[Congressional Record Volume 140, Number 2 (Wednesday, January 26, 1994)]
[House]
[Page H]
From the Congressional Record Online through the Government Printing Office [www.gpo.gov]


[Congressional Record: January 26, 1994]
From the Congressional Record Online via GPO Access [wais.access.gpo.gov]

 
                         DERIVATIVE REGULATIONS

  The SPEAKER pro tempore (Ms. Brown of Florida). Under a previous 
order of the House, the gentleman from Iowa [Mr. Leach] is recognized 
for 60 minutes.
  Mr. LEACH. Madam Speaker, today I am introducing legislation to 
provide an enhanced framework for Federal regulations of derivative 
activities.
  By background, 2 months ago I released a 900-page minority staff 
report on derivatives, concluding with 30 recommendations for 
constraining public risk in the marketplace.
  This report, in effect, complements a private sector report issued by 
the Group of 30 which represents a consensus effort of the most 
respected market participants to establish minimum standards of 
industry self-regulation.
  By further background, my operating assumption is that derivatives 
are the new wild care in international finance.
  There is an American adage: ``I wouldn't do that for all the money in 
the world.'' Interestingly, the multitrillion dollar derivatives 
activities of the 10 largest American commercial banks alone amount to 
double the annual GNP of the United States which, in turn, is more 
money than all the money in the world. If this doesn't define a 
pyramidal house of cards--particularly in the event of a market shock 
sparked abroad by warmongers or at home by private sector speculators 
or public pandering protectionists--what does?
  Everett Dirksen once commented that a billion here and there pretty 
soon added up to real money. With regard to derivatives, it would 
appear that a trillion here and there may add up to a real problem.
  As the Federal deficit bears proof, Congress has yet to understand 
how to manage figures followed by 9 digits. With derivatives it is 
asked to understand quantumly larger figures--numbers followed by 12 
digits.
  Derivatives pose an interesting conundrum in that the problems they 
present may be too sophisticated for a Congress of generalists to deal 
with in any detail. However, this does not mean that legislators do not 
have the responsibility to set forth a general framework of concerns 
with the understanding that the executive branch and Federal Reserve 
must be held accountable for responsible oversight of the financial 
markets.
  Congress should be extraordinarily wary of setting specific 
regulatory standards but legislation is clearly warranted to empower an 
interagency commission to issue prudential guidelines which would have 
cross-industry enforceability tied to cross-border standard setting 
efforts. Unless derivatives are regulated by product type as well as 
institution kind, the market will simply be skewed to those market 
participants not subject, as commercial banks are, to safety and 
soundness scrutiny. And unless efforts are made to develop 
international standards, the market will be skewed to the advantage of 
foreign participants.
  Conventional wisdom is that derivatives trading is currently being 
conducted in a manner that does not adversely effect the safety and 
soundness of the financial system and does not represent significant 
systemic risk. However, the sheer magnitude of the market and the 
extraordinary growth in product trading present worrying concerns. 
Regulators have no choice except to establish as the highest possible 
priority the need to be vigilant in guarding against the potential 
risks to individual institutions and to the financial system as a whole 
posed by derivatives trading. Despite the apparent benefits of wider 
use of derivative products, a persuasive argument can be made that only 
sophisticated users with comprehensive risk management strategies, 
qualified personnel, and deep financial reserves should participate 
actively in this exploding market.
  In analyzing the public policy concerns related to derivatives, 
legislators and regulators have an obligation to repeatedly review the 
following questions:
  First, are adequate uniform capital, accounting and disclosure 
standards for derivative products in place?
  Second, is there adequate coordination between United States and 
foreign regulators?
  Third, are there unique issues regarding the payments, clearing and 
settlement systems related to derivatives?
  Fourth, what are the benefits realized by users of derivatives for 
risk-management purposes?
  Fifth, do dealers and end-users of derivatives have adequate internal 
controls?
  Sixth, are there adequate protections in place to protect 
unsophisticated end-users?
  Seventh, how extensively are derivatives used for purposes of 
speculation and what should be the role of speculator? and
  Eighth, what is the level of systemic risk posed by derivatives?
  Policymakers must be careful to understand the broad array of 
products and services that are subsumed under the term of derivatives. 
For example, the ratings agencies assign widely varying levels of 
credit risk to different products which are all considered derivatives 
instruments. Commodity or equity contracts, currency swaps, currency 
options, currency futures or forwards, interest rate swaps, interest 
rate options and interest rate futures or forwards represent different 
types of derivative products, all with an entirely separate risk 
factor. This highlights the sophistication in the market and also 
highlights the problems that policymakers may confront as they consider 
the need to supervise this market.
  In examining the different types of derivative instruments, it is 
important to acknowledge the benefits that derivative products provide 
as a risk management tool for both financial and nonfinancial firms. By 
allowing companies to better manage the risk on their balance sheets, 
the prudent use of derivatives helps market participants guard against 
market volatility, thus providing a more stable environment for job 
creation. In particular, prudential use of derivatives products 
insulates companies from volatile interest rate and foreign currency 
exposures.
  In addition, the lower cost of funds, made possible by the growing 
use of derivative instruments, has provided more affordable housing and 
cheaper student loans while decreasing taxpayer exposure at Government 
sponsored enterprises such as Fannie Mae, Freddie Mac, and Sallie Mae. 
In fact, the U.S. Government may want to examine the advantages of 
these products to lower its funding costs and thereby reduce the budget 
deficit. Sovereigns throughout the industrialized world use 
sophisticated financial techniques, including derivatives, for more 
efficient management of their financial needs to the direct benefit of 
their taxpayers. Although risks exist in the speculative use of 
derivatives, a strong case can be made that for hedging purposes, 
greater use of derivatives should be contemplated by the U.S. 
Government. In fact, the U.S. Treasury today may be assuming a greater 
risk in its current efforts to shorten maturities of U.S. borrowings 
than it would be in using derivative products for financial management 
purposes.
  While derivatives make up only a small fraction of the trading 
activities at insured financial institutions, and while derivative 
products often serve a useful role in reducing rather than increasing 
institutional risk, the potential exists that these products can also 
be used for speculative activities. There is no escaping the 
circumstance that derivative activities in the 1990's must be examined 
in the context of the decade of the 1980's where America overleveraged 
itself with junk bonds, junk real estate, junk S&L's of its own making, 
and junk debt of LDC manufacture.
  It may be irrational to draw parallels with other circumstances in 
other time frames, but there are several aspects of mistakes made in 
private sector finance over the past several decades worthy of review 
in the context of derivatives trading.
  As we look at Penn Square, which symbolized an imprudent effort to 
advance a credible idea, that is, merchant banking, it is impressive 
that several of America's largest, most respected banks fell prey to 
the idea of rewarding a few key employees on a quasi-commission basis 
for increasing volume in loan originations. Quality which had been the 
hallmark of Continental Bank in secondary agricultural loan purchases 
was given limited purview with the more fashionable oil field generated 
loans of Penn Square. Likewise, as we look at the high flyers in the 
S&L industry in the 1980's, it is impressive how they understood that 
extraordinary leveraging implied socializing risk for the public 
taxpayer in the long run, but privatizing profit for the few in the 
short-run. In federally insured banking institutions, the small number 
of employee traders dealing in derivatives instruments today are in 
effect being paid multimillion dollar commissions, privatizing 
individual gain but leaving risk to be absorbed by the shareholders of 
the institutions in the first instance and the public through the 
deposit insurance safety net in final resort.
  The question of whether too many money managers are putting too much 
of other people's money at risk in a game in which they win big if they 
bet right and others lose bigger if they bet wrong is one that 
institutions must continually confront. Culturewise, investment banks 
lack the advantages of commercial bank customer ties and the right to 
tap federally insured deposits, yet they appear at this time to 
understand better than their commercial bank competitors the need to 
have in place mark-to-market risk restraints. Both Salomon Bros. and 
the Bank of England have released studies last year that found risk 
management tools inadequate in many banks.
  As we look at the junk bonds of the 1980's, it is impressive how a 
credible social idea--the need for secondary financing of below grade 
debt--was mispriced and misadvanced. As we look at the growth of LDC 
debt in the 1970's and early 1980's, it is impressive how fast growth 
of a historically risk-averse product changed its nature and how little 
prudential protection emerged from the fact that a number of respected 
large institutions expanded market share together. Follow thy 
competitor policies produced beggar thy neighbor effects.
  In some circumstances we have with derivatives a product designed 
exclusively for prudent hedging. In other circumstances we have an 
analogous situation to the 1920's when a market participant could buy 
equities on minimal margins. The margins are so low in some derivatives 
trading that speculative market participants can make or lose 
substantial sums on negligible shifts in product pricing.
  In this historical circumstance, bank management would appear to have 
a profound obligation to be particularly attentive to the risks 
inherent in markets that compound in size. Accountability must be the 
watchword.
  Derivatives instruments may be designed to help financial managers 
diminish risk, but, ironically, if tremors emerge in the international 
financial community, a product designed to modestly reduce risk for an 
individual company or institution may quantumly increase risk for the 
system as a whole.
  Human nature being what it is, the prospect of destabilizing 
speculation in certain types of these products cannot be ruled out. 
Financial markets and the risks involved change rapidly. New products 
are introduced every day and it is often difficult for private sector 
participants as well as policymakers in Government to judge adequately 
new risks. Currency markets, for instance, which have been such a 
source of money center bank profitability in recent years, could become 
more problematic if new, less sophisticated entrants attempt to play 
leveraged games with other peoples' money.
  It should be noted that in anlayzing over 10 years of trading 
results, quarterly trading losses were posted only four times by 
derivatives dealers--once by J.P. Morgan and three times by First 
Chicago. Cumulative losses incurred in those quarters were just $19 
million. These are dwarfed by the trading revenues earned in the other 
36 quarters examined: $35.9 billion, which amounts to almost a 2,000 to 
1 profit-to-loss relationship. The fact that trading activities have 
been so consistently profitable indicates that the proprietary risk 
taken by banks in these activities so far has been prudent or at least 
quite fortunate. These statistics give some comfort that risk 
management constraints have not been ignored in the private sector. 
However, all parties must recognize that while the past may be 
prologue, historical experience is not always a guide to the future, 
especially when a relatively new market explodes in size. Hence, 
regulators have an obligation to stay on guard as this marketplace 
expands in a time of unprecedented economic uncertainties.
  For example, the question of the adequacy of regulation for insurance 
companies involved in derivatives activities appears to be an 
unresolved issue. Currently, regulation of insurance companies' 
derivative activities is handled at the State level. While apparently 
no material losses have been realized in the insurance industry related 
to derivatives trading to date, there is no indication that State 
insurance regulators have the expertise to monitor such trading. 
Therefore, legislating Federal accountability for derivative activities 
of unregulated companies is an issue that can't be ducked. Such an 
approach may involve regulating some derivatives trading by product 
type, rather than simply by type of institution. Segments of the 
derivatives market should thus be regulated under a framework similar 
to the Federal securities laws where regulatiory standards exist for 
securities products, regardless of the type of issuer. Administration 
of a Federal regulatory approach for derivatives could be handled by 
existing agencies coordinated through an interagency commission.
  One of the oft-noted problems in financial regulation is the 
circumstance that there are competitive-for-jurisdiction regulators, 
not only of financial institutions, but of market instruments. Hence, 
the SEC and the CFTC have comparable mandates, but differing and to 
some degree overlapping markets to regulate and swirling industry 
pressures with which to cope. Some public policy observers have 
suggested the appropriateness of merging the SEC and CFTC, particularly 
given the relatively small staff but quantumly increasing market 
jurisdiction of the CFTC. Merits of such a combination aside, it would 
appear that one way to eliminate pressure to diminish regulation 
through choice of market arena is to allow an inter-agency group such 
as designated above to have rulemaking authority binding on all 
exchanges and any regulator. This would also appear to avoid certain 
jurisdictional problems in Congress that have impacted on the 
regulation of exchange traded derivatives. It is inexcusable that 
prudential regulation may be hamstrung by the competitive 
considerations of Committees of jurisdiction in a legislative body.
  In the derivatives arena there is also the problem of new entrants. 
Herds that feed on tall grass don't go unnoticed. If problems develop 
in the derivatives marketplace, it appears that they will be less 
likely to stem from the major firms operating in the mainstream, than 
from firms that are new entrants or operating at the fringes of this 
market. Any regulation in the derivatives area must be premised on the 
assumption that all market participants are not equal in sophistication 
or integrity and that distinctions must inevitably be made between 
prudential and less prudential actors. Just as well-run, well-
capitalized financial institutions have a powerful case for 
considerable deregulation today, poorly run, poorly capitalized 
institutions demand significant, if not draconian oversight.
  As the market expands to new entrants, inevitably small businesses 
become increasingly involved. The more profitable a market becomes, the 
more likely that a large party will be in a position to take advantage 
of a smaller party. I am particularly concerned that the farther 
trading relationships take place away from the money centers, the 
further away business people are from eye contact and handshakes, the 
more likely bottom line incentives will override ethical concerns in 
the relations of larger financial intermediaries to smaller, less 
sophisticated end-users. In these markets, the small fish must be 
protected from the sharks. Disclosure rules are crucial. For example, 
the FDIC has suggested that there should be enhanced disclosures by 
dealers to end-users. In addition, the OCC's new guidelines suggest a 
form of suitability requirement for national bank dealers in their 
relationships with derivatives customers.
  Regulators must also be sensitive to questions of suitability related 
to derivative instruments and discerning in their supervision of 
derivative products. Wall Street cannot be allowed to use 
unsophisticated investors to absorb its problems. Looking back on the 
last decade, there is no doubt that if Wall Street had not used insured 
S&L's as a repository for its mistakes concerning mortgage backed 
securities and junk bonds, then the taxpayer would be better off today. 
Where the profit motive exists, regulators must ensure that fair 
markets develop and unsophisticated customers such as small businesses 
and municipalities are protected.
  While not inherently destabilizing, derivatives provide ways of 
either leveraging or deleveraging financial institutions. One 
institution's hedge may be another's speculation. In hindsight it is 
clear that in a rising interest rate market, derivative products would 
have been particularly useful for S&L's during the late 1970's and 
early 1980's to hedge against interest rate risk. such a use of 
derivatives as a financial management tool could have saved the 
taxpayer significant sums of money.
  Alternatively, overuse or misuse of derivatives when markets turn can 
cause market participants to get into trouble. This is evidenced in the 
questions that still persist related to the case of Franklin Savings in 
Kansas, Merits of the legal circumstance aside, the Franklin case 
underscores the need for industry and regulators to share on a timely 
basis their concerns, and for risk management education to be a mutual 
responsibility.
  The use of derivative instruments must be weighed from a policy 
perspective in terms of systemic as well as institutional risk, 
especially as such risk may relate to the federally insured deposit 
system.
  In examining the risk posed by derivative instruments, three issues 
stand out: capital, accounting, and disclosure. Of these three issues, 
capital would appear to be the most important factor. Capital is the 
cushion that protects a firm from credit and market risk. For an 
insured institution, capital represents the best protection for the 
taxpayer from the risks inherent in the marketplace.
  Below is a table summarizing the 10 largest U.S. bank participants in 
derivatives trading, as of October 29, 1993:

------------------------------------------------------------------------
                                                                 Credit 
                              Total      Total       Credit     exposure
                             assets   derivatives  equivalent   percent 
                                                    exposure    capital 
------------------------------------------------------------------------
Chemical Bank..............   $110.4    $2,114.0        $32.9        268
Bankers Trust Co...........     63.9     1,802.3         29.5        571
Citibank...................    168.6     1,789.3         38.2        230
Morgan Guaranty Trust Co...    103.5     1,537.5         37.9        458
Chase Manhattan............     79.9     1,026.1         23.0        269
Bank of America............    134.0       893.5         21.7         91
First National Bank of                                                  
 Chicago...................     34.1       457.4         10.1        269
Continental Bank...........     22.0       169.9          2.5         91
Republic National Bank of                                               
 New York..................     28.4       167.7          2.7        104
Bank of New York...........     35.8        92.2          1.7        41 
------------------------------------------------------------------------
Source: Office of the Comptroller of the Currency.                      

  It is not an easy task to determine the amount of capital--that is, 
government imposed friction costs--that should be dedicated or reserved 
by a bank for purposes of its derivative business. What is possible to 
note is that if market participants are not required to maintain strong 
capital positions and/or reserve against systemic risk, it will be 
nonparticipants--community banks in the first instance through the 
deposit insurance safety net and the taxpayers in the event of a market 
debacle--who will pick up the tab for the mistakes of a few.
  While the new proposed BIS capital standards would take into account 
netting and apply separate standards for interest rate and market 
risks, new interest rate and market risk standards are not an adequate 
substitute for a strong leverage requirement. A strong leverage ratio 
remains the most important protection for taxpayers against risk in the 
financial system. It also remains the fairest way to constrain 
competitive growth within the banking sector. One of the least analyzed 
parts of the American S&L expansion in the 1980's was the degree to 
which lack of attention to capital standards caused disproportionate 
deposit growth in certain institutions in a certain industry in certain 
parts of the country. Attention to leverage ratios is not only 
important in assessing taxpayer risk, but also for competitive equity, 
and regional and industrial credit allocation.
  The issue of capital standards for derivatives trading is an area in 
which further research should be encouraged, recognizing that public 
sector judgments may not always coincide with private sector 
recommendations.
  Concerning accounting and disclosure standards, greater harmonization 
of international standards should be strongly supported. Greater 
transparency is critical to the integrity of our financial markets.
  Derivatives have profound implications in the international arena. No 
area of modern finance demonstrates a greater need for international 
cooperation across industries. The BCCI scandal demonstrated the 
critical need for communication and cooperation among international 
supervisors when activities cross country lines and I am hopeful that a 
similar episode will not be necessary in order to spur greater 
cooperation and coordination among international regulators concerning 
derivatives.
  I am particularly concerned that widely different standards exist in 
different countries related to the crucial issues of capital, 
accounting and disclosure treatment for derivatives. Minimum 
international standards should be set in these areas. While some 
progress has been made concerning capital standards for derivatives 
under the pending BIS proposals, I fear that these proposals may be a 
lowest common denominator approach. Even more troubling is the fact 
that the international securities regulators have been unable to come 
up with any common approach on capital requirements.
  One final area for supervisory concern that is often overlooked is 
the question of the legal risk involved in derivatives activities. 
Legal risk is a surprisingly large element of uncertainty in the 
international financial system and, as evidenced by the case of U.K. 
authorities in Hammersmith and Fulham, one that is unpredictable even 
in developed societies. If the global financial system is to fully 
realize the risk management benefits of these instruments, governments 
must cooperate to provide greater legal certainty across country lines. 
Until this goal is reached regulators must be especially sensitive to 
this potential problem area and ensure that proper controls are put in 
place.
  Even more problemsome is politician risk as it relates to potential 
swings toward protectionism in a fracturing world, particularly if 
regional or global recessions develop.
  In dealing with supervisory standards for capital, accounting, and 
disclosure, legislators have little choice but to be cautious of 
overreacting and to rely instead rather heavily on the judgment of 
regulatory agencies. This leads to one of the most pressing challenges 
of Government--the need for careful attention to quality control in 
appointments. In general, the private sector, because of incentive 
motivations, is much smarter with money than the public sector. This is 
why it is particularly important to have people at Government agencies 
with proven expertise. The Government cannot be run with campaign 
managers, particularly at organizations that demand sophisticated 
knowledge such as the financial regulatory agencies. Appointments to 
these agencies must be made based on merit and not as a reflection of 
political indebtedness by a candidate to an individual or industry 
group. Nothing underscores the need for a government of meritocracy 
more than the challenges the executive branch faces in regulating 
products such as derivatives.
  Derivatives also underscore the need for the Government and industry 
to work together to ensure that a profitable past does not prove prolog 
for a profligate future. While the history of industry self-regulation 
has not been overly impressive, clearly to date, in the derivatives 
area, the private sector is leading the public, not only in the 
development of new market instruments, but with techniques to manage 
and constrain risk. Care, however, must be taken to ensure that we not 
have a least common denominator approach taken to regulation which 
might be adequate for one kind of institution in one timeframe. 
Tomorrow's market circumstances and market participants may not be the 
same as today's.
  It is true that when a corporation hedges its risks and a financial 
intermediary provides for fee a derivative product, a credible economic 
purpose is served and all participants are acting in their proper self-
interest. But it is simply not true that all aspects of the derivatives 
business are risk free, that all derivatives trading is unspeculative 
in nature, and that all trading has a clear-cut, defensible social 
purpose. Parts of the game are played in such a way that there can be 
losers as well as winners and if there is a traumatic event, virtually 
all players can become entwined in a lose-lose, rather than a win-win, 
scenario.
  As for the public interest, it is also not clear in all instances 
that what provides quick profit for a few necessarily advances, to 
resurrect a 19th century utilitarian concept, the greater good of the 
greater number. For instance, while derivative products can prudently 
reduce exchange rate risk for market participants, they can also 
increase exchange rate volatility. As the Soros-led raid a year ago on 
the Bank of England and more recently the new-entrant attack on the 
Bank of France indicates, an increased use of leveraged financial 
instruments makes stable exchange rates impossible to maintain.
  While I have never been wedded to the notion that trade is 
facilitated by arbitrarily maintained, fixed exchange rates, and while 
I have long believed governments should be chary about massive 
intervention in currency markets, I believe exchange rate mechanisms 
are more likely to foster stable economic growth if flexibility is 
reflected in gradualist rather than abrupt change. What derivative 
products induce is extended swings in the market, which self-servingly 
makes use of such products more important for commercial firms, but 
more dangerous for the taxpayer bystander. For, to date, the losers in 
this game of financial chicken have largely been taxpayers in countries 
like Britain and France. Governments, in effect, have chosen to bail 
out the market, providing windfalls to a few and accepting losses on 
behalf of the many. But even bureaucrats wise up. Once-burned Finance 
Ministries are likely to be less inclined to protect or, perhaps in the 
case of the Japanese, be less likely to attempt to depreciate their 
currencies and shift losses in the future more squarely on private 
sector players. Traders beware.
  In addition, implicit or explicit credit extensions through the 
offering of derivative products which lack traditional capital offsets 
makes the conduct of monetary policy increasingly problemsome. It also 
makes regulatory assessments of bank risk increasingly difficult to 
evaluate.
  While the downside of variables is impossible to quantify, the 
likelihood of a number of individual institutions making mistakes in 
the near future that will jeopardize their very viability and 
potentially that of the deposit insurance fund is anything but 
negligible.
  All financial players have a sudden vested interest in precisely what 
they have, to date, considered not in their best interest: that is, 
modest prudential regulation that only governments of the world have 
the capacity to instill.
  A summary of the legislation I am introducing today follows:

                              {time}  1540

  Mr. Speaker, I submit for the Record a section-by-section analysis of 
the legislation to which I refer.

                  Derivatives Supervision Act of 1994


                TITLE 1--FEDERAL DERIVATIVES COMMISSION

                    Sec. 101. Declaration of Purpose

       This title establishes the Federal Derivatives Commission 
     to establish principles and standards for the supervision by 
     Federal financial institutions regulators of financial 
     institutions engaged in derivatives activities.

                         Sec. 102. Definitions

       (1) ``Federal financial institutions regulators'' means the 
     OCC, Federal Reserve, FDIC, OTS, SEC and CFTC.
       (2) ``Commission'' means the Federal Derivatives 
     Commission.
       (3) ``Federal banking agencies'' has the same meaning as 
     section 3 of the FDI Act.
       (4) ``Financial institution'' means any institution subject 
     to section 402(9) of FDICIA, any government sponsored 
     enterprise, or any other institution (including any type of 
     end-user of derivatives) as determined by the Commission.
       (5) ``Government sponsored enterprise'' has the same 
     meaning as in section 1404(e) of FIRREA.
       (6) ``Qualified financial contract'' has the same meaning 
     as in section 11(e)(8)(D) of the FDI Act, except that the 
     Commission may determine any similar agreement to be a 
     qualified financial contract for purpose of this title.
       (7) ``Derivatives activities'' means activities involving 
     qualified financial contracts, including those activities 
     determined by the Commission to be qualified financial 
     contracts for purposes of this title.

                Sec. 103. Federal Derivatives Commission

       The Commission shall consist of: the Chairman of the Board 
     of Governors of the Federal Reserve System: the Comptroller 
     of the Currency; the Chairman of the Board of Directors of 
     the Federal Deposit Insurance Corporation; the Director of 
     the Office of Thrift Supervision; the Chairman of the 
     Securities Exchange Commission; the Chairman of the Commodity 
     Futures Trading Commission; and the Secretary of the 
     Treasury. The chairman of the Commission shall be the 
     Chairman of the Board of Governors of the Federal Reserve 
     System.

               Sec. 104. Costs and Expenses of Commission

       One-sixth of the costs and expenses of the Commission shall 
     be paid by each of the Federal financial institutions 
     regulatory agencies.

                   Sec. 105. Functions of Commission

       (a) Establishment of Principles and Standards.--
       (1) The Commission shall establish principles and standards 
     related to capital, accounting, disclosure, suitability, or 
     other appropriate regulatory actions for the supervision of 
     financial institutions engaged in derivatives activities.
       (2) Each regulatory agency shall issue substantially 
     similar regulations governing derivatives activities to 
     implement the Commission's standards, unless it finds that 
     implementation of such regulations is not necessary or 
     appropriate.
       (3) Any financial institution not subject to supervision by 
     a Federal banking agency or the CFTC shall be supervised by 
     the SEC to the extent of their derivatives activities, except 
     as otherwise provided by the Commission.
       (b) Recommendations Regarding Supervisory Matters.--
       (1) In establishing principles and standards under 
     subsection (a), the Commission shall consider and may make 
     recommendations for comparable regulatory action by the 
     Federal financial institutions regulators in other matters 
     related to financial institutions engaged in derivatives 
     activities, such as, but not limited to, the need to 
     establish principles and standards for:
       (A) strong capital requirements (with particular attention 
     to a leverage ratio where appropriate) to guard generally 
     against risks at financial institutions, including added 
     risks that may be posed by derivatives activities;
       (B) discouraging active trading in derivatives markets by 
     financial institutions, particularly those with access to 
     federally insured deposits, unless management can demonstrate 
     that the institution has adequate capital and technical 
     capabilities;
       (C) joint regulatory examinations by the federal banking 
     agencies of insured depository institutions that are 
     derivatives dealers and any affiliates;
       (D) board of director responsibility with respect to the 
     oversight of derivatives activities, including specific 
     written policies regarding internal controls and risk 
     management approved by the board of directors of institutions 
     engaged in derivatives activities;
       (E) guidelines for the prudent use of collateral by 
     counterparties to derivatives transactions;
       (F) the appropriate parameters, models and simulations for 
     purposes of evaluating an institution's credit and market 
     risk posed by derivatives activities;
       (G) guidelines as to the appropriate credit risk reserves 
     in connection with derivatives activities;
       (H) increased standardization of documentation and use of 
     such documentation by all market participants;
       (I) minimum prudential practices for municipalities and 
     pension funds that may use derivatives;
       (J) enhanced disclosures to mutual fund customers of the 
     risks that may be posed to mutual funds that are end-users of 
     derivative products;
       (K) guidelines related to legal risk, including, but not 
     limited to, foreign legal risk; and
       (L) regulations to protect against systemic risk.
       (2) When an applicable regulatory agencies finds a 
     recommendation of the Commission unacceptable, that agency 
     must provide a written statement to the Commission explaining 
     its objections, and such statement shall be published in the 
     Federal Register.
       (c) Development of Uniform Reporting System.--The 
     Commission shall develop uniform reporting systems for 
     financial institutions engaged in derivatives activities.
       (d) Training for Examiners and Assistant Examiners.--The 
     Commission shall sponsor training programs concerning 
     derivatives activities for Federal examiners. The programs 
     shall also be open to state examiners, employees of the 
     Federal Housing Finance Board, and employees of the 
     Department of Housing and Urban Development.
       (e) Effect on Federal Regulatory Agency Research and 
     Development of New Financial Institutions Supervisory 
     Methods.--Nothing in this title shall be construed to limit 
     or discourage Federal financial institutions regulatory 
     agency research and development of new financial institutions 
     supervisory methods related to derivatives activities.
       (f) Annual Report.--The Commission shall prepare an annual 
     report.

                        Sec. 106. State Liaison

       The Commission shall establish a liaison committee composed 
     of three representatives of state agencies which supervise 
     financial institutions, which shall meet at least twice a 
     year with the Commission.

                        Sec. 107. Administration

       The Chairman of the Commission is authorized to carry out 
     and to delegate the authority to carry out the internal 
     administration of the Commission. The Commission may also 
     utilize personnel and facilities of the regulatory agencies, 
     may appoint employees, and may obtain the services of experts 
     and consultants.

                   Sec. 108. Risk Management Training

       The Commission shall develop training seminars in risk 
     management techniques related to derivatives activities for 
     employees of both regulatory agencies and financial 
     institutions.

                  Sec. 109. International Negotiations

       The Chairman of the Board of Governors of the Federal 
     Reserve, in consultation with the members of the Commission, 
     shall encourage governments, central banks, and regulatory 
     authorities of other industrialized countries to work toward 
     maintaining, and, where appropriate, adopting comparable 
     supervisory standards and regulations, particularly capital 
     standards, for financial institutions engaged in derivatives 
     activities.

                        Sec. 110. Credit Unions

       Insured credit unions shall be supervised for purposes of 
     derivatives activities by the National Credit Union 
     Administration under standards no less stringent than 
     standards under which Federal depository institutions are 
     supervised by the Federal banking agencies.


                   TITLE II--SUPERVISORY IMPROVEMENTS

             Sec. 201. Unsafe or Unsound Banking Practices

       Failure of an institution-affiliated party engaged in 
     derivatives activities to have adequate technical expertise 
     may be deemed to constitute an unsafe or unsound banking 
     practice within the meaning of section 8 of the FDI Act.

                      Sec. 202. Internal Controls

       Standards for safety and soundness prescribed by the 
     Federal banking agencies, in accordance with section 132 of 
     FDICIA, should include internal controls for derivatives 
     activities.

                   Sec. 203. Foreign Bank Supervision

       The International Banking Act of 1978 is amended to require 
     that when evaluating the adequacy of supervision of a foreign 
     bank engaged in derivatives activities by its home country, 
     the Federal Reserve determine whether such country has 
     comprehensive supervision and regulation for derivatives 
     activities. In making any determination under this paragraph, 
     the Federal Reserve shall consider whether the home country 
     maintains comprehensive supervision and regulation of 
     derivatives activities, including capital and disclosure 
     standards, not less stringent than U.S. standards.


          TITLE III--FINANCIAL INSTITUTION INSOLVENCY REFORMS

                    Sec. 301. Conforming Definitions

       This section expands the FDI Act with conforming amendments 
     to the Bankruptcy Code to include derivatives products 
     currently being used in the market and to accommodate future 
     growth in the derivatives products industry.

               Sec. 302. Failed and Failing Institutions

       This section alleviates the uncertainty about the scope of 
     the automatic stay for the FDIC when it is a counterparty, as 
     this section clarifies that insolvency and bankruptcy 
     proceedings should not delay or limit the FDIC's rights to 
     repudiate, terminate and net qualified financial contracts 
     involving an insolvent or bankrupt party or counterparty.
       This section also requires that the FDIC, in consultation 
     with the other regulatory agencies, prescribe regulations 
     requiring expanded recordkeeping for qualified financial 
     contracts by insured depository institutions that are 
     undercapitalized.

            Sec. 303. Qualified Financial Contract Transfers

       This section amends the FDI Act to provide that if the FDIC 
     as receiver of a depository institution notifies a party to a 
     qualified financial contract by the close of business on the 
     business day following its appointment as receiver that all 
     qualified financial contracts between the depository 
     institution and that person or its affiliates were 
     transferred to another depository institution in accordance 
     with 11(e)(9)(A), the provisions of 11(e)(8)(A) allowing the 
     party to terminate or liquidate the contract will not apply. 
     This section also allows the FDIC to extend the notice period 
     up to 5 days if the FDIC determines that the extension may 
     maximize the return on the contract.
       This section also amends the FDI Act to explicitly provide 
     that the FDIC may transfer qualified financial contracts to a 
     bridge bank or to analogous types of 
     conservatorships.

                    Sec. 304. Clarifying Amendments

       This section amends the Bankruptcy Code to require a master 
     agreement governing multiple transactions be treated as one 
     swap agreement in bankruptcy. This swap agreement shall be 
     exempt from the stay, regardless of product type or contract 
     type.

                     Sec. 305. Technical Amendments

       This section makes technical amendments to the FDI Act.


                        title iv--miscellaneous

                      Sec. 401. Savings Provision

       The provisions of this Act shall be in addition to and not 
     in derogation of any existing authority of a Federal 
     financial institution regulatory agency to supervise or 
     regulate derivatives activities provided under any other 
     applicable law.

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