The Federal Reserve Board is warning banks to tread carefully when investing trust assets in mutual funds managed by an affiliate.

In a letter being sent to all Fed-supervised banks and holding companies, the agency also said banks risk being accused of having a conflict of interest if they accept incentive payments for investing trust assets in specific mutual funds.

"Institutions should ensure that they perform and document an appropriate level of due diligence before entering into any fee arrangement," the Fed said.

Before investing trust assets in proprietary mutual funds or accepting incentive payments, a bank should solicit a legal opinion addressing the permissibility of the investment strategy, the Fed said.

Banks also should have written policies that detail who at the bank must approve these investments and how these decisions should be documented. Institutions also should explain how they comply with state trust laws and should outline training programs, the Fed said.

Finally banks should document analyses supporting investment decisions, the Fed said. "This analysis should be performed on a regular, on-going basis," the Fed said. "The institution should document its assessment that the investment is, and continues to be, appropriate for the individual account."

Copies of the supervisory letter are available at www.federalreserve.gov.

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