Alert February 01, 2011

FRB Issues Supervisory Letter on the Impact of High-Cost Credit Protection Transactions on Capital Adequacy

The FRB issued a supervisory letter (Letter SR 11-1, the “Letter”) which provides guidance concerning the potential impact of high-cost credit protection transactions on banking organizations’ overall capital adequacy.  The FRB notes that if a banking organization pays too high a fee for a specific credit protection transaction, rather than safely and soundly managing the banking organization’s credit risk, the banking organization may, in effect, be paying, in the form of premiums and fees, a high percentage of the expected losses in the applicable pool of assets.  In the Letter, the FRB instructs supervisory staff that in the cases of such high-cost credit protection transactions, examiners should carefully scrutinize the transaction and, when appropriate, preclude favorable risk-based capital treatment.