By John Thackray

The term "risk management czar" has gained a certain cachet lately. A number of investment firms have created such positions on the theory that their czars will set the Cossacks on anyone even thinking about putting on risky trades and/or stuffing tickets in a drawer.

At the Bank of America, however, czar-making is not in the cards. It wouldn't fit its collegial-style management. "There are two models for risk management in big banks," explains Lewis W. "Woody" Teel, the bank's executive vice president for trading risk and regulatory compliance. "In one model risk managers act as policemen. They watch and report and set control limits and then monitor compliance with them. In the other model risk managers are risk czars. They watch exposures, but if they think traders have crossed the comfort level, they will actually execute contracts to bring total exposure down to where they want it. We're not czars in any fashion. We're friendly policemen."

Teel, 55, projects the image of a friendly traffic officer in a banker's dark suit. Joseph P. Bauman, who heads the bank's derivatives group, calls him "a benevolent cop." Not that the twinkle in Teel's eye cannot suddenly turn hard, or that there are not moments of conflict and disagreement. There are, as is only to be expected. When they occur, "Our first line of attack is always the analytic approach," says Bauman. "We look for an appropriate framework and common ground to understand the dynamics of a transaction or a potential business line.

This dialogue, however, doesn't always yield agreement. Analysts in the derivatives group may have a different take on the risks of a transaction than do Teel's analysts. Or the proposed transaction may violate established limits, whereupon Bauman and his staffers look to the outside for valuation models and structures, which they then present to reassure risk managers. In cases where the contemplated transaction or business line is so novel that the two sides still have trouble coming to an agreement, Bauman might get the okay to place the trade in what he calls an "incubator." That involves putting on a few small-scale transactions to allow a business to start and help "get our toes in the water," he says.

Of course there are times when risk management takes a negative view of a particular derivatives trade and that's it. "There have been situations where we've wanted to do something and risk management has said they don't think it's prudent," says Bauman. "If it's that kind of disagreement, then they hold 51 percent of the vote."

Keep it simple

There is a pretty low incidence of such clashes, in part because BofA has not taken the high ground as an innovator. "The bank is not going to sacrifice its risk management discipline to what seems to be the flavor of the moment. We have not tended to be leaders in new product development," says Bauman.

BofA is, in fact, a mountain of plain vanillas. All told, 95 percent of all FX and derivative products outstanding at year-end 1995 were in spot and forward FX contracts, exchange-traded futures contracts and conventional interest rate swaps, caps and floors. According to the 1995 annual report, the notional value of outstanding interest-rate contracts totaled $920 billion. But BofA also mentioned plans to increase usage of nontraditional derivative financial instruments.

As the bank goes down this path, Teel and his staff of 11-about 10 of whom are quants-will continue their practice of "reverse engineering" models used by the derivatives group, part of a certification process for all new products. This process defines mark-to-market and risk assessment procedures and the models and systems to be used in different circumstances.

Teel and Bauman stress that most of the analytical give-and-take occurs on more exotic structures. On vanilla structures Teel's job is to prevent losses arising from three different sources: voluntary positions, inadvertent exposures stemming from a poor understanding of consequences, and outright trader fraud. The latter, of course, is a generic risk in any big bank. "It is something you always worry about," says Teel. "The ticket in the drawer doesn't go into the system. It has happened to us and it has happened to our competitors. When tickets don't go into the system and the counterparty doesn't confirm, there's no way to identify the mounting exposure."

Teel has had to almost triple the size of his department in recent years in order to the manage risks resulting from two BofA mergers: with Security Pacific in 1992 and with Continental Bank in 1994. The combination with SecPac virtually doubled the bank's presence in the swap market, while Continental gave BofA strong product lines in commodities, discounted debt trading and emerging markets.

Teel also stresses that the bank's internal risk management is constantly evolving. Virtually every day some trade opportunity will come up somewhere in the world that needs some tweaking of those limit systems, and Teel's operation is designed to be alert to these opportunities and react promptly. "We want to make sure that our limit systems are flexible so we can adapt to new products and variations that hadn't been thought of last week," he explains. "The markets for trading products are just too complex to try to set anything in concrete."

Pulse of the Market

Corporate relationships are the chief drivers of derivatives at BofA, so naturally there is a high concentration of interest rate and currency derivatives. This focus also gives the bank a deep perspective on Corporate America's mood shifts toward derivatives use, which Bauman believes have been significant in recent months. "We've seen more of a return to products that may be complex for the dealer to hedge but which still address the underlying risks that our clients want to manage," he says. "We are also seeing a healthy flow of new counterparties. There are still a large number of corporations picking up on how to use these instruments. They are being less casual, to be sure, and more careful, as we are, to make sure the product has value."

One growth area targeted by Bauman is public utilities, heretofore low-volume users. Another area where BofA has already made good progress is higher-end middle-market companies with sales of less than $250 million. BofA has a marketing team dedicated to this segment. "It is an area where the need for risk management products is great because these firms have a higher potential to be exposed to big market moves in commodity prices or interest rates," he says.

Earlier this year Bauman formed a structured derivatives group that has been aggressively courting the investment clientele, offering repackaged new and secondary market issues. They've sold step-up notes that have met investor interest and allowed the issuer to achieve attractive after swap funding. Other issues have been more complete re-design jobs.

One such deal that the bank is proud of involved the purchase of municipal tax-exempt paper that was then repackaged for the appetites of money market funds. Earlier this year the City and County of Sacramento issued pension obligation bonds with a pretty unmarketable structure: a zero-coupon issue that converted to interest-paying three years hence. "It wasn't mispriced, but it was an ugly duckling," says James Gill, head of BofA's structured securities team. BofA purchased $79 million of the paper and placed it in a trust structure, which then turned around and paid six monthly dividends. Says Gill, "We took a public instrument that was hard to price and not easy to understand, and which very few investors were looking at, and converted it into something that a money market fund could get its hands around right away."