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Five federal agencies Friday asked for public comment on a set of recommended internal controls and risk management procedures for financial institutions engaging in complex structured finance activities. The explicitly post-Enron scandal guidelines are for bank holding companies, investment advisers and broker-dealers governed by the agencies. The promulgating bodies were the Federal Reserve Board, the Securities and Exchange Commission, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, and the Office of Thrift Supervision. While the four banking agencies rarely issue guidelines with the SEC, said banking agency spokesmen, they do act in unison when dealing with issues relating to the financial stability of the economy. The initiative was sparked by the improper use of these transactions to manipulate figures released in public filings or mask the financial position of a company. “The events associated with Enron Corp. demonstrate the potential for the abusive use of complex structured finance transactions,” said the agencies in their statement. Such investments include financial derivatives used to hedge risks, asset-backed securities with customized cash-flow features, and instruments used to managed pools of assets. Several investment banks including CIBC, Citigroup and J.P. Morgan Chase have settled with federal agencies for their role in the Enron debacle. In addition to payments totaling hundreds of million of dollars, the settlements often included prescriptive measures aimed at preventing similar mishaps. Friday’s statement builds on these earlier government actions by providing a comprehensive industrywide compliance program. The agencies call for financial institutions to beef up programs to review and approve complex structured finance transactions. The measures recommended by the statement, such as the establishment of formal review and approval mechanisms for structured finance instruments, do not present major changes to industry practices, said Kevin Mukri, a spokesman from the Office of the Comptroller of the Currency, which is responsible for regulating national banks. The radical changes induce top-level managers and board members to consider the “legal reputational risk” of entering into transactions that otherwise pass a legal litmus test, said Mukri. Such risks include liabilities arising from lawsuits by aggrieved investors and damages to the trust in financial institutions, for instance. If a company realizes that a transaction involves “heightened legal and reputational risk” from its initial analysis, the agencies wrote, “the institution should ensure that these transactions receive an elevated and thorough review.” “If, after conducting this review,” they continued, “the financial institution determines that a proposed transaction may result in the customer filing materially misleading financial statements,” the financial institution can take several measures. Enron’s shadow looms large over this portion of the statement. The regulators recommend that financial institutions forgo their fees and resign from the transaction unless the client in question agrees to “making express and accurate disclosures regarding the nature and financial impact of the transaction on the customer’s financial condition.” “We regulators want banks to take prudent risks,” explained Mukri, so that misguided transactions do not later disrupt the national economy and the entire banking system. “The whole system is based on trust and confidence,” he said in explaining the measures recommended to protect the integrity of individual banks. Through these guidelines, agencies want to “[e]nsure that the institution’s board of directors establishes the institution’s overall appetite for risk (especially reputational and legal) and effectively communicates the board’s risk tolerances throughout the organization,” Governor Susan Bies of the Federal Reserve Board said in a recent speech. Financial regulators expect company leaders to play the central role in this “legal and reputational” risk analysis, added Mukri, and not pass responsibility on to junior employees. But the statement does not set out legal requirements, explained Mukri. Regulators will look to the guidelines when examining the internal controls and risk management procedures used by financial institutions, he said. Dave Skidmore, a spokesman for the Federal Reserve Bank, elaborated by saying that banking regulators constantly supervise banks rather than taking action only when they suspect wrongdoing. Instead, their supervisors regularly monitor and improve practices within individual banks — sometimes on a daily basis. The statement, he said, acts as advice for banks and will be used by banking supervisors in conducting their oversight duties.

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