Must Knows - (3.3-3.8) Investments, ORE, Other Assets

Question 1

The 7 investment risk exposures - COSMILL

Answer 1

o Credit risk
o Operating risk
o Settlement risk
o Market Risk
o Interconnection risk
o Liquidity Risk
o Legal Risk

Question 2

Failure to understand and adequately manage investment activity risks is an

Answer 2

Unsafe and Unsound Practice

Question 3

The 9 characteristics of an effective investment risk management program

Answer 3

o The board should adopt policies that establish clear goals and risk limits.
o The board should review and act upon management’s reports.
o The board should establish an independent review function and review its reports.
o Management should develop investment strategies to achieve the board’s goals.
o Management should analyze and select investments consistent with its strategies.
o Management should maintain an effective internal control program.
o Management should regularly measure the portfolio’s risk levels and performance.
o Management should provide periodic reports to the board.
o The board and management should periodically evaluate and, when warranted, modify the program.

Question 4

The 3 methods of managing investment risk (individual instrument, aggregate portfolio, whole bank)

Answer 4

1. Individual Instrument Basis
2. Aggregate Portfolio Basis
3. Whole Bank Basis

Question 5

The 8 areas that should be addressed by an Investment Policy

Answer 5

1. The Board’s investment goals
2. Authorized activities and instruments
3. Internal controls and independent review
4. Selecting broker/dealers
5. Risk limits
6. Risk and performance measurement
7. Reporting
8. Accounting and taxation

Question 6

The 5 types of risk limits that should be established in an Investment Policy

Answer 6

• Market risk,
• Credit risk,
• Liquidity risk,
• Asset types, and
• Maturities.

Question 7

The different types of unsuitable investment activities, and their characteristics

Answer 7

• Gains trading,
• When-issued securities,
• Pair-offs,
• Extended settlement,
• Repositioning repurchase agreement, and
• Adjusted trading.

Question 8

Is payment default is a presumptive indicator of OTTI?

Answer 8

Yes. Apart from classification, for impairment write-downs or charge-offs on adversely classified debt securities, the existence of a payment default will generally be considered a presumptive indicator of other-than-temporary impairment.

Question 9

The definitions of Trading, Held to Maturity, and Available For Sale securities, and how the accounting treatments for these differ

Answer 9

The unrealized holding gains (losses) on these securities, net of tax effects, are excluded from earnings and reported in a separate component of equity capital on the balance sheet.

Question 10

types of investment strategies

Answer 10

o Passive – do not require forecasting or complex analysis
o Active – detailed forecasting and analysis and choosing investments to fit those forecasts
o Modern portfolio theory (MPT) refers to a variety of portfolio construction, asset valuation, and risk measurement concepts and models that rely on the application of statistical and quantitative techniques.

Question 11

“Cash”

Answer 11

o Cash - U.S. and/or foreign coin and currency on hand.

Question 12

“Due From”

Answer 12

o Due From - due from accounts enable the transfer of funds between banks. The accounts are used to facilitate the collection of cash items and cash letters, the transfer and settlement of security transactions, the transfer of participation-loan funds, the purchase or sale of Federal funds, and for many other purposes.

Question 13

“Cash Items”

Answer 13

o Cash Items - Cash items are checks or other items in process of collection payable in cash upon presentation.
o Clearings - The term clearing is used to describe the activities involved with processing financial transactions from the time a transaction is made until it is settled.

Question 14

When to list Due Froms as a concentration

Answer 14

If significant due from balances; or advances, or commits to advancing, significant funds to a correspondent or their related entities. Liability concentrations may exist when an institution maintains If significant due to balances; or depends on a correspondent or their related entities for a disproportionate share of its total funding.

Question 15

The policy/procedure requirements of Regulation F

Answer 15

Policy standards should include exposure limits when a correspondent’s financial condition, or the general level of exposure to a correspondent, creates a significant risk to a bank.

Question 16

The maximum level for exposure to an institution that is less than adequately capitalized

Answer 16

25% of Total Capital

Question 17

Definition of premises and equipment

Answer 17

Premises include the cost, less accumulated depreciation, of land and buildings actually owned and occupied (or to be occupied) by the bank, its branches, and consolidated subsidiaries. This includes vaults, fixed machinery, equipment, parking lots, and real estate acquired for future expansion. Interest costs associated with the construction of a building should be capitalized as part of the cost of the building. Bank premises also include leasehold improvements. Leasehold improvements comprise two types of accounts:
-Buildings constructed on leased property, and
-Capitalized disbursements directly related to leased quarters such as vaults, renovations, or fixed equipment.
Equipment includes all movable furniture, fixtures, and equipment of the bank, its branches, and consolidated subsidiaries, including automobiles and other vehicles, and any liens on the above. The institution’s ownership interest in premises or equipment of non-majority-owned corporations is also included.

Question 18

How to account for owned and leased fixed assets, including sale-leaseback transactions

Answer 18

o Owned - Fixed assets are reported at original cost and are depreciated over their estimated useful life, except for land which is not a depreciable asset. Interest may be capitalized as part of the historical cost of acquiring assets that need a period of time to be brought to the condition and location necessary for their intended use.
o Leased - Any lease entered into by a Lessee bank, which at its inception meets one or more of the four following criteria must be accounted for as a property acquisition financed with a debt obligation (i.e., as a capitalized lease). The criteria are:
 Ownership of the property is transferred to the lessee at the end of the lease term.
 The lease contains a bargain purchase option.
 The lease term represents at least 75 percent of the estimated economic life of the leased property.
 The present value of the minimum lease payments at the beginning of the lease term is 90 percent or more of the fair value of the leased property to the lessor at the inception date, less any related investment tax credit retained by or expected to be realized by the lessor.
o If none of the above criteria is met, the lease should be accounted for as an operating lease. Normally, rental payments should be charged to expense over the term of the operating lease as they become payable.
o Sale-leaseback - Sale-leaseback transactions involve the sale of property by the owner and a lease of the property back to the seller. If a bank sells premises or fixed assets and leases back the property, the lease shall be treated as a capital lease if it meets any one of the four criteria above for capitalization. Otherwise, the lease shall be accounted for as an operating lease.

Question 19

How to determine the BV of OREO at acquisition, and thereafter, and the effects, if any, on the ALLL

Answer 19

Call Report Instructions provide that foreclosed real estate received in full or partial satisfaction of a loan be recorded at the fair value less cost to sell the property. This fair value (less cost to sell) becomes the “cost” of the foreclosed real estate. If the recorded amount of the loan exceeds the “cost” of the property, the difference is a loss which must be charged to the Allowance for Loan and Lease Losses (ALLL) at the time of foreclosure or repossession. However, if an asset is sold shortly after it is received in a foreclosure or repossession, it may be appropriate to substitute the value received in the sale (net of the cost to sell the property) for the fair value, with any adjustments made to losses previously charged against the ALLL.

Question 20

The Cost Recovery method of accounting for financed sales of OREO and when each must be used (FDIC Rules)

Answer 20

Cost Recovery Method - This method also recognizes a sale and corresponding loan and may apply when dispositions do not qualify under the full accrual or installment methods. No profit or interest income is recognized until either the aggregate payments exceed the recorded amount of the loan or a change to another accounting method is appropriate. The loan is maintained on nonaccrual status while this method is used.

Question 21

The Full Accrual method of accounting for financed sales of OREO and when each must be used (FDIC Rules)

Answer 21

Full Accrual Method - Under this method, the disposition is recorded as a sale. Any resulting profit is recognized in full and the seller-financed asset is reported as a loan. (Downpayment between 5-25% depending on the type of property.

Question 22

The Reduced Profit method of accounting for financed sales of OREO and when each must be used (FDIC Rules)

Answer 22

Reduced Profit Method - This method is appropriate in those situations where the bank receives an adequate down payment, but the loan amortization schedule does not meet the requirements of the full accrual method. Like the installment method, any profit is recognized as payments are received. However, profit recognition is based on the present value of the lowest level of periodic payments required under the loan agreements. (Rarely used)

Question 23

The Installment Method of accounting for financed sales of OREO and when each must be used (FDIC Rules)

Answer 23

Installment Method - This method recognizes a sale and corresponding loan. Profits are recognized as the bank receives payments. Interest income is recognized on an accrual basis, when appropriate.

Question 24

Accounting treatment of OREO reserves

Answer 24

A valuation allowance is made for each piece of ORE with impairment. They are NOT recognized as a component of capital. The risk-based capital standards permit only the “allowance for loan and lease losses” to be included in Tier 2 capital up to a maximum of 1.25% of risk-weighted assets.

Question 25

The categories of “Other” assets and liabilities, their characteristics, and accounting treatment

Answer 25

o Accrued Income - Accrued income represents the amount of interest earned or accrued on earning assets and applicable to current or prior periods that has not yet been collected.
o Tax Assets - Deferred tax assets and liabilities represent the amount by which taxes receivable (or payable) are expected to increase or decrease in the future as a result of temporary differences and net operating losses or tax credit carryforwards that exist at the reporting date.
o Interest Only Strips – reported at fair value.
o Equities without readily determinable fair values
o BOLI - In general, it is not prudent for an institution to hold BOLI with an aggregate CSV that exceeds 25 percent of its Tier 1 capital. (or it’s a concentration)
o Misc Assets – computer software, derivative instraments held for purposes other than trading, bullion.
o Prepaid expenses - prepaid expense that is overstated should be classified Loss.
o Repossessed Personal Property – fair value less cost to sell
o Suspense Accounts
o Cash items not in the process of collection
o Other accrued interest receivable – retained interests in credit card securitizations, purchased securities not accounted for with other securities
o Indemnification assets – rights to payments from the FDIC for losses

Question 26

Accounting treatment of goodwill

Answer 26

analyzed for impairment annually, NOT amortized. Other intangible assets resulting from a business combination, such as core deposit intangibles, purchased credit card relationships, servicing assets, favorable leasehold rights, trademarks, trade names, internet domain names, and non-compete agreements, should be recognized as an asset separate from Goodwill. It is inappropriate to sell goodwill as a stand-alone asset, distribute it to the parent company, or charge it off in the year it is acquired

Question 27

The bank must include which types of letter of credit when determining compliance with legal lending limits?

Answer 27

Standby letter of credit only and adequate records of SBLCs must be kept

Question 28

The four types of Letters of Credit

Answer 28

There are four basic types of letters of credit: travelers, those sold for cash, commercial, and standby.

Question 29

The characteristics of Commercial LOCs and SBLCs

Answer 29

o Commercial – A commercial letter of credit is issued specifically to facilitate trade or commerce. Generally, drafts will be drawn when the underlying transaction is consummated as intended. Commercial letters of credit not sold for cash do, however, represent contingent liabilities and should be accorded examination treatment as such. Refer to the International Banking section of this Manual for further details on commercial letters of credit.
o Standby – A standby letter of credit (SBLC) is an irrevocable commitment on the part of the issuing bank to make payment to a designated beneficiary. It obligates the bank to guarantee or stand as surety for the benefit of a third party. SBLCs can be either financial-oriented, where the account party is to make payment to the beneficiary, or performance-oriented, where a service is to be performed by the account party.

Question 30

The two primary risks of SBLCs

Answer 30

The two primary areas of risk relative to SBLCs are credit risk (the possibility of default on the part of the account party), and funding risk (the potential inability of the bank to fund a large draw from normal sources).

Question 31

The definition of a revolving underwriting facility

Answer 31

A revolving underwriting facility (RUF) (also referred to as a note issuance facility) is a commitment by a group of banks to purchase at a fixed spread over some interest rate index, the short-term notes that the issuer/borrower is unable to sell in the Euromarket at or below this predetermined rate.