1) Bank and thrift regulators should retain a strong leverage capital standard to generally guard against risks at insured financial institutions, including risks posed by derivative instruments. Regardless of the new risk-based standards that take into account netting, market risk, and interest rate risk, there is no substitute for a strong leverage capital requirement.
2) Comparable rules concerning capital, accounting, disclosure, and suitability should exist whether derivatives activities are conducted by a bank, broker-dealer, insurance company, or other type of financial institution.
3) Regulatory agencies, led by the Federal Reserve and the Treasury, should pursue international discussions to achieve harmonization of international standards related to derivatives trading with the understanding that U.S. standards may, if appropriate, be more stringent.
4) An interagency commission should be established by statute to consider comparable rules related to capital, accounting, disclosure, and suitability for dealers and end users of over-the-counter derivative products. In addition, the commission should meet regularly to keep abreast of changes in the derivatives marketplace and consider other issues related to derivatives as appropriate. Members of the commission should include the federal banking commission agencies, the Securities and Exchange Commission, the Commodity Futures Trading Commission, and the secretary of the Treasury or a designee. Uniform commission rules for derivatives should he applied to all market participants.
Currently unregulated market participants, such as insurance companies, should be supervised by either the SEC or the secretary of the Treasury.
5) Banking regulatory agencies should discourage active trading in derivative markets by insured institutions, particularly smaller institutions, unless management can convincingly demonstrate both sufficient capitalization and sophisticated technical capabilities.
6) The federal banking agencies should conduct joint regulatory examinations for major derivatives dealers, including coordinated examination of banks and their affiliated holding companies.
7) The federal banking agencies should establish coordinated training programs for examiners involved in monitoring derivatives activities at dealer banks and end users.
8) Regulators should require specific written policies approved by the board of directors to be in place for dealers and end users of derivatives setting prudential standards for management of the risks involved in derivative activities and establishing a framework for internal controls.
9) Regulations or guidelines implementing Section 132 of the Federal Deposit insurance Corporation improvement Act of 1991 should outline proper internal controls for derivatives activities at insured institutions
10) The federal banking agencies should define the failure of institution-affiliated parties to have adequate technical expertise to be engaged in derivatives activities, commensurate for the level of activity, as an "unsafe or unsound" banking practice, subject to civil money penalties or a corrective cease and desist order. If an insured institution suffers or will probably suffer a financial loss or other damage involving the willful or continuing disregard of such an unsafe or unsound banking practice, then appropriate institution-affiliated parties should be removed by the regulator.
11) The federal banking agencies should work to enhance the current risk-based capital standards to include off-balance sheet instruments and activities not currently covered. The federal banking agencies should evaluate the need to potentially increase, capital requirements associated with the "future credit component" or "add-on" component of the current riskbased capital standards. In addition, the federal banking regulators should not implement proposals related to bilateral netting if such proposals have the effect of reducing capital standards for derivative activities without a clearly commensurate decrease in credit and legal risk.
12) Regulators should set guidelines for the use of collateral by counterparties to derivatives transactions. Some market participants have negotiated contracts that require the posting of collateral if certain "triggering events" occur. In some cases, the triggering event is based on the size of exposure using market values; in other cases it may be based on the creditworthiness of the counterparty. Excessive reliance on such collateral triggers, particularly those based on creditworthiness, may be imprudent. In particular, such collateral arrangements could place substantial liquidity pressures on a counterparty just when its creditworthiness is weakening and its access to liquidity is more limited.
13) In evaluating a firm's models and simulations for purposes of evaluating credit and market risk, the regulators should adopt capital, accounting, and disclosure standards based on a 99% confidence interval (three standard deviations).
14) Call reports should be expanded to include enhanced information to assess market risks, concentration of counterparty exposures, and the risk-reducing effects of legally enforceable netting contracts. In addition, incremental information that would differentiate derivatives used for hedging purposes from other derivatives and that would identify the related impact of each category on bank earnings and balance sheets as well as any deferred hedging losses or gains could also be useful. Call report changes should be made in a manner designed to minimize any additional regulatory burden placed on insured institutions.
15) Enhanced uniform disclosure standards should be established by the regulators for derivatives activities. These enhanced disclosures should include:
a) Greater disclosure of the extent of derivatives activities by an institution, both on-and off-balance sheet, as well as additional numerical data regarding the types and maturities of various derivative instruments. These disclosures would be beneficial to regulators and to the market.
b) Disclosure to the regulators of individual revenue sources from derivatives activities.
c) Disclosure of the level of speculative activity in derivatives conducted by dealers.
While this form of disclosure may be difficult for some institutions under their current structure, it is currently available at certain dealers. There is no reason that trading activities cannot be broken down into component parts and that, for instance, customer trading services, institution hedging, and risk management activities cannot be segregated from speculative activities with these differentiations disclosed, at least to regulatory agencies.
16) The Financial Accounting Standards Board and others responsible for setting accounting standards should, as a high priority, issue definitive guidance on reporting for financial instruments, including derivatives.
17) Regulators and other standard-setting bodies need to provide clearer guidance on defining when risk management or hedge accounting is appropriate.
18) Regulators should establish uniform guidelines as to an appropriate credit risk reserve that should be taken in conjunction with each transaction. While reserving for credit risk appears to be common among major derivatives dealers, it does not appear to be a uniform practice.
19) Non-U.S. firms operating in this country should be subject to the same capital, accounting, disclosure, and suitability requirements as U.S. firms.
20) Regulators must adequately account for the legal risk related to non-U.S. counterparties. Regulators should ensure that institutions have adequate internal controls that take into account and set limits for legal risk. Higher capital requirements should be imposed in cases where the legal enforceability of agreements with counterparties is not certain.
21) Regulators should work with industry groups to increase the standardization of documentation and the use of standard documents by all market participants. Increased standardization of documentation should decrease legal risk. In addition, as documentation becomes standardized, it will be easier for end users to assess the risk/reward trade-offs of proposed derivative transactions.
22) Regulators of financial firms marketing derivative products should insist upon high ethical standards in the sales practices of derivative units. The federal banking agencies should adopt uniform guidelines, similar to the Office of the Comptroller of Currency guidelines, requiring that a dealer bank should seek to understand the applicability of financial derivative instruments to the risks a bank customer is attempting to manage. The bank dealer should be required to evaluate whether a particular transaction is appropriate for a particular customer.
Proper due diligence in evaluating the appropriateness of a derivative product for a prospective customer is the best safeguard for both the dealer and the end user. The regulators should also consider whether industry-wide suitability rules should be enacted and cross-industry guidelines enacted.
23) Regulators should examine the merits of whether dealer disclosures as part of individual counterparty agreements should be significantly expanded and improved, particularly with regard to the specific costs and risks of derivative instruments in varying interest rate or other market change scenarios. Such disclosures could be made mandatory when dealers enter into transactions with customers, particularly less sophisticated end users such as many smaller banks, thrifts, businesses, and retail customers.
24) The federal banking agencies should jointly promote and participate in educational programs related to derivatives so that potential end users, particularly smaller institutions, may be better informed as to the risks and benefits of derivatives activities.
25) The appropriate regulators should establish minimum prudential practices for municipalities and pension funds that may use derivatives. Taxpayers and pension fund participants may unknowingly be at risk from inappropriate investments in derivatives. Anecdotal evidence indicates that the level of expertise with derivatives exhibited by municipalities and pension funds is widely varying.
26) Regulators should examine the need for enhanced disclosures to customers of the risks that may be involved with derivative products, including embedded securities, for mutual funds that are end users of derivatives.
27) The regulatory agencies should provide to Congress recommendations to conform the netting provisions contained in the Bankruptcy Code; the Financial Institutions Reform, Recovery and Enforcement Act of 1989; and the Federal Deposit Insurance Corporation Improvement Act of 1991 to a single standard for purposes of greater efficiency. Pursuant to the recommendation of the FDIC, any prospective legislation should expand record-keeping requirements for qualified financial contracts at undercapitalized institutions. In addition, pursuant to the recommendation of the Fed, federal funds transactions and spot contracts should be covered under the statutory scheme.
28) Regulators should examine the need for regulations to protect against systemic risk. While the OCC has expressed reservations about such need, the SEC would appear to have a persuasive case in suggesting that regulation may be the only means of ensuring that systemic risk is adequately addressed by participants. As the SEC points out, there is no agreement among dealers and end users on how to manage systemic risk. Since dealers and end users currently have a competitive bias against factoring systemic risk into their individual risk calculations, it would appear that regulation is the only responsible method of achieving such an objective.
29) The Treasury should evaluate the benefits of utilizing derivative instruments for hedging purposes to improve the efficiency of government financial management practices. Sovereigns around the world use derivatives for financial risk management purposes.
30) To the extent that the recommendations described above may not be implemented administratively, framework legislation outlining regulatory responsibilities without delineating specificity in standards setting may be necessary.