High-profile fiascos with derivatives point up the need for more vigilance.

Amid the shouting and headlines over the recent gyrations of the stock and bond markets, a low but insist message could be heard:

"Directors, executives, treasurers - regain control of your financial exposure. Temper your company's appetite for derivative investments. Demand better understanding and more information. Wake up to the unpleasant prospect that market turmoil could easily break into your company and put its very survival at risk."

As if to underscore the severity of the threat, a number of prominent banks and manufacturers reported substantial "hits" because of their derivatives operations.

J.P. Morgan & Co. reportedly lost $100 million because it bet wrong on the future direction of bonds, First Chicago reported it lost $54 million on Latin American stocks and bonds, and Procter & Gamble - the consumer products giant and on everybody's list of "most conservatively managed companies" - took a $102 million after-tax charge on two interest rate swaps that had been arranged by Bankers Trust.

Major Failure Looms

But after the current crescendo dies down, after the markets return to a state of relative stability, the day-to-day risks posed by derivatives will remain - and continue to grow. The simple truth remains: The estimated $16 trillion worldwide derivatives market has not been tested by a major failure.

The Morgan and Procter & Gamble examples reemphasize the point: Now is the time for decision-makers to begin putting their financial houses in order, carefully controlling off-balance-sheet exposures, such as derivatives, before the next market surprise sends financial projections into a tailspin.

Derivative have, in one form or another, been around for many years. A "futures" contract, after all, is simply a forward contract that is traded on an exchange. Today, commonly traded derivatives based on such indexes as the S&P 500 are popular choices for many investors, who want to be able to hold a scurity that tracks the broader movements of a market, not that of a specific stock or bond.

Spreading Risks

Indeed, it is the very flexibility derivatives provide, if used properly as a risk management tool, that has led to the extraordinary growth in the size of the market. By pooling risks or spreading them around a number of different entities in different time zones and geographic areas, or by increasing liquidity, these financial devices provide for a more smoothly functioning and ultimately more prosperous economy.

But while Mae West once observed, "Too much of a good thing can be wonderful," many in the fast-growing derivatives markets see cause for alarm. One concern is the role of leverage in amplifying the effects of market changes on derivative instruments. Furthermore, the very uniqueness narrows the marketabilityof such instruments to the point where liquidity can be a major problem.

In short, there is no question that indiscriminate or unsupervised dealings in derivatives present bank boards of directors with a very different and very substantial risk element with which to be concerned.

Policy Initiatives

The first significant warning about derivatives' potential for serious problems ws raised in January 1992 by former New York Federal Reserve Bank President E. Gerald Corrigan, who said: "Given the sheer size of the [derivatives] market, I have to ask myself how it is possible that so many holdersof fixed- or variable-rate obligations want to shift those obligations from one form to the other... I hope this sounds like a warning because it is.

"Off-balance-sheet activities have a role, but they must be managed and controlled carefully, and they must be understood by top management, as well as by traders and rocket scientists." For many, this was a central bankr doing his worrying about financial stability. For others this was a warning light blazing in the distance.

Based on actions that have been taken in the last 18 months to address derivatives risks, it seems that Mr. Corrigan's warning was heard loud and clear by many market followers - including the regulator and Congress.

The banking regulators have issued comprehensive examination guidelines and proposed disclosure requirements, and are meeting on a regular basis to develop comprehensive regulatory accounting guidance.

The Financial Standards Board has also issued proposed disclosure requirements. And the Securities and Exchange Commission and the Commodities Futures Trading Commission have proposed changes in the way they regulate derivatives activities.

The legislators have jumped into the fray as well. Congress has issued studies on the over-the-counter market, made a series of recommendations to the regulators and industry, held some hearings (and will hold more) on the risks posed by derivatives, and introduced derivatives bills designed to enhance oversight.

The industry has responded by conducting its own studies and voluntarily improving disclosure of derivatives data in public financial reports.

Group of 30 Offers Advice

The most comprehensive study of the derivatives market to date was conducted by the Group of 30 (an industry and academic coalition chaired by Paul Volcker). In its July 1993 report on the over-the-counter market, the group made a series of recommendations on ways to effectively manage derivatives risks.

The group's recommendations are too voluminous to be recounted here. But certainly those recommendations, if not the entire study, should be required for any institution considering becoming involved in derivatives.

At this pont, a "rush to regulate" could be counterproductive, disrupting the orderly operations of a market that virtually all observers feel plays a vital role in international financial stability. It is also my view that regulation is already behind the learning curve on understanding, much less supervising, the derivatives markets.

Self-Regulation Needed

Regardless of the eventual regulatory shape and structure, it is incumbent on the players in the markets to manage and control their risk exposure with the utmost discipline and care. It is the resonsibility of boards of directors and senior management of individual companies, not the regulators, to oversee this management and control process.

The need for such oversight is articulated clearly in the first recommendation in the Group of 30's recent report:

"Dealers and end users should use derivatives in a manner consistent with the overall risk management and capital policies approved by their boards of directors. These policies should be reviewed as business and market circumstances change.

"Policies governing derivatives use sould be clearly defined, including the purposes for which these transctions are to be undertaken. Senior management should approve procedures and controls to implement these policies, and management at all levels should enforce them."

Understanding Risks

Tor bank boards of directors and senior management, the message is clear: Do your job. Do not allow the complexity and speed of derivatives trading and investing dissuade you from exercising your legal and moral oversight obligations.

In order to manage derivatives activities, senior management and boards of directors must be able to understand, quantify, evaluate, assign value to, and manage the associated risks. This should not be a difficult concept for banking institutions to grasp, as they have traditionally made their money by being able to adequately assess and control risk.

Adequately risk management is essential because it is the confidence in and integrity of banks that help determine the well-being of the overall economy. Thus, when it comes to derivatives trading, banks must hold themselves to a higher standard in understanding the risks involved and putting in place systems to manage them.

Derivatives risks have been defined and discussed by the regulators, congress, and the industry and include credit, market, liquidity, operational, and legal risk.

Risk of Default

Credit risk is essentially the risk of counterparty default on an obligation. This risk exists both prior to and on the settlement date. Essentially credit risk boils down to a capital issue -- does the bank have an adequate capital cushion set aside for credit exposure.

Banks prefer capital requirements to be based on "net" exposure, while the regulators believe "gross" exposures, considered individually, more accurately reflect true exposure. The regulators also tend to look at credit exposure in terms of the "worst case" rather than "most probable" scenario.

As Mr. Corrigan said in his speech, "[I]n the event of a major market distribution, I assure you that it will be the gross, not thenet, that will really matter in most . . . national and international markets."

Regardless of the regulatory approach, banks must have systems in place that limit and accurately measure both pre-settlement and settlement risk. To limit exposure, banks should use bilateral netting arrangements to the extent legally enforceeable and multilateral netting facilities that meet specific industry criteria.

Credit Enhancements

Collateral and other credit enhancements should become standard components of all over-the-counter derivatives transactions. Most important, credit expsure stemming from derivatives transactions should not be managed in a vacuum. It is essential for credit exposure to specific derivatives counterparties to be amalgamated with credit extended by all other business units of the bank to that entity.

As is done for traditional lending activities, banks must have independent credit committees that are responsible for approving credit lines before any trading begins and monitoring counterparty creditworthiness on an ongoing basis.

Market risk results from adverse movements in market prices, including interest rates, exchange rates, and equity values. For options, risk elements include terms like "delta," "gamma," "vega," "theta," and "rho" --and it requires high-tech mathematics to accurately assess these risks.

Despite banks' established ability to understand and make profitable trades in currency exchange, the rapid unpredictable movement of derivative-based prices adds another level of complexity in judging one's exposure to market risk. This, perhaps, makes market risk the most problematic of derivatives risksq, because it requires reaching a judgment in independent of any other institution.

No Perfect Hedge

Also, some element of market risk is almost always present because rarely -- if ever -- is there a perfect long-term hedge. In judging these markets, there is no safety in numbers, as indeed the recent downturn in the stock and bond markets demonstrated.

There has been talk of incorporating a market risk assessment inthe international capital standards (that is, imposing capital requirements for open positions in debt securities, equities, and foreign exchange). Regardless of capital or accounting treatment, portfolios should be valued on at least a daily basis by dealers, and market risk estimates should be made for risk management purposes.

To test the efficacy of the uderlying models, these market risk projections should be compared with actual results. The regulators and industry gurus have been advocating a "value at risk" approach to measuring market risk that essentially involves calculating losses due to adverse changes in market rates given a specified probability and time horizon. Market risk limits should be set by the boards of directors, and any exceptions to the parameters must be reported and resolved effectively.

Liquidity risk can result from both intenal and external forces. Market liquidity risk stems from a bank's inability to close out a position due to market or product illiquidity. Funding risks result from internal cash flow deficiencies. Both of these risks should be controlled through the development of and adherence to risk limits.

Troubleshooting System

Market liquidity risk can be further reduced through the establishment of internal communication links designed to quickly detect and respond to liquidity problems in the market. The wrinkle in managing liquidity risks is understanding what the risk limits are in a derivatives contract, where upside and downside potentials may be very difficult to establish.

Operational risk is the risk of unexpected loss due to system mulfunctions, human error, or fraud. While this may seem to be an easily controllable risk, recent market events demonstrate that every organization must assume that it is not -- and take appropriate protective measures.

Operational risks should be evaluated and controlled through the use of inernal audits, documentation, and contingency planning. The crucial thing for senior management and boards of directors to remember is that risk measurement systems are only as good as the underlying data, and strong operational controls can serve to minimize data integrity concerns.

The Character Issue

Legal risk reflects loss exposure due to unenforceable contracts caused by documentation deficiencies or a counterparty's lack of legal authority to enter into contract. Beyond the consideration of character -- the truthfulness of a counterparty -- is the question of sophistication: Does a counterparty understand exactly what he is getting involved ina nd the risks he is accepting, and is the dealer liable if he doesn't and the counterparty suffers losses?

A bank's legal counsel should assist risk management personnel in establishging policies and procedures to limit legal risk. Counsel should determine whether banks are adequately documenting all legally binding contracts and property assessing a counterparty's legal authority prior to establishing a contract obligation.

The recent public dispute between Bankers Trust and two customers -- Procter & Gamble and Gibson Greeting Cards -- over derivatives-related losses incurred by the two companies provides an object lesson in how critical correct legal procedures can be.

Director and management responsibility starts with simply understanding derivatives and their associated risks. It doesn't end thee, however, and there are a number of specific steps that should be seriously considered to improve oversight of this complex and problematic issue. These include the following:

Establishing an independent risk management function, whose duties should include monitoring and control of derivatives exposure. The derivatives risk management function should be entirely independent of the trading desk, with a direct reporting line to the board of directors or a committee designated by the board. It is essential that the risk management function assess and control the impact of derivatives activities on the overall risk profile of the organization.

Set forth clear, specific risk parameters that document the risk tolerance of the board of directors, and make sure these parameters are understood and adhered to by all principals -- from senior management to traders. Adherence to board-mandated risk parameters is crucial. While the regulatory line between hedging and speculation is hazy, the internal lines set by the board of directors should be clear and decisive.

Keep Management Informed

Improve the management information system. Bad news doesn't improve with age. As derivative exposures change, the board must be able to look to a single source and learn the extent of the damage (or reward).

Accurate and timely identification, measurement, monitoring, and control of derivatives risks must be the goalof any MIS system. While the "quannts" are able to speak the technical language of the derivatives markets, boards of directors should not be expected to do so.

Thus, reports must be in a format that they can decipher in order to make high-level decisions relating to a bank's derivatives strategy. The MIS system must support the risk management committee and incorporate the risk parameters agreed to by the board of directors.

Put the right people in place. Those occupying executive trading and risk management positions can hold the bank's future in their hands. Personnel chosen for the positions must have the necessary background, experience, sophistication, integrity, and intelligence to be able to handle this very stressful function.

Contingency Plans

While most staffing decisions can safely be left to management, bank directors must have oversight into these extremely critical personnel positions. And, once in place, derivatives professionalsa must be provided the resources to effectively carry out their jobs.

Rewrite the "play book." Boards must draw up contingency plans that allow for the early identification of a quick response to rapidly changing market conditions -- and then communicate, in writing, these plans to key personnel and follow up to make sure the plans are being followed on a consistent basis.

The contingency plans must also include timely and accurate reporting of relevant information to the public and internally. As markets have demonstrated, "no news is bad news" in the eyes of most investors. Make sure a bad news day doesn't turn into a crisis of confidence regarding your bank, with ominous implications for the bank's future.

Work with the legislators and regulators to evolve the next generation of rules. More forceful regulation of the derivatives market is probably inevitable.

It is in shareholders' interest for representative bank directors and management to join together in an informal or formal manner, perhaps under the auspices of a trade association, with the dual goal of meeting legislators' and regulators' requirements while continuing to allow the derivatives market to flourish.

Push for coordination of regulation on a global basis. The Basle Committee has been setting the stage for global capital standards. This concept of international accords shouldq be expanded.

The only way regulation of derivatives can truly work is if it is done on a global basis. Regardless of how stringent domestic regulation is, the market and players are gloabl. The U.S. market can be adversely impacted by international players subject to different regulation in their home countries.

Thus, it is imperative that domestic regulators be encouraged to continue to work with their foreign counterparts to institute international regulatory requirements.

Notably, the Basle Committee influences only bank regulatory approaches. Thus, there is a need to bring in both securities and fudures and options regulators into any discussion of global oversight of derivatives markets.

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