# OCC Interpretive Letter No. 1051: Letter provides confirmation that national bank may purchase and hold below investment grade debt in connection with a comprehensive program to hedge the counterparty credit risk exposure that arises from its derivatives activities. The letter concludes that the bank may engage in the transactions it proposes, where the bank's examiner-in-charge is satisfied that the bank has adequate risk management and measurement systems and controls and does not object to the activity

> Federal · Agency guidance · In force

URL: https://www.frixlaw.com/law-library/statutes/OCC_INT1051

## Section

- **Citation:** OCC Interpretive Letter No. 1051
- **Heading:** Letter provides confirmation that national bank may purchase and hold below investment grade debt in connection with a comprehensive program to hedge the counterparty credit risk exposure that arises from its derivatives activities. The letter concludes that the bank may engage in the transactions it proposes, where the bank's examiner-in-charge is satisfied that the bank has adequate risk management and measurement systems and controls and does not object to the activity
- **Jurisdiction:** Federal
- **Kind:** Agency guidance
- **Status:** In force
- **Text as of:** August 14, 2026
- **Source:** Compiled text
- **Location:** OCC Interpretive Letters / Letter provides confirmation that national bank may purchase and hold below investment grade debt in connection with a comprehensive program to hedge the counterparty credit risk exposure that arises from its derivatives activities. The letter concludes that the bank may engage in the transactions it proposes, where the bank's examiner-in-charge is satisfied that the bank has adequate risk management and measurement systems and controls and does not object to the activity.

## Text

O

Comptroller of the Currency
Administrator of National Banks

Washington, DC 20219

Interpretive Letter #1051
March 2006
February 15, 2006 12 USC 24(7)

Re: [ ] (“Bank”)

Dear [ ]:

The Bank is seeking confirmation that it is permissible for the Bank to enter into contingent
credit default swaps (“C-CDS”) and hold below-investment grade debt to hedge and manage the
counterparty credit risks and liability exposures that arise from its derivatives activities. For the
reasons discussed below, we conclude that the Bank may engage in the hedging and risk
management transactions it proposes, provided the Bank’s examiner-in-charge is satisfied that
the Bank has adequate risk management and measurement systems and controls to conduct the
activities on a safe and sound basis.

Background

The Bank has an active and growing derivatives business. Counterparty credit risk is an
important risk of the derivatives business, and the Bank establishes credit limits to control such
exposures. When a new derivative transaction would create a potential credit exposure beyond
the limit for a client, the Bank may approve the transaction subject to the condition of dynamic
management of the resulting exposure. By dynamically managing the credit exposures of the
incremental derivative transaction, through a series of credit default swap (“CDS”) and bond
transactions, the Bank can manage counterparty credit risk more effectively and maintain
potential credit exposure within approved limits.

The Bank may hedge the price or market risk of an incremental derivative transaction by
executing a similar transaction in the opposite direction with a third party in the market (“Market
nsaction, through a series of credit default swap (“CDS”) and bond
transactions, the Bank can manage counterparty credit risk more effectively and maintain
potential credit exposure within approved limits.

The Bank may hedge the price or market risk of an incremental derivative transaction by
executing a similar transaction in the opposite direction with a third party in the market (“Market

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Risk Hedge”).1 Although this transaction protects the Bank from market risks, the Bank
continues to face credit risk2 if the counterparty defaults and owes payments to the bank. The
Bank also faces a liability risk, i.e., it has the obligation to make a cash payment to the
counterparty if the Bank is out-of-the-money on the derivative when the counterparty defaults.

The Bank proposes to manage the counterparty credit and liability exposures related to a single
OTC derivative contract or a portfolio of OTC derivative contracts in a more cost effective
manner, both before and after downgrades by rating agencies,3 by using CDS and debt
instruments. To implement effectively the dynamic management of the underlying exposures
requires the ability to purchase and sell securities issued by the derivatives counterparty as credit
exposure changes. As a result, the Bank seeks authority to acquire below-investment grade
debt.4 Under the proposed dynamic credit hedging program, the Bank seeks to be economically
indifferent whether the Bank owes or is owed money by a defaulting counterparty.

The Bank first hedges its counterparty credit exposure for the original trade by buying a C-CDS
(“Asset Hedge”). A C-CDS resembles a traditional CDS. Both instruments settle in the same
way. If a credit event occurs, the protection buyer delivers to the protection seller debt issued by
the reference entity with a total face amount equal to a notional amount
y by a defaulting counterparty.

The Bank first hedges its counterparty credit exposure for the original trade by buying a C-CDS
(“Asset Hedge”). A C-CDS resembles a traditional CDS. Both instruments settle in the same
way. If a credit event occurs, the protection buyer delivers to the protection seller debt issued by
the reference entity with a total face amount equal to a notional amount. In return, the protection
seller pays the protection buyer an amount in cash equal to the same notional amount. There is
an important distinction between the two instruments. While the notional amount of a CDS
remains constant over the life of the contract, the notional amount of a C-CDS will change to
reflect the current mark-to-market value of a specified reference derivative. The notional amount
of a C-CDS is fixed only if and when the specified reference entity defaults on its debt
obligations and the reference derivative has positive value for the bank. If the reference entity
does not default on its debt obligations over the life of the C-CDS, then the instrument will
expire at maturity.5

The Asset Hedge protects against the risk that the original trade may be in-the-money to the
Bank when the counterparty defaults and the counterparty is unable to pay at settlement on the

1 Price risk is the risk to earnings or capital arising from changes in the value of traded portfolios of financial
instruments. See Comptroller’s Handbook: Community Bank Supervision (2003) at p. 156.

2 Credit risk is the current and prospective risk to earnings and capital arising from an obligor’s failure to meet the
terms of any contract with the bank or otherwise to perform as agreed. See Comptroller’s Handbook: Community
Bank Supervision (2003), at p. 141.

3 The Bank represents that statistically, in a portfolio of investment grade names, a small percentage will migrate to
below-investment grade status over time as a result of downgrades by the rating agencies
ng from an obligor’s failure to meet the
terms of any contract with the bank or otherwise to perform as agreed. See Comptroller’s Handbook: Community
Bank Supervision (2003), at p. 141.

3 The Bank represents that statistically, in a portfolio of investment grade names, a small percentage will migrate to
below-investment grade status over time as a result of downgrades by the rating agencies. For example, a company
with a BBB rating has more than a 15% chance of becoming below-investment grade over a period of five years. As
a result, the Bank wishes to hedge the credit risk of its counterparty, notwithstanding the counterparty’s below-
investment grade rating, or any subsequent downgrade to below-investment grade.

4 The Bank currently uses CDS, C-CDS, and investment grade bonds to help manage credit and liability risks
arising from derivative transactions.

5 The C-CDS will also not have value to the bank if the reference entity defaults while the reference derivative
transaction has negative value to the bank, i.e., the bank has a negative mark-to-market on the transaction.

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trade. In an Asset Hedge, the Bank purchases credit protection through a C-CDS from a third
party or an affiliate6 where the reference entity is the counterparty to the original trade. If the
reference entity defaults on its debt obligations, and the reference derivative is in-the-money to
the bank, the protection seller pays the Bank cash in an amount equal to the notional amount
(i.e., the in-the-money amount of the reference derivative) of the C-CDS. In return, the Bank
delivers to the protection seller bonds issued by the reference entity with a total face amount
equal to this same notional amount. At the time of the reference entity’s default, the Bank will
need to obtain the requisite amount of bonds to meet this obligation
an amount equal to the notional amount
(i.e., the in-the-money amount of the reference derivative) of the C-CDS. In return, the Bank
delivers to the protection seller bonds issued by the reference entity with a total face amount
equal to this same notional amount. At the time of the reference entity’s default, the Bank will
need to obtain the requisite amount of bonds to meet this obligation. The ability to realize the
value of credit protection on a credit derivative contract requires a protection buyer to purchase
below-investment grade debt securities of an issuer that has had a credit event, such as a
bankruptcy filing. The Bank can recover all or a portion of the cost of the Asset Hedge by
selling credit protection to a third party or an affiliate through another C-CDS (“Liability
Hedge”).

In a Liability Hedge, the Bank manages the risk of owing money to its counterparty on the
original trade by selling credit protection to a third party or an affiliate through a second C-CDS
where the reference entity is the counterparty to the original trade, and the reference derivative is
the Market Risk Hedge. If the reference entity defaults on its debt obligations, and the reference
derivative is in-the-money (i.e., the original client trade is out-of-the-money to the Bank), the
Bank pays the protection buyer cash in an amount equal to the notional amount of this second C-
CDS. In return, the protection buyer delivers to the Bank bonds issued by the reference entity
with a total face amount equal to this same notional amount. Since the Bank is now the current
holder of these bonds, the Bank has a claim against the issuer (which is also the counterparty on
the original derivative) equal to the face amount of the bonds. If the Bank owes on the original
trade at the time of default, the Bank can set-off its claim on the bonds against the amount that
the Bank owes the counterparty under the original trade
nal amount. Since the Bank is now the current
holder of these bonds, the Bank has a claim against the issuer (which is also the counterparty on
the original derivative) equal to the face amount of the bonds. If the Bank owes on the original
trade at the time of default, the Bank can set-off its claim on the bonds against the amount that
the Bank owes the counterparty under the original trade. This set-off can occur with any
counterparty, either investment grade or below-investment grade, under the relevant derivative
contract.7 The Bank represents that purchases and sales of below-investment grade debt are
essential to administering and maintaining effective Liability and Asset Hedges that enable the
Bank to be economically indifferent whether the Bank owes or is owed funds when the
counterparty defaults.

There is a concern that, where a counterparty on the original trade is insolvent at the time of
default, and the Bank does not hold the bonds it receives in the Liability Hedge at least 90 days
before the reference entity’s bankruptcy filing date or insolvency, the Bank may be precluded
under the U.S. Bankruptcy Code from exercising its right to set-off the bonds it received through
the Liability Hedge against amounts the Bank may owe under the original trade. Therefore, to
achieve the economically indifferent position it seeks in structuring these transactions, the Bank
represents that it must purchase the bonds whenever necessary (including when it enters into the
original trade with its counterparty and subsequently). The Bank will periodically adjust its bond

6 The Bank represents that all transactions with affiliates will be consistent with sections 23A and 23B of the Federal
Reserve Act, 12 U.S.C. 371c and 371c-1, and the Federal Reserve Board's Regulation W, 12 CFR part 223.

7 The Bank represents that each of its counterparties on the original derivative trades has previously agreed to the
Bank’s right of set-off in the relevant derivative contract.
ank represents that all transactions with affiliates will be consistent with sections 23A and 23B of the Federal
Reserve Act, 12 U.S.C. 371c and 371c-1, and the Federal Reserve Board's Regulation W, 12 CFR part 223.

7 The Bank represents that each of its counterparties on the original derivative trades has previously agreed to the
Bank’s right of set-off in the relevant derivative contract.

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holdings throughout the life of the original trade to reflect any changes in the Bank’s 90-day
VAR model amount and the mark-to-market of the derivative. While it holds legal title to the
bonds, the Bank will use a total return swap to neutralize the economic risk of holding the bonds.

Discussion

Longstanding OCC precedent establishes that national banks may engage in certain customer-
driven derivative transactions as part of a financial intermediation business, subject to safety and
soundness parameters.8 National banks also may manage risks arising from permissible
derivatives activities as an essential part of the activities. 9 For example, national banks use
credit derivative transactions, including a CDS and C-CDS, to manage credit risks arising from a
permissible derivatives business.10 A C-CDS is identical to a common CDS, except that the
notional amount is variable at inception and becomes fixed only upon the default of a reference
entity, if a specified reference derivative has positive value. These differences do not affect the
ability of a national bank to engage in a C-CDS to manage risks arising from permissible
banking activities
permissible derivatives business.10 A C-CDS is identical to a common CDS, except that the
notional amount is variable at inception and becomes fixed only upon the default of a reference
entity, if a specified reference derivative has positive value. These differences do not affect the
ability of a national bank to engage in a C-CDS to manage risks arising from permissible
banking activities. National banks can engage in a variety of transactions where one (or more) of
the key terms is variable.11 Further, the OCC has specifically permitted national banks to use
below-investment grade debt to hedge the risks arising from bank-permissible derivative
activities.12

A national bank may use derivatives to hedge the risks arising from the gamut of activities that
are reflected on the Bank’s balance sheet and income statement, including holding assets, taking
liabilities, assuming off-balance sheet risks, and hedging the market risk associated with
investment advisory fee income.13 For example, in MII Deposit, the OCC authorized a national
bank to purchase equity index futures to hedge interest rate exposures on deposit accounts with
interest rates tied to movements in the S&P 500 Index.14 The OCC noted that national banks are
permitted and even encouraged to manage prudently the exposures arising from bank activities
and they must be allowed the flexibility to use the most suitable risk management tool. In DPC
Shares, the OCC permitted a national bank to buy and sell options to manage market risks
associated with changes in the value of shares of a company the bank had acquired in satisfaction

8 See 12 U.S.C. 24(Seventh).

9 See OCC Interpretive Letter No. 892 (Sept. 8, 2000).

10 National banks have engaged in credit derivative transactions since at least 1996. See OCC Bulletin 96-43 (Aug.
12, 1996).

11 See, e.g., Decision of the Office of the Comptroller of the Currency on the Request by Chase Manhattan Bank,
N.A
hares of a company the bank had acquired in satisfaction

8 See 12 U.S.C. 24(Seventh).

9 See OCC Interpretive Letter No. 892 (Sept. 8, 2000).

10 National banks have engaged in credit derivative transactions since at least 1996. See OCC Bulletin 96-43 (Aug.
12, 1996).

11 See, e.g., Decision of the Office of the Comptroller of the Currency on the Request by Chase Manhattan Bank,
N.A. to Offer the Chase Market Index Investment Deposit Account (Aug. 8, 1988) (“MII Deposit”), 1988 OCC Ltr.
LEXIS 266 (deposit rates tied to performance of S&P 500 Index).

12 See OCC Interpretive Letter No. 935, (May 14, 2002).

13 See OCC Interpretive Letter No. 1037 (Aug. 9, 2005).

14 MII Deposit, supra.

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of a debt previously contracted.15 The OCC found the hedging strategy helped the bank reduce
credit risk by protecting against fluctuations in the value of the shares. A national bank may use
derivatives to hedge a variety of financial risks, besides price or market risk, that may arise in
connection with permissible banking activities.

The Bank already has authority to use below-investment grade debt as a risk management tool
and it engages in a variety of customer-driven credit derivative transactions, including credit
default swaps.16 The primary difference between the Bank’s current activities and its proposal is
the types of risk that the bank would hedge or manage through the use of use below-investment
grade debt. Here the Bank proposes to manage both credit and liability risks arising from
permissible derivative activities. Banks have long had authority and recognized expertise in
managing credit risk.17 The Bank has designed the Asset and Liability Hedges specifically to
manage both credit exposures and liabilities to counterparties, so that the Bank is economically
neutral to counterparty performance on the derivative transaction
both credit and liability risks arising from
permissible derivative activities. Banks have long had authority and recognized expertise in
managing credit risk.17 The Bank has designed the Asset and Liability Hedges specifically to
manage both credit exposures and liabilities to counterparties, so that the Bank is economically
neutral to counterparty performance on the derivative transaction. The Bank represents that
purchases and sales of below-investment grade debt are essential to administering those hedges
and maintaining their effectiveness. When viewing the Bank’s risk management model as a
whole, the use of below-investment grade debt in the manner proposed is an essential part of that
strategy of managing risks associated with its derivatives business and therefore is permissible.

Safety and Soundness Requirements

For the Bank to engage in the proposed activity, the Bank’s risk management and measurement
capabilities must be of appropriate sophistication to ensure that the activity can be conducted in a
safe and sound manner and in accordance with applicable law. Accordingly, the Bank must
demonstrate to the satisfaction of its examiner-in-charge that the Bank has established an
appropriate risk management and measurement process for the proposed activity. As detailed
further in the OCC Handbook: Risk Management of Financial Derivatives18 and OCC Banking
Circular No. 277,19 an effective risk measurement and management process includes managerial
and staff expertise, comprehensive policies and operating procedures, risk identification and
measurement, and management information systems, as well as an effective risk control function
that oversees and ensures the appropriateness of the risk management process. Moreover, the
Bank should ensure that the reputation and other risks presented by this program are assessed
and reviewed by personnel from appropriate risk management areas within the Bank
ocedures, risk identification and
measurement, and management information systems, as well as an effective risk control function
that oversees and ensures the appropriateness of the risk management process. Moreover, the
Bank should ensure that the reputation and other risks presented by this program are assessed
and reviewed by personnel from appropriate risk management areas within the Bank. We note
that the Bank’s proposed risk management activities raise unique reputation risk issues because
the Bank may use below investment grade debt instruments, with market values below par, to
offset payments that the Bank would otherwise owe to the counterparty. The Bank’s risk

15 See OCC Interpretive Letter No. 961 (Mar. 17, 2003) (“DPC Shares”).

16 See OCC Interpretive Letter No. 935, supra.

17 See, e.g., OCC Interpretive Letter No. 1019 (Feb. 10, 2005).

18 OCC Handbook: Risk Management of Financial Derivatives (Jan. 1997).

19 OCC Banking Circular No. 277 (Oct. 27, 1993).

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management systems should include appropriate controls and disclosures to manage those
reputation risks.

The Bank may not commence the proposed activities unless and until its examiner-in-charge has
expressed no supervisory objection based on these criteria.

Conclusion

We conclude that the Bank may engage in the transactions it proposes, provided the Bank’s
examiner-in-charge is satisfied that the Bank has adequate risk management and measurement
systems and controls to conduct the activities on a safe and sound basis. The OCC views
expressed in this letter are based specifically on the Bank’s representations and written
submissions describing the facts and circumstances of the Bank’s proposed hedging and risk
management transactions. Any change in the facts or circumstances could result in different
conclusions. If you have any questions concerning this letter, please contact Donald N. Lamson,
Assistant Director, Securities and Corporate Practices Division, at (202) 874-5210
nk’s representations and written
submissions describing the facts and circumstances of the Bank’s proposed hedging and risk
management transactions. Any change in the facts or circumstances could result in different
conclusions. If you have any questions concerning this letter, please contact Donald N. Lamson,
Assistant Director, Securities and Corporate Practices Division, at (202) 874-5210.

Sincerely,

signed

Julie L. Williams
First Senior Deputy Comptroller and Chief Counsel

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