Landmark Derivatives Guide By Group of 30 Credited for Keeping Industry

Banks have endured a loans-to-developing-countries crisis, an energy loan crisis, and a real estate lending crisis, but never a derivatives crisis.

Credit for this feat, according to many observers, goes to the Group of 30. Five years ago this month the international coalition of bankers and academics released a pivotal report on derivatives that spelled out the responsibilities of users and providers of these instruments.

"It is very difficult to overstate how important it was for the Group of 30 to assemble the people they did and come out with the document they did," said Michael L. Brosan, deputy comptroller for risk evaluation at the Office of the Comptroller of the Currency. "Even five years later this is a very solid template."

"This was the seminal report in this area," said Robert J. Mackay, vice president at National Economic Research Associates, a consulting firm based here. "It was the first to lay out a coherent and systematic set of recommendations for good risk management practices for dealers and users."

The report made 24 recommendations for the industry and regulators. One of the key provisions required the CEO and senior management to understand their firm's strategy for employing derivatives.

The group also said dealers should value portfolios daily at the market price, use computer models to test the riskiness of holdings, and publicly disclose their strategies for using derivatives.

The report was an instant hit. By December 1994, 54% of institutions were testing the riskiness of their derivatives portfolios, and 39% said they would adopt a testing program within a year.

"It helped demystify the subject because the report was in relatively simple language," said Dennis Weatherstone, former chairman of J.P. Morgan & Co. and co-chairman of the steering committee responsible for the study. "It was only 64 pages and written in plain English."

Mr. Mackay credited the industry's quick embrace of the report for keeping regulators at bay. "The industry's quick move to improve risk management systems played a substantial role in relieving some of the concerns of public policymakers about derivatives," he said.

Despite the report, derivatives have not been completely free of controversy. The biggest dispute involved Orange County, Calif., which gambled its budget on risky swaps contracts. When the market turned, the county lost about $2 billion. Also, a rogue trader's derivatives gamble caused British-based Barings Bank to fail, and several big companies, including Procter & Gamble, lost millions speculating in derivatives.

Yet these scandals appear to be isolated incidents, especially given the size of the market. According to the OCC, banks held $26 trillion in notional value of derivatives in the first quarter, up more than 250% since the Group of 30 released its report.

Mr. Weatherstone said there would have been far more derivatives fiascoes if the industry had not embraced the report's recommendations. "By getting it out quickly we stopped a couple of accidents from taking place," he said.

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