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Managing affiliate transactionsPractical components of a leading governance framework and operating model

Transactions with affiliates have received increased regulatory scrutiny as part of the “heightened standards” for large financial institutions that the Office of the Comptroller of the Currency issued in 2014.1 Banks with U.S. operations must strengthen their governance and risk management practices to comply with these new regulatory requirements.Regulation W (Reg. W) implements Sections 23A and 23B of the Federal Reserve Act and governs transactions between banks and their affiliates.2 This regulation, effective April 1, 2003, mandates that all covered transactions between banks and their affiliates should be on market terms and conditions that abide by safe and sound bank practices. This means that a regulated entity cannot be disadvantaged as a result of transacting business with an affiliate.

In addition to achieving the arm’s-length nature of affiliate transaction pricing, regulators are particularly concerned with how well a company manages transactions with its affiliates. This article outlines leading practices in managing affiliate transactions in terms of governance structure and operating model.

The leading practices outlined in this article provide a high-level overview on how banks can adopt a strong program that can help them stay one step ahead in the evolving regulatory environment.

1 Section 39 of the Federal Deposit Insurance Act (FDIA), 12 USC 1831p-1.

2 67 FR 76560, December 12, 2002. The text of the regulation is contained on the Board’s public website at www.federalreserve.gov/boarddocs/press/bcreg/2002/20021127/attachment1.pdf.

What does a strong governance structure look like?

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A governance structure is the supervision that management uses to ensure a bank provides effective oversight and control over the identification, setup, and ongoing management of transactions with affiliates. Regulators pay particular attention to the level of senior management involvement in Reg. W compliance as well as to the various levels of “defense” in place to prevent or detect issues of noncompliance.

Achieving a leading governance structure is not something that can be accomplished overnight. It takes time to adapt a bank’s culture to the new world of heightened expectations and to hire or retrain resources to take on new responsibilities. The first step in the transformation process involves setting a vision for the ideal end state. The following table provides specific leading practices banks should consider as they work towards enhancing their governance structure.

Governance structure

Oversight committee

– Senior management, including senior financial executives, responsible for assessing and managing all risk associated with Reg. W requirements

– Serves as a point of escalation to resolve issues and as a link to board-level communications concerning affiliate risk management

Intercompany program manager

– Senior manager that independently oversees the bank’s risk taking activities and enforces accountability

– Takes primary responsibility for ensuring intercompany transactions are executed in compliance with Reg. W requirements

Enterprise-wide policies and procedures

– Aligns policies and procedures with the governance structure

– Establishes and provides consistent processes that can be adhered to throughout the enterprise

– Should document in sufficient detail to guide the day-to-day work of individuals responsible for initiating and processing intercompany transactions

Roles and responsibilities (first, second, and third lines)

– Must be clearly delineated and documented

– Each line of defense must have an understanding of its independent role and operate with segregated duties and proper accountability.

Resource plan – Effectively identifies current and future needs in relation to staffing and technology

– Should also discuss regulatory environment, emerging risks, training, succession, compliance, and overall business unit strategy

Training program

– Should be tailored to meet risk appetite

– Everyone with a role in the end-to-end process must receive training at least annually.

Documentation – Supports the governance structure and the end-to-end process, which is critical to meeting regulatory expectations and establishing an effective environment

– Such documentation not only facilitates the institution’s communications with regulators, but is also key to improving stakeholder understanding of the broad infrastructure in place to ensure compliance with Reg. W.

Record to Report

Manage, Maintain &

Monitor

– Develop and post intercompany journal entries

– Issue invoices for confirmation

– Conduct dispute resolution, as required

– Reconcile intercompany accounts

– Conduct settlement of intercompany balances

– Perform reporting (management and financial)

– Review and update transaction inventory listing periodically

– Review and update intercompany agreements periodically

– Conduct compliance testing

– Conduct training and confirm compliance with training programs

Perform accounting and reportingMonitor compliance with

policies and contracts

Operating modelEstablishing a strong governance structure is the foundation of a clearly defined operating model that is designed to execute a functional end-to-end process on an ongoing basis. But it is only the first step helping to ensure compliance with Reg. W. Banks must also establish an effective operating model.

An operating model provides a set of processes, controls, and accountabilities designed to meet Reg. W requirements. It is the means by which employees across the organization operate to successfully achieve regulatory compliance.

Reg. W Section 23B is concerned with how banks manage intercompany transactions among affiliates. This scrutiny is applied from the point at which transactions are identified through journal entry posting in the general ledgers and cash settlement. At each stage of the transaction, regulated institutions have an opportunity to establish sound processes and controls and assign specific accountabilities for performance. The following figure provides an overview of this operating model for affiliate transactions.

Intercompany Process Flow

Key Processes

Identify and record transaction

– Identify initial transaction (new or amended)

– Review for Reg. W compliance

– Record all information required to set up an intercompany agreement

– Record details in the transaction inventory listing

– Establish transfer pricing and costing approach

– Define implementation approach and ongoing accountabilities

– Update intercompany accounting “rules hub” and intercompany subledgers to support pricing method

Establish price and calculate transaction cost

Identification & Initiation

1

Pricing & Costing

2

4 3

The specific design of an effective operating model differs by company depending on the organizational structure, nature of intercompany arrangements, cultural differences (e.g., the degree of centralized control over business operations), and information technology environment. Nevertheless, in our experience, common leading practices do emerge. A sample of such leading practices, which span the intercompany process flow, include:

– Assigning central project management responsibility for managing the end-to-end process flow

– Maintaining a thorough inventory of intercompany transactions with cross-reference to the applicable intercompany agreements

– Centralizing the analysis of arm’s-length pricing for all intercompany transactions to ensure Reg. W and tax regulatory standards are applied correctly and consistently

– Enabling affiliate code fields and transaction identifiers in transaction processing systems to facilitate identification of intercompany transactions; periodically reconciling transaction data to what is in the transaction inventory list for completeness

– Eliminating manual journal entry posting as much as possible; only allowing intercompany transaction posting on the general ledger through accounts restricted for intercompany account purposes

– Applying the “seller’s rule” to all intercompany transactions. The recipient of an intercompany transaction should not refuse to post a transaction, but should resolve any issues through a predefined dispute resolution process

Designing and implementing a leading operating model requires cross-functional engagement from stakeholders in tax, compliance, finance, accounting, and information technology. Furthermore, highly visible leadership from top executives is often necessary to drive true transformation in how intercompany processes are managed. Finally, although resources may be redeployed to more value-added activities under the new target operating model, by following Lean Six Sigma design principles, the new operating model should not require a significant increase in resource allocation to intercompany transactions in most cases.

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A major undertakingKPMG LLP has significant experience helping financial institutions design and implement effective governance programs to address affiliate transactions properly from start to finish. Our integrated, multidisciplinary team includes finance, accounting, regulatory compliance, risk and controls, and economic pricing professionals. Together, we collaborate with you to better align company practices with regulatory expectations.

Developing a strong governance structure and operating model to manage affiliate transactions is a major undertaking that requires the proper resources, tools, and industry knowledge. The emerging regulatory climate calls for banks to be adequately staffed with management applying strong governing oversight. Management must ensure that there is an adequate end-to-end process in place with proper documentation, training, and monitoring of affiliate transactions. Finally, providing a senior manager as a central point of contact to help enforce the bank’s risk-taking activities and manage this process should help banks meet regulatory standards.

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AuthorsBurcin Nee Principal, Operational Transfer Pricing KPMG LLP bnee@kpmg.com

Kenneth Albertazzi Partner, Regulatory Advisory KPMG LLP kalbertazzi@kpmg.com

Burcin Nee, an economist with more than 15 years of experience, provides transfer pricing consulting services to financial services institutions and for financial transactions. Notably, she has advised U.S. and non-U.S. financial institutions on implementing transfer prices and in developing or improving existing frameworks around intercompany transactions with a focus on processes, people, controls, and supporting technologies in accordance with regulatory requirements.

With over 25 years of financial services regulatory and advisory experience, including nine years with the Federal Reserve Bank of Boston as a Supervisory Examiner, Kenneth Albertazzi has advised large financial institutions on many complex issues, including corporate governance, enterprise risk management, asset/liability management, internal audit, operational risk management, recovery and resolution planning, regulatory change management, and regulatory reporting. Recently, he has led numerous projects to address regulatory safety and soundness and compliance examination requirements.

This article represents the views of the authors only and does not necessarily represent the views or professional advice of KPMG LLP.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.

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