WASHINGTON - In a recent letter to examiners, the Federal Reserve Board expanded the scope of its derivatives guidelines to include contracts a bank plans to hold to maturity.
The Fed told examiners to treat derivatives being held to maturity the same as those the bank trades. Banks often hold derivatives as investments to hedge against fluctuations in interest or foreign exchange rates.
The central bank also noted that the guidelines cover derivative and securities contracts held by bank trust and investment management departments.
"We have not seen that before, and I think it will provide some welcome guidance to those segments of the industry," said Sarah A. Miller, senior government relations counsel at the American Bankers Association.
Previous Fed guidelines have focused on derivatives trading, the type of activity that recently sunk Barings PLC.
International Swaps and Derivatives Association chairman Gay Evans said the Fed letter is on the mark.
"The guidance being given to examiners is a valuable reminder that the same risks are found in trading and nontrading transactions," she said in a prepared statement.
The letter, SR #95-17 (SUP), lays out a series of common sense measures that bankers should take. Most of the provisions come straight from previous Fed advisories.
However, some are new. For example, the guidelines clarify the responsibility of top bank officials.
Directors must monitor a bank's risk-management activities, and must set risk-taking limits, the Fed said. Directors do not need to review the actual instruments within the portfolio, the Fed noted.
"It hasn't been spelled out that clearly before," said Karen Shaw, president of the industry consulting firm ISD/Shaw Inc. "There had been a lot of ambiguity, with directors saying, 'Wait a minute, I can't oversee the whole portfolio.'"
Senior management must oversee trading activities, ensuring that all bank policies are followed. Also, these top officials must understand the bank's risk profile, and they must ensure that all traders are competent.
The Fed also said banks must maintain written policies governing the use of these instruments and the introduction of new derivative products.
Examiners will evaluate if banks are accurately measuring their risk exposure, and if they are comparing prices before buying a derivative or a security.
Finally, regulators will be checking to see if banks have separated traders and back-office personnel. And, examiners will review all significant internal controls, and evaluate all internal and external audits.
Failure to implement and follow risk-management rules violates safety and soundness regulations, the Fed wrote.
ISDA's Ms. Evans praised the Fed's decision to focus on risk management, rather than product offerings. She said this is a more effective way to limit risk.