Following through on promises made last year after the Daiwa bank scandal, the Federal Reserve Board has issued guidelines requiring external audits for poorly run foreign bank branches.

In a letter sent to examiners on Nov. 12, the Fed said foreign bank branches with management ratings of three or worse must hire independent accountants to perform audits.

The auditors, according to the letter, must look for unreported losses that the branch could be hiding. This requires auditors to review financial statements, study transaction logs, and interview bank customers. They also must verify the accuracy of all reports the branch files with government regulators, including the branch's statement of financial condition.

The letter also requires auditors to search for ways the branch could improve its internal controls and oversight, focusing particularly on potential trouble spots identified by examiners.

"This guidance is effective immediately and should be applied to all branches and agencies," wrote Richard Spillenkothen, the Fed's director of banking supervision and regulation.

Paul S. Pilecki, a partner at the Washington law firm of Shaw, Pittman, Potts & Trowbridge, praised the Fed for limiting the audit requirement to poorly run branches. "This recognizes that banks with a one or two rating are paying attention to financial controls," he said.

The Fed closed Daiwa's U.S. operations last fall after the bank waited six weeks to inform regulators that a trader in its New York branch had hidden $1.1 billion in losses. The scandal led several Fed officials to call for regular external audits of foreign bank branches.

In a separate supervisory letter, the Fed reminded examiners on Nov. 7 about the capital requirements for holding companies that securitize assets with recourse. The Fed said the holding company must maintain the full 8% capital reserve requirement against the entire asset, even if the recourse provision only exposes the bank to limited losses.

The only exception is when the reserve requirement is bigger than the amount the banking company could lose if the deal goes bad. In those cases, the holding company must maintain reserves equal to the potential losses.

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