June 14, 2005 **Interpretive Letter #1033**

**July 2005**

**12 USC 24(7)**

Re: Offering Equity Index Swaps and Holding Baskets of Securities for
Hedging Purposes

Dear **\[ \]**:

This letter confirms that **\[ \]** (the "Bank") may, with the approval
of the Bank's examiner-in-charge ("EIC"), engage in customer-driven
equity index derivatives transactions and may use baskets of securities
to hedge its risk exposures to the index swaps where the baskets do not
exactly match the underlying index, but are designed to replicate the
sector and industry weightings and general risks of the index.

**I. Background**

The Bank currently offers equity derivatives to customers as a financial
intermediary and hedges those derivatives with equity derivatives or
holdings of individual stocks. The Bank would like to expand its program
to include equity index swaps that provide customers economic returns
similar to investments in equity index portfolios and to hedge its
exposures from the program by holding baskets of securities that closely
replicate the performance of the equity index swaps.

The Bank has seen a growing use of index swaps by customers to provide
them with economic results similar to investments in index portfolios
without the costs of ownership. In a long index swap, the customer pays
the Bank LIBOR plus a spread and any depreciation on the underlying
equity. In return, the customer receives the appreciation plus any
dividends on the underlying equity. Index swaps often reference the S&P
500 but with a growing frequency also refer to the Russell 1000 and
Russell 3000 and many subsets of these indices.

The Bank proposes to hedge its obligations under the equity index swaps
with a basket of securities that does not exactly match the underlying
index, but is designed to replicate the sector and industry weightings
and general risks of the index. The Bank believes that these baskets
offer practical and economic advantages over other hedging options.

The Bank states that maintaining stock holdings that precisely match all
the index holdings can be unnecessarily costly, particularly for smaller
holdings. Also, the Bank is restricted from buying and selling certain
stocks that are included in indices, such as stock of affiliates or
stock of companies involved in the Bank's management and advisory work.

The Bank proposes to design baskets of securities to hedge its risk
exposures in a manner that provides tax advantages under the Internal
Revenue Code (the "Code"). Under sections 243 through 246 of the Code,
in certain circumstances, the Bank may be entitled to exclude from
taxation 70% of the dividends received from other U.S. corporations.
However, under IRS rules applicable to hedges, the "dividends received"
deduction (the "DRD") is reduced or disallowed if the hedge portfolio
and index portfolio overlap by more than 70 percent.[^1]

The Bank expects that complying with the DRD rules will result in a
relatively small tracking error (less than 1 percent based on several
probable scenarios) between the basket of securities and the index the
basket hedges. Although the basket will hold less than 70 percent of the
securities in an index, the basket will be weighted to closely track the
performance of the index.

The Bank believes the DRD tax benefits will exceed any losses resulting
from the tracking error. The Bank also believes it must conduct hedging
activities in conformance with the DRD rules in order to provide
competitive pricing for its index swaps products. It hedges these
customer trades by trading in the futures market on the underlying index
or by trading the stocks that underlie the index. As with any derivative
product, hedging strategies are used to dramatically reduce the risks
associated with these positions, but some small and measurable amount of
basis risk remains. The Bank believes it can best deal with this basis
risk from the customer activity by using customized stock baskets to
hedge index swaps. These customized baskets are designed to match the
sector and industry weightings and general risks of the underlying
indices.

Using proprietary software, the Bank can create customized baskets that
effectively hedge equity indices without replicating the index exactly.

##### II. Legal Analysis

You have asked if the Bank may engage in customer-driven equity index
derivatives transactions and whether the Bank may design baskets of
securities to hedge its risk exposures to the index swaps where the
baskets do not exactly match the underlying index, but are designed to
replicate the sector and industry weightings and general risks of the
index. This activity is permissible provided it has the approval of the
Bank's EIC.

**A. Equity Index Swaps**

National banks may engage in customer-driven derivatives transactions,
including equity swaps, as financial intermediaries.[^2] In 1994, the
OCC addressed the legal permissibility of national banks engaging in
swap activities tied to equities and equity indices.[^3] The OCC
recognized that swap contracts are, in some respects, direct descendants
of traditional deposit contracts because payments under the contracts
are similar to the receipt of deposits and the payment of interest on
deposits.[^4] Based, in part, on that line of authority, the OCC
concluded that national banks may make payments to, or receive payments
from, equity and equity index swap customers in the event of a gain or
loss in a designated equity or equity index. The OCC further recognized
that equity and equity index swap activities are permissible for
national banks as a financial intermediation activity.[^5] In such
arrangements, national banks act as financial intermediaries between
customers that want to manage risks resulting from the variations in a
particular equity or equity index. Customers do not deal directly with
one another, but instead make payments through the intermediary bank.

Banks, through their equity derivative transactions, are better able to
meet customer needs by offering financial instruments that serve
important risk management and other financial functions. National banks
have benefited from equity derivative transactions that enable them to
diversify, expand their customer base, and increase revenues.[^6] Equity
derivative transactions pose risks similar to those inherent in other
types of banking activities that national banks are familiar with and
manage, *e.g.,* interest rate, liquidity, credit, and compliance risks.

We conclude that the Bank may engage in customer-driven equity index
derivatives transactions, with the approval of the Bank's EIC.

**B. Hedging Equity Index Swaps with Securities Baskets**

The OCC has determined that it is legally permissible for a national
bank to purchase and hold equity securities that banks do not generally
have authority to purchase to hedge customer-driven, bank permissible
equity derivative transactions.[^7] A national bank may hold these
securities to hedge bank permissible equity derivative transactions if
the activities comply with the standards set forth below, which include
obtaining the approval of its EIC. Before establishing an equity hedging
program, a national bank must provide written documentation to its EIC
that evidences compliance with the following standards, and must obtain
the EIC's approval. The documentation should establish to the
satisfaction of the EIC that:

1.  The Bank will hold the securities solely to hedge risks arising from
    bank permissible derivative transactions originated by customers for
    the customers' valid and independent business purposes;

2.  The Bank will not hold the securities for speculative purposes;

3.  The securities will offer a cost-effective means to hedge risks
    arising from permissible banking activities;

4.  The Bank will not take anticipatory, or maintain residual positions
    in the non-qualifying securities except as necessary for the orderly
    establishment or unwinding of a hedging position.

5.  The Bank will not acquire equity securities for hedging purposes
    that constitute more than 5% of a class of securities of any issuer;
    and

6.  The Bank will have an appropriate risk management process in place,
    satisfactory to the EIC, for its hedging activities.[^8]

National banks may hedge risks arising from bank permissible equity
derivative transactions with either long or short positions in an equity
or equity index.[^9] A national bank can protect itself against changes
in the value of the security underlying an equity derivative transaction
by taking an offsetting (long or short, as appropriate) position in that
equity or index. A national bank also may cross-hedge its equity
derivatives where consistent with the bank's OCC approved hedging risk
management process.[^10] While the baskets created by the Bank to hedge
its equity index swap activities do not exactly match the applicable
underlying index, we find that the extent of the mismatch is so slight
as to still fall within the scope and rationale of the OCC precedents
cited in support of bank hedging activities. The baskets will be
designed and weighted to closely track the performance of the applicable
index, *i.e.,* less than 1% deviation under several probable scenarios.
Thus, the likely potential mismatch is *de minimis*. Based on this
authority, we conclude a national bank may purchase a basket of equities
that closely tracks but does not exactly replicate the performance of an
equity index, with the approval of the Bank's EIC.

##### III. Conclusion

We conclude, that the Bank, with the approval of the Bank's EIC, may
engage in customer-driven equity index derivatives transactions and may
use baskets of securities to hedge its risk exposures to the index swaps
where the baskets do not exactly match the underlying index, but are
designed to replicate the sector and industry weightings and general
risks of the index.

If you have additional questions, please do not hesitate to contact
Eugene H. Cantor, Counsel, Securities & Corporate Practices Division at
202-874-5202.

Sincerely,

**signed**

Daniel P. Stipano

Acting Chief Counsel

[^1]: The bank has obtained an opinion of tax counsel that it should not
    be precluded from taking the DRD. The OCC takes no position on the
    tax aspects of the proposed transaction.

[^2]: OCC Interpretive Letter No. 935 (May 14, 2002) and OCC
    Interpretive Letter No. 892 (September 13, 2000).

[^3]: OCC Interpretive Letter No. 652 (September 13, 1994). The OCC has
    recognized the ability of banks to engage in swap products for a
    number of years. In the 1980's the OCC opined on the permissibility
    of national banks engaging in interest rate, currency, and commodity
    price index swaps and caps. OCC No-Objection Letter No. 87-5 (July
    20, 1987); OCC Interpretive Letter No. 462 (December 19, 1988); OCC
    Letter from J. Michael Shepherd, Senior Deputy Comptroller,
    Corporate and Economic Programs (July 7, 1988) (unpublished). Later,
    in the 1990's, the OCC recognized that national banks may advise,
    structure, arrange, and execute transactions, as agent or principal,
    in connection with interest rate, basis rate, currency, currency
    coupon, and cash-settled commodity swaps; swaptions, captions, and
    other option-like products; forward rate agreements, rate locks and
    spread locks, as well as similar products that national banks are
    permitted to originate and trade in and in which they may make
    markets. OCC Interpretive Letter No. 725 (May 10, 1996); OCC Letter
    from Jimmy F. Barton, Deputy Comptroller Multinational Banking, to
    Carl Howard, Associate General Counsel, Citibank, N.A. (May 13,
    1992) (unpublished); OCC Letter from Horace G. Sneed, Senior
    Attorney, Legal Advisory Services Division (March 2, 1992)
    (unpublished); OCC No-Objection Letter No. 90-1 (February 16, 1990).

[^4]: OCC Interpretive Letter No. 652, *supra.*

[^5]: OCC Interpretive Letter No. 652, *supra.* That Interpretive Letter
    pre-dated *NationsBank of North Carolina v. Variable Annuity Life
    Insurance Co., 513 U.S. 251 (1995)* and characterized swaps as a
    financial intermediary activity incidental to a bank's express power
    to engage in deposit and lending activities under 12 U.S.C. §
    24(Seventh). Upon re-examination, the OCC since has concluded that
    swap and funds intermediation activities are part of the business of
    banking. Letter from Ellen Broadman, Director, Securities and
    Corporate Practices Division, OCC, to Barbara Moheit, Regional
    Counsel, FDIC (October 29, 1998) (unpublished).

[^6]: OCC Bank Derivatives Report, Second Quarter (2000).

[^7]: *See* OCC Interpretive Letter No. 935 (May 14, 2002) and OCC
    Interpretive Letter No. 892 (September 13, 2000).

[^8]: As detailed further in the Comptroller's Handbook, *Risk
    Management of Financial Derivatives*, (January 1997) and OCC Banking
    Circular 277 (October 27, 1993), an effective risk management
    process will include board of directors supervision, managerial and
    staff expertise, comprehensive policies and operating procedures,
    risk identification, measurement and management information systems,
    as well as effective risk control functions that oversee and ensure
    the continuing appropriateness of the risk management process.

[^9]: See OCC Interpretive Letter No. 892 *supra*.

[^10]: OCC Interpretive Letter No. 935 *supra*. A cross-hedge is based
    on the premise that, although certain securities are not the same,
    the securities are similar and their price movements strongly
    correlate.