Small Banks' Derivatives Deals Face Tougher OCC Oversight

WASHINGTON - Derivatives activities in small national banks will get closer scrutiny under updated examination guidelines issued by the Office of the Comptroller of the Currency.

The exam guidelines, which apply to "noncomplex" community banks with assets of less than $250 million, were originally issued in July 1994. The revised exam includes two new areas: derivatives and data processing done outside the bank.

The revisions, released last week, are effective immediately.

"While small banks tend to hold relatively low-risk derivatives, our examiners wanted more specific guidance on exactly what to look for in these areas," said OCC spokesman Sam Eskenazi.

Under the revised guidelines, examiners will look at whether a bank has tested the effect of sharp interest rate fluctuations on the institution's derivatives investments.

Examiners also will inspect the maturities of the derivatives held by small banks. This is a crucial area to watch because the maturities of some derivatives instruments are contingent on interest rates, said Heinz Binggeli, a managing director at Emcor Risk Management in Irvington, N.Y. So when interest rates drop, the maturity date on these derivatives shortens.

While all such investments have a maximum maturity, often a bank will buy them with the expectation that they will mature earlier because interest rates are falling at the time of purchase, Mr. Binggeli said.

"It's an appropriate thing to add (to the exam) because of the possibility of the classic asset-liability maturity mismatch that has gotten banks in trouble before," Mr. Binggeli said.

The value of a bank's total derivatives investment relative to its capital also will be checked under the revised exams, according to the Comptroller's office.

If the examiner in charge of a bank decides there is a "significant" volume of these investments and they pose a high risk, the updated guidelines require a more elaborate exam. The agency is leaving the definition of "significant" to examiners.

The OCC also is taking a closer look at small banks that hire outside firms to do their data processing.

Under the revised guidelines, examiners will assess how thoroughly a bank reviews its financial statements and audit reports prepared by a vendor. The accuracy, consistency, and completeness of the vendor's work will be scrutinized as well.

Examiners also will check whether a vendor knows how to access a bank's backup data, in case the institution's computer systems fail. Vendors must be able to get to the data quickly to prevent any major disruptions in data processing, Mr. Eskenazi said.

"This recognizes that most small bank don't have inside systems," said Karen Thomas, director of regulatory affairs for the Independent Bankers Association of America. "It's important to make sure an outside data processor is accurate and reliable."

Under the revised exams, examiners also must report whether the bank is considering hiring a new vendor or shifting to in-house data processing. Examiners also will make sure bank managers maintain proper control over information security.

While the agency may make further changes to the small bank exam if examiners request them, Mr. Eskenazi said, "This is probably the version that we will be sticking with for a while."

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