16 April 2003To Managers All commercial banks* No. SorNorSor. (21) Wor. 56/2546 Re: Submission of The Bank of Thailand's Notification, Re: Permission for Commercial Banks to Engage in Transactions Used as Risk Management Tools for Debt Instruments To encourage the development of Thailand's debt instruments market, to provide a variety of tool for management of risk arising from investment in debt instruments and to increase risk management alternatives and allocation of investment returns in equity and debt instruments, the Bank of Thailand hereby submits the Bank of Thailand's Notification, Re: Permission for Commercial Banks to Engage in Transactions Used as Risk Management Tools for Debt Instruments dated 8 April 2003, issued by virtue of Section 9 bis of the Commercial Banking Act, B.E 2505 (1962) as amended, which allows commercial banks to conduct three transactions for use as risk management tools for debt instruments; namely, (1) forward bond transactions; (2) bond options transactions; and (3) equity index linked swap transactions. Scopes of transactions and supervision policy can be summarized as follows: 1. Commercial banks are allowed to conduct all three transactions under a transaction framework stipulated in the Bank of Thailand's Notification as mentioned above, which has been announced in the Government Gazette, General Notification Edition, Volume 120, Special Section 45 Ngor dated 11 April 2003, and which shall come into force from 12 April 2003. 2. Commercial banks engaging in forward bond transactions, bond options transactions and equity index linked swap transactions shall comply with the regulations on maintenance of capital funds and the large exposure supervision where forward bond transactions and bond option transactions shall be considered an "interest rate-related contract" derivative whereas equity index linked swap transactions shall be considered an equity-based derivative. The Bank of Thailand is currently adjusting the regulations on maintenance of capital funds and the large exposure supervision to accommodate transactions of the "equity-based derivative" as mentioned. Therefore, in the meantime, commercial banks are required to consider all three transactions as creating obligations in the category of "interest rate-related contracts" until the Bank of Thailand issues further notice. Please be informed and observed accordingly. Yours sincerely, (Mr. Samart Buranawatanachoke) Senior Director, Financial Institutions Policy Group For GovernorEnclosure: The Bank of Thailand's Notification Re: Permission for Commercial Banks to Engage in Transactions Used as Risk Management Tools for Debt Instruments dated 8 April 2003Risk Supervision Policy and AnalysisTel 0-2283-5843, 0-2283-5886 Note [ ] The Bank of Thailand will arrange a meeting to clarify on ______, at _______. [X] No meeting for clarification will be arranged. Notification of the Bank of Thailand Re: Permission for Commercial Banks to Engage in Transactions Used as Risk Management Tools for Debt Instruments By virtue of Section 9 bis of the Commercial Banking Act, B.E 2505 (1962) and as amended, the Bank of Thailand hereby permits commercial banks to enter into three transactions as risk management tools for debt instruments as follows: 1. Forward bond transaction 2. Bond options transaction 3. Equity index linked swap transaction Definitions of Transactions 1. Forward Bond Transaction means a purchase or sales of debt instruments where the period in which the debt instruments are to be delivered and the price to be paid are set for more than two business days after the date of agreement of purchase price, but not more than one year. 2. Bond Options Transaction means a purchase or sales of a call or a put option of an underlying debt instrument or a portfolio at an agreed price according to a contract at any day within the period of such contract (American options) or at a contract expiration date (European options), limiting to plain vanilla options with maturity date of not more than one year. 3. Equity Index Linked Swap Transaction means an agreement between two parties, who will swap the rate of return based on fixed or floating reference rates with the rate of return based on equity index. Scope and Terms of Transactions 4. Commercial banks shall conduct forward bond transactions and bond options transactions with underlying debt instruments denominated in Baht only in the following cases: 4.1 Underlying securities are treasury bonds, government bonds, Bank of Thailand (BOT) bonds, state enterprise bonds and debentures guaranteed by the government, debt instruments issued by international organizations such as the International Monetary Fund (IMF), the Asian Development Bank (ADB) and the World Bank and investment-graded debt instruments with BBB rating or equivalent from credit rating agencies approved by the Office of the Securities and Exchange Commission. 4.2 An agreement of notional amount and payment of price shall be made in Thai Baht only. 4.3 Counterparties are institutional investors only as stipulated in the appendix. 5. Commercial banks shall conduct forward bond transactions and bond options transactions with underlying debt instruments denominated in foreign currency only when parties are financial institutions authorized to conduct foreign exchange business or being non-resident person. Transactions with a non-resident person must result in an agreement where notional amount and payment is made in foreign currencies only. 6. Commercial banks are allowed to conduct equity index linked swap transactions only in the following cases: 6.1 It is a swap between rate of return of domestic reference rate and rate of return of Thai equity index; namely, SET Index, SET 50 and Basket Index of listed securities in the Stock Exchange of Thailand with a maturity date of not more than three years, with counterparties who are institutional investors as stipulated in the appendix where notional amount and payment must be agreed upon in Baht currency only. 6.2 It is a swap between the rate of foreign reference rate and rate of return of foreign equity index, with trading partners who are financial institutions authorized to conduct foreign exchange business or being a non-resident person whereby transactions with such non-resident person must include agreement on notional amount and payment in foreign currencies only. 7. Commercial banks shall comply with the following: 7.1 Commercial banks are allowed to engage in the following transactions: (1) Forward bond transactions for hedging purposes (2) Purchase of bond options both for hedging and trading purposes (3) Sale of bond options where commercial banks have ownership thereof 7.2 Commercial banks are allowed to engage in forward bond transactions, and sales of bond options for trading purposes and equity index linked swap transaction provided that commercial banks are complying with the following conditions: (1) A bank's Board of Directors or its management with relevant power and responsibility (in case of a foreign commercial bank branch) must understand the characteristics of the transactions and related risks. A sub-committee and a high-level management designated to supervise the engagement of such transactions must have high knowledge and understanding of such transactions and related risks. They must also be persons who closely monitor such transactions in accordance with an approved policy and must place a priority on risk management incurring from engaging in such transactions. (2) Commercial banks must determine a policy, strategy, procedure relating to the transactions, risk management relevant thereto and internal auditing in a clear and written form. The policy must be approved by the bank's Board of Directors or an executive committee having related duties and responsibilities (in case of foreign bank branch) or a sub-committee designated to supervise engaging in such transactions. (3) Commercial banks must establish an independent risk management unit to assess, follow-up, supervise and monitor the overall risk management practice of their commercial banks. Reports shall be made directly to the Board of Director via the risk management committee on a regular basis. In case of a foreign bank branch, such risk management unit may be established at a regional office, but a report shall be regularly made to a unit designated by the head office. (4) Commercial banks must provide adequate personnel to accommodate an efficient and comprehensive conduct of the transactions. The personnel shall be knowledgeable, insightful with enough expertise and experiences. (5) Commercial banks must be confident that they have put in place overall supervision and risk management measures, which are effective and reflective as well as absorb all risks that may incur from a transaction. Such measures shall focus on efficiency in managing interest rate risk, equity price risk, all risks resulted from options transaction, liquidity risk and credit risk. Commercial banks shall also put in place a risk-measuring system, which can reflect an overall risk as well as each type of risk in a clear, accurate and precise manner. The risk management system shall be implemented to control and supervise risks in practical terms. Criteria and procedures to assess the mark to market value in an appropriate, clear and reflecting the actual market value shall also be determined. The assessment of mark to market value of the outstanding balance must be made at the end of every business day. Limits shall be determined to be in line with the overall risk management system, its operation and its capital fund position. A test for efficiency, accuracy and preciseness of its internal risk management system must be conducted within an appropriate timeframe by; for example, a back test. A stress test of the Value at Risk model shall also be conducted on a consistent basis. (6) Commercial banks must be confident that its internal supervision system is able to support the engagement of such transactions efficiently, adequately and appropriately. There shall be clear and written regulations and practice guidelines of an internal control. A controlling structure shall be determined together with a proper division of responsibilities. There shall be an auditing of the internal control system and compliance with the internal control measures on a regular basis. In addition, a data system to report risks shall be established where report is to be submitted to the Audit Committee or an authority designated by the head office, in case of foreign bank branch, whereby the authority may locate at the regional office. (7) Commercial banks are required to deduct, in a trial manner, net loss of each month resulted from an assessment of a mark to market value of portfolio of transactions in Clause 1, Clause 2 and Clause 3 and transactions acting as hedging instruments of portfolio in Clause 1, Clause 2 and Clause 3, from an amount of capital fund at the latest month being reported. If it appears that commercial bank's capital fund after the deduction is lower than the minimum capital fund legally required to maintain, the commercial bank is prohibited to conduct further transaction to avoid further losses, unless it is to unwind position. The commercial bank's risk management unit must be responsible for closed supervision to ensure that there is compliance according to a pre-determined stop loss limit. 8. Commercial banks about to conduct the transaction in Clause 1, Clause 2 and Clause 3 must analyze credit risk of their counterparties in accordance with approval procedures to consider limit amount for doing such transactions in a thorough and precautious manner. 9. Commercial banks must record transaction activities, recognize profit and loss as well as disclose information in their financial statements in an accurate way according to the accounting standards or international practices. 10. Commercial banks must report forward bond transactions and bond options transactions to the Thai Bond Dealing Center (TBDC) based on details determined thereby. 11. Commercial banks about to conduct the transactions mentioned above must comply with supervisory regulation of these kinds of transactions determined by the Bank of Thailand. 12. Commercial banks must keep evidences of entering into the transactions at the banks for commercial bank auditor to examine or they may send copies thereof to the Bank of Thailand upon request. 13. This Notification shall come into force from the day following the date of its announcement in the Government Gazette. Notified on this 8th of April 2003. (M.R. Pridiyathorn Devakula) Governor Bank of Thailand List of Institutional Investors 1. Commercial banks 2. Finance companies 3. Securities companies 4. Non-life insurance companies 5. Life insurance companies 6. Bank of Thailand 7. Juristic persons established under specific laws 8. Government agencies and state enterprises established under the laws governing budget procedures 9. The Financial Institution Development Fund 10. Pension funds 11. Provident funds 12. Mutual funds 13. Private funds 14. Juristic persons having total assets according to an audited financial statement at the latest period of Baht 500 million or moreNote: Institutional investors subject to supervision by other state agencies must be permitted to engage in these kinds of transactions by such agencies as well.-NT-