Credit Derivatives: Guidelines for National Banks

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) 649-6370.

Michael L. Brosnan
Acting Senior Deputy Comptroller for Capital Markets

Jimmy F. Barton
Chief National Bank Examiner