Client Derivatives Audit Program
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Client Derivatives Audit Program

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Client Derivatives Audit Program Client Derivatives Audit Program Document Transcript

  • Contributed March 16, 2002 by Rob McDonough <exactmerob@mindspring.com> Bank Client Derivatives Audit Program I. AUDIT PROGRAM GOALS AND SCOPE: To review the system of internal controls and procedures established over the transactions of derivative instruments executed by Client Derivatives for both internal and external customers and determine that they can be relied on to ensure that: 1 Derivative transactions are properly authorized. 2 Binding commitments are established for every derivative transaction. 3 Adequate risk disclosures are provided to all clients or counterparties. 4 Derivative trades are accurately and completely recorded. 5 Limits are monitored and excesses are duly and promptly approved or resolved. 6 All payments/receipts are properly authorized and paid/received promptly. 7 All derivative positions are revalued regularly with rates obtained independent of dealers. 8 Accounting entries are properly authorized, accurately and completely recorded in all management information sub-systems as well as the General Ledger system. 9 Management information reporting is thorough, timely, and accurate. The scope of this Audit Program will be confined to the following three functional activities: 1 Derivative transactions with external clients that facilitate lending relationships and which are held in the Trading Account and are continuously marked to market. 2 Derivative transactions for internal clients that are intended to provide interest rate risk hedges for existing on-balance sheet positions of Bank and which are subject to SFAS 133 and other accounting standards.
  • 3 Derivative transactions executed by the Client Derivatives line of business on behalf of Investment Bank Subsidiary where Investment Bank Subsidiary is acting as an agent for their client. Derivatives transactions within the consolidated Bank entity which are explicitly excluded from the scope of this Audit Program include (but are not limited to): 1 Transactions executed by Mortgage Subsidiary (a mortgage subsidiary) to hedge their mortgage pipeline risk. 2 Transactions executed by Investment Bank Subsidiary with broker/dealers other than the Client Derivatives line of business. 3 Foreign exchange-related forward transactions on behalf of Bank or their customers 4 Derivatives transactions that are assets under management for the Trust line of business of Bank. A. Selection of Transactions for Review 1. Select a sample of client transactions, including each of the following types: a. Bank client b. Investment Bank Subsidiary client c. All “potentially unsuitable transactions” 2. “Matched” dealer transactions that go with each client transaction in (1) above 3. Select all transactions for the balance sheet book 4. Select all transactions that do not have a matched transaction 5. Verify that all transaction files are being stored in fire-proof file cabinet For each transaction selected, collect the trade file and, for client transactions, the client communication file created by the derivatives marketing specialist (DMS).
  • B. Marketing and Front Office Objectives 1. Ensure client transactions are suitable for client 2. Ensure that trades are properly authorized and executed 3. Ensure dealer trades accurately match and effectively hedge client transactions 4. Evaluate control procedures for front office operations 5. Evaluate front office market risk management process 6. Ensure balance sheet trades are properly authorized, executed, and documented C. Marketing 1. For non-CARLA transactions, verify that the transaction has a valid ISDA agreement. (not applicable for options) a. Signed by client b. Dated prior to transaction 2. Verify that Customer Derivatives Transaction Authorization (“CDTA”) is complete and accurate a. All required fields completed b. Transaction details correspond with characteristics of transaction c. Signed by Relationship Manager, dated prior to or as of transaction date d. Signed by Derivatives Marketing Specialist (“DMS”), dated prior to or as of transaction date e. CDTA indicates valid credit approval for transaction 3. Suitability a. Client profile, derivatives product profile i. Determine client type (I, II, III) (see CDTA) ii. Confirm that file contains documentation to support client type classification and client’s level of understanding of derivatives transactions iii. Determine derivative product type (I, II, III) (see CDTA) iv. Compare client type and derivative product types. If derivative type is higher than client type, refer to section below on Potentially Unsuitable Transactions b. Review documentation to determine if DMS has: i. Performed derivatives “needs assessment” for client ii. Determined the hedge purpose of the transaction
  • iii.Explained the terms and structure of the transaction to the client iv. Explained the risks of the transaction to the client v. For CARLA clients, explained “two-way make whole” provision vi. Provided derivatives risk disclosure information (if deemed appropriate) vii. Assessed client’s understanding of derivatives in general and this transaction in particular c. Potentially Unsuitable Transactions i. Review documentation that provides rationale for transaction where product type is higher than client type or is otherwise considered a potentially unsuitable transaction. Rationales might include the following: 1. Client has initiated or decided on a single inappropriate structure that will be transacted with another dealer if Bank refuses to participate 2. The structure is the only structure that will accommodate client’s risk management objectives and the DMS believe that other “prudent experts” would enter into a similar transaction with the client 3. Complex elements of the derivative structure are pass- throughs of the riskier components of the hedged instrument, and the resulting synthetic instrument fits with the client’s financial profile and philosophy ii. Verify that client received risk disclosure documentation; iii. Verify that risk disclosure documentation included language indicating that transactions may create significant or inappropriate risks iv. Verify that Bank has a signed acknowledgement from client v. File includes the documentation that all of the following factors are met: 1. DMS determines transaction is prudent 2. RM determines the transaction is prudent and client can perform transaction 3. Risk Management and CM manager agree transaction is prudent 4. Appropriate disclosures were made and acknowledged by client
  • 4. Review Marketing procedures for reasonableness and ensure that Capital Markets manager approves them on an annual basis or in the event of any material changes in operations D. Front Office 1. For all client trades (including CARLA transactions) a. Verify that trade ticket, CDTA, and other required forms are in the file b. Ensure that trade ticket is complete and accurate i. Complete with respect to all transaction details: counterparty name contract rate notional amount transaction date/maturity date value date/settlement agent buy/sell date ii. Transaction details match transaction described in CDTA, other documentation iii. Trade ticket is signed by trader and DMS and dated as of trade date iv. Copy of trade ticket was faxed to back office c. Verify that amortization schedule is in file, if appropriate for transaction (not applicable for bullet transactions) d. Verify that every client transaction has offsetting (“matched”) dealer transaction. 2. Trades with dealers (including trades for Bank’s balance sheet book) a. Verify that trade ticket and any other required forms are in the file b. Ensure that trade ticket is complete and accurate i. Complete with respect to all transaction details ii. Transaction details match transaction in matching client trade, except for fixed rate of swap or option strike (same index, payment convention, start and maturity dates, payment dates, product characteristics, etc.) iii. Trade ticket is signed by trader and dated as of trade date iv. Trade ticket is signed by CM manager and dated as of trade date v. Copy of trade ticket was faxed to back office c. Verify that amortization schedule is in file, if appropriate for transaction d. Verify that transaction counterparty is on Bank’s approved dealer list e. Confirm that trade did not violate counterparty credit risk limit or other limits f. Confirm that trades without matching client trade are designed to hedge residual front office interest rate or market risk i. Ensure transaction has been authorized by CM manager ii. Review documentation for purpose of transaction
  • iii. Review documentation showing hedge effectiveness of proposed transaction iv. Ensure transaction has been authorized by Risk Management 3. Verify authorization of dealers: For each dealer, confirm and review a. Signed and authorized ISDA agreement b. Signed and authorized collateral agreement c. Credit risk assessment of dealer d. Credit risk approval e. Confirm that credit positions are within established limits for each dealer 4. Controls on front office transactions a. Trade tickets should be produced automatically by front office systems, or trader should use sequentially numbered trade tickets. (Back office should have procedure to confirm trade tickets received are sequential and matched with confirmations from counterparties.) b. Confirmations from counterparties should be sent directly to back office c. Front office should not have access to G/L systems d. CDTAs must be signed by DMs and RM e. Client trade tickets must be signed by DMS and trader f. Transaction limits i. Limits on size, type of transaction trader can undertake without additional approval ii. Limit on size, type of transaction trader can undertake with CM manager approval 5. Front office systems a. Systems should provide analytics adequate to evaluate characteristics of transactions, including current and potential risk exposures of transactions 6. Review Front Office procedures for reasonableness and ensure that Capital Markets manager approves them on an annual basis or in the event of any material changes in operations. E. Trades for Balance Sheet Book 1. Perform same trade ticket reviews as dealer trades (see above) 2. Ensure file contains properly authorized trade request from Treasury a. Properly signed and dated by Treasurer or authorized officer b. Approved by CM manager and Risk Manager
  • 3. Ensure that file contains proper justification for hedge accounting treatment a. Item to be hedged b. Hedging instrument c. Accounting treatment: cash flow vs market value hedge d. Method for calculating hedge effectiveness e. For existing transactions, verify the effectiveness of the hedge according to the methodology F. Back and Middle Office Objectives: 1. Ensure that all required documentation is contained in the customer folder and is accurate 2. Ensure that all required documentation is contained in the bank confirmation folder and is accurate 3. Ensure that all relevant trade information is accurately entered into the Derivatives Counterparty Database (Currently the Derivatives Access Database) 4. Ensure that payments and receipts are being processed in a timely and accurate manner 5. Verify accuracy and timeliness of position, P&L and risk reporting 6. Test back office Access database for stability and capacity issues to ensure the system can perform adequately given current and future transaction volumes 7. Ensure that information being transferred to the General Ledger and other management information sub-systems is timely and accurate G. Back Office 1. Back office should match received confirms to trade tickets a. Determine status of any missing confirmations (currently in the Confirmation Tracking List (spreadsheet: Confirm Tracking.xls)) b. Verify that confirmations from Bank to counterparty are sent within two business days 2. In addition to trade information, verify that Customer folder has complete information including: a. Borrowing Authorization (or Operating Agreement for LLPs)
  • b. Supporting documentation i. Faxed confirmations ii. Phone records of all follow-up calls 3. For each file selected above, review the documentation and ensure that the information matches that contained in the database and the hard copy reports for the following sections: a. Counterparty data (currently contained in the Derivatives Access database in the Open Counterparty menu): i. Customer contact information for confirmations and payments ii. ISDA documentation date iii. Status of any missing documentation iv. Review comments section for outstanding issues or incomplete documents v. Verify follow-up efforts for any material issues or incomplete documents 4. Trade information (currently in the Open Trade Information Menu or Open Journal Report): a. Transaction information i. Type (swap, cap, etc.) ii. Notional amount iii. Trade, start, and maturity dates iv. Special instructions b. Payment information i. Verify whether Bank is paying fixed or floating ii. Verify index (1 month LIBOR, 3 month LIBOR, etc.) iii. Re-set frequency 5. Payment Advices (currently in the Open Billing/Reset Menu or Pay Schedule report) a. Re-set date b. Pay start date c. Next Pay date d. Payment frequency e. Confirm that payment advices were faxed to counterparty one week before payment is due f. Confirm most recent payment was made 6. Review Missing Document report for outstanding items a. Determine if any missing documentation is material
  • b. Verify that adequate follow-up procedures are in place to obtain missing documentation 7. Profit and Loss (P&L) Reporting a. Ensure that the mark to market (MTM) marks have been added to the database (currently in the spreadsheet MTM all.xls) generated from the Theoretics software application at least monthly b. Compare internally derived MTM values with a sample of dealer marks from appropriate external sources c. Note any material discrepancies with external sources and determine the source of the discrepancy i. Dates, time of day of interest rate data ii. Timing of cash flows iii. Transaction structure d. Assess the adequacy of procedures to resolve material MTM discrepancies 8. Capacity of Existing Derivatives Access database: a. Assess the capacity of the current Derivatives Access Database and verify that it is adequate to support the current volume of Client Derivatives transactions i. Estimate the current percentage capacity utilization of the existing system ii. Verify that the system has the capability of supporting all existing approved product types 1. Bullet plain vanilla interest rate swaps 2. Amortizing plain vanilla interest rate swaps 3. Caps, floors, swaptions, and collars b. Obtain the most recent Client Derivatives business plan for projected volume increases for the remainder of this fiscal period as well as for the next annual fiscal period and determine whether current Derivatives Access Database will be adequate to support these projected volumes. i. Estimate the projected capacity utilization of the existing system based on volume projections for the remainder of this fiscal year as well as the next annual fiscal year ii. Verify that the current system has the capability to support any new products envisioned by the Client Derivatives business plan 1. Knock-out swaps 2. Cancelable swaps 3. Collared swaps 4. Other products (verify with Capital Markets Manager) c. Determine steps taken, if any, to address capacity or product complexity issues or other shortcomings with the existing system.
  • 9. General Ledger reporting a. Ensure that the existing system is generating appropriate data for feeding the General Ledger system or any other management information subsystems (i.e. asset/liability management, interest rate sensitivity, etc.) b. Verify that these data are being supplied on a timely basis 10. Verify that the risk reporting process is adequately capturing the exposures across all products and positions a. Ensure that all exposures are within policy limits b. Verify that the Capital Markets Manager has either approved any limit exceptions or has initiated and documented specific steps to return to limit compliance 11. Review Back and Middle Office procedures for reasonableness (including compliance with the Capital Markets policy) and ensure that Capital Markets manager approves them on an annual basis or in the event of any material changes in operations. 12. Evaluate new product approval procedures a. Verify that Risk Management/Treasurer must approve all new products b. Assess the capability of the current system’s ability to measure and monitor the risks and ongoing transactions associated with new products 13. Verify that all questions in the Client Derivatives Internal Control Questionnaire have been answered satisfactorily