establish definite procedures for:

• Balancing of accounts?

• Holdover deals?

• Rendering of reports to management,external auditors, and regulatingagencies?

• Accounting cut-off deadlines?• Handling of interest?

5. Are the policies and procedures for duefrom bank accounts reviewed at least annu-ally to determine their adequacy in light of changing conditions?




BANK RECONCILEMENTS

6. Are branch reconcilements preparedpromptly upon receipt of the statements?

7. Are statements examined for any sign of

alteration and are payments or paid draftscompared with such statements by the per-sons who prepare branch reconcilements? If yes, skip question 8.

8. If the answer to question 7 is no, arestatements and paid drafts or paymentshandled before reconcilement only by per-sons who do not also:a. Issue drafts or official checks and pre-

pare, add, or post the general or subsid-iary ledgers?

b. Handle cash and prepare, add, or post thegeneral ledger or subsidiary ledgers?

9. Are branch reconcilements prepared by per-sons who do not also:a. Issue drafts or official checks?b. Handle cash?c. Prepare general ledger entries?

OTHER

10. Is a separate general ledger account orindividual subsidiary account maintainedfor each due from bank account?

11. Are overdrafts in due from bank accountsproperly recorded on the branch’s recordsand promptly reported to the responsibleofficer?

12. Are individual interestcomputations checked

or adequately tested by persons independentof those functions?13. Are accrual balances for due from banks-

time verified periodically by an authorizedofficial? If so, indicate frequency.

14. Do all internal entries require the approvalof appropriate officials?

CONCLUSION

15. Is the information covered by this ICQadequate for evaluating internal controls inthis area? If not, indicate any additionalexamination procedures deemed necessary.

16. Based on the information gathered, evaluatethe internal controls in this area (i.e., strong,satisfactory, fair, marginal, unsatisfactory).

3070.4 Due From Nonrelated Banks: Internal Control Questionnaire


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Due From Nonrelated BanksAudit GuidelinesEffective date July 1997 Section 3070.5

1. Determine the number of the last unissueddraft of each due from bank account and

record for comparison when performingreconcilements.2. Prepare a listing of all due from bank

accounts, together with their balances fromthe branch’s daily statement as of the exami-nation date. Compare each balance or totalbalances to the appropriate subtotal in thegeneral ledger as of the examination date.

3. Request a cut-off statement as of the exami-nation date and for a subsequent date, notless than five days later for each due from

account. Include instructions that the state-ments be addressed to the examiner-in-charge and be delivered unopened.

4. In preparing or reviewing reconcilements:

a. Review reconciling items carefully todetermine that the time period betweendebit or credit entries and the offsettingcredit or debit by the correspondent bank is comparable for similar types of items. If any differences in timing occur, ascertainthe reason.

b. Determine that wire transfers appear onthe correspondent statement the same dayas entered on the branch’s books. Deter-mine the reason for any exception.

c. Test all drafts included in the cut-off statement for authorized signature, properendorsement, dates of drafts, payee, andamounts and determine that:

• Dates drawn are not subsequent to datespaid by the correspondent bank.

• Drafts issued to transfer funds from thebranch’s account to the correspondent’saccount are not outstanding more thanthe normal transit time.

• Drafts are numbered.

• Drafts are issued sequentially.

5. Reconcile due from bank accounts on areconcilement form using the following steps:

a. Prove the mathematical accuracy of theprior reconcilement by a machine run of the figures.

b. Determine that our balance to their debit agrees to general ledger as of their priorreconcilement date.

c. Determine that their balance to our credit agrees to each correspondent bank state-ment as of the prior reconcilement date.

d. Determine that the closing balance anddate listed on the statement used in the

branch’s last reconcilement agrees to theopening balance and date listed on thecut-off statement as of the examinationdate.

e. Determine that any open items from pre-vious reconcilements have cleared.

f. If any items on a previous reconcilementdo not clear, list on the reconcilementform being prepared.

g. Determine that each debit and credit entryshown on the general ledger since the date

of the last reconcilement is offset by acorresponding credit or debit on the cor-respondent bank’s cut-off statement.

h. Any items on the general ledger, exceptoutstanding drafts, that are not offset byan appropriate debit or credit on the cor-respondent bank’s cut-off statement areconsidered open and should be transferredto the reconcilement form under theappropriate we debit or we credit captionalong with the date and a brief description.

i. Any items on the correspondent bank’scut-off statement that are not offset by anappropriate debit or credit on the branchgeneral ledger are considered open andshould be transferred to the reconcilementform under the appropriate they debit orthey credit caption along with the date anda brief description.

j. ‘‘We credit’’ items that represent draftsoutstanding should not be listed on the

‘‘we credit’’ section of the reconcilementform. Each outstanding draft should belisted by number on the reverse side of thereconcilement form and the total shouldbe carried forward opposite the captiondrafts outstanding. The listing shouldinclude any drafts still outstanding fromthe previous reconcilement.

k. Prove the reconcilement.

6. Determine clearance of ‘‘we debit’’ and ‘‘wecredit’’ items using later cut-off statements,when available, and:a. If an item is cleared by reversing the entry,

that is, by a subsequent offsetting debit orcredit entry on the ledger of the branchunder examination, check the entry throughto its source.




b. All material ‘‘we debit’’ and ‘‘we credit’’items that do not clear on the later cut-off statements received should be confirmed,with a copy of the confirmation tracerretained for comparison to the original

after it is returned.7. Utilizing the general ledger or appropriatesubsidiary ledger, determine clearance of ‘‘they debit’’ and ‘‘they credit’’ items. Thereason for nonclearance should be deter-mined for all ‘‘they debit’’ and ‘‘they credit’’items that do not clear in a reasonable amountof time.

8. Review the accrued interest accounts by:

a. Reviewing and testing procedures foraccounting for accrued interest and forhandling adjustments.

b. Scanning accrued interest for any unusualentries and following up on any unusual

items by tracing them to initial and sup-porting records.9. Obtain or prepare a schedule showing the

accrued interest balances and the depositbalances for selected time periods since theprevious examination.a. Calculate ratios.b. Investigate significant fluctuations and/or

trends.

3070.5 Due From Nonrelated Banks: Audit Guidelines


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Financing Foreign ReceivablesEffective date July 1997 Section 3080.1

Financing foreign receivables includes openaccount financing, sales on consignment,advances against collections, banker’s accep-

tances, factoring, and forfaiting. Certain foreignreceivables are guaranteed or insured for creditand political risk by the Export-Import Bank of the United States, the Foreign Credit InsuranceAssociation, or other American and foreignorganizations.

OPEN ACCOUNT FINANCING

The simplest method of financing foreign receiv-

ables is on open account. In such a sale, thebuyer and seller agree on payment at a specifieddate without any negotiable instruments, such asa draft or acceptance, evidencing the obligation.In most instances, the shipping documents aresent directly to the buyer rather than through abank. The exporter may request the buyer tomake payment to the bank in which the exportermaintains an account. The advantages of anopen account sale are its simplicity and the lack of bank charges and stamp duties applied todrafts by certain countries.

The financing of open account sales containscertain risks. The lending bank and exporterhave no control over the documents and thebuyer (importer) may take possession of thegoods without the bank’s or the exporter’sconsent. In addition, if the importer does notregister the goods with the proper authorities,the dollar or other exchange may not be avail-able at the time of payment. Probably the

greatest risk in open account financing is thelack of standard trade financing documentationon which to base legal action against the importerin the event of default. Therefore, open accountsales are most appropriate when the buyer(importer) is a subsidiary of a related companyor is well-known to the seller.

SALES ON CONSIGNMENT

Under a consignment arrangement, goods areconsigned to the importer (consignee) abroadand the exporter (consignor) retains title to themuntil they are sold to a third party. However,unless the shipment is made to an exporter’soverseas branch or subsidiary, the credit risk is

considerable. As with open account sales, thereis a lack of standard trade financing documen-tation on which to base legal action if the

consignee defaults. The exporter should thor-oughly understand the inherent credit risks,especially when goods are consigned to anagent, representative, or import house abroad.

In countries with free ports or free tradezones, consigned goods may be placed in abonded warehouse in the name of a foreign bank or branch of the bank. Arrangements may thenbe made to release the consigned merchandise atthe time it is sold. Merchandise is clearedthrough customs after the sale has been com-

pleted. However, that type of consignment shouldnot be made and will not usually be accepted bymany foreign banks until all pertinent condi-tions, regulations, and storage facilities are veri-fied. The exporter’s bank also should verify thatgoods not sold may be returned to the country of origin. Bank financed consignment shipmentsshould be limited to those countries that do nothave burdensome foreign exchange restrictionsand have sufficient foreign exchange availableto pay for imports.

To overcome the disadvantages of financingshipments on an open account or consignmentbasis, exporters frequently ship goods againstdocumentary collections. That practice meansthat the exporter, in the case of a time or arrivaldraft, and the exporter and the importer, jointly,in the case of a sight draft, finance(s) theshipment. The exporter and the importer mayhave unused credit lines with their banks and beable to borrow the needed money without tyingthe financing to the trade transaction. Often,

however, the exporter’s or the importer’s regularbank lines are used up for other transactions.Consequently, they may ask their bankers toprovide financing through advances against out-ward collections, discounting trade acceptances,bankers’ acceptances, factoring, or forfaiting.

ADVANCES AGAINST FOREIGN

COLLECTIONSA manufacturer or merchant conducting a strictlydomestic business often gets a loan from a bank,finance company, factor, or forfaiter by usingaccounts receivable as security. Because out-ward collections are the same as foreign receiv-




ables, the same general type of financing vehicleis available to exporters.

A common method of financing foreignreceivables is for the exporter to pledge alloutward collections to its bank. The exporter

may then borrow from the bank up to a statedmaximum percentage of the total amount of receivables pledged at any one time. Whennotes, rather than drafts, are used to financeforeign collections, they are usually paid ondemand enabling the exporter to increase ordecrease the loan depending on need and thecurrent amount of collections outstanding. Pref-erably, all of the collections lodged with theexporter’s bank should be pledged to the bank.When a particular collection is paid, it is remit-

ted by the foreign collecting bank to the domes-tic bank that has advanced the funds. The latteruses the proceeds of the collection to reduce theexporter’s loan. Some exporters have no needfor a continuous financing arrangement butoccasionally may wish to obtain financing ononly one large foreign collection. In suchinstances, the branch may be willing to advancemoney with only that one receivable as security.Again, the branch establishes a maximum per-centage of the amount of the draft that it is

willing to advance. When payment for thereceivable is obtained, the branch uses theproceeds to liquidate the loan, crediting anyexcess to the exporter. Bank financing in theform of advances against export collections is anaccepted practice in international trade and isnot considered factoring.

Besides having a pledge on the exporter’soutward collections, the branch usually retainsrecourse to the exporter whose financial condi-tion and reputation are of prime importance.

Other factors, however, are also significant. If the foreign importers are prime companies withundoubted reputation and financial strength, thebranch will probably advance a larger percent-age on collections directed to them. The branchwill also advance a larger percentage of funds toimporters in those countries that promptly paydrafts drawn on them. In other countries, wherepayment is generally slow, perhaps becauseimporters are financially weak or because U.S.dollar or other foreign currency exchange ishard to obtain, the branch will advance a lowerpercentage on collections. Certain collections tohabitually slow paying importers or countriesmay be entirely ineligible for financing.

When a branch advances against foreign col-lections, it must carefully scrutinize the support-

ing documents. Because the branch wishes tomaintain control of the merchandise, the bill of lading should be either to the order of the shipperand blank endorsed or to the order of the branch.The bill of lading must not be consigned to the

buyer (importer); otherwise, the buyer has con-trol over the goods. In addition, shipmentsfinanced should be covered by adequateinsurance.

DISCOUNTING TRADEACCEPTANCES

A draft accepted by the foreign buyer becomes atrade acceptance, carrying the full credit obliga-

tion of the importer. Such trade acceptances arealso frequently called trade bills or trade paper.The acceptance is returned to, and becomes theproperty of, the exporter, who will ask thecollecting bank to present it to the acceptor forpayment at maturity. The exporter is, therefore,providing the financing or carrying its ownforeign receivables. However, if the exporterneeds the funds before maturity of the tradeacceptance, the exporter may ask the branch todiscount the draft with or without recourse. If

the primary obligor (acceptor) is a well-knowncompany of good credit standing, the branchmay be willing to discount the draft withoutrecourse to the exporter. More commonly, how-ever, the lending bank looks to the exporter forrecourse, should the primary obligor fail to paythe amount when due.

When discounting a trade acceptance, thebranch advances the face amount of the draft tothe exporter, minus discount charges, until thematurity date. In that case, the branch is buying

the trade acceptance for value and is entitled toany benefits due it from the primary obligor as aholder in due course of a negotiable instrument.That is also the case whenever the branch makesadvances against a single collection or a pool of collections. Any intermediary collecting bank also has a financial interest in the collection andhas all the rights of a holder in due course underthe Uniform Commercial Code.

BANKER’S ACCEPTANCESCREATED AGAINST FOREIGNCOLLECTIONS

During periods of tight money, branches maychoose to finance foreign collections by using

3080.1 Financing Foreign Receivables


Page 2



banker’s acceptances. Banker’s acceptances arediscussed separately in this manual, so thefollowing comments relate only to the financingof foreign collections.

As with all acceptance financing, the exporter

first submits a signed acceptance agreement toits bank. To obtain acceptance financing forforeign receivables, the exporter draws twodrafts. The first is a time draft drawn on theforeign buyer (importer) that, along with thenecessary documents, is sent for collection inthe usual manner. The other draft, for the sameor smaller amount as agreed on by the branchand exporter, is drawn by the latter on the branchand has the same tenor as the draft drawn on theimporter. The branch accepts the latter draft and

discounts it, crediting the net amount to theexporter’s account. The branch has now createda banker’s acceptance that can be sold in thehighly liquid acceptance market, provided thebranch’s reputation is fully established. Whenpayment is received from the importer, thebranch applies the proceeds to pay its ownacceptance, which will be presented for paymentif sold in the market. Should the importerdefault, the branch has recourse on the drawerand can demand payment from that source.

FACTORING

A factor buys accounts receivable with or with-out recourse. In the past, factoring was usedprimarily in domestic trade in certain industries,such as textiles. In recent years, however, sev-eral domestic factors have established foreignaffiliates or invested in foreign finance compa-nies and several banks have purchased or estab-

lished factoring firms to finance foreign trade.Branches are also financing foreign trade byfactoring.

Factoring is the purchase, on a withoutrecourse basis, of the accounts receivable of aclient. Factoring differs from asset-based lend-ing financing, in that the factor assumes thecredit and collection risk associated with thereceivables. In asset-based lending these risksremain with the client. Among the principaladvantages of factoring to the client, is that theclient is certain of the collection of the proceedsof its sales, regardless of whether or not thefactor is paid. Other advantages of factoring arethat the client does not have to maintain a creditdepartment to evaluate the creditworthiness of customers and collect past due accounts or

maintain bookkeeping or accounting recordspertaining to the status of receivables. Theseresponsibilities have been assumed by the fac-tor. In addition, under the terms of an advancefactoring arrangement, the client receives pay-

ment for its receivables before the time agreedupon under the normal terms of the invoice.Maturity factoring and advance factoring are

two basic types of service offered by the indus-try. In maturity factoring, an average maturitydue date is computed for the receivables pur-chased during a period and the client receivespayment on that date. Advance factoring usesthe same computations; however, the client hasthe option of taking advance payments equal toa percentage of the balance due at any time prior

to the computed average maturity due date. Theunadvanced balance, sometimes called the cli-ent’s equity, is payable on demand at the duedate.

The typical factoring agreement stipulatesthat all accounts receivable of a client areassigned to the factor but not all are purchasedwithout recourse. The agreement between thefactor and the client will usually state thatreceivables subject to shipping disputes, errors,returns, and adjustments are chargeable back to

the client because they do not represent bonafide sales. In addition, sales made by the clientwithout the factor’s approval are consideredclient risk receivables, with full recourse to theclient if the customer fails to pay. The usualapproval process requires the client to contactthe factor’s credit department before filling asales order on credit terms. The credit depart-ment will conduct a credit review, determine thecreditworthiness of the customer and approve orreject the sale. If the credit department rejects

the sale, the client may complete the sale but atthe client’s own risk. The most commonlyrejected sales are those to affiliates, to knownbad risks, to customers whose credit cannot beverified, and to those customers whose outstand-ing payables exceed the factor’s credit line tothose customers.

Once a sale has been made and the receivable,whether or not approved, is assigned to thefactor, the client’s account will be credited forthe net invoice amount of the sale. Trade orvolume discounts, early payment terms, andother adjustments are deducted from the invoiceamount. The receivable then becomes part of theclient’s availability to be paid in advance or atthe computed date, depending upon the basis of the factoring arrangement.

Financing Foreign Receivables 3080.1




Factoring Foreign Receivables

A factor who purchases a foreign receivablemust approve the credit standing of a specifiedforeign obligor before the sales contract is

concluded. If the foreign buyer’s credit is notapproved, the exporter may still make the ship-ment but at its own risk. If shipments to approvedimporters are made on a documentary collectionbasis, the drafts and documents are submitted tothe factor who purchases them without recourse.The factor pays the money to the exporter eitherat the average maturity date, when actuallyreceived or, if financing is also required, imme-diately. Thereafter, the drafts and documents arerouted through commercial banks for collection.

Because the factor owns the drafts and docu-ments, the collection process is undertaken forits account. Occasionally, a factor will make useof its own credit line with a commercial bank tocarry receivables purchased from the exporteruntil payment is received from the ultimatebuyer.

When financing imports, the factor mayarrange for the opening of a letter of creditthrough its bank in favor of an overseas supplier.

The factor becomes an intermediary between itscustomer and the bank, substituting its owncredit for that of the client. Because the factor isguaranteeing the letter of credit, the bank iswilling to open the credit, which it might nothave done for the importer directly.

When the goods are shipped, the title docu-ments are either consigned or endorsed over tothe factor. The factor, in turn, releases thedocuments to the importer against either a trustreceipt or warehouse receipt. All proceeds from

subsequent sales are turned over to the factor.Once the final sale has been made to a customerapproved by the factor, an account receivable iscreated. The factor, according to its agreementwith the customer, buys that receivable withoutrecourse.

When the bank turns over the shipping docu-ments to the factor, arrangements must be madeto pay under the sight letter of credit. The factormay pay the bank from its own funds. The goodsare cleared through customs and the factor is

paid on the average or final maturity date of theaccounts receivable, which the factor has boughtfrom its customer without recourse.

Time letters of credit are paid to the bank bythe factor at maturity and the resulting accep-tances are charged to the customer’s account for

payment to the factor when due.

Frequently, instead of making immediate pay-ment under a sight letter of credit, the factor willutilize its credit line with the bank. This optionmay be taken by either asking the bank to create

a banker’s acceptance or by charging the fac-tor’s loan account. In both instances, the factormust pay the bank at maturity of the acceptanceor loan. Such maturities should coincide asclosely as possible with the expected payment of the accounts receivable by the ultimate customer.

A factor buying foreign accounts receivablescreated through open account shipments followsthe same basic procedures as in purchasingdomestic receivables. As discussed heretofore,the exporter and financing institution could lose

control over the goods because the shippingdocuments are consigned directly to theimporter. Consequently, open account shipmentsshould be conducted only with prime foreignbuyers.

Client Records

A client’s balance sheet will have a due from

factor account instead of accounts receivable.The account balance may be somewhat lowerthan a normal receivables balance, thus affectingturnover ratios and other short-term ratios. Thedifference relates to the client’s ability to con-vert sales to cash faster with a factor than if thereceivables were to be collected by the client.

Each month, the client receives an accountscurrent statement from the factor, detailing trans-actions on a daily basis. This statement reflectsthe daily assignments of receivables, remit-

tances made (including overadvances andamounts advanced at the client’s risk), deduc-tions for term loans, interest charges, and fac-toring commissions. Credit memos, client risk charge-backs, and other adjustments also will beshown. Client risk charge-backs are the amountsdeducted from the balance due to the client uponthe failure of customers to pay receivablesfactored at client risk. The accounts currentstatement and the availability sheets are neces-sary for asset analysis. The accounting systemthat develops this data probably will be auto-mated, allowing the factor to compare andmonitor data on the client. Examiners shoulduse the data provided, within client records,toenhance the asset analysis process for thesetypes of credits.



Page 4



Factor Records

The factor’s balance sheet reflects the purchasedaccounts receivable as factored receivables onthe asset side and due to clients as the corre-

sponding liability. Usually, the due to clientsbalance will be less than the factored receivablesbalance because of payments and advances tothe clients. If, however, the factor makesadvances to the client for greater amounts thanare due to the client, these amounts will bereflected on the asset side of the balance sheet asoveradvances. Overadvances are tantamount tounsecured loans. A limit on the amount of overadvances available at any one time to theclient should be included in the factoring agree-

ment. Such limitation is generally based upon,but not necessarily secured by, the amount of theclient’s inventory. This relationship is usedbecause, theoretically, the inventory will be soldto generate receivables that the factor has con-tracted to purchase. The proceeds from thefactored receivables will then be used to repaythe overadvance. The factor’s income statementwill show factoring commissions that representthe discount on the receivables purchased asincome. Interest income for advances on the due

to client balances may or may not be a separateline item.

An analysis of the changes in the relativeproportions of the due to clients account shouldprovide valuable input into the analysis of theearnings of a branch’s factoring operation.Because factoring is a highly competitive indus-try, price cutting has reduced factoring commis-sions to a point where they provide minimalsupport to earnings; therefore, the interest mar-

gins on factoring advances have a significantimpact on net income. The implication of theanalysis of proportional changes is that as moreclients take advances (reducing due to clients),profit margins should widen. Conversely, as thedue to clients proportion of total liabilities rises,profit margins may be expected to narrow.

Evaluating the Factoring Operation

The evaluation of a branch’s factoring operationincludes: (a) a review of its systems and con-trols, and (b) an analysis of the quality of itsassets. A major portion of a factor’s assets willbe factored receivables, for which the creditdepartment has the responsibility for credit qual-

ity and collection. The other major portion of theassets will be the client loans and credit accom-modations, such as overadvances and amountsadvanced at the client’s risk, for which theaccount officers are responsible.

Any factor’s ability to buy receivables with-out recourse is predicated on its ability to makesound credit judgments regarding buyers. Thefactor, therefore, replaces the credit and, in part,the receivables bookkeeping departments of sell-ers. The credit department maintains a credit filefor each of its client’s customers, which arecontinually updated as purchases are made andpaid for by the customers. These files includefinancial statements, credit bureau reports, anddetails of purchasing volume and paying habits.

Credit information on domestic buyers is easierto obtain than on buyers located overseas. How-ever, by establishing foreign affiliates, factorshave improved their ability to determine thecredit standing of foreign importers.

Systems and Controls

Considering the large volume of daily transac-

tions that flows through a factor, any internalcontrol that can be easily negated represents apotential problem. The review of the factoringdepartment’s internal systems and controlsshould be continuous during the examination.This review should include the credit controlsfor both clients and customers. Credit controlsand systems must be responsive to the identifi-cation of these problems because problems candevelop rapidly in factoring. Earnings are evalu-ated in terms of the department’s own perfor-

mance. The factoring department’s earningstrends may be evaluated by using a comparativeyield on assets approach. By analyzing yields onasset categories from period to period, theexaminer will be able to make a judgment as tothe efficiency of the systems. Factors are subjectto the same price competition in the commercialfinance market as accounts receivable finan-ciers. Declining portfolio yields may reflect theinroads made by competition and may indicate adecline in future profitability.

Asset Evaluation

The asset evaluation involves an evaluation of (1) credit accommodations to each client and





(2) customer receivables purchased by the factorat its own risk. For the first part of the evalua-tion, generate a list of each client’s aggregatecredit exposure to the factor, both direct andindirect, including overadvances and receiv-

ables purchased at the client’s risk. For thesecond part of the evaluation, use the agingschedule of factored receivables aggregated bycustomer but net of client risk receivables.Select clients and customers for review basedupon the same selection methods used for thecommercial loan review. Clients with high dilu-tion of receivables (i.e., customer nonpaymentdue to returns, shipping disputes, and errors andthe like) and those with client risk receivablesequal to 20 percent or more of factored volume

may also be included.

Credit Accommodations to EachClient

In order to evaluate credit accommodations toeach client, generate a list of each client’saggregate credit exposure to the factor, bothdirect and indirect, including overadvances and

receivables purchased at the client’s risk.Although past due status is an essential elementin evaluating customer accounts, it should benoted that for its clients, a factor usually collectsprincipal and interest payments directly from theclient’s availability. This practice means that theexpected delinquency rate is minimal. Past duevolume is not an effective measure of clientquality.

A client’s availability is the sum of all fac-tored receivables, less trade and other discounts,

factoring commissions, client risk charge-backs,and other miscellaneous charges to the client’saccount. There may also be other deductions forletters of credit and other credit accommoda-tions. An advance client’s availability would befurther reduced by advances on the factoredreceivables, interest charges, and the reciprocalof the contractually agreed upon advance per-centage. This reciprocal, 20 percent in the caseof an 80 percent advance client, is sometimesreferred to as the client’s equity in the factoredreceivables. Availability may be increased byliens on additional collateral, such as inventory,machinery and equipment, real estate, and othermarketable assets. Loans against this type of collateral may be handled in the commercialfinance section of a factoring department.

An analysis of the client’s balance sheetshould incorporate an assessment of the client’sability to absorb normal dilution and the poten-tial losses associated with client risk receiv-ables, particularly when these elements are

higher than usual for the portfolio. The analysisalso should consider the client’s ability to repayany advances received from the factor in theform of overadvances, term loans, or othercredit accommodations.

When classifying the credit exposure to aclient, the client risk receivables portion of factored volume is the only amount appropriatefor use in the classification. Because of therecourse aspect, the balance is considered as anindirect obligation rather than a direct obliga-

tion. Any other credit accommodations to aclient that are not reflected in factored receiv-ables, such as overadvances, term loans, etc., arealso appropriate for classification. Asset quality,as measured by classifications, may be influ-enced by seasonal aspects of clients’ businessesand should be carefully analyzed allowing forsuch influences.

Customer Receivables Purchased bythe Factor at its Own Risk

To evaluate receivables purchased by the factorat its own risk, use the aging schedule of factored receivables aggregated by customer butnet of client risk receivables. Select customersfor review based upon the same selectionsmethods used for the commercial loan review.Past due volume is an essential element in

evaluating customer accounts. In addition, cus-tomer files maintained by the factor shouldinclude financial statements and an analysis of the customers’ financial condition.

When classifying credit exposure to a cus-tomer, factored receivables are appropriate forclassification. Care should be taken not to clas-sify any receivables that have already beenclassified under client risk exposure.

FORFAITING

A number of financial institutions are financingreceivables from Eastern European and devel-oping countries by a method called forfaiting.



Page 6



Forfaiting is nonrecourse financing of receiv-ables similar to factoring. However, while afactor normally purchases a company’s short-term receivables, a forfait bank purchases notesthat are long-term receivables with maximum

maturities of eight years. The forfaiting bank hasno recourse to the seller of the goods but gets thenotes at a substantial discount for cash.

The centers of forfaiting are Zurich andVienna, where many large banks, includingAmerican institutions, provide forfaiting througheither their branches or specialized subsidiaries.

Forfaiting is used when government exportcredits or credit guarantees are not available orwhen a seller does not extend long-term creditsto areas, such as Eastern Europe. Forfaiting is

also an important method of financing for smalland medium-sized companies because it enablesthem to negotiate transactions that would nor-mally exceed their financial capabilities. Byusing forfaiting, small and medium-sized con-cerns can immediately sell their long-termreceivables without recourse.

The examiner should review the branch’sforfaiting activities carefully to determine whetherlong-term receivables have been purchased from

countries prone to frequent political changes andfluctuations in exchange rates. In addition, theother risks peculiar to factoring are present inforfaiting, along with the risks associated withthe long-term nature of receivables purchased.

U.S. AND FOREIGNRECEIVABLES GUARANTEE AND

INSURANCE PLANS

To reduce credit, political, and other risks asso-ciated with foreign receivables financing,branches may avail themselves of a variety of guarantee and insurance plans, both public andprivate, that are available in many countries.

Because of the complexity of the numerousplans available, an examiner must frequentlyrely on the technical knowledge of the staff of the branch. Nevertheless, the examiner shouldknow the risk coverage and claim adjustmentprovisions of the major plans. Often a branch’sexperience with its receivables insurance andguarantee plans indicates its effectiveness andwhether the branch has properly met its respon-sibilities under the programs.

THE EXPORT-IMPORT BANK OFTHE UNITED STATES

The Export-Import Bank of the United States(Eximbank) issues to commercial banks, for a

fee, guarantees of payment for foreign receiv-ables that the branch purchases from exporters,generally without recourse to the latter. Thematurities of the receivables range from 181days to over five years. Generally, the foreignbuyer must make a cash payment, either beforeor upon delivery, of at least 10 percent of theinvoice value and the amount of receivablespurchased by the branch without recourse to theexporter normally cannot exceed 90 percent of the financed portion of the sale (invoice amount

less cash payment). That guarantee coverspolitical risks, such as inconvertibility of foreigncurrencies into U.S. dollars, governmental actionspreventing importation of goods, war, civil strife,expropriation, and confiscation by governmentaction. Commercial risks, basically the creditrisk of the foreign purchaser, usually are coveredfrom six months to five years.

THE FOREIGN CREDITINSURANCE ASSOCIATION

The Foreign Credit Insurance Association (FCIA)is an association of leading marine, property,and casualty insurance companies. In coopera-tion with Eximbank, FCIA offers a comprehen-sive selection of credit insurance policies, whichprotect policyholders against loss from failure toreceive payment from foreign buyers.

FCIA coverage protects the exporter againstthe failure of the buyer to pay dollar obligationsfor commercial or political reasons; enables theexporter to offer foreign buyers competitiveterms of payment; supports the exporter’s pru-dent penetration of higher risk foreign markets;and, gives the exporter greater financial liquidityand flexibility in administering a foreign receiv-ables portfolio.

The FCIA does not itself finance export sales;however, the exporter who insures accountreceivables against commercial and politicalrisks is usually able to obtain financing fromcommercial banks and other lending institutionsat lower rates and on more liberal terms thanwould otherwise be possible by assigning theproceeds of the FCIA insurance to the lenders.





Comprehensive FCIA policies protect insur-ers against nonpayment of receivables due tounforeseeable commercial and political occur-rences. Commercial risks that are coveredinclude insolvency or protracted default, which

may be caused by economic deterioration in thebuyer’s market area, shifts in demand, unantici-pated competition, tariffs, or technical changes.Political risk coverage applies to defaults due togovernment action, such as currency inconvert-ibility, expropriation, and cancellation of importlicense and to political disturbances such as war,revolution, and insurrection.

FCIA generally offers four basic types of insurance policies covering political and com-mercial risks (Source: Washington Agencies

that Help to Finance Foreign Trade, SeventhEdition, Bankers Trust Company, N.Y.C.):

1. Short-term policies covering shipments nor-mally sold on terms up to 180 days. Theusual policy covers 100 percent of politicalrisk and 90 percent of any losses fromcommercial risk.

2. Minimum-term policies insuring transactionsfrom six months to five years. FCIA coversup to 90 percent of commercial risks and up

to 100 percent of political risks, with theremainder retained by the exporter.

3. Combined short-term/medium-term policiesfor sales that pass through distributors beforereaching final buyers.

4. Master policies that include the basic insur-ance features of the previous policies, plus

discretionary and deductible provisions. Undera master policy, usually only for short-termand seldom for medium-term transactions,exporters may obtain FCIA authority to grantinsured credit up to a certain amount withoutseeking prior approval. The deductible pro-vision, used only for commercial risks andnot political risks, requires the exporter toassume a fixed amount of the first loss ontotal debts.

OTHER INSURERS

There are numerous other private and govern-mental institutions, both in the U.S. and over-seas, that guarantee or insure risks assumed bybanks financing foreign receivables. Some for-eign examples are the Export Credits GuaranteeDepartment (ECGD) in the United Kingdom,COFACE in France, and HERMES in West

Germany.



Page 8



Financing Foreign ReceivablesExamination ObjectivesEffective date July 1997 Section 3080.2

1. To determine if the policies, practices, pro-cedures, and internal controls regarding the

financing of foreign receivables are adequate.2. To determine if branch officers are operatingin conformance with established branchguidelines.

3. To evaluate the portfolio for credit quality,collectibility, and collateral sufficiency.

4. To determine the scope and adequacy of theaudit function as it relates to the financing of

foreign receivables.5. To recommend corrective action when poli-cies, practices, procedures, or internal con-trols are deficient.




Financing Foreign ReceivablesExamination ProceduresEffective date July 1997 Section 3080.3

1. If selected for implementation, complete orupdate the Internal Control Questionnaire.

2. Determine the scope of the examinationbased on the evaluation of internal controlsand the work performed by internal andexternal auditors.

3. Test for compliance with policies, practices,procedures, and internal controls in conjunc-tion with performing the remaining exami-nation procedures. Obtain a listing of anydeficiencies noted in the latest reviews byinternal and external auditors from theexaminer performing the audit assignment,

and determine if appropriate correctionshave been made.

4. Obtain the following information for:

a. Open Account Financing:

• Whether the shipment is directed tothird parties or branches and subsidi-aries of the borrower.

• The financial strength and trustworthi-ness of the overseas buyer.

• The extent of foreign exchange control

and the availability of exchange for theimporter to effect payment.

• The branch’s past experience in deal-ing with the borrower who sells onopen account.

b. Sales on Consignment:

• Whether the shipment is directed tothird parties or branches and subsidi-aries of the obligor.

• The financial strength and trustworthi-

ness of the foreign consignee.• The responsibilities of the foreign salesagent, overseas representative, or importhouse under contract.

• The extent of foreign exchange controland the availability of exchange forthat type of transaction in the countryof destination.

• Whether the borrower’s goods withouta definite buyer are consigned abroadin the name of the borrower’s bank or

a foreign bank.• Whether the goods being shipped are

assigned to a responsible warehouse.

• Any arrangements that have been madewhereby the selling agent negotiatesfor the sale of the goods.

• The regulations in the country of des-tination regarding the return of unsold

consigned goods to the country of origin.• The branch’s past experience in deal-

ing with the borrower who sells onconsignment.

c. Advances Against Collections:• The relationship between the amount

collected in a month on the collectionspledged as collateral and the borrow-er’s credit limit.

• The tenor of sight drafts stated number

of days after sight or a stated numberof days after the date of the draft.

• Instructions regarding delivery of docu-ments against payment (D/P) or docu-ments against acceptance (D/A).

• Whether amounts advanced against col-lections are within the percentage of advance limitation established.

• Aging of drafts (collections).• Ineligible drawees, including house

bills.

• Concentrations of drawees.• Financial strength of drawees.• Unusual situations such as disputes,

nonacceptance of goods, and posses-sion of goods without payment.

• Dishonor and protest instructions.• Any special instructions.• The extent of foreign exchange con-

trols and the availability of exchangefor that type of transaction in thecountry of destination.

• The branch’s experience in dealingwith the borrower who receivesadvances against collections.

d. Discounted Trade Acceptances:• The relationship between the amount

collected in a month on the tradeacceptances discounted and the bor-rower’s credit limit.

• Whether the branch discounted thetrade acceptance with or withoutrecourse.

• Whether the borrower retains a per-centage of the trade acceptanceendorsed to the branch.

• Aging of trade acceptances.• Ineligible drawees, including house

bills.




• Concentrations of drawees.• Financial strength of the drawees.• Unusual situations, such as disputes,

nonacceptance of goods, and posses-sion of goods without payment.

• Dishonor and protest instructions.• Any special instructions.• The extent of foreign exchange con-

trols and the availability of exchangefor that type of transaction in thecountry of destination.

• The branch’s experience in dealingwith the borrower for whom its tradeacceptances are discounted by thebranch.

e. Banker’s Acceptance Financing:

• The relationship between the amountcollected from the foreign buyer in amonth and the borrower’s credit limit.

• Whether the discounted draft drawn bythe exporter (customer) on the export-er’s bank has the same tenor as thedraft addressed to the foreign buyer.

• The procedures for applying paymentreceived from the foreign buyer to paythe branch’s own acceptance.

• Aging of time drafts drawn on theimporter (drawee).

• Ineligible foreign buyers (drawees),including house bills.

• Concentrations of foreign buyers(drawees).

• Financial strength of the foreign buy-ers (drawees).

• Disputes, nonacceptance of goods, andpossession of goods without payment.

• Dishonor and protest instructions.

• Any special instructions.• The extent of foreign exchange control

and the availability of exchange forthat type of transaction in the countryof destination.

• The branch’s experience in dealingwith the borrower.

f. Factoring:• The extent of factor guarantees (letters

of credit opened by the branch in favorof overseas suppliers).

• Whether the title documents on importtransactions are consigned to orendorsed over to the factor.

• Whether the importer who receivesgoods under trust receipt agrees tohold them in trust for the factor.

• Whether the imported goods held underwarehouse receipt are stored in anindependent warehouse for the accountof the factor.

• Whether banker’s acceptances are

charged to the branch customer’saccount for payment to the factor whendue.

• Whether the factor creates a banker’sacceptance pending payment of accounts receivable resulting from thesale of goods imported under letters of credit.

• The financial strength of the importerfor whom the branch opened the letterof credit.

• Any disputes, nonacceptance of goods,and possession of goods withoutpayment.

• The branch’s experience in dealingwith the factor.

g. Forfaiting:• Agings of debtor accounts purchased.• Ineligible debtor accounts purchased,

including affiliate receivables, if any.• Concentration of debtor accounts

purchased.• The adequacy of the branch’s credit

investigation before approving the sale(or signing of a sales contract) creatinga receivable.

• The financial strength of the debtoraccounts purchased.

• The capability of the exporter fromwhom receivables were purchased toprovide any required after-sales ser-vice and to honor warranties.

• Disputes and returns.• The extent of foreign exchange restric-

tions, availability of exchange, andcountry risk involved that could jeop-ardize collection of receivablespurchased.

• The branch’s experience in dealingwith both the debtors and the exporter.

h. U.S. and foreign receivables guaranteeand insurance plans:

• Whether foreign receivables coverageby FCIA, Eximbank, or other insur-ance or guarantee programs is suffi-cient, adequately identifies risks, and isconsistent with established limits.

5. Analyze secondary support offered by guar-antors and endorsers.

3080.3 Financing Foreign Receivables: Examination Procedures


Page 2



6. Determine compliance with the branch’sestablished loan policy.

7. At this point, the examiner needs to decidewhether further examination and testing isneeded. If further work is warranted, refer

to the audit guidelines. After reviewing theaudit guidelines, proceed to step 8.8. Discuss with appropriate officers and pre-

pare summaries in appropriate report formof:a. Delinquent loans.b. Loans not supported by current and com-

plete financial information.c. Loans on which documentation is

deficient.d. Loans with credit weaknesses.

e. Inadequately collateralized loans.f. Criticized loans, including supporting

commentaries.

g. Concentrations of credit.h. Other matters regarding the condition of

the department.9. Evaluate the branch with respect to:

a. The adequacy of written policies relating

to financing foreign receivables.b. The manner in which branch officers areoperating in conformance with estab-lished policy.

c. Adverse trends in those sections con-cerned with financing foreign receivables.

d. Recommended corrective action whenpolicies, practices, or procedures aredeficient.

e. The competency of departmentalmanagement,

f. Other matters of significance.10. Update the workpapers with any informa-

tion that will facilitate future examinations.

Financing Foreign Receivables: Examination Procedures 3080.3




Financing Foreign ReceivablesInternal Control QuestionnaireEffective date July 1997 Section 3080.4

POLICIES

1. Has the head office adopted policies that:a. Establish procedures for reviewing financ-

ing applications?b. Establish standards for determining credit

lines?c. Establish standards for determining the

percentage of advances made againstacceptable collections (receivables)?

d. Define acceptable receivables(collections)?

e. Establish minimum requirements for veri-

fication of borrower’s receivables(collections)?

f. Establish minimum standards for docu-mentation in accordance with the Uni-form Commercial Code?

2. Are policies reviewed at least annually todetermine if they are compatible with chang-ing market conditions?

ACCOUNTING RECORDS

If the following questions have been answered in

the Credit Risk section (3010), skip to ques-tion 9.

3. Is the preparation and posting of subsidiaryrecords performed or adequately reviewedby persons who do not also:a. Issue official checks or drafts?b. Handle cash?

4. Are subsidiary records reconciled, at leastmonthly, with the appropriate general led-ger accounts, and are reconciling itemsadequately investigated by persons who donot normally handle foreign receivablesfinancing?

5. Are inquiries regarding loan balances forforeign receivables financing received andinvestigated by persons who do not nor-mally process documents, handle settle-ments, or post records?

6. Are bookkeeping adjustments checked andapproved by an appropriate officer?

7. Is a daily record maintained summarizingtransaction details, i.e., loans made, pay-ments received, and interest collected tosupport applicable general ledger entries?

8. Are frequent debt instrument and liabilityledger trial balances prepared and recon-

ciled monthly with control accounts byemployees who do not process or recordloan transactions?

DOCUMENTATION

9. Are terms, dates, weights, description of themerchandise, etc., shown on invoices, ship-ping documents, trust receipts, and bills of lading scrutinized for differences?

10. Are procedures in effect to determine if thesignatures shown on the above documentsare authentic?

11. Are payments received from customers scru-tinized for differences in invoice dates,numbers, terms, etc.?

LOAN INTEREST

If the following questions have been answered inthe Credit Risk section (3010), skip to ques-tion 14.

12. Is the preparation and posting of loan inter-est records performed or adequately reviewedby persons who do not also:a. Issue official checks or drafts?b. Handle cash?

13. Are independent interest computations madeand compared or adequately tested to initial

loan interest records by persons who do notalso:a. Issue official checks or drafts?b. Handle cash?

COLLATERAL

14. Does the branch record a first lien onassigned foreign receivables for each bor-rower on a timely basis?

15. Do loans granted on the security of theforeign receivables also have an assignmentof the inventory?

16. Does the branch verify the borrower’sreceivables or require independent verifica-tion on a periodic basis?




17. Does the branch require the borrower toprovide aged receivables schedules on aperiodic basis?

18. Are underlying bills of lading coveringshipments either to the order of the shipper

or blank endorsed to the order of the branchrather than the foreign buyer?

19. Are the shipments being financed coveredby adequate insurance?

ADVANCES AGAINSTCOLLECTIONS ANDDISCOUNTED TRADEACCEPTANCES

20. Are permanent registers kept for foreigncollections against which advances weremade or trade acceptances were discounted?

21. Are all collections indexed in a collectionregister?

22. Do these registers furnish a complete his-tory of the origin and final disposition of each collection against which advances weremade or trade acceptances were discounted?

23. Are receipts issued to loan customers for allcollections received from them?

24. Are serial numbers or prenumbered formsassigned to each collection item and allrelated papers?

25. Are all incoming tracers and inquirieshandled by an officer or employee notconnected with the processing of collections?

26. Is a daily record maintained showing thevarious collections that have been paid andcredited to the borrower’s advance?

27. Are proceeds of paid collections credited tothe correct customer’s advance?

28. Is an itemized daily summary made of allinterest charged and received from theexporter or importer (drawee) indicatingunderlying collection numbers and amounts?

29. Are payments collected from importers(drawees) by foreign banks or branches of U.S. banks forwarded directly to the branchand not through the exporter?

30. If the exporter accepts importer (drawee)payments directly, are controls establishedor audits of exporter’s books conducted? If so, explain briefly.

31. Are employees handling collections periodi-cally rotated, without advance notification,to other banking duties?

32. Is the employee handling collection pro-ceeds required to apply them to the borrow-er’s advance on the same business day thatpayment is received?

33. Is the disposition of each collection noted

on the register so that verification of dispo-sition can be made?

34. Has a regular policy of follow-up proce-dures been established for sending tracersand inquiries on unpaid collections in thehands of correspondents?

35. Should the foreign drawee refuse to honorthe draft, are instructions clear as to whatactions should be taken by the collectingbank?

36. In the event of nonpayment of the collec-tion, is the borrower promptly notified bythe branch?

37. Are collections against which advances havebeen made or trade acceptances discounteddistinctly segregated from ordinary collec-tion items?

38. Are financed collections maintained undermemorandum control and is the controlbalanced regularly?

39. Are collections against which advances havebeen made or trade acceptances discountedbooked by persons other than employeeshandling those items?

40. Are collections carried over to the nextbusiness day adequately secured?

41. Does the customer for whom trade accep-tances were discounted know whether theywere purchased with or without recourse tothat customer?

42. Do all parties, i.e., the seller (exporter),importer (buyer), and banks, clearly under-stand whether interest, discount, and collec-tion charges are to be absorbed by the selleror paid by the importer?

FACTORING

43. Has the branch properly surrendered the

shipping documents to the factor eitherthrough endorsement or consignment?

44. Do advances or banker’s acceptances coin-cide with the expected payment of theaccounts receivable by the ultimatecustomer?

3080.4 Financing Foreign Receivables: Internal Control Questionnaire


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FOREIGN CREDIT INSURANCEASSOCIATION INSURANCE

45. Is the branch aware of risks not coveredunder its assigned FCIA insurance?

46. Does the branch monitor whether the bor-rower exceeded its FCIA established creditlimits?

47. Does the branch monitor whether the bor-rower properly assigned the proceeds of itsFCIA insurance to the branch?

48. Is the branch aware of whether the FCIAinsurance is on either simple notice or aspecial assignment basis?

49. Does the branch retain recourse to theexporter under its FCIA arrangement?

50. Has the branch reported delinquencies toFCIA in accordance with its agreement withthe Association?

51. If default occurs, does the branch file aproper claim with FCIA?

EXPORT-IMPORT BANK OF THEUNITED STATES

52. Does the branch, financing under Eximbank arrangements, have properly executedEximbank guarantees or commitments cov-ering transactions?

53. If the branch has discretionary authorityfrom Eximbank, does it nevertheless informEximbank of each transaction thereunder?

54. If the branch has been issued an equipmentpolitical risk guarantee by Eximbank, does

it have a written statement from the govern-ment of the country in which the equipmentwill be used indicating that it will permit theimportation, use, and any subsequent expor-tation of the equipment?

55. Does the branch monitor whether loan agree-ments between applicable borrowers andthe branch are acceptable to Eximbank?

56. Does the branch report delinquencies toEximbank in a timely manner, as specifiedin its agreement with that agency?

57. If default occurs, does the branch file aproper claim with Eximbank?

CONCLUSION


59. Based on the information gathered, evaluatethe internal controls in this area (i.e. strong,satisfactory, fair, marginal, unsatisfactory).

Financing Foreign Receivables: Internal Control Questionnaire 3080.4




Financing Foreign ReceivablesAudit GuidelinesEffective date July 1997 Section 3080.5

1. Test the addition of trial balances and theirreconciliation to the general ledger. Include

loan commitments and other contingentliabilities.2. If memoranda controls are maintained, pre-

pare a trial balance of each account socontrolled. Using an appropriate samplingtechnique, select representative items and:a. Review all supporting documents.b. Verify the authenticity of each item

selected and trace and clear each itemthrough final payment, including appropri-ate credit to the customer’s account.

c. In the case of unusual, altered, or long-standing items, prepare and mail confir-mation requests to customers.

d. Examine financing instruments for com-pleteness and verify dates, amounts, anditems to the trial balance.

e. Check to see that financing instrumentsare signed, appear to be genuine, and arenegotiable.

f. Check to see that required initials of anapproved lending officer are on the financ-

ing instrument.g. Determine that the amount is within the

officer’s lending limit.h. Determine that any necessary insurance

coverage is adequate and that the branchis named as loss payee.

i. Review disbursement ledgers and autho-rizations to determine if:• Authorizations are signed in accordance

with the terms of the loan agreement.• Collection funds received are credits in

accordance with provisions of the bor-rower’s loan agreement.

j. Determine that records are posted promptlyon collections settled, preferably on the

same day they are received.3. Review the applicable accrued interest

accounts by:

a. Reviewing and testing procedures of accounting for accrued interest and forhandling adjustments.

b. Scanning accrued interest for any unusualentries and following up on any unusualitems by tracing them to initial and sup-porting records.

c. Independently calculating for those credit

extensions selected in step 2, the amountof accrued interest and confirming theamount to the detail of accrued interestreceivable for that loan.

4. Using a list of nonaccruing loans, check accrual records to determine that interestincome is not being recorded.

5. Test appropriate records to determine thatdiscount, commissions, fees, and collectioncharges are in accordance with established

amounts and that the income accounts areproperly credited.

6. Obtain or prepare a schedule showing themonthly interest income amounts and appli-cable loan balances at each month-end sincethe last audit and:

a. Calculate yield.

b. Investigate significant fluctuations andtrends.




Other Real Estate OwnedEffective date July 1997 Section 3090.1

A branch’s authority to hold real estate restswith the laws of its respective state (if statelicensed) or the National Banking Act (if feder-

ally licensed). State and federal laws and regu-lations may dictate accounting procedures, maxi-mum holding periods, and other details relatingto other real estate owned. Examiners shouldfollow the most recent interagency guidelineswhen verifying the proper identification, report-ing, valuation, and accounting for disposal of other real estate owned (OREO).

Relevant interagency joint statements include‘‘Interagency Guidance on Accounting forDispositions of Other Real Estate Owned,’’

dated July 16, 1993, and ‘‘Interagency Guidanceon Reporting of In-Substance Foreclosures,’’dated June 10, 1993. In addition, refer to thefinal rule entitled ‘‘Real Estate Lending Stan-dards,’’ promulgated by the Federal ReserveBoard, FDIC, OTS, and OCC in December1992. See Final Rule, 57 Fed. Reg. 62890(December 31, 1992). The various state andfederal agencies may differ in terms of specificpractices and methodologies used to implementthe above guidelines. For further guidance in

this area, examiners should consult with theirrespective agencies.

Real property becomes other real estate ownedthrough:

• Conveyance in satisfaction of debts previ-ously contracted;

• Exchange for future advances to an existingborrower to fully or partially satisfy debtspreviously contracted;

• Purchase to secure debts previously contracted;

• Relocation of branch premises; or

• Abandonment of plans to use real estateacquired for future expansion for bankingpremises.

Although the borrower may still retain pos-session and legal title to the property, certaintroubled loans secured by real estate are consid-ered to be ‘‘insubstance foreclosures’’ and arealso treated as other real estate owned. Aninsubstance foreclosure situation is generallycharacterized by a borrower with little or noequity and the sale of the property is the onlysource of repayment.

ENVIRONMENTAL LIABILITY

Under federal and state environmental liability

statutes, a branch may be liable for cleaning uphazardous substance contamination of other realestate owned. In some cases, the liability mayarise before the branch takes title to a borrow-er’s collateral real estate. A property’s transitionfrom collateral to branch ownership may take anextended period of time. As the financial prob-lems facing a borrower worsen, a branch maybecome more involved in managing a companyor property. Such involvement may becomeextensive enough that the branch is deemed to

have met substantially all ownership criteria, theabsence of a clear title in the branch’s namenotwithstanding. Generally, the more involvedbranch management is in such activity, thegreater the branch’s exposure to any futureclean-up costs assessed in connection with theproperty. A more thorough discussion of envi-ronmental liability can be found in the RealEstate Loans section of this manual.

TRANSFER OF ASSETS TOOTHER REAL ESTATE OWNED

Real estate assets transferred to OREO shouldbe accounted for individually on the date of transfer, at the lower of the recorded investmentin the loan or fair value. The recorded invest-ment in a loan is the unpaid balance, increasedby accrued and uncollected interest, unamor-tized premium, finance charges, and loan-

acquisition costs, if any, and decreased by pre-vious write-downs and unamortized discount, if any. Any excess of the recorded investment inthe loan over the property’s fair value must becharged against the allowance for loan and leaselosses immediately upon the property’s transferto OREO. Legal fees should generally be chargedto expenses unless payment of the fees is for thepurpose of enhancing the property’s value (forexample, obtaining a zoning variance).

Establishing a valuation allowance for esti-mated selling expenses may also be necessaryupon transferring each property to OREO tocomply with AICPA Statement of Position 92-3,Accounting for Foreclosed Assets. According tothis pronouncement, the value of OREO prop-erties must be reported at the lesser of the fair




value minus estimated selling expenses or therecorded investment in the loan. For example, if the recorded investment of the property is $125,the fair value is $100, and the estimated sellingexpenses are $6, the carrying value for this

property would be $94. The difference betweenthe recorded investment and the fair value ($25)would be charged to the allowance for loan andlease losses at the time the property was trans-ferred to OREO. In addition, since the branchestimated it would incur selling expenses of $6,a valuation reserve for this amount must beestablished. The net of the fair value and thisvaluation reserve for selling expenses is calledthe ‘‘net realizable value,’’ and in this examplewould be $94. Changes to this valuation reserve

should be handled as outlined in the subsection‘‘Accounting for Subsequent Changes in MarketValue.’’

On the other hand, if the recorded investmentin the property is $250, the fair value is $300,and the estimated selling expenses are $18, thecarrying value of this property would be $250(the lesser of the recorded investment or the fairvalue). In this example, a valuation reserve forestimated selling expenses is unnecessary, asnetting the estimated selling expenses ($18)from the fair value ($300) would yield a netrealizable value of $282.

The transfer of a loan to OREO is consideredto be a ‘‘transaction involving an existing exten-sion of credit’’ under 12 CFR 225.63(a)(7) andis exempt from Regulation Y’s appraisal require-ment. However, under 12 CFR 225.63(b), thebranch must obtain an ‘‘appropriate evaluation’’of the real estate that is ‘‘consistent with safeand sound banking practices’’ to establish the

carrying value of the OREO. A branch mayelect, but is not required, to obtain an appraisalto serve as the ‘‘appropriate evaluation.’’ Untilthe evaluation is available, a branch should relyon its best estimate of the property’s value toestablish the carrying value. The federal bank-ing agencies have issued appraisal and evalua-tion guidelines to provide guidance to examin-ing personnel and federally regulated institutionsregarding prudent appraisal and evaluation poli-cies, procedures, practices, and standards.

The appraisal or evaluation should provide anestimate of the parcel’s market value. Refer toReal Estate Loans section of this manual for adefinition of market value. Generally, marketvalue and fair value are equivalent when anactive market exists for a property. In discussing

OREO, it is common practice to use the terms‘‘fair value’’ and ‘‘market value’’ interchange-ably. When no active market exists for a prop-erty, the accounting industry’s definition of fairvalue applies because the appraiser cannot deter-

mine a market value. The accounting industrydefinition requires the appraisal or evaluation tocontain an estimate of the property’s fair valuebased on a forecast of expected cash flows,discounted at a rate commensurate with the risksinvolved. The cash flow estimate should includeprojected revenues and the costs of ownership,development, operation, marketing, and sale. Insuch situations, the appraiser or evaluator shouldfully describe the definition of value and themarket conditions that have been considered in

estimating the property’s value.When a branch acquires a property through

foreclosure as a junior lienholder, whether or notthe first lien has been assumed, the fair value of the property should be recorded as an asset andthe senior debt as a liability. The senior debtshould not be netted against the assets. Anyexcess of the recorded investment of the prop-erty over the fair value should be charged off, asthe recorded investment may not exceed the sumof the junior and senior debt. Payments made on

senior debt should be accounted for by reducingboth the asset and the liability, and interest thataccrues on the senior debt after foreclosureshould be recognized as interest expense.

For regulatory reporting purposes, a collateral-dependent real estate loan should be transferredto OREO only when the lender has taken pos-session (title) of the collateral. Nevertheless, tofacilitate administration and tracking, branchesmay choose to include a collateral-dependentreal estate loan in the OREO portfolio as poten-tial or probable OREO. Examiners should reviewthese loans using the same criteria applied toOREO.

CARRYING VALUE OF OTHERREAL ESTATE OWNED

A branch should have a policy for periodicallydetermining the fair value of its OREO propertyby obtaining an appraisal or an evaluation, asappropriate. While the Federal Reserve has noprescribed time frame for when a branch shouldreappraise or reevaluate its OREO property, thebranch’s policy should conform to state or

3090.1 Other Real Estate Owned


Page 2



federal law, if applicable, and address the vola-tility of the local real estate market. Specifically,a branch should determine if there have beenmaterial changes to the underlying assumptionsin the appraisal or valuation that have affected

the original estimate of value. If material changeshave occurred, the branch should obtain a newappraisal or evaluation based on assumptionsthat reflect the changed conditions.

ACCOUNTING FOR SUBSEQUENTCHANGES IN MARKET VALUE

Charges for subsequent declines in the fair valueof OREO property should never be posted to theallowance for loan and lease losses. If anappraisal or evaluation indicates a subsequentdecline in the fair value of an OREO property,the loss in value should be recognized by acharge to earnings. Branches should attempt todetermine whether a property’s decline in valueis temporary or permanent, taking into consid-eration each property’s characteristics and exist-ing market dynamics. The preferred treatment

for permanent losses in value is the directwrite-down method, in which the charge toexpenses is offset by a reduction in the OREOproperty’s carrying value. If the reduction invalue is deemed temporary, the charge to earn-ings may be offset by establishing a valuationallowance specifically for that property. In theevent of subsequent appreciation in the value of an OREO property, the increase can only bereflected by reducing this valuation allowance orrecognizing a gain upon disposition, but never

by a direct write-up of the property’s value. Achange to the valuation allowance should beoffset with a debit or credit to expense in theperiod in which it occurs.

In addition to the preceding treatment of thewrite-down in the OREO value, the previoussubsection ‘‘Transfer of Assets to Other RealEstate Owned’’ discusses setting up a valuationallowance for estimated selling expenses asso-ciated with the sale of the other real estate. Thebalance of this valuation reserve can fluctuatebased on changes in the fair value of theproperty held, but it can never be less than zero.The following examples are presented to illus-trate the treatment that subsequent depreciationand appreciation would have on OREOproperties.

Depreciation in OREO Property Value

Assume a branch has written down its initialrecorded investment in an OREO property from$125 to its fair value of $100. Since the fair

value of the property was less than the initialrecorded investment, a valuation reserve forestimated selling expenses was established. Inthis example, assume these to be $6. Accord-ingly, the net realizable value was $94 ($100minus $6). Next, assume a new appraisal indi-cates a fair value of $90, reducing the estimatedselling expenses to $5. Although the branchmust expense the depreciation in the fair value($10), the valuation reserve for selling expenseswould be reduced by the difference in the

estimate of the selling expenses ($1). Given thisscenario, the ‘‘adjusted’’ net realizable valuewould be $85 ($90 minus $5).

Appreciation in OREO Property Value

Assume a branch has written down its recordedinvestment in an OREO property to its fair valueof $100. Since the fair value of the property was

less than the original recorded investment, anestimated valuation reserve for selling expensesof $6 was established. Accordingly, the netrealizable value was $94. A new appraisalindicates an increase in the fair value of theproperty to $110, with selling expenses nowestimated at $7. As a result, the net realizablevalue is now $103. Given that the new netrealizable value is greater than the recordedinvestment of $100, the selling expense valua-tion reserve is no longer necessary and the $6

can be reversed to income. Notwithstanding theproperty’s increased fair value, the recordedinvestment value cannot be increased above$100. The valuation reserve for selling expensescan never be less than zero, thus prohibiting anincrease in the value of the property above therecorded investment.

ACCOUNTING FOR INCOME ANDEXPENSE

Gross revenue from other real estate ownedshould be recognized in the period in which it isearned. Direct costs incurred in connection withholding an OREO property, including legal fees,

Other Real Estate Owned 3090.1




real estate taxes, depreciation, and direct write-downs, should be charged to expense whenincurred.

A branch can expend funds to develop andimprove OREO when it appears reasonable to

expect that any shortfall between the property’sfair value and the branch’s recorded book valuewill be reduced by an amount equal to or greaterthan the expenditure. Such expenditures shouldnot be used for speculation in real estate. Theeconomic assumptions relating to the branch’sdecision to improve a particular OREO propertyshould be well documented. Any payments fordeveloping or improving OREO property aretreated as capital expenditures and should bereflected by increasing the property’s carrying

value.

DISPOSITION OF OTHER REALESTATE OWNED

OREO property must be disposed of within anyholding period established by state law and, inany case, as soon as it is prudent and reasonable.Branches should maintain documentation reflect-

ing their efforts to dispose of OREO property,which should include a record of inquiries andoffers made by potential buyers, methods usedin advertising the property for sale whether bythe branch or its agent, and other informationreflecting sales efforts.

The sale or disposition of OREO property isconsidered a real estate-related financial trans-action under the Board’s appraisal regulation. Asale or disposition of an OREO property thatqualifies as a federally related transaction under

the regulation requires an appraisal conformingto the regulation. A sale or disposition that doesnot qualify as a federally-related transactionnonetheless must comply with the regulation byhaving an appropriate evaluation of the realestate, that is consistent with safe and soundbanking practices.

The branch should promptly dispose of OREOif it can recover the amount of its original loanplus additional advances and other costs relatedto the loan or the OREO property before the endof the legal holding period. The holding periodgenerally begins on the date that legal title to theproperty is transferred to the branch, except forreal estate that has become OREO because thebranch no longer contemplates using it as itspremises. The holding period for this type of

OREO property begins on the day that plans forfuture use are formally terminated. Some statesrequire OREO property to be written off ordepreciated on a scheduled basis, or to bewritten off at the end of a specified time period.

The branch should determine whether suchrequirements exist and comply with them.

ACCOUNTING FOR THE SALE OFOTHER REAL ESTATE OWNED

Gains and losses resulting from a sale of OREOproperties for cash must be recognized imme-diately. A gain resulting from a sale in which

the branch provides financing should beaccounted for under the standards described inStatement of Financial Accounting Standards 66(SFAS 66).

SFAS 66 recognizes that differences in termsof the sale and in selling procedures lead todifferent profit recognition criteria and methods.Branches may facilitate the sale of foreclosedreal estate by requiring little or no down pay-ment, or by offering loans with favorable terms.

Profit shall only be recognized in full when thecollectibility of the sales price is reasonablyensured and when the seller is not obligated toperform significant activities after the sale toearn the profit. Unless both conditions exist,recognition of all or part of the profit shall bedeferred. Collectibility of the sale price of OREOproperty is demonstrated when the buyer’sinvestment is sufficient to assure that the buyerwill be motivated to honor his or her obligationto the seller rather than lose the investment.

Collectibility shall also be assessed by consid-ering factors such as the credit standing of thebuyer, age and location of the property, andadequacy of cash flow from the property.

The practice of recognizing all profit from thesale of branch-financed OREO at the time of thesale is referred to as the full-accrual method. Abranch shall not recognize profit using thismethod until all of the following general criteriaare met:

• A sale is consummated.• The buyer’s initial and continuing investments

adequately demonstrate a commitment to payfor the property.

• The branch’s loan is not subject to futuresubordination.



Page 4



• The branch has transferred to the buyer theusual risks and rewards of ownership in atransaction that is in substance a sale, and ithas no substantial continuing involvement inthe property.

A sale will not be considered consummateduntil the parties are bound by the terms of thecontract, all consideration has been exchanged,and all conditions precedent to closing havebeen performed.

Initial investment, as defined by SFAS 66,includes only cash down payments, notes sup-ported by irrevocable letters of credit from anindependent lending institution, payments bythe buyer to third parties to reduce existing debt

on the property, and other amounts paid by thebuyer that are part of the sale price. In thesesituations, SFAS 66 requires that profit on thesale be deferred until a minimum down paymenthas been received and annual payments equalthose for a loan for a similar type of propertywith a customary amortization period. Theamount of down payment required varies bycategory of property: land, 20–25 percent; com-mercial and industrial, 10–25 percent; multifam-ily residential, 10–25 percent; and single-familyresidential, 5–10 percent. Ranges within thesecategories are defined further in the statement.

Continuing investment requires the buyer tobe contractually obligated to make level annualpayments on his or her total debt for the pur-chase price of the property. This level annualpayment must be able to service principal andinterest payments amortized for no more than 20years for raw land, and for no more than thecustomary amortization term for a first-mortgage

loan by an independent lending institution forother types of real estate.

If a branch finances the sale of foreclosedproperty it owns with a loan at less than currentmarket interest rates or noncustomary amortiza-tion terms, generally accepted accounting prin-ciples require that the loan be discounted tobring its yield to a market rate, using a custom-ary amortization schedule. This discount willeither increase the loss or reduce the gainresulting from the transaction. Interest income is

then generally recognized at a constant yieldover the life of the loan.

If a transaction does not qualify for thefull-accrual accounting method, SFAS 66 iden-tifies alternative methods of accounting for salesof OREO property as described below.

The Installment Method

This method is used when the buyer’s downpayment is insufficient to allow the full-accrualmethod, but when recovery of the cost of the

property is reasonably assured if the buyerdefaults. The installment method recognizes thesale of the property and the booking of thecorresponding loan, although profits from thesale are recognized only as the branch receivespayments from the buyer. Under this method,interest income is recognized on an accrualbasis, when appropriate.

Since default on the loan usually results in theseller (the branch) reacquiring the real estate, thebranch is reasonably assured that it will be able

to recover its costs with a relatively small downpayment. Cost recovery is especially likely whenloans are made to buyers who have verifiable networth, liquid assets, and income levels adequateto service the loan. Reasonable assurance of costrecovery also may be achieved when the buyerpledges adequate additional collateral.

The Cost-Recovery Method

Dispositions of OREO that do not qualify foreither the full-accrual or installment methods aresometimes accounted for using the cost-recoverymethod. This method recognizes the sale of theproperty and the booking of the correspondingloan, but all income recognition is deferred.Principal payments are applied by reducing theloan balance, and interest payments are accountedfor by increasing the unrecognized gross profit.No profit or interest income is recognized until

either the buyer’s aggregate payments exceedthe recorded amount of the loan or a change toanother accounting method (for example, theinstallment method) is appropriate. Conse-quently, the loan is maintained on nonaccrualstatus while this method is being used.

The Reduced Profit Method

This method is used in certain situations whenthe branch receives an adequate down payment,but the loan amortization schedule does notmeet the requirements for use of the full-accrualmethod. The branch again recognizes the sale of the property and the booking of the correspond-ing loan but, as under the installment method,

Other Real Estate Owned 3090.1




profits from the sale are recognized only as thebranch receives payments from the buyer. Sincesales with adequate down payments generallyare not structured with inadequate loan-amortization schedules, this method is seldom

used.

The Deposit Method

This method is used when a sale of OREO hasnot been consummated. It also may be used fordispositions that could be accounted for underthe cost-recovery method. Under this method, asale is not recorded, so the asset continues to bereported as OREO. Further, no profit or interest

income is recognized. Payments received fromthe buyer are reported as a liability until the useof one of the other methods is appropriate.

Branches may promote the sale of foreclosedreal estate by offering nonrecourse financing tobuyers. These loans should be made under thesame credit terms and underwriting standardsthe branch employs for its regular lendingactivity. Financing arrangements associated withthis type of transaction are subject to the account-ing treatment discussed above.

Branch records should (1) indicate the account-ing method used for each sale of OREO, (2) sup-port the choice of the method selected, and(3) sufficiently document that the institution iscorrectly reporting associated notes receivable,as either loans or OREO property, with valua-tion allowances as appropriate.

CLASSIFICATION OF OTHER

REAL ESTATE OWNED

The examiner should generally evaluate thequality of each OREO property to determine if classification is appropriate. OREO usuallyshould be considered a problem asset, evenwhen it is carried at or below its appraised value.Despite the apparent adequacy of the fair ormarket value, the branch’s acquisition of OREOthrough foreclosure usually indicates a lack of demand. As time passes, the lack of demand can

become more apparent, and the value of the realestate can become increasingly questionable.

When evaluating the OREO property forclassification purposes, the examiner must con-sider the property’s market value, whether it isbeing held in conformance with state law, andwhether it is being disposed of according to the

branch’s plan. The amount of an OREO prop-erty subject to classification is the carrying valueof the property, net of any specific valuationallowance. The existence of a specific valuationallowance does not preclude adverse classifica-tion of OREO. The examiner should review alltypes of OREO for classification purposes,including sales that fail to meet the standardsrequired for the full-accrual method of account-ing. When the branch provides financing, theexaminer should determine whether it is pru-

dently underwritten.The examiner should review all relevant fac-

tors to determine the quality and risk of theOREO property and the degree of probabilitythat its carrying value will be realized. Somefactors the examiner should consider include :

• The property’s carrying value relative to itsmarket value (including the date of anyappraisal or evaluation relative to changes inmarket conditions), the branch’s asking price,

and offers received;• The source and quality of the appraisal or

evaluation, including the reasonableness of assumptions, such as projected cash flow forcommercial properties;

• The length of time a property has been on themarket and local market conditions for thetype of property involved, such as history andtrend of recent sales for comparable properties;

• Branch management’s ability and track record

in liquidating other real estate and assetsacquired in satisfaction of debts previouslycontracted;

• Income and expenses generated by the prop-erty and other economic factors affecting theprobability of loss exposure;

• The manner in which the branch intends todispose of the property; and

• Other pertinent factors, including property-title problems, statutory redemption privi-leges, pending changes in the property’s zon-

ing, environmental hazards, other liens, taxstatus, and insurance.



Page 6



Other Real Estate OwnedExamination ObjectivesEffective date July 1997 Section 3090.2

1. To determine if the policies, practices, pro-cedures, and internal controls regarding other

real estate owned are adequate.2. To determine that branch officers andemployees are operating in conformance withthe established guidelines.

3. To verify the carrying value of all other realestate owned.

4. To determine the scope and adequacy of theinternal/external audit function.

5. To determine compliance with applicablelaws and regulations.6. To recommend corrective action when poli-

cies, practices, procedures, or internal con-trols are deficient or when violations of lawor regulations have been noted.




Other Real Estate OwnedExamination ProceduresEffective date July 1997 Section 3090.3

1. If included in the scope of the examination,complete or update the Internal Control

Questionnaire.2. Test for compliance with policies, practices,procedures, and internal controls in conjunc-tion with performing the remaining examina-tion procedures. Obtain a listing of any auditdeficiencies noted in the latest review byinternal/external auditors, and determine if appropriate corrections have been made.

3. Obtain a list of other real estate owned andreconcile the total to the general ledger.

4. Review the other real estate owned account

to determine if any property has been dis-posed of since the prior examination and:a. If so, determine that:

• The branch accepted written bids for theproperty.

• The bids are maintained on file.• There is justification for accepting a

lower bid if the branch did not acceptthe highest one.

b. Investigate any insider transactions.5. Test compliance with applicable laws and

regulations:a. Determine that other real estate owned is

held in accordance with the provisions of applicable state or federal laws andregulations.

b. Determine if other real estate is beingamortized or written off in compliancewith applicable state or federal laws andregulations.

c. Consult with the examiners assigned to‘‘Loan Portfolio Management,’’ ‘‘Other

Assets (and Other Liabilities),’’ and ‘‘Bank Premises and Equipment’’ to determine:• If the branch holds real estate acquired

as salvage on uncollectible loans, aban-doned bank premises, or property origi-nally purchased for future expansion butwhich is no longer intended for suchusage.

• If troubled real estate loans meeting thecriteria for in-substance foreclosures andcovered transactions are identified.

• If covered transactions and in-substanceforeclosures are being properlyaccounted for and reported as other realestate owned.

d. Review the details of all other real estateowned transactions to determine that:

• The property has been booked at its fairvalue.• The documentation reflects the branch’s

persistent and diligent effort to disposeof the property.

• If the branch has made expenditures toimprove and develop other real estateowned, proper documentation is in thefile.

• Real estate that is former banking prem-ises has been accounted for as other real

estate owned since the date of its aban-donment.

• Such property is disposed of in accor-dance with state or federal laws andregulations, including Regulation Y.

• The valuation is not affected by anEnvironmental Protection Agency issue.

6. Review parcels of other real estate ownedwith appropriate management personnel and,if justified, assign appropriate classification.Classification comments should include:

a. Description of property.b. How and when real estate was acquired.c. Amount and date of appraisal.d. Amount of any offers and branch’s asking

price.e. Other circumstances pertinent to the clas-

sification.7. Review the following with appropriate man-

agement personnel or prepare a memo toother examiners for their use in reviewingwith management:

a. Internal control exceptions and deficienciesin, or noncompliance with, written poli-cies, practices, and procedures.

b. Uncorrected audit deficiencies.c. Violations of law.

8. Prepare comments in appropriate report formfor all:a. Criticized other real estate owned.b. Deficiencies noted.c. Violations of law.

9. Update the workpapers with any informationthat will facilitate future examinations.




Other Real Estate OwnedInternal Control QuestionnaireEffective date July 1997 Section 3090.4

OTHER REAL ESTATE OWNEDRECORDS

1. Are postings to the general ledger accountfor other real estate owned approved and/ortested, prior to posting, by persons who donot have direct, physical, or accounting,control of those assets?

2. Are the subsidiary records for other realestate owned balanced at least quarterly tothe appropriate general ledger accounts bypersons who do not have direct, physical, oraccounting control of those assets?

3. Are supporting documents maintained forall entries to other real estate ownedaccounts?

4. Are acquisitions and disposals of other realestate owned reported to senior manage-ment at the head office?

5. Does the branch maintain insurance cover-age on other real estate owned, includingliability coverage where necessary?

6. Are all parcels of other real estate ownedreviewed at least annually for:

a. Current appraisal or certification?b. Documentation inquiries and offers?c. Documented sales efforts?d. Evidence of the prudence of additional

advances?

e. Anticipated methods for disposal of property?

f. Changes in tax status, zoning restric-tions, other liens, etc.?

OTHER PROCEDURES

7. Does the branch have written policies andprocedures relating to other real estateowned?

8. Does the branch factor in EnvironmentalProtection Agency issues and their impacton valuation into its policies?

CONCLUSION


10. Based on the information gathered, evaluate

the internal controls in this area (i.e. strong,satisfactory, fair, marginal, unsatisfactory).




Other Real Estate OwnedAudit GuidelinesEffective date July 1997 Section 3090.5

1. Test the additions of the subsidiary ledgersand reconcile the total to the general ledger.

Include insubstance foreclosures and prop-erty sold in ‘‘covered transactions.’’2. Using appropriate sampling techniques, select

specific properties and determine that:a. Legal title to the property is obtained

when the asset is recorded as other realestate owned.

b. Legal fees and direct costs of acquiringtitle, including payment of existing liens,taxes, and recording fees are expensedwhen incurred and are not capitalized.

c. Insurance, including liability coverage, isadequate and the branch is named as losspayee.

3. Using appropriate sampling techniques,select specific properties, and for expenses

incurred in maintaining the properties orcapitalized costs of improvement anddevelopment:a. Trace the transaction to any previous

records and to postings in the generalledger.

b. Examine documentation supporting thetransaction and prove any computationsreflected on the supporting document.

Documents

US Federal Reserve: 3000 2