Bankers should institute comprehensive risk management systems before purchasing loan syndications, loan participations, and credit derivatives, according to the Federal Reserve Board.
Richard Spillenkothen, the Fed's director of supervision and regulation, wrote in a supervisory letter that examiners will check to see if banks:
Identify and measure the risk of secondary market credit activities.
Communicate the risk of these activities to senior management and the board of directors.
Stress-test portfolios to learn what would happen to the balance sheet if interests rates changed.
Allocate sufficient capital to cover potential losses from secondary- market credit activities.
"Failure to understand adequately the risks inherent in secondary-market credit activities and to incorporate them into risk management systems and internal capital allocations may constitute an unsafe and unsound banking practice," Mr. Spillenkothen warned.
A copy of the letter will be sent this month to all state-chartered member banks, holding companies, and foreign bank branches.
Recent exams have uncovered instances in which banks involved in loan syndications have failed to conduct independent reviews of borrowers, Mr. Spillenkothen said. Also, he said, the market for secondary-market credit products has become so competitive that underwriting institutions are accepting loans they previously would have rejected.
"Although the recent easing may not be imprudent, the incentives and pressures to lower credit standards have increased as competition has intensified," he said.
Comptroller of the Currency Eugene A. Ludwig issued a similar warning in March.
Industry officials said the Fed's recommendations make sense.
"It is always useful for the regulators to remind banks about how to conduct their operations in a safe and sound manner," said Karen M. Thomas, director of regulatory affairs at the Independent Bankers Association of America. "Concern has been growing that loan quality may deteriorate. This is probably an apropos time to issue this reminder."
"This is consistent with all of the relatively new initiatives on risk management," said Cynthia A. Glassman, a consultant at Ernst & Young. "The message from the regulators has been that whatever activity you are in, you need to know what the risk is and how much risk you want to take."