Accountability * Integrity ✶ Reliability
United States General Accounting Office
Washington, DC 20548
The Honorable James A. Leach
House of Representatives
This report responds to your request that we review the Office of the
Comptroller of the Currency's (OCC) legal decision and the process OCC
used to allow national banks' to acquire equities to hedge the risks arising
from customer-driven equity derivative transactions. Over the last 10
years, a small number of large national and state banks have become
equity derivative dealers. Prior to OCC's decision to allow national banks
to hedge their equity derivative transactions within the bank, national
banks had been hedging these transactions through nonbank affiliates of
holding companies. Rather than hedge in this manner, four national banks
sought OCC's opinion on whether it was permissible to hedge their equity
derivative transactions by holding equities in the bank. Section
24(Seventh) of the National Bank Act, 12 U.S.C. § 24(Seventh), contains
equity-related limitations and restrictions that generally prohibit a national
bank from purchasing equities for its own account. These same limitations
and restrictions also apply to state banks.3 OCC considered the
permissibility of banks owning equities under the National Bank Act and
approved four national banks' requests, concluding that the equity
limitations in section 24(Seventh) of the National Bank Act do not prohibit
the purchase of equities for the purpose of hedging customer-driven equity
derivative transactions.
Because of your view on the equity ownership prohibitions contained in section 24(Seventh), you questioned OCC's decision, stating that allowing banks to own equity in commercial companies is something that is not
'National banks are banks that are federally chartered and regulated by OCC.
Equities are stocks (ownership interest possessed by shareholders of a corporation). In a
letter to you (OCC interpretive Letter No. 892 at 1 (Sept. 8, 2000)), the Comptroller of the
Currency described "customer driven" transactions as "originated by customers for their
valid and independent business purposes." The Comptroller also stated that the term
"equity derivative transactions" means "transactions in which a portion of the return
(including interest, principal or payment streams) is linked to the price of a particular
equity security or to an index of such securities."
3See footnotes 19 and 20.
sanctioned by law. You also questioned the way in which OCC made its decision, noting that OCC appeared to have granted its approval to the national banks in "virtual secrecy," or without notice or opportunity for public comment.
Our objectives in this review were to (1) provide you with information on the process OCC used to make its decision to allow banks to acquire equities and discuss whether the decision was consistent with the way in which OCC generally makes and communicates its decisions and (2) provide a legal opinion as to whether national banks are authorized to purchase equity securities to hedge their equity derivative transactions under existing law.
OCC has discretion to determine how it will convey its decisions, but the
criteria it uses to determine when and whether to publish its decisions are
unclear. For the equity hedging decision, OCC first determined that banks
holding equities to hedge equity derivative transactions was a permissible
activity under the National Bank Act. OCC then decided that the
requesting banks would not be allowed to engage in the activity of equity
hedging without first obtaining supervisory staff approval of their
activities and risk management systems, enabling OCC to ensure that each
bank had the necessary risk management systems in place to monitor risks
and prevent speculation. OCC did not publish its interpretation until after
it received a congressional inquiry in September 2000 questioning its
decision. In making certain other decisions interpreting the National Bank
Act, OCC has published written interpretive letters. By approving the
equity hedge decision the way it did, OCC has been criticized for using
supervisory approval as a way to avoid public scrutiny of its decision and
has left itself open to questions not only about the process used in this
case, but also about the criteria OCC uses to decide when to publish its
interpretive decisions. Helping the Congress and other banking regulators
affected by OCC's decisions understand the criteria OCC uses to
determine when and whether to publish interpretive decisions could help
mitigate concerns that arise when OCC interprets federal banking laws
that not only affect other banking regulators but are also considered
controversial.
We agree with OCC's conclusion that the four national banks have authority under the National Bank Act to own equities to hedge their equity derivative transactions. To support this conclusion, OCC first determined that certain equity derivative transactions and managing the risks of those transactions are a permissible banking activity authorized by
section 24(Seventh) of the National Bank Act. OCC next found that
owning equities to conduct these hedging activities is not prohibited by the stock-related limitations contained in the section. We concur with OCC's conclusion that those limitations do not prohibit the four banks from maintaining the stock hedges as an incidental activity.
We recommend that the Comptroller of the Currency establish a policy that articulates the criteria OCC uses in deciding when and whether to publish its interpretive decisions. We also recommend that the Comptroller of the Currency publish legal interpretations that pertain to section 24(Seventh) of the National Bank Act in order to keep other federal bank regulators and financial institutions informed of its interpretation.
We provided a draft of this report to the Comptroller of the Currency.
OCC agreed with our recommendations.
The rapid rise in equity prices over the last 10 years has been accompanied
by new strategies for hedging equity positions. In the mid-1990s, some
national banks began engaging in customer-driven equity derivative
transactions. Since then, equity derivatives have become an increasing
part of banks' businesses, as bank customers, both institutions and private
clients, increasingly use equity derivative products to hedge their equity
positions. Equity derivative products include instruments such as equity
options, equity collars, equity and equity-indexed swaps, and other
products. Although the notional amount of equity derivatives is still small
compared with the volumes of other types of derivatives that bank
customers use, it has tripled in the last 5 years. According to the Bank for
International Settlements, the volume of equity derivative notional
amounts has gone from $630 billion in 1995 to almost $1.9 trillion in 2000,
while the notional amount for all over-the-counter derivatives has
increased from $41 trillion in 1995 to over $95 trillion in 2000. According to
OCC officials, the trading revenue from equity derivatives has also
increased as a share of bank customer revenues. As the equity derivatives
*An equity option is the right to buy (call option) or sell (put option) a specified amount of shares of an underlying instrument (equity) for an agreed upon amount. An equity collar is an option that limits upside and downside risk by selling a call and buying a put. An equity index swap is an arrangement in which two parties (called counterparties) enter into an agreement to exchange periodic appreciation or depreciation on an equity index such as the Standard and Poor's 500 Index.
business has grown, banks have increasingly had to devote more attention and resources to managing the risks related to equity derivatives. Banks hedge in order to offset or manage the risks arising from engaging in equity derivative transactions.
Until recently, national banks hedged their equity derivative transactions through holding company affiliates. The equity derivative was booked at the bank, and the equities used to hedge the equity derivative transactions were booked in a holding company affiliate. The holding company affiliates were usually nonbank entities that were not broker-dealers and were set up for the express purpose of hedging the bank's equity derivative risks. The banks would instruct the affiliates on the structure, nature, and timing of the relevant hedging transactions, and the affiliates would enter into the hedging transactions only when directed. These arrangements allowed the banks to hedge their equity derivative exposures without ever directly owning or selling the stock, in accordance with prevailing guidelines.
The hedging transactions that the affiliates engaged in included “mirror” transactions and going long or short in a particular equity or basket of equities. For example, if a bank sold an equity derivative to its customer, it would purchase an identical equity derivative from its affiliate in order to hedge any risk, "mirroring” the initial transaction. Some of the banks we spoke with said that instead of entering into mirror transactions with their affiliates, they would instruct their affiliates to buy or short (sell) equities on a delta equivalent basis. Banking officials told us that no matter what type of hedge the bank booked through the affiliate, the risks arising from engaging in customer-driven equity derivative transactions always remained in the bank, even when the bank hedged its risks through the affiliate. See appendix I for a more detailed example of an equity derivative hedge.
"Delta is a hedge ratio that banks calculate to determine the amount of equity the bank must buy or short, so that for any given change in the price of the equity, the equity hedge position will change by the same amount as the change in the equity derivative position. With delta 1 hedging, a one-to-one correlation exists between the amount of shares the bank instructs the affiliate to purchase or short to hedge the bank's exposure and the amount of shares underlying the equity derivative. Delta hedging, as distinct from delta 1 hedging, usually involves equity options. The objective of delta hedging is to have the change in the value of the client derivative transaction match the change in the value of the equity hedge, but in different directions. Unlike delta 1 hedging, the amount of equity the bank would instruct its affiliate to hold would vary over time as the price of the underlying equity changed.
OCC's Process in
Making Its Equity
Hedging Decision Is
Controversial
Beginning in December 1999, certain national banks requested OCC's
opinion on whether it would be permissible for them to hedge their
customer-driven equity derivative transactions within the bank,
eliminating the need to enter into hedging transactions with affiliates.
After months of consideration, on July 20, 2000, OCC began verbally
approving the banks' requests, relying on its internal written interpretation
of section 24(Seventh). As a result of OCC's decision, the banks have
begun to directly book equity hedges within the banks. In addition, some
state-chartered banks have also asked their primary federal banking
regulators about OCC's decision and its implication for their activities.
Beginning in December 1999, three national banks requested OCC's
opinion on whether the banks may hold equities to hedge their customer-
driven equity derivative transactions. The banks said that their inability to
hedge their equity derivative transactions directly in the bank had caused
them to incur additional expenses and potentially increased their risk.
OCC approved the banks' requests, but initially did not make its decision
public. After deciding that equity hedging in the bank was a permissible
activity, the process OCC used to approve the banks' request was one in
which OCC required each bank to obtain supervisory staff approval prior
to engaging in the activity of equity hedging within the bank. OCC has
acknowledged that its initial decision was made in a nonpublic manner.
But OCC has insisted that it was necessary to grant the approval on a
bank-by-bank basis rather than issuing a blanket approval, in order to
ensure that each bank had the necessary risk management systems in
place to monitor risks and prevent speculation. In making certain other
decisions about equities or hedges, OCC has published written legal
interpretations. Because OCC has the discretion to determine how it will
convey its decisions, no one process exists for doing so. Consequently,
OCC leaves itself open to being questioned when it does not publish a
written interpretation on issues that others may consider controversial.
Banks Request OCC's
Approval to Equity Hedge
Within the Banks
Three banks initially requested OCC's interpretation about whether it would be permissible to hold equities in the bank in order to hedge their equity derivative transactions. Prior to OCC's decision, the banks hedged their equity derivative exposures through contractual arrangements with holding company affiliates, which were set up as separate legal entities for
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