Financial Services Alert

Vol. 1 No. 19

Goodwin, Procter & Hoar LLP, a firm of over 350 lawyers, has one of the largest financial services practices in the United States. We have created the Financial Services Alert as a service to advise our clients and other financial institutions to news of importance to the industry in a timely manner. Some issues of the Alert, such as this one, will principally summarize significant recent developments in financial services law and regulation. Other issues will provide more in-depth analysis about specific areas of financial services law. We hope that you will find the Financial Services Alert to be helpful. We welcome your suggestions for future topics of interest.

Developments of Note

OCC, FRB, and FDIC Ease Market Risk Rules

The OCC, FRB, and FDIC eased the burden imposed on financial institutions with sufficient trading activities to be subject to the market risk component of the risk-based capital rules. Under the previous rule, if a financial institution used its own internal model to measure specific risk (i.e., the risk attributable to changes in the market value of individual holdings from factors other than broad market movements), its capital charge for that risk could be no less than 50% of the specific risk capital charge calculated using agency-mandated guidelines (the so-called "minimum specific risk charge"). In September, 1997, however, the Basle Committee determined that banks had made substantial progress in developing internal modelling techniques that effectively account for market risk. As a result, if an institution is able to demonstrate that its internal model accurately captures specific risk (by explaining the historical price variation in the portfolio, and being sensitive to changes in portfolio concentrations), it generally will no longer have to calculate and be subject to the minimum specific risk charge derived from agency guidelines. Rather, the specific risk charge may be based exclusively on the bank's internal model. The amendments became effective on December 31, 1997, but the agencies are accepting comments until March 2, 1998.

OTS Finalizes Fiduciary Rules

The OTS finalized amendments to the fiduciary rules governing federal and state savings banks which substantially mirror the proposed rules described in the September 9, 1997 issue of the Financial Services Alert. As with the proposal, the final rules substantially conform the OTS fiduciary regulations to those of the OCC. For example, the rule amends the definition of "fiduciary" to include acting as an investment advisor for a fee, and even expressly states in the preamble that the OTS will follow the OCC's proposed interpretative rule (when it is finalized) further clarifying the definition of investment advisor. Similarly, the OTS expressly incorporates the OCC collective fund rules. Unlike the proposed rule, the final rule requires federal savings banks to maintain written policies and procedures concerning their fiduciary activities, including, at a minimum, policies regarding brokerage placement practices, prevention of the misuse of material inside information, and prevention of self dealing and conflicts of interest. In light of the interstate trust activities of federal savings banks, it is also noteworthy that while the final rule generally provides that federal savings banks may conduct fiduciary activities only at offices that have been approved for such activities pursuant to an application to the OTS, an applicant also may request that the OTS (in its order approving the fiduciary activities) allow geographic trust expansion after only filing a notice with the agency. The rule also adopts the proposed exemption from CRA requirements for special purpose federal savings banks, including trust banks, that do not accept deposits from or extend credit to the public in the ordinary course of business, other than as an incident to their specialized operations. The final rule became effective January 1, 1998.

OCC Permits Crop Insurance Sales by National Banks by Agents

The OCC ruled that national banks may sell crop insurance as agent in connection with their agricultural lending activities without regard to the town of 5,000 geographic limitations generally applicable to those sales. Rather than relying upon Section 92 of the National Bank Act (which governs insurance agency activities in towns of less than 5,000), the OCC cited a three-part test distilled by the agency from previous court rulings (especially VALIC) and agency interpretations to determine that the crop insurance sales activities are part of, or are incidental to, the business of banking (principally as a result of their relationship to agricultural lending activities). Thus, these agency activities are permissible more generally under Section 24 (Seventh) of the National Bank Act.

Federal Banking Agencies Issue Internal Audit Function Policy Statement

The four federal banking agencies issued an interagency policy statement regarding a bank's internal audit function and the outsourcing of that function to third party vendors. The policy sets forth a number of directives, including that the organizational structure of the bank should ensure that the information provided to directors is impartial and not improperly influenced by management; that staff should have the expertise and resources to adequately assess the effectiveness of internal controls; that the frequency and extent of the audit review should be consistent with the institution's size and complexity; and that it is necessary to effectively communicate audit control deficiencies within the institution. If the audit function is outsourced, the vendor contract must provide bank examiners access to the vendor's audit reports and related work papers, and examiners will separately evaluate how the third party arrangement affects the quality of the audit program. The policy further declares that the bank's external auditor also may serve as its internal-audit outsourcing vendor, provided that the external auditor strictly complies with ethical rules.

Massachusetts Issues Warning Regarding Subprime Lending

The Massachusetts Commissioner of Banks issued a letter expressing two warnings regarding subprime lending (lending to borrowers perceived to pose extraordinary credit risk): issues relating to safe and sound lending practices, and consumer protection and compliance issues. As to safety and soundness issues, the letter emphasizes that it is the responsibility of lender management to ensure that adequate procedures are in place prior to the commencement of any new activity, particularly an activity with high risk such as subprime lending. To fulfil its responsibility, management should have policies that identify various forms of risks (such as default risk) associated with subprime lending, create and implement controls for those risks (through the use of pricing models and testing), and establish internal limits to ensure that risks are within acceptable levels. As to consumer protection issues, because delinquencies are more likely with subprime loans, management must insure the institution's compliance with fair debt collection laws and regulations, as well as disclosure and anti-discrimination laws. The Commissioner also noted that repeated refinancing of loans and other debts (referred to as "flipping"), a high percentage of consumer acceptance of credit insurance, and extraordinarily high debt-to-income ratios will receive particular scrutiny during the examination process. To limit questions about the suitability of subprime lending (and possible violations of the Massachusetts unfair practices laws), the Commissioner also urges banks to refer borrowers to credit counselling before accepting a subprime application.

SEC Proposes Changes to the Net Capital Rules

The SEC is proposing changes to its net capital rules designed to reduce the deductions (more commonly referred to as "haircuts") brokers must make from net worth in computing net capital (i.e., the amount by which broker-dealers must reduce the market value of their securities when calculating the value of assets for purposes of the net capital rule) for certain fixed income products, such as government securities, pass-through mortgage-backed securities, most investment grade nonconvertible debt securities, money market debt instruments, and futures or forward contracts relating to the foregoing. Under the proposal, a broker would calculate two haircuts on fixed income products, a general market risk charge (the risk that the price of the product will change because of market-wide changes in interest rates) and a specific market risk charge (the risk of an adverse price movement for a security which is unique to a particular issue). Unlike the current rules, which limit netting between different types of fixed income securities (e.g., corporate bonds and government securities), the proposed amendments would treat most of these securities as effectively part of a single portfolio (with categorization based principally on residual time to maturity rather than the nature of the instrument), thereby allowing greater hedging benefits from general market-wide changes in value among the various types of securities when calculating general market risk. The proposal excludes certain fixed income products, such as municipal securities, non-investment grade debt securities, and hedges denominated in different currencies.

Separately, the SEC proposed to amend its net capital rules to define the term "nationally recognized statistical rating organization," the ratings of which generally distinguish between investment grade and non-investment grade debt securities. Presently, the SEC relies on no-action procedures to determine whether a rating organization is an NRSRO. The proposal would codify the standards used in that no-action procedure, requiring any entity seeking to be designated as an NRSRO to: be registered as an investment advisor; be recognized on a national basis in the United States as an issuer of credible and reliable ratings by the users of securities ratings; have adequate staffing, financial resources, and structures to ensure that it can issue credible ratings and operate independently of economic pressures by the companies it rates; use systematic rating procedures designed to ensure credible ratings; have extensive contacts with management of issuers, including access to senior management; and have internal procedures to prevent misuse of non-public information. Comments on the proposed haircut and NRSRO rules must be received by March 30, 1998 and March 2, 1998, respectively.

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The contents of this publication are intended for informational purposes only and should not be construed as legal advice or legal opinion, which can be rendered properly only when related to specific facts. This document may be considered advertising under the rules of the Supreme Judicial Court of Massachusetts. (c)GPH LLP 1997