Remarks by
Julie L. Williams
1st Senior
Deputy Comptroller of the Currency
and Chief Counsel
Office of the
Comptroller of the Currency
Before the
Risk USA 2003
Conference
Boston, Massachusetts
I am delighted to be with you this morning and its a
particular honor to address this conference, which is deservedly described in
your brochure as North Americas premier annual congress examining the latest
innovations, trends, and methodologies for effective risk management and optimal
derivatives trading. Having said
that, I suspect many of you now may be wondering why one of your keynote
speakers at such a conference is a bank regulator, and even worse, a lawyer.
Regrettably, innovation and
trend-setting are qualities not typically associated with either regulators or
lawyers.
I hope I have a pleasant surprise in store for you. What
Ill talk about this morning is the approach my agency -- the Office of the
Comptroller of the Currency -- has taken to the role of banks as financial
intermediaries; how this approach has evolved; how it has enabled the national
banks we regulate to become robust, vital and successful and safe and sound
participants in the derivatives markets, and how we take supervisory and
regulatory concerns into consideration when we evaluate proposals by national
banks to engage in new facets of the derivatives business.
Brief Overview of Banks Role in the Derivatives Business
At the risk of telling you some things you already know,
allow me to provide a little background.
First, my agency -- the Office of the Comptroller of the Currency --
does not print money; we regulate the national banking system, including most
of our nations largest, most complex and sophisticated banks. The largest of these banks are active
participants in the derivatives business, and the growth of their business has
been a significant component of the overall growth of derivatives markets.
Indeed, the phenomenal growth of derivatives has been one of
the defining features of global capital markets over the past decade or two,
and an increasingly important part of the commercial banking business
worldwide. In 1990, total notionals
held by U.S. banks was well under $10 trillion; in the first quarter of 2003,
they stood at some $61.4 trillion, overwhelmingly in interest rate
contracts. U.S. banks generated $3
billion in trading cash instruments and derivatives activities during that same
three-month period a tidy sum that reflects one of the better quarters in
recent reporting time periods.
As bullish as these numbers are, they dont begin to tell
the whole story. Indeed, for technical
reasons, the actual profitability of derivatives trading is even greater than
reflected in the reported numbers.
But for banks actively participating in the derivatives
market admittedly, still a relative handful -- trading income is but one of
the benefits they derive -- icing on the cake, as it were. In a recent speech
that deserved more attention than it received, Federal Reserve Board Chairman
Alan Greenspan endorsed the view that much of the credit for the resilience of
the financial system during the economic turbulence of past three years may
belong to the improvements in risk measurement and management techniques in use
at our leading banks. And of those improvements, he singled out the growing use
of derivatives as of particular importance in assisting financial institutions
in unbundling and managing financial risks. As a result, U.S. financial
institutions were not only able to withstand the largest corporate defaults in
history, and the largest sovereign
default in history Argentina but are now poised to lend again as companies
anticipate quickening demand for their products and services in a recovering
economy. Derivatives, as a key risk
management device, may thus have helped to play a decisive role in keeping the
recent recession both shorter and milder than would otherwise have been the
case.
Of course, derivatives continue to be controversial in some
quarters. They havent quite overcome
the taint of association with Barings and Long Term Capital Management. Their complexity can be daunting. One investment banker famously observed that
he had been trying to explain [the subject] to my parents and my wife for nine
years and they still dont understand it. I still have to assure my mother that
what I do for a living is legal.
Especially in inexperienced or unethical hands, the risks posed by
derivatives are very real.
OCCs Approach to National Banks Derivatives Activities
At the OCC, we have tried to view the derivatives business
not in isolation, but rather as part of an overall approach to the business of
banking, its safe and sound conduct, and the management of the risks associated
with it. Banks are in the business of
serving the needs of their customers, and the OCC has consistently taken the
position that the national charter is a dynamic instrument for the delivery of
bank products and services. When we
authorize -- indeed, before we authorize -- national banks to undertake new
banking activities, we also consider how those risks will be managed and
mitigated. Banks are quintessential
financial intermediaries and derivatives can play an important part in the
risk-management strategies employed by financial institutions and their
customers. Thus it was logical that
banks would seek to enter the derivatives business, and as they did, it
presented a new range of legal, regulatory and supervisory considerations for
the OCC.
We initially found national banks have authority to enter
into derivatives, including swaps, options, and forwards, by looking to the
nature of the investment on which the derivative was based. In those cases where national banks could
own the underlying investment, we concluded banks may enter into derivatives
with payments tied to the value of those investments. Based on these precedents, national banks were able to launch
derivatives businesses that focused on management of interest rate and foreign
exchange risks and price risk of particular precious metals.
Later, banks explored with the OCC the possibility of
expanding their derivative business to include cash-settled derivatives based
on the value of investments that banks generally cannot own, such as
commodities (including oil, gas and electricity) and certain securities
(generally equities and some types of debt).
Banks sought to provide customers with derivative products useful for
managing risks of price fluctuations in those commodities or securities.
In reviewing these proposals, the OCC considered carefully
the nature of the transactions and activities involved and determined that cash
settled derivatives with payments tied to the value of securities or
commodities essentially involve exchanges of payments, similar to traditional
banking activities. We also concluded
that this line of business was fundamentally financial intermediation -- a new
form of banks long-recognized role as financial intermediaries. I will have more to say about these
precedents in a moment.
Today, as in the past, the OCC takes a favorable view of
banks efforts to conduct banking activities in new ways to respond to changing
financial needs of customers. In this regard, we also support and encourage
national banks in their well-established history of serving as leaders in the
development of risk management and controls.
Legal Foundation for National Banks Ability to Conduct
Derivatives Activities
Now I get to the part where I explain how our legal
positions actually have been constructive.
OCC legal precedents interpret banks statutory authorities
broadly, consistent with both the language and goals of the National Bank
Act. We approach banking powers --
guided by decisions of the U.S. Supreme Court
-- as not just the activities listed in the National Banking Act, but as
including a more general authority to engage in the business of banking and
incidental activities. Our precedents
have permitted ever expanding and more sophisticated banking activities. At the same time, and of equal importance,
we have developed supervisory guidance to ensure these activities are conducted
safely and soundly and we have assembled a talented staff with outstanding
expertise, who understand this business and take a risk-focused approach to
applying that guidance to the banks they supervise.
Using the procedures, interpretations and safeguards I have
described, the OCC has permitted new and more efficient forms of hedging
risk. Banks do not need to hedge each
transaction, but can hedge on a portfolio basis to within appropriate risk
limits.
The OCC also has permitted hedging with holdings that
generally are not permissible for banks.
Equity hedges are an example of this.
Our decision to permit this new form of hedging was based on evidence
from a national bank that conducting the hedges within the bank resulted in
substantial savings and reduced operational and other risks arising from the
banks derivatives business. Our legal
opinion was that the equity hedges are incidental to that business because they
enable the bank to conduct the business more profitably and effectively.
Also permitted are new forms of settlement to allow banks to
participate in a broader range of markets.
Over the last year, the OCC issued two newsworthy rulings authorizing a
national bank to engage in what appeared to be novel types of financial
intermediation transactions. In the
first case, a bank proposed to add transactions based on the price of
electricity to its existing energy-related financial intermediation derivatives. In the second case, a bank proposed to
expand its financial intermediation business to include customer-driven,
electricity derivative transactions that involve transfers of title to
electricity.
In both cases, however, there actually may have been less
news than met the eye. The rulings were premised on a common set of assumptions
assumptions that have long been the foundation of our approach to bank powers
generally.
First, we held that financial intermediation transactions
involving commodities are authorized as part of the business of banking. We have previously recognized, in a variety
of contexts, that commodity and commodity index derivatives are a modern form
of traditional financial intermediation functions performed by banks. Based in part on that lineage, we have
concluded that national banks may make payments to or receive payments from
customers under commodity derivative contracts in the event of a gain or loss
in a metal or energy product or index thereon. These derivative transactions
thus have been recognized as permissible for national banks as a financial
intermediation activity.
In these arrangements, national banks act as financial
intermediaries between customers that want to manage risks resulting from the
variations in the price of a particular commodity or commodity index. Customers do not deal directly with one
another, but instead make payments to the intermediary bank. Under these
authorities, the OCC has determined that national banks may engage in matched and
unmatched commodity price index swaps, and manage and warehouse them on a
portfolio basis.
Based on similar reasoning, we have permitted national banks
to engage in various commodity-linked transactions involving oil, gas, other
hydrocarbons, and metals. Commodity-linked transactions include making loans,
taking deposits, and issuing debt instruments having terms related to commodity
prices, sales, or indices, or measured in relation to the future; and entering
into swaps, forwards, and other transactions relating to commodity prices and
indices, or combinations thereof, in order to assist bank customers in managing
their financial exposures.
The second assumption behind our recent approvals was that
the electricity derivatives business is the functional equivalent of other
commodity derivatives transactions that the OCC has previously determined are
permissible for national banks. They are privately negotiated contracts between
the parties to the transaction, individually tailored to the specific risk
sensitivities of the customers. The parties agree to make payments based on the
performance of a particular commodity or commodity index, whether the commodity
is a hydrocarbon or a foodstuff.
Third, again, the OCC has long recognized that using derivatives
to hedge against the risks associated with bank permissible activities is an
integral part of those permissible banking activities. We have determined that national banks may
hedge bank permissible commodity derivative transactions with other
commodity derivatives, such as futures, and swaps and options and other
over-the-counter instruments, when conducted in a safe and sound manner as
provided in OCC guidance. Hence, as
with other commodity derivatives, national banks may hedge bank permissible electricity
derivative transactions with electricity futures, and swaps and options and
over-the-counter derivative instruments. Further, we have specifically endorsed
the hedging of commodity transactions on a transaction-by-transaction or
portfolio basis.
How Supervisory Considerations Intersect with Legal
Standards
Perhaps most important, the approval I have described was
predicated on the requirement that electricity derivatives like all financial
intermediation transactions that we approve will be conducted in a safe and
sound manner. That is, just because the
proposed activity may closely resemble a previously approved activity does not
mean that it will automatically qualify for approval itself. Such activities require sophisticated risk
measurement and management capacities on the part of a bank, as well as
qualified personnel, in order for the activity to operate in a safe and sound
manner.
Thus, in order for us to reach the conclusion that the
proposed activity was permissible for the bank, the bank was required to
demonstrate to the OCCs satisfaction that it had established appropriate risk
measurement and management processes including board supervision, managerial
and staff expertise, comprehensive policies and operating procedures, risk
identification and measurement, and management information systems, as well as
an effective risk control function. In
other words, we did not reach a general conclusion that the activity was
permissible for every national bank. We
explicitly linked our conclusion about legal permissibility with our
supervisory conclusion about the capacity and expertise of the particular bank
to conduct the business in question.
But the Enron
debacle and other events that led to the passage of the Sarbanes-Oxley Act
reminded us that risk management is not just about financial exposure; it is
also about reputation risk. There was
time when some questioned why the OCC included reputation risk as one of the
types of risks that we evaluate in our supervision of national banks. We dont hear that much any more. Certainly many shareholders would agree that
events of the last two years have shown that an institutions corporate
reputation has a significant economic value.
We recognize that when national banks engage in complex
structured transactions involving derivatives, issues concerning the
appropriateness of a transaction may arise.
Thus, in our review of a banks risk management approval process, we
look to see how the bank evaluates that consideration, in other words, what it
does to protect its good name in choosing the transactions it is willing to
conduct and the parties with which it is willing to do business. We expect that banks involved in complex
structured transactions involving derivatives will subject those transactions
to review and oversight through their risk management oversight process to
ensure that transactions conform to the banks standards of appropriateness and
integrity.
We look to see if committees independent of the sponsoring
business review the complex structured transactions. In addition, we look to see whether the bank has a process by
which it will evaluate the purpose of a transaction to assess whether a client
has attempted to achieve a financial statement objective that could be
construed as materially misrepresenting its financial condition, even if in
conformance with generally accepted accounting principles. And, where such could be the case, we look
for an undertaking from the bank to take appropriate steps, including declining
to participate in the transaction, or requiring its counterparty to make
appropriate disclosures concerning the nature and impact of the transaction on
the financial position, so that there will be no misperception of the
transactions purpose and effect..
Conclusion
As I have recounted, the derivatives markets play a vital
role in the management and intermediation of risk in our financial system, and
the participation of banks, in their natural role as financial intermediaries,
has, and should continue to, grow.
Whether and how much it does, will be influenced by whether regulators
-- or legislators or government officials -- feel the need to intervene to
affect the way the business is conducted.
And that, in turn, will depend to an important extent on how well you,
and other industry participants, help to ensure that, in your derivatives
business, appropriate attention is paid to both financial and reputation risk.
What does all this presage for the future of banks as
participants in this business? The OCC
expects that national banks role as financial intermediaries will continue to
grow and evolve in response to customer financial risk management needs and
market developments. We view these
developments favorably. We support
national banks efforts to better serve customers with new and innovative
products. We will continue to strive to
take a risk-focused approach to our supervisory responsibilities. But one thing we will insist on is
that this evolution of activities continues to be coupled with appropriate
financial risk controls, and internal checks and balances to ensure that these
activities are conducted with integrity and due regard for the banks good
name.
Thank you very much.
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The OCC charters, regulates
and examines approximately 2,100 national banks and 52 federal branches of
foreign banks in the U.S., accounting for more than 55 percent of the
nations banking assets. Its mission is to ensure a safe and sound and
competitive national banking system that supports the citizens, communities
and economy of the United States.
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