Comptroller counsels caution with derivatives.

Eugene A. Ludwig, comptroller of the currency, made the following remarks to the Savings and Community Bankers of America:

Derivatives pose many of the same risks present in other financial transactions -- credit risk, market risk, liquidity risk, legal risk, operations and systems risk, and reputation risk.

But for certain derivative instruments, those risks may be present in less intuitive ways.

For example, certain types of structured notes pose very little credit risk but are very sensitive to change in interest rates. And if market liquidity declines, the price you paid for those notes may greatly exceed what you would get by selling them, even if interest rates have not changed much.

Using derivatives tends to require mathematical models developed by highly skilled financial professionals. Sophisticated models are useful tools for measuring and monitoring the risks associated with derivatives. Depending upon the activities of your institution, such models may be essential. Mathematical models, however, have their limits.

Any effort to quantify risk depends upon numerous assumptions. Derivatives are no exception. But the appropriateness of any particular assumption depends upon the market environment and the context for which the risk measure will be used.

As a consequence, there is an inherent degree of subjectivity in the quantification of risk -- it has been and remains today an art as well as a science. For that reason, the essence of sound risk management will always be good judgment and experience.

Let me give you two helpful rules of thumb.

Rule 1: If a security looks too good to be true, it probably is. Most likely, you or your staff do not understand all of the risk elements. If you don't understand a security, don't buy it.

Rule 2: "Buy" your portfolios; don't have them "sold" to you. You know the difference. An institution that buys its portfolio is following an investment strategy that outlines what the portfolio is trying to accomplish -- usually an asset-liability management objective. But a portfolio that's been sold to an institution typically looks like a collection of "deals of the week" and doesn't fit a coherent strategy.

Ask questions about the mathematical models, too. Even the most sophisticated mathematical models are based on logical and, in most cases, timetested valuation methods. If you don't understand the answers you receive, it may be [that] the person explaining the model to you does not understand it very well.

Look for somebody who can explain the model in understandable financial concepts. Somebody who has to rely on mathematical symbolism to talk about one of their models is unlikely to understand the model's limitations. And if a model doesn't make sense to you in terms of understandable financial concepts, it may be that the model itself is flawed.

A year ago, my office issued Banking Circular 277 -- "Risk Management of Financial Derivatives" -- which provided guidance for risk management practices to national banks. The guidelines in the circular represent prudent practices that will enable a bank to conduct financial derivatives activities in a safe and sound manner.

To the extent possible, the guidelines should be applied to all of a bank's risk-taking activities. The document covers all aspects of risk management, including senior management and board oversight, market risk management, credit risk management, credit risk management, liquidity risk management, [and] operations and systems risk management.

In addition, our guidance discussed the need for banks to put together systems that [would] allow them to uncover new risk combinations -- so-called interconnected risks -- in other words, to expect the unexpected.

In short, for our part, the OCC expects each bank to adopt and have in place a "no surprises" risk management policy [that is] made concrete in systems and controls.

More recently, last July, my office issued Advisory Letter 94-2 -- "Purchase of Structured Notes" -- out of concern that some national banks, particularly community banks, had purchased structured notes without fully understanding all of the risks they had assumed.

That letter stated that, "because of the risks involved and the difficulty in assessing those risks, some types of structured securities are inappropriate investments for most national banks. The determination of whether a particular instrument is appropriate depends on the bank's ability to understand, measure, monitor, and control that instrument's risk, consistent with Banking Circular 277."

Some have interpreted this guideance as saying that banks shouldn't purchase and hold structured notes, or engage in other types of derivatives transactions.

That is not our intent. Rather, our supervisory approach is designed to ensure that the risk management of those activities is sound and proper.

For reprint and licensing requests for this article, click here.
MORE FROM AMERICAN BANKER