After studying the way national banks manage risks stemming from derivatives transactions, the Comptroller's Office has found four areas that need improvement.
National banks involved in derivatives should expand their understanding of the instruments, enhance independent oversight, bolster computer systems tracking these transactions, and pinpoint risks cropping up in emerging markets, said an executive in the Office of the Comptroller of the Currency.
Michael Brosnan, the OCC's acting senior deputy comptroller for capital markets, prescribed those remedies in a recent interview.
"While we have substantive compliance ... there are certain issues that we and banks need to focus on," Mr. Brosnan said. "We need to point out to banks the areas that need work."
The agency surveyed examiners this summer to find out how faithfully national banks are observing Banking Circular 277 - the October 1993 policy statement laying out how risks involved in derivatives transactions should be managed.
The OCC's biggest concern, according to Mr. Brosnan, is that some national banks - especially smaller institutions - are getting involved without fully understanding the risks.
"We have found that certain end-user banks were using these things without understanding what they were doing," he said. "At smaller banks, you obviously have less people, so there is more struggling in terms of understanding derivatives."
Ann Grochala, director of bank operations at the Independent Bankers Association of America, agreed that small-bank officials do not always fully understand how the value of a derivative can fluctuate.
"Often, community bankers have the opportunity to purchase an investment with an initial rate that looks very good," Ms. Grochala said, "but they don't fully understand what indexes may cause the rate to change in the future."
Banks also should ensure that derivatives activities are reviewed by employees not directly involved in the transactions, Mr. Brosnan advised.
"Everybody has to have independent oversight," he said; "otherwise, the bank directors are going to rely on the people who are taking the risks." Part of the problem, Mr. Brosnan said, is that employees most knowledgeable about complicated derivatives transactions are often lured to better-paying jobs.
"As a bank, you're looking for someone with expertise and experience in these areas, and ability to communicate," he said. "These people tend to get hired away, so banks shouldn't be dependent on just one person - it's a bench-strength issue."
OCC examiners are also noticing - especially in regional banks - that as banks acquire or merge into other institutions, incompatible computer systems at different offices cannot communicate with each other. This makes it difficult to know exactly how much the successor bank holds in derivatives.
"We don't have any bank that can hit a button and know their overall corporate position right then and there," Mr. Brosnan said, "so the bank has to manage the risk in a more fragmented way. Banks are definitely moving toward having this one button, but they're not there."
The fourth concern involves only the 10 or so national banks that use derivatives to hedge risks stemming from emerging-market investments, Mr. Brosnan said. These instruments are hard to value.
"The vast majority of positions," Mr. Brosnan said, are valued from "public sources, but in these emerging-market situations, banks rely heavily on traders' valuations.
"It requires a very high level of independent scrutiny of the information that traders are providing because the absence of pure valuations creates an opportunity for surprise."