WASHINGTON -- Federal officials, worried that the explosive growth of derivatives has outpaced the market's understanding of the risks. are asking market participants to set up systems to manage those risks.
In a speech to the Institute of International Bankers this week, Eugene A. Ludwig, Comptroller of the Currency, said his agency expects every U.S. bank involved in derivatives to adopt a "no surprises" risk management policy that is "made concrete" by a series of systems and controls.
Ludwig also called for the development of an interagency task force to examine the risks and other issues posed by the involvement of U.S. banks in the derivatives market.
At another meeting this week, William J. McDonough, president of the Federal Reserve Bank of New York, said that financial institutions involved in derivatives should develop risk management systems that integrate credit, market, liquidity, and other risks to obtain an overall risk profile of their derivatives activities.
These risks include whether a counterparty in a derivatives transaction will continue to fulfill its contractual obligations, whether the market and the price of the underlying bond or security will unexpectedly change, and whether the sale of a product will have an adverse affect on its price.
"Firms must be able to aggregate, at least roughly, the consequences of major market events across all product and activity groups for all of these areas of risk," McDonough said at the meeting. which was sponsored by the Group of Thirty, a group of international financial experts.
Ludwig's and McDonough's remarks come in the wake of a new report by the International Monetary Fund that says "the most notable development" in the major financial markets during the past five years has been the explosive growth in the volume and diversity of derivative products.
The notional value of outstanding exchange-traded and over-the-counter derivative contracts has grown globally from roughly $1.6 trillion in 1997 to about $8 trillion in 1991, the report said. To put these figures in perspective, the report noted that they equal from 35% to 140% of the U.S. gross domestic product.
Regulators are concerned that, because derivatives increasingly are used globally by a wide range of financial and nonfinancial firms in most financial markets, the failure of a large firm involved in these products or some other unexpected crisis could cause domino-like repercussions are difficult to contain, the report said. This is called "systemic risk."
McDonough and David Mullins, the vice chairman of the Federal Reserve Board who spoke at the same seminar, both applauded the Group of Thirty's recent report on derivatives. The report contains 24 recommendations for market participants regulators, most of which are aimed at identifying and reducing the risks associated with derivatives.
McDonough said the group produced "an excellent study" and "comprehensive overview" on derivatives. He said he agreed with the report's recommendations but would go further in a few cases.
The report said, for example, that senior management should develop risk management policies for derivatives.
However, McDonough said that senior management should go beyond establishing policies and should play an active role in monitoring and assessing the risks associated with derivatives on a constant basis.
Senior management should regularly ask probing questions about what events could expose the firm to substantial losses and what internal control systems exist to recognize the potential for such losses, he said.
McDonough warned the top officials at banks and securities firms to stay out of derivatives unless they understand them.
"To put it simply and directly, if the bosses do not or cannot understand both the risks and rewards in their products, their firm should not be in the business," he said.
McDonough had been prepared to say in a written speech that the end users of derivatives should maintain the same sound financial practices as the financial institutions that are involved in them. He had also planned to call for the creation of a steering committee of market participants and regulators to help accounting and disclosure practices for derivatives activities, But he cut the speech short.
McDonough told those attending the seminar that while he does not believe derivatives are the sole or even principal source of systemic risk in today's financial markets, "the increasingly widespread use of [them] has altered firm-level exposures and market dynamics" such that "we must consider how these changes modify our thinking on possible sources of systemic disruptions and how they play out."
Rep. James A. Leach, R-Iowa, the ranking minority member of the House Committee on Banking, Finance, and Urban Affairs, told those attending the seminar that derivatives "are way too sophisticated for a Congress of generalists to deal with legislatively."
Leach said that more regulatory oversight of derivatives is needed. The complexity of derivatives, he said, highlights the need for top administration officials to appoint federal regulators on the basis of their expertise rather than because of some political debt. "The government cannot be run by campaign managers," he said.
Meanwhile, the International Swaps and Derivatives Association announced in London last week that it plans to conduct a survey to determine the extent to which members have followed the Group of Thirty's recommendations on derivatives. The survey will be conducted after the Group of Thirty's study is completed, the association said. The Group of Thirty is planning to issue two more appendices to its study.
The ISDA also announced that it will hold a series of conferences and seminars to help financial institutions implement the study's recommendations.