O-Der Comptroller of the Currency Administrator of National Banks Risk Management of Financial Derivatives Comptroller’s Handbook Narrative - January 1997, Procedures - February 1998 O Other Areas of Examination Interest As of January 12, 2012, this guidance applies to federal savings associations in addition to national banks.* Risk Management of Financial Derivatives Table of Contents Introduction 1 Background 1 Risks Associated With Derivative Activities 2 Use of This Guidance 2 Roles Banks Take in Derivative Activities 3 Senior Management and Board Oversight 6 Policies and Procedures 6 New Products 8 Oversight Mechanisms 9 Risk Measurement 11 Risk Limit 11 Risk-Adjusted Return Analysis 12 Affiliates 13 Management Information Systems 13 Personnel and Compensation Plans 14 Strategic Risk 16 Reputation Risk 17 Price Risk 18 Types of Price Risk 18 Price Risk Management 22 Pricing and Revaluation Systems 23 Price Risk Measurement 23 Evaluating Price Risk Measurement 24 Price Risk Limits 25 Management Information Systems 27 Interest Rate Risk 30 Interest Rate Risk Management 31 Interest Rate Risk Measurement 32 Interest Rate Risk Limits 33 Management Information Systems 34 Liquidity Risk 36 Types of Liquidity Risk 36 Liquidity Risk Management 39 Liquidity Risk Measurement 41 Liquidity Risk Limits 41 Management Information Systems 43 Foreign Exchange Risk 43 Credit Risk 44 Comptroller's Handbook i Risk Management of Financial Derivatives As of January 12, 2012, this guidance applies to federal savings associations in addition to national banks.* Types of Credit Risk 44 Credit Risk Management 46 Credit Risk Measurement 50 Credit Risk Limits 52 Mechanisms to Reduce Credit Exposure 52 Management Information Systems 53 Transaction Risk 55 Transaction Risk Management 56 Transaction Risk Measurement 57 Role of Operations 58 Compliance Risk 67 Counterparty Authority 68 Credit Enhancement 70 Bilateral Netting 70 Multilateral Netting 73 Physical Commodities 74 Equity Derivatives 75 Capital Issues 76 Accounting Issues 76 Sample Request Letter 78 Tier I and Tier II Dealers 78 Active Position-Takers/Limited End-Users 83 Examination Procedures 87 Appendix 161 A. Uniform Product Assessment 161 B. The “Greeks” 162 C. Evaluating Models for Measuring Price Risk 165 D. Evaluating Price Risk Measurement 169 E. Stress Testing 172 F. Interconnection Risk 173 G. Fundamental Issues B Price Risk Measurement Systems 175 H. Credit Risk Add-on 180 I. Netting Arrangements 182 J. Credit Enhancements 183 K. Early Termination Agreements 186 References 187 Risk Management of Financial Derivatives ii Comptroller's Handbook As of January 12, 2012, this guidance applies to federal savings associations in addition to national banks.* Risk Management of Financial Derivatives Introduction Background Market deregulation, growth in global trade, and continuing technological developments have revolutionized the financial marketplace during the past two decades. A by-product of this revolution is increased market volatility, which has led to a corresponding increase in demand for risk management products. This demand is reflected in the growth of financial derivatives from the standardized futures and options products of the 1970s to the wide spectrum of over-the-counter (OTC) products offered and sold in the 1990s. Many products and instruments are often described as derivatives by the financial press and market participants. In this guidance, financial derivatives are broadly defined as instruments that primarily derive their value from the performance of underlying interest or foreign exchange rates, equity, or commodity prices. Financial derivatives come in many shapes and forms, including futures, forwards, swaps, options, structured debt obligations and deposits, and various combinations thereof. Some are traded on organized exchanges, whereas others are privately negotiated transactions. Derivatives have become an integral part of the financial markets because they can serve several economic functions. Derivatives can be used to reduce business risks, expand product offerings to customers, trade for profit, manage capital and funding costs, and alter the risk-reward profile of a particular item or an entire balance sheet. Although derivatives are legitimate and valuable tools for banks, like all financial instruments they contain risks that must be managed. Managing these risks should not be considered unique or singular. Rather, doing so should be integrated into the bank's overall risk management structure. Risks associated with derivatives are not new or exotic. They are basically the same as those faced in traditional activities (e.g., price, interest rate, liquidity, credit risk). Fundamentally, the risk of derivatives (as of all financial instruments) is a function of the timing and variability of cash flows. Comptroller's Handbook 1 Risk Management of Financial Derivatives As of January 12, 2012, this guidance applies to federal savings associations in addition to national banks.* There have been several widely publicized reports on large derivative losses experienced by banks and corporations. Contributing to these losses were inadequate board and senior management oversight, excessive risk-taking, insufficient understanding of the products, and poor internal controls. These events serve as a reminder of the importance of understanding the various risk factors associated with business activities and establishing appropriate risk management systems to identify, measure, monitor, and control exposure. Risks Associated with Derivative Activities Risk is the potential that events, expected or unanticipated, may have an adverse impact on the bank’s capital and earnings. The OCC has defined nine categories of risk for bank supervision purposes. These risks are: strategic, reputation, price, foreign exchange, liquidity, interest rate, credit, transaction, and compliance. These categories are not mutually exclusive. Any product or service may expose the bank to multiple risks. For analysis and discussion purposes, however, the OCC identifies and assesses each risk separately. Derivative activities must be managed with consideration of all of these risks. Use of This Guidance This guidance is intended to provide a framework for evaluating the adequacy of risk management practices of derivative dealers and end-users. Although this guidance is comprehensive in scope, it provides only a framework. Bankers and examiners must still exercise judgment when determining whether risk management processes are appropriate. Also, while this guidance specifically addresses derivatives, many of the risk management concepts described herein can (and should) be applied to other risk-taking activities. The main body of this guidance provides an overview of sound risk management practices for derivatives. More technical information on the various aspects of derivatives risk management, such as evaluating statistical models, is available in the appendix. Separate examination procedures, internal control questions, and verification procedures are provided for dealers and end-users. The examination procedures are designed to be comprehensive. At Risk Management of Financial Derivatives 2 Comptroller's Handbook As of January 12, 2012, this guidance applies to federal savings associations in addition to national banks.* many banks, some of these procedures will not apply. Examiners should tailor the procedures to a bank’s activities. This guidance reflects the policies communicated in the following documents issued by the OCC: • Banking Circular 277: “Risk Management of Financial Derivatives” • OCC Bulletin 94-32: “Questions and Answers About BC-277" • OCC Advisory Letter 94-2: “Purchases of Structured Notes” • Comptroller’s Handbook: “Futures Commission Merchant Activities” • Comptroller’s Handbook: “Emerging Market Country Products and Trading Activities” • OCC Bulletin 96-25: “Fiduciary Risk Management of Derivatives and Mortgage-Backed Securities” • OCC Bulletin 96-36: “Interest Rate Risk” • OCC Bulletin 96-43: “Credit Derivatives” These guidelines and procedures focus principally on off-balance­ sheet derivatives and structured notes. OCC policy on evaluating the risks in more traditional cash products with derivative characteristics (e.g., mortgage-related holdings and loans with caps/floors, etc.) is available in other sections of the Comptroller’s Handbook. Examiners and bankers evaluating derivative activities at national banks should also consult, as applicable, the following sections of the Comptroller's Handbook: “Interest Rate Risk Management,” “Investment Portfolio Management,” “Emerging Market Country Products and Trading Activities,” “Futures Commission Merchant Activities,” and “Fiduciary and Asset Management Activities.” Roles Banks Take in Derivative Activities National banks participating in the derivative markets function in two general roles: dealer and end -user. These two roles are not mutually exclusive; in most cases, a bank that functions as a derivative dealer will also be an end-user. Dealers A bank that markets derivative products to customers is considered a dealer. For purposes of this guidance, the OCC has classified dealers into two types. Comptroller's Handbook 3 Risk Management of Financial Derivatives As of January 12, 2012, this guidance applies to federal savings associations in addition to national banks.* Tier I. A Tier I dealer acts as a market-maker, providing quotes to other dealers and brokers, and other market professionals. Tier I dealers may also take proprietary positions in derivatives in anticipation of changes in prices or volatility. Tier I dealers actively solicit customer business, often using a dedicated sales force. These dealers also develop new derivative products. Typically, they have systems and personnel that allow them to tailor derivatives to the needs of their customers. Large portfolios, complex contracts, and high transaction volume distinguish Tier I dealers from other market participants. Tier II. The primary difference between Tier I and Tier II dealers is that Tier II dealers are not market-makers. Tier II dealers tend to restrict quotes to a select customer base even though they may have a high volume of transactions. Tier II dealers typically do not actively develop new products. Tier II dealers may match or offset their customer transactions with other dealers or professional counterparties or they may choose to manage risk on an aggregate basis. Throughout this guidance, the terms dealer and dealing will collectively refer to both customer and proprietary trading activities. End-Users An end-user engages in derivative transactions for its own account. An end-user may use derivatives as a substitute for cash market investments, a tool for interest rate risk management, or for other balance sheet management purposes. In this guidance, the OCC has classified end-users into two types, which are defined below. Active Position-Taker. This type of end-user employs derivatives to dynamically manage risk, either to reduce risk or purposefully increase the risk profile of the institution. Active position-takers often use derivatives as surrogates for cash market instruments. These banks generally have large derivative positions relative to their total asset size. They also tend to use more complex derivative structures than other end-users. Limited End-User. Limited end-users are characterized by smaller portfolios and lower transaction volume than active position-takers. This type of end-user primarily uses derivatives as an investment alternative or to manage interest rate risk. Many limited end-users Risk Management of Financial Derivatives 4 Comptroller's Handbook As of January 12, 2012, this guidance applies to federal savings associations in addition to national banks.* engage in derivatives solely through ownership of structured notes in their investment portfolios. These banks tend to use simpler, more mature products (although certain structured notes may be extremely complex and illiquid). The following chart may be useful in distinguishing among participants in derivative markets: Derivative Tier I Tier II Active Limited Activity Dealer Dealer Position- End-User Taker Provides quotes to X dealers Develops new X products Provides quotes to X X customers Uses complex structures X X X * Frequently engages in X X X derivative transactions Acts as principal X X X X Takes position risk X X X X Uses mature products X X X X *Although limited end-users generally tend to use simpler products, some have purchased certain structured notes that may be extremely complex and illiquid. Comptroller's Handbook 5 Risk Management of Financial Derivatives As of January 12, 2012, this guidance applies to federal savings associations in addition to national banks.* Senior Management and Board Oversight The safe and sound use of derivatives is contingent upon effective senior management and board oversight. It is the responsibility of the board to hire a competent executive management team, endorse the corporate vision and the overall business strategy (including the institutional risk appetite), and hold executive management accountable for performance. The board must understand the role derivatives play in the overall business strategy. It is the responsibility of senior management to ensure the development of risk management systems. This entails developing and implementing a sound risk management framework composed of policies and procedures, risk measurement and reporting systems, and independent oversight and control processes. The formality of senior management and board oversight mechanisms will differ depending on the derivatives activities conducted by the bank. However, the board and senior management must provide adequate resources (financial, technical expertise, and systems technology) to implement appropriate oversight mechanisms. The management of derivative activities should be integrated into the bank's overall risk management system using a conceptual framework common to the bank's other businesses. For example, the price risk exposure from derivative transactions should be assessed in a comparable manner to and aggregated with all other price risk exposures. Risk consolidation is particularly important because the various risks contained in derivatives and other market activities can be interconnected and may transcend specific markets. Policies and Procedures A bank’s policies should provide a framework for the management of risk. Dealers and active position-takers should have written policies for derivative activities to ensure proper identification, quantification, evaluation, and control of risks. Banks whose derivative activities are limited in volume, scope, and nature may not need the formality of written policies and procedures provided that the board and senior management have established and communicated clear goals, objectives, authorities, and controls for this activity. Risk Management of Financial Derivatives 6 Comptroller's Handbook As of January 12, 2012, this guidance applies to federal savings associations in addition to national banks.* Derivative policies need not be stand-alone documents. Rather, derivative-related guidelines can be included in policies that control financial risk-taking (e.g., price, interest rate, liquidity, and credit risk) on an aggregate bank level, as well as at the functional business unit or product level. Operating, accounting, compliance, and capital management policies should also address the use of derivatives. Senior management should ensure that policies identify managerial oversight, assign clear responsibility, and require development and implementation of procedures to guide the bank's daily activities. Policies should detail authorized activities, as well as activities that require one-off approval and activities that are considered inappropriate. Policies should articulate the risk tolerance of the bank in terms of comprehensive risk limits, and require regular risk position and performance reporting. When developing policies and controls for derivative activities, senior management should not overlook the bank’s use of derivatives in a fiduciary capacity. Fiduciary policies are usually separate from the commercial bank policies because of business and customer privacy considerations. National banks that purchase derivative instruments for fiduciary accounts should fully understand the associated credit, interest rate, liquidity, price, and transaction risks of such instruments. Additionally, national bank fiduciaries should consider the compliance and reputation risks presented by investing fiduciary assets in derivatives, and the appropriateness of derivative instruments for customer accounts. Policies must keep pace with the changing nature of derivative products and markets. On an ongoing basis, the board or appropriate committee should review and endorse significant changes in derivative activities. At least annually, the board, or a designated committee, should also approve key policy statements. Meeting minutes should document these actions. (Note: Given the extent and nature of demands placed on the board, committees may be created to handle matters requiring detailed review or in- depth consideration, with each committee reporting to the board. Accordingly, the words board and committee are used synonymously throughout this document.) Comptroller's Handbook 7 Risk Management of Financial Derivatives As of January 12, 2012, this guidance applies to federal savings associations in addition to national banks.*