All Institutions Letter Concerning Banking Department Procedures for Review and/or Approval of Certain New Products of Banking Organizations
January 10, 2007
TO EACH INSTITUTION ADDRESSED:
Re: All Examiner Memo concerning Banking Department procedures for review and/or approval of certain New Products of Banking Organizations.
The attached recently issued New York State Banking Department All Examiner Memorandum (AEM) may be of interest to banking organizations.
The AEM provides guidance, and clarifies current Department practice, relating to when prior review and/or approval by the Department may be required before a banking organization engages in new activities or trades new products. The focus is mainly on certain complex products, such as commodity- and equity-linked derivative products. A discussion of the Department’s basis for requiring review and/or approval of certain banking organization new products is on pages 2-4 of the AEM.
The AEM also addresses the role of the banking organization and its counsel in determining when Department review and/or approval may be required, and encourages the banking organization to contact the Department where there may be uncertainty. The type of information typically requested of banking organizations when a review is determined to be necessary is also addressed (see page 6 of the AEM).
Any questions concerning the AEM may be directed to Acting General Counsel Rosanne Notaro at (212) 709-1663.
Very truly yours,
Diana L. Taylor
Superintendent of Banks
ALL EXAMINER MEMO
PROCEDURES FOR REVIEW AND/OR APPROVAL OF CERTAIN
NEW PRODUCTS OF BANKING ORGANIZATIONS
This AEM addresses the procedures and processes the Department should follow in reviewing and/or approving certain new products to be offered or traded by state-chartered and state-licensed banking organizations. The Department does NOT require prior review of all, or even most, new products of banking organizations. An important purpose of this AEM is to identify situations where an examiner should raise questions within the Department concerning a particular new product of a banking organization.
The same processes and procedures described in this AEM would apply for all types of banking organizations, but the institutions most likely to be the subject of such reviews are commercial banks, foreign bank branches and agencies, and, to lesser extent, Article XII investment companies.
Terminology Used in this AEM
“Banking organization” means a “banking organization” as defined in section 2(11) of the New York Banking Law (which includes banks, trust companies, private bankers, savings banks, safe deposit companies, savings and loan associations, credit unions and investment companies (formed under Article XII of the Banking Law)), as well as a foreign banking corporation licensed to maintain a branch or agency in New York. For ease of reference, banking organizations will sometimes be referred to throughout this AEM as “banking institutions”, or simply “banks” or “institutions.”
The term “Division” is sometimes used in this AEM informally to refer to the various areas within the Department that will participate in a review and/or approval of a new product. For example, the Department’s Capital Markets Team will frequently, if not always, be involved in any formal review of new products, although the Capital Markets Team is currently part of the Foreign and Wholesale Banks Division. Also, the Director of the Financial Services Research Unit, the Supervising Credit Risk Management Specialist and the Chief of Regulatory Accounting, who are currently part of the Research, Applications and Technical Assistance Division (RATA), will frequently participate in new product reviews, while RATA, as a Division, will not be involved.
Reason for the Procedure
The offering of new products, particularly complex products, by banking organizations can raise issues concerning the legality of offering the product for the type of banking organization involved, as well as issues of safety and soundness for the institution involved. The purpose of this AEM is to provide guidance to examiners concerning the situations where review and/or prior Department approval may be required, as well as guidance concerning communication that is expected between and among examiners and other Divisions within the Department, with respect to banking organizations’ new products.
As a general rule, there are two situations when prior review, or approval, by the Department might be required: (1) when the product or products being offered might raise a legal issue about the permissibility (i.e. power) of banking organizations to offer or trade the product; and (2) when the offering of the product or products by the banking organization in question could raise safety and soundness concerns.
Experience over the years has revealed that certain types of products necessitate prior review or approval by the Department for possible legal, risk management or other safety and soundness issues. These include, but are not limited to, commodity- and equity-linked derivative products (such as swaps, forwards, futures, options, notes, and related hedging activities), as well as certain complex product or loan structures (for example, those that are tax-driven, involve the use of special purpose vehicles, involve complex movement of funds, etc.). While it is not possible to set a bright line, examiners should be aware that the above types of transactions may require additional review or even prior approval before banking organizations undertake them.
Department’s Basis and Authority for Requiring Additional Review or Approval
Although prior experience has revealed that it is not always clear to our institutions, the Department’s authority for requiring review or approval of products in certain instances is both legal- and safety and soundness-based. Experienced counsel for the institutions will also recognize when prior review or approval may be required, and it should be recognized that the Department’s practice in this regard is substantially the same as the practice employed by our counterpart federal chartering authority, the Office of the Comptroller of the Currency.
When a banking organization is considering offering or trading in new derivative products, particularly commodity- or equity-linked products, such products and structures must be analyzed to determine whether the banking organization’s proposed activities constitute activities legally permissible for banking institutions to engage in under both New York and federal law (sometimes referred to as “bank-permissible” activities). As a general rule, under current law and longstanding precedents, most commodities (other than certain metals considered bullion) and equities are not bank-permissible investments. It has been recognized by regulators, however, that as part of a bank’s lawful “incidental powers”, a bank may make loans or act as an intermediary in trading products that may be linked to commodities or equities. (New York Banking Law section 96(1) grants New York State commercial banks “such incidental powers as shall be necessary to carry on the business of banking.” Similar legal authority exists in the Banking Law for other types of banking organizations). Thus, under several scenarios, banking regulators have determined that a bank’s offering or trading of commodity- or equity-linked derivative products (such as notes, options, futures, forwards, etc.) as well as the related hedging of such activities can be considered “bank-permissible” activities. Generally speaking, to be considered bank-permissible, the banking institution may not, as a result of such activities, own or hold the underlying commodities or equities which would otherwise be impermissible as bank investments. Some exceptions to this rule exist, however; for example, to allow banking organizations to properly hedge such commodity- or equity-linked activities. Overall, however, commodity- and equity-related derivatives activities have been found to be lawful by bank regulators on the theory that certain trading in these products is a logical extension of a bank’s proper role as a financial intermediary. Note that investment companies chartered under Article XII of the New York Banking Law have broader investment and trading powers than most other banking organizations. Therefore, some bank-impermissible activities may be permissible for Article XII investment companies. Also, bank-impermissible activities may often be conducted through a broker-dealer affiliate of a banking organization.
An analysis of whether proposed derivatives activities constitute lawful activities can be quite complex. This analysis should be undertaken, in the first instance, by an institution’s own counsel (whether in-house or outside counsel). The Department’s Legal Division must be involved when a question of the legality of activities needs to be resolved. This AEM should not be read to infer that only commodity- and equity-related derivatives activities require the Department’s prior review and approval, or even that all commodity- and equity-related activities require the Department’s prior review and approval. However, because the structures for these products must be analyzed to determine the bank’s role (e.g. whether the bank ever owns the underlying commodity or equity, under what circumstances, etc.), these products (as opposed to financial-based derivatives such as foreign currency, interest rate, etc.) are highlighted in this AEM as the type of product that will frequently require review for permissibility. Certain other complex products also often raise questions in the areas of legality and safety and soundness. For example, even well-established lawful banking activities such as lending, if performed through complex structures involving the establishment of subsidiaries or special purpose vehicles and/or the circuitous movement of funds or assets between parties, often for tax-driven purposes, can require prior review and/or approval by the Department on legal and/or safety and soundness grounds.
It should be noted that in structures involving the establishment of subsidiaries or special purpose vehicles by the banking institution, the institution would be required to make a written submission to the Department in any event for the establishment of such subsidiary vehicles pursuant to Part 14 of the General Regulations of the Banking Board.
The basis for the Department’s position in some cases that it must “approve” the activities institution-by-institution is bound up with the fact that, if permissible, it is because a determination can be made that the proposed activities are a lawful “incidental” part of the business of banking of the institution. Accordingly, the proposed activities must be evaluated for legality in the context of an institution’s business. It may be a lawful “incidental power” for a large complex financial institution to offer equity derivatives to its customer, but the same activities might not be considered properly “incidental” to the business of a small community bank.
In addition, separate from the question of legality, safety and soundness issues, in particular, risk management issues, must be analyzed on an institution-by-institution basis. While it may be well-established (based on prior precedents) that certain activities may be considered lawfully engaged in by banks, it might be the case the Department would have no objection to such activities being engaged in at some banking institutions, while, due to risk management control issues or other safety and soundness concerns, the Department would not approve of the same activities being conducted by other institutions, or at least not until risk management issues are addressed. This illustrates another reason why the Department may require a case-by-case review and/or approval of certain new products to be offered by banking institutions. Moreover, review and/or approval by federal banking regulators of an institution’s new activities may also be required in some cases.
PROCEDURES TO BE FOLLOWED FOR DETERMINING WHETHER REVIEW/APPROVAL BY THE DEPARTMENT IS REQUIRED AND FOR PERFORMING THE REVIEW AND/OR GRANTING OF APPROVAL
Gateways or Entry Points of Information
Awareness by Department staff that an institution is considering offering a new product which may require legal or safety and soundness review by the Department can be gained in several ways. For example, in some cases, counsel for the institution telephones the Department’s Legal Division to discuss the new product and inquires about the legality thereof and whether approval would be needed. In other cases, the Supervisory Division responsible for the institution may learn about new business proposals in discussions with the institution or review of media reports. In other cases, the Department’s Capital Markets Team may first learn of new products or proposed new products.
The point at which, and the formality with which, the Department learns of the new products can vary greatly. For example, in some cases, the institution has made a determination to advise, or seek the concurrence or review, of the Department for a new activity or product, and a written submission constitutes the first awareness for the Department. Such written submissions are made most often to either the Supervisory Division responsible for the institution or the Legal Division. On the other end of the spectrum, no area within the Department (e.g. Supervisory Division examiners, Capital Markets Team, Legal Division) will have heard of the offering or trading of new products by an institution, and the activity will only first be observed at an examination of the institution, or perhaps discovered through routine supervisory discussions. In between these extremes of very early and/or formal awareness, and very late and/or no prior awareness, there are various other possibilities. For example, as noted, an institution may have a formal or informal discussion with Department staff concerning its intention to engage in the new activities. This can range from a formally arranged meeting with several Divisions of the Department present to a single conversation with an individual Department staff member.
Communication Among Department Staff Members Expected
Regardless of the point of entry of the initial information, where new activities or products may require review or approval, information concerning the institution’s proposal should be shared with the areas, persons or teams within the Department that normally participate in such a review. Currently, these include: (1) the Supervisory Division responsible for the institution; (2) the Director of the Capital Markets Team; (3) the Director of the Financial Services Research Unit; (4) the Legal Division; (5) the Supervising Credit Risk Management Specialist; and (6) the Chief of Regulatory Accounting.
An important reason to communicate between Divisions is that the staff member who initially received the information may not be in a position to know whether the proposed activities or products are of the type that would require a prior review and/or approval by the Department. As an example, an examiner may need to communicate with a member of the Legal Division to know whether proposed trading activities may raise any legal permissibility issues. Likewise, a member of the Legal Division who receives an initial call from counsel about proposed products or trading activities may not realize that such products can involve difficult accounting or risk management issues. It is precisely because different areas of expertise are needed to properly consider all aspects of such complex transactions that the Department’s practice is to review such activities on a multi-disciplinary basis.
Generally speaking, as a starting point, the best practice is for the Department staff member who receives initial information about a proposed new product or activity to request a brief written summary of the product from the institution. It should be kept in mind that the Department is NOT seeking to perform the role of “gate keeper” in approving each and every activity or new product of our regulated banking institutions. Therefore, judgment must be exercised by Department staff as to when such a request is prudent. The proper role for the Department is to assure itself that an institution will not be undertaking an activity that is not legally authorized or that may not be conducted safely and soundly. Therefore, where there may be doubt in either of these areas, it may be helpful for the Department staff member initially receiving the information to contact a Department staff member in another area (e.g. Legal, Capital Markets Team) for thoughts concerning whether the Department should be reviewing and/or approving an activity. An internal Department meeting involving all interested Divisions may also be helpful at this stage, even prior to a formal written submission by the institution, but generally this would not be expected.
Not all activities or new products that are brought to the attention of Department staff members will necessarily require an up-front review. Upon internal consultation, Department staff may conclude that the proposed products or activities do not require prior review or approval, but should be reviewed during the regular course of examination of the institution. In fact, as noted, most of an institution’s new products and activities will not require an up-front review. Existing examination guidance states that new products should normally be reviewed during the regular examination of an institution. On the other hand, simply because already-commenced new products or activities were first discovered during an examination, for example, does not mean that they should not properly have been the subject of a prior review and/or approval. In such cases, an after-the-fact review of the activities or products by the Department may be determined to be necessary.
In recent years, the commodity- and equity-related derivatives activities mentioned above have generally required prior review and approval to ensure legality and safety and soundness. This requirement is likely to continue. However, it is possible that certain products would require a less formal review as a result of precedent and the Department’s experience with institutions offering similar products.
Information to be Provided by the Institutions
As noted, to assist the Department in determining whether a review and/or approval of proposed new activities will be required, it may be helpful for the institution to initially provide a brief written summary of the products involved and the business proposal. This need not be formal – an email communication or materials already prepared by the institution’s business unit may suffice.
Institutions should not conclude that the Department needs to see a summary of all of an institution’s new products. The scope of this AEM is only those products which it could reasonably be concluded might raise legal or safety and soundness issues. The primary responsibility for this determination rests with the institution and its counsel. When there is doubt, the Department should be consulted. The fact that it is the institution’s primary responsibility to seek approval if required does not mean that examiners should not raise questions or point out the possibility of an approval requirement to the institution where it appears the institution may be overlooking such requirement.
If it is determined that the activity or product is of a type requiring prior review and/or approval by the Department, the institution should be asked to prepare a more formal submission, which should fully address the business proposal and the specifics of the products, and also include a legal analysis concerning the permissibility of the proposed activities for the institution in question. The Department generally expects the submission to address other relevant points, such as, by way of illustration: typical customer base, rationales for the transactions for all involved parties, hedging strategies and policies, monitoring and reporting of exposure, analysis of risks (e.g. credit, market, legal, reputational, etc.), customer suitability policy, new product approval process and approvals obtained for the specific products, cash flows and accounting treatment, accounting and legal opinions obtained, and other regulatory approvals required. The Department may of course raise additional questions following an initial submission.
Review of an Institution’s Submission by the Department – Roles of Various Divisions
This section applies to a formal written submission that has been made by an institution upon suggestion or request of the Department, as well as those that the Department has received directly from an institution on the institution’s own initiative.
First, the recipient or recipients of the submission should ensure that the submission is distributed to, at a minimum, all areas, persons, or teams within the Department that would normally participate in a review. Currently, these include: (1) the Supervisory Division responsible for the institution; (2) the Director of the Capital Markets Team; (3) the Director of the Financial Services Research Unit; (4) the Legal Division; (5) the Supervising Credit Risk Management Specialist; and (6) the Chief of Regulatory Accounting.
After a suitable period for review by each participating area or Division, an internal meeting should be arranged including all such Divisions to discuss the submission. There may be instances where it is determined that a meeting is unnecessary, or the participation of a particular Division (specialist, etc.) is unnecessary, but generally a multi-Divisional meeting should take place so that various reactions to the proposal can be discussed and compared. Additional internal meetings can be arranged if necessary.
At such internal meetings, one or more of several things may occur, including but not limited to:
- Ideas of Department staff should be shared on the overall plausibility, acceptability, etc. of the proposal. Specific issues and concerns of the various Divisions should be aired (e.g. issues of legality, accounting questions, risk management concerns).
- Generally, a list of specific questions arising out of the issues discussed should be developed.
- Decisions should be reached on how the questions raised should be asked and who should address them.
- Department staff may itself investigate certain questions (e.g. legal, accounting questions).
- Questions may be developed in letter or email form and transmitted to the institution.
- Visitations to the institution for informal discussions may be appropriate – e.g. the Capital Markets Team may be requested to perform a risk management assessment.
- It may be decided that a formal meeting at the Department with the institution is required for further explanation and questioning on the proposal.
- Responses to questions, additional institution submissions, etc. should be discussed at subsequent Department internal meetings as necessary, until the Department is ready to produce a response to the institution.
Consideration of institutions’ submissions for review/approval of new activities and products should remain a cooperative and communicative endeavor between all participating Divisions throughout the process. Departmental Divisions should not communicate an approval to the institution regarding the aspect of the proposal they are reviewing (e.g. legal, risk management) until an overall Departmental decision is ready to be communicated. However, each Division, Team, etc. that has participated in the review should present their conclusions or sign-off within the Department in an appropriate manner. Generally, this would be expected to be in written form (e.g. email or memo), directed to the Supervisory Division with responsibility for the institution.
Communicating a Departmental Decision
Prior to any formal written decision being sent to an institution, such proposed written communication should be approved as part of a Round Robin to the Superintendent. The Round Robin must have sign offs by the following areas, at a minimum: (1) the Supervisory Division responsible for the institution; (2) the Capital Markets Team; (3) the Legal Division; and (4) the Executive Division.
The form of response provided by the Department will depend on whether the activity in question is subject only to review, or rather to specific approval of the Department, as well as the nature of the major issues raised by the proposal.
For example, if a proposed activity raises legal issues which have not previously been ruled on by the Department, a decision may be made that a letter from the Legal Division should be sent to the institution rendering a decision on the legality of the proposed activities. If the proposed activities do not raise significant legal issues, but the main issue is whether the particular institution in question has adequate controls to conduct the activity prudently, a letter from the relevant Supervisory Division with input from the Capital Markets Team and/or the Accounting and Internal Controls Team may be all that is necessary. In some cases, a single letter combining all of the Department’s conclusions and conditions may be appropriate.
In other instances, a formal written response may be deemed unnecessary given the nature of the Department’s review (for example, if a visitation by the Capital Markets Team to meet the institution’s business team is all that was determined to be necessary). The Round Robin process would not generally be expected to be followed for responses to the institution short of a formal written decision.
In summary, feedback or response to the institutions can take many forms. However, all participating Divisions should agree on what form the response will take, and it should be made clear to the institution, once it is known, what form of response the institution may expect from the Department. Of course, the institution’s needs should be considered in determining the most appropriate form of communication.
Examination Follow Up After New Activities Commenced
An institution’s new product activities should generally be reviewed in routine examinations of the institution following commencement of the activities. The scope and detail of the review is to be determined as is customary during the development of the supervisory plan by the appropriate Supervisory Division staff (see AEM 2003-06). However, where a written approval of a new product or activity has been transmitted to the institution by the Department, the Supervisory Division should ensure that the examiner’s review includes a review of the activities against such written approval and any conditions contained therein. The Supervisory Division should have a process in place to make any such conditions and approval available to the examiner so that the examiner can scope such review into the examination.