In a move to preempt trading disasters similar to those in other markets this year, the Comptroller's office has issued new examiner guidelines for banks' activities in emerging markets.
While the new guidelines provide a blueprint for managing risks associated with the nearly $3 trillion market for debt of lesser-developed nations, the directive also clarifies the agency's views on compensation of traders.
The guidelines follow the same principles regarding senior management responsibility that the agency has used in directives issued earlier this year for derivatives and bank-owned futures commission merchants.
As in these previous instances, the guidelines call for the separation of trading and back-office operations and require banks to have written policies and procedures for risk tolerance in these markets.
Douglas E. Harris, deputy comptroller for capital markets, said the recent spate of guidelines will help the agency fill in gaps in guidance relating to these new product areas.
"These are major activities with some of the banks, and ones that hadn't been addressed by the agency," said Mr. Harris.
What makes its emerging markets guidance unique, however, is that the agency tackles the volatile issue of trader compensation.
In a speech last month, Mr. Harris told a group of London bankers that compensation packages rewarding high returns may subject the bank to unreasonable risk. At the time, he said the agency would issue guidelines to examiners - and ultimately to banks themselves - on this issue.
The emerging markets directive attempts to give banks direction on how to pay traders without putting a bank's financial condition in jeopardy.
"At times, these may seem to be competing considerations," said Mr. Harris. But, he added, "the bank ought to ensure that compensation policies bring the interests of the bank and its traders into line."
The guide addresses this subject in two ways. First, the agency recommended that senior management consider bank policies, laws and regulations, and competitors' pay structures, along with such factors as traders' risk-adjusted returns, performance relative to the bank's stated goals, and the levels of risk caused by other trading activities.
At the same time, the agency urged that banks pay their traders enough to reduce "intellectual risk," which refers to the potential loss of an entire emerging markets trading desk to a competitor. Such a situation could leave the bank without personnel capable of handling the risks associated with specific countries or instruments.
But this kind of risk is not something that banks should dwell on, said William Ferrell, president of Ferrell Capital Management in Greenwich, Conn.
"That to me is a sign of bank insecurity more than it is a problem with best practices," he said. "You're not going to have any problem keeping staff by telling them that their compensation is going to be linked to the amount of danger they put the bank's capital in."
More important, he said, are the requirements that senior management understand the risks involved with emerging markets.
"Any financial manager in 1995 should be able to tell their board of directors that they understand what their risks are," he said. "And the further away you get from liquid global markets, the more difficult it becomes to put an analytical value to the amount of risk taken, and the more you have to do things on the basis of stress testing."
To cover these areas, the guidelines alert examiners to the potential for political upheaval in one nation to affect the ability of other nations or companies in those nations to meet their obligations to a bank. The reason, Mr. Harris said, is that the value of bank-owned debt and other financial instruments relating to emerging nations are more susceptible to social, political, and market upheavals than are instruments issued in developed countries.
"One of the things we've seen with respect to the situations with the peso is that the various emerging markets may not be as disconnected as previously thought," said Mr. Harris. "Following the collapse of the peso, we saw volatile movements in currencies and interest rates in Asia and other markets."
So far, the guidelines have the conditional support of emerging markets specialists. Michael Chamberlain, executive director of the 160-member Emerging Markets Traders Association, said he has followed the process leading up to the Comptroller's guidelines. Though he has not seen the final version, he said he does not expect any surprises.
"I think the OCC is saying that because of the rapid growth in this market, this is an appropriate time to look at it," Mr. Chamberlain said. "My sense is that it is consistent with the positions other bank regulators have taken."
He added that despite the rapid growth in these markets, there has not been a market disaster like those involving Barings Brothers and Daiwa Bank earlier this year.
Instead, he said, the market is "maturing gracefully" thanks to the increased democratization and market reforms many of these nations have implemented.
"This market has essentially grown up in what was previously a disappointing area for banks," he said. "It's a very big part of their international business now."
