Conclusion:
The quality of risk management is (strong, satisfactory, weak).Policy
Conclusion:
The board (has, has not) established effective policiesrelating to the bank’s derivatives activities.
Objective:
To determine if policies adequately address use of derivativesas investment substitutes or risk management tools.
1. Evaluate the adequacy of policies with respect to use of
derivatives as investment substitutes or risk management tools. Determine if they:
• Authorize the use of derivatives.
• Address overall net income and capital objectives. • Require analysis that reflects the expected impact of
derivatives on the overall interest rate risk profile in terms of earnings-at-risk or economic value.
• Require the periodic testing of interest rate risk positions and the derivatives cash flows under adverse changes in interest rates and other market conditions.
• Describe which derivatives instruments are authorized. Determine that the approval process considers:
– The liquidity of the instrument. – Leverage.
– The capacity and creditworthiness of approved
counterparties.
– The ability of interest rate risk models to evaluate the
derivatives instruments.
• Require that derivatives be independently revalued for
Comptroller’s Handbook 137 Risk Management of Financial Derivatives
risk control purposes.
• Require outside price sources be used where appropriate.
• Establish, in the absence of authoritative accounting guidance, hedge accounting criteria, including ongoing testing of hedging effectiveness.
• Detail appropriate accounting procedures.
• Require annual board approval.
For banks investing in structured notes:
2. Determine whether the investment policy allows the purchase
of structured notes that are leveraged or whose principal redemption amount is based on a formula. These types of structured notes generally have more risk and should be explicitly authorized by policy.
3. Determine whether the bank has established limits for the
degree of interest rate risk acceptable for structured notes and other investment securities.
4. Review the bank's policies with respect to secondary market
purchases and sales of structured notes to determine whether the bank obtains price quotations from several firms to ensure fair prices.
Objective: To determine the adequacy of derivatives policies relating to liquidity risk management activities.
1. Evaluate the adequacy of liquidity risk management policies
and procedures. Determine if they:
• Require that liquidity-related management information systems and contingency plans address derivatives and corresponding collateral, margin arrangements, and early termination agreements when such activities are material.
• Detail circumstances in which the bank will honor noncontractual early termination requests.
• Provide guidance on the use of credit enhancements.
• Limit the amount of assets that can be encumbered by collateral and margin arrangements. (Such limits are
generally determined after performing analyses to identify requirements under adverse scenarios.)
• Limit the amount of collateral tied to common triggers (e.g., credit rating).
• Require annual board approval.
Objective
: To determine the adequacy of derivatives policies relating tocredit risk management activities.
1. Evaluate the adequacy of credit risk policies and procedures
with respect to use of derivatives as investment substitutes or risk management tools. Determine if the policies:
• Establish guidelines for derivatives portfolio credit quality, concentrations, and tenors.
• Require periodic counterparty review and assignment of risk ratings.
• Prescribe the method of calculating counterparty credit risk exposure.
• Establish and define formal reporting requirements on counterparty credit exposure.
• Require designation of separate counterparty limits for presettlement and settlement credit risk.
• Require independent monitoring and reporting of aggregate credit exposure for each counterparty (including all credit exposure arising in other business lines) and comparison with limits.
• Describe the mechanism for policy and limit exception approvals and reporting.
• Outline what to do when a limit on a counterparty credit line is exceeded because of a large market move (e.g.,
collateral calls, up-front payments, termination).
• Require annual board approval.
Comptroller’s Handbook 139 Risk Management of Financial Derivatives
2. Determine if the bank’s procedures and written agreements
regarding the use of credit enhancements and early termination clauses address:
• Evaluating the counterparty’s ability to provide and meet collateral or margin requirements at inception and during the term of the agreement.
• Acceptable types of instruments for collateral and margin.
• Ability to substitute assets.
• Time of posting (i.e., at inception, upon change in risk rating, upon change in level of exposure).
• Valuation methods (i.e., sources of pricing, timing of revaluation).
• Ability to hypothecate contracts.
• Physical control over assets.
Objective:
To determine the adequacy of derivatives policies relating totransaction risk management activities.
1. Evaluate the adequacy of operational policies and
procedures. Determine if they address:
• Segregation of duties between trading, processing, and payment functions.
• Description of accounts.
• Trade entry and transaction documentation.
• Confirmations.
• Settlement. • Exception reporting.
• Documentation tracking and reporting.
• Revaluation.
• Reconciliations including frequency.
• Discrepancies and disputed trades.
• Broker accounts.
• Accounting treatment.
• Management reporting.
Objective: To determine the adequacy of derivatives policies relating to compliance risk management activities.
1. Ensure that policies require appropriate legal review for new
products, counterparty or agreement forms, and netting arrangements.
2. Obtain a copy of the hedge accounting policies and review
for conformance with authoritative pronouncements by the Financial Accounting Standards Board and call report
instructions.
3. In the absence of authoritative accounting guidance,
determine whether the accounting policy for derivatives transactions is reasonable and consistently applied.
Objective:
To determine the adequacy of derivatives policies relating toreputation risk management activities.
1. If the bank uses derivatives in a fiduciary capacity, determine
whether appropriate policies and procedures are in place to ensure effective risk management. (Refer to OCC Bulletin 96- 25, “Fiduciary Risk Management of Derivatives and Mortgage- backed Securities.”)