The Office of the Comptroller of the Currency issued guidelines Monday that are designed to reduce bank losses on emerging markets trading and loans to hedge funds.
The 16-page bulletin, sent to national bank executives and the agency's examiners, concluded that some losses are the result of flaws in risk management systems. But other problems stem from blind faith in borrowers such as Long Term Capital Management or irresponsible reactions to competitive pressures, the agency said.
"Lenders seemingly were too timid or embarrassed to impose the same kinds of collateral and financial disclosure requirements as would normally be pursued with other, less 'sophisticated' customers," the OCC said in a section of the guidelines devoted to credit risk management.
"These shortcomings compromised the accuracy and rigor of subsequent parts of the credit process."
Volatility in global financial markets has hurt second-half earnings at many large banks. Trading revenue plunged to $614 million in the third quarter, from $2.6 billion in the second quarter.
So far these trading and credit losses have not reduced banks' reported capital, the Comptroller's Office said.
However, these banks "suffered significant losses in market capitalization as their equity prices declined disproportionately relative to other industry groups," the agency said.
Michael L. Brosnan, deputy comptroller for risk evaluation, wrote the guidelines. He said, "The risk to the bank's reputation and the stock market impact can be substantial."
The OCC guidelines, which build on advice issued in October 1993, are divided into five sections covering the management of price risk, credit risk, transaction risk, compliance risk, and corporate risk oversight. The bulk of the bulletin is devoted to price and credit risk management of financial derivatives.
According to the OCC, the notional amount of derivatives grew 16% in the third quarter, to $4.5 trillion. The seven largest banks hold 94% of that total. Though still small, credit losses tied to derivatives jumped in the period as banks charged off $445 million, compared with $94 million in the second quarter.
On price risk management, the OCC said banks better evaluate the danger that a sudden shift in economic conditions will reduce the value of the derivatives portfolio.
Models now being used do not include improbable conditions, the agency said.
"Banks may be reluctant to incur expenses to measure events that management believes will never occur," OCC said. "Effective risk managers should ensure that the bank has properly identified, measured, and communicated to senior management scenarios that could threaten the bank's viability or reputation."
Such forecasts would include worst case scenarios, such as a stock market crash, or a spike in interest rates.
On credit risk management, the OCC said the decision to lend to a hedge fund must be consistent with overall credit standards. Hedge funds should provide complete financial information, divulge leverage and risk concentrations, explain the relative size of aggregate positions in a given market, and disclose performance obligations with other creditors.
The OCC also said that collateral is not an excuse to compromise credit underwriting standards.
Bankers must realize that risks are often interconnected. For example, a country's political instability could affect foreign exchange rates.
Banks also must "stress test counterparty credit exposures to identify individual counterparties, or groups of counterparties, with positions that are particularly vulnerable to extreme or one-way directional market movements," the OCC added.
Finally, the OCC said credit limits should be tied to the bank's appetite for risk.