Table Of Content

SAFETY AND SOUNDNESS ISSUES RELATED TO IVATIVES ACTIVITIES—PART 2 HEARING BEFORE THE COMffiTTEE ON BANKING, FINANCE AND URBAN AFFAIRS HOUSE OF REPRESENTATIVES ONE HUNDRED THIRD CONGRESS FIRST SESSION OCTOBER 28, 1993 (PART 2) Printed for the use of the Ckjmmittee on Banking, Finance and Urban Affairs Serial No. 103-88 APR ig )qoM SAFETY AND SOUNDNESS ISSUES REUTt BANK DERIVATIVES ACTIVITIES—PART HEARING BEFORE THE COMMITTEE ON BANKING, FINANCE AND UEBAN AFFAIRS HOUSE OF REPRESENTATIVES ONE HUNDRED THIRD CONGRESS FIRST SESSION OCTOBER 28, 1993 (PART 2) Printed for the use of the Committee on Banking, Finance and Urban Affairs Serial No. 103-88 U.S. GOVERNMENT PRINTING OFFICE 74-907=; WASHINGTON 1994 : ForsalebytheU.S.GovernmentPrintingOffice SuperintendentofDocuments.CongressionalSalesOffice,Washington,DC 20402 ISBN 0-16-043588-9 HOUSE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS HENRY B. GONZALEZ, Texas, Chairman STEPHEN L. NEAL, North Carolina JAMES A. LEACH, Iowa JOHN J. LaFALCE, New York BILL McCOLLUM, Florida BRUCE F. VENTO, Minnesota MARGE ROUKEMA, New Jersey CHARLES E. SCHUMER, New York DOUG BEREUTER, Nebraska BARNEY FRANK, Massachusetts THOMAS J. RIDGE, Pennsylvania PAUL E. KANJORSKL Pennsylvania TOBY ROTH, Wisconsin JOSEPH P. KENNEDY H, Massachusetts ALFRED A. (AD McCANDLESS, California FLOYD H. FLAKE, New York RICHARD H. BAKER, Louisiana KWEISI MFUME, Maryland JIM NUSSLE, Iowa MAXINE WATERS, California CRAIG THOMAS, Wyoming LARRY LaROCCO, Idaho SAM JOHNSON, Texas BILL ORTON, Utah DEBORAH PRYCE, Ohio JIM BACCHUS, Florida JOHN LINDER, Georgia HERBERT C. KLEIN, New Jersey JOE KNOLLENBERG, Michigan CAROLYN B. MALONEY, New York RICK LAZIO, New York PETER DEUTSCH, Florida ROD GRAMS, Minnesota LUIS V. GUTIERREZ, Illinois SPENCER BACHUS, Alabama BOBBY L. RUSH, Illinois MIKE HUFFINGTON, California LUCILLE ROYBAL-ALLARD, California MICHAEL CASTLE, Delaware THOMAS M. BARRETT, Wisconsin PETER KING, New York ELIZABETH FURSE, Oregon NYDIA M. VELAZQUEZ, New York BERNARD SANDERS, Vermont ALBERT R. WYNN, Maryland CLEO FIELDS, Louisiana MELVIN WATT, North Carolina MAURICE HINCHEY, New York CALVIN M. DOOLEY, California RON KLINK, Pennsylvania ERIC FINGERHUT, Ohio (n) CONTENTS Hearing held on: October 28, 1993 Appendix: Page October 28, 1993 1 Miscellaneous Material Submitted for the Record Supplementary Materials on Derivatives (continued from Part 1): Federal Deposit Insurance Corporation 2 Office ofthe Comptrollerofthe Currency 343 OCCGuidelineson Derivative Activities 737 Federal Reserve: Federal Reserve Guidelines on Derivative Activities 767 SummariesofVarious Studieson Derivatives: The Report ofthe Commodities Futures Trading Commission: OTC Deriv- ative Markets and Their Regulation (October 1993) 1139 The Institute of International Finance: An Integrated Bank Regulatory Approach to Derivative Activities (May 1993) 1159 International Monetary Fund: Systematic Issues in International Finance (August 1993) 1165 Group ofThirty: Derivatives: Practices and Principles Appendix I Work- ing Papers (July 1993) 1177 Problems Real and Imagined: A Washington Perspective on Derivatives, Christopher Whalen 1197 " Perspective on Trading Revenues: Keefe, Bruyette & Woods, Inc. (July 29, ]^993) 1209 Swaps Revisited, David NrPringie, Lazard Freres& Co. (October 26, 1993) 1219 Moody's Assessment ofDerivative Risk, by Douglas Lewis, Moody's Inves- tors Service (June 8, 1993) 1233 StatementofFinancial AccountingStandards Board [FASB] 1239 Various Newspaper Articleson Derivatives 1241 (III) APPENDIX PART 2 (Continued from Part 1) FDIC Appendix I 3 Appendix I GlossaryofTerms Add-ons: Thetermusedinthe 1988Baslecapitalaccordthatdenotestheamountsadded tothecreditequivalentvalueofderivativecontractstoreflectpotential creditexposures arising from future price orvolatility changes. Add-ons are calculated on the basis of notional principal values, and vary according to the nature ofthederivative instrument and its maturity. Agencies: For the purpose of this document, refers to the four principal financial institution regulatory agencies, the FDIC, OCC, FRB and OTS. Aggregation Risk: This refers to linkages between products or markets which are created orheightened byderivatives. (Also called Intereconnection Risk) Arbitrage: Tradingstrategiesdesigned toprofit from pricedifferences forthe sameor similargoods indifferent markets. Historically theterm implied little ornorisk in the trade, but more recently it has come to suggest some risk ofloss or uncertainty about total profits. Backroom Operations: Segregated supporting orcontrol functions. Bid/OfTerSpread: Thedifferencebetweenthebuyingandsellingpriceofaninstrument. Bilateral Netting : A proposed method fordetermining credit risk exposure positions which permits the offsetting ofpositions or payment obligations between two parties wherebyalargenumberofindividualpositionsorpaymentobligationsarereducedtoone single position orpayment obligation, such that in the event ofa counterparty's failure toperformduetodefault, bankruptcyorliquidation, the othercounterparty would have a claim or payment obligation to receive or pay only the net value of the sum of unrealized gains and lossesonall transactions. BIS : Bank forInternational Settlements. Caps: An option-like contract for which the buyer pays a fee, orpremium, to obtain protection againstarisein aparticularinterestrateaboveacertain level. Forexample, an interestrate cap may cover a specifiedprincipal amountofa loan over a designated time period such as a calendarquarter. Ifthe covered interest rate rises above the rate ceiling, the seller ofthe rate cap pays the purchaser an amount ofmoney equal to the average ratedifferential times theprincipal amounttimes one quarter. ClearingSystem (orClearingHouseArrangement): A mechanism forcalculation of mutual positions withinagroupofparticipants with aview to facilitating the settlement oftheir mutual obligations on a netbasis. Collar: The simultaneous purchase of a cap and the sale of a floor with the aim of maintaining interest rates within adefined range. Thepremium income from thesaleof the floor reduces oroffsets the costofbuying the cap. CollateralizedMortgageSecurities: Mortgage-backedbondsorobligationssecuredby the cash flow ofapool ofmortgages. CommodityOptions:Acontractprovidingthepurchasertheright,butnottheobligation, to buy or sell a given quantity ofa commodity at a strike price, on or before a given date. Commodity Swaps: A transaction thatallows an investortoexchangepayment streams which are based on commodity prices. Commodity swaps involve swaps of payment streamsonlyandareusuallysettledincash. However, physicaldeliverymayalsooccur. Commodity swaps enable producers and consumers to hedge commodity price risk. Usually, the consumerpays fixed, the producerfloating. Counterparty : One ofthe two entities engaged in a derivative transaction. Both the buyerand the sellerare counterparties toeach other. Covered Option: Anoptionposition hedged with aposition in the cash instrument. CreditEquivalentValue: Amountrepresenting the credit riskexposure in off-balance sheet transactions. In the case of derivatives, credit equivalent value represents the potential cost atcurrent marketprices ofreplacingthe contract's cash flows inthecase ofdefaultby the counterparty. CreditRisk: Theriskthatacounterpartytoatransactionwill fail toperformaccording tothetermsand conditionsofthecontract, thuscausingtheholderoftheclaim tosuffer aloss. Cross-CurrencyInterestRateSwaps: Atransactioninvolvingtheexchangeofstreams ofinterest ratepayments (butnotnecessarilyprincipalpayments) indifferentcurrencies and often on different interestbases (e.g., fixed Deutsche Mark against floating dollar, butalso fixed Deutsche Mark againstfixed dollar). u