Current Legal Issues Affecting Central Banks, Volume V
Chapter

COMMENT

Author(s):
Robert Effros
Published Date:
May 1998
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Author(s)
DOUGLAS E. HARRIS

Introduction

The answer to the question of whether derivatives are speculative instruments or whether they are useful risk-management tools depends on how they are used and for what purpose. There is no doubt that many investors take financial positions in a manner that reflects their views about potential market changes. In some instances, this may be viewed as prudent risk management; however, such positioning can also be speculative. To say, therefore, that derivatives should be prohibited simply because they can be used for speculative purposes is an anomaly for many financial institutions that are involved in a number of risk-taking activities, one of the biggest of which is lending their money to others. One of the things that the Office of the Comptroller of the Currency (OCC) has found by tracking the exposures—specifically, credit exposure—of some of the largest banks is that, as large as derivatives activities have grown, the exposure on credit card loans was much greater than the exposure from derivatives. Nevertheless, derivatives are generally perceived as very risky. The revenues that flow from derivatives are volatile, but, in fact, the greater risk—and thus the potential for greater loss—is still associated with lending out a bank’s own money.

To put this in perspective, some derivatives have been designed specifically to hedge risk—witness the growth and development of the futures markets. These markets started out as places where farmers could hedge their exposure to rising and falling grain prices, and they were used successfully for that purpose for years. Currently, you can also trade in foreign currency futures, treasury bond futures, insurance futures, and other catastrophe futures. However, one reason these markets work is because some investors come to the markets specifically to speculate. They are not wrongdoers. In fact, speculators are needed to provide liquidity to the markets so as to allow those investors that need to hedge the ability to do so. Without speculators providing liquidity to the markets, there are no markets. However, by their very nature, speculators generally take onesided financial exposures—that is, they are betting that a particular market change will occur. As a consequence of their activities, their risk profiles tend to reflect higher risk exposures. In order to mitigate the potential risk speculators might pose to the markets, there are restrictions on the markets and the way the markets operate.

Other types of derivative contracts can provide substantial benefits for risk management, but they can also pose material amounts of risk. As a result, the OCC expects that the institutions that it supervises should implement comprehensive risk management and control practices commensurate with the level and extent of their activities.

There is absolutely no doubt that derivatives have had a profound effect on the way that banks conduct their business. In addition, they also have had a profound effect on the way the OCC supervises banks. Much attention has been focused on derivatives, primarily because they are new products and also because of their perceived risk. While some derivatives, as previously noted, are no more risky than lending one’s own money, particular derivatives can be extremely risky, as evidenced over the past few years. However, individually and collectively, both the banks and the regulatory agencies have come to the conclusion that it is the risk, and not necessarily the specific product, that should be the focus of concern. The risk matters, and it is the risk that needs to be controlled. One of the first ways in which bank supervisors started to address this risk was through capital standards. Bank supervisors have now gone further to address risk management and internal controls, as well.

Although there are certain procedures and practices that should be uniform and applied to most financial institutions, the OCC found that any attempt to make these risk-management principles invariable almost amounts to micromanagement, which would ultimately be a mistake. The risk-management procedures, or risk-management principles, that banks use to manage risk are changing constantly. Therefore, the whole area calls for a flexible approach to supervision. With a few qualified exceptions, the OCC, as well as the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance Corporation (FDIC), have issued only guidance and advisories in the area of derivatives and risk management. Inflexible rules and regulations have not been issued. The following are some examples of the guidance and advisories that have been released.

OCC Guidance and Advisories

One of the first things that the OCC did to address the supervisory issues that arose in connection with bank derivatives was to issue Banking Circular No. 277, Risk Management of Financial Derivatives (BC-277).1 BC-277 provided basic guidance on how banks should identify, measure, monitor, and control the risks arising out of their derivatives activities, whether the banks were acting as dealers, active position takers, or limited end users. Although the title is Risk Management of Financial Derivatives, it is clear from the document that it was not meant to be limited to derivatives. The guidance itself can be applied as broadly as possible to a bank’s risk-taking activities. This is a significant point that will be addressed again. BC-277 was followed with a set of questions and answers that clarified and provided further guidance on some of the issues addressed in the circular.2 In the summer of 1994, the OCC issued an Advisory on Structured Notes,3 which was one of the few examples of a situation in which the OCC actually focused on a specific product. However, even here, the OCC’s focus was on the risk. The OCC cautioned banks, especially the smaller banks, that there could be significant market and liquidity risks associated with some forms of structured notes. At that time, there was an interest rate spike in this country, and many small banks were discovering for the first time that the structured notes that they had purchased—which seemed to be so valuable and initially offered them such high rates of return (over what was otherwise available in the market)—were in fact depreciating rapidly in value. What those banks and many market participants had not focused on were the substantial market and liquidity risks associated with the notes because of the way they were structured, even though most of these notes were being issued by the most creditworthy borrowers.

In the fall of 1994, the OCC issued nearly 100 pages of detailed guidance to its examiners on how they should determine whether a bank is complying with BC-277.4 In early 1995, the OCC issued an advisory on the measurement, monitoring, and control of interest rate risk.5 Specifically, the OCC cautioned banks, many of whom had already moved away from a simple gap analysis to an earnings-at-risk analysis, that neither of these analyses may be sufficient to monitor adequately and control their interest rate risk, especially at those institutions with substantial medium- and long-term exposures. The OCC suggested that banks should consider whether the addition of a value-at-risk model to their risk-management arsenal would be appropriate.

In November 1995, the OCC issued guidance to its examiners on examining futures brokerage subsidiaries.6 Those are the entities that broker exchange-traded futures and options for clients. This is an activity that U.S. banks first became involved in during the early 1980s, and it is one that has grown. It is clear that the OCC’s interest in providing guidance—even though the OCC supervises only a handful of banks that have these subsidiaries—was brought on by the Barings incident. Although it was Barings, the bank, that collapsed, the problems were located in its futures brokerage subsidiary in the Far East. The OCC wanted to ensure that the proper management and control of risk existed in such subsidiaries for national banks, so that the risks in these subsidiaries would be well contained and would not necessarily be transferred to the parent bank. In fact, the OCC specifically commented on the fact that there are substantial liquidity risks and transaction risks associated with futures brokerage activities.

In December 1995, the OCC issued guidance on emerging markets activities.7 The OCC cautioned banks about the substantial liquidity risk and sovereign risk associated with emerging markets activities.

In May 1996, the OCC issued a bulletin providing guidance as to how banks should manage the risk arising out of their fiduciary activities, specifically, investing in derivatives in a fiduciary capacity.8 In this instance, the OCC was specifically concerned with investments in structured notes and collateralized mortgage securities. It is clear that some of these derivatives were being acquired for investment purposes. There was no semblance of hedging. Rather, they were viewed as investment substitutes and, as such, were being acquired for “speculative purposes” to achieve a high investment return. In many cases, as the OCC found with structured notes a couple of years ago, some of the fiduciary accounts were beginning to suffer losses as a result of these investments.

Providing guidance to banks on proper risk management of various products and activities has caused the OCC to change its initial approach and, in this connection, to rethink how it examines and supervises banks. As described in Chapter 10A, in early 1996 the OCC unveiled a new supervisory program called “Supervision by Risk.” Under this new program, OCC examiners make an assessment of the quantity and quality of risk management at individual banks, and then the OCC allocates its supervisory resources accordingly. One of the first steps in developing this approach was to come to an agreement on a common lexicon of risk. The OCC came up with nine categories: credit risk, interest rate risk, liquidity risk, price risk, foreign exchange risk, transaction risk, compliance risk, strategic risk, and reputation risk. One important risk that is probably subsumed in a couple of these risks is intellectual risk. Although the OCC has not specifically identified intellectual risk in its lexicon of risks, it is something the OCC takes seriously in risk management, especially for capital markets activities.

One part of intellectual risk relates to the concentration of knowledge that may exist on the trading floor and the risk that this concentrated knowledge may move to a competitor. Another element of intellectual risk is the gap in knowledge that can exist in an institution. While there may be a concentration of knowledge down on the trading floor with respect to specific innovative products and activities, there may nevertheless be a gap between the knowledge of the traders and the amount of knowledge about those same products and activities that is held by senior management. The OCC believes this to be a big problem. Ultimately, it is senior management that has the responsibility for ensuring that proper risk-management procedures are in place and that they are being followed. Both ensuring that risk-management procedures are appropriate and ensuring that they are being properly implemented depend upon having an understanding of the product and the activity. Such knowledge gaps often arise with respect to capital markets activities because senior management in many institutions is very often drawn from the corporate lending side of the business. However, those on the trading floor are often younger and do not have the same level of experience and capacity for judgment that senior management has.

Depending heavily on experience and good judgment, the last two of the OCC’s nine risks—strategic risk and reputation risk—are in a somewhat different category from the first seven. The first seven are more quantifiable. Strategic risk and reputation risk are somewhat soft in terms of the institution’s consistent and recognized ability for good decision making. This can be difficult, if not impossible, to quantify. Yet, the recent Bankers Trust case is evidence of the high degree of reputation risk involved in derivatives trading.9

The OCC’s program of supervision by risk is certainly the right approach. The Federal Reserve and the FDIC have similar programs. Risk can serve as a common denominator to provide a consistent way of analyzing potential effects on earnings or capital across a variety of bank products and activities. Bank supervisors need to be concerned about the overall quality of a bank’s assets. In other words, it is important not to lose sight of the combined effects of the separate categories of risk. Different types of risk are not necessarily independent. Bank supervisors could miss significant problems if they only focus on whether or not individual risks are being managed and controlled.

Sales Practices

There has been much work in the area of sales practices at the OCC. Sales practices were first addressed when BC-277 was developed, but they were addressed in a different way from the risk-management perspective of a bank. Two concepts are relevant: “appropriateness” and “suitability.” Appropriateness describes an effective way for a bank to manage and control its credit risk, litigation risk, and reputation risk. It requires the bank to make an assessment, prior to engaging in a derivative transaction, as to whether the transaction is consistent with its counterparty’s policies and procedures for engaging in such transactions. The term suitability is associated with the duty that one party has to the other party to ensure that the obligation is a suitable obligation for that counterparty, where suitable means consistent with its financial resources, its expertise, and its knowledge. The OCC’s appropriateness standard is more limited than the suitability standard. The former is concerned only with whether a transaction is consistent with the counterparty’s policies and procedures. It is primarily designed to protect the bank; however, it can serve to provide indirect protection for bank customers as well.

Bank regulators in the United States have also recently proposed for adoption a suitability standard with respect to government securities.10 It is essentially the same interpretation that the National Association of Securities Dealers has set forth under the Government Securities Act, which provides a carveout for certain institutional customers.11 This is noteworthy because government securities include not only U.S. treasury bonds, notes, and bills, but also most structured notes, inasmuch as many of these are commonly issued by government-sponsored enterprises. It is thus possible that bank supervisors are starting down the slippery slope of making dealers more legally obligated for the mistakes of their counterparties. Hopefully, they will know where to draw the line. In May 1996, a judge decided in Procter & Gamble’s case against Bankers Trust that Procter & Gamble was a sophisticated counterparty and that the transactions in question were made at arm’s length.12 For the near term, it is relevant to consider whether actions that regulators have taken to implement the Government Securities Act Amendments of 199313 are inconsistent with the Procter & Gamble ruling or, for that matter, with the Principles and Practices for Wholesale Financial Market Transactions, which was recently developed by several financial market trade associations.14

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