Pickering, C. J., Independent Banker
Several key regulatory events concerning bank investments occurred late in 1994 or will occur in early 1995. Among those events: the Federal Financial Institutions Examination Council (FFIEC) announced in November that Financial Accounting Standard No. 115 (FAS 115) would not impact regulatory capital; the OCC and FDIC released several derivative/structured note guidelines; and the regulators are working on another proposal to include interest rate risk in risk-based capital.
Sharon Lee, from the FDIC's Office of Capital Markets, discussed these and other topics as one of the featured speakers at the 1994 fall session of the Vanderbilt University/ IBSC Investment School for Community Bankers.
This month's column is based on a pseudo-interview on Lee's comments at the Investment School and her responses to questions.
Pickering: Structured notes have been a hot topic recently, due to some large, publicized losses. Are most structured notes out of bounds for banks?
Lee: Not at all. You can't paint one picture to represent all structured notes. Even the more complex structured notes have a place in some bank's portfolios. The new guidance provided to FDIC examiners is intended to illustrate the risks and the appropriate management and control procedures expected of banks that purchase structured notes. The guidance was not meant to discourage bank ownership of these securities, with the exception of those that pose an explicit risk of loss of principal.
Pickering: What about community banks?
Lee: Community bankers typically do not invest in the more complex securities that can have risk of loss of principal. Many community bankers have invested in multi step-up callable notes and dual-index notes. The multi step-up callable notes are the more liquid, easily priced structured notes.
Pickering: What if a multi step-up fails the stress test?
Lee: Although multi step-ups and all other structured notes must be stress tested, the designation as high-risk, as applied to mortgage derivative products, does not apply to structured notes. If they have price volatility of greater than 17 percent, given a +/-300 basis points parallel shift in rates, they must be evaluated monthly.
Pickering: What about dual indexed floaters, i.e. floaters tied to two indices such as the 10-year CMT minus 3-month LIBOR?
Lee: Notes tied to two indices will subject the investor to yield curve risk, or the risk of non-parallel shifts in the yield curve. The example you cited has a coupon that will typically go down when the yield curve flattens. By that I mean when short rates increase, long rates remain the same or increase less than short rates. In some instances, it acts like an inverse floater.
Pickering: The FFIEC recently announced that FAS 115 mark-to: market changes in the AFS (available for sale) portfolio would not count against Tier 1 capital. What then are the regulatory implications of FAS 115?
Lee: For regulatory capital calculation purposes, net unrealized losses on AFS equity securities will continue to be deducted from Tier 1 capital as they have been under existing capital standards. For debit securities, the FDIC will continue to take held-to-maturity (HTM) and AFS portfolio gains/losses into consideration when evaluating capital adequacy. …