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and income reporting that resulted in a bank’s taking significant
reserves, deferring income recognition, and using conservative
carrying values for swaps. The OCC’s role as regulator of the
bank was to oversee the risk management systems employed by the
bank.
The OCC endorsed valuing financial derivative portfolios at
adjusted midmarket values and considered the adjustments
“holdbacks” (i.e., reserves) designed to provide for likely
future costs and to attribute trading income to the appropriate
source of income. This endorsement reflected the OCC’s
acceptance of a 1986 recommendation of the Basel Committee on
Banking Supervision (Basel Committee) that banks should build a
cautious bias into their estimates of the replacement costs of
off-balance-sheet instruments. Neither the OCC nor the Basel
Committee provided specific guidelines for calculating midmarket
value adjustments. The OCC did require banks to take into
account changes in counterparty credit quality in swap
revaluations. In making credit adjustments to midmarket values,
it was the view of the OCC that the credit adjustment was
typically calculated by formulas based on the counterparty credit
rating, maturity of the transaction, collateral, netting
arrangements, and other credit factors.
In 1994, the FRB expressed concerns about the potential for
income manipulation by use of midmarket adjustments.
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