Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities

On 16 May, 2006, five US regulatory agencies, including the Federal Reserve and the Securities and Exchange Commission issued a revised version of a statement on sound practices concerning elevated risk complex structured finance activities (the “Statement”).  The original version (issued in 2004) had drawn much comment and criticism from the financial services industry in the US and beyond.

The revised version of the Statement attempts to set out some guidelines for financial institutions entering into “elevated risk” “complex structured finance activities”. Neither of these terms is specifically defined.  However, the revised Statement appears to identify one such type of activity as those “designed or used to shield their customers’ true financial health from the public”. 

Interestingly, neither the revised Statement nor any of the published responses to it, have identified the issue mis-selling of complex structured finance instruments as one that “may pose heightened levels of legal or reputational risk to the relevant institution” (these words are used to give a general description to the term “elevated risk CSFTs”).  Nevertheless, at least in the European market, the allegation of mis-selling is among the most common type of complaint made by institutional investors in complex structured finance products.

It seems to us that the issue of highlighting and explaining the increasingly complex risks inherent in many of the structured instruments on offer in the international markets today should be a matter of equal concern to regulators in the US and indeed beyond.

Excerpts from Interagency Statement on Sound Financial Practices Concerning Elevated Risk Complex Structured Finance Activities

There follow excerpts from the joint statement of 4 May 2006 by five US agencies (the “Agencies”) the Office of the Comptroller of the Currency, Treasury (OCC); Office of Thrift Supervision, Treasury (OTS); Board of Governors of the Federal Reserve System (Board); Federal Deposit Insurance Corporation (FDIC); and Securities and Exchange Commission (SEC).

Scope and purpose of Statement

“The regulatory Agencies are issuing this Statement to describe the types of risk management principles that we believe may help a financial institution to identify CSFTs that may pose heightened legal or reputational risks to the institution (“elevated risk CSFTs”) and to evaluate, manage and address these risks within the institution’s internal control framework.

Structured finance transactions encompass a broad array of products with varying levels of complexity. Most structured finance transactions, such as standard public mortgage-backed securities transactions, public securitizations of retail credit cards, asset-backed commercial paper conduit transactions, and hedging-type transactions involving “plain vanilla” derivatives and collateralized loan obligations, are familiar to participants in the financial markets, and these vehicles have a well-established track record. These transactions typically would not be considered CSFTs for the purpose of this Statement.”

Identification and review of Elevated Risk Complex Structured Transactions

“A financial institution’s policies and procedures should establish a clear framework for the review and approval of individual CSFTs. These policies and procedures should set forth the responsibilities of the personnel involved in the origination, structuring, trading, review, approval, documentation, verification, and execution of CSFTs. Financial institutions may find it helpful to incorporate the review of new CSFTs into their existing new product policies. In this regard, a financial institution should define what constitutes a “new” complex structured finance product and establish a control process for the approval of such new products. In determining whether a CSFT is new, a financial institution may consider a variety of factors, including whether it contains structural or pricing variations from existing products, whether the product is targeted at a new class of customers, whether it is designed to address a new need of customers, whether it raises significant new legal, compliance or regulatory issues, and whether it or the manner in which it would be offered would materially deviate from standard market practices. An institution’s policies should require new complex structured finance products to receive the approval of all relevant control areas that are independent of the profit center before the product is offered to customers.”

Conclusion
“Structured finance products have become an essential and important part of the U.S. and international capital markets, and financial institutions have played an important role in the development of structured finance markets. In some instances, however, CSFTs have been used to misrepresent a customer’s financial condition to investors and others, and financial institutions involved in these transactions have sustained significant legal and reputational harm. In light of the potential legal and reputational risks associated with CSFTs, a financial institution should have effective risk management and internal control systems that are designed to allow the institution to identify elevated risk CSFTs, to evaluate, manage and address the risks arising from such transactions, and to conduct those activities in compliance with applicable law.”