REFinBlog

September 12, 2015

Banks Should Know Their Investment Risks

The latest issue of the Federal Deposit Insurance Corporation’s Supervisory Insights (Devoted to Advancing the Practice of Bank Supervision) has an esoteric, but important article on Bank Investment in Securitizations: The New Regulatory Landscape in Brief (starting on page 13). The article opens,

The recent financial crisis provided a reminder of the risks that can be embedded in securitizations and other complex investment instruments. Many investment grade securitizations previously believed by many to be among the lowest risk investment alternatives suffered significant losses during the crisis. Prior to the crisis, the marketplace provided hints about the embedded risks in these securitizations, but many of these hints were ignored. For example, highly rated securitization tranches were yielding significantly greater returns than similarly rated non-securitization investments. Investors found highly rated, high yielding securitization structures to be “too good to pass up,” and many investors, including community banks, invested heavily in these instruments. Unfortunately, when the financial crisis hit, the credit ratings of these investments proved “too good to be true;” credit downgrades and financial losses ensued.

In the aftermath of the financial crisis, interest rates have remained at historic lows, and the allure of highly rated, high-yielding securitization structures remains. Much has been done to mitigate the problems experienced during the financial crisis with respect to securitizations. Congress responded with the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), and regulators developed and issued regulations and other guidance designed to increase investment management standards and capital requirements.

The gist of these new requirements is simple: banks should understand the risks associated with the securities they buy and should have reasonable assurance of receiving scheduled payments of principal and interest. This article summarizes the most pertinent of these requirements and provides practical advice on how the investment decision process can be structured so the bank complies with the requirements.

The guidance and regulations applicable to bank investment activities reviewed in this article are: „

• Office of the Comptroller of the Currency (OCC): 12 CFR, Parts 1, 5, 16, 28, 60; Alternatives to the Use of External Credit Ratings in the Regulations of the OCC;
• OCC: Guidance on Due Diligence Requirements to determine eligibility of an investment (OCC Guidance);
• Federal Deposit Insurance Corporation (FDIC): 12 CFR Part 362, Permissible Investments for Federal and State Savings Associations: Corporate Debt Securities;
• FDIC: 12 CFR Part 324, Regulatory Capital Rules; Implementation of Basel III (Basel III); and  „
• FDIC: 12 CFR Part 351, Prohibitions on certain investments (The Volcker Rule).

As financial institutions move into an investment world where relying on credit ratings from third party providers is not longer sufficient, the advice in this article is welcome. One wonders though what the consequences will be, if any, for those who do not follow it.