INTRODUCTION

This bulletin provides Michigan state-chartered banks with guidance on the use of off-balance-sheet interest rate risk management instruments (hereinafter "risk management instruments"). These instruments are commonly referred to in the financial community as derivatives. Given the swift pace at which new instruments are introduced and evolve in today's markets, the Financial Institutions Bureau does not attempt an all inclusive definition but instead recognizes that such instruments are those that derive their value from the performance of other assets, interest or currency exchange rates, or indexes, and whose primary purpose is to transfer price risks associated with fluctuations in asset, rate, or index values. These instruments include a wide variety of financial contracts, but are not necessarily limited to forwards, futures, swaps, options, caps, floors, collars, and various combinations thereof.

The financial community is well aware of the corrosive losses which may result from speculative or inappropriate use of risk management instruments. The Financial Institutions Bureau neither discourages nor encourages the use of risk management instruments and recognizes that prudent investment can provide banks with flexibility in managing risks. However, banks that engage in the use of risk management instruments must do so in accordance with safe and sound banking practices.

The Financial Institutions Bureau is concerned if banks use risk management instruments without adequate internal controls, or adequate knowledge of particular instruments or counterparties. The Bureau believes the best defense against individual or systemic disruptions is the implementation and use of effective risk management systems by individual banks. No system, however, can provide an institution with total protection. Therefore, it is imperative that every bank using risk management instruments fully understands the nature of the instruments and the risks associated with their use.

The guidelines set forth in this bulletin represent prudent practices that, if followed, should enable a bank to conduct interest rate risk management activities in a safe and sound manner. Banks engaged in such activities are expected to follow these guidelines.

INVESTMENT AUTHORITY AND SCOPE

A bank may invest, or otherwise participate in the use of risk management instruments for the primary purpose of reducing, or "hedging" against formally identified interest rate risk. The Financial Institutions Bureau recognizes these activities may necessarily involve dealing in or taking a position in capital market products in order to meet customer demands. The bank must provide documentation to support the existence of interest rate risk or necessity of providing a customer with capital market products, and demonstrate that the volume of activity constitutes a legitimate interest rate risk reduction position. A bank must also document and demonstrate that any position is within safe and sound risk parameters. Any use of a risk management instrument other than as set forth in this paragraph shall be considered speculative, and an unsafe and unsound practice.

BOARD OVERSIGHT AND WRITTEN POLICY

Prior to investing in, or otherwise participating in any risk management instrument(s), the Board of Directors must adopt a specific written policy and procedures related to such instruments. The Board should fully understand the nature of and the risks associated with the use of the particular risk management instrument(s) it intends to employ. These policy and procedures should address risks (market, liquidity, credit, legal, settlement, and operations), methods of managing, measuring, and reporting those risks, capital requirements, accounting standards, and regulatory compliance, and must be consistent with the Board's overall risk management philosophy and the bank's business strategies. The Board should ensure that the financial condition of the institution and the expertise of designated personnel are adequate to support the level of the bank's proposed activity.

The Board should review the adequacy of the policy and procedures on a regular basis and in view of changes in market conditions or the bank's exposure. Appropriate governance from the Board should include endorsement of periodic revisions to the policy and procedures.

RISK MANAGEMENT

A bank should have risk identification and management systems that are commensurate with the scope, size, and complexity of its activities and the risks inherent in those activities. Such systems must ensure that market factors affecting exposure are adequately measured, monitored, and controlled. An adequate risk management system will incorporate management supervision and Board oversight, timely measurement of risk, limitations and other controls on the level(s) of risk, and mechanisms that accurately report present and potential risk exposure to the Board.

The person(s) responsible for risk monitoring should be independent of the person(s) that create risk exposures, and should have the ability and authority to communicate the implications of the institution's positions and exposure to the Board of Directors.

AUDIT COVERAGE

A bank should have independent audit coverage of its risk management instrument(s) and activities that is adequate to ensure timely identification of internal control weaknesses and systemic deficiencies. Audit functions should be commensurate with the scope, size, and complexity of a bank's activity and the risks inherent therein. The audit scope should include an appraisal of compliance with internal policy and procedures, including risk management systems and accounting procedures, regulations, and overall safety and soundness of the risk management instruments and activities. The person(s) responsible for audit coverage should be knowledgeable of the risks inherent in risk management instruments and have a level of expertise consistent with the scope of activity and the degree of risk assumed by the bank.

CAPITAL ADEQUACY

A bank should ensure that it maintains sufficient capital to support the risk exposures that arise from interest rate risk management activities. This requires timely and accurate reporting of exposure by the risk management function of the bank. Internal review and analyses of capital adequacy in relation to interest rate risk management activities should be commensurate with the bank's level of risk, volume, and scope of activity. In addition to internal review and analysis, the Board of Directors should ensure that the bank meets applicable regulatory capital standards.

ACCOUNTING PROCEDURES AND DOCUMENTATION PRACTICES

A bank should maintain accounting and documentation practices and procedures consistent with its written policy and procedures adopted by the Board of Directors. Accounting practices should conform to GAAP standards, or if different, regulatory standards, and include general ledger memoranda accounts sufficient to identify and control all off-balance-sheet activities in risk management instruments. Accounting procedures should, at a minimum, also include the type of instrument, nature of the position, and actual market value or notional amount. A bank must also provide sufficient documentation to demonstrate that it has made an informed and prudent decision consistent with safe and sound banking practices.

DISCLOSURES

A bank should make the proper disclosures of risk management instruments and activities in its Consolidated Reports of Condition and Income (call reports) in accordance with Federal Financial Institutions Examination Council reporting instructions and in other reports as required.

REGULATORY CONSISTENCY

The Financial Institutions Bureau recognizes any related regulatory bulletin, advisory, or guideline issued by an appropriate federal banking regulatory authority is also applicable to a Michigan state-chartered bank. Bureau examiners will use this Bulletin and any applicable federal guidelines in reviewing a bank's use of risk management instruments. Any activity or risk management instrument disallowed or considered an unsafe or unsound activity by an appropriate federal banking regulatory authority will be treated in the same manner by the Financial Institutions Bureau.

This bulletin replaces and supersedes Bank Bulletin No. 24, "Hedging Interest Rate Risks," dated June 23, 1981.

Signed:	Patrick M. McQueen, Commissioner
	Donald P. Mann, Director, Bank & Trust Division
Dated:	December 7, 1995