The regulatory climate for banks' derivative products has improved dramatically past year and a half

In January 1992, E. Gerald Corrigan, president of the Federal Reserve Bank of New York, raised fears of a regulatory crackdown on the booming business in a speech to the New York Bankers Association.

"High-tech banking and finance has its place, but it's not all that it's cracked up to be," he said. "I hope this sounds like a warning, because it is."

The regulatory crackdown has not materialized.

"If they were doing something wrong, we would have shut them down," said Oliver I. Ireland, associate general counsel at the Federal Reserve Board. "We ink what is is basically prudent."

Mr. Corrigan declined to comment on his remarks, but a New York Fed spokesman said Mr. Corrigan's views on derivatives have not changed.

A Crisis that Didn't Happen

Bankers believe Mr. Corrigan feared another savings and loan crisis was in the making. They said derivatives is a fast-growing business and Mr. Corrigan worried that some bank users of derivatives did not fully understand the risks.

But since Mr. Corrigan's warning, regulators have found nothing fundamental to criticize about the way banks manage derivatives dealerships.

No bank has withdrawn from dealing or scaled back operations, which would be expected if regulators had found sloppy business practices.

Even newcomers to derivatives dealing, such as First Union Corp., have gotten a regulatory green light in the past year.

No dealer had to raise capital at regulators' behest, though they may have to now under a proposal from the Bank for International Settlements.

Controls Seen as Adequate

Other regulators, including two members of the Federal Reserve Board, have said that banks have a good grasp of the risks in the business and that adequate controls on the business are in place.

Fed Governor Susan M. Phillips backs a self-regulatory system for the business -- an indication tion of her comfort with the activities. "We should not seek to discourage banks from assuming risks" in the derivatives market," she said in a speech last December.

Fed Governor John LaWare recently told Reuters that the derivatives scare is overblown. "Big banks are pretty sophisticated, and there is not much risk in what they do," he said.

Mr. Corrigan's comments surprised bankers and sent shock waves through the industry, customers, and Congress.

As a result of his comments, bank executives were forced to examine their derivative operations.

As soon as Mr. Corrigan's remarks were reported in the press, bank executives got a flurry of phone calls from customers. Those who use swaps and other financial instruments to hedge exposures to interest rate and currency risks were worried about the riskiness of their transactions.

Studies on the Hill

Studies of the $4 trillion global derivatives business were launched on Capitol Hill and elsewhere.

In addition, investors showed little appetite last year for shares of Bankers Trust New York Co. and J.P. Morgan & Co., which receive a bigger portion of their income from derivatives than other money center banks.

To be sure, regulatory examinations since the speech have exposed some sloppy back-office practices at some banks. Regulators have found that some documents were not processed quickly enough or were never sent to the counterparty.

A New York Fed spokesman said that examiners have discussed the need to raise capital with some banks and have cautioned others about the nature of risk and internal practices.

Minor Changes Requested

But bankers said the the Fed requested minor changes.

"I can't think of any changes regulators asked for that were outside the normal course of development," said Brian Walsh, managing director at Bankers Trust.

That's true even for banks with lower credit ratings than Bankers Trust.

"We haven't been asked to make fundamental changes in the way we conduct the business," said Kenneth W. Cunningham, managing director at Continental Bank Corp. "We've only gotten suggestions about details."

"In a new business with rapid growth, it's not surprising that the operations lagged behind the front office," said Tanya Azarchs, an analyst with Standard & Poor's Corp. But that problem, "never got to the point where it caused a noticeable loss to anyone," she said.

The losses in this business - and all major dealers have lost millions of dollars in deals that have gone sour - have never amounted to much compared with banks' lending losses. Even regulators describe the business as "highly profitable."

No one disputes Mr. Corrigan's underlying message that derivative dealing is risky. A counterparty could fail to make a payment or could make one late. A payment may not be worth as much as anticipated, due to a change in rates.

Mr. Ireland, the Fed associate general counsel, said banks have a good handle on the first two types of risks but do not fully understand the third type, market risk. Bankers say they do.

Market Better Understood

The New York Fed spokesman said: "The Fed is pleased that more attention has been paid to these instruments and that there is greater sensitivity and awareness of the nature of the market. The risk of derivative markets far better understood today."

Even Mr. Corrigan, who will leave the New York Fed this summer, shows signs of lightening up, though the New York Fed denies this.

Mr. Corrigan is chairman of the bank regulatory committee of the Bank for International Settlements, a central banking group. His committee recently proposed imposing capital requirements on derivatives exposures.

However, the proposal would allow banks to "net" their credit exposures in derivatives transactions, a technique that could reduce their capital requirements.

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