Which of the following organizations serves the purpose of protecting public customers against the risk of loss due to the failure of a broker

Purpose

The following guidance alerts banks to the potentially significant credits risks they incur when safekeeping investment portfolio assets with third parties, such as brokers, broker/dealer firms and banks. It supplements the bulletin, OCC 98-20, "Supervisory Policy Statement on Investment Securities and End-User Derivatives Activities," dated April 27, 1998.

Background

When purchasing investment assets for their own portfolios, banks typically use a third party to act as safekeeping agent or custodian. Such third parties may include registered broker-dealers, commercial banks, or unregulated entities. Each of these entities presents certain safekeeping, or "custodial" risks. A number of financial institutions have suffered losses following the insolvency of two custodian deposit brokers that had sold insured certificates of deposit (CDs) to, and safekept them for, these institutions. While this bulletin will use these recent incidents involving CDs to illustrate custodial risks, national banks should strongly consider the precautions set forth herein with regard to all investment assets purchased and held through third parties.

With market yields at historically low levels, many banks have purchased insured CDs as a low-risk alternative to longer maturity investments. When done properly, this strategy can produce some incremental yield with minimal credit and interest rate risks. However, banks must recognize that the credit risk for investment transactions extends beyond the issuer of the instrument; it also includes the actions and judgment of the safekeeping agent (custodian).

Banks frequently buy insured CDs from deposit brokers (i.e., entities that broker CDs). National banks should be aware of the credit quality and external supervision distinctions among deposit brokers, and the implications these distinctions have on the credit risks banks face when dealing with these entities. A deposit broker is not required to obtain any type of certification, or to be registered with any government agency. However, in some cases, a deposit broker may be a broker/dealer registered with the Securities and Exchange Commission (SEC), or it may be a bank or other deposit institution. If a deposit broker is SEC-registered, it will be subject to certain requirements and to regulation by that agency as well as by a self-regulatory organization (e.g., the National Association of Securities Dealers, Inc.). The legal requirements applicable to a registered broker/dealer include minimum capital requirements, but capital requirements may vary significantly among broker/dealers. A bank or other depository institution will be subject to federal or state banking regulation, or both, as well as minimum leverage and risk-based capital requirements.

Deposit Brokers

A deposit broker typically acts as an agent for both the issuer and the investor. After purchasing insured CDs from a deposit broker, investing banks generally allow the deposit broker to act as custodian (safekeeping agent) for the assets. Many banks have not considered the credit risk associated with custody relationships for insured CDs and other types of investments. If the custodian fails, banks can lose, and have lost, some of their investment assets. Therefore, banks must carefully evaluate the creditworthiness and market reputation of the investment organizations through which they purchase, and then safekeep, both insured CDs and other investment assets.

Deposit brokers generally fall into the following categories: 1) unregistered entities, activities of which are limited to deposit brokerage; 2) broker/dealers registered with the SEC that also engage in deposit brokerage; and 3) commercial banks.

Unregistered Deposit Brokers. When assessing the creditworthiness of a deposit broker, banks should first determine whether the deposit broker's activities are limited to deposit brokerage only, or are part of a larger broker/dealer function. Many deposit brokers that are not registered with the SEC have little (or no) capital. Such firms may be subject to no external supervision and often will not be creditworthy counterparties. Because unregistered deposit brokers are agents and frequently have little capital strength, national banks generally should use them as "finders" only. The unregistered deposit broker can identify an issuing institution offering to pay a certain rate, but investing banks generally should wire funds directly to the issuer when purchasing the CD. It is an unsafe and unsound practice for banks to wire funds to purchase deposits to an unregistered deposit broker, or to allow that deposit broker to act as custodian for insured CDs, unless the deposit broker's financial strength and reputation warrants an unsecured credit facility in the cumulative amount of the investments a bank has purchased.

Deposit Brokers Registered As Broker/Dealers. Some deposit brokers are registered with the SEC as securities broker/dealers and are subject to that agency's minimum capital requirements. Capital requirements vary significantly among broker/dealers, depending on whether the broker/dealer clears or carries customer accounts, or does not carry accounts and, instead, clears its brokerage transactions through a full-service broker. Therefore, banks should not assume that a deposit broker is a creditworthy counterparty simply because it is registered with the SEC.

Commercial Banks. Bank deposit brokers do not register with the SEC, but they are subject to supervision from federal and/or state banking regulatory agencies. Bank deposit brokers may have strong capital bases and, therefore, represent creditworthy custodians. However, investing banks should not assume that another commercial bank is a creditworthy custodian simply because it is subject to minimum risk-based capital requirements and external supervision.

It is not uncommon for banks that have accounts with other banks and registered broker/dealers that act as deposit brokers to wire funds to these entities for CD purchases and to allow them to serve as custodian for the assets. The risk of loss from the failure of a custodian can potentially be very significant; therefore, as in any relationship that involves credit risk, banks should conduct a thorough credit review of the financial strength of potential custodians before initiating a custodial relationship. The credit review should assess the custodian's operating performance, market reputation, insurance coverage maintained, registration status (if applicable), as well as its commitment to, and experience in, the custody business.

Deposit Broker Failures

Recently, there have been two failures of custodians with deposit brokerage activity. One of the failed custodians was a deposit broker not registered with the SEC; the other was an SEC- registered broker/dealer with a subsidiary (also a registered broker/dealer) engaging in deposit brokerage activities.

1) Unregistered Deposit Broker Failure: Rather than wire funds for CD purchases to issuing institutions, as is appropriate when doing business through a thinly capitalized, unregistered, deposit broker, a number of banks inappropriately wired funds to the deposit broker for the purchase of CDs. These banks then further allowed the deposit broker to serve as custodian. The deposit broker did not invest the funds according to the terms it had confirmed to its clients. Instead, the deposit broker took investor funds and invested them in its name and for its own terms. As a result, when the deposit broker failed, its actual CD investments did not correspond to the terms of the transactions that it had confirmed to its investing clients. Investors now have uninsured obligations of the failed firm. Despite the low risk of insured CD investments, banks now face losses because they failed to assess the credit risk of advancing funds to an unregistered deposit broker, and allowing the broker to act as custodian.

Some institutions exposed to losses from transactions with this deposit broker had dealt with the firm on a satisfactory basis for a number of years. The loss exposure on otherwise low-risk assets underscores the important credit principle that banks must understand, on an ongoing basis, the creditworthiness and reputation of firms to which they advance funds.

2) Registered Broker/Dealer Failure: In another recent case, banks have suffered losses following the failure of a broker/dealer custodian whose subsidiary broker/dealer had brokered insured CDs into bank portfolios. The broker/dealer subsidiary also sold banks other non-CD investments. Banks have suffered losses even though the broker/dealer, unlike in the case of the unregistered deposit broker above, purchased (and, through its parent, held for customers) insured CDs with the identical terms it had confirmed to its customers. The trustee for the broker/dealer's liquidation, in accordance with the Securities Investor Protection Act (SIPA), has withheld CDs and other investments registered in "street name." 1

When a broker/dealer fails, if there are losses involving customer assets2, investments of customers that the broker/dealer holds in "street name" become "customer property," which is segregated from the broker/dealer's other assets and is distributed to all of the firm's customers.

Banks are customers of a broker/dealer for purposes of the SIPA and have a claim on these assets. But, under the terms of the SIPA, banks are not entitled to the Securities Investor Protection Corporation (SIPC) protection that generally covers $500,000 in property for other investors. Under SIPC procedures, the trustee for the failed broker/dealer first returns property to customers, if that property is registered in a specific customer's name ("customer name" securities). Second, the trustee calculates, and then distributes to customers, their pro rata share of customer property held in "street name." The pro rata distribution reflects the trustee's recovery of customer assets. As the trustee recovers more property for the estate, it seeks court approval to make additional distributions of that property to customers. Finally, customers entitled to SIPC protection receive up to $500,000 to cover any remaining shortfall in what is due to the customer following the pro rata distribution. Banks are not entitled to receive SIPC protection and thus receive only their pro rata distributions from the estate.

The SIPC trustee in this particular broker/dealer failure made an initial 90 percent pro rata distribution of customer property, an unusually large amount compared to other broker/dealer failures. As a result, banks that used the broker/dealer as a custodian had 10 percent of their investment assets withheld to pay for losses on other customers' assets. A smaller distribution, more in line with past experience, would have resulted in considerably more losses and underscores the magnitude of potential losses in custody relationships. A subsequent 6 percent distribution in this case has reduced losses to 4 percent of the property safekept at the failed firm.

In contrast to a broker/dealer failure, if an insured bank custodian fails, the FDIC, as receiver, would determine whether a custodial CD or other investment asset legally belongs to particular customers or to the failed bank. This determination would depend upon whether the bank accepted the funds in an agency or custodial capacity and whether the bank segregated the funds from its own assets. If the FDIC determines that the CD or other securities do not belong to the failed bank, then the FDIC would release the assets to the actual owners (or continue to hold them for the benefit of those owners).

The practical difference between the failure of an insured bank and broker/dealer custodian involves the distribution of losses. With a broker/dealer failure, if there are losses on customer securities, all customers share those losses equally, regardless of whether any particular customer had a loss in his or her account. With an insured bank custodian failure, a customer incurs a loss only if there is a shortfall in his or her account.

Measures To Reduce Custodial Risk

To minimize custodian risk with respect to the purchase of insured certificates of deposit, and other investments, banks should consider the following strategies:

This is a prudent practice for nearly all transactions arranged by unregistered deposit brokers and can also be followed in the case of registered broker/dealers and banks. The CD will have applicable FDIC deposit insurance. This strategy may, however, result in some reduction in yield relative to brokered CDs.

2. Purchase insured CDs and other investment assets from, and safekeep them with, a well-capitalized and reputable commercial bank or broker/dealer.

Investors can suffer losses if either a bank or broker/dealer custodian fails and has committed fraud, or had an operational error, with respect to customer security holdings. Investors should recognize, however, that they incur a unique risk when dealing with a broker/dealer, because failed broker/dealers, unlike failed banks, subject investors to the SIPA-mandated pro rata distribution process. 3 But, that unique risk does not dictate that banks should safekeep investment assets only with another commercial bank simply because there is a more limited risk of a pro rata distribution. A well-capitalized broker/dealer with an excellent market reputation may represent a low risk comparable to that of a well-run commercial bank. National banks evaluating custody options should carefully consider the risks of insolvency and market reputations for both banks and broker/dealers.

3. When using broker/dealers as custodians, banks may reduce the risk of a pro rata distribution by:

• Having the assets registered in the investing bank's name. Since the trustee for the SIPC in a broker/dealer liquidation returns "customer name" assets to their owners prior to the pro rata distribution process, registration reduces risk. This strategy does not eliminate risk, however, because even "customer name" securities may disappear (e.g., in the case of fraud) in connection with a broker/dealer's insolvency. When a broker/dealer fails, the investing bank will have to file a claim promptly to recover the registered assets. Failure to file the appropriate claim in a timely manner may result in significant delays in recovering the asset or, worse, denial of the claim in its entirety. Registration may, however, reduce the practical liquidity of the investments because the bank will have to re-register the assets, and incur related expenses, in order to sell them. Banks should carefully evaluate the costs and benefits of this risk-reducing strategy, including an assessment of coverage available under the custodian's insurance policy. The stronger the reputation and capital position of the broker/dealer, the less likely the benefits of this risk reduction technique will exceed the costs. Moreover, for some assets, such as insured CDs, registration may not be practical. 4
• Diversifying custodian relationships. Rigorous credit analysis and a thorough inquiry into a custodian's market reputation are critical steps to demonstrate prudence in selecting, and continuing, a custodian relationship. These steps can reduce, but not eliminate, the likelihood that a custodian fails. In the case of the failure of the registered broker/dealer referred to above, sound credit due diligence may not have prevented loss exposure because the firm failed so suddenly that a review of its financial statements may not have provided an early warning of financial troubles. As a result, banks can reduce the impact of a pro rata distribution when safekeeping "street name" investments with broker/dealers by diversifying custodian relationships. Banks should consider safekeeping assets at more than one broker/dealer custodian so that a sudden failure of any one firm does not expose an excessive level of assets to the pro rata distribution process. This principle applies to all investments, not only to CDs.

National banks should immediately evaluate the creditworthiness of their custodians, carefully consider their market reputation, and reduce unwarranted exposures or concentrations.

Obtaining Pass-Through Deposit Insurance

For deposit insurance to pass through to the investor on an insured CD held by a third party, the deposit broker must observe certain record keeping conventions.

A deposit placed by an agent (such as broker/dealer) on behalf of a principal (such as the purchaser), is considered insured by the FDIC to the same extent as if the investor purchased the CD directly from the issuer, provided certain conditions are met. Typically, the custodian or its agent holds a large-denomination CD evidencing a number of $1,000 deposits owned by various depositors for which the custodian acts as agent. 5 National banks purchasing CDs through deposit brokers should consider the following FDIC requirements in order to determine whether FDIC insurance passes through to their holding: 6

• The issuing bank's records of the CD's ownership must disclose the existence of the fiduciary or agency relationship under which the deposit broker holds the CD. Examples:
  • "ABC Broker/Dealer Co. as Agent for Customers" when the deposit broker is the only agent acting for a customer; and
  • "ABC Broker/Dealer Co. as Agent for Customers, Who May, in Turn, Be Acting as Agents for Others" when the CD is held for the customer through multiple levels of agents.
• The interest of each owner of the CD must be ascertainable from the deposit accounts records of the CD issuer or records maintained in the regular course of business by the agent. If a CD is held for an owner through multiple levels of agents, the records of each agent must identify the interest of that agent's principal(s).
• The CD must belong to the customer and not to the agent or to another customer. This means that the agent must not have sold to the purchasing bank and others more CDs than the agent has recorded in its name or the name of its agent.
• Finally, when the CD is fractionalized, its terms generally must remain the same through the various levels of ownership. For example, a change in the CD's maturity date will likely cut off the insurance pass-through, whereas a change in the CD's interest rate may or may not, depending on the nature of the change. The FDIC has not articulated the extent to which changes are permitted without cutting off pass-through insurance, and a bank considering the purchase of a fractionalized interest in a CD, where the interest being purchased is different from the original CD, should consider contacting the FDIC for guidance.

Investors, including banks, are generally not in a position to review the details of a custodian's compliance with the record keeping conventions necessary to assure the availability of deposit insurance pass-through. However, registered broker/dealers and banks active in marketing CDs typically have established programs that incorporate the requisite record keeping arrangements. These deposit brokers adhere to a number of conventions, including: (i) providing a detailed information statement that outlines the operation of the CD program and discusses the availability of pass-through deposit insurance; (ii) delivering a confirmation in connection with each sale of a CD; and (iii) providing periodic statements of account to customers showing transactions in CDs and positions held at the end of the period. In addition, each of these broker/dealers and banks is able to provide, if requested, samples of the forms of CDs, including large-denomination CDs, and ownership registrations used in the deposit broker's CD program.

The insured CD investor must ultimately rely upon the integrity, creditworthiness, and competence of any deposit broker used as a custodian for CDs. A deposit broker's failure to adhere to one or more of the conventions described above, or an inability or unwillingness to provide samples of the forms of CDs used in the deposit broker's program, should raise issues about the soundness of the CD program.

Responsible Office

For further information about this bulletin, contact the Office of the Chief National Bank Examiner (202) 649-6360.

Kathryn E. Dick
Deputy Comptroller for Risk Evaluation