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4000 - Advisory Opinions
Custodial Holdings of Government Securities Held for Customers by
Depository Banks
FDIC--95--18
October 12, 1995
Stephen H. Stiller, Senior Regional Attorney
In essence, you asked whether the failure or inability of an
insured State nonmember bank to obtain verification of the safekeeping
of its government securities from another bank constitutes: (i) a
violation of the Government Securities Act of 1986 ("G.S.A."),
15 U.S.C. § 78o-5, as
implemented by the G.S.A. Regulations, 17 C.F.R. Ch. IV; or (ii)
noncompliance with the basic external audit procedures for investment
securities of the FDIC Statement of Policy entitled, "Statement of
Policy Providing Guidance on External Auditing Procedures for State
Nonmember Banks," 55 Fed. Reg. 2145 (1990) reprinted in 2
Federal Deposit Insurance Corporation Law, Regulations and Related Acts
(FDIC) at 5302.01 (1990). The facts posed in your inquiry are simply
too indefinite to draft an appropriate response tailored to those
facts. In the alternative, we have summarized the applicable G.S.A.
Regulations, consisting principally of requirements in Part 450 and
section 403.5 of the G.S.A. Regulations,
17 C.F.R. Part 450 and
§ 403.5, and commented on
the applicability of the referenced FDIC Statement of Policy. We
apologize for the very long delay in responding. However, the lengthy
legal research and analysis involved as well as the press of other
assignments occasioned the delay.
We will limit our discussion of the G.S.A. Regulations to their
effect on insured depository institutions, as defined in section
3(c)(2) and (3) of the Federal Deposit Insurance Act ("Act"),
12 U.S.C. § 1813(c) (1) and
(2). In fact, the coverage of the G.S.A. Regulations reaches more
entities than insured depository institutions and, in so doing, the
terms "financial institutions" and "depository institution"
used in the G.S.A. Regulations are defined more broadly than insured
depository institution is defined in our Act.
17 C.F.R. § § 400.3(j)
and 450.2(b). When referring
to insured depository institutions hereafter, the terms "depository
bank" or "custodian bank" will be used.
{{2-29-96 p.4933}}
Part 450 Overview
Part 450 prescribes the rules with which depository banks must
comply when holding government securities for their customers. Part 450
is comprised of five sections. Section 450.1 covers the scope of the
Part and describes the capacities in which government securities held
by a depository bank trigger the requirements of Part 450. However,
Section 450.3 exempts
depository banks from Part 450 with respect to government securities
held in a fiduciary 1
or custodial capacity, provided that: (i) the depository bank has
policies and procedures which apply the requirements of its appropriate
regulatory agency to its custodial holdings of government securities
held in a fiduciary capacity, and (ii) the custodial holdings are
subject to examination by such agency for compliance with its fiduciary
requirements. The FDIC's requirements for government securities held in
a fiduciary capacity by a depository bank for which it is the
appropriate regulatory agency are set forth in FDIC Bank Letter No.
BL-5-89 (March 2, 1989), Exhibit A, pages 4-6. For all the depository
banks which do not come within the exemption,
section 450.4 prescribes the
specific recordkeeping and handling requirements with which a covered
depository bank must comply.
Scope of Part 450
The requirements of Part 450 apply to any depository bank which
holds government securities for customers: (1) as a fiduciary or
custodian, unless exempt under section 450.3 (17 C.F.R.
§ § 403.5(a)(1) and 450.1(a)); (2) as a government securities
broker or dealer 2
for fully paid and excess margin government securities (17 C.F.R.
§ § 403.5 (a) (2) and 450.1(a)); and (3) as a government securities
broker or dealer under repurchase ("repo") agreements, as
described in section 403.5(d), which is discussed below at pages 6 and
7.
In addition, there is a fourth category which triggers the
application of Part 450. In this category, even though Part 401 of the
G.S.A. Regulations exempts certain limited activities by a depository
bank from regulation as a government securities broker or dealer, Part
450 is still expressly applicable to such limited activities. Thus,
Part 450 applies to the exempt activity under section 401.2, which
covers depository banks which limit their transactions in government
securities to the tender or subscription for the purchase of original
issue U.S. Treasury securities for the account of customers. Similarly,
Part 450 applies to the exempt activity under section 401.3, which
covers depository banks which effect fewer than 500 government
securities brokerage transactions per year or conduct all of their
brokerage transactions through arrangements with one or more govenment
securities brokers or dealers. Finally, Part 450 applies to the exempt
activity under section 401.4, which covers depository banks engaged in
government securities dealer activities which are limited to sales or
purchases in a fiduciary capacity, or to repo or reverse repo
agreements.
Part 450 Custodial Requirements
Section 450.4(a) prescribes the Part 450 custodial requirements for
depository banks which hold government securities for customer
accounts, unless, as noted above, exempt under section 450.3. Section
450.4(a)(1) provides that a depository bank must maintain possession or
control of all government securities held for customer accounts by: (i)
segregating them from its own assets and (ii) keeping them free of any
lien, charge or third
{{2-29-96 p.4934}}party claim granted or created by the
depository bank. Notwithstanding the admonition to maintain the
securities free of any lien, charge, or claim, section 450.4(a)(6)
permits the bank to lend customer securities, provided there is a
written agreement with the customer allowing it and the loan fully
complies with the supervisory guidelines of the appropriate regulatory
agency.
Section 450.4(a)(2)(i) describes how a depository bank, including a
correspondent bank or trust company, may comply with section
450.4(a)(1) when it maintains a customer's government securities at
another bank ("custodian bank"), as follows: (i) by notifying the
custodian bank that the securities are customer securities, (ii) by
instructing the custodian bank to maintain the securities free of any
lien, charge, or claim of any kind in favor of the custodian bank or
any persons claiming through it, and (iii) by the custodian bank
maintaining the securities in an account designated for customers of
the depository bank which has no securities belonging to the depository
bank.
Section 450.4(a)(2)(ii) provides that, once the depository bank
identifies government securities held by the custodian bank as customer
securities of the depository bank, the custodian bank must treat the
securities as customer securities separate from any other securities
held for the account of the depository bank.
Part 450 Documentation Requirements
Except for securities which are subject to repo agreements, under
section 450.4(b)(1), a depository bank must issue a confirmation or
safekeeping receipt for each government security held for a customer,
which identifies the issuer, maturity date, par amount, and coupon rate
of the security. Corresponding confirmation requirements for securities
which are the subject of repo agreements are governed by section
403.5(d), which is discussed on pages 6 and 7.
Section 450.4(c) requires a depository bank to maintain records of
government securities held for customers separately from other records
and prescribes that the records:
(1) Provide a system for identifying each customer, and
each government security (or the amount of each issue of a government
security in book-entry form) held for the customer;
(2) Describe the customer's interest in the government
security;
(3) Indicate all receipts and deliveries of government
securities and all receipts and disbursements of cash by the depository
institution in connection with such securities;
(4) Include a copy of the safekeeping receipt or a
confirmation issued for each government security held; and
(5) Provide an adequate basis for audit of the above
information.
Under section 450.4(d), government securities held for customers
must be counted at least annually and reconciled with customer account
records. Subdivisions (1), (2), and (3) of section 450.4(d) elaborate
on how the count must be made and verified, including where the
securities are held outside the possession, but not the control,
of the depository bank. Thus, section 450.4(d)(1) covers where
government securities are held outside the possession of the depository
bank and mandates reconciliation of the depository bank's records with
those of the entity with which the depository bank has securities
accounts, including any Federal Reserve bank. Section 450.4(d)(2)
requires the depository bank conducting the count to verify any
government securities held for customers which are subject to its
control but not in its physical possession and which have been "in
transfer, in transit, pledged, loaned, borrowed, deposited, failed to
receive, failed to deliver, subject to repurchase or reverse repurchase
agreements or otherwise subject to the depository institution's control
or direction" for more than 30 days. Finally, under section
450.4(d)(3), the dates and results of the counts and reconciliations
must be documented and, within seven business days after each required
count and reconciliation, any differences must be noted "in a
security count difference account."
{{2-29-96 p.4935}}
Under section 450.4(e), a depository bank must treat a government
securities broker or dealer as a customer with respect to: (i)
securities maintained by the broker or dealer in a Segregated
Account 3
established by written agreement between the broker or dealer and the
depository bank whereby (A) securities under the control of a broker or
dealer that belong to the broker's or dealer's customers are segregated
from those belonging to the broker or dealer and (B) the bank agrees
not to assert any claim or lien against the securities maintained in
the account or grant any third party an interest in such securities,
and (ii) securities otherwise identified to the depository bank as
customer securities for purposes of possession or control. Subdivision
(e) also provides that, under the recordkeeping requirements of section
450.4(c), the depository bank must treat such securities as customer
securities separate from any other securities held for the account of
the government securities broker or dealer, but does not have to
identify individual customers of the broker or
dealer. 4
Section 450.4(f) provides that the records required by sections
450.4(c) and 450.4(d)(3) must be maintained for at least six years and
for the first two years "in an easily accessible place."
Section 403.5 Custodial,
Documentation and Disclosure Requirements
In addition to the foregoing Part 450 requirements, depository banks
when serving as government securities brokers or dealers which hold for
customer accounts (i) fully paid and excess margin government
securities and/or (ii) government securities subject to hold-in-custody
repo agreements, as described in section 403.5(d), are subject to the
custodial, documentation, and disclosure requirements of sections
403.5(b), (c) and (d).
Section 403.5(c) Custodial Requirements
Under section 403.5(c)(1), depository banks must determine on each
business day the quantity and issue of government securities, including
repo securities, that are required to be, but are not, in the bank's
possession or control and promptly take any of the following steps
necessary to bring such securities into its possession or control: (i)
obtain the release of any lien, charge, or other encumbrance against
the securities; (ii) obtain the return of any securities loaned; (iii)
obtain possession or control of securities it has not received for more
than 30 days, or in the case of mortgage-backed securities, for more
than 60 days; or (iv) buy securities as necessary to cover any shortage
which cannot be resolved by any of the other enumerated steps. Section
403.5(c)(2) requires a depository bank to prepare and maintain a
current and detailed description of procedures and internal controls
used to comply with section 403.5(c)(1) and to make them available to
the bank's appropriate regulatory agency upon request.
Section 403.5(d) Hold-in-Custody Repo Requirements
The repo agreement described in section 403.5(d), which is
referenced in the third category under "Scope of Part 450" above,
is where the depository bank ("repo seller") retains control of
the government securities it sold subject to the repo agreement
("repo securities"). This type of repo agreement is called a
"hold-in-custody" repo agreement, which is distinguished from
both "deliver out" and "tri-party" repo agreements. In the
"deliver out" repo agreement, the repo securities are delivered
to the repo purchaser or a depository bank designated by the repo
purchaser. Under a "tri-party" repo agreement, a custodian bank
enters into an agreement with both the repo seller and repo purchaser
and has custodial responsibilities to each.
The documentation and disclosure requirements for government
securities held by depository banks under hold-in-custody repo
agreements are found in sections 403.5(d)(1)
{{2-29-96 p.4936}}and (2). Section 403.5(d)(1)(i)
requires that the repo seller obtain the repo agreement in writing.
Section 403.5(d)(1)(ii) requires that the repo seller confirm in
writing: (1) by the close of business of the day the repo transaction
is initiated, the specific securities subject to the repo agreement and
(2) any day thereafter, when the repo securities have been replaced
with securities having a different issuer, maturity date, par amount,
or coupon rate from the government securities specified in the previous
confirmation. The requirements in Sections 403.5(d)(1)(iv) and (v)
provide that, where the repo purchaser grants the repo seller a right
to substitute repo securities, the repo agreement must include the
right of substitution and, immediately preceding the provision
containing the right of substitution, the disclosure
statement 5
set forth in the regulation. Under section 403.5(d)(2), any
confirmation must contain specified information about the repo
securities, including the issuer, maturity date, coupon rate, par
amount, and market value.
Additionally, section 403.5(d) contains a custodial requirement.
Under section 403. 5(d)(1)(vi), the repo seller is required to maintain
possession or control of the repo securities in accordance with section
450.4(a), discussed on pages 3 and 4 above, except when exercising a
right to substitute securities expressly agreed to by the repo
purchaser in the repo agreement.
Section 403.5(b) Exception to Sections 403.5(c) and (d) Requirements
Under section 403.5(b), a depository bank is determined not to be in
violation of sections 403.5(c) and (d) when, by reason of "temporary
lags" in its normal business operations, the bank fails to have
possession or control of a security in accordance with the requirements
of sections 403.5(c) or (d), provided that the bank acts
promptly and in good faith to establish possession or control.
Nevertheless, with respect to overnight repo transactions, the normal
business lags exception is not applicable to a depository bank which is
not in possession or control of the repo securities by the close of the
business day it engaged in the repo transaction.
FDIC Statement of Policy
The purpose of the FDIC Statement of Policy Providing Guidance on
External Auditing Procedures for State Nonmember Banks, cited above, is
to provide guidance and encouragement to state nonmember banks to have
the external auditing procedures listed therein performed and reported
on annually by an independent auditor. These enumerated auditing
procedures involve testing and evaluation consistent with generally
accepted auditing standards of high risk areas of a bank's business.
One of the enumerated auditing procedures pertains to the ability to
confirm the existence of the securities belonging to a bank, including
their safekeeping if held by another institution, through the
examination of a sample number of the bank's securities.
From the foregoing, determination of a bank's compliance with the
referenced FDIC Statement of Policy would not be based on the results
of the auditing procedures performed, which are included in the
independent auditor's report to the bank's board of directors, but
rather would depend upon whether the enumerated auditing procedures
were
{{2-29-96 p.4937}}performed and, if performed, whether
they were performed timely and properly, i.e., consistent with
generally accepted auditing
standards.
1"Fiduciary capacity" is defined in the G.S.A.
Regulations to include a trustee, executor, administrator, registrar,
transfer agent, guardian, assignee, receiver, managing agent, and any
other similar capacity involving the sole or shared exercise of
discretion by a depository bank having fiduciary powers that is
supervised by a federal or state financial institution regulatory
agency. 17 C.F.R. § 450.2 (d). Go Back to Text
2A "government securities broker" is defined in the
G.S.A. Regulations as "any person regularly engaged in the business
of effecting transactions in government securities for the account of
others. . . ." 17 C.F.R. § 400.3(k). A "government
securities dealer'' is defined in the G.S.A. Regulations as "any
person engaged in the business of buying and selling government
securities for his own account, through a broker or
otherwise. . . ." Banks are excluded from this dealer definition
unless engaged in buying and selling for their own account "other
than in a fiduciary capacity." 17 C.F.R. § 400.3(1). Go Back to Text
3"Segregated Account" is defined in 17 C.F.R. § 403.4
(f)(1). Go Back to Text
4The FDIC has noted that a depository bank may be entrusted
with the safekeeping of customer securities of another depository bank
("customer bank") which is also a government securities broker or
dealer. Consistent with the requirements of section 450.4(e), the
depository bank entrusted with safekeeping would not have to maintain
records identifying individual customers of the customer bank. FDIC
Bank Letter No. BL-5-89 (March 2, 1989), Exhibit A, page 6. Go Back to Text
5This disclosure statement reads, as follows:
Required Disclosure--The (seller) is not permitted
to substitute other securities for those subject to this agreement and
therefore must keep the (buyer's) securities segregated at all times,
unless in this agreement the (buyer) grants the (seller) the right to
substitute other securities. If the (buyer) grants the right to
substitute, this means that the (buyer's) securities will likely be
commingled with the (seller's) own securities during the trading day.
The (buyer) is advised that, during any trading day that the (buyer's)
securities are commingled with the (seller's) securities, they may be
subject to liens granted by the (seller) to third parties and may be
used by the (seller) for deliveries on other securities transactions.
Whenever the securities are commingled, the (seller's) ability to
resegregate substitute securities for the (buyer) will be subject to
the (seller's) ability to satisfy any lien or to obtain substitute
securities.
17 C.F.R. § 403.5(d)(1)(v). Go Back to Text
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