Safety and soundness issues related to bank derivatives activities : hearing before the Committee on Banking, Finance, and Urban Affairs, House of Representatives, One Hundred Third Congress, first session

1314 Pages·1994·38.9 MB·English

by  United States. Congress. House. Committee on Banking, Finance, and Urban Affairs

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