Risk Management of Financial Derivatives: Banking Director's and Senior Managment's Responsibilities

On July 18, 1994, the Chairman of the Senate Banking Committee introduced legislation which would require banks to limit their investment in financial derivatives to transactions designed to hedge their loans and other investments, with investments in other derivatives permissible only for banks qualified as financial derivatives dealers and non-insured affiliates of a holding company. This proposed legislation is the strictest form of financial derivatives legislation proposed in this Congress. Although it is unlikely that such legislation could be adopted before the end of the year, it is likely to increase the pressure on regulators and others to carefully scrutinize the investments in financial derivatives by banks.

On May 27, 1994, Federal Reserve Chairman Alan Greenspan testified before Congress about banks' financial derivative activities and said that the banking regulators would take steps to "encourage the enhancement of risk management systems" at banks. Mr. Greenspan's euphemistic announcement of increased regulation and enforcement of activities related to financial derivatives was one of a series of pronouncements on that topic this year. The non-partisan investigative arm of Congress, the General Accounting Office ("GAO"), reported on the risks posed by derivative activities and the adequacy of current regulatory efforts on May 18, 1994. The Office of the Comptroller of the Currency ("OCC") released a statement on May 10, 1994 that clarified its previous guidance on risk management of financial derivatives in October of 1993 with the release of Banking Circular 277 ("BC-277").

Pillsbury Madison & Sutro has reviewed this matter and prepared this bulletin to alert our clients, and their boards of directors and senior management, to the evolving standards regarding oversight of derivative activities at financial institutions. The OCC has been the most active agency in this area and is particularly sensitive to a financial institution's use of highly complex derivative instruments. If a national bank engages in unsafe and unsound derivative activities and does not follow the guidelines set forth in BC-277, the OCC has the option to enforce the guidelines utilizing its wide array of traditional administrative remedies (including civil money penalties). In addition, the imposition of new accounting rules, combined with the 1991 banking law's prompt corrective action features, subject a bank to the possibility of capital restoration plans or other regulatory control resulting from portfolio value fluctuations and their impact on an institution's capital. The Securities and Exchange Commission is also concerned that public companies are not providing adequate disclosure of their derivative activities. Therefore, we recommend that public companies engaging in hedging or other derivative activities consult with securities counsel.

Regulatory sanctions are not the only concern. In view of the recent interest rate fluctuations and the significant losses suffered here and abroad by companies engaged in derivative activities, directors and officers need to be aware of the risk of claims for damages arising from inadequate risk management. Procter & Gamble's $157 million loss on its investment in certain derivatives resulted in a shareholders' suit filed on April 25, 1994. Procter & Gamble, in turn, has publicly threatened to bring suit against the bank from which it purchased the derivatives.

The following is a brief summary of the views of the regulators that we feel should be brought to your attention and discussed with your directors and senior management:

Decision to Engage in Derivative Activities

Prior to engaging in derivative activities, the board and senior management should determine that any necessary regulatory approvals have been obtained, that adequate operational procedures and risk control systems are in place and that such derivative activities are consistent with a bank's overall risk management philosophy and business strategy. National banks, for example, planning to carry out their derivative activities through operating subsidiaries must receive OCC approval to establish such a subsidiary. Even if a bank intends to invest in derivatives of a type and in a manner that does not require a formal application to its regulators, new types of derivative activities that present potentially significant legal or business issues should generally be discussed with the appropriate regulators before implementation.

Initial Policies and Controls

Written Policies and Procedures. Comprehensive written policies and procedures should govern a bank's use of derivatives.

General Risk Monitoring and Control. Units or individuals independent from those responsible for execution of derivative trades should monitor and report on the risk exposure of such derivative activities.

Risk Management Systems. Risk management systems should be commensurate with the scope, size and complexity of the derivative activities. The board (or an appropriate committee) should review the risk management policies and internal controls that senior management proposes. For such a review to be effective, the directors must have a basic understanding of the type and amount of exposure resulting from the activity and the impact derivatives might have on the bank under varying scenarios.

Measures should also be implemented to assure that its counterparties have the legal and regulatory authority to engage in the contemplated activities and that the terms of any contract governing the bank's derivatives activities with a counterparty are legally sound.

The board and senior management should carefully consider the resources, both financial and human, required to enter into the derivative activities. Undue reliance on the knowledge of a specific individual or a small group is generally to be avoided since it exposes a bank to greater risk.

Audit Coverage. Audit controls should ensure timely identification of internal control weaknesses and/or system deficiencies. The board's audit committee is responsible for oversight of internal and external auditor activity to ensure appropriate focus and to ensure that senior management is not overriding internal controls. The regulators have stated that the audit committee should have access to legal counsel and to other outside experts to help assess these risks and exposures.

Ongoing Management Concerns

The regulators do not expect the board and senior management to have "operating expertise" in a bank's derivative activities. The OCC stated in its May 10, 1994 release that the board and senior management should "have general familiarity with the nature of the business, including an understanding of the nature of the risks taken" in order to limit the potential loss of earnings or capital.

Prior to entering into new types of derivatives, management should clearly understand the accounting impact on the bank of the specific financial derivative to be purchased. For example, whether mark-to-market accounting is required.

A bank acting as a dealer also should maintain documentation in the file that indicates if a counterparty requested a transaction that a bank believed was inappropriate for that counterparty given its level of financial sophistication. Although there is currently no legal bar against executing such a transaction for a counterparty, given the risks of liability, the bank should retain documentation that details the individuals involved in the discussions (both bank and counterparty).

Banks should consider obtaining an opinion of counsel in the jurisdiction of any foreign counterparties to support bilateral netting agreements for purpose of calculating credit exposure for transactions with such counterparties or U.S. branches or offices of such counterparties. The legal status of netting for these counterparties in some foreign countries is uncertain, and banks should obtain legal assurance that netting agreements will be valid in the event of default or bankruptcy.

Changes in Derivative Activities

Any significant changes in, or additions to, a bank's derivative activities should be approved by the board and senior management. Determination of what constitutes a significant new activity will vary depending on the character of each bank's operations and can generally only be determined on a case-by-case basis.

End-User vs. Dealer

The board and senior management must clearly understand and agree on the risk management and reporting procedures to be used if a bank is an end-user of a derivative product. Banks entering into derivative activities as a dealer are held to a higher standard. The board and senior management not only must determine that they clearly understand the potential risk exposure of the bank, but also that the bank employees can identify instances in which a bank customer may not fully understand the risks associate d with a particular derivative transaction.

"Interconnection Risk"

"Interconnection risk" refers to risk combinations in a bank's portfolio that may not be immediately obvious. For example, a market event that affects the value of a specific type of financial instrument may also affect financial instruments in other markets because of cross-market price correlations. Such an event can have a significant impact on a bank's holdings as well as the holdings of the bank's counterparties.

Conclusion

Effective risk management systems must be capable of responding to rapid and unanticipated changes in portfolio values resulting from volatility in the financial markets. Banks must be vigilant as regulatory and legal standards in this area continue to evolve. Although we cannot predict the final form such standards will take, banks engaged in derivative activities, and their boards and senior management, may face increased burdens in conducting their operations, and in designing and implementing internal controls for such operations.

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