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Advice from the Comptroller: 15 bucks

By Robert Hunter

Publishing companies typically release updated editions of books only after a shrewd analysis of the marketplace, making sure that they have sucked every last cent from the previous edition. The Office of the Comptroller of the Currency plays by different rules. Though the skeletal 1994 first edition of the Comptroller's Handbook for National Bank Examiners was a big hit in its narrow demographic, and a steal at $15, it quickly became a quaint anachronism that failed to cover quickly evolving topics in the risk-management arena.

In January, the OCC released a new, radically revised edition that logs in at 190 pages-more than twice the size of the original-and covers eight new areas of interest to risk managers. The most conspicuous addition is a drastically expanded section on internal control procedures, offering more questions (59 in all, with sub-bullets) for the examiner checklist. "We have quite a bit more detail," says Michael Brosnan, director of the treasury and market risk division at OCC and principal author of the new edition.

Another important-and somewhat controversial-addition is a section on employee compensation. The handbook argues that derivatives personnel should be paid based on five factors-individual overall performance, performance relative to the bank's stated goals, risk-adjusted return, compliance with bank policies and the compensation packages of competitors. Banks that pay personnel based only on the profits they earn "encourage excessive risk-taking," according to the handbook. The book also recommends that certain key staff members be required to take their two-week vacations consecutively, with no ability to make transactions, to help detect concealed trading activity.

Other areas of interest include an expanded section on risk measurement that supports the use of Value-at-Risk as a common denominator; an improved section on early termination agreements that is "improved to reflect business practices," according to Brosnan; a section on undisclosed counterparties; an evaluation of dealer books; a more thorough description of price risk-management models, which supports Brosnan's claim that "the document is educational as well"; and a section on stress testing which argues that "good stress testing involves finding things that make bank management uncomfortable and then making probability analyses," says Brosnan.

To order a copy of the handbook, send a check for $15 to the Comptroller of the Currency, P.O. Box 70004, Chicago, IL 60673-0004.

Revising Hedging Theory

Classical risk management theory argues that companies facing large exposures to changing rates can increase their market values by using derivatives to reduce the variability of corporate cash flows and the costs associated with financial distress. In practice, most corporates practice selective rather than "full-cover" hedging and allow views of future rates to influence their hedging ratios. Large companies, moreover, make far more use of derivatives than smaller companies, even though smaller companies have more volatile cash flows and more to lose if they get in financial trouble.

Does this mean that selective hedging is misguided and that "variance minimization" is an inappropriate goal? Not necessarily, argues Rene Stulz, a professor at Ohio State University, in "Rethinking Risk Management," an article in the recently published Fall 1996 issue of the Journal of Applied Corporate Finance.

She concludes that some companies "have a comparative advantage in bearing certain financial risks (while other companies mistakenly think and act as if they do)." She then proposes a new goal: "elimination of costly lower-tail outcomes that is designed to reduce the expected costs of financial trouble while preserving a company's ability to exploit any comparative advantage in risk bearing it may have." In trader talk, that means corporates prefer to buy well out-of-the-money put options that eliminate downside risk, while preserving as much of their upside as they feel is justified.