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Subject: Fiduciary Risk Management of Derivatives and Mortgage-backed Securities: Guidance for Bankers
Date: April 30, 1996
To: Chief Executive Officers of All National Banks, Senior Trust Officers, OCC Department and Division Heads, and all Examining Personnel
Description: Guidance for Bankers
The Office of the Comptroller of the Currency (OCC) wants to ensure that all national banks acting as fiduciaries prudently manage the risks associated with their utilization of financial derivatives and mortgage-backed securities. National banks that purchase derivative instruments, structured notes, and mortgage- backed securities for fiduciary accounts should fully understand the associated credit, interest rate, liquidity, price, and transaction risks of such instruments. Additionally, national bank fiduciaries should consider the compliance and reputation risks presented by investing fiduciary assets in derivatives and other complex instruments. This guidance summarizes general risk management principles and considerations for national banks' fiduciary investment activities.
The OCC considers it an unsafe and unsound practice for a bank to purchase derivative instruments or mortgage-backed securities, or any other asset in a fiduciary capacity, without a full appreciation of the risks involved. A risk management framework should be developed and implemented to ensure safe and sound fiduciary investment activities. This framework should include the risk identification, measurement, monitoring, and control principles that apply to bank risk management systems. When derivative instruments and mortgage-backed securities are being considered as investments for fiduciary accounts, risk management procedures should be adopted to address the financial risks as well as compliance, transaction, and reputation risks that exist in fiduciary relationships.
Broadly defined, financial derivatives are instruments which derive their value from the performance of other assets, interest or currency exchange rates, or indices. Derivative transactions include financial contracts, such as futures, forwards, options, caps, floors, and combinations thereof. National bank fiduciaries may also invest in debt securities, such as structured notes and deposits and certain mortgage-backed securities, whose cash flow characteristics (coupon, redemption amounts or stated maturity) depend upon one or more indices and/or certain embedded forwards or options.
Banking Circular 277, "Risk Management of Financial Derivatives," October 27, 1993, Banking Bulletin 94-31, May 10, 1994, and OCC Advisory Letter 94-2, July 21, 1994, are all applicable to fiduciary activities. Because these issuances outline sound risk management principles generally, they apply to all risk-taking activities within a national bank.
The management of national banks should address all risks, including credit, interest rate, liquidity, price, foreign exchange, transaction, compliance, strategic, and reputation risks, as they relate to all fiduciary investments. For example, management should carefully assess the liquidity risk of derivative instruments and mortgage-backed securities being considered as investments for fiduciary accounts. Liquidity risks can be extremely high and secondary markets are often limited, with market prices difficult to obtain because of the complexity of the structures of some of these financial instruments. A key factor in evaluating price and interest rate risks is understanding an instrument's cash flows. It is critical to understand how these cash flows change under alternative market conditions, and how changes in these conditions affect prepayment speeds, values, and returns on these instruments.
Investing in derivative instruments and mortgaged-backed securities for a fiduciary client requires that a national bank conduct an analysis of fiduciary compliance and legal considerations. A national bank should determine whether derivative instruments and mortgage-backed securities are permissible investments for a given fiduciary account according to applicable law and the instrument creating and defining the fiduciary relationship. The fiduciary should also review the fiduciary account's investment objectives, portfolio size, investment horizon, principal and income distribution, liquidity needs, tax consequences, and overall risk profile to determine the appropriateness of a particular investment.
Improperly managed derivative activities may increase compliance and reputation risks to the bank. As a fiduciary, the bank is investing for the benefit of another. Accordingly, beneficial interest holders may monitor investment performance. Losses that are beyond the beneficiary's tolerance level or expectations may result in litigation, account terminations, and loss of future fiduciary business because of the bank's diminished reputation in the marketplace.
Prudential Risk Management
Management Supervision and Oversight
National bank senior management should be knowledgeable concerning fiduciary investment activities, including the use of derivative instruments and mortgage-backed securities. Fiduciary investment activities should be prudently conducted within the fiduciary risk management framework established by the board of directors. This framework should include appropriate policies and procedures, risk measurement and reporting systems, and independent oversight and control processes. The risk management framework should be in place before the bank engages in derivative transactions in a fiduciary capacity.
Management should also establish an effective audit program addressing the fiduciary investment process. At a minimum, this program should verify the integrity of risk measurement and control, related management reporting systems, and compliance with approved investment policies and procedures.
Investment Expertise and Risk Control
Bank management should determine that fiduciary officers possess sufficient investment expertise to manage all investment activities undertaken by a national bank fiduciary. In some banks this may require support from nonfiduciary personnel or risk managers who possess specialized product knowledge and technical and analytical risk management skills. Successful administration and execution of a risk management system are dependent on recruiting, developing, and retaining employees with appropriate knowledge, skills, and experience.
The individuals or units responsible for risk monitoring and control functions should be independent of the investment officer making investment decisions for fiduciary accounts. The risk control process should also be independent of traders executing the transactions or the unit that is engaging in these transactions for the fiduciary unit. Risk control personnel are generally responsible for developing and supporting risk management systems, establishing credit risk measurement systems, establishing price and credit risk approval processes, developing appropriate risk control policies, reporting risk exposures, and monitoring the fiduciary activities risk position against approved limits. The individuals or units may be part of a bank's more general operations, compliance, or risk management units.
Risk Measurement and Monitoring
Bank management should be able to determine accurate market values for derivative instruments and mortgage-backed securities held in fiduciary accounts. Bank management should measure and control risk exposures for all fiduciary investment activities, including investments in derivative instruments and mortgage-backed securities. Scenario analysis, including stress tests that take into consideration how the cash flows and economic values of derivative instruments and mortgage-backed securities may change under varying market conditions, should be conducted. The analysis should consider changes in market factors, such as interest rates, yield curve shape, commodity prices, equity indices, and foreign exchange rates and the associated volatilities of these factors. Bank fiduciaries that rely on cost or par values as their primary mechanism for measuring, monitoring, and controlling the risks of derivatives investment activities should confine fiduciary investments to more traditional and liquid products and markets.
National banks should establish a reporting mechanism that ensures senior management and the board of directors are adequately informed concerning the nature and level(s) of investment risks taken in fiduciary accounts. These reports should include information addressing derivative instruments and mortgage-backed securities. Management should monitor compliance with approved fiduciary investment policies and limits.
In addition, when derivative instruments and mortgage-backed securities are used as investments in fiduciary accounts, management should determine that these instruments can be accurately valued. These values should be determined by sources independent from the dealer from whom the bank purchased the investments. Accurate values are necessary to provide accurate statements to parties having an interest in the fiduciary account.
Fiduciary Duty Of Care
A fiduciary owes an obligation to invest and protect the assets of beneficiaries and manage investments solely in their best interests. Investment transactions which are acceptable for a national bank may not be acceptable for a bank acting as a fiduciary. When investing for others, the standard of care to which the fiduciary must conform is that of a prudent person. Investment practices in private or individual accounts are governed by the prudent man rule or the prudent investor rule, as established by local law and the terms of the instruments establishing and defining the fiduciary relationship. For employee benefit accounts, the "Prudent Man Rule" is codified in Section 404 of the Employee Retirement Income Security Act of 1974 (ERISA), as amended.
For additional discussion of the fiduciary duty of care, see the Portfolio Management section in the Comptroller's Handbook for Fiduciary Activities, September 1990; the Investment and Portfolio Management Procedures in the Fiduciary Activities Section of the Comptroller's Handbook for Compliance, September 1991; and Restatement (Third) of Trust, Section 277, 1992 (not adopted in all jurisdictions).
Crossing Between Accounts
In some circumstances, a bank fiduciary may divide or participate a derivative instrument or mortgage-backed security among several fiduciary accounts. However, before engaging in such practices, the fiduciary should consider the loss of liquidity that is characteristic of these divided units. This loss of liquidity diminishes the value of the instrument.
To compensate for the loss of liquidity in the market, banks may seek to sell the participation between accounts. Such transactions are permissible only if they are fair to both accounts and not prohibited by governing law. The bank should determine that the asset being sold is appropriate for the purchasing fiduciary account. In addition, the sale should be done at the current market value of the divided unit.
Questions or concerns regarding the general risk management of derivatives should be directed to Treasury and Market Risk, (202) 874-5670. Questions or concerns regarding fiduciary duties and responsibilities should be directed to Fiduciary Activities, (202) 874-4447.
Douglas E. Harris