Publication of the May 2003 update to the Commercial Bank Examination Manual.

The May 2003 update to the Commercial Bank Examination Manual, Supplement No. 18, has been published and is now available. The Manual comprises the Federal Reserve System's regulatory, supervisory, and examination guidance for state member banks. The new supplement includes the following subjects:

1. The Interagency Policy Statement on the Internal Audit Function and Its Outsourcing. The March 17, 2003, policy statement supercedes a 1997 interagency policy statement on internal auditing. This new policy conveys recent developments in internal auditing and addresses supervisory concerns, policies, practices, and procedures about the internal audit function and its outsourcing. Supervisory guidance is also provided on the independence of accountants, especially those who provide both internal and external audit services to institutions.

Provisions of the 2002 Sarbanes-Oxley Act and associated SEC rules are also addressed within the 2003 policy statement. Banking institutions that are subject to section 36 of the Federal Deposit Insurance Act--essentially those with $500 million or more in assets--should comply with the Sarbanes-Oxley Act prohibition on internal audit outsourcing to an external auditor. The examination objectives, examination procedures, and internal control questionnaire were revised to consider the new provisions within this policy statement. (See SR letters 03-5 and 02-20.)

2. An Interagency Advisory on Mortgage Banking. This February 25, 2003, advisory highlights various supervisory concerns regarding the valuation and hedging of mortgage-servicing assets and similar mortgage banking assets. Supervisory guidance is also provided on sound risk-management practices pertaining to valuation and modeling processes, management information systems, and internal audit involved with mortgage banking activities. The examination objectives, examination procedures, and internal control questionnaire were also revised. (See SR letter 03-4.)

3. The Interagency Guidance on Supervisory Account Management and the Allowance for Loan and Lease Losses (ALLL) Methodology for Credit Card Lending. In addition to setting forth supervisory expectations for credit card credit line management, over-limit practices, minimum payments, negative amortization, and workout and forbearance practices, this January 8, 2003, guidance clarifies various reporting requirements related to income recognition and the ALLL. The credit card lending examination procedures were also revised and expanded. These credit card lending examination procedures also include the credit card lending examination procedures that are currently found in examination modules. The examination objectives and the internal control questionnaire were also revised. (See SR letter 03-1.)

4. The Board's October 31, 2002, Approval of an Amendment to Regulation A. This revised rule (effective January 9, 2003) sets forth the Federal Reserve's primary and secondary credit programs, which replace the adjustment and extended credit programs. The seasonal credit program is essentially unchanged.

5. The Board's November 22, 2002. Approval of Regulation W. Regulation W (effective April 1, 2003) applies to transactions with affiliates under the statutory provisions of sections 23A and 23B of the Federal Reserve Act. The rule facilitates compliance with these statutes, provides new exemptions, and combines the statutory restrictions on transactions between a member and its affiliates that were found within the previously issued Board interpretations and exemptions. (See SR letter 03-2.)

6. Examiner Guidance on the Review of Regulatory Reports, Considering the Provisions of the Securities and Exchange Act of 1934 (as amended by the Sarbanes-Oxley Act of 2002). The Board was given the authority to administer and enforce certain provisions of the 1934 Act and the Sarbanes-Oxley Act with respect to state member banks that have a class of securities registered under section 12(b) or 12(g) of the 1934 Act (registered state member banks). Examiners should consult with a registered state member bank's management to ensure that the required reports have been filed with the Federal Reserve Board pursuant to section 208.36(a) of Regulation H. Some of the most common SEC forms that must be filed under the 1934 Act and the Sarbanes-Oxley Act are listed and discussed.

7. The Board's January 6, 2003, Revision to Subpart D of Regulation K, Sections 211.41-43. The definition and detailed components of the allocated transfer-risk reserve (ATRR) are discussed, as stated in the rule (effective February 10, 2003). The rule also provides that international loan fees are to be accounted for in accordance with GAAP.

8. The Use of the Federal Reserve's Statistically Based Sampling Approach for Loan Reviews at Certain Community Banks. The use of a statistically based sampling approach to loan reviews is discussed as an alternative to the traditional target-coverage approach. The loan-sampling program is directed toward banks currently having a CAMELS composite and asset-quality rating of 1 or 2 and also having assets of less than $1 billion. Examination objectives and examination procedures are provided. (See SR letter 02-19.)

9. The FFIEC Interagency Guidance on Authentication in an Electronic Banking Environment. This August 8, 2001, guidance provides a discussion of the risks and needed risk-management measures and controls pertaining to existing and emerging authentication practices. The processes are addressed for verifying the identity of prospective customers and for the authentication of existing customers who use online systems, such as Internet banking services. (See SR letter 01-20.)

A more detailed summary of changes is included with the update package. The Manual and updates, including pricing information, are available from Publications Fulfillment, Mail Stop 127, Board of Governors of the Federal Reserve System, Washington, DC 20551 (or charge by facsimile: 202-728-5886). The Manual is also available on the Board's public web site at www.federalreserve.gov/ boarddocs/supmanual/.