Risk Management of Financial Derivatives

management oversight, excessive risk-taking, insufficient understanding of the products, and poor internal controls. These Comptroller’s Handbook 1 Risk Management of Financial … 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 …

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 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” Risk Management of Financial Derivatives 2 Comptroller’s Handbook
•*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. 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.

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