Bank regulators are grappling with capital rules for a new breed of derivative designed to hedge loan concentration risk, a top official in the Comptroller's Office said Thursday.
Douglas E. Harris, senior deputy comptroller for capital markets, said that so-called total rate of return swaps present a problem for regulators because they pose both credit and market risks.
"Our risk-based capital rules currently prescribe quite different treatment for credit risk and market risk," Mr. Harris said in an interview previewing a speech delivered Thursday to a Futures Industry Association conference in Baltimore.
"We're asking; 'Where do these products fall? Are they really credit or market risk products?'" he added.
Total rate of return swaps allow a bank to push off credit risk to a second institution more willing take on that risk. If the market value of the loans drops below its original value, the second bank pays the difference to the first bank. If the market value of the loans increase above par, then the first bank pays the amount of the increase to the second.
The market risk involved with these complex agreements stems from fluctuations in market values, but the underlying loans also can pose credit risks.
"That raises some very interesting and complex supervisory questions," Mr. Harris said.
Staff members of the three federal banking agencies met recently to discuss how to hammer out capital requirements for these instruments, Mr. Harris said. Although the OCC has been ruling on banks' use of these credit derivatives on a case-by-case basis, the agencies are not prepared to propose a rule soon, he said.
"This market is still in its infancy, so we're on a steep learning curve," he said. "We are trying to adequately understand how these instruments work before developing any hard and fast rules."