Comments on “The Regulation of Futures and Forward Trading by Depository Institutions:

A Legal and Economic Analysis” Owen Carney

agree with many of Frank Edwards’ conclusions, although not always for the I same arguments Frank puts forth. We share his concerns about realistic regula- tion of these markets and acknowledge that this is a complex task.

It is refreshing and somewhat disconcerting to have someone conclude we may have taken too liberal a regulatory stance on any issue. Are we too liberal in the futures area? Not many bankers or futures commission merchants share that view. Frank Edwards may be right; time will tell. To date our track record in regulating the most troublesome aspects of the forward market is better than I expected and better than the track record of some of our fellow regulators.

The Comptroller of the Currency is a regulator; regulation is our primary business. We have no vested interest in the futures or cash market. Our concerns are directed to the solvency and liquidity of individual banks and the system as a whole. Traditionally we have pursued a preventive style of regulation; i.e., we try to prevent problems or identify them while they are still manageable. In keeping with this tradition our approach to the futures market has been cautious.

Our initial approach to bank use of futures involved a legal analysis. Interest rate futures are legally Commodities contracts. The National Bank Act is silent on bank use of commodities. State banking law is generally silent. Court cases are outdated and generally negative.

In the absence of specific authority for a national bank to buy or sell com- modities contracts, our attorneys tell me the legal basis for national bank involve- ment in the financial futures markets is uncertain. However, the section of National Bank Act (the seventh paragraph of 12 USC 24) that lists the expressed powers con- ferred on national banks includes the following language; “all such incidental powers as shall be necessary to carry on the business of banking.” It is clear that one necessary aspect of the business of banking in today’s interest rate environ- ment is the reduction of interest rate exposure. Accordingly the Comptroller’s of- fice has ruled the use of interest rate futures to be incidental to banking provided the actual use of futures relates to legally permissible banking activity. We think bank use of futures is an activity incidental to banking when the contracts are used with the intent of reducing the risk of loss resulting from interest rate fluctuations on appropriate corresponding cash transactions.

Owen Carney is the Director of the Investment Securities Division at the Comptroller of the Currency’s Washington office. He received a B.S. in Finance f r o m Boston College.

The Journal of Futures Markets, Vol. 1, No. 2 , 219-223 (1981) 6 1981 by John Wiley & Sons, Inc. ccc 02:0-7314/81l0202 19-05101 .oo

We are willing to accept most fixed rate cash transactions, actual or anticipated, in assets or liabilities as being appropriate cash transactions to correspond to futures positions.

We accept the notion that most types of normal banking activities are speculative to some degree. We also accept the responsibility to monitor that level of risk in each bank and in the system as a whole. We know futures contracts, like ,almost all types of financial instruments, can be used to reduce or increase risk. Our approach to futures is no different than our approach to other banking activities. If in our Ex- aminer’s judgment a bank’s use of futures limits or lowers risk it is acceptable. If futures use introduces unacceptable risks we will not accept the use of futures.

We are unwilling to accept excessive speculation in futures as an incidental or appropriate banking activity. We are not willing to accept the use of futures when their use substantially increases the overall levels of interest rate risk assumed by an institution. We are unwilling to accept the use of futures as a substitute for pru- dent management.

Actual or anticipated banking transactions which may correspond to futures use include management of:

(1) portfolios of fixed income assets, generally bonds or marketable real es- tate mortgages, (2) asset and liability funding strategies calling for a predetermined blend or balancing of fixed and variable rate assets and source funds, (3) bank dealer department securities inventory management.

An interest rate futures strategy calling for the use of futures in order to reduce the risk of loss which may result from the impact of interest rate fluctuations on corresponding cash transactions sounds like a hedging strategy. We try not to use the word “hedge” in our published policy statements on futures. We are not sure a bank can hedge in the conventional sense with a futures position. In some respects the business of banking is a continuing series of hedges. Money of one maturity is purchased at a certain price and invested for another maiurity at a given yield. The use of futures hedges in this purposeful matching or mismatching of the maturities and interest rate sensitivity characteristics of bank assets and liabilities can be helpful by reducing risks-or harmful by increasing risks. We are not willing to accept the substitution of futures contracts hedges for a prudent banking decision that can be made with available cash market instruments.

We encourage bankers to protect themselves against the potential of financial loss. Banking inherently involves some degree of speculation; we try to discourage bankers from speculating excessively. This is what bank regulation is all about.

Banking risks must be moderate and manageable for banking activity to be ac- ceptable to the regulators, Congress, and the general public. If the assumption of any banking risk must be moderate and manageable, leverage transactions such as futures purchases and sales also must be approached in a moderate fashion and be managed very carefully.

As in all banking activities, we expect to see the initial step toward prudent management of futures activities to begin with written policies endorsed by the bank’s Board of Directors. Policies must be specific enough to outline acceptable futures strategies and relate the strategies to the investment funds management, and securities dealer strategies already used by the bank. One story we are not buying is the old adage about specific written policies limiting the flexibility of

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the traders. If banks cannot operate within the confines of a reasonable specific policy we do not want them buying or selling futures.

Policies must also consider the bankwide impact of various futures strategies. It makes little sense to deem a particular strategy acceptable if, while reducing specific interest rate risks, the strategy introduces additional bankwide risks.

If the risks assumed through the use of futures are to be manageable, essential components to written policies will include personnel authorizations and limits as to the amounts of futures contracts that can be employed in acceptable strategies. Dollar limits must have a reasonable correlation to contemplated strategies. Limits used to moderate risks cannot be developed in a vacuum. We expect to be able to relate the levels of futures contract positions a bank can potentially take to similar amounts of appropriately corresponding cash positions in which a bank becomes involved.

We also expect that personnel authorized to purchase and sell futures contracts will be authorized to purchase and sell contracts only in amounts reasonably cor- responding to their authorities in the cash markets. Limitations must also reflect the ability of the institutions to fulfill their overall commitments.

Because futures undertakings are relatively new to most banks, we are taking particular care to insure that participating banks’ operational and control systems are equal to the task. We are directing each national bank wishing to buy or sell futures contracts to develop detailed work processing and management reporting systems.

Operational systems must be designed to process and record each transaction ac- curately. Record-keeping systems must provide audit trails and be sufficiently detailed to permit internal auditors and bank examiners to determine if the ac- tivities are in conformance with predetermined strategies and limitations. Needless to say, all futures record-keeping systems are to be maintained on a trade date or committed basis.

In the case of futures positions used to reduce the risk in assethiability funding strategies, we expect to see the strategies supported with interest rate and balance sheet projections and detailed AssetlLiability Management Committee minutes outlining strategies.

Management reports must concentrate on reporting of outstanding positions and profits and losses on a gross basis and, in the case of measurable hedge situa- tion, on a net basis.

Operational internal controls must include the following basics: (i) Comparison of incoming confirmations and margin disbursements must

be made by someone totally independent of the purchase and sale func- tion.

(ii) Statement reconcilement and records posting duties should be rotated on a regular basis.

(iii) Corporate resolutions indicating personnel authorizations and trade limits should be filed with commodities dealers transacting business with the bank. These agreements should specify details concerning confirma- tion, statement, and margin run mailings.

(iv) Numerical accountability for the forms used to process futures transac- tions should be maintained, i.e., prenumbered forms, periodically recon- ciled.

(v) Audit programs should be designed before futures trading begins. Train-

COMMENTS O N LEGAL AND ECONOMIC ANALYSIS OF REGULATION /221

ing in futures use and strategies should be a part of any audit program to control the use of futures.

I mentioned earlier that we rely heavily on examiner judgment in making a deter- mination about the acceptability of the futures uses by an individual bank. We are concerned about the ability of our examiners to make this judgment, so we are doing extensive training in the area. We are not completely satisfied that our examiners are capable of making this judgment. Accordingly, we require each na- tional bank wishing to engage in futures or forward contract activities to file a state- ment with our regional offices. This filing includes a statement of the bank’s objec- tives, detailed strategies (including dollar limits for each strategy) managerial and control policies, written operating procedures, and audit programs.

Since 1976 we have reviewed approximately 80 bank filings concerning futures activities. Many of the filings did not gain approval in the first submission. The most consistent problems encountered involved a lack of coordination within the applicant bank. The rejected filings were most frequently prepared by securities traders who by all appearances had not bothered to consult with their bank’s auditors, accountants, systems managers, or control department personnel.

Our finding through the filings review and examination processes have re- vealed no real surprises. Certain banks have a lot to learn about futures. Most commodities sales representatives have a lot to learn about banking.

The adverse results of futures use have been limited to date. Continuous use of short hedges against investment portfolios have resulted in some problem when bank management chooses to take futures income without recognizing the atten- dant increase in portfolio depreciation. We are encouraging banks to use futures short hedge income to offset portfolio losses while they upgrade portfolio yields. We have encountered record-keeping systems which were less than adequate. Banks with inadequate systems have been advised to improve them.

We remain relatively flexible in our approach to the use of interest rate futures. We view futures as simply another tool available to bankers. We think it can be a beneficial tool, if properly managed, or a potential disaster if imprudently used. We do not want to design the type of permissible hedging strategies that unduly restrict bank use of futures. The garden variety hedge requires specific identifica- tion of an asset or liability as an offset to the futures position. We do not think this type of specific hedge is best suited for bank use because this type of hedging will not assure a reduction of bankwide interest rate risk. It may actually increase risk.

Efficient hedging in banks appears to be most closely associated with overall funding techniques, not the traditional specifically identifiable asset or liability hedge. We refer to the balance sheet funding style of hedging as “net-balance- sheet” or “macro” hedging. Net-balance-sheet hedging entails matching (or mismatching) the interest sensitivity characteristics of both sides of the balance sheets so that a net exposure to interest rate risk can be determined. Undesirable mismatches can be identified and, if appropriate, the degree of interest rate risk can be modified by assumption of an offsetting futures position. Unfortunately, accounting techniques have not developed to a point which permits potential bank macro or net-balance-sheet hedgers to contemporaneously realize futures gains or losses and cash market gains or losses. Authoritative accounting literature presently calls for specific identification of a cash asset or liability offsetting a

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futures hedge, without a consideration of the existing cash balance sheet asset or liability offset.

Authoritative accounting literature also permits situations where bank users of futures have the option of taking futures gains in the current period while not recognizing the offsetting cash position loss. Similarly, accounting literature per- mits situations where bank futures users can defer futures gains or losses in the current period.

At best, accounting theory provides for accounting symmetry in contem- poraneous recognition of futures and cash gain and loss, but only if potentially burdensome and unrealistic record-keeping requirements are met. At worst, ac- counting theory permits bank users to take gains immediately and defer losses over time, often extended periods of time. The regulators cannot accept extended- term loss deferrals.

Accounting techniques are still evolving; recent AICPA proposals are getting better, but still have a way to go before they reflect the economic substance of what an efficient bank hedger is attempting to do.

Frank Edwards validly questions a number of traditionally accepted bank ac- counting principals. He has asked the question, “Are accounting principals govern- ing bank participation in the cash or Futures market rational or valid?” The answer to this question is, “Probably not.” We hope accounting standards will continue to move toward a reflection of the economic substance of the transac- tions.

Frank also asks the question, “Can the regulators control, monitor and police bank use of futures?” The answer is yes, with the primary regulatory effort being provided by the self-regulatory user and through traditional market discipline. The secondary regulatory effort and responsibility remains with the financial in- stitution reguiators.

COMMENTS ON LEGAL AND ECONOMIC ANALYSIS OF REGULATION /223