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the sole purpose of hedging the bank's equity derivative transactions. The banks hedged in this manner largely because of the perceived legal constraints preventing banks from direct ownership of equities. In making their requests to OCC, the banks stated that purchasing, holding, or selling equities was a more cost-effective and accurate way to hedge exposures arising from equity derivative transactions. The banks also maintained that they could more practically manage the risks associated with equity derivative transactions by purchasing and booking equity hedges within the bank.

The primary reasons the banks gave for requesting OCC's approval were that booking equity hedges within the bank was likely to reduce their costs and their exposure to operations risks. The cost savings would result from eliminating the need for corporate funding and the expense of maintaining and managing a separate legal entity. The corporate funding expense occurred because a bank's affiliate obtained its funding from the bank's corporate parent at a rate higher than the bank's own funding rate.' In addition, the banks maintained the affiliate as a separate legal entity, sometimes incurring the expense of maintaining separate staff and supporting the processing, reconciliation, accounting, and reporting requirements for internal transactions between the bank and its affiliate. The cost of both corporate funding and maintaining a separate legal entity made it expensive for the banks to hedge their equity derivative transactions through affiliates.

The banks also said that they could reduce operations risks by directly hedging their equity derivative transactions within the bank. According to banking officials, hedging through an affiliate created numerous trading, operational, and funding inefficiencies. For example, a bank's affiliate might have to maintain a long equity position in one account and a short position in another because of the limitations on the banks holding

"By funding the hedging activity through the bank holding company rather than the bank, the banks were trying to avoid creating a covered transaction. Under the Federal Reserve Act and Federal Reserve Board regulations, certain financial transactions between banks and their affiliates, such as loans, are defined as “covered transactions” subject to requirements intended to limit the bank's exposure to an affiliate's credit or investment risk. 12 U.S.C. $$ 371c, 371c-1 (1994 & Supp. 2000); 12 C.F.R. Part 250 (2001). A bank could have created a covered transaction if the bank directly extended credit to its affiliate to fund the purchases and sales of equities used to hedge the bank's equity derivative transactions.

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SThis expense, which included capital usage, was included in a fee the bank paid to its corporate parent.

equities. Long and short positions in different entities were not effectively netted, or canceled out, in the risk reports a bank produced. Risk management systems would not always recognize all positions taken by a bank and its affiliate, increasing the chance of trading, risk management, and operational inefficiencies. The banks said that the optimal way to hedge would be to net the long and short position in the same entity, increasing the bank's operational efficiency. Banking officials also said that in order to hedge through an affiliate, banks must make multiple trades, resulting in more transactional inputs that can lead to errors and the need for more reconciliation.

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Banking officials said two developments spurred their requests: OCC's decision to allow national banks to hedge nonqualified employee deferred compensation plans, and the passage of the Gramm-Leach-Bliley Act (GLBA) of 1999.' In December 1999, OCC decided to allow national banks to hold an interest in insurance company products and other products in order to hedge, on a dollar-for-dollar basis, their deferred compensation obligations to employees." Banking officials said that they thought the same analysis would support a bank's ability to hedge its equity derivative transactions within the bank. In addition, with the passage of GLBA, the Federal Reserve Board was instructed to address the question of whether credit exposures arising from derivative transactions between an insured depository institution and its affiliates should be covered by section 23A of the Federal Reserve Act." The Federal Reserve was considering whether transactions between the banks and their hedging affiliates constituted loans or extensions of credit instead of funding for the purchases and sales that banks termed the transactions." Banking officials said that if the Federal Reserve Board did determine that credit exposure arising from derivative transactions was covered by section 23A of the Federal Reserve

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Gramm-Leach-Bliley Act, Pub. L. No. 106-102, 113 Stat. 1338 (1999). loOCC Interpretive Letter No. 878 (Dec. 22, 1999). Banks proposed to offer their employees a variety of registered investment companies and private investment funds as benchmarks under the employee compensation plan. The benchmark funds were to include funds that invest exclusively in bank-eligible assets, as well as funds that invest in assets traditionally impermissible for investment by national banks. To hedge their obligations under the employee compensation plan, the banks were proposing to acquire the number of units of each benchmark fund selected by the employee. "Pub. L. No. 106-102 & 121(b)(3), 12 U.S.C. $ 371c(f)(3) (Supp. 2000). 12 Federal Reserve officials said that the banks were providing the holding company with funds that ultimately allowed holding company affiliates to purchase or sell the equities used to hedge the banks' equity derivative transactions.

Act, then the Federal Reserve could impose collateral requirements, markedly increasing the cost of hedging their equity derivative transactions through affiliates." Lawyers representing two of the banks said that they could not get a definitive reply from Federal Reserve Board officials on this question. As a result, the banks turned to OCC.

OCC Determines Equity
Hedging Is Permissible,
Subject to Supervisory
Approval

After the decision that equity hedging in the bank was a permissible activity, the process OCC used to allow four national banks to hedge their equity derivative transactions was one in which OCC required each bank to obtain supervisory approval prior to engaging in the activity of equity hedging within the bank. OCC officials said that the legal determination allowing banks to hold equities to hedge equity derivative transactions could not be made without OCC supervisory staff generally determining that there was no safety and soundness risk in allowing banks to hedge their equity derivative transactions within the bank. Once the legal determination was made, OCC decided that in order for equity hedging within a particular bank to be permissible, OCC supervisory staff would have to first review and approve the types of equity derivative transactions, processes governing proposed hedges, and internal risk management systems of the requesting banks. OCC considered its approval to be a supervisory matter relating to each institution rather than one that is generally applicable to all national banks. As a result, OCC decided not to publish its interpretation, even though OCC has previously published interpretations on the National Bank Act, including decisions relating to hedging and equities.

Supervisory Concerns
Dominated OCC's
Decisionmaking Process

In December 1999, outside counsel for two national banks called OCC to ask if OCC was receptive to allowing banks to hedge their equity derivative transactions by holding equities within the bank. The Chief Counsel's Office agreed to explore the legal issue. In January 2000, OCC requested that the outside counsel for one of the banks submit a written letter to the Chief Counsel's Office in order to facilitate OCC's consideration of a possible framework for banks themselves to engage in equity derivative hedges. The outside counsel complied and sent requests on behalf of these banks to OCC for its interpretation on whether the National Bank Act provides the authority for banks to minimize the risks associated with customer-related equity derivative transactions through

13 See 12 U.S.C. 371c(c), (f) (1994 & Supp. 2000).

hedging transactions, including hedging transactions involving long and short positions in physical equity securities.

In considering whether banks should be allowed to hold equities for hedging purposes, OCC decided that its supervisory office would need to determine if this activity posed a safety and soundness risk. OCC officials said that in making any decision, they always consult with the examinerin-charge (EIC) or the deputy comptroller for large bank supervision of the institution requesting an opinion on possible issues that need to be taken into consideration before an interpretation is issued. However, in this case OCC said that the supervisory judgment was to be a major factor in determining whether this activity would be permitted. OCC's Chief Counsel told us that the agency was looking not so much for examiner approval as for assurances that OCC supervisory staff would have no objections to OCC determining that holding equities within the bank to hedge equity derivative transactions is a permissible activity. Thus, if OCC supervisory staff had determined that equity hedging within a national bank posed safety and soundness risks, OCC could not have permitted the activity. OCC supervisory staff said they did not see a reason to oppose the permissibility of equity hedging on a safety and soundness basis. Based on the supervisory staff's findings, OCC moved ahead with its deliberations.

After being informed that OCC would consider the legal aspects, the banks sent in proposals for their equity hedging programs. Our review of OCC documents and discussions with OCC officials showed that OCC supervisory staff sought to understand the specific nature of the banks' hedging proposals, the benefits of allowing banks to engage in this activity, and OCC's examiners' ability to supervise the activity effectively. In May 2000, OCC formed a working group separate from field staff, which immediately decided that the requesting banks should brief OCC on the methods they would use to control the risks arising from the transactions.

In considering the equity hedging proposals, OCC evaluated the types of products that would be involved, as well as the risk management systems the banks would need to have in place to effectively equity hedge within the banks." OCC supervisory staff said they focused on the models and methodologies the banks would use to measure risk, such as the risk limits

l*The type of equity products the banks were engaging in included equity options, equity forwards, equity swaps, and variable forwards.

that would be imposed to manage the risks." OCC was particularly concerned about whether the risks at the bank level, especially market risk, would change because of this proposal. Other supervisory concerns related to the types of controls that would need to be in place to prevent speculation and the taking of anticipatory or residual positions in stocks.

In order to ensure that banks effectively monitored their equity derivative
transactions and hedges, OCC decided that while it would determine that
it was legal for banks to hold equities to hedge equity derivative
transactions, it would not be permissible for banks to engage in this
activity without obtaining EIC approval of their activities and risk
management systems. Furthermore, when the four banks submitted their
equity hedging proposals to OCC, the banks made certain representations
as to how they would conduct hedging within the bank. OCC determined
that the banks would be allowed to engage in equity hedges within the
bank only if the equity hedges were done the way the banks represented to
OCC in their requests. The banks represented that they would

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use equities solely for hedging and not speculative purposes and
not take anticipatory or maintain residual positions in equities except as
necessary to the orderly establishment or unwinding of a hedging position.

OCC officials said that if in practice the bank's equity hedging programs did not meet those representations, the banks would not be engaging in a permissible activity, and OCC could take enforcement actions against them if necessary.

OCC Did Not Initially Make Its
Approval Public

OCC Chief Counsel's Office prepared an “Equity Hedge Memorandum” on July 13, 2000, that was for internal use only and not for public distribution. The memorandum, which laid out the rationale for OCC's legal decision allowing banks to hold equities in order to hedge equity derivative transactions, was sent solely to the Deputy Comptrollers for Large Bank Supervision.

16 Specific types of equity derivative transactions, such as options and collars, pose specific risks. In order to manage price or market risk, banks first have to quantify them. Several measures exist to quantify risk, including delta, gamma, and vega. As previously stated, delta measures the sensitivity of an option's value to small changes in the price of the underlying asset. Gamma measures the amount delta would change in response to a change in the price of the underlying asset (in this case equity). Vega measures the sensitivity of an option's price to changes in the volatility of the price of the underlying asset (equity). In managing an options portfolio, managers try to limit the bank's exposures to these risks.

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