**TO**: Chief Executive Officers of National Banks, General Managers of
Federal Branches and Agencies, Deputy Comptrollers, Department and
Division Heads, and Examining Personnel

##### PURPOSE

This banking circular provides guidance on risk management practices to
national banks and federal branches and agencies engaging in financial
derivatives activities. The guidelines in this circular represent
prudent practices that will enable a bank to conduct financial
derivatives activities in a safe and sound manner. National banks
engaged in financial derivatives transactions are expected to follow
these guidelines. (Financial derivatives transactions are sometimes
referred to herein as \"financial derivatives,\" \"derivatives
transactions,\" or \"derivatives.\")

##### REFERENCE

This banking circular replaces and supersedes Banking Circular 79 (3rd
Rev.), \"National Bank Participation in the Financial Futures and
Forward Placement Markets,\" dated April 19, 1983.

##### SCOPE

Financial derivatives transactions currently represent a relatively
small portion of the total credit, market, liquidity, and operational
risk to which most banks are routinely exposed. However, because of
their complexity, many banks involved in financial derivatives
transactions have developed sophisticated approaches in managing those
traditional types of risk. These guidelines reflect such approaches and,
therefore, represent sound procedures for risk management generally.
Therefore, to the extent possible, they should be applied to all of a
bank\'s risk-taking activities.

##### PRESENTATION

An outline of the guidance in this banking circular follows. Within the
topical discussions, a summary statement of the guidance appears in bold
type. Each summary is followed by supplemental discussion. References to
\"national banks\" or \"banks\" throughout the circular also include, to
the degree appropriate, federal branches and agencies of foreign banks.

####### OUTLINE

###### 

###### Page

Definition 4

Background 4

Guidance 5

> A. Senior Management and Board Oversight 5
>
> 1\. Written Policies and Procedures 6
>
> 2\. General Risk Monitoring and Control 7
>
> 3\. Risk Management Systems 8
>
> 4\. Audit Coverage 9
>
> B. Market Risk Management 9
>
> 1\. Dealers and Active Position-Takers 9
>
> 2\. Limited End-Users 10
>
> C. Credit Risk Management 11
>
> 1\. Credit Approval Function 12
>
> 2\. Pre-Settlement Risk 13
>
> 3\. Settlement Risk 14
>
> 4\. Credit Risk Monitoring 14
>
> D. Liquidity Risk Management 15
>
> 1\. Market/Product Liquidity Risk 15
>
> 2\. Cash Flow/Funding Liquidity Risk 16
>
> 3\. Early Termination Arrangements and Credit Enhancements 16
>
> 4\. Monitoring 17
>
> *Page*
>
> E. Operations and Systems Risk Management 18
>
> 1\. Quality of Personnel 18
>
> 2\. Systems 19
>
> 3\. Segregation of Duties 19
>
> 4\. Valuation Issues 20
>
> 5\. Documentation 21
>
> F. Legal Issues 21
>
> 1\. Bilateral Netting 22
>
> 2\. Multilateral Netting 23
>
> 3\. Physical Commodity Transactions 24
>
> G. Capital Adequacy 24
>
> H. Accounting 25

**DEFINITION**

Financial derivatives may be broadly defined as financial instruments
which derive their value from the performance of assets, interest or
currency exchange rates, or indexes. Derivative transactions include a
wide assortment of financial contracts, including structured debt
obligations and deposits, swaps, futures, options, caps, floors,
collars, forwards, and various combinations thereof.

##### BACKGROUND

Financial derivatives, properly used, provide national banks with
substantial benefits. They provide banks greater flexibility in managing
risk by separating out the different types of risks that are found in
financial instruments and services, and by transferring those risks to
parties who are more willing, or better suited, to take or manage them.
Financial derivatives transactions also often provide users with the
lowest cost funding alternatives by reducing transaction costs and, in
some cases, by exploiting arbitrage opportunities across financial
markets. Further, banks can use financial derivatives to efficiently
reduce undesirable exposures to factors such as interest rate changes or
currency fluctuations. Finally, banks can offer financial derivatives to
customers seeking risk management tools to assist in meeting business
objectives. The Office of the Comptroller of the Currency (OCC)
encourages national banks to use derivatives for such purposes.

The complexities of financial derivatives, however, raise concerns about
some institutions\' use of derivatives under certain circumstances.
National banks engaging in derivatives transactions must do so in
accordance with safe and sound banking practices. The OCC is concerned
about how the use of financial derivatives can influence the risk of
failure of any institution, and particularly those institutions whose
failure might threaten the solvency of other institutions or negatively
affect liquidity in the nation\'s financial system.

The OCC believes that the best defense against sizeable individual
losses or significant systemic disruptions is the implementation and use
by individual banks of sound and efficient risk management systems. Such
systems for managing credit, market, liquidity, operational, and legal
risks should prevent significant losses due to counterparty failure or
adverse changes in market conditions. No systems, however, can
substitute for open and timely communications between trading,
operating, and risk management units.

**GUIDANCE**

##### A. Senior Management and Board Oversight

National banks that engage in derivatives activities should have
effective senior management supervision and oversight by the Board of
Directors to ensure that such activities are conducted in a safe and
sound manner and are consistent with the Board of Directors\' overall
risk management philosophy and the bank\'s business strategies.

Before engaging in derivatives activities, bank management should ensure
that all appropriate regulatory approvals are obtained and that adequate
operational procedures and risk control systems are in place.

Any derivatives activities also should be approved by the Board of
Directors; by a committee thereof; or by appropriate senior management,
as designated by the Board of Directors. Proposals to undertake
derivatives activities should include, as applicable:

-   A description of the relevant financial products, markets, and
    business strategies;

-   The costs of establishing sound and effective risk management
    systems and of attracting and retaining professionals with specific
    expertise in derivatives transactions;

-   An analysis of the reasonableness of the proposed activities in
    relation to the bank\'s overall financial condition and capital
    levels;

-   An analysis of the risks that may arise from the activities;

-   The procedures the bank will use to measure, monitor and control
    risks;

-   The relevant accounting guidelines; and

-   An analysis of any legal restrictions and whether the activities are
    permissible.

A bank\'s Board of Directors and senior management should carefully
consider the resources required to enter into the derivatives business.
At a minimum, senior management and the Board of Directors should ensure
that the financial condition of the institution and the professional
expertise of designated personnel are adequate to support the bank\'s
proposed activity.

After the bank\'s initial entry into derivatives activities has been
properly approved, any significant changes in such activities or any new
derivatives activities should be approved by the Board of Directors or
by an appropriate level of senior management, as designated by the Board
of Directors. What constitutes a new activity will vary among
institutions. Examples include entry into different product lines or
markets, the use of derivatives instruments with different risk
characteristics, the use of derivative instruments to implement
different business strategies and goals, and the use of derivative
instruments with cash flow performance dependent upon markets in
different geographic regions.

Banks that propose to enter the derivatives markets as end-users should
ensure that the Board of Directors and senior management understand and
agree that the risk management techniques and reporting procedures that
will be used are appropriate. Banks entering into derivatives
transactions as dealers should ensure that their Boards of Directors and
senior management understand the potential risk exposure, and the
appropriateness of the proposed business in light of the strategies and
objectives approved by the Board of Directors.

Senior management of national banks that act as dealers of financial
derivatives should establish procedures necessary to ensure that
individuals involved in the sales and trading units sufficiently
understand derivatives instruments to identify instances in which a bank
customer may not fully understand the risks associated with a particular
transaction.

**1. Written Policies and Procedures**

A bank should have comprehensive written policies and procedures to
govern its use of derivatives. Senior management should review the
adequacy of these policies and procedures, in light of the bank\'s
activities and market conditions, at least annually. Appropriate
governance by the Board of Directors should include an initial
endorsement of significant policies (and changes, as applicable) and
periodic approval thereafter, as appropriate, considering the scope,
size and complexity of the bank\'s derivatives activities.

A bank\'s policies and procedures governing the use of derivatives may
be part of a broader set of policies and procedures, such as those
addressing financial risk management, customer-related business
activities, and/or proprietary trading activities. Written policies and
procedures should address risk management (market, credit, liquidity,
and operations), legal issues, capital requirements and accounting
standards. At a minimum, such policies and procedures should identify:

-   Managerial oversight and responsibilities;

-   Scope of activities;

-   Risk limits;

-   Risk measurement and reporting processes; and

-   Operational controls.

**2. General Risk Monitoring and Control**

**Senior management of each national bank engaging in derivatives
transactions should establish an independent unit or individual
responsible for measuring and reporting risk exposures. That
responsibility should include monitoring compliance with policies and
risk exposure limits.**

The individuals or units responsible for risk monitoring and control
functions should be independent of the units that create risk exposures.
Such individuals or units are responsible for developing and supporting
risk measurement systems, establishing market and credit risk approval
processes, developing appropriate risk control policies, reporting risk
exposures, and monitoring the bank\'s risk position against approved
limits. These individuals or units should have sufficient experience and
authority to make and direct critical position and transaction decisions
if circumstances require. The individual or unit may be part of a more
general operations, compliance, or risk management unit.

Regardless of how the risk monitoring and control operation is
structured, personnel should have appropriate experience and ability to
understand and communicate the implications of the institution\'s
exposure to senior management and the Board of Directors in a timely
manner. This function should also be supported with the technical and
financial resources and the corporate visibility and authority necessary
to ensure effective oversight.

**3. Risk Management Systems**

**National banks engaged in financial derivatives transactions should
have comprehensive risk management systems that are commensurate with
the scope, size, and complexity of their activities and the risks they
assume. Such systems must ensure that market factors affecting risk
exposures are adequately measured, monitored, and controlled. These
factors include changes in interest and currency exchange rates,
commodity and equity prices and their associated volatilities, changes
in the credit quality of counterparties, changes in market liquidity,
and the potential for major market disruptions. Risk management
procedures also should adequately control potential losses arising from
system deficiencies.**

A comprehensive risk management system will incorporate:

-   Effective management supervision and oversight by the Board of
    Directors;

-   Procedures that identify and quantify the level(s) of risk on a
    timely basis;

-   Limits and other controls on the level(s) of risk with respect to
    counterparty credit, concentrations, and other relevant market
    factors;

-   Limits and other controls on inter-connected risk positions (i.e.,
    two or more risk positions that are correlated and would be expected
    to change in value due to a change in the same market factors);

-   Reports to senior management and the Board of Directors that
    accurately present the nature and level(s) of risk taken and
    compliance with approved policies and limits; and

-   Auditing procedures to ensure the integrity of measurement, control,
    and reporting systems, and compliance with approved policies and
    procedures.

When determining risk exposure limits, senior management should consider
the nature of the bank\'s strategies and past performance, the level of
earnings and capital available to absorb potential losses, and the
Board\'s tolerance for risk. This analysis should be available for bank
examiners to review. The Board of Directors, or its designees), should
review the appropriateness of established limits and controls whenever
significant changes occur in the size and scope of the bank\'s
activities or market conditions, or if the bank experiences significant
reductions in earnings or capital that were not anticipated at the time
the limits and controls were established.

**4. Audit Coverage**

**National banks should have audit coverage of their financial
derivatives activities adequate to ensure timely identification of
internal control weaknesses and/or system deficiencies. Such audit
coverage should be provided by competent professionals who are
knowledgeable of the risks inherent in the financial derivatives
transactions.**

Audit coverage of derivatives activities should be commensurate with a
bank\'s level of risk and volume of activity. For those banks with
end-user activities, audit coverage is likely to be included within the
scope of audits of the interest rate, foreign currency, and liquidity
risk management functions. Banks that function as dealers need audit
coverage sufficient to assess other risks associated with these
businesses. For all financial derivatives users, the audit scope should
include an appraisal of the soundness and adequacy of accounting,
operating, legal, and risk controls. The audit scope also should include
testing for irregularities and compliance with the bank\'s policies and
procedures.

As with any effective audit program, the audit of financial derivatives
activities should be conducted by competent auditors who are both
independent of the business unit being audited and yet knowledgeable of
the risks unique to that unit. The level of auditor expertise should be
consistent with the level of activity and degree of risk assumed by the
bank with respect to its derivatives activities.

####### B. Market Risk Management

**1. Dealers and Active Position-Takers**

**National banks whose financial derivatives activities involve dealing
or active position-taking should have risk measurement systems that can
quantify risk exposures arising from changes in market factors. Those
systems should be structured to enable management to initiate prompt
remedial action. The systems also should facilitate stress testing and
enable management to assess the potential impact of various changes in
market factors on earnings and capital.**

The bank should evaluate risk exposures under various scenarios that
represent a broad range of potential market movements and corresponding
price behaviors and that consider historical and recent market trends.
Statistical analyses should be used to characterize market scenarios and
price behaviors. Before they are used, and whenever market conditions
change significantly, the analyses should be validated by a source
independent of the trading desk or risk assumption unit. At a minimum,
all risk measurement applications and models should be reviewed and
validated annually, and management should maintain adequate
documentation to support the reliability of the validation process.

The frequency with which exposures should be evaluated varies by the
nature and size of a bank\'s financial derivatives activities. For
dealing and trading units, such evaluations should be available on a
daily, and even intra-day, basis. For banks actively using derivatives
as part of their overall risk management, less frequent evaluations may
be sufficient.

At some national banks, financial derivatives activities span numerous
products, markets, currencies, and geographic regions. These activities
may be conducted in numerous profit centers or branches and may be
managed on a decentralized basis. At a minimum, such banks should be
able to measure their derivatives-related risks for each major
portfolio, branch, and profit center. In addition, bank management
should develop the ability to aggregate such risks across various profit
centers and branches to determine the aggregate risk profile of the
institution. The OCC recognizes that developing such consolidated risk
measurement systems may require significant time and resources. However,
given the complexity, potential volatility, and size of risk exposures
in derivatives positions, the OCC believes that such capabilities are
necessary for banks that are dealers and/or active position-takers in
derivatives transactions.

**2. Limited End-Users**

A bank whose derivatives activities are limited in volume and confined
to risk management activities may need less sophisticated risk
measurement systems than those required by a dealer or active
position-taker. Senior management at such a bank should ensure that all
significant risks arising from their derivatives transactions can be
quantified, monitored, and controlled. At a minimum, risk management
systems should evaluate the possible impact on the bank\'s earnings and
capital which may result from adverse changes in interest rates and
other market conditions that are relevant to the bank\'s risk exposure
and the effectiveness of financial derivatives transactions in the
bank\'s overall risk management.

Each financial derivatives transaction should have a clear objective
that is consistent with the bank\'s overall risk management objectives
and strategies. Further, the bank\'s risk measurement systems should be
capable of demonstrating the effectiveness of derivatives transactions
in achieving such objectives.

####### C. Credit Risk Management

Credit risk management should parallel the prudent controls expected in
traditional lending activities. Policies and procedures should be
formalized to address concerns such as significant counterparty
exposures, concentrations, credit exceptions, risk ratings,
nonperforming contracts, and allowance allocations. Timely, meaningful
reports should be generated and distributed consistent with policy and
procedure requirements.

Credit exposures to an individual counterparty, which are significant in
size relative to capital, should be addressed in the bank\'s credit risk
policy. Bank management should establish internal limits that are
prudent in light of the bank\'s financial condition and management\'s
expertise. The Board of Directors\' risk tolerance for concentrations
and credit exceptions should be reflected in policies and procedures.
Policies addressing credit management functions, such as risk ratings,
nonperforming contracts, and allowance allocations, should be consistent
throughout the bank.

Senior management should receive reports that document line usage by
significant counterparties and new credit relationships. Such reports
should consolidate derivatives credit exposure with all other lending
exposure the bank might have to a particular customer.

**1. Credit Approval Function**

To ensure safe and sound management of derivatives credit risk exposure,
bank management should make sure that credit authorizations are provided
by personnel independent of the trading unit. Credit officers should be
qualified to identify and assess the level of credit risk inherent in a
proposed derivatives transaction. Approving officers also should be able
to identify if a proposed derivatives transaction is consistent with a
counterparty\'s policies and procedures with respect to derivatives
activities, as they are known to the bank.

Derivative credit lines should be approved using the same credit
discipline as credit exposures arising from traditional lending
products. Credit should be approved by a level of senior management
sufficient to ensure consistency with corporate objectives. Banks that
function as dealers should ensure that personnel approving credit lines
for financial derivatives transactions do not have any trading authority
or any reporting responsibility to trading unit management. Credit
analysis supporting credit lines and sub-limits should be performed
before financial derivatives transactions are executed. This analysis
should parallel analysis conducted in connection with traditional
extensions of credit.

Credit officers should be able to effectively analyze the impact of
proposed derivatives activities on the financial condition of the
customer. The availability and impact of credit exposure reduction
techniques, such as netting arrangements and collateral agreements, also
should be considered. Consistent with good practice in traditional
lending, the creditworthiness of the counterparty should be assessed
periodically throughout the life of the derivatives transaction.

The credit officers responsible for establishing and changing financial
derivatives credit lines should understand the applicability of
financial derivatives instruments to the risks the bank customer is
attempting to manage. When the bank believes a particular transaction
may not be appropriate for a particular customer, but the customer
wishes to proceed, bank management should document its own analysis and
the information provided to the customer.

**2. Pre-Settlement Risk**

The system a bank uses to quantify pre-settlement credit risk exposure
should take into account current exposure (\"mark-to- market\") as well
as potential credit risk due to possible future changes in applicable
market rates or prices (\"add- on\"). That system should use a reliable
source for determining the credit risk factor used to calculate the
credit risk add-on.

This methodology should produce a number representing a reasonable
approximation of loan equivalency, that is, the amount of credit
exposure inherent in a comparable extension of credit. The
mark-to-market calculation should incorporate the same controls as the
mark-to-market calculation used to identify profits and losses. Prices
should be obtained independently from qualified sources on a periodic
basis, the frequency of which should be determined by the extent and
type of a bank\'s financial derivatives activities. The bank\'s traders
should not be used as the source of market valuations unless an
independent unit (risk management and/or operations) verifies the
traders\' input against published quotes.

The credit risk add-on should determine the potential for future
increases in credit exposure based on the likelihood that market rates
or prices will change over the life of a contract. Although the
methodology used to calculate this exposure should be consistent with
that used for calculating market risk, the credit risk add-on
calculation differs in at least one significant aspect. Specifically,
the time horizon for market risk is the time it would take to offset or
close- out a position, whereas the time horizon for credit risk
appropriately is the remaining life of the contract because default
could occur at any time during the remaining life.

Correlations among off-setting or matched positions with a single
counterparty can reduce the overall potential for future credit exposure
to that counterparty, but determining the extent of such reductions
generally requires sophisticated simulation analysis. Consequently, if a
bank adjusts for such correlations when summing and evaluating
counterparty credit exposures, the simulation analysis supporting any
such adjustment should be available to bank examiners.

The sophistication of a bank\'s credit risk measurement system should be
consistent with the level of activity and degree of risk assumed by the
bank in its derivatives activities. Banks active in derivatives
transactions should have internal systems to determine potential credit
risk. Limited end-users may rely on estimates from dealers or other
third party sources, provided the sources are independent of the bank\'s
counterparty.

**3. Settlement Risk**

A bank\'s system for managing counterparty credit risk should address
settlement risk.

Settlement risk can be defined as the risk a bank faces when it has
performed its obligations under a contract, but has not yet received
value from its counterparty. The time horizon for settlement risk is
typically very short (less than 24 hours). Bank management should
establish limits and monitoring procedures for settlement risk
exposures. Settlement risk limits should be established separately from
pre-settlement credit limits and should consider the bank\'s capital
adequacy, operations efficiency, and credit analysis expertise. Because
settlement risk becomes credit risk if the counterparty defaults during
the settlement cycle, the ability of bank management to limit this
exposure should be the key determining factor in establishing settlement
limits. Monitoring reports should provide sufficient detail to identify
credit risk arising from settlement versus pre-settlement exposure.

**4. Credit Risk Monitoring**

**Credit risk monitoring should be independent of the units that create
financial derivatives exposures. This risk monitoring unit should be
responsible for producing and distributing timely, accurate information
about credit exposures such as line usage, concentrations, credit
quality, limit exceptions, and significant counterparty exposures.
Credit exposure reports should provide aggregate information about the
bank\'s credit risk to a given counterparty (including products such as
loans, securities underwritings and other traded products). The risk
monitoring unit should ensure that appropriate levels of senior
management and the Board of Directors receive relevant information about
credit exposure arising from derivatives activities on a periodic and
timely basis.**

The methodology the bank adopts to measure and monitor credit risk
should be controlled by personnel independent of the trading unit. As
with the methodologies used to measure mark-to-market value and
potential market risk exposure, it is important that the assumptions and
variables used in such models be kept current. Periodic validation
should be an integral part of this process.

**D. Liquidity Risk Management**

Bank management should establish effective controls over the liquidity
exposure arising from financial derivatives activities. Key principles
in the governance and management of this risk are diversification and
communication.

With respect to financial derivatives products, liquidity risk takes two
forms: market/product liquidity and cash flow. If there is insufficient
market activity or prices are not available, a bank risks loss due to
its inability to exit or unwind a position. The inability to meet cash
flow obligations at an acceptable price as they become due may also
present a risk of loss.

Management of the liquidity exposure resulting from financial
derivatives activities should be an integral part of day-to-day
operations, as well as contingency and liquidity planning processes. The
depth and formality of management systems governing this risk should
reflect the volume and complexity of activities undertaken and the
overall liquidity of the bank.

**1. Market/Product Liquidity Risk**

**Exposure to market/product liquidity risk should be formally addressed
within market risk limits. Diversification policies specifically
addressing known or potential liquidity problems also should be
implemented. Limits should be designed to trigger management action and
control loss. Quality and timely communication also should be an
integral part of a bank\'s risk management culture.**

Effective market risk exposure limits should incorporate orderly
liquidation periods based on the length of time required to hedge or
liquidate a position under normal market conditions. When markets or
products are illiquid and there is little variety or depth to hedging
alternatives, market and credit exposure measures should be based on
longer time frames.

Communication and management/trader action are important during periods
of illiquidity. A policy in which traders communicate early warning
signs to risk control units is critical. At a minimum, traders should
routinely report instances of unusually wide spreads and the absence of
regular market participants.

Operating procedures should require traders to alert line and risk
control units to early market indicators of resistance to the bank or to
significant counterparties, as well as resistance with respect to
particular products or maturities, or by particular markets or
geographic regions.

**2. Cash Flow/Funding Liquidity Risk**

**A bank should have liquidity policies to formally govern its exposure
to cash flow gaps (from intermediate payments or settlements) arising
from financial derivatives activities.**

Controls over a bank\'s current and projected liquidity positions should
include limits on cash flow gaps, in the aggregate and by currency.
Based on the bank\'s organizational structure, it also may be
appropriate to establish such limits according to legal or geographic
entities, as well as on a firm-wide basis.

Banks engaged in significant financial derivatives trading activities
should consider having an internal transfer pricing system that
incorporates an appropriate \"charge\" for liquidity usage. Such a
charge could help provide financial derivatives users with the
appropriate economic incentive to manage their cash flow gaps and
funding requirements according to overall organizational needs and
strategies.

The limits previously discussed for controlling market/product liquidity
risk also should assist in diversifying cash flows and avoiding
concentrations around specific dates, within specific time periods, and
by currency, product, or customer.

**3. Early Termination Arrangements and Credit Enhancements**

**Policies should control the bank\'s exposure arising from early
termination arrangements, as well as collateralization or other credit
enhancements.**

Banks should carefully evaluate the risks of entering into agreements
governing their financial derivatives transactions that include
provisions allowing a counterparty to terminate the agreement or
liquidate outstanding transactions upon a deterioration in the bank\'s
financial condition. Even absent such provisions, counterparties may
request a bank that is experiencing real or perceived problems to unwind
financial derivatives transactions before they mature. Bank policy
should formally address how such requests will be handled, because in
either situation, the early termination of trades may result in an
undesired cash outflow and an increase in market risk at the least
opportune time.

Banks\' policies also should limit the amount of assets that may be
encumbered by collateral arrangements or other credit enhancements
triggered by a deterioration in the bank\'s financial condition. In
developing such limits, a bank should consider potential exposures and
alternative financing sources to meet liquidity requirements under a
series of successive declines in its credit standing.

**4. Monitoring**

**Banks should have management information systems that permit daily
monitoring of liquidity positions relative to limits. These reports
should be prepared by an area or employee(s) independent of the trading
unit.**

Information reflecting current and prospective cash flows from financial
derivatives activities should be included in bank-wide liquidity
management processes and contingency funding plans. Reports showing
actual positions relative to diversification limits also should be
readily available for management\'s review.

The frequency with which reports are prepared should be based on the
relative risk exposures of a bank\'s activities, as well as its
liquidity needs. Such information should be provided to trading, risk
control, and funding units.

**E. Operations and Systems Risk Management**

The Board of Directors and senior management should ensure the proper
dedication of resources (financial and personnel) to support operations
and systems development and maintenance. The operations unit for
financial derivatives activities, consistent with other trading and
investment activities, should report to an independent unit, and should
be managed independently of the business unit. The sophistication of the
systems support and operational capacity should be commensurate with the
size and complexity of the derivatives business activity.

To ensure effective transaction processing, exposure and profit and loss
reporting, valuation of positions and documentation, the operations unit
should be independent of the business unit.

Systems support and operational capacity should be able to adequately
accommodate the types of financial derivatives activities in which the
bank engages. This includes the ability to efficiently process and
settle the volume of business transacted through the business unit, to
provide support for the complexity of the transactions booked, and to
provide accurate and timely input. Support systems and the systems
developed to interface with the official databases should generate
accurate information sufficient to allow business unit management and
senior management to monitor risk exposures in a timely manner.

Systems needs and adequacy for financial derivatives activities should
be evaluated during the strategic planning process. Current and
projected volume should be considered together with the nature of the
derivatives activity and the user\'s expectations. Consistent with other
systems plans, a written contingency plan for financial derivatives
products should be in place.

**1. Quality of Personnel**

Senior management should recognize the need for, and devote appropriate
resources to, employing knowledgeable and experienced personnel in the
operations area.

Although organizational structures may vary from one bank to another,
trading operations should report to high-level management. This assures
that senior management is aware of significant operational risks. With
the complexity of financial derivatives products and the size and
rapidity of transactions, it is essential that operational units be able
to capture all relevant details of trades, identify errors, and process
payments or move assets quickly and accurately. This requires a staff of
sufficient size, knowledge and experience to support the volume and type
of transactions generated by the business unit.

Management should develop appropriate hiring practices and compensation
plans to recruit and retain high caliber staff,

**2. Systems**

Systems design and needs may vary according to the size and complexity
of a bank\'s financial derivatives business. However, each system should
provide for accurate and timely processing and allow for proper risk
exposure monitoring.

Operational systems should be tailored to each bank\'s needs. Limited
end-users of financial derivatives may not require the same degree of
automation needed by more active trading and position-taking banks.
However, all operational systems and units should adequately provide for
basic processing, settlement, and control of derivatives transactions.

The more sophisticated the bank\'s activity, the more need there is to
establish automated systems to accommodate the complexity of the deals
transacted, to accommodate the volume of trades conducted, and to
reconcile more efficiently and report position information accurately.

It is appropriate for front and back office systems to become more
highly integrated as the bank\'s financial derivatives activities
expand.

**3. Segregation of Duties**

**Segregation of operational duties, exposure reporting, and risk
monitoring from the business unit is critical to proper internal
control.**

To provide proper control over the recordation, settlement, and
monitoring of the financial derivatives business activities, operational
duties should be segregated and managed independently from the business
unit. Proper internal control should be provided over the entry of deals
into the database, transaction numbering, date and time notation, and
the confirmation and settlement processes. Operational controls also
should be in place to resolve disputes over contract specifications. In
this regard, banks which act as dealers of derivatives transactions
should consider employing recorded telephone lines for both dealing and
operational units.

The operations department, or another unit or entity independent of the
business unit, should be responsible for ensuring proper reconciliation
of front and back office databases on a regular basis. This includes the
verification of position data, profit and loss figures, and
transaction-by-transaction details.

**4. Valuation Issues**

Banks that engage in financial derivatives activities should ensure that
the methods they use to value their derivatives positions are
appropriate and that the assumptions underlying those methods are
reasonable.

Dealers and active position-takers should have systems that accurately
measure the value of their financial derivatives portfolios. The pricing
procedures and models the bank chooses should be consistently applied
and well-documented. Models and supporting statistical analyses should
be validated prior to use and as market conditions warrant.

The best approach is to value derivatives portfolios based on mid-market
levels less adjustments. Adjustments should reflect expected future
costs such as unearned credit spreads, close-out costs, investing and
funding costs, and administrative costs. Most limited end-users (and
some traders) may find it too costly to establish systems that
accurately measure the necessary adjustments for mid-market pricing. In
such cases, banks may price derivatives based on bid and offer levels,
provided they use the bid side for long positions and the offer side for
short positions. This procedure will ensure that financial derivatives
positions are not overvalued.

Banks adopting mid-market pricing should recognize that mid-market
prices are not observable for many instruments. In those cases, banks
should derive unbiased estimates of market prices from prices in similar
markets or from sources that are independent of the bank\'s traders. The
bank\'s operations staff should develop procedures to verify the
reasonableness of all pricing variables or, if that is not possible,
should limit the bank\'s exposure through position or concentration
limits and develop appropriate reporting mechanisms.

Traders may review and comment on prices. When material discrepancies
occur, senior management should review them. If, in an extenuating
circumstance, senior management overrides a back office estimate, it
should prepare a written explanation of the decision.

**5. Documentation**

Bank management should ensure a mechanism exists whereby financial
derivatives contract documentation is confirmed, maintained, and
safeguarded. Documentation exceptions should be properly monitored and
resolved.

Controls must be in place to ensure that the appropriate contract
documentation is timely and properly executed and maintained. The bank
should establish a process through which documentation exceptions are
monitored and appropriately reviewed by senior management and legal
counsel. Banks with more active derivatives businesses should consider
establishing a separate documentation unit to control financial
derivatives contracts and supporting documents. Such a unit may be part
of a broader documentation unit or the legal department.

######## F. Legal Issues

Prior to engaging in derivatives transactions, a national bank should
reasonably satisfy itself that its counterparties have the legal, and
any necessary regulatory, authority to engage in those transactions. In
addition to determining the authority of a counterparty to enter into a
derivatives transaction, a national bank also should reasonably satisfy
itself that the terms of any contract governing its derivatives
activities with a counterparty are legally sound.

Participants in the financial derivatives markets have experienced
significant losses because they were unable to recover losses from a
defaulting counterparty when a court held the counterparty had acted
outside of its authority in entering into such transactions. National
banks, especially dealers, should ensure that their counterparties have
the power and authority to enter into derivatives transactions, and that
the counterparties\' obligations arising therefrom are enforceable.
Similarly, a national bank also should ensure that its rights with
respect to any margin or collateral received from a counterparty are
enforceable and exercisable. The bank should be able to be use such
margin or collateral to offset actual losses upon the default of the
counterparty.

A national bank also should reasonably satisfy itself that the terms of
any contract governing its derivatives transactions with a counterparty
are legally sound. This is especially important with respect to
provisions governing (i) the timing of the termination of outstanding
transactions and (ii) the calculation of settlement amounts payable to
or between parties upon the termination of a transaction or an
agreement.

**1. Bilateral Netting**

**In order to reduce counterparty credit exposure, a national bank
should use master close-out netting agreements with its counterparties
to the broadest extent legally enforceable, including in any possible
insolvency proceedings of such counterparties. However, the reliance
upon such agreements where the enforceability of such agreements against
a particular counterparty has not been legally established should be
considered carefully and will be scrutinized closely by the OCC.**

In the United States the enforceability of bilateral close-out netting
arrangements for various derivatives transactions in the insolvency
proceedings of U.S. counterparties is almost certain. The advantages of
such netting arrangements include a reduction in credit and liquidity
exposures, the potential to do more business with existing
counterparties within existing credit lines, and a reduced need for
collateral to support counterparty obligations. National banks,
therefore, gain substantial potential benefits by documenting their
relationships in master agreements that contain close-out netting
provisions.

The enforceability of such provisions against many foreign
counterparties or U.S. branches or offices of some foreign
counterparties, however, is less certain. National banks that rely on
netting arrangements with such counterparties may understate credit and
liquidity exposures, As a result, they may improperly monitor and
control that exposure, assume unintended credit risk, and increase
systemic risk.

Only when the enforceability of close-out netting arrangements with
counterparties has a high degree of certainty should national banks
monitor their credit and liquidity risks, and account for financial
derivatives transactions with such counterparties, on a net basis.

**2. Multilateral Netting**

**A national bank should determine credit and liquidity exposure and
account for financial derivatives transactions on a
multilaterally-netted basis only if cleared through a clearinghouse,
organization, or facility that meets the conditions set forth in the
Report of the Committee on Interbank Netting Schemes of the Central Bank
of the Group of 10 Countries, Bank for International Settlements, Nov.
1990 (\"Lamfalussy Report\").**

Under a multilateral netting facility, a central counterparty or
clearinghouse is designated as the common legal counterparty for each
participant in the facility. The reductions in credit risk resulting
from a well-designed facility can be substantial and, generally, the OCC
encourages the development of such arrangements.

In order to provide the highest level of certainty with respect to (i)
the enforceability of the obligations of the participants, (ii) the
ability of the system to freely and promptly exercise the right of
set-off with respect to any property deposited with the system by a
defaulting participant as security for its obligations, (iii)
limitations on the obligations of non-defaulting participants to cover
the losses arising out of defaulted transactions, and (iv) the financial
integrity of the system as a whole, national banks should only
participate in multilateral netting facilities that meet the conditions
set forth in the Lamfalussy Report.

**3. Physical Commodity Transactions**

**National banks may engage in physical commodity transactions in order
to manage the risks arising out of physical commodity financial
derivatives transactions if they meet the following conditions:**

-   **Any physical transactions supplement the bank\'s existing risk
    management activities, constitute a nominal percentage of a bank\'s
    risk management activities, are used only to manage risk arising
    from otherwise permissible (customer-driven) banking activities, and
    are not entered into for speculative purposes; and**

-   **Before entering into any such physical transactions, the bank has
    submitted a detailed plan for the activity to the OCC and the plan
    has been approved.**

The OCC has concluded that a national bank may engage in physical
commodity transactions in order to manage the risks arising out of
physical commodity financial derivatives transactions. However, given
the potential additional risks associated with physical hedging
activities, a national bank must first develop a detailed plan, which
should be approved by the bank\'s Board of Directors and the supervisory
staff of the OCC, before the bank begins engaging in such activities.
Requests for plan approval must be submitted to: Senior Deputy
Comptroller for Bank Supervision-Operations, Office of the Comptroller
of the Currency, Washington, D.C. 20219.

Upon OCC approval, a national bank may engage in such activities only
under the conditions specified above and in accordance with safe and
sound banking practices.

Financial derivatives transactions with respect to bank-eligible
precious metals (gold, silver and platinum) are not subject to this
guideline.

####### G. Capital Adequacy

The Board of Directors should ensure that the bank maintains sufficient
capital to support the risk exposures (e.g., market risk, credit risk,
liquidity risk, operation and systems risk, etc.) that may arise from
its derivatives activities. Significant changes in the size or scope of
a bank\'s activities should prompt an analysis of the adequacy of the
amount of capital supporting those various activities by senior
management and/or the Board of Directors. This analysis should be
approved by the Board of Directors and be available for bank examiner
review. In addition to internal reviews of capital adequacy, senior
management should ensure that the bank meets all regulatory capital
standards for financial derivatives activities.

Under current risk-based capital requirements national banks must hold
capital for counterparty credit risk exposures in financial derivatives
contracts. These requirements are specified in 12 CFR 3 Appendix A. The
OCC is developing additional capital requirements for banks\' interest
rate exposures which would include requiring capital to cover interest
rate risk exposures arising from financial derivatives positions. As
these and any other modifications or additions to capital requirements
are adopted, bank management must ensure that all financial derivatives
activities are properly incorporated into their minimum capital levels.

####### H. Accounting

Accounting guidance for financial derivatives instruments is not
comprehensive. Generally accepted accounting principles (GAAP) include
definitive accounting standards only for futures contracts. Regulatory
accounting principles (RAP), set forth in the Instructions to
Consolidated Reports of Condition and Income, address only futures,
forwards, and options. Due to the lack of comprehensive GAAP or RAP
guidance for all derivatives, inconsistent accounting practices have
developed for some products.

The OCC is currently studying the issue of accounting for financial
derivative instruments. A consistent regulatory accounting policy will
be developed for all derivative products. That policy will consider the
impact of accounting rules on business decisions, with a view to
minimizing regulatory burden, and will be a cooperative effort with the
other U.S. banking agencies. In the interim, each bank should review its
accounting practices and documentation to ensure consistency with the
strategies and objectives approved by its Board of Directors.

**RESPONSIBLE OFFICE**

Questions or concerns regarding this banking circular or the information
it contains should be directed to: Capital Markets Division, Office of
the Chief National Bank Examiner, (202) 874-5070,

Douglas E. Harris

Senior Policy Advisor to the Comptroller