CTP Exam Quiz 03

FDIC
The Federal Deposit Insurance Corporation (FDIC) provides deposit insurance to depository institutions and is the default trustee in the event of failure. It was created after the massive bank failures of the early 1930’s as part of the Glass- Steagall act of 1933. It regulates commercial banks, state non-member banks, mutual savings banks, and savings and loans. It examines these depository institution’s books and imposes restrictions on their assets.

OTS
The Office of Thrift Supervision (OTS) is similar to the Office of the Comptroller of the Currency (OCC), in that they are both part of the Treasury Department. However, the OTS was established in 1989, more than 100 years after the OCC, in response to the S&L crisis of the 1980s.It was created as part of the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA). The OTS has responsibilities that are similar to the OCC in that it acts as the primary regulator of national and state chartered savings and loans and savings banks. The OCC has regulatory responsibilities for federally chartered commercial banks.

Treasury Department agencies
In addition to the OCC and the OTS, the Treasury Department created the Office of Foreign Assets Control (OFAC) in 1950 and the Financial Crimes Enforcement Network (FinCEN) in 1990. OFAC implements economic sanctions against foreign entities that violate U.S. policy. FinCEN is an intelligence network designed to detect money laundering and other financial crimes. The Office of Patriot Act has expanded the roles of OFAC and FinCEN. OFAC can freeze assets and the Bank Secrecy Act permits FinCEN to bring regulatory actions against depository institutions that engage in money laundering. Depository Institutions are required to large money transfers or suspicious banking activity.

Banking legislation

Regulation of the banking industry comes from legislation. The key banking legislation is summarized below.
• The National Bank Act of 1863 created a system of federally chartered banks that would be supervised by the Office of the Comptroller of the Currency.
• The Federal Reserve Act of 1913 created a new banking system that required all federally chartered banks to become members of and subject to a Federal Reserve System. This System divided the country into 12 banking regions and each region had a Reserve Bank within it. The Federal Reserve Act permitted the Fed to control discount loans only and did not require state banks to become members. Many state banks did not join.
• The McFadden act of 1927 sought to make branching among state and national banks equal by just prohibiting altogether any branching across state lines.
• The Banking Act of 1933 (also known as the Glass Steagall Act) created the FDIC, put limits on interest payments on certain deposits, and prohibited interest payments entirely on checking deposits. It also effectively separated the securities industry from the banking industry. It also expanded the Federal Reserve System’s powers to include managing Open Market Operations and setting reserve requirements.

Banking legislation
Regulation of the banking industry comes from legislation. The key banking legislation is summarized below.
• The Bank Holding Company (BHC) Act and Douglas Amendment of 1956 gave the Federal Reserve authority to supervise Bank Holding Companies. The BHC Act also defined and clarified the status of BHCs. A BHC is a corporation that owns a controlling interest in several companies, bank and just bank related. BHCs avoided restrictions on having bank branches in different states.
• The Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 deregulated thrift depository institutions. It permitted sweep accounts, eliminated interest rate limits on deposits, and increased FDIC insurance to $100,000 per depositor.
• The Depository Institutions Act of 1982 (Garn – St. Germain) permitted mergers of banks and thrifts across state lines in emergencies. It also expanded the consumer lending activities of thrifts and banks including granting permission to offer Money Market Deposit Accounts (MMDAs) to depositors.
• The Competitive Equality in Banking Act (CEBA) of 1987 permitted regulatory forbearance in certain depressed areas and granted $ 10 billion dollars to the Federal Savings and Loan Insurance Corporation.

National Bank Act of 1863
Prior to 1863, all U.S. commercial banks were chartered by the states in which they were located. They were ‘state banks’ and each state had their own regulatory agency to govern them. A lack of rule enforcement, however, led to a high number of bank failures. To remedy that problem, the National Bank Act of 1863 established the federally chartered banking system that was governed by the U.S. Treasury via the Office of the Comptroller. State banks were not required to participate and many did not. Consequently, a unique dual banking system developed in the U.S. with national and state banks operating together. Then, after the 1929 stock market crash, it was believed that bank investment activities contributed to the high number of bank failures during that time.

Glass-Steagall Act of 1933
In 1933 the Glass-Steagall Act was passed that effectively separated bank activities from security firm activities. It also created the Federal Deposit Insurance Corporation (FDIC) to protect bank deposits. The Glass-Steagall Act was repealed in 1999 which enabled banks to invest in securities and security firms to offer banking.

Financial Institutions Reform, Recovery and Enforcement Act of 1989
The most significant banking legislation to occur after 1933 was the Financial Institutions Reform Recovery and Enforcement Act (FIRREA) of 1989 which basically provided funds (about $150 billion) for resolving the Savings and Loan failures of the previous years. The funds were used to help the newly created Resolution Trust Corporation (RTC) resolve or manage the failed or failing S&Ls. After the RTC completed this task, it was allowed to simply go out of business. The FIRREA also accomplished other objectives. It eliminated the Federal Home Loan Bank Board and transferred its regulatory responsibilities to the Office of Thrift Supervision (OTS).

Bank Secrecy Act and the USA Patriot Act
The Bank Secrecy Act (BSA) of 1970 sought to control the flow of ill gotten funds through the banking system. To do this it required financial institutions to report suspicious activity such as large or irregular sums of money being transferred to various accounts. The USA Patriot Act (Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism) of 2001 added amendments to the BSA that made money laundering terrorism financing easier to detect and to prevent. The Patriot Act extended the BSA to include non- bank financial institutions and, essentially, foreign banks in U.S. jurisdictions. It also prohibited involvement with ‘shell banks’ (i.e. banks that do not exist physically in any jurisdiction) and foreign banks that fail to take anti-terrorism measures.

Federal Deposit Insurance Corporation Improvement Act
The Federal Deposit Insurance Corporation Improvement Act of 1991 sought to reform the deposit insurance system. It required members to pay higher insurance premiums, required the FDIC to maintain reserves that equaled 1.2 % of the deposits it insured, and enabled the FDIC to more easily borrow from the treasury. An important and effective provision of this Act has been to establish categories of banks to classify their soundness.

Federal Deposit Insurance Corporation Improvement Act
An important and effective provision of this Act has been to establish categories of banks to classify their soundness.
• Group 1 banks have reserves that exceed capital requirements.
• Group 2 banks have reserves that meet minimum capital requirements.
• Group 3 banks have reserves that are less than capital requirements.
• Group 4 banks have reserves that are ‘significantly’ less than capital requirements.
• Group 5 banks have reserves that are less than 2% of assets.
Each category of bank has a certain degree of either privilege or restriction. The Group 1 banks are sound enough to be allowed to underwrite securities, while the Group 5 banks must be closed down by the FDIC.

Oxley Act of 2002
The primary purpose of the Sarbanes Oxley Act (SOX or the Public company Accounting Reform and Investor Protection Act) of 2002 is to increase transparency of accounting practices and in financial statements. It was a reaction to the lax auditing and accounting that led to numerous corporate scandals of the previous years. It is meant to increase consumer protection from large financial losses. Firms are required to disclose to customers the code of ethics that the CFO is required to adhere to and requires that the CEO sign the company tax return. It also requires that external auditors be independent of the company they are auditing and to prohibit any other kind of conflict of interest.

The legislation that has affected interstate banking and FHCs
In the past, banking across state lines was a physical process. Today, electronic transfer of funds across state lines can be done instantly and almost without obvious detection. Consequently, previous legislation that prohibited this has become increasingly repealed. The Interstate Banking and Branching Efficiency Act (IBBEA) of 1994 permit BHCs to acquire (not just hold stock in) banks located in any state. Additionally, if the state permits it, banks can merge with other banks or open branches in other states.

FFEIC and the UCC
In order for financial institutions to be effectively regulated, it is necessary that there be identifiable standards to compare their information to. The Federal Financial Institution Examination Council (FFIEC) was formed in 1979 to develop uniform standards and forms for reporting financial information. These standards and forms are used by all the regulating bodies, including the OCC, Federal Reserve, OTS, FDIC, and the NACU (National Credit Union Administration). In addition to standardized reports, standardized transactions also help regulators and the institutions comply with the rules. The Uniform Commercial Code (UCC) is a set of laws that define the rights and responsibilities of all participants in a commercial transaction. Though each state has some version of the UCC, it always includes rules on negotiable instruments, bank deposits including fund transfers, and letters of credit.

DIDMCA
The Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 required the Federal Reserve to phase out Regulation Q which set limits on interest paid on certain consumer deposits. Restrictions still apply to accounts of S and C corporations. It also required the Federal Reserve to reduce and/or price services that it was providing for free, including payment system float. The pricing is required to be comparable to that offered by tax paying entities. In addition, this Act required the Federal Reserve to offer check clearing services and its discount window services to all depository institutions. The Electronic Funds Transfer Act (EFTA) of 1978 limits consumer liability from unauthorized electronic funds transfers provided the customer notifies the financial institution promptly. The Federal Reserve Regulation E pertains to EFTA.

Other Federal Reserve regulations
• Generally, treasury managers must comply with several Federal Reserve regulations that apply to basic functions of a financial institution. The following is a list of some of the most important Federal Reserve regulations that were meant to implement a specific banking legislation.
• The CRA requires depository institutions to serve the community in which it exists and does business with. The Federal Reserve Regulation BB addresses this requirement
• The Expedited funds Availability Act of 1988 required that banks return unpaid checks promptly and requires that banks treat ‘payable through
drafts’ in the same manner as they treat checks. Federal Reserve Regulation CC complies with this Act.
• To control the money supply, the Federal Reserve sets reserve requirements on certain deposits. All depository institutions must maintain uniform reserve requirements. Federal Reserve Regulation D details this requirement.
• The EFTA limits consumer liability when using electronic funds transfer such as credit cards, ATMs, and ACH. Federal Reserve Regulation E requires appropriate documentation such as a printed receipt for such transfers.

Non-bank finance options

Non-bank finance is a growing source of funds for borrowers and an important investment for savers. It includes life insurance and pension funds. To encourage more diversified and stable banks, the OCC has permitted and even promoted banks to become involved with life insurance instruments. Despite protests from the life insurance industry, both life insurance companies and banks now engage in insurance activities such as annuities. An annuity is similar to a life insurance policy in that the purchaser pays premiums.

Non-bank finance options
Unlike a traditional life insurance policy, at a certain age the purchaser of an annuity can start receiving regular payments from the annuity policy. The largest pension plan is a public one, the Social Security pension plan. Contributions to the plan are obtained, via the employer, from taxpayer paychecks as mandated by the Federal Insurance Contribution Act (FICA). It is a ‘pay as you go’ system and payments from the plan are distributed to the elderly, the disabled and through the Medicare program. Private pension funds can be maintained through a variety of ways, but usually through an employer sponsored plan. Recently however, banks, insurance companies can also arrange and manage pension funds.

Finance companies
Finance companies acquire funds by issuing stock, bonds, or commercial paper which is a short term lending instrument for corporations. Essentially, finance companies buy funds in bulk and sell funds retail. Finance companies are generally far less regulated than either banks or thrift institutions. There are three kinds of finance companies: consumer, business, and sales. Consumer finance is for small loans for mostly durable goods, like appliances. Sales finance is usually apart of an existing manufacturer, like a house builder or car company. It provides financing for its own products. Business financing uses a kind of credit known as factoring.

GAAP
The Generally Accepted Accounting Principles (GAAP) is a set of standards that was developed in the 1970s to act as a guide for financial accounting. Accountants and auditors use these standards when preparing or reviewing financial statements. There are certain principals that act as the foundation of these standards. These principals include matching expenses with revenue, recognizing when revenue is generated and not just received, disclosure of material information, and the use of historical cost for assets and liabilities.

Cash and Accrual methods
The Financial Accounting Standards Board (FASB) organized accounting principals into a set of standards known as GAAP (Generally Accepted Accounting Principles). Included in these standards is the recognition that there can be different methods of accounting. Two main methods of accounting are the cash method and the accrual method. The cash method claims income when it is received and deducts expenses when they are paid. The accrual method claims income when it is earned but not necessarily received. It deducts expenses when they are incurred but not necessarily paid out.

Cash and Accrual methods
Service businesses generally use the cash method of accounting. The accrual accounting method is more flexible regarding financial management. It is also useful when a business has depreciating assets. In that case, the asset can be capitalized. That is, the cost of the depreciating asset can be matched to revenues from numerous future time periods.

Financial statements
Firms prepare financial statements for a variety of reasons. When firms, whether public or private, make financial statements, the statements can be either a balance sheet (statement of financial position), an income statement (statement of earnings), or a cash flow sheet. The SEC requires publicly held companies to include all three of these financial statements in their quarterly and annual reports. A balance sheet is an organized list of a firm’s assets and liabilities.

Financial statements
Banks also include the uses of funds in the assets part, and the sources of funds in the liabilities part of their balance sheet. An Income statement is also referred to as a profit or loss statement. It lists expenses incurred, revenues earned, and any gains or losses from held assets. It calculates the net income of the firm for a given accounting period. A cash flow statement indicates a firm’s cash inflow and cash outflow. The cash flow statement is divided into operating, investing, and financing activities. Cash flow information is derived from the balance sheet.

Opinions
When a firm requires an independent audit, the auditor reviews the financial statements and then gives 1 of 5 possible opinions. These are called opinions because the auditor is only able to give opinions, not guarantees about a firm’s financial status.

The opinions are:
• Standard Unqualified: This is an opinion that is devoid of any extra, limiting, qualifiers.
• Modified Unqualified: This is an opinion that is devoid of qualifiers but includes an extra note that indicates a change in auditors, the possibility of a firm’s pending status change, or suggests further inspection of certain information.
• Qualified: This opinion is given when the auditor finds exceptions in the information that are significant but not necessarily detrimental.
• Adverse: This opinion is given when the auditor finds that the exceptions in the information are significant and detrimental.
• Disclaimed: This is a statement that the auditor uses when they cannot give an opinion either because there is simply insufficient information or because the auditor is affiliated with the company being audited.

FAS 115
The Financial Accounting Standard (FAS) number 115 requires special treatment for unrealized gains and losses from securities. There are three kinds of short term investments that are indicated in FAS115.They are HTM, AFS, and Trading. Held to Maturity (HTM) is an investment that the holder is willing and able to hold to its maturity. This designation permits the holder to report its value at historical cost plus accretion or minus amortization.

The Financial Accounting Standard (FAS) number 115
Gains and losses derived from securities that are held to maturity are not included in income statements or balance sheets. Available for Sale (AFS) is an investment that the holder not willing or able to hold to maturity. It does not mean that the holder has sold the security. Unrealized gains and losses from AFS securities must be reported as changes in reported equity. Trading securities are held for a short time and then sold specifically for generating profit.

GASB
The Government Accounting Standards Board (GASB) is a non-profit organization that develops accounting standards for local and state governments and other non- profit institutions such as public universities and some private colleges. Even though these governmental and non-profit entities conform to GAAP, there are elements of their financial statements that are unique to these groups that are not covered by GAAP. Adherence to theses Government Accounting standards enables these entities to provide accurate and reliable financial information to potential contributors or investors in the case of local governments seeking to issue municipal bonds. The Financial Accounting foundation provides oversight to the GASB and the FASB (Financial Accounting Standards Board).

Off Balance Sheet Arrangements
The Public company Accounting Reform and Investor Protection Act of 2002 (Sarbanes Oxley Act of 2002) contains 11 sections that address accounting issues such as increased CEO and CFO responsibility. It also established a new agency the Public Company Accounting Oversight Board (PCAOB) that is designed to regulate accounting firms that prepare financial statements for publicly held companies. It is a non-profit corporation and its officers are appointed by the SEC. Financial statements that the SEC requires from publicly held companies include a firm’s balance sheet.