Q: Rep. Jim Leach, the Iowa Republican, just released a 900-page report on derivatives with 30 recommendations for federal regulators. Have you seen it?

A: We've had a chance to review the recommendations but not the entire report. We endorse many of the recommendations and consider them, overall, to be thoughtful and to represent an honest attempt to address the risks inherent in engaging in derivative transactions. Some of the recommendations, however, are novel and represent very clear departures from the recommendations that have been made by the regulators.

Q: Which ones are troublesome for you?

A: The thirteenth recommendation talks about banks evaluating risks based on a 99% confidence level and three standard deviations. That's a pretty high standard.

The twenty-eighth recommendation suggests there may be a need to adopt regulations to protect against systemic risk. We think that the best protection against systemic risk is the adoption by each individual institution of proper risk management policies and procedures and, specifically, controls on their interconnected risk positions and controls to address concentration risks.

We've specifically addressed that in guidance we recently issued for banks engaged in derivatives activities [Banking Circular 277]. The [Leach] recommendation seems to suggest that there's some other way to address systemic risk, and we just have doubts about that.

We're happy about the twenty-second recommendation because it suggests that the other federal banking agencies should adopt guidelines similar to ours that call for a dealer to assess whether a transaction is appropriate for a customer. But the recommendation also suggests that regulators consider whether industry-wide suitability rules should be enacted. Our guidance certainly doesn't go as far as being a suitability rule.

We don't think that at this point there is any need for a suitability rule or that it would be of any benefit to the market or market participants.

Q: What about Leach's indicating that he may propose legislation?

A: We don't see the need for legislation at this point. We think we've done what is appropriate by taking two steps: by issuing the banking guidance - which will be followed up with more detailed guidance for examiners - and by coordinating the organization of an interagency task force which is already addressing the accounting and disclosures issues.

The Securities and Exchange Commission and the Commodity Futures Trading Commission are not currently part of that group. But it's certainly our idea that once we reach some agreement among the banking regulators, that we would move to bring in the CFTC and the SEC.

And we're even thinking of just sharing what we're doing with them at this point even though we're not yet ready to ask them to formally join the group. So we think we're addressing a number, if not most, of issues raised by Congressman Leach. If we and the other regulators can show that we're not only on top of these issues but are trying to address the additional concerns of Congress, it may not be necessary to enact legislation.

Q: Leach has suggested that the agencies should focus on products rather than institutions. He's concerned, for example, that the derivatives activities of insurance companies are not regulated at the federal level.

A: That is a valid concern. That having been said, I believe there are only two U.S. insurance companies of any size in the market. There is a particular problem if one decides to try to regulate derivatives transactions or products rather than institutions, and that is, it is extremely hard to define what the product is. You can certainly define it, but different people define derivatives in different ways.

Q: Lawmakers in recent weeks have called derivatives everything from "a form of gambling" to the "next S&L crisis" to "an important risk management tool." What's your view?

A: Our view is that derivatives have a very useful place in the portfolio of most banks. Most banks, almost all banks in fact, are using derivatives for risk management purposes.

Q: Isn't it difficult sometimes to distinguish between speculative and nonspeculative activities?

A: It may or may not be. We think that most of our examiners can spot appropriate risk management uses of derivatives as opposed to speculative activities. We do not believe that derivatives are being used to any great extent for speculative activities. About 90% of the activities of the largest banks involved in derivatives are market-making activities, and the other 10% are proprietary activities. We think that a very small percentage of those proprietary activities are position-taking.

Q: The banking circular you recently issued is supposed to ensure a bank engaging in derivatives activities Puts a ~no surprises' risk management system in place. Is this a departure from previous guidance?

A: Well, the Federal Reserve Board, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency, in 1981, each issued interpretations on bank holding company uses of interest rate futures, forwards, and standby contracts.

The OCC issued Banking Circular 79, and it talked about the appropriate uses for those types of derivatives. It also imposed restrictions, in the case of standby contracts, on the maturity of the contracts that banks could enter into. That's the kind of supervision that we've tried to step back from with the banking guidance we recently issued.

We no longer intend to impose restrictions like that on banks - restrictions as to the maturity of the type of instrument in which they can trade, or the type of rate or price to which they can index instruments. We're less concerned with those matters and much more concerned with how banks manage the risks arising out of the transactions that they do.

Q: Is the new guidance enforceable?

A: It's going to be the basis for the examiner guidance that we're going to be coming out with shortly. It reflects the types of risk management, management controls, and procedures that our examiners are going to be looking for when they examine a bank's derivatives activities. It represents the OCC's views about safe and sound banking practices. To the extent the OCC finds a bank operating with unsafe or unsound practices, it can take enforcement action against that bank.

Q: What are the major points in the circular?

A: First of all, we quite explicitly require senior management and the board of directors of a bank to adopt policies and procedures for engaging in derivatives activities.

As part of that, we expect them to adopt limits and controls on the various types of risks that are assumed in connection with derivatives activities: credit risk, market risk, liquidity risk, and operational risk.

We also expect the units within the bank that are responsible for measuring and monitoring those risks in each case to be independent from the business unit that is incurring the risk.

The key to this ~no surprises' risk management policy is the requirement that banks have limits and controls on the interconnected risk positions that are incurred with regard to their derivatives activities. If a bank is looking separately at these various risks and not at how they relate to each other and affect each other, we don't believe that they're appropriately monitoring their whole risk profile.

Q: Some industry officials worry that the OCC has gone too far in that the circular says dealer banks should make sure their derivatives products are appropriate for customers. They fear this could lead disgruntled customers to sue banks over losses.

A: There's certainly a concern there. But there's nothing that we can do or say that's going to stop a disgruntled customer, or more likely a trustee or receiver of a disgruntled customer, from trying to use this particular guidance as a basis for a suit.

Certainly it is not our intention that we're giving rise to any third party rights. If we were called upon to support such a case, I don't know that we would do that.

Q: What about accounting and disclosure?

A: Right now the only disclosures of derivatives that we have are in the quarterly call reports [Reports of Condition of Income]. The call reports require that banks state the notional principal amounts of their derivative transactions, but do not require that they break out their market-making activities from their proprietary activities.

We need to have a clearer picture of what percentage of the transactions, and especially of the dealer banks' portfolios, are as a result of market-making that is dealer-related or customer driven, and what percentage are for their own account, including transactions taken for risk management and those that are not strictly risk management.

The accounting guidance is slim with respect to derivatives. Everyone's waiting for the Financial Accounting Standards Board, and they haven't figured it out yet. FASB is unlikely to come out with anything before two years from now.

The result of having no clear generally accepted accounting principals and no clear regulatory accounting principals is that different institutions are accounting for derivatives transactions in different ways. Some institutions are applying hedge accounting treatment to derivatives positions that are used only for risk reduction.

Some, we believe, are applying hedge accounting treatment to derivatives positions that are used for risk management. We worry that some accounting practices could cause banks to make decisions that might not be consistent with the decisions they would make if they were focusing purely on economic concerns.

Q: What's needed?

A: Uniform guidance, guidance that is consistent, that doesn't cause banks to artificially engage in transactions or to shift transactions around. Clearly accounting and disclosure need to be addressed, and we hope to do that. The interagency task force has met twice, and we are trying to address the accounting and disclosure issues at this point.

Q: What about capital requirements?

A: Well, there's a lot going on in the capital area because it's one area in which there really has been an attempt to bring some kind of international standard to the market. That's being done by way of the Basle Committee initiatives.

The current risk-based capital requirements address credit risk of derivatives. There are a couple of new proposals. One would affect credit risk by allowing for the netting of exposures where there's a valid and enforceable netting agreement in place. The other would address market and foreign exchange risk.

The netting proposal is pretty far along. I would say a notice of proposed rulemaking might be out in the next month or two.

Q: To what extent is there an unfair playing field between banks and securities firms because of disclosure or capital requirements. SEC Commissioner Carter Beese said in a recent interview that one example of an unfair playing field is that the U.S. government has shown it is willing to bail out banks but not broker-dealers and that this may have put broker-dealers at a little bit of a competitive disadvantage with European counter-parties.

A: That may have been the case in the past. I would wonder whether the depositor preference provisions in the Omnibus Budget Reconciliation Act change all of that. I think those provisions give preference in the liquidation of a bank to the FDIC over uninsured depositors and other senior creditors, including those from derivatives transactions.

Q: I understand that a number of banks are seeking to set up their own derivatives products companies. What are your views about such companies?

A: We don't currently have any applications or formal requests before us. Some banks have informally expressed an interest. Our views would depend upon the structure that a particular entity takes.

To the extent that a derivatives product company engages in derivatives transactions and is capitalized by the parent or affiliate bank, we would be concerned about the bankruptcy-remote issue.

The concern there is that the good assets are going out of the bank and into a separately incorporated subsidiary so that they may not be available to the FDIC in the event of the insolvency of the bank.

But we are also concerned about maintaining the competitive position of U.S. banks, both versus foreign banks and their nonbank U.S. counterparts.

And to the extent that the establishment of a derivatives product company allows the banks to maintain their competitive position or to be more profitable, that's certainly something that we would view favorably. The volume of derivatives transactions has been increasing at U.S. banks over the last few years, but their market share has been decreasing.

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