[Federal Register Volume 59, Number 113 (Tuesday, June 14, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-14266]
[[Page Unknown]]
[Federal Register: June 14, 1994]
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DEPARTMENT OF THE TREASURY
Office of Thrift Supervision
12 CFR Part 567
[No. 94-95]
RIN 1550-AA75
Risk-Based Capital Standards; Bilateral Netting Requirements
AGENCY: Office of Thrift Supervision (OTS), Treasury.
ACTION: Notice of proposed rulemaking.
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SUMMARY: The Office of Thrift Supervision (OTS) is proposing to amend
its risk-based capital standards to recognize the risk-reducing
benefits of netting arrangements. Under the proposal, savings
associations would be permitted to net, for risk-based capital
purposes, interest and exchange rate contracts (rate contracts) subject
to legally enforceable bilateral netting contracts that meet certain
criteria. The OTS is proposing these amendments on the basis of
proposed revisions to the Basle Accord which would permit the
recognition of such netting arrangements. These amendments parallel
recent amendments proposed by the Board of Governors of the Federal
Reserve System (FRB) and the Office of the Comptroller of the Currency
(OCC). 59 FR 26456 (May 20, 1994). The effect of the proposed
amendments would be to allow thrift institutions to net positive and
negative mark-to-market values of rate contracts in determining the
current exposure portion of the credit equivalent amount of such
contracts to be included in risk-weighted assets.
DATES: Comments must be received on or before July 14, 1994.
ADDRESSES: Written comments should be submitted to the Director,
Information Services Division, Public Affairs, Office of Thrift
Supervision, 1700 G Street, NW., Washington, DC 20552, Attention Docket
No. 94-95. These submissions may be hand delivered at 1700 G Street,
NW., from 9 a.m. to 5 p.m. on business days; they may be sent by
facsimile transmission to FAX Number (202) 906-7755. Submissions must
be received by 5 p.m. on the day they are due in order to be considered
by the OTS. Late filed, misaddressed or misidentified submissions will
not be considered in this notice of proposed rulemaking. Comments will
be available for public inspection at 1700 G Street, NW., from 1 p.m.
until 4 p.m. on business days. Visitors will be escorted to and from
the Public Reading Room at established intervals.
FOR FURTHER INFORMATION CONTACT: John F. Connolly, Senior Program
Manager, Capital Policy (202) 906-6455; Lorraine E. Waller, Counsel
(Banking and Finance) (202) 906-6458, Regulations & Legislation
Division, Office of Thrift Supervision, 1700 G Street, NW., Washington,
DC 20552.
SUPPLEMENTARY INFORMATION:
A. Background
The international risk-based capital standards (Basle Accord)1
include a framework for calculating risk-weighted assets by assigning
assets and off-balance sheet items, including interest and exchange
rate contracts, to broad risk categories based primarily on credit
risk. The OTS and the other banking agencies2 each adopted in 1989
similar frameworks to assess the capital adequacy of the banking
organizations under their supervision. Banking organizations and
savings associations (institutions) must hold capital against their
overall credit risk, that is, generally, against the risk that a loss
will be incurred if a counterparty defaults on a transaction.
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\1\The Basle Accord is a risk-based framework that was proposed
by the Basle Committee on Banking Supervision (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, the Netherlands, Sweden, Switzerland,
the United Kingdom, and the United States) and Luxembourg.
\2\The banking agencies are the Office of Thrift Supervision,
the Office of the Comptroller of the Currency, the Board of
Governors of the Federal Reserve System and the Federal Deposit
Insurance Corporation.
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Under the risk-based capital framework, off-balance sheet items are
incorporated into risk-weighted assets by first determining the on-
balance sheet credit equivalent amounts for the items and then
assigning the credit equivalent amounts to the appropriate risk
category according to the obligor, or if relevant, the guarantor or the
nature of the collateral. For many types of off-balance sheet
transactions, the on-balance sheet credit equivalent amount is
determined by multiplying the face amount of the item by a credit
conversion factor. For interest and exchange rate contracts however,
credit equivalent amounts are determined by summing two amounts: the
current exposure and the estimated potential future exposure.3
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\3\Exchange rate contracts with an original maturity of 14
calendar days or less and instruments traded on exchanges that
require daily payment of variation margin are excluded from the
risk-based ratio calculations.
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The current exposure (sometimes referred to as replacement cost) of
a contract is derived from its market value. In most instances the
initial market value of a contract is zero.4 An institution should
mark-to-market all of its rate contracts to reflect the current market
value of the transaction in light of changes in the market price of the
contracts or in the underlying interest or exchange rates. Unless the
market value of a contract is zero, one party will always have a
positive mark-to-market value for the contract, while the other party
(counterparty) will have a negative mark-to-market value.
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\4\An options contract has a positive value at inception, which
reflects the premium paid by the purchaser. The value of the option
may be reduced due to market movements but it cannot become
negative. Therefore, unless an option has zero value, the purchaser
of the option contract will always have some credit exposure, which
may be greater than or less than the original purchase price, and
the seller of the option contract will never have credit exposure.
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An institution holding a contract with a positive mark-to-market
value is ``in-the-money,'' that is, it would have the right to receive
payment from the counterparty if the contract were terminated. Thus, an
institution that is in-the-money on a contract is exposed to
counterparty credit risk, since the counterparty could fail to make the
expected payment. The potential loss is equal to the cost of replacing
the terminated contract with a new contract that would generate the
same expected cash flows under the existing market conditions.
Therefore, the in-the-money institution's current exposure on the
contract is equal to the market value of the contract.
An institution holding a contract with a negative mark-to-market
value, on the other hand, is ``out-of-the-money'' on that contract,
that is, if the contract were terminated, the institution would have an
obligation to pay the counterparty. The institution with the negative
mark-to-market value has no counterparty credit exposure because it is
not entitled to any payment from the counterparty in the case of
counterparty default. Consequently, a contract with a negative market
value is assigned a current exposure of zero. A current exposure of
zero is also assigned to a contract with a market value of zero, since
neither party would suffer a loss in the event of contract termination.
In summary, the current exposure of a rate contract equals either the
positive market value of the contract or zero.
The second part of the credit equivalent amount for rate contracts,
the estimated potential future exposure (often referred to as the add-
on), is an amount that represents the potential future credit exposure
of a contract over its remaining life. This exposure is calculated by
multiplying the notional principal amount of the underlying contract by
a credit conversion factor that is determined by the remaining maturity
of the contract and the type of contract.5 The potential future
credit exposure is calculated for all contracts, regardless of whether
the mark-to-market value is zero, positive, or negative.
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\5\For interest rate contracts with a remaining maturity of one
year or less, the factor is 0% and for those over one year, the
factor is .5%. For exchange rate contracts with a maturity of one
year of less, the factor is 1% and for those over one year the
factor is 5%.
Because exchange rate contracts involve an exchange of principal
upon maturity and are generally more volatile, they carry a higher
conversion factor. No potential future credit exposure is calculated
for single-currency interest-rate swaps in which payments are made
based on two floating indices (basis swaps).
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The potential future exposure is added to the current exposure to
arrive at a credit equivalent amount.\6\ Each credit equivalent amount
is then assigned to the appropriate risk category, according to the
counterparty or, if relevant, the guarantor or the nature of the
collateral. The maximum risk weight applied to such rate contracts is
50 percent.
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\6\This method of determining credit equivalent amounts for rate
contracts is known as the current exposure method, which is used by
most international banks. The Basle Accord permits, subject to each
country's discretion, an alternative method for determining the
credit equivalent amount known as the original exposure method.
Under this method, the capital charge is derived by multiplying the
notional principal amount of the contract by a credit conversion
factor, which varies according to the original maturity of the
contract and whether it is an interest or exchange rate contract.
The conversion factors, which are greater than those used under the
current exposure method, make no distinction between current
exposure and potential future exposure.
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B. Netting and Current Risk-Based Capital Treatment
The banking agencies and the Basle Supervisors' Committee have long
recognized the importance and encouraged the use of netting
arrangements as a means of improving interbank efficiency and reducing
counterparty credit exposure. Netting arrangements are increasingly
being used by institutions engaging in rate contracts. Often referred
to as master netting contracts, these arrangements typically provide
for both payment and close-out netting. Payment netting provisions
permit an institution to make payments to a counterparty on a net basis
by offsetting payments it is obligated to make with payments it is
entitled to receive and, thus, to reduce its costs arising out of
payment settlements.
Close-out netting provisions permit the netting of credit exposures
if a counterparty defaults or upon the occurrence of another event such
as insolvency or bankruptcy. If such an event occurs, all outstanding
contracts subject to the close-out provisions are terminated and
accelerated, and their market values are determined. The positive and
negative market values are then netted, or set off, against each other
to arrive at a single net exposure to be paid by one party to the other
upon final resolution of the default or other event.
The potential for close-out netting provisions to reduce
counterparty credit risk, by limiting an institution's obligation to
the net credit exposure, depends upon the legal enforceability of the
netting contract, particularly in insolvency or bankruptcy.\7\ In this
regard, the Basle Accord noted that while close-out netting could
reduce credit risk exposure associated with rate contracts, the legal
status of close-out netting in many of the G-10 countries was uncertain
and insufficiently developed to support a reduced capital charge for
such contracts.\8\ There was particular concern that a bank's credit
exposure to a counterparty was not reduced if liquidators of a failed
counterparty might assert the right to ``cherry-pick,'' that is, demand
performance on those contracts that are favorable and reject contracts
that are unfavorable to the defaulting party.
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\7\The primary criterion for determining whether a particular
netting contract should be recognized in the risk-based capital
framework is the enforceability of that netting contract in
insolvency or bankruptcy. In addition, the netting contract as well
as the individual contracts subject to the netting contract must be
legally valid and enforceable under non-insolvency or non-bankruptcy
law, as is the case with all contracts.
\8\While payment netting provisions can reduce costs and the
credit risk arising out of daily settlements with a counterparty,
such provisions are not relevant to the risk-based capital framework
since they do not in any way affect the counterparty's gross
obligations.
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Concern over ``cherry-picking'' led the Basle Supervisors'
Committee to limit the recognition of netting in the Basle Accord. The
only type of netting that was considered to genuinely reduce
counterparty credit risk at the time the Accord was endorsed was
netting accomplished by novation.\9\ Under legally enforceable netting
by novation, ``cherry-picking'' cannot occur and, thus, counterparty
risk is genuinely reduced. The Accord stated that the Basle
Supervisors' Committee would continue to monitor and assess the
effectiveness of other forms of netting to determine if close-out
netting provisions could be recognized for risk-based capital purposes.
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\9\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, is legally substituted for the amalgamated gross
obligations. Parties to the novation contract, in effect, offset
their obligations to make payments on individual transactions
subject to the novation contract with their right to receive
payments on other transactions subject to the contract.
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The banking agencies' risk-based capital standards provide for the
same treatment of rate contracts as the Basle Accord, but require that
institutions use the current exposure method. The banking agencies, in
adopting their standards, generally stated they would work with the
Basle Supervisors' Committee in its continuing efforts with regard to
the recognition of netting provisions for capital purposes.
C. Basle Supervisors' Committee Proposal
Since the Basle Accord was adopted, a number of studies have
confirmed that close-out netting provisions can serve to reduce
counterparty risk. In response to the conclusions of these studies, as
well as to industry support for greater acceptance of netting contracts
under the risk-based capital framework, the Basle Supervisors'
Committee issued a consultative paper on April 30, 1993, proposing an
expanded recognition of netting arrangements in the Basle Accord.\10\
Under the proposal, for purposes of determining the current exposure
amount of rate contracts subject to legally enforceable bilateral
close-out netting provisions (that is, close-out netting provisions
with a single counterparty), an institution could net the contracts'
positive and negative mark-to-market values.
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\10\The paper is entitled ``The Prudential Supervision of
Netting, Market Risks and Interest Rate Risk.'' The section
applicable to netting is subtitled ``The Supervisory Recognition of
Netting for Capital Adequacy Purposes.'' This paper is available for
review through the OTS's public information office.
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Specifically, the Basle proposal states that a banking organization
would be able to net rate contracts subject to a legally valid
bilateral netting contract for risk-based capital purposes if it
satisfied the appropriate national supervisor(s) that:
(1) In the event of a counterparty's failure to perform due to
default, bankruptcy or liquidation, the banking organization's claim
(or obligation) would be to receive (or pay) only the net value of the
sum of unrealized gains and losses on included transactions;
(2) It has obtained written and reasoned legal opinions stating
that in the event of legal challenge, the netting would be upheld in
all relevant jurisdictions; and
(3) It has procedures in place to ensure that the netting
arrangements are kept under review in light of changes in relevant law.
The Basle Supervisors' Committee agreed that if a national
supervisor is satisfied that a bilateral netting contract meets these
minimum criteria, the netting contract may be recognized for risk-based
capital purposes without raising safety and soundness concerns. The
Basle Supervisors' Committee proposal includes a footnote stating that
if any of the relevant supervisors is dissatisfied with the status of
the enforceability of a netting contract under its laws, the netting
contract would not be recognized for risk-based capital purposes by
either counterparty.
In addition, the Basle Supervisors' Committee is proposing that any
netting contract that includes a walkaway clause be disqualified as an
acceptable netting contract for risk-based capital purposes. A walkaway
clause is a provision in a netting contract that permits the non-
defaulting counterparty to make only limited payments, or no payments
at all, to the estate of the defaulter even if the defaulter is a net
creditor under the contract.
Under the proposal, a banking organization would calculate one
current exposure under each qualifying bilateral netting contract. The
current exposure would be determined by adding together (netting) the
positive and negative market values for all individual interest rate
and exchange rate transactions subject to the netting contract. If the
net market value is positive, that value would equal the current
exposure. If the net market value is negative or zero, the current
exposure would be zero. The add-on for potential future credit exposure
would be determined by calculating individual potential future
exposures for each underlying contract subject to the netting contract
in accordance with the procedure already in place in the Basle
Accord.11 A banking organization would then add together the
potential future credit exposure amount (always a positive value) of
each individual contract subject to the netting arrangement to arrive
at the total potential future exposure it has under those contracts
with the counterparty. The total potential future exposure would be
added to the net current exposure to arrive at one credit equivalent
amount that would be assigned to the appropriate risk category.
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\1\1Under the proposal, a banking organization could net in this
manner for risk-based capital purposes if it uses, as all U.S.
banking organizations are required to use, the current exposure
method for calculating credit equivalent amounts of rate contracts.
Organizations using the original exposure method would use revised
conversion factors until market risk-related capital requirements
are implemented, at which time the original exposure method will no
longer be available for netted transactions.
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D. Description of the Proposal
The banking agencies concur with the Basle Supervisors' Committee
determination that the legal status of close-out netting provisions has
developed sufficiently to support the expanded recognition of such
provisions for risk-based capital purposes. Therefore, the OTS is
proposing to amend its risk-based capital standards in a manner
consistent with the Basle Supervisors' Committee's proposed revision to
the Basle Accord and the recently proposed amendments by the OCC and
the FRB. These proposed amendments would allow institutions to 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 netting
contract.
The proposed amendments would add provisions setting forth criteria
for a qualifying bilateral netting contract and an explanation of how
the credit equivalent amount should be calculated for such contracts.
The risk-based capital treatment of an individual contract that is not
subject to a qualifying bilateral netting contract would remain
unchanged.
For interest and exchange rate contracts that are subject to a
qualifying bilateral netting contract under the proposed standards, the
credit equivalent amount would equal the sum of (i) the current
exposure of the netting contract and (ii) the sum of the add-ons for
all individual contracts subject to the netting contract. (As with all
contracts, mark-to-market values for netted contracts would be measured
in dollars, regardless of the currency specified in the contract.) The
current exposure of the bilateral netting contract would be determined
by adding together all positive and negative mark-to-market values of
the individual contracts subject to the bilateral netting
contract.12 The current exposure would equal the sum of the market
values if that sum is positive, or zero if the sum of the market values
is zero or negative. The potential future exposure (add-on) for each
individual contract subject to the bilateral netting contract would be
calculated in the same manner as for non-netted contracts. These
individual potential future exposures would then be added together to
arrive at one total add-on amount.
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\1\2For regulatory capital purposes, the agencies would expect
that institutions would normally calculate the current exposure of a
bilateral netting contract by consistently including all contracts
covered by that netting contract. In the event a netting contract
covers transactions that are normally excluded from the risk-based
ratio calculation--for example, 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--
institutions may elect to consistently either include or exclude all
mark-to-market values of such transactions when determining net
current exposures.
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The proposed amendments provide that an institution may net, for
risk-based capital purposes, interest and exchange rate contracts only
under a written bilateral netting contract that creates a single legal
obligation covering all included individual rate contracts and that
does not contain a walkaway clause. In addition, if a counterparty
fails to perform due to default, insolvency, bankruptcy, liquidation or
similar circumstances, the institution must have a claim to receive a
payment, or an obligation to make a payment, for only the net amount of
the sum of the positive and negative market values on included
individual contracts.
Today's proposal requires that a savings association obtain a
written and reasoned legal opinion(s), representing that an
organization's claim or obligation, in the event of a legal challenge,
including one resulting from default, insolvency, bankruptcy, or
similar circumstances, would be found by the relevant court and
administrative authorities to be the net sum of all positive and
negative market values of contracts included in the bilateral netting
contract.13 The legal opinion normally would 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 bilateral netting contract; and (iii) the law
that governs the netting contract. The multiple jurisdiction
requirement is designed to ensure that the netting contract would be
upheld in any jurisdiction where the contract would likely be enforced
or whose law would likely be applied in an enforcement action, as well
as the jurisdiction where the counterparty's assets reside.
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\1\3The Financial Accounting Standards Board (FASB) has issued
Interpretation No. 39 (FIN 39) relating to the ``Offsetting of
Amounts Related to Certain Contracts.'' FIN 39 generally provides
that assets and liabilities meeting specified criteria may be netted
under generally accepted accounting principles (GAAP). However, FIN
39 does not specifically require a written and reasoned legal
opinion regarding the enforceability of the netting contract in
bankruptcy and other circumstances. Therefore, under this proposal a
banking organization might be able to net certain contracts in
accordance with FIN 39 for GAAP reporting purposes, but not be able
to net those contracts for risk-based capital purposes.
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A legal opinion could be prepared by either an outside law firm or
in-house counsel. If a savings association obtained an opinion on the
enforceability of a bilateral netting contract that covered a variety
of underlying contracts, it generally would not need a legal opinion
for each individual underlying contract that is subject to the netting
contract, so long as the individual underlying contracts were of the
type contemplated by the legal opinion covering the netting contract.
The complexity of the legal opinions will vary according to the
extent and nature of the organization's involvement in rate contracts.
For instance, an institution that is active in the international
financial markets may need opinions covering multiple foreign
jurisdictions as well as domestic law. The OTS expects that in many
cases a legal opinion will focus on whether a contractual choice of law
would be recognized in the event of default, insolvency, bankruptcy or
similar circumstances in a particular jurisdiction rather than whether
the jurisdiction recognizes netting. For example, a U.S. institution
might engage in interest rate swaps with a non-U.S. institution under a
netting contract that includes a provision that the contract will be
governed by U.S. law. In this case the U.S. institution should obtain a
legal opinion as to whether the netting would be upheld in the U.S. and
whether the foreign courts would honor the choice of U.S. law in
default or in an insolvency, bankruptcy, or similar proceeding.
For a savings association that engages solely in domestic rate
contracts, the process of obtaining a legal opinion may be much
simpler. For example, for an institution that is an end-user of a
relatively small volume of domestic rate contracts, the standard
contracts used by the dealer bank may already have been subject to the
mandated legal review. In this case the end-user institution may obtain
a copy of the opinion covering the standard dealer contracts, supported
by the bank's own legal opinion.
The proposed amendments require a savings association to establish
procedures to ensure that the legal characteristics of netting
contracts are kept under review in the light of possible changes in
relevant law. This review would apply to any conditions that, according
to the required legal opinions, are a prerequisite for the
enforceability of the netting contract, as well as to any adverse
changes in the law.
As with all of the provisions of the risk-based capital standards,
a savings association must maintain in its files documentation adequate
to support any particular risk-based capital treatment. In the case of
a bilateral netting contract, a savings association must maintain in
its files documentation adequate to support the bilateral netting
contract. In particular, this documentation should demonstrate that the
bilateral netting contract would be honored in all relevant
jurisdictions as set forth in this rule. Typically, these documents
would include a copy of the bilateral netting contract, legal opinions,
and any related English translations.
The OTS would have the discretion to disqualify any or all
contracts from netting treatment for risk-based capital purposes if the
bilateral netting contract, individual contracts, or associated legal
opinions do not meet the requirements set out in the applicable
standards. In the event of such a disqualification, the affected
individual contracts subject to the bilateral netting contract would be
treated as individual non-netted contracts under the standards.
As a general matter, relevant legal provisions for institutions in
the U.S. make it clear that netting contracts with close-out provisions
enable such organizations to setoff included individual transactions
and reduce the obligations to a single net amount in the event of
default, insolvency, bankruptcy, liquidation, or similar circumstances.
Today's proposal provides that netting by novation arrangements
would not be grandfathered under the standards if such arrangements do
not meet all of the requirements proposed for qualifying bilateral
netting contracts. Although netting by novation would continue to be
recognized under the proposed standards, institutions may not have the
legal opinions or procedures in place that would be required by the
proposed amendments. The OTS believes that holding all bilateral
netting contracts to the same standards will promote certainty as to
the legal enforceability of the contracts and decrease the risks faced
by counterparties in the event of a default.
E. Request for Comment
The OTS is seeking comment on all aspects of its proposed
amendments to the risk-based capital standards. In addition, the OTS
notes that under current risk-based capital standards for individual
contracts, the degree to which collateral is recognized in assigning
the appropriate risk weight is based on the market value of the
collateral in relation to the credit equivalent amount of the rate
contract. The OTS seeks comment on the nature of collateral
arrangements and the extent to which collateral might be recognized in
bilateral netting contracts, particularly taking into account legal
implications of collateral arrangements (e.g., whether the collateral
pledged for an individual transaction would be available to cover the
net counterparty exposure in the event of legal challenge) and
procedural difficulties in monitoring collateral levels.
F. Regulatory Flexibility Act
Pursuant to section 605(b) of the Regulatory Flexibility Act, the
OTS hereby certifies that this proposed rule will not have a
significant impact on a substantial number of small business entities.
Accordingly, a regulatory flexibility analysis is not required.
The OTS believes that a small institution is more likely than a
large institution to enter into relatively uncomplicated transactions
under standard bilateral netting contracts and may need only to review
a legal opinion that has already been obtained by its counterparties.
G. Executive Order 12866
It has been determined that this proposal is not a significant
regulatory action as defined in Executive Order 12866.
List of Subjects in 12 CFR Part 567
Capital, Reporting and recordkeeping requirements, Savings
associations.
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 proposed to be amended
as set forth below.
SUBCHAPTER D--REGULATIONS APPLICABLE TO SAVINGS ASSOCIATIONS
PART 567--CAPITAL
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 must be 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 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
credit exposure is equal to 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 on an off-balance sheet rate contract, including contracts
with negative mark-to-market values, is estimated by multiplying the
notional principal9 by one of the following credit conversion
factors, as appropriate:10
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\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.
\1\0No 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.
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Foreign
Interest exchange
Remaining maturity rate rate
contracts contracts
(percents) (percents)
------------------------------------------------------------------------
One year or less................................ 0 1.0
Over one year................................... 0.5 5.0
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(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, and provides, in effect, that the
savings association would have 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 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) that represents 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
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\1\1By 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
paragraph (a)(2)(v)(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.
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(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 a defaulter is a net creditor under the bilateral netting
contract.
(D) Risk weighting. Once the savings association determines the
credit equivalent amount for off-balance sheet rate contracts, that
amount is assigned to the risk-weight category appropriate to the
counterparty, or, if relevant, the nature of any collateral or
guarantee. However, the maximum weight that will be applied to 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 considered
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: June 1, 1994.
By the Office of Thrift Supervision.
Jonathan L. Fiechter,
Acting Director.
[FR Doc. 94-14266 Filed 6-13-94; 8:45 am]
BILLING CODE 6720-01-P
