Financial Management Policies; Financial Derivatives

SUMMARY: The Office of Thrift Supervision (OTS) is issuing a final rule

on financial derivatives. The final rule permits savings associations

to engage in transactions involving financial derivatives to the extent

that these transactions are authorized under applicable law and are

otherwise safe and sound. In addition, the final rule describes the

responsibilities of a savings association's board of directors and

management with respect to financial derivatives. Elsewhere in today's

Federal Register, OTS is publishing a Thrift Bulletin that provides

supplemental supervisory guidance on the use of financial derivatives.

EFFECTIVE DATE: This final rule is effective January 1, 1999. OTS will

not object if an institution wishes to apply this final rule beginning

December 1, 1998.

FOR FURTHER INFORMATION CONTACT: Anthony G. Cornyn, Director of Risk

Management, (202/906-5727), Ed Irmler, Senior Project Manager, (202/

906-5730), Jonathan D. Jones, Senior Economist (202/906-5729), Risk

Management; or Vern McKinley, Senior Attorney (202/906-6241),

Regulations and Legislation Division, Office of the Chief Counsel,

Office of Thrift Supervision, 1700 G Street, N.W., Washington, DC

20552.

SUPPLEMENTARY INFORMATION:

I. Background

OTS's current regulations on financial derivatives were first

adopted over fifteen years ago.1 These regulations have

remained virtually unchanged, notwithstanding the development of new

financial derivative instruments. On April 23, 1998, OTS proposed a

comprehensive revision of these outmoded regulations.2

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\1\ 44 FR 29870 (May 23, 1979) (Forward commitments); 46 FR

36832 (July 16, 1981) (Futures transactions); 47 FR 36625 (August

23, 1982) (Financial options).

\2\ 63 FR 20252 (April 23, 1998).

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One of the goals of the proposed rule was to address the broad

range of financial derivative transactions in which thrifts may

currently engage. The current regulations address three types of

financial derivatives: forward commitments, futures transactions and

financial options transactions. See 12 CFR 563.173, 563.174 and

563.175. The current rules, thus, do not address all of the derivative

instruments that have been developed over the past twenty years.

Significantly, these rules do not address interest rate swaps, a

derivative instrument that thrifts commonly use to address interest

rate risk.

The overriding goal of the proposed rule, however, was to ensure

the safe and sound management of the risks associated with financial

derivatives. Accordingly, the proposed regulation emphasized that

derivatives activities must be conducted in a safe and sound manner,

and set forth the responsibilities of the board of directors and

management with respect to financial derivatives.

The proposed rule was also intended to reduce regulatory burden

consistent with statutory requirements for safe and sound operations.

Accordingly, OTS proposed to delete regulatory requirements that were

no longer considered to be essential for safety and soundness,

redrafted other requirements as guidance, and revised the remaining

existing requirements as broader and more flexible regulatory

requirements for all types of financial derivative transactions. OTS's

proposed approach, which relied more on guidance than detailed

regulations, more closely resembled the bank regulatory agencies'

approach with regard to banks' use of financial

derivatives.3

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\3\ See e.g., OCC Banking Circular 277 (October 27, 1993).

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At the same time it issued the proposed rule, OTS proposed

comprehensive guidance regarding savings associations' risk management

practices, including those pertaining to derivatives

transactions.4 Proposed Thrift Bulletin 13a (TB 13a)

(``Management of Interest Rate Risk, Investment Securities, and

Derivatives Activities'') included specific guidance on how thrifts

should implement the Federal Financial Institutions Examination

Council's ``Supervisory Policy Statement on Investment Securities and

End-User Derivatives Activities'' (FFIEC policy statement).5

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\4\ 63 FR 20257 (April 23, 1998).

\5\ 63 FR 20191 (April 23, 1998). The FFIEC policy statement

provides general guidance on sound practices for managing the risks

of investment securities and derivatives activities.

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II. Summary of Public Comments

The public comment period on the proposed rule and the proposed

thrift bulletin closed on June 22, 1998. One commenter, a savings

association, filed a comment supporting the proposed rule.

The OTS received twenty-seven comments on proposed TB 13a. The

substance of these comments is addressed in connection with the related

TB 13a. Some of the commenters also addressed issues related to the

proposed rule.

Several commenters suggested that the proposed thrift bulletin and

the proposed regulation on financial derivatives should be finalized

simultaneously. The OTS believes that TB 13a provides important and

necessary guidance on the management of interest rate risk, investment

securities and derivatives activities. Accordingly, it has made this

guidance effective on the date of publication in the Federal Register.

Subject to certain exceptions, however, 12 U.S.C. 4802(b) provides that

new regulations and amendments to regulations prescribed by a Federal

banking agency which impose additional reporting, disclosures, or other

new requirements on an insured depository institution shall take effect

on the first day of a calendar quarter which begins on or after the

date on which the regulations are published in final form. Section

4802(b) also permits persons who are subject to such regulations to

comply with the regulation before its effective date. Accordingly, OTS

will not object if an institution wishes to apply the provisions of

this final rule beginning with the date it is published in the Federal

Register.

One commenter, a law firm representing numerous savings

associations, noted that the proposed rule text would incorporate TB

13a in several places. Proposed Sec. 563.172(c)(2), for example, states

that the savings association's board of directors should review TB 13a

and other applicable agency guidance on establishing a sound risk

management program. Similarly, proposed Sec. 563.172(d)(2) states that

management should review the thrift bulletin and other applicable

agency guidance on implementing a sound risk management program. The

commenter also noted that OTS sought public comment on TB 13a, a

procedural step that it does not generally follow for thrift bulletins.

The commenter asked OTS to clarify whether the cross-references in the

rule text and the procedures followed in promulgating the thrift

bulletin were intended to change the legal status of guidance in the

bulletin.

The inclusion of cross-references to TB 13a and other agency

guidance in

[[Page 66349]]

the rule text merely serves as a reference point to the board of

directors and management in establishing and implementing written

policy and procedures on financial derivatives. As such, the cross-

references to TB 13a only provide guidance on how financial derivatives

activities may be conducted in a safe and sound manner.6

They do not alter the legal status of the guidance contained in the

bulletin. Similarly, publication of TB 13a for public comment does not

change its legal status as a thrift bulletin. Rather, the bulletin

represents the Agency's best judgment in interpreting regulations and

statutes which it administers. The administrative procedures used

specifically to develop TB 13a were intended to provide OTS with public

comment on all possible aspects of the management of interest rate

risk, investment securities and derivative activities.

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\6\ OTS has incorporated other similar cross-references into its

regulations. See 12 CFR 562.2(b) which cross-references guidance in

OTS bulletins, and examination handbooks.

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One commenter on the Thrift Bulletin urged the OTS to amend its

capital regulations to eliminate the interest rate risk component at 12

CFR 567.7. The agency believes that a review of Sec. 567.7 may have

merit. However, neither the proposed Thrift Bulletin nor the notice of

proposed rulemaking suggested that the OTS was considering any revision

to its capital rules.

In order to get the full benefit of public comment on this issue,

the OTS will shortly initiate a rulemaking that will examine the need

to retain Sec. 567.7 in light of the tools that are currently available

to measure and control interest rate risk.

III. Final Rule

Since no commenter suggested substantive changes to the proposed

rule and OTS has identified no other reasons to modify the text, OTS

has adopted the proposed rule without substantive change. Elsewhere in

today's Federal Register, OTS is also publishing a final TB 13a, which

provides supplemental supervisory guidance on the use of financial

derivatives.

IV. Executive Order 12866

OTS has determined that this final rule does not constitute a

``significant regulatory action'' for the purposes of Executive Order

12866.

V. Regulatory Flexibility Act Analysis

Pursuant to section 605(b) of the Regulatory Flexibility Act, OTS

has determined that this final rule does not have a significant

economic impact on a substantial number of small entities. The final

rule reduces the burden of complying with detailed regulations and

allows for more flexible treatment of derivatives activities for all

institutions, including small institutions.

VI. Paperwork Reduction Act

The recordkeeping requirements contained in this final rule have

been submitted to and approved by the Office of Management and Budget

in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C.

3507(d)) under OMB Control No. 1550-0094. Comments on all aspects of

this information collection should be sent to Office of Management and

Budget, Paperwork Reduction Project (1550), Washington, D.C. 20503 with

copies to the Office of Thrift Supervision, Regulations and Legislation

Division, Chief Counsel's Office, 1700 G Street, NW., Washington, D.C.

20552.

The information collection requirements contained in this rule are

found in 12 CFR 563.172. OTS requires this information for the proper

supervision of interest rate risk for its regulated savings

associations. The likely respondents/recordkeepers are OTS-regulated

savings associations.

Respondents/recordkeepers are not required to respond to the

collections of information unless the collection displaces a current

valid OMB control number.

VII. Unfunded Mandates Reform Act of 1995

Section 202 of the Unfunded Mandates Reform Act of 1995, Pub. L.

104-4 (Unfunded Mandates Act) requires that an agency prepare a

budgetary impact statement before promulgating a rule that includes a

Federal mandate that may result in expenditure by State, local, and

tribal governments, in the aggregate, or by the private sector, of $100

million or more in any one year. If a budgetary impact statement is

required, section 205 of the Unfunded Mandates Act also requires an

agency to identify and consider a reasonable number of regulatory

alternatives before promulgating a rule. As discussed above, this final

rule reduces regulatory burden by eliminating unnecessarily restrictive

regulations. OTS has, therefore, determined that the effect of the

final rule will not result in expenditures by State, local, or tribal

governments or by the private sector of $100 million or more.

Accordingly, OTS has not prepared a budgetary impact statement or

specifically addressed the regulatory alternatives considered.

List of Subjects in 12 CFR Part 563

Accounting, Advertising, Crime, Currency, Investments, Reporting

and recordkeeping requirements, Savings associations, Securities,

Surety bonds.

Accordingly, the Office of Thrift Supervision amends part 563,

chapter V, title 12, Code of Federal Regulations as set forth below:

PART 563--OPERATIONS

1. The authority citation for part 563 continues to read as

follows:

Authority: 12 U.S.C. 375b, 1462, 1462a, 1463, 1464, 1467a, 1468,

1817, 1820, 1828, 3806, 42 U.S.C. 4106.

Secs. 563.173, 563.174, 563.175 [Removed]

2. Sections 563.173, 563.174, and 563.175 are removed.

3. Section 563.172 is added to read as follows:

Sec. 563.172 Financial derivatives.

(a) What is a financial derivative? A financial derivative is a

financial contract whose value depends on the value of one or more

underlying assets, indices, or reference rates. The most common types

of financial derivatives are futures, forward commitments, options, and

swaps. A mortgage derivative security, such as a collateralized

mortgage obligation or a real estate mortgage investment conduit, is

not a financial derivative under this section.

(b) May I engage in transactions involving financial derivatives?

(1) If you are a federal savings association, you may engage in a

transaction involving a financial derivative if you are authorized to

invest in the assets underlying the financial derivative, the

transaction is safe and sound, and you otherwise meet the requirements

in this section.

(2) If you are a state-chartered savings association, you may

engage in a transaction involving a financial derivative if your

charter or applicable state law authorizes you to engage in such

transactions, the transaction is safe and sound, and you otherwise meet

the requirements in this section.

(3) In general, if you engage in a transaction involving a

financial derivative, you should do so to reduce your risk exposure.

(c) What are my board of directors' responsibilities with respect

to financial derivatives? (1) Your board of directors is responsible

for effective oversight of financial derivatives activities.

(2) Before you may engage in any transaction involving a financial

derivative, your board of directors must establish written policies and

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procedures governing authorized financial derivatives. Your board of

directors should review Thrift Bulletin 13a, ``Management of Interest

Rate Risk, Investment Securities, and Derivatives Activities,'' and

other applicable agency guidance on establishing a sound risk

management program.

(3) Your board of directors must periodically review:

(i) Compliance with the policies and procedures established under

paragraph (c)(2) of this section; and

(ii) The adequacy of these policies and procedures to ensure that

they continue to be appropriate to the nature and scope of your

operations and existing market conditions.

(4) Your board of directors must ensure that management establishes

an adequate system of internal controls for transactions involving

financial derivatives.

(d) What are management's responsibilities with respect to

financial derivatives? (1) Management is responsible for daily

oversight and management of financial derivatives activities.

Management must implement the policies and procedures established by

the board of directors and must establish a system of internal

controls. This system of internal controls should, at a minimum,

provide for periodic reporting to the board of directors and

management, segregation of duties, and internal review procedures.

(2) Management must ensure that financial derivatives activities

are conducted in a safe and sound manner and should review Thrift

Bulletin 13a, ``Management of Interest Rate Risk, Investment

Securities, and Derivatives Activities'' (available at the address

listed at Sec. 516.1 of this chapter), and other applicable agency

guidance on implementing a sound risk management program.

(e) What records must I keep on financial derivative transactions?

You must maintain records adequate to demonstrate compliance with this

section and with your board of directors' policies and procedures on

financial derivatives.

Dated: November 20, 1998.

By the Office of Thrift Supervision.

Ellen Seidman,

Director.

[FR Doc. 98-31673 Filed 11-30-98; 8:45 am]

BILLING CODE 6720-01-P