November 10, 2006
Comptroller Dugan Tells Bankers that Managing Risk in Derivatives Markets Is Essential to Maintain Public Confidence in Nation's 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 Association’s 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 OCC’s approach to large bank supervision, which involves the continuous, on-site presence of large teams of examiners at each of the agency’s largest banks, gives the OCC useful insights into conditions in derivatives markets.
Three focal points for the OCC’s 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 bank’s 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 aren’t 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.