EB 93-6, Attachment B: Interbank Liabilities EXAMINATION OBJECTIVES, EXAMINATION PROCEDURES, AND INTERNAL CONTROL QUESTIONNAIRE EXAMINATION OBJECTIVES 1. To determine if the policies, practices, procedures, and internal controls on interbank liabilities adequately address the risks posed by exposure of the bank to other depository institutions. 2. To determine if bank officers and employees are operating in compliance with the policies and procedures established by the bank. 3. To determine the existence of any excessive interbank liability risks. 4. To initiate corrective action when policies, procedures, or internal controls are deficient, or when violations of laws or regulations have been noted. EXAMINATION PROCEDURES Examiners should obtain or prepare the information necessary to: 1. Complete or update the Interbank Liabilities section of the Internal Control Questionnaire prior to commencing the examination procedures. 2. Based on the evaluation of internal controls and review of committee minutes, exception reports, and audit reports, determine the scope of the examination. 3. Test for compliance with policies, practices, procedures, and internal controls together with performing the remaining examination procedures. 4. Request bank files relating to exposure to correspondents as defined in the "Prudential Standards" section, and a. Request documentation demonstrating that the bank has periodically reviewed the financial condition of all correspondents to which the depository institution has significant exposure. The bank should address the capital level of the correspondent, the level of nonaccrual and past due loans and leases, the level of earnings, and other factors affecting the financial condition of the correspondent. b. Request information from the bank indicating the level of exposure to correspondents as measured by its internal control systems (e.g., for smaller banks this information may include correspondent statements and a list of securities held in the investment portfolio). c. Request that examiners review the information for reasonableness relative to their findings from performing examination procedures for the various departments. In addition to the regular asset departments, examiners will consider the Handbook sections on computer services, payments systems and funds transfer activities, private placements, international, and off-balance sheet products. d. Determine if the frequency of the reviews of financial condition are adequate for those institutions to which the bank has very large or long maturities, or for correspondents in deteriorating condition. e. If a bank relies on another party (such as its bank holding company, a bank rating agency, or another correspondent) to provide financial analysis of a correspondent, determine if its board of directors has reviewed and approved the assessment criteria used by the other party. f. When the bank relies on its bank holding company to select and monitor correspondents, or on a correspondent, such as a bankers' bank, to choose other correspondents with which to place the depository institution's federal funds, ensure that its board of directors has reviewed and approved the selection criteria used. g. If the bank is exposed to a correspondent that has experienced a deterioration in its financial condition, ascertain that it has considered the deterioration in evaluating the creditworthiness of the correspondent and the appropriate level of exposure to it. h. When internal limits for significant exposure have been established by the bank, determine that it either monitors its exposure or structures transactions with the correspondent to ensure that exposure ordinarily remains within the internal limits it established for the risk undertaken. i. If the bank chooses to establish separate limits for different forms of exposure, products, or maturities and does not set an overall internal limit on exposure to a correspondent, review information on actual interday exposure to determine if the aggregate exposure (especially for less than adequately capitalized correspondents or financially deteriorating correspondents) is consistent with the risk undertaken. j. When monitoring is used, determine if the level of ex post monitoring of significant exposure (especially for less than adequately capitalized correspondents or financially deteriorating correspondents) is appropriate given the type and volatility of exposure, the extent to which it approaches the bank's internal limits, and the condition of the correspondent. k. Determine if the bank had any occasional excesses over the internal limits and verify that it used appropriate procedures to address them. l. If the size of intraday exposure to a correspondent and its condition indicate that payments may not be made as contemplated, verify that the bank has established intraday limits consistent with the risk undertaken and has monitored intraday exposure. 5. 1 Request a list of all institutions to which the bank regularly has "credit exposure," as defined in the "Credit Exposure" section (section 206.4) of Regulation F, greater than 25 percent of capital during a specified time interval (allow banks to use existing risk monitoring and control systems and practices when they effectively maintain "credit exposure" within prescribed limits) and review the bank's files to: a. Verify that the capital levels of correspondents are monitored quarterly. b. Verify that those institutions are at least adequately capitalized as defined by Regulation F. c. Determine that "credit exposure" to those correspondents at risk of dropping below the capital levels required to be adequately capitalized could be reduced to 25 percent of capital or less in a timely manner. 6. Determine any violations of law or regulation. If violations were noted, determine whether corrective action was taken. 7. Review the following items with appropriate management personnel or prepare a memo to examiners to use in reviewing with management. a. The adequacy of written policies on interbank liabilities. b. The manner in which bank's officers operate in conformance with established policies. c. Comments for the report of examination. d. The adequacy of available information on interbank liabilities for management and the board of directors. 8. Prepare in appropriate form, comments for the examination report on interbank liabilities and include any deficiencies reviewed with management and any remedial actions recommended. 9. Prepare a memorandum and update work programs with any information that will facilitate future examinations. INTERNAL CONTROL QUESTIONNAIRE Review the bank's internal controls, policies, practices, and procedures for interbank liabilities before commencing the examination procedures. The bank's system should be documented in a complete and concise manner and should include, where appropriate, narrative descriptions, flowcharts, copies of forms used, and other pertinent information. Prudential Standards 1. Has the bank developed written policies and procedures to evaluate and control exposure to all correspondents? 2. Have the written policies and procedures been reviewed and approved annually by the board of directors? 3. Do the written policies and procedures adequately address the bank's exposure(s) to a correspondent including: - Credit risk? - Liquidity risk? - Settlement risk? (See the Introduction) 4. Has the bank evaluated its intraday exposure adequately? 5. Does it have significant exposure to its correspondent because of operational risks, such as extensive reliance on a correspondent for data processing? 6. If so, has the bank addressed those risks (may be elsewhere in its operational procedures)? 7. Do the written policies and procedures establish criteria for selecting a correspondent or terminating that relationship? 8. Do the written policies and procedures require a periodic review of the financial condition of a correspondent whenever the size and maturity of exposure is considered significant relative to its financial condition? (See the Introduction) 9. When exposure is considered significant, is the correspondent's financial condition reviewed periodically? 10. Does the periodic review of the correspondent's financial condition include its level of: - Capital? - Nonaccrual and past due loans and leases? - Earnings? - Other relative factors? 11. If a party other than bank management conducts the financial analysis of or selects a correspondent, has the bank's board of directors reviewed and approved the general assessment or selection criteria used by that party? 12. If the financial condition of the correspondent, or the form or maturity of exposure creates significant risk, do the written policies and procedures establish internal limits or other procedures, such as monitoring to control exposure? 13. Are the internal limits or controls described in question 11 appropriate for the level of risk exposure? 14. If no internal limits have been established, is this appropriate based on the financial condition of the correspondent and size, form, and maturity of exposure, and, if so, why not? 15. When a bank has set internal limits for significant exposure to a correspondent, has it established procedures or structured transactions with the correspondent to ensure that the exposure ordinarily remains within those limits? 16. If not, is actual exposure to a correspondent monitored to ensure that it ordinarily remains within the bank's established internal limits? 17. Is the level (frequency) of monitoring performed appropriate for: - The type and volatility of the exposure? - The extent to which the exposure approaches the bank's internal limits? - The financial condition of the correspondent? 18. Are transactions and/or monitoring reports on exposure reviewed for compliance with internal policies and procedures? If so, by whom and how often? 19. Do the bank's written policies and procedures address deterioration in a correspondent's financial condition for: - The periodic review of the correspondent's financial condition? - Appropriate limits on exposure? - Monitoring the exposure or structuring transactions with the correspondent to ensure that the exposure remains within the internal limits established? 20. Are these policies and procedures for deterioration appropriate and realistic? 21. Do the written procedures establish guidelines to address such excesses over the internal limits as unusual late incoming wires, unusually large cash letters, unusual market moves, or other unusual increases in activity or operational problems? 22. Are the procedures to address such excesses appropriate? Credit Exposure Limits 1. Do the bank's written policies and procedures effectively limit overnight "credit exposure" to 25 percent or less of bank's capital, if a correspondent is less than adequately capitalized? (See the Introduction) 2. If "credit exposure" is not limited to 25 percent or less of the bank's capital, does the bank: a. Obtain quarterly information to determine its correspondent's capital levels, and, if so, from what source? b. Monitor its overnight "credit exposure" to its correspondents, and, if so, how frequently? Conclusion 1. Is the foregoing information an adequate basis for evaluating internal control in that there are no significant additional internal auditing procedures, accounting controls, administrative controls, or other circumstances that impair any controls or mitigate any weaknesses indicated above (explain negative answers briefly, and indicate conclusions as to their effect on specific examination or verification procedures)? 2. Based on a composite evaluation, as evidenced by answers to the foregoing questions, internal control is considered (good, medium, or bad). _______________________________ 1 Phase-in beginning June 19, 1994. 2 Phase-in beginning June 19, 1994.