Comptroller Dugan Tells Bankers that
Managing Risk in Derivatives Markets
Is
Essential to Maintain Public Confidence in Nations Financial Institutions
PHOENIX Comptroller
of the Currency John C. Dugan said today that ensuring effective management of the
large credit risks that have accumulated in the derivatives portfolios of the
major trading banks is a matter of concern for all banks, even those not active
in derivatives markets.
Significant mismanagement of these risks could
precipitate market disruptions that affect public confidence in financial
institutions generally, he said in a speech to the New York Bankers
Associations annual convention. The OCC's most recent quarterly report on derivatives shows that nearly one in six national banks uses derivatives to control and reduce uncertainty and risk.
The Comptroller said that the OCCs approach to
large bank supervision, which involves the continuous, on-site presence of
large teams of examiners at each of the agencys largest banks, gives the OCC
useful insights into conditions in derivatives markets.
Three focal points for
the OCCs supervision of derivatives activities involve pricing, credit, and
operational risk, he said. Although
trading losses at banks have been low historically, our concern is that even
with prudent internal limits, a banks risk profile can change very quickly in
the event of a market disruption, with the potential for losses far exceeding
such limits.
While credit exposures
currently totaling about $199 billion are quite large, the Comptroller said
it is important to recognize that banks actively secure much, and sometimes
all, of such exposures with high quality collateral, or margin, to mitigate
this risk.
Nevertheless,
derivatives credit exposure remains a real and quite significant risk, Mr.
Dugan added. Competitive pressure may
induce banks to lower collateral requirements, and unexpected market
disruptions can dramatically increase credit exposures. In addition, many derivatives counterparties
are highly leveraged and their balance sheets are frequently too opaque to
easily evaluate.
Operational risk the
risk that arises from trade and settlement processing has surfaced most
prominently in the rapidly expanding market for credit derivatives, the
Comptroller said.
We found that the
processing infrastructure for these often sophisticated risk management
products was decidedly unsophisticated and low tech, with significant manual
trade confirmations in a high volume business, he said. As a result, we observed an unacceptably
high volume of unconfirmed transactions and undisclosed trade assignments a
practice where a hedge fund counterparty arranges for another dealer to assume
its position without informing the derivatives dealer.
The Comptroller noted
that five institutions, all national banks, account for 97 percent of the $119
trillion notional amount of outstanding derivatives and said that type of
concentration would ordinarily be a significant concern for the OCC.
But derivatives arent
like other products, he said. Given the
resource commitment necessary to conduct a derivatives business in a safe and
sound manner, and the critical importance of credit quality to assure
performance on contracts, it is understandable that derivatives activity is
concentrated in those few institutions with the requisite credit strength and
scale required to effectively compete, Mr. Dugan said.
Of course, we
supervise large dealer banks with the goal of ensuring that they are well
capitalized and have the necessary expertise, personnel, and resources to
manage their derivatives effectively a process that also should help mitigate
concentration risk, the Comptroller added.
The speech is available
at http://www.occ.gov/ftp/release/2006-121a.pdf.
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The
Office of the Comptroller of the Currency was created by Congress to charter
national banks, to oversee a nationwide system of banking institutions, and to
assure that national banks are safe and sound, competitive and profitable, and
capable of serving the banking needs of their customers in the best possible
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