# O

+-----------------------------------------------------------------------+
| ## Comptroller of the Currency                                        |
|                                                                       |
| > Administrator of National Banks                                     |
+-----------------------------------------------------------------------+

Washington, DC 20219

February 10, 2005 **Interpretive Letter #1018**

**March 2005**

**12 USC 24(7)**

Re: Equity Derivatives Hedging

Dear **\[** **\]**:

This is in response to your inquiry regarding whether **\[** **\]** (the
"Bank") may enter into derivatives transactions with certain of its
affiliates and subsidiaries that mirror the affiliates' and
subsidiaries' transactions with their customers, and may hedge the risks
of those transactions in the same manner as it hedges the risks of its
existing derivatives business. The transactions would be permissible for
the Bank to conduct directly, and the mirror transactions enable the
Bank to centrally and more efficiently manage the risks of such
transactions conducted by the Bank and certain of its affiliates and
subsidiaries. For the reasons set forth below, we conclude that these
activities, as described herein, are permissible for the Bank, provided
the Bank's Examiner-in-Charge ("EIC") has no supervisory objection.

## A. Background

The Bank has a well-established equity derivatives business involving
transactions conducted directly with Bank customers for the customers'
own business purposes. The Bank hedges the risks arising from those
activities through equity derivatives transactions and physical
positions in equity securities, based upon prior authorization.[^1]

The Bank now proposes to enter into derivatives transactions with
affiliates or subsidiaries that mirror the affiliates' and subsidiaries'
transactions with their customers.[^2] The Bank will only mirror equity
transactions with subsidiaries and affiliates that are
customer-driven[^3] and bank permissible.[^4] The Bank will hedge the
risks of those derivatives transactions with subsidiaries and affiliates
in the same manner as it hedges its existing equity derivatives business
(through derivative and physical equity positions) and subject to the
same risk management systems and controls. Due to regulatory
considerations, the Bank will not conduct mirror transactions with
affiliates or subsidiaries that are U.S. registered securities
broker-dealers. The Bank represents that these transactions will
accomplish a centralization of risk management of equity derivatives
transactions that will be cost effective and will reduce the operational
risks that are present when those activities are dispersed across
numerous subsidiaries and affiliates across varying geographies within
the same organization.

The Bank's fees for the transactions with its subsidiaries and
affiliates will be the same as the fees the Bank charges for
transactions with other customers, and the transaction fees will be
determined using the same processes and systems. However, because the
subsidiary or affiliate will retain the credit risk that a customer may
default, and because the subsidiary or affiliate is the counterparty and
the subsidiary or affiliate will provide collateral that covers the
mark-to-market amount for the derivatives transaction, the Bank will not
charge a fee for credit risk. The Bank represents that all of the
transactions with its affiliates will be conducted on market terms
pursuant to section 23B of the Federal Reserve Act.[^5]

The Bank will hedge the subsidiary-affiliate transactions on the public
trading desk side of the Bank, which has in place Chinese walls to
prevent this desk from receiving material nonpublic information from the
parts of the Bank with access to such information.

## B. Discussion

National banks may engage in customer-driven equity derivatives
transactions, including cash-settled options, forwards, and swaps, as
part of a financial intermediation business.[^6] National banks also may
hedge risks arising from those permissible banking activities. Because
equity holdings provide cost-effective hedges for risks arising from
permissible equity derivatives transactions, the OCC has found banks may
hold equities to manage those risks, if appropriate risk management
processes are established.[^7]

Through the derivatives and hedging activities, national banks serve as
financial intermediaries, a traditional and permissible banking
function.[^8] Financial intermediation includes, for example, engaging
in swap transactions and assuming offsetting swap positions and hedges.
In assuming an offsetting swap or hedge, a bank protects itself against
risks arising from an established, permissible banking activity and acts
as a financial intermediary by interposing itself between customers
initiating swaps and customers providing offsetting cash flows or
returns. Thus, hedging can be an integral part of financial
intermediation services permissible for national banks.[^9]

The major difference between the activities previously authorized for
the Bank and the Bank's current proposal is that in the former the Bank
entered into derivatives transactions directly with its own customers,
while here the Bank will enter into derivatives transactions with a
subsidiary or an affiliate that mirror that entity's customer
transactions, and then hedge the risks of the equity derivatives
transactions by holding a limited amount of equity securities. Through
the proposed derivatives and hedging activities, the Bank will serve as
a financial intermediary, a traditional and permissible banking
function. In so doing, the Bank will assume derivatives risks similar to
those arising from its existing business and hedge those risks using the
same hedging methods. The Bank will only enter into transactions with
subsidiaries and affiliates that are the types of derivatives
transactions permissible for the Bank, and that the Bank could enter
into with unrelated third parties under U.S. laws. The Bank will act as
a risk manager, by hedging the risks of its derivatives transactions
with its subsidiaries and affiliates in the same manner as it hedges its
existing equity derivatives business (through derivatives and physical
equity positions) and subject to the same risk management systems and
controls. Through these activities, the Bank will serve as a financial
intermediary, effectively interposing itself between customers of the
subsidiary or affiliate initiating equity derivatives transactions and
third party customers providing offsetting cash flows. Thus, the
proposed centralized risk management activities rely upon the same core
competencies developed by the Bank in managing its own risks as
financial intermediary and, for that reason, are a logical outgrowth of
those activities and are part of the business of banking.

The Bank will obtain financial and operational advantages through the
proposed centralization of risk management for derivatives transactions
based on U.S. equities within the Bank's holding company organization.
The arrangement will enable the Bank to receive additional revenues and
profits generated by the fees the Bank will charge the subsidiaries and
affiliates that originate the transactions. Further, the arrangement
permits the Bank and its holding company to select the most efficient
and cost effective means for managing risks arising from equity
derivatives transactions throughout their organization.

The OCC previously has recognized that banking organizations should be
able to exercise their business judgment in deciding which entities
within the organization are the most efficient for conducting their
activities.[^10] Specifically, the Bank may conduct permissible U.S.
equity derivatives activities through operating subsidiaries, including
Edge corporations.[^11] Operating subsidiaries, including Edge
corporations, are structures through which national banks are
specifically authorized to conduct their business.[^12] The activities
of operating subsidiaries and Edge corporation subsidiaries are
consolidated with the Bank for financial reporting purposes.
Accordingly, the decision whether to conduct an activity directly in the
bank itself or through a subsidiary or Edge corporation is fundamentally
a business decision that may be influenced by customer needs, internal
efficiencies or risk management objectives. Thus, the Bank may conduct
U.S. equity derivative transactions through such subsidiaries that would
be permissible for the Bank to conduct directly. The Bank also may
internally transfer the risks arising from those transactions through
mirror transactions between the Bank and such subsidiaries, in order to
more efficiently manage risks arising from those transactions, using the
same hedging methods applied generally to its derivatives business.

OCC precedents also recognize that it may be advantageous for a national
bank to centralize risk management of activities conducted by the bank
and its subsidiaries and/or affiliates. For example, national banks may
self insure risks arising from their own activities and may provide
insurance coverage for activities of bank affiliates.[^13] National
banks also may provide credit-related insurance coverage for loans they
or their affiliates extend to customers.[^14] Through these activities,
the banks assume credit-related risks arising from permissible banking
activities of affiliates and centrally manage those risks.

Similarly, the Bank may centrally manage risks arising from U.S. equity
derivatives transactions of affiliates and subsidiaries that are
permissible for the Bank. Affiliates and subsidiaries of the Bank are
engaged in a variety of customer-driven derivatives transactions as part
of a financial intermediation business. The Bank may conduct those types
of transactions directly with customers and also may assume the risks of
those transactions by entering into transactions with affiliates and
subsidiaries that mirror their transactions with customers. Further, the
Bank may hedge risks arising from those transactions using the same risk
management tools applied to its own equity derivatives business. The
hedges used by the Bank to manage resulting risks will be identical to
those currently used by the Bank for its existing hedging activities and
subject to the same risk management controls. By assuming a centralized
risk management function, the Bank enhances the efficiency of its own
risk management functions and also benefits from the compensation it
receives for its role with respect to transactions of subsidiaries and
affiliates.

## *Safety and Soundness*

The proposed activity must be conducted in a safe and sound manner. As
indicated above, the Bank represents that all of the transactions with
its affiliates will be conducted on market terms pursuant to section 23B
of the Federal Reserve Act, and that collateral will be posted by the
affiliates to cover the mark-to-market amount that would be owed to the
Bank under derivatives transactions to isolate the Bank from credit
risks in the transactions with the affiliates.

In addition, the Bank must establish to the satisfaction of the Bank's
EIC that the Bank has an adequate and effective risk measurement and
management program for the expanded activities. As detailed in the OCC
handbook, *Risk Management of Financial Derivatives,*[^15] and OCC

Banking Circular 277,[^16] an effective risk measurement and management
process includes board supervision, managerial and staff expertise,
comprehensive policies and operating procedures, risk identification and
measurement, and management information systems, as well as effective
risk control function that oversees and ensures the appropriateness of
the risk management process.

In addition to a risk management program, the Bank's process must
include an independent compliance monitoring program to ensure ongoing
compliance with the specific commitments made by the Bank, including its
commitment to conduct its financial intermediation activities in
equities as a customer-driven, and non-proprietary trading
business.[^17] The Bank must have an adequate and effective compliance
monitoring program that includes policies, training, independent
surveillance and well-defined exception approval and reporting
procedures.

The OCC will make these determinations through the Bank's EIC, and the
Bank may not commence the proposed activities unless and until its EIC
has determined that he has no supervisory objection to the expanded
activities, as described herein.

## 3. Conclusion

Based upon a review of the information you provided, including the
representations and commitments made in your letters to the OCC, and for
the reasons discussed above, we conclude that the Bank may enter into
the proposed mirror transactions with subsidiaries and affiliates and
may hold limited amounts of equity securities to hedge the risks arising
from those transactions. This conclusion is subject to the condition
that the Bank will have an appropriate risk management process in place,
satisfactory to the Bank's EIC, for its expanded activities.
Accordingly, the Bank may not commence the proposed activity unless and
until its EIC has determined that he has no supervisory objection to the
expansion of the Bank's activities, as described herein.

Sincerely,

/s/ Daniel P. Stipano

Daniel P. Stipano

Acting Chief Counsel

[^1]: *See* Interpretive Letter No. 892 (Sept. 13, 2000).

[^2]: Some customers conduct transactions with subsidiaries and
    affiliates of the Bank, rather than the Bank itself, due to foreign
    legal and regulatory requirements or because the customers prefer to
    do so because they have existing business relationships with the
    subsidiaries and affiliates. The customers may include other
    financial institutions, public and private investment companies,
    corporations, private banking clients, other high net worth
    individual customers, and retail customers purchasing equity-linked
    securities. The Bank will conduct all equity derivatives
    transactions governed by the Commodity Exchange Act (7 U.S.C. §§ 1
    *et seq*.) in conformity with that Act.

[^3]: A customer-driven transaction is one entered into for another
    party's valid and independent business purpose. *See* Interpretive
    Letter No. 892, *supra*.

[^4]: The Bank's proposed equity derivatives transactions involve swaps,
    forwards, options, and equity-linked notes, all of which the OCC has
    affirmed are bank permissible transactions. *See* Interpretive
    Letter No. 949 (Sept. 19, 2002).

[^5]: 12 U.S.C. 371c-1.

[^6]: *See* Interpretive Letter No. 949, *supra.*

[^7]: *See* Interpretive Letter 892, *supra*.

[^8]: National banks may use a variety of cash-settled derivatives for
    financial intermediation purposes. *See* Interpretive Letter No.
    949, *supra*. National banks may engage in interest rate, currency,
    and commodity price index swaps and caps. *See, e.g.,* No-Objection
    Letter No. 87-5 (July 20, 1987) and Interpretive Letter No. 462
    (Dec. 19, 1988). National banks also may engage in transactions
    involving interest rate, basis rate, currency, currency coupon, and
    cash-settled commodity and equity swaps, swaptions, captions, and
    other option-like products, forward rate agreements, rate locks and
    spread locks. *See, e.g.,* Interpretive Letter No. 725 (May 10,
    1996), Interpretive Letter No. 652 (Sept. 13, 1994), and
    No-Objection Letter No. 90-1 (Feb. 16, 1990)*.* Swap and funds
    intermediation activities are part of the business of banking. *See*
    Interpretive Letter No. 937 (June 27, 2002) and Interpretive Letter
    No. 892, *supra*.

[^9]: The General Accounting Office ("GAO") reviewed and affirmed the
    OCC's determination in Interpretive Letter 892, *supra*, in a report
    issued in August 2001. GAO Report 01-945 (Aug. 16, 2001). In its
    report, the GAO stated that it agreed with the OCC's conclusion that
    national banks, subject to supervisory approval, have authority
    under the National Bank Act to own corporate stock to hedge their
    customer-driven equity derivative transactions. The GAO found that
    the OCC had reasonably determined that dealing in equity derivatives
    and managing the risks of that activity are part of the business of
    banking. The GAO also found that the OCC had reasonably concluded
    that equity hedging is incidental to the business of banking.
    Finally, the GAO concluded that 12 U.S.C. 24 (Seventh) does not
    prohibit national banks from owning stocks for incidental purposes.

[^10]: *See, e.g.,* Interpretive Letter No. 845 (Oct. 20, 1998) (for
    efficiency reasons, national bank may use operating subsidiary to
    self-insure business risks of bank and its bank affiliates) and
    Interpretive Letter No. 398 (Sept. 28, 1987) (for efficiency reasons
    a national bank may centralize its internal security in an operating
    subsidiary that would also provide such services to nonbank
    affiliates within holding company system).

[^11]: An Edge corporation is a corporation organized under Section 25A
    of the Federal Reserve Act, 12 U.S.C. 611-631, through which a
    national bank may engage in international operations.

[^12]: *See, e.g.,* 69 Fed. Reg. 1895, 1900 (Jan. 13, 2004) and
    Corporate Decision No. 2000-07 (May 10, 2000).

[^13]: In Corporate Decision 99-03 (Dec. 21, 1998), several affiliated
    banks proposed transferring banking risks to a central national bank
    subsidiary that would manage the risks by providing insurance
    coverage. The OCC determined that inherent in the power of national
    banks to carry on a "business" under 12 U.S.C. 24(Seventh) is the
    authority to assume risks associated with operating a bank and the
    ability to manage those risks to the bank's best advantage. *See
    also* CRA Decision 125 (Dec. 21, 2004) (excess lines insurance
    coverages are within the types of insurance coverages a national
    bank subsidiary may provide for its parent bank and bank
    affiliates).

[^14]: A national bank may provide mortgage insurance on loans
    originated, purchased, or serviced by the bank, its subsidiaries or
    its affiliates. *See* Corporate Decision No. 99-02 (Dec. 11, 1998).
    National banks may underwrite credit life and credit health,
    accident, disability and/or involuntary unemployment insurance
    written in connection with loans extended by a bank and affiliated
    and unaffiliated lenders. *See* Corporate Decision No. 2001-10
    (April 23,2001), Corporate Decision No. 2000-16 (Aug. 29, 2000), and
    Corporate Decision Nos. 98-31 (May 26, 1998) and 98-28 (May 11,
    1998).

[^15]: January 1997.

[^16]: October 27, 1993.

[^17]: The OCC has long considered safety and soundness issues when
    determining whether an activity is part of, or incidental to the
    business of banking. *See e.g.*, Interpretive Letter 892, *supra*
    (national bank may engage in equity hedging activities only if it
    has an appropriate risk management process in place); Banking
    Bulletin

    96-5 (Sept. 20, 1996) (replaced by Bulletin 2000-23 (July 20, 2000))
    (national bank's purchase of life insurance is incidental to banking
    if it is convenient or useful in connection with the conduct of the
    bank's business and consistent with safe and sound banking
    practices); Interpretive Letter No. 684 (Aug. 4, 1995) (commodity
    hedging is a permissible banking activity provided the activity is
    conducted in accordance with safe and sound banking practices);
    Decision of the Office of the Comptroller of the Currency on the
    Request by Chase Manhattan Bank, N.A. to Offer the Chase Market
    Index Investment Deposit Account (Aug. 8, 1988) (national banks have
    the authority to establish the amount of the payments to be made and
    received under their deposit and loan contracts and may determine
    the amount of those payments by reference to any index or standard
    as long as the bank complies with safe and sound banking principles
    and, in the case of loans, with state usury laws); Interpretive
    Letter No. 376 (Oct. 22, 1986) (indemnification from losses
    resulting from participation in the bank's fiduciary securities
    lending program is a permissible incidental activity provided the
    indemnification is consistent with OCC guidance and safety and
    soundness); Interpretive Letter No. 274 (Dec. 2, 1983) (a national
    bank's authority to lease its office space provides the authority
    for it to establish appropriate lease terms if consistent with safe
    and sound banking practices).