Managing Structured Notes

Article excerpt

Derivatives, and the regulation of these investments, are a hot topic in Washington. Some in Congress want new laws, while the regulators believe that new and improved regulations will suffice. To forestall derivatives legislation, the regulators have released new policies and examination guidelines to help bankers and examiners better understand and manage the risks associated with derivative investments.

Community banks have made significant investments in at least one form of derivatives--structured notes. The FDIC, OCC and Federal Reserve have all published structured-note guidelines that make sense for community bankers. OCC addressed structured notes in a July advisory letter. FDIC sent a supervisory memorandum to banks in September. Most recently, OCC released a 91-page examination handbook on derivatives which includes structured-note guidelines.

The regulatory definitions of structured notes include IANs (indexed adjustable notes), range bonds, deleveraged bonds, inverse floaters and other complex securities in which community bankers typically do not invest. Rather than summarizing all the available information, this month's column will concentrate on those structured notes in which community bankers have invested: multi-step-up callable bonds and dual-index bonds.

Types of Users

The Comptroller's handbook now defines four levels of derivative users: Tier I and Tier II dealer banks, active position-takers (who dynamically manage risks) and limited end-users--those banks that "use derivatives as investment alternatives or to manage interest rate or foreign exchange risk. Limited end-users are characterized by smaller portfolios, less complex products, and lower transaction volumes than active position takers." This definition is important since limited end-users are exempted from many of the more stringent and sophisticated derivatives management requirements.

Limited end-users are expected to have senior management and board understanding and oversight of:

* Policies and procedures.

* New products.

* Risk control.

* Risk measurement.

* Risk versus return.

* Audit coverage.

* Management information systems.

Structured Notes Guidelines

The 91-page OCC handbook, titled "Risk Management of Financial Derivatives," includes good general guidelines for managing all investment risks. The examination procedures for "limited end-users, whose only derivatives exposure is in the form of structured notes," are contained on pages 84 through 91. These 30 exam procedures call for examiners to:

* Assess structured note risks by considering: maturities, stress tests, variable principal redemption, amount of structured notes relative to capital, management's understanding.

* Determine whether the bank's policy allows leveraged or variable principal redemption notes (not generally held by community banks).

* Determine if the bank has established limits for degree of price risk acceptable for structured notes and other investment securities.

* Determine validity of stress tests.

* Determine if the bank gets fair purchase/sale prices.

* Verify accuracy of current market prices.

* Make sure available-for-sale write-downs have been taken.

The FDIC guidelines are also very specific, particularly on stress tests for structured notes. Structured notes with "price volatility greater than 17 percent given a +/-300 basis point interest rate change should be evaluated monthly. Limits regarding the amount of price volatility acceptable for structured notes should be established in the bank's policies. …