OCC 96-43
OCC Bulletin

Subject:      Credit Derivatives
Description:  Guidelines for National Banks

Date:         August 12, 1996
         
TO:  Chief Executive Officers of all National Banks, Department
     and Division Heads, and all Examining Personnel

PURPOSE

This bulletin informs bankers of a new set of derivative products
and provides initial guidance on supervisory issues related to
bank participation in the developing market for credit
derivatives.  The guidance is principally intended for end-user
banks, rather than dealers, unless otherwise indicated.

BACKGROUND

Credit derivatives are new financial instruments marketed as an
efficient way to manage credit exposure.   Credit derivatives
permit the transfer of credit exposure between parties -- i.e.,
the buyer and seller of the credit protection -- in isolation
from other forms of risk.  These derivatives represent a natural
extension of the market for similar products that "unbundle"
risks, such as certain interest rate and foreign exchange
products.

When used properly, credit derivatives can help to diversify
credit risk, improve earnings, and lower the risk profile of an
institution.  Conversely, the improper use of credit derivatives,
similar to poor lending practices, can result in an imprudent
credit risk profile.  Although the current volume of credit
derivative activity in U.S. banks is quite small and mainly
limited to dealers, many banks have begun to evaluate these
products as tools for credit risk management.

With a credit derivative, a bank can both acquire and hedge risk.
When a bank acquires risk, it takes on a credit exposure.  Unlike
traditional loan assets, most credit derivatives, except for
credit-linked notes (discussed below), are off-balance-sheet
contracts.  The risk acquiror (i.e., seller of credit protection)
may have several reasons for assuming the risk of a specific
reference credit.  For example, the protection seller may be
underloaned, and would like to take carefully targeted credit
risk in order to improve earnings, while also diversifying credit
risk by assuming a risk position that has a low correlation with
existing portfolio risks.

When a bank hedges risk, it transfers a credit exposure, but not
the asset itself, to a counterparty who agrees to make a payment
under certain conditions.  Thus, the buyer of credit protection
can hedge an existing exposure, much as the bank can with a loan
participation.  With a credit derivative, however, the asset
remains on the bank's books.  Because the exposure, but not the
asset itself, is sold, credit derivatives can assist banks in
managing internal limits, while avoiding customer relationship
problems that can arise if the bank sells the asset.

There are three principal types of credit derivatives: credit
default swaps, total rate of return (TROR) swaps, and credit-
linked notes.  Credit default swaps and TROR swaps are off-
balance-sheet transactions.  Credit-linked notes are credit-
sensitive, cash-market structured notes that appear on the
balance sheet like any other security.  While these three
vehicles are currently the predominant types of credit derivative
transactions, the OCC expects that many variations, as well as
new product types, will develop.

Credit default swaps are similar to standby letters of credit.
The risk hedger (i.e., buyer of credit protection) pays a fee,
which effectively represents an option premium, in return for the
right to receive a conditional payment if a specified "reference
credit" defaults.  A reference credit is simply the party whose
credit performance will determine credit derivative cash flows.
Typically, the reference credit has a borrowing relationship with
the bank that is buying credit protection.   The bank may
diversify its portfolio by reducing its exposure to the borrower,
and the swap enables it to do so without disturbing its
relationship with the customer.  The methods used to determine
the amount of the payment that would be triggered by the default
vary by instrument.  In some contracts, the amount of the payment
is agreed upon at the inception of the contract.  In others, the
amount paid is determined after the default event and is based
upon the observed prices of similar debt obligations of the
borrower in the corporate bond market.  A default event typically
must exceed a materiality threshold in order to trigger a payment
under the swap contract.

A TROR swap transfers the total economic performance of a
reference asset (or index), which includes all associated cash
flows, as well as capital appreciation or depreciation.  The
total return payer pays the total rate of return on a reference
asset, which includes contractual payments plus any price
appreciation, in return for a floating rate plus any depreciation
on the reference asset.   The total return payer has hedged its
credit risk, while the  total return receiver has accepted credit
risk.  If the reference asset depreciates, the total return payer
will receive the depreciation amount from its counterparty.
Although the hedger has transferred the risk of the asset, it
does not transfer the asset itself.  It retains the customer
relationship and must continue to fund the earning asset.  TROR
swaps may, but need not, terminate upon a default event.

A credit-linked note is an on-balance-sheet, cash-market
structured note often issued by a special purpose trust vehicle.
The note represents a synthetic corporate bond or loan, because a
credit derivative (credit default or TROR swap) is embedded in
the structure.  Depending upon the performance of a specified
reference credit, and the type of derivative embedded in the
note, the note may not be redeemable at par value.  These notes
are similar to variable principal redemption (VPR) bonds
referenced in Advisory Letter 94-2, "Purchases of Structured
Notes."  The primary difference is that credit-linked notes have
principal (par value) at risk depending upon the credit
performance of a reference credit, whereas VPR bonds have
principal at risk based upon changes in financial market rates.
For example, the purchaser of a credit-linked note with an
embedded default swap may receive only 60 percent of the original
par value if a reference credit defaults.  Investors in credit-
linked notes assume credit risk of both the reference credit and
the underlying collateral.  The trust is generally collateralized
with high-quality assets to assure payment of contractual amounts
due.  Like other structured notes, credit-linked notes allow an
investor to take a customized investment view.  Credit-linked
notes may contain leverage that can magnify the risk and return
of the asset.

When properly used, credit derivatives, like other financial
derivatives, can provide national banks with substantial
benefits.   Most significantly, credit derivatives can allow
banks to reduce concentration risks.  For example, using a credit
default swap, a bank may hedge a concentration risk by purchasing
credit protection against a specific borrower's default.  A bank
can hedge against credit deterioration of a specific asset, short
of an actual default, by paying the total return on a TROR swap.
Alternatively, banks can adjust their credit profile by
purchasing credit protection (i.e., hedging risk) against
borrowers in an industry where an undesired exposure exists and
selling protection (i.e., acquiring risk) in another industry.
Portfolio management techniques can allow banks to increase the
return on a portfolio, for a given level of risk, by structuring
the portfolio to diversify credit exposures.  To effectively
diversify credit exposures, however, banks should understand how
their asset risks are correlated.  For example, if a fall in
commodity prices will affect land prices, credit portfolios
exposed to both commodity and land prices will typically have
greater risks than portfolios without such correlated credit
exposures.  Using credit derivatives to manage the risk/return
trade-off in a portfolio is an appropriate use of these products.

Banking Circular 277 (Risk Management of Financial Derivatives)
used the term "interconnection risk" to describe "cross-risk"
effects within a portfolio, such as when interest rate and credit
risks of assets in a portfolio are inter-related.  For example,
an increase in interest rates, which lowers the value of a bank's
fixed income assets, can also increase the default likelihood of
borrowers in rate-sensitive industries.  A change in a foreign
currency exchange rate, which might increase a bank's foreign
exchange risk, will likely affect the creditworthiness of a
bank's domestic loan customer that has significant operations in
that foreign country.  Given that a bank has properly identified
the risk dimensions within its portfolio, credit derivatives
represent products that banks can use to manage such risks more
precisely.

SUPERVISORY POLICY

Banking Circular 277 provides guidance for financial derivatives
activities, and is equally appropriate for users of credit
derivatives.  Proper control over derivatives activities begins
with effective senior management and board oversight.  The
oversight process includes sound policies and procedures to
govern the use of derivatives, systems to identify, measure,
monitor, and control risks, and independent oversight systems,
such as audit coverage, to identify deficiencies in internal
controls or systems.

While credit derivatives offer banks the potential to improve the
risk/return profile of their credit portfolios through asset
diversification, these products are new and largely untested.
Valuation methods for transactions are not as analytically
developed as they are for other financial derivatives.  Capital
requirements and accounting standards are not yet definitive, and
clarity on these issues will almost certainly lag advances in
product development.   In light of these uncertainties, before
participating, banks interested in using credit derivatives
should use proper care and due diligence.

Much of the benefit credit derivatives can provide in
diversifying portfolio risks depends upon a thorough
understanding of the portfolio's existing risk profile,
particularly credit concentrations.  Prior to substantial
participation in the market for credit derivatives, protection
selling banks should thoroughly evaluate their credit portfolios,
identifying credit concentrations and risk inter-connections, in
order to assess how these products can best help to achieve
strategic portfolio objectives.

National banks should subject credit derivatives, as they would
any new product, to a uniform product assessment process to
ensure that all significant risks have been addressed in the face
of changing markets, organizational structure, systems, policies,
and procedures.  This process should generally include, as
appropriate, a description of the risk management processes,
limits and exception approval processes, legal documentation
approvals, capital allocations, and accounting procedures.  Also,
systems support and operational capacity should be able to
adequately accommodate the types of credit derivatives activities
in which the bank engages.  Further guidance on the uniform
assessment process is contained in the "Risk Management of
Financial Derivatives" booklet of the Comptroller's Handbook.

RISKS ASSOCIATED WITH CREDIT DERIVATIVES

In discussing risk with bankers, the OCC's examiners assess
banking risk relative to its impact on capital and earnings.
From a supervisory perspective, risk is the potential that
events, expected or unanticipated, may have an adverse impact on
the bank's capital or earnings. The OCC has defined nine
categories of risk for bank supervision purposes.  These risks
are: credit, interest rate, liquidity, price, foreign exchange,
transaction, compliance, strategic, and reputation.  These
categories are not mutually exclusive; any product or service may
expose the bank to multiple risks.  For analysis and discussion
purposes, however, the OCC identifies and assesses the risks
separately.

For end-users, the risks associated with credit derivatives are
credit, transaction, liquidity, compliance and strategic.  For
dealers in credit derivatives, the risk spectrum also includes
price and reputation risks.  The definitions of these risks are
summarized below.  For complete definitions, see the "Bank
Supervision Process" booklet of the Comptroller's Handbook.  The
following paragraphs contain a discussion of how credit
derivatives entail these risks.

Credit Risk

Credit risk is the risk to earnings or capital arising from an
obligor's, or counterparty's, failure to meet the terms of any
contract with the bank or to perform otherwise as agreed.  All
credit derivative transactions expose a bank to credit risk.  The
credit quality of both the reference asset and the derivative
contract counterparty (if a bank is buying protection) are the
principal determinants of credit risk.  Even though these
instruments are referred to as credit derivatives, some forms are
the functional equivalents of letters of credit or options.

Counterparty credit risk should be strictly controlled through a
formal and independent credit process.  The credit department
should periodically review the creditworthiness of both
derivatives counterparties and reference credits, assign risk
ratings to them and adjust credit reserves.  Nonperforming
contracts should be treated consistently with the bank's internal
policy for nonperforming loans, and credit policies should
address collateral requirements.

For the seller of credit protection (risk acquiror), the primary
credit risk is to a reference credit, because the contract
typically requires a payment from one party to the second when
the credit quality of a reference credit has deteriorated.  Thus,
a bank that provides credit protection to a counterparty through
a credit derivative is principally exposed to the credit risk of
the reference asset, as though that reference asset itself were
on the bank's balance sheet.  The credit risk borne by the
provider of credit protection should generally be measured as an
exposure to the reference asset, rather than as an exposure to
the contract counterparty.  For TROR swaps, however, the
protection seller (TROR receiver) receives appreciation from its
counterparty.  Therefore, in these transactions, the protection
seller incurs credit risk for both the reference credit, and to a
lesser extent, the counterparty.

For the purchaser of credit protection, the credit risk is
exposure to the contract's counterparty.  The protection
purchaser is exposed to the credit risk associated with the
failure of its counterparty (i.e., the "guarantor") to fulfill
its obligation.  This counterparty credit risk is similar to that
of other derivative contracts, such as swaps, forwards, and
options.   To suffer a loss when purchasing credit protection,
the reference credit and the counterparty provider both would
have to default on their obligations.  For this reason, banks
that buy credit protection on a specified reference credit should
generally solicit counterparties whose creditworthiness has a low
default correlation (i.e., not closely related) with that of the
reference credit.

Before entering into a credit derivative transaction as the buyer
of protection, a bank should evaluate the financial condition of
the provider of the credit protection.  While the contract is in
place, the buyer should continually monitor the condition of this
counterparty.  As with lending, the depth and frequency of the
analysis of the counterparty should be a function of the
potential size of the credit exposure.

Likewise, before entering into a credit derivative transaction as
a seller of protection, a bank should conduct a complete credit
review of the reference asset and, as necessary, the
counterparty.  That review should be similar to the process of
granting a loan or providing a letter of credit.

Default swaps pose many of the same credit risk management issues
as loans.  Depending upon contract terms, protection sellers
often have the choice of making a payment (given a default of the
reference credit) equal to the decline in value of the reference
asset, or acquiring the asset at the notional contract amount and
working it out.  When developing credit policies and procedures
for these derivative structures, management should specifically
address information disclosures and post-default strategies,
considering the impact on relationships, liquidity, and legal
standing.

Transaction Risk

Transaction risk is the risk to earnings or capital arising from
problems with service or product delivery.  Such problems with
credit derivatives often arise when a bank does not fully
understand or implement the transaction.  Bank management should
fully understand how the product works and the variables that
determine its performance.

Unlike most other credit enhancements, such as letters of credit,
the degree of credit risk transference in a credit derivative
depends on the design of the product.  One credit derivative can,
by design, transfer a much higher proportion of the credit risk
than another.  For example, some credit derivatives pay a
protection-buyer only when a previously defined default or
downgrade occurs.  Other derivatives might make a payment only
for the loss in value beyond a threshold.  Some derivatives might
specify a reference asset that is similar, but not identical, to
an asset the bank owns.  Thus, a protection-buying bank should
carefully consider the degree of correlation between the owned
asset and the reference asset specified in the credit derivative.
Finally, a credit derivative may provide protection against loss
on loans to the reference credit for a period of time that is
less than the remaining maturity of the loan or security.

When evaluating credit derivative transactions, banks should
carefully assess the costs and benefits of each transaction.
Protection-buying banks need to consider the effect of any
feature that would alter the amount of credit protection provided
by the contract.  Likewise, as a provider of credit protection,
banks should consider how various contract features affect the
credit risk it is taking on and the compensation it receives for
doing so.

Liquidity Risk

Liquidity risk is the risk to earnings or capital arising from a
bank's inability to meet its obligations when they come due.  End-
users typically measure liquidity risks by evaluating cash
flow/funding risks.  Dealers measure liquidity risks by
considering both funding risks and individual product liquidity
risks.

Cash flow risks depend upon the bank's role in a transaction.
Much like other financial derivatives, most credit derivatives
allow a bank to accept an exposure without incurring an on-
balance-sheet funding requirement.  As a protection seller, a
bank can create an off-balance-sheet exposure similar to, though
generally with considerably less cash flow requirements than, a
standby letter of credit.  Upon default of a reference credit,
the protection seller must make a payment.  The protection buyer
hedges the on-balance-sheet credit exposure but retains the
obligation to fund the asset.

Dealers measure product liquidity risks by the size of the
bid/ask spread.  As with most new product types where transaction
liquidity is limited, credit derivatives can have higher bid/ask
spreads, which increase transaction costs.  Dealers need to
assess product liquidity risks and evaluate the need for close-
out reserves.   End-users should recognize that limited market
depth can make it difficult to offset their positions prior to
contract maturity.

National banks participating in credit derivatives markets should
incorporate the impact of these activities on their cash flows
into regular liquidity planning and monitoring systems.  For both
dealers and end-users, cash flow projections should incorporate
all significant sources and uses of cash and collateral.  The
bank's contingency funding plan should address the impact of any
early termination agreements or collateral/margin arrangements,
as well as any unique issues associated with credit derivatives.

Compliance Risk

Compliance risk is the risk to earnings or capital arising from
violations of, or non-conformance with, laws, rules, regulations,
prescribed practices, or ethical standards.  Such failures could
adversely affect a bank's success in the market for credit
derivatives and could lessen its overall financial condition.
Because credit derivative instruments are new and evolving, there
are uncertainties about certain legal issues, the appropriate
regulatory capital and reporting treatment, as well as other
regulatory issues.

The OCC expects that U.S. bank and thrift supervisory agencies,
as well as banking supervisors internationally, will continue to
evaluate the market and discuss the supervisory treatment of
these products.  Therefore, over time, national banks should
expect revised or more detailed guidance regarding credit
derivatives.

Before engaging in credit derivatives transactions a national
bank should reasonably satisfy itself that it and its
counterparties have the legal and necessary regulatory authority
to engage in the transactions.  In addition, national banks
engaging in credit derivative transactions should closely
evaluate the legal documentation underlying the transactions.
They should ensure that the transactions comply with applicable
laws.

Participants are encouraged to use standardized documents as they
become available.  Currently, however, because the market is new,
the standardized documentation that generally exists for other
financial derivatives may not be present for credit derivatives.
Two dealers offering identical transactions may document them in
different ways, and the methods used to determine cash flows may
also differ.  For default swaps and credit-linked notes with
embedded default swaps, the definition of a default and the
determination of the payout following default are major issues to
evaluate.  End-user national banks should have legal counsel
review credit derivative contracts, including credit-linked notes
for an investment portfolio, before execution.  These steps
should ensure that the terms of the contracts are well understood
and that the contracts are legally sound.  Moreover, bank
management should establish procedures to ensure that the
contract's terms are consistent with the desired risk profile.
Dealers should have legal counsel review documentation, prior to
transaction execution, for non-standard or complex transactions.

Price Risk

Price risk is the risk to earnings or capital arising from
changes in the value of portfolios of financial instruments.  In
the market for credit derivatives, some banks will participate as
end-users, while others will act as dealers who will both buy and
sell credit protection on the same (or similar) underlying
reference assets.  The OCC expects dealer banks to have sound
policies, procedures, and systems to ensure that exposures are
measured in a timely fashion and are within board-approved risk
limits.  As with other financial derivatives, the dealer's risk
measurement system should include stress testing to evaluate the
bank's exposure in a highly stressed market scenario.

The absence of historical data on defaults, and on correlations
between default events, complicates the precise measurement of
risk and makes the contingent exposures of credit derivatives
difficult to forecast and fully hedge.  In default swaps, the
sellers of credit protection will likely make infrequent
payments.  However, when they are required to do so, those
payments can be large.  Also, because of the limited liquidity
due to the absence of a deep dealer market, bank dealers may find
it difficult to price transactions and to hedge cash flow
exposures on a timely basis.   As a result, dealer banks may find
themselves more vulnerable to high volatilities of anticipated
cash flows than with other financial derivative products.  When
evaluating credit derivatives as a line of business, and
particularly when establishing risk limits, national bank dealers
should carefully consider the differences in the potential
liquidity characteristics of credit derivatives compared to other
more familiar derivatives, such as interest rate and foreign
exchange swaps and forwards.

Strategic Risk

Strategic risk is the risk to earnings or capital arising from
adverse business decisions or improper implementation of those
decisions.  National banks that plan to enter the market for
credit derivatives should ensure that the activity is consistent
with the overall business strategies and credit risk appetite
that have been approved by the board.  The decision to use credit
derivatives to manage risk in credit portfolios, much as the
decision to use financial derivatives to manage interest rate and
price risks, represents a strategic management decision.  To
achieve the significant benefits that credit derivatives can
provide, many end-users will find it necessary to merge the
talents of both credit and treasury (as well as trading) risk
management personnel.  Historically, these areas have been
separated within most banks.

Reputation Risk

Reputation risk is the risk to earnings or capital arising from
negative public opinion.  This affects the bank's ability to
establish new relationships or services, or to maintain existing
ones.  Because credit derivatives are new and take many different
forms, the OCC is concerned that dealer banks may enter into
transactions with counterparties that do not fully understand the
terms and risks of the transactions.  These risks could expose
the bank to litigation, financial loss, or damage to its
reputation.
Credit derivatives with leveraged payoff profiles pose particular
reputation risks.   Examples include binary default swaps, which
require the protection seller to make a fixed payment upon
default, without regard to any recovery on the reference asset,
and certain credit-linked notes. Before recommending leveraged
credit derivative products, national bank dealers should have
rigorous policies and procedures in place to ensure that
transactions are appropriate, that the counterparty will be able
to fulfill its obligations under the terms of the contract, and
that the transaction will not undermine longstanding customer
relationships.

ACCOUNTING CONSIDERATIONS

Consistent with the FFIEC's decision to follow generally accepted
accounting principles (GAAP) beginning with the March 1997 call
reports, national banks should follow GAAP for regulatory
reporting purposes.  Currently, however, there is no
authoritative guidance under GAAP that covers credit derivatives.
Accordingly, as part of the new product approval process,
national banks should consult with qualified independent
accountants to determine the accounting effects of credit
derivative transactions and to develop appropriate accounting
policies.

RISK-BASED CAPITAL AND REGULATORY REPORTING

Bank management must ensure that credit derivatives are
incorporated into their risk-based capital (RBC) computation.
Over the near-term, the RBC treatment of a credit derivative will
be determined on a case-by-case basis through a review of the
specific characteristics of the transaction.  For example, banks
should note that some forms of credit derivatives are
functionally equivalent to standby letters of credit or similar
types of financial enhancements.  However, other forms might be
treated like interest rate, equity, or other commodity
derivatives, which have a different RBC requirement.  As the
market for credit derivatives expands, the OCC will provide
additional guidance on the appropriate regulatory capital
treatment.

ORIGINATING OFFICE

For further information about this bulletin, contact the Office
of the Chief National Bank Examiner (202) 874-5070 or the
Treasury and Market Risk Division (202) 874-5670.

__________________________              __________________________  
Michael L. Brosnan                      Jimmy F. Barton
Acting Senior Deputy Comptroller        Chief National Bank
Examiner for Capital Markets