[Federal Register Volume 59, Number 248 (Wednesday, December 28, 1994)]
[Unknown Section]
[Page ]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-31730]
[Federal Register: December 28, 1994]
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DEPARTMENT OF THE TREASURY
12 CFR Part 3
[Docket No. 94-24]
RIN 1557-AB14
Office of Thrift Supervision
12 CFR Part 567
[Docket No. 94-258]
RIN 1550-AA75
Risk-Based Capital Standards; Bilateral Netting Requirements
AGENCIES: Office of the Comptroller of the Currency (OCC), Department
of the Treasury and the Office of Thrift Supervision (OTS), Department
of the Treasury.
ACTION: Final rule.
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SUMMARY: The OCC and the OTS (the banking agencies) are amending their
respective risk-based capital standards to recognize the risk-reducing
benefits of qualifying bilateral netting contracts. On December 7,
1994, the Board of Governors of the Federal Reserve System (Board)
issued a similar final rule. This final rule implements a recent
revision to the Basle Accord permitting the recognition of such netting
arrangements. The effect of the final rule is that banks, thrifts and
savings associations (institutions or banking institutions) may net
positive and negative mark-to-market values of interest and exchange
rate contracts in determining the current exposure portion of the
credit equivalent amount of such contracts to be included in risk-
weighted assets.
EFFECTIVE DATE: December 31, 1994.
FOR FURTHER INFORMATION CONTACT:
OCC: For issues relating to netting and the calculation of risk-
based capital ratios, Roger Tufts, Senior Economic Advisor (202/874-
5070), Office of the Chief National Bank Examiner. For legal issues,
Eugene H. Cantor, Senior Attorney, Securities & Corporate Practices
(202/874-5210), or Ronald Shimabukuro, Senior Attorney, Legislative and
Regulatory Activities Division (202/874-4460), Office of the
Comptroller of the Currency, 250 E Street, SW., Washington, DC 20219.
OTS: John F. Connolly, Senior Program Manager, Capital Policy (202/
906-6465); Vicki Hawkins-Jones, Senior Attorney (202/906-7034),
Regulations and Legislation Division, Office of Thrift Supervision,
1700 G Street, NW., Washington, DC 20552.
SUPPLEMENTARY INFORMATION:
Background
The Basle Accord\1\ established a risk-based capital framework
which was implemented in the United States by the banking agencies in
1989. Under this framework, off-balance-sheet interest rate and
exchange rate contracts (rate contracts) are incorporated into risk
weighted assets by converting each contract into a credit equivalent
amount. This amount is then assigned to the appropriate credit risk
weight category according to the identity of the obligor or
counterparty or, if relevant, the guarantor or the nature of the
collateral. The credit equivalent amount of an interest or exchange
rate contract can be assigned to a maximum credit risk category of 50
percent.
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\1\The Basle Accord is a risk-based framework that was proposed
by the Basle Accord Committee on Banking Supervison (Basle
Supervisors' Committee) and endorsed by the central bank governors
of the Group of Ten (G-10) countries in July 1988. The Basle
Supervisors' Committee is comprised of representatives of the
central banks and supervisory authorities from the G-10 countries
(Belgium, Canada, France, Germany, Italy, Japan, Netherlands,
Sweden, Switzerland, the United Kingdom, and the United States) and
Luxembourg.
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The credit equivalent amount of a rate contract is determined by
adding together the current replacement cost (current exposure) and an
estimate of the possible increase in future replacement cost in view of
the volatility of the current exposure over the remaining life of the
contract (potential future exposure, also referred to as the add-
on).\2\
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\2\This method of determining credit equivalent amounts for rate
contracts is identified in the Basle Accord as the current exposure
method, which is used by most international banks.
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For risk-based capital purposes, a rate contract with a positive
mark-to-market value has a current exposure equal to that market value.
If the mark-to-market value of a rate contract is zero or negative,
then there is no replacement cost associated with the contract and the
current exposure is zero. The original Basle Accord and U.S. banking
agency standards provided that current exposure would be determined
individually for each rate contract entered into by an institution;
institutions generally were not permitted to offset, that is, net,
positive and negative market values of multiple rate contracts with a
single counterparty to determine one current credit exposure relative
to that counterparty.\3\
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\3\It was noted in the Basle Accord that the legal
enforceability of certain netting arrangements was unclear in some
jurisdictions. The legal status of netting by novation, however, was
determined to be settled and this limited type of netting was
recognized. Netting by novation is accomplished under a written
bilateral contract providing that any obligation to deliver a given
currency on a given date is automatically amalgamated with all other
obligations for the same currency and value date. The previously
existing contracts are extinguished and a new contract for the
single net amount, in effect, legally replaces the amalgamated gross
obligations.
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In April 1993 the Basle Supervisors' Committee proposed a revision
to the Basle Accord, endorsed by the G-10 Governors in July 1994, that
permits institutions to net positive and negative market values of rate
contracts subject to a qualifying, legally enforceable, bilateral
netting arrangement. Under the revision, institutions with qualifying
netting arrangements may calculate a single net current exposure for
purposes of determining the credit equivalent amount for the included
contracts.\4\ If the net market value of the contracts included in such
a netting arrangement is positive, then that market value equals the
current exposure for the netting contract. If the net market value is
zero or negative, then the current exposure is zero.
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\4\The revision to the Basle Accord notes that national
supervisors must be satisfied about the legal enforceability of a
netting arrangement under the laws of each jurisdiction relevant to
the arrangement. The Basle Accord also states that, if any
supervisor is dissatisfied about enforceability under its own laws
the netting arrangement does not satisfy this condition and neither
counterparty may obtain supervisory benefit.
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The Banking Agencies' Proposals
On May 20, 1994, the OCC issued a joint proposal with the Board to
amend their respective risk-based capital standards (59 FR 26456) in
accordance with the Basle Supervisors' Committee's April 1993 proposal.
The OTS and the Federal Deposit Insurance Corporation (FDIC) issued
their parallel netting proposals on June 14, 1994 (59 FR 30538) and
July 25, 1994 (59 FR 37726), respectively. The banking agencies each
proposed that for capital purposes the institutions under their
supervision could net the positive and negative market values of
interest and exchange rate contracts subject to a qualifying, legally
enforceable, bilateral netting contract to calculate one current
exposure for that master netting contract.
The proposals provided that the net current exposure would be
determined by adding together all positive and negative market values
of individual contracts subject to the netting contract. The net
current exposure would equal the sum of the market values if that sum
is a positive value, or zero if the sum of the market values is zero or
a negative value. The proposals did not alter the calculation method
for potential future exposure.\5\
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\5\Potential future exposure is estimated by multiplying the
effective notional amount of a contract by a credit conversion
factor which is based on the type of contract and the remaining
maturity of the contract. Under the proposals, a potential future
exposure amount would be calculated for each individual contract
subject to the netting contract. The individual potential future
exposures would then be added together to arrive at one total add-on
amount.
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Under the proposals, institutions would be able to net for risk-
based capital purposes only with a written bilateral netting contract
that creates a single legal obligation covering all included individual
rate contracts and does not contain a walkaway clause.\6\ The proposals
required an institution to obtain a written and reasoned legal
opinion(s) stating that under the master netting contract the
institution would have a claim to receive, or an obligation to pay,
only the net amount of the sum of the positive and negative market
values of included individual contracts if a counterparty failed to
perform due to default, insolvency, bankruptcy, liquidation, or similar
circumstances.
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\6\A walkaway clause is a provision in a netting contract that
permits a non-defaulting counterparty to make lower payments than it
would make otherwise under the contract, or no payment at all, to a
defaulter or to the estate of a defaulter, even if the defaulter or
the estate of the defaulter is a net creditor under the contract.
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The proposals indicated that the legal opinion must normally cover:
(i) The law of the jurisdiction in which the counterparty is chartered,
or the equivalent location in the case of noncorporate entities, and if
a branch of the counterparty is involved, the law of the jurisdiction
in which the branch is located; (ii) the law that governs the
individual contracts covered by the netting contract; and (iii) the law
that governs the netting contract.
The proposals provided that an institution must maintain in its
files documentation adequate to support the bilateral netting contract.
Documentation would typically include a copy of the bilateral netting
contract, legal opinions and any related translations. In addition, the
proposals required an institution to establish and maintain procedures
to ensure that the legal characteristics of netting contracts would be
kept under review.
Under the proposals, the banking agencies could disqualify any or
all contracts from netting treatment for risk-based capital purposes if
the requirements of the proposals were not satisfied. In the event of
disqualification, the affected contracts would be treated as though
they were not subject to the master netting contract. The proposals
indicated that outstanding netting by novation arrangements would not
be grandfathered, that is, such arrangements would have to meet all of
the proposed requirements for qualifying bilateral netting contracts.
The proposals requested general comments as well as specific
comments on the nature of collateral arrangements and the extent to
which collateral might be recognized in conjunction with bilateral
netting contracts. On December 7, 1994, the Board which worked with the
banking agencies on the proposal, issued its version of the final rule
in 59 FR 62987 (December 7, 1994).
Comments Received
The banking agencies together received 21 public comments on their
proposed amendments. Thirteen comments were from banks, thrifts, and
bank and thrift holding companies and five were from industry trade
associations and organizations. In addition, there were three comments
from law firms. All commenters supported the expanded recognition of
bilateral netting contracts for risk-based capital purposes. Several
commenters encouraged recognition of such contracts as quickly as
possible. Many of the commenters concurred with one of the principal
underlying tenets of the proposals, that is, that legally enforceable
bilateral netting contracts can provide an efficient and desirable
means for institutions to reduce or control credit exposure. A few
commenters noted that, in their view, the recognition of bilateral
netting contracts would create an incentive for market participants to
use such arrangements and would encourage lawmakers to clarify the
legal status of netting arrangements in their jurisdictions. One
commenter noted that the expanded recognition of bilateral netting
contracts would help keep U.S. banking institutions competitive in
global derivatives markets.
While generally expressing their endorsement for the expanded
recognition of bilateral netting contracts, nearly all commenters
offered suggestions or requested clarification regarding details of the
proposals. In particular, the commenters raised issues concerning
specifics of the required legal opinions, the treatment of collateral,
and the grandfathering of walkaway clauses and novation agreements.
Legal Opinions
Almost all commenters addressed the proposed requirement that
institutions obtain legal opinions concluding that their bilateral
netting contracts would be enforceable in all relevant jurisdictions.
Commenters did not object to the general requirement that they secure
legal opinions, rather they raised a number of questions about the form
and substance of an acceptable opinion.
Form
Several commenters requested clarification as to the specific form
of the legal opinion. Commenters wanted to know if a memorandum of law
would satisfy the requirement or if a legal opinion would be required.
They questioned whether a memorandum or opinion could be addressed to,
or obtained by, an industry group, and whether a generic opinion or
memorandum relating to a standardized netting contract would satisfy
the legal opinion requirement.
Several commenters suggested that an opinion secured on behalf of
the banking industry by an institution should be sufficient so long as
the individual institution's counsel concurs with the opinion and
concludes that the opinion applies directly to the institution's
specific netting contract and to the individual contracts subject to
it. A few commenters requested confirmation that legal opinions would
not have to follow a predetermined format.
Scope
Several commenters identified two possible interpretations of the
proposed language with regard to the scope of the legal opinions. They
asked the banking agencies to clarify whether the opinions would be
required to discuss only whether all relevant jurisdictions would
recognize the contractual choice of law, or whether they must also
discuss the enforceability of netting in bankruptcy or other instances
of default. One commenter suggested deleting the requirement for a
choice of law analysis.
A number of commenters objected to the proposed requirement that
the legal opinion for a multibranch netting contract (that is, a
netting contract between multinational banks that includes contracts
with branches of the parties located in various jurisdictions) address
the enforceability of netting under the law of the jurisdiction where
each branch is located. These commenters stated that it should be
sufficient for the legal opinion to conclude that netting would be
enforced in the jurisdiction of the counterparty's home office if the
master netting contract provides that all transactions are considered
obligations of the home office and the branch jurisdictions recognize
that provision.
Severability
Several commenters expressed concern about the proposed treatment
for netting contracts that include contracts with branches in
jurisdictions where the enforceability of netting is unclear. In such
circumstances, commenters asserted, unenforceability or uncertainty in
one jurisdiction should not invalidate the entire netting contract for
risk-based capital netting treatment. These commenters contended that
contracts with branches of a counterparty in jurisdictions that
recognize netting arrangements should be netted and contracts with
branches in jurisdictions where the enforceability of netting is not
supported by legal opinions should, for risk-based capital purposes, be
severed, or removed from the master netting contract and treated as
though they were not subject to that contract. These commenters noted
that this treatment should only be available to the extent it is
supported by legal opinion.
Conclusions
The proposals required a legal opinion to conclude that ``relevant
court and administrative authorities would find'' the netting to be
effective. Many commenters that discussed this aspect of the proposals
expressed concern that this standard was too high. They suggested,
instead, that the opinions be required to conclude that netting
``should'' be effective.
A few commenters requested clarification regarding the proposed
requirement that the netting contract must create a single legal
obligation.
Collateral
Twelve commenters addressed the proposals' specific request for
comment on the nature of collateral and the extent to which collateral
might be recognized in conjunction with bilateral netting contracts.
All of these commenters believed collateral should be recognized as a
means of reducing credit exposure. A few commenters noted that
collateral arrangements are increasingly being used with derivative
transactions.
Several commenters stated that for netting contracts that call for
the use of collateral, the amount of required collateral is determined
from the net mark-to-market value of the master netting contract. A few
commenters added that mark-to-market collateral often is used in
conjunction with a collateral ``add-on'' based on such things as the
notional amount of the underlying contracts, the maturities of the
contracts, the credit quality of the counterparty, and volatility
levels.
A number of commenters offered their opinions as to how collateral
should be recognized for risk-based capital purposes. Some suggested
that the existing method of recognizing collateral for purposes of
assigning credit equivalent amounts to risk categories is applicable to
derivative transactions as well. Other commenters expressed the view
that collateral should be recognized when assigning risk weights to the
extent it is legally available to cover the total credit exposure for
the bilateral netting contract in the event of default and that this
availability should be addressed in the legal opinions.
Several other commenters suggested separating the net current
exposure and potential future exposure of bilateral netting contracts
for determining collateral coverage and appropriate risk weights. One
commenter favored recognizing collateral for capital purposes by
allowing an institution to offset net current exposure by the amount of
the collateral to further reduce the credit equivalent amount.
Two commenters requested clarification that contracts subject to
qualifying netting contracts could be eligible for a zero percent risk
weight if the transaction is properly collateralized in accordance with
the collateralized transactions rule proposed by the OCC in August
1993, when it is issued as a final rule. \7\
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\7\In August 1993, the OCC issued a proposed amendment to its
risk-based capital guidelines permitting certain collateralized
transactions to qualify for a zero percent risk weight (58 FR 43822,
August 18, 1993). In order to qualify for a zero percent risk
weight, an institution would need to maintain a positive margin of
qualifying collateral at all times. The collateral arrangement
should provide for immediate liquidation of the claim in the event
that a positive margin of collateral is not maintained. The Board
issued a final rule with similar provisions in December 1992 (57 FR
62180, December 30, 1992).
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Walkaway Clauses
Several commenters addressed the proposed prohibition against
walkaway clauses in contracts qualifying for netting for risk-based
capital purposes. While most of these commenters agreed that,
ultimately, walkaway clauses should be eliminated from master netting
contracts, they favored a phase-out period, during which outstanding
bilateral netting contracts containing walkaway clauses could qualify
for capital netting treatment. Several commenters contended that if a
defaulter is a net debtor under the contract, the existence of a
walkaway clause would not affect the amount owed to the non-defaulting
creditor.
Novation
A few commenters expressed concern that the banking agencies'
proposals did not grandfather outstanding novation agreements. These
commenters suggested a phase-in period during which novation agreements
would not be required to be supported by legal opinions.
Other Issues
One commenter requested greater detail on the nature and extent of
examination review procedures. Two commenters stated that in some
situations obtaining translations might be burdensome. Another
commenter suggested assurance that the banking agencies would not
disqualify netting contracts in an unreasonable manner.
Approximately one-half of the commenters expressed concern that the
banking agencies' proposals specifically were limited to interest rate
and exchange rate contracts. All of these opposed limiting the range of
products that could be included under qualifying netting contracts. In
this regard, one commenter noted that where there is sufficient legal
support confirming the enforceability of cross-product netting it
should be recognized for capital purposes.
A number of commenters used the proposal as an opportunity to
discuss the manner in which the add-on for potential future exposure is
calculated. They suggested netting contracts should be recognized not
only as a way to reduce the current exposure to a counterparty, but
also the effects of such netting contracts should be taken into account
to reduce the amount of capital institutions must hold against the
potential future exposure to the counterparty.
Final Rule
After considering the public comments received and further
deliberating the issues involved, the banking agencies are adopting a
final rule recognizing, for capital purposes, qualifying bilateral
netting contracts. This final rule is substantially the same as
proposed.
Legal opinions
Form
The final rule affirms the usual and customary industry practice by
providing that institutions obtain a written and reasoned legal
opinion(s) concluding that the netting contract is enforceable in all
relevant jurisdictions. The legal opinion provisions of the final rule
are aimed at ensuring there is a substantial legal basis supporting the
legal enforceability of a netting contract before reducing a banking
institution's capital requirement based on that netting contract. A
legal opinion, as that phrase is commonly understood by the legal
community in the United States, can provide such a legal basis. A
memorandum of law may be consistent with prudent banking practices
provided it addresses all of the relevant issues in a credible manner
and represents that netting is enforceable in all relevant
jurisdictions.
As discussed in the proposals, legal opinions on bilateral netting
contracts are prepared by either an outside law firm or an
institution's in-house counsel, and need to (i) address all relevant
jurisdictions, and (ii) conclude with a high degree of certainty that
in the event of a legal challenge the banking institution's claim or
obligation would be determined by the relevant court or administrative
authority to be the net sum of the positive and negative mark-to-market
values of all individual contracts subject to the bilateral netting
contract. The subject matter and complexity of required legal opinions
will vary.
Institutions sometimes use general, standardized opinions to help
support the legal enforceability of their bilateral netting contracts.
For example, a banking institution may have obtained a memorandum of
law addressing the enforceability of netting provisions in a particular
foreign jurisdiction. This opinion may be used as the basis for
recognizing netting generally in that jurisdiction. However, with
regard to an individual master netting contract, the memorandum of law
is supplemented by an opinion that addresses issues such as the
enforceability of the underlying contracts, choice of law, and
severability.
For example, a generic opinion prepared for a trade association
with respect to the effectiveness of netting under the standard form
agreement issued by the trade association, by itself is generally
inadequate to support a netting contract. Banking institutions
supplement the generic opinion with a review of the terms of the
specific netting contract that the institution is executing.
Scope
With regard to the scope of the legal opinions, institutions
following prudent banking practices insure that legal opinions address
the validity and enforceability of the entire netting contract. This
generally involves a legal conclusion that under the applicable state
or other jurisdictional law the netting contract is a legal, valid, and
binding contract, enforceable in accordance with its terms, even in the
event of insolvency, bankruptcy, or similar proceedings. Opinions
provided on the law of jurisdictions outside of the U.S. should include
a discussion and conclusion that netting provisions do not violate the
public policy or the law of that jurisdiction.
A critical aspect of a qualified netting contract is the contract's
enforceability in any jurisdiction whose law would likely be applied in
an enforcement action, as well as the jurisdiction where the
counterparty's assets reside. In this regard, and in light of the
policy in some countries to liquidate branches of foreign banking
institutions independent of the head office, prudent banking practices
include ensuring that legal opinions address the netting contract's
enforceability under: (i) The law of the jurisdiction in which the
counterparty is chartered, or the equivalent location in the case of
noncorporate entities, and if a branch of the counterparty is involved,
the law of the jurisdiction in which the branch is located; (ii) the
law that governs the individual contracts subject to the bilateral
netting contract; and (iii) the law that governs the netting contract.
Severability
The banking agencies recognize that for some multibranch netting
contracts an institution may not be able to obtain a legal opinion(s)
concluding that netting would be enforceable in every jurisdiction
where branches covered under the master netting contract are located.
The banking agencies concur with commenters that in such situations it
may be inefficient for institutions to renegotiate netting contracts to
ensure they cover only those jurisdictions where netting is clearly
enforceable. In certain circumstances for capital purposes, banking
institutions may use master bilateral netting contracts that include
contracts with branches across all jurisdictions. Banking institutions
should calculate their net current exposure for the contracts in those
jurisdictions where netting clearly is enforceable as supported by
legal opinion(s). The remaining contracts subject to the netting
contract are severed from the netting contract and treated as though
they were not subject to the netting contract for capital and credit
purposes. This approach of essentially dividing contracts subject to
the netting contact into two categories--those that clearly may be
netted and those that may not--is consistent with prudent banking
practices provided that the banking institution's legal opinions
conclude that the contracts that do not qualify for netting treatment
are legally severable from the master netting contract and that such
severance will not undermine the enforceability of the netting contract
for the remaining qualifying contracts.
Conclusions
The banking agencies have retained the proposed language concerning
legal opinions, which is consistent with the prudent industry practice
of obtaining legal opinions representing that netting is enforceable in
all relevant jurisdictions. In response to commenters' assertions that
the standard for this type of legal opinion is too high, the banking
agencies note that use of the word ``would'' in the capital rules does
not necessarily mean that the legal opinions must also use the word
``would'' or that enforceability must be determined to be an absolute
certainty. The intent, rather, is for banking institutions to continue
to secure a legal opinion indicating with a high degree of certainty
that a netting contract will survive a legal challenge in any
applicable jurisdiction. The degree of certainty should be apparent
from the reasoning set out in the opinion.
As discussed above, a netting contract may include individual
contracts that do not qualify for netting treatment, provided that
these individual contracts are legally severable from the contracts to
be netted for capital purposes. Legal opinions obtained by banking
institutions under this final rule will address only those individual
contracts that are covered by, and included under, the netting contract
for capital purposes, e.g., not severed contracts.
Institutions generally must include all contracts covered by a
qualifying netting contract in calculating the current exposure of that
netting contract. In the event a netting contract covers transactions
that are normally excluded from the risk-based ratio calculation, an
institution may choose to either include or exclude all mark-to-market
values of such contracts when determining net current exposure, but
this choice must be followed consistently. Examples of such contracts
include exchange rate contracts with an original maturity of fourteen
calendar days or less or instruments traded on exchanges that require
daily payment of variation margin.
Collateral
The final rule permits, subject to certain conditions, institutions
to take into account qualifying collateral when assigning the credit
equivalent amount of a netting contract to the appropriate risk weight
category in accordance with the procedures and requirements currently
set forth in each banking agencies' risk-based capital standards. The
banking agencies have added language to the final rule clarifying that
collateral must be legally available to cover the credit exposure of
the netting contract in the event of default. For example, the
collateral may not be pledged solely against one individual contract
subject to the master netting contract. The legal availability of the
collateral must be addressed in the legal opinions.
Walkaway Clauses
The banking agencies have considered the suggestion made by some
commenters of a phase-out period for outstanding contracts with
walkaway clauses. The banking agencies continue to believe that
walkaway clauses do not reduce credit risk. Accordingly, the final rule
retains the provision that bilateral netting contracts with walkaway
clauses are not eligible for netting treatment for risk-based capital
purposes and does not provide for a phase-out period.
Novation
The proposal required all netting contracts, including netting by
novation agreements, to be supported by written legal opinions. The
banking agencies do not agree with commenters that a grandfathering
period for outstanding novation agreements is needed. Rather, the
banking agencies continue to believe that all netting contracts must be
held to the same standards in order to promote certainty as to the
legal enforceability of the contracts and to decrease the risks faced
by counterparties in the event of default. Under the final rule, a
netting by novation agreement must meet the requirements for a
qualifying bilateral netting contract.
Other Issues
The banking agencies have considered all of the other issues raised
by commenters. With regard to documentation, the banking agencies
reiterate that, as with all provisions of risk-based capital, a banking
institution must maintain in its files appropriate documentation to
support any particular capital treatment including netting of rate
contracts. Appropriate documentation typically would include a copy of
the bilateral netting contract, supporting legal opinions, and any
related translations. The documentation should be available to
examiners for their review.
The banking agencies recognize commenters' concerns that the
proposed rule was limited specifically to interest and exchange rate
contracts. The banking agencies note that both the Basle Accord and
their risk-based capital standards currently do not address derivatives
contracts other than rate contracts. This final rule does not attempt
to go beyond the scope of the existing risk-based capital framework and
applies only to netting contracts encompassing interest rate and
foreign exchange rate contracts. The banking agencies, however, note
that the Basle Supervisors' Committee issued a proposal for public
comment in July 1994 to amend the Basle Accord which explicitly would
set forth the risk-based capital treatment for other types of
derivative transactions, such as commodity, precious metal, and equity
contracts. In this regard, the OCC issued a similar proposal, based on
the Basle Supervisors' Committee proposal, to amend its risk-based
capital standards (59 FR 45243, September 1, 1994).\8\ The OTS intends
to issue a similar proposal in the near future.
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\8\The Board and the FDIC have issued similar proposed rules (59
FR 43508, August 24, 1994 and 59 FR 52714, October 19, 1994,
respectively).
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Until the Basle Accord has been revised and the banking agencies'
risk-based capital rules have been amended to encompass commodity,
precious metal, and equity derivative contracts, the banking agencies,
rather than automatically disqualifying from capital netting treatment
an entire netting contract that includes non-rate-related transactions,
will permit institutions to apply the following treatment. In
determining the current exposure of otherwise qualifying netting
contracts that include non-rate-related contracts, institutions will be
permitted to net the positive and negative mark-to-market values of the
included interest and exchange rate contracts, while severing the non-
rate-related contracts and treating them for risk-based capital
purposes as individual contracts that are not subject to the master
netting contract. (This treatment is similar to the treatment applied
to a netting contract that includes contracts in jurisdictions where
the enforceability of netting is not supported by legal opinion. With
non-rate-related contracts, however, legal opinions on severability are
not required.)
The banking agencies note that the regulatory language with regard
to the calculation of potential future exposure remains essentially the
same as that proposed. The banking agencies have clarified an
underlying premise of the current exposure method for calculating
credit exposure as set forth in the Basle Accord, that is, the add-on
for potential future exposure must be calculated based on the
effective, rather than the apparent, notional principal amount and the
notional amount an institution uses will be subject to examiner
review.\9\
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\9\The notional amount is, generally, a stated reference amount
of money used to calculate payment, streams between the
counterparties. In the event that the effect of the notional amount
is leveraged or enhanced by the structure of the transaction,
institutions must use the actual, or effective, notional amount when
determining potential future exposure. For example, a stated
notional amount of one million dollars with payments calculated at
2X Libor, would have an effective notional amount of two million
dollars.
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Regulatory Flexibility Act Analysis
Pursuant to section 605(b) of the Regulatory Flexibility Act, the
banking agencies hereby certify that this final rule will not have a
significant impact on a substantial number of small business entities.
Accordingly, a regulatory flexibility analysis is not required.
Executive Order 12866
The OCC and the OTS have determined that this final rule is not a
significant regulatory action as defined in Executive Order 12866.
Effective Date
Section 302 of the Riegle Community Development and Regulatory
Improvement Act of 1994 (Pub. L. 103-325, 108 Stat. 2160) provides that
the federal banking agencies must consider the administrative burdens
and benefits of any new regulations that impose additional requirements
on insured depository institutions. Section 302 also requires such a
rule to take effect on the first day of the calendar quarter following
final publication of the rule, unless the agency, for good cause,
determines an earlier effective date is appropriate. Similarly, the
Administrative Procedure Act requires a 30-day delayed effective date,
unless the rule either relieves a restriction or the agency finds good
cause. 5 U.S.C. 553(d) (1) and (3).
This final rule imposes certain requirements on depository
institutions that wish to net the current exposures of their rate
contracts for purposes of calculating their risk-based capital
requirements. For these institutions, any burden of complying with the
requirements of netting under a legally enforceable netting contract
and obtaining the necessary legal opinions should be outweighed by the
benefits associated with a lower capital requirement. This final rule
will not affect institutions that do not wish to net for capital
purposes. For these reasons, the banking agencies have determined that
there is sufficient good cause to provide for an effective date of
December 31, 1994. A year-end effective date allows banking
institutions to take advantage of netting in their year-end statements,
if they so desire. Delay in implementation of this final rule to the
next calendar quarter would be unnecessary and contrary to the public
interest because compliance would be more difficult and costly, and
could require additional accounting adjustments and disclosures.
List of Subjects
12 CFR Part 3
Administrative practice and procedure, Capital, National banks,
Reporting and recordkeeping requirements, Risk.
12 CFR Part 567
Capital, Reporting and recordkeeping requirements, Savings
associations.
Comptroller of the Currency
12 CFR Chapter I
Authority and Issuance
For the reasons set out in the preamble, part 3 of title 12,
chapter I of the Code of Federal Regulations is amended as set forth
below.
PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES
1. The authority citation for part 3 is revised to read as follows:
Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n
note, 3907, and 3909.
2. In Appendix A to part 3, paragraph (c)(15) of section 1 is
removed, paragraphs (c)(16) through (c)(29) are redesignated as
paragraphs (c)(15) through (c)(28), and a new paragraph (c)(29) is
added to read as follows:
Appendix A to Part 3--Risk-Based Capital Guidelines
Section 1. Purpose, Applicability of Guidelines, and Definitions.
* * * * *
(c) * * *
(29) Walkaway clause means a provision in a bilateral netting
contract that permits a nondefaulting counterparty to make a lower
payment than it would make otherwise under the bilateral netting
contract, or no payment at all, to a defaulter or the estate of a
defaulter, even if the defaulter or the estate of the defaulter is a
net creditor under the bilateral netting contract.
* * * * *
3. In appendix A, paragraph (b)(5) of section 3 is revised to read
as follows:
* * * * *
Section 3. Risk Categories/Weights for On-Balance Sheet Assets and
Off-Balance Sheet Items.
* * * * *
(b) * * *
(5) Off-balance sheet contracts--interest rate and foreign
exchange rate contracts. (i) Calculation of credit equivalent
amount. The credit equivalent amount of an off-balance sheet
interest rate or foreign exchange rate contract equals the sum of
the current credit exposure (also referred to as the replacement
cost) and the potential future credit exposure of the off-balance
sheet rate contract. The calculation of credit equivalent amounts is
measured in U.S. dollars, regardless of the currency or currencies
specified in the off-balance sheet rate contract.
(A) Current credit exposure. The current credit exposure for a
single off-balance sheet rate contract is determined by the mark-to-
market value of the off-balance sheet rate contract. If the mark-to-
market value is positive, then the current exposure equals that
mark-to-market value. If the mark-to-market value is zero or
negative, the current exposure is zero. However, in determining its
current credit exposure for multiple off-balance sheet rate
contracts executed with a single counterparty, a bank may net
positive and negative mark-to-market values of off-balance sheet
rate contracts if subject to a bilateral netting contract as
provided by section 3(b)(5)(ii) of this appendix A. If the net mark-
to-market value is positive, the current credit exposure equals that
net mark-to-market value. If the net mark-to-market value is zero or
negative, the current exposure is zero.
(B) Potential future credit exposure. The potential future
credit exposure of an off-balance sheet rate contract, including a
contract with a negative mark-to-market value, is estimated by
multiplying the notional principal\19\ by a credit conversion
factor. Banks, subject to examiner review, should use the effective
rather than the apparent or stated notional amount in this
calculation. The credit conversion factors are:\20\
---------------------------------------------------------------------------
\19\For purposes of calculating potential future credit exposure
for foreign exchange contracts and other similar contracts, in which
notional principal is equivalent to cash flows, total notional
principal is defined as the net receipts to each party falling due
on each value date in each currency.
\20\No potential future credit exposure is calculated for single
currency interest rate swaps in which payments are made based upon
two floating rate indices, so-called floating/floating or basis
swaps; the credit equivalent amount is measured solely on the basis
of the current credit exposure.
------------------------------------------------------------------------
Foreign
Interest exchange
Remaining maturity rate rate
contracts contracts
(percents) (percents)
------------------------------------------------------------------------
One year or less.............................. 0.0 1.0
Over one year................................. 0.5 5.0
------------------------------------------------------------------------
(ii) Off-balance sheet rate contracts subject to bilateral
netting contracts. In determining its current credit exposure for
multiple off-balance sheet rate contracts executed with a single
counterparty, a bank may net off-balance sheet rate contracts
subject to a bilateral netting contract by offsetting positive and
negative mark-to-market values, provided that:
(A) The bilateral netting contract is in writing;
(B) The bilateral netting contract is not subject to a walkaway
clause;
(C) The bilateral netting contract creates a single legal
obligation for all individual off-balance sheet rate contracts
covered by the bilateral netting contract. In effect, the bilateral
netting contract provides that the bank has a single claim or
obligation either to receive or pay only the net amount of the sum
of the positive and negative mark-to-market values on the individual
off-balance sheet contracts covered by the bilateral netting
contract. The single legal obligation for the net amount is
operative in the event that a counterparty, or a counterparty to
whom the bilateral netting contract has been validly assigned, fails
to perform due to any of the following events: default, insolvency,
bankruptcy, or other similar circumstances;
(D) The bank obtains a written and reasoned legal opinion(s)
representing, with a high degree of certainty, that in the event of
a legal challenge, including one resulting from default, insolvency,
bankruptcy, or similar circumstances, the relevant court and
administrative authorities would find the bank's exposure to be the
net amount under:
(I) The law of the jurisdiction in which the counterparty is
chartered or the equivalent location in the case of noncorporate
entities, and if a branch of the counterparty is involved, then also
under the law of the jurisdiction in which the branch is located;
(II) The law that governs the individual off-balance sheet rate
contracts covered by the bilateral netting contract; and
(III) The law that governs the bilateral netting contract;
(E) The bank establishes and maintains procedures to monitor
possible changes in relevant law and to ensure that the bilateral
netting contract continues to satisfy the requirements of this
section; and
(F) The bank maintains in its files documentation adequate to
support the netting of an off-balance sheet rate contract.\21\
---------------------------------------------------------------------------
\21\By netting individual off-balance sheet rate contracts for
the purpose of calculating its credit equivalent amount, a bank
represents that documentation adequate to support the netting of an
off-balance sheet rate contract is in the bank's files and available
for inspection by the OCC. Upon determination by the OCC that a
bank's files are inadequate or that a bilateral netting contract may
not be legally enforceable under any one of the bodies of law
described in sections 3(b)(5)(ii)(D) (I) through (III) of this
appendix A, the underlying individual off-balance sheet rate
contracts may not be netted for the purpose of this section.
---------------------------------------------------------------------------
(iii) Risk weighting. Once the bank determines the credit
equivalent amount for an off-balance sheet rate contract, it assigns
that amount to the counterparty's appropriate risk weight category
or, if relevant, to the nature of any collateral or guarantee.
Collateral held against a netting contract is not recognized for
capital purposes unless it is legally available for all contracts
included in the netting contract. However, the maximum risk weight
for the credit equivalent amount of such an off-balance sheet rate
contract is 50 percent.
(iv) Exceptions. The following off-balance sheet rate contracts
are not subject to the above calculation, and therefore, are not
part of the denominator of a national bank's risk-based capital
ratio:
(A) A foreign exchange rate contract with an original maturity
of 14 calendar days or less; and
(B) Any interest rate or foreign exchange rate contract that is
traded on an exchange requiring the daily payment of any variations
in the market value of the contract.
* * * * *
4. The table title and the introductory text to Table 3 to appendix
A are revised to read as follows:
* * * * *
Table 3--Treatment of Interest Rate and Foreign Exchange Rate Contracts
The current exposure method is used to calculate the credit
equivalent amounts of these off-balance sheet rate contracts. These
amounts are assigned a risk weight appropriate to the obligor or any
collateral or guarantee. However, the maximum risk weight is limited
to 50 percent. Multiple off-balance sheet rate contracts with a
single counterparty may be netted if those contracts are subject to
a qualifying bilateral netting contract.
* * * * *
Office of Thrift Supervision
12 CFR Chapter V
Authority and Issuance
For the reasons set out in the preamble, part 567, of chapter V,
title 12 of the Code of Federal Regulations is amended as set forth
below:
SUBCHAPTER D--REGULATIONS APPLICABLE TO ALL SAVINGS ASSOCIATIONS
1. The authority citation for part 567 continues to read as
follows:
Authority: 12 U.S.C. 1462, 1462a, 1463, 1464, 1467a, 1828
(note).
2. Section 567.6 is amended by revising paragraph (a)(2)(v) to read
as follows:
Sec. 567.6 Risk-based capital credit risk-weight categories.
(a) * * *
(2) * * *
(v) Off-balance sheet contracts; interest-rate and foreign exchange
rate contracts (Group E)--(A) Calculation of credit equivalent amounts.
The credit equivalent amount of an off-balance sheet interest rate or
foreign exchange rate contract that is not subject to a qualifying
bilateral netting contract in accordance with paragraph (a)(2)(v)(B) of
this section is equal to the sum of the current credit exposure, i.e.,
the replacement cost of the contract, and the potential future credit
exposure of the off-balance sheet rate contract. The calculation of
credit equivalent amounts is measured in U.S. dollars, regardless of
the currency or currencies specified in the off-balance sheet rate
contract.
(1) Current credit exposure. The current credit exposure of an off-
balance sheet rate contract is determined by the mark-to-market value
of the contract. If the mark-to-market value is positive, then the
current credit exposure equals that mark-to-market value. If the mark-
to-market value is zero or negative, then the current exposure is zero.
In determining its current credit exposure for multiple off-balance
sheet rate contracts executed with a single counterparty, a savings
association may net positive and negative mark-to-market values of off-
balance sheet rate contracts if subject to a bilateral netting contract
as provided in paragraph (a)(2)(v)(B) of this section.
(2) Potential future credit exposure. The potential future credit
exposure of an off-balance sheet rate contract, including a contract
with a negative mark-to-market value, is estimated by multiplying the
notional principal\9\ by a credit conversion factor. Savings
associations, subject to examiner review, should use the effective
rather than the apparent or stated notional amount in this calculation.
The conversion factors are:\10\
---------------------------------------------------------------------------
\9\For purposes of calculating potential future credit exposure
for foreign exchange contracts and other similar contracts, in which
notional principal is equivalent to cash flows, total notional
principal is defined as the net receipts to each party falling due
on each value date in each currency.
\10\No potential future credit exposure is calculated for single
currency interest rate swaps in which payments are made based upon
two floating rate indices, so-called floating/floating or basis
swaps; the credit equivalent amount is measured solely on the basis
of the current credit exposure.
------------------------------------------------------------------------
Foreign
Interest exchange
Remaining maturity rate rate
contracts contracts
(percents) (percents)
------------------------------------------------------------------------
One year or less.............................. 0.0 1.0
Over one year................................. 0.5 5.0
------------------------------------------------------------------------
(B) Off-balance sheet rate contracts subject to bilateral netting
contracts. In determining its current credit exposure for multiple off-
balance sheet rate contracts executed with a single counterparty, a
savings association may net off-balance sheet rate contracts subject to
a bilateral netting contract by offsetting positive and negative mark-
to-market values, provided that:
(1) The bilateral netting contract is in writing;
(2) The bilateral netting contract creates a single legal
obligation for all individual off-balance sheet rate contracts covered
by the bilateral netting contract. In effect, the bilateral netting
contract provides that the savings association has a single claim or
obligation either to receive or pay only the net amount of the sum of
the positive and negative mark-to-market values on the individual off-
balance sheet rate contracts covered by the bilateral netting contract.
The single legal obligation for the net amount is operative in the
event that a counterparty, or a counterparty to whom the bilateral
netting contract has been validly assigned, fails to perform due to any
of the following events: default, insolvency, bankruptcy, or other
similar circumstances;
(3) The savings association obtains a written and reasoned legal
opinion(s) representing, with a high degree of certainty, that in the
event of a legal challenge, including one resulting from default,
insolvency, bankruptcy or similar circumstances, the relevant court and
administrative authorities would find the savings association's
exposure to be the net amount under:
(i) The law of the jurisdiction in which the counterparty is
chartered or the equivalent location in the case of noncorporate
entities, and if a branch of the counterparty is involved, then also
under the law of the jurisdiction in which the branch is located;
(ii) The law that governs the individual off-balance sheet rate
contracts covered by the bilateral netting contract; and
(iii) The law that governs the bilateral netting contract;
(4) The savings association establishes and maintains procedures to
monitor possible changes in relevant law and to ensure that the
bilateral netting contract continues to satisfy the requirements of
this section; and
(5) The savings association maintains in its files documentation
adequate to support the netting of an off-balance sheet rate
contract.\11\
---------------------------------------------------------------------------
\11\By netting individual off-balance sheet rate contracts for
the purpose of calculating its credit equivalent amount, a savings
association represents that documentation adequate to support the
netting of an off-balance sheet rate contract is in the savings
association's files and available for inspection by the OTS. Upon
determination by the OTS that a savings association's files are
inadequate or that a bilateral netting contract may not be legally
enforceable under any one of the bodies of law described in
paragraphs (a)(2)(v)(B)(3) (i) through (iii) of this section, the
underlying individual off-balance sheet rate contracts may not be
netted for the purposes of this section.
---------------------------------------------------------------------------
(C) Walkaway clause. A bilateral netting contract that contains a
walkaway clause is not eligible for netting for purposes of calculating
the current credit exposure amount. The term ``walkaway clause'' means
a provision in a bilateral netting contract that permits a
nondefaulting counterparty to make a lower payment than it would make
otherwise under the bilateral netting contract, or no payment at all,
to a defaulter or the estate of a defaulter, even if the defaulter or
the estate of the defaulter is a net creditor under the bilateral
netting contract.
(D) Risk weighting. Once the savings association determines the
credit equivalent amount for an off-balance sheet rate contract, that
amount is assigned to the risk-weight category appropriate to the
counterparty, or, if relevant, to the nature of any collateral or
guarantee. Collateral held against a netting contract is not recognized
for capital purposes unless it is legally available for all contracts
included in the netting contract. However, the maximum risk weight for
the credit equivalent amount of such off-balance sheet rate contracts
is 50 percent.
(E) Exceptions. The following off-balance sheet rate contracts are
not subject to the above calculation, and therefore, are not part of
the denominator of a savings association's risk-based capital ratio:
(1) A foreign exchange rate contract with an original maturity of
14 calendar days or less; and
(2) Any interest rate or foreign exchange rate contract that is
traded on an exchange requiring the daily payment of any variations in
the market value of the contract.
* * * * *
Dated: December 7, 1994.
Eugene A. Ludwig,
Comptroller of the Currency.
Dated: December 1, 1994.
Jonathan L. Fiechter,
Acting Director, Office of Thrift Supervision.
[FR Doc. 94-31730 Filed 12-27-94; 8:45 am]
BILLING CODE 4810-33-P AND 6720-01-P
