The Office of the Comptroller of the Currency on Monday advised national banks to institute risk management systems for credit derivatives, a new breed of instruments designed to reduce a bank's exposure to loan concentration risk.
In a bulletin issued to national banks, the OCC said credit derivatives offer substantial risk management benefits but must be treated with the same care as any other hedging instrument. That means banks should install systems to monitor and control risks stemming from these instruments. For example, the guidelines recommended that credit derivatives activities be reviewed by bank employees not directly involved in the transactions.
Blythe Masters, global head of credit derivatives for J.P. Morgan, called the OCC's approach "very encouraging."
"The absence of any regulatory discussion whatsoever has been a constraint on the short-term growth of credit derivatives," Ms. Masters said. "Had any initial statement from the regulators been overly conservative, we would have been concerned that the growth of this product would have been stymied.
"The OCC has made the regulatory environment a much friendlier place," she added.
The Federal Deposit Insurance Corp. and the Federal Reserve are expected to issue similar guidelines soon. Michael Brosnan, acting senior deputy comptroller for capital markets, said that regulators are holding off with capital rules for credit derivatives in order to give the market a chance to develop. The agencies acted because bankers and examiners are increasingly asking about credit derivatives, he said.
"We felt it was necessary to inform banks as to what credit derivatives are, and what the supervisory issues are," Mr. Brosnan said in an interview Monday. "For banks to hedge most efficiently, they need to understand what kind of risks stem from their portfolio, and then how credit derivatives fit into those risks."
Experts say the current size of the credit derivatives market is about $50 billion, but they estimate that figure may balloon to $1 trillion in the next five years.
Credit derivatives allow a bank to transfer credit risk, but not the assets themselves, to a second institution. The contract requires the second bank to compensate the original bank if the value of the portfolio falls. In return, the original bank agrees to pay the second bank if the portfolio increases in value.