[Federal Register Volume 59, Number 141 (Monday, July 25, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-17762]
[[Page Unknown]]
[Federal Register: July 25, 1994]
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FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Part 325
RIN 3064-AB42
Risk-Based Capital Standards; Bilateral Netting Requirements
AGENCY: Federal Deposit Insurance Corporation (FDIC or Corporation).
ACTION: Notice of proposed rulemaking.
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SUMMARY: The FDIC is proposing to amend its risk-based capital
standards to recognize the risk reducing benefits of netting
arrangements. Under the proposal, state nonmember banks 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 FDIC is
proposing these amendments on the basis of proposed revisions to the
Basle Accord which would permit the recognition of such netting
arrangements. The effect of the proposed amendments would be to allow
state nonmember banks 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 by the FDIC on or before August 24,
1994.
ADDRESSES: Send comments to Robert E. Feldman, Acting Executive
Secretary, Federal Deposit Insurance Corporation, 550 17th Street NW.,
Washington, DC 20429. Comments may be hand delivered to room F-402,
1776 F Street NW., Washington, DC, on business days between 8:30 a.m.
and 5:00 p.m. [Fax number: (202) 898-3838.] Comments may be inspected
at the FDIC's Reading Room, room 7118, 550 17th Street NW., Washington,
DC between 9:00 a.m. and 4:30 p.m. on business days.
FOR FURTHER INFORMATION CONTACT: William A. Stark, Assistant Director,
(202) 898-6972, Curtis Wong, Capital Markets Specialist, (202) 898-
7327, Division of Supervision, FDIC, 550 17th Street NW., Washington,
DC 20429; Jeffrey M. Kopchik, Counsel, (202) 898-3872, Christopher
Curtis, Senior Counsel, (202) 898-3728, FDIC, Legal Division, 550 17th
Street NW., Washington, DC 20429; Linda L. Stamp, Counsel, (202) 736-
0161, FDIC, Legal Division, 1717 H Street NW., Washington DC 20429.
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 FDIC adopted in 1989 similar frameworks to assess the capital
adequacy of state nonmember banks. Banks 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, Netherlands, Sweden, Switzerland, the
United Kingdom, and the United States) and Luxembourg.
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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.2
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\2\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.3 A bank 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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\3\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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A bank 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, a bank
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.4 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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\4\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 or 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.5 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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\5\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 FDIC 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.6 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.7 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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\6\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.
\7\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.8 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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\8\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. The FDIC's
risk-based capital standards provide for the same treatment of rate
contracts as the Basle Accord, but require that banks use the
current exposure method. The FDIC, in adopting its standards,
generally stated it would work with the Basle Supervisors' Committee
in its continuing efforts with regard to the recognition of netting
provisions for capital purposes.
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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.9
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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\9\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.''
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Specifically, the Basle proposal states that a bank 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 state nonmember bank 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.10 A bank 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\0Under the proposal, a state nonmember bank 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.
Banks 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. The Banking Agencies' Proposal
The FDIC concurs 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 FDIC 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. The FDIC's proposed amendments would allow banks 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 FDIC's proposed amendments would add provisions to its
standards 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.11 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\1For regulatory capital purposes, the FDIC 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 a bank 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 bank 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.
The FDIC's proposal requires that a bank 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 a failure to perform due to 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.12 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\2The 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
bank 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 bank 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 bank's involvement in rate contracts. For
instance, a bank that is active in the international financial markets
may need opinions covering multiple foreign jurisdictions as well as
domestic law. The FDIC 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 bank 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 bank 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 bank must maintain in its files documentation adequate to support any
particular risk-based capital treatment. In the case of a bilateral
netting contract, a bank 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 FDIC 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 banks 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 a
counterparty fails to perform due to default, insolvency, bankruptcy,
liquidation or similar circumstances. The FDIC notes that pursuant to
section 11(e) of the Federal Deposit Insurance Act (FDI Act), 12 U.S.C.
1821(e), the FDIC, in its capacity as conservator or receiver of a
failed insured depository institution, may transfer all or none of a
failed institution's qualified financial contracts (QFCs)13 with a
given counterparty and its affiliates to an assuming insured depository
institution. Such a transfer by the FDIC as receiver, if accompanied by
the statutorily mandated notice, overrides any contractual right the
counterparty might otherwise have to terminate, close-out, and net its
contracts by reason of the appointment of the FDIC as receiver.
Further, the FDIC as conservator may, under section 11(e) of the FDI
Act, enforce continued performance of QFCs without transferring them,
even if the contracts contain clauses that would otherwise enable the
counterparty to treat them as in default, and hence to terminate and
net them, by reason of the appointment of a conservator.14
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\1\3The scope of this transfer power is established in the FDIC
Statement of Policy on Qualified Financial Contracts adopted
December 12, 1989. The term QFC is defined in section 11(e)(8)(D)(i)
of the FDI Act. It includes securities contracts, commodity
contracts, forward contracts, repurchase agreements, swap
agreements, and any similar agreement that the FDIC determines by
regulation to be a QFC. Interest and exchange rate contracts, as
specifically referred to in the risk-based capital guidelines, are
generally QFCs.
\1\4 The Board of Governors of the Federal Reserve System (Fed),
the Office of the Comptroller of the Currency (OCC), and the Office
of Thrift Supervision (OTS) (collectively, the other banking
agencies) either have published or are in the process of publishing
notices of proposed rulemaking amending their risk-based capital
guidelines which are similar to the FDIC's proposal. The other
banking agencies are not addressing the scope of the FDIC's transfer
and enforcement powers under section 11 of the FDI Act.
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The FDIC is of the opinion that its transfer and enforcement powers
under the FDI Act are consistent with the netting provisions of the
FDIC Improvement Act of 1991 (FDICIA). Those provisions specifically
sanction the enforceability of bilateral netting contracts (12 U.S.C.
4403(a)); so do the FDI Act's QFC provisions (12 U.S.C.
1821(e)(8)(A)(iii), (E)(iii)). The FDIC's transfer and enforcement
powers, described in the text, are associated with its power to
override a different kind of contractual provision--the so-called
``ipso facto'' clauses that permit a counterparty to terminate a
contract by reason of the appointment of a receiver or conservator even
if there has been no default in performance. Although such clauses may
activate netting clauses, they are not themselves specifically
addressed in, or protected by, the FDICIA netting provisions. Thus,
there is no conflict of language between the FDI Act's QFC provisions
and the FDICIA netting provisions. Nor is there any inconsistency in
the statutes' underlying policy. The policy of the FDI Act's QFC
provisions, like that of the FDICIA netting provisions, is to preserve
a counterparty's net position: If the FDIC does not transfer or enforce
a counterparty's QFCs, then the contracts may be terminated and netted
to the extent provided by their terms; and if the contracts are
transferred or enforced, then the netting provisions continue in force
as a part of the entire complex of contractual obligations. The
transfer and enforcement provisions of the FDI Act do no more than to
preserve the continuity of contractual relationships in cases of
receivership and conservatorship, an effect that the FDIC believes to
be consistent with the letter and spirit of the FDICIA netting
provisions.
In the event that QFCs are transferred from a failed institution to
a new depository institution, the amount of credit risk the non-failed
counterparty is exposed to remains the same. Thus, the netting
provisions in the contracts may be enforced against or by the assuming
insured depository institution in the event of a subsequent default.
Therefore, the FDIC would not regard a netting contract as
unenforceable, for risk-based capital purposes, simply because the FDIC
as receiver might transfer it within the limited circumstances
prescribed in section 11(e) of the FDI Act. In the case of QFCs
enforced without transfer by the FDIC as conservator, the counterparty
would continue to enjoy its contractual rights to terminate and net
such enforced contracts by reason of a default in performance (as
distinct from a contractually defined default by reason of appointment
of a conservator). In this regard, the FDIC would not regard a netting
contract as unenforceable simply because the FDIC as conservator might
enforce the underlying contracts within the circumstances prescribed in
section 11(e) of the FDI Act.15
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\1\5To facilitate the utilization of risk reducing bilateral
netting contracts which will permit institutions to take advantage
of the new capital standards prescribed in this proposal, the FDIC
has determined not to exercise any potential power as a conservator
selectively to enforce or to repudiate QFCs with the same
counterparty that are subject to a bilateral netting contract. The
FDIC would not regard bilateral netting contracts as unenforceable
solely by reason of the apparent presence of such a power in section
11(e) of the FDI Act.
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The FDIC'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 FDIC 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.
The FDIC is seeking comment on all aspects of its proposed
amendments to the risk-based capital standards. In addition, the FDIC
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 FDIC is seeking 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.
Regulatory Flexibility Act Analysis
The FDIC does not believe adoption of this proposal as a final rule
would have a significant economic impact on a substantial number of
small business entities (in this case, small banking organizations), in
accord with the spirit and purposes of the Regulatory Flexibility Act
(5 U.S.C. 601 et seq.). In this regard, the final rule would reduce
certain regulatory burdens on banking organizations as it would reduce
the capital charge on certain transactions.
Banks that enter into bilateral netting contracts must obtain a
legal opinion(s) on the enforceability of those contracts if they wish
to net for purposes of calculating their capital ratio. A small
institution may find it more burdensome to obtain a legal opinion(s)
than a large institution. A small institution, however, 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. The benefits to a small institution of lower capital
charges after netting will likely outweigh the burdens of obtaining the
necessary legal opinions.
Paperwork Reduction Act
The FDIC has determined that the proposed amendments, if adopted,
would not significantly increase the regulatory burden of state
nonmember banks pursuant to the Paperwork Reduction Act (44 U.S.C. 3501
et seq.).
List of Subjects in 12 CFR Part 325
Bank deposit insurance, Banks, banking, Capital adequacy, Reporting
and recordkeeping requirements, Savings associations, State nonmember
banks.
For the reasons set out in the preamble, the Board of Directors of
the FDIC proposes to amend 12 CFR part 325 as follows:
PART 325--CAPITAL MAINTENANCE
1. The authority citation for part 325 continues to read as
follows:
Authority: 12 U.S.C. 1815(a), 1815(b), 1816, 1818(a), 1818(b),
1818(c), 1818(t), 1819(Tenth), 1828(c), 1828(d), 1828(i), 1828(n),
1828(o), 1831o, 3907, 3909; Pub. L. 102-233, 105 Stat. 1761, 1789,
1790 (12 U.S.C. 1831n note) Pub. L. 102-242, 105 Stat. 2236, 2355,
2386 (12 U.S.C. 1828 note).
2. In appendix A to part 325, section II.E. is amended by revising
the first sentence of the introductory text of II.E.1. and removing the
footnote in II.E.1.(a); removing the last two sentences of the second
paragraph of II.E.2.; and adding new II.E.3. to read as follows:
Appendix A to Part 325--Statement of Policy on Risk-Based Capital
* * * * *
II. * * *
E. * * *
1. Credit Equivalent Amounts for Interest Rate and Foreign Exchange
Rate Contracts. The credit equivalent amount of an off-balance sheet
rate contract that is not subject to a qualifying bilateral netting
contract in accordance with section III.E.3. of this appendix A is
equal to the sum of (i) the current exposure (which is equal to the
mark-to-market value39 and is sometimes referred to as the
replacement cost) of the contract and (ii) an estimate of the potential
future credit exposure over the remaining life of the contract. * * *
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\3\9Mark-to-market values should be measured in dollars,
regardless of the currency or currencies specified in the contract,
and should reflect changes in both interest (or foreign exchange)
rates and in counterparty credit quality.
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* * * * *
3. Netting. (1) For purposes of this appendix A, netting refers to
the offsetting of positive and negative mark-to-market values when
determining a current exposure to be used in the calculation of a
credit equivalent amount. Any legally enforceable form of bilateral
netting of rate contracts is recognized for purposes of calculating the
credit equivalent amount provided that:
(a) The netting is accomplished under a written netting contract
that creates a single legal obligation, covering all included
individual contracts, with the effect that the bank would have a claim
or obligation to receive or pay, respectively, only the net amount of
the sum of the positive and negative mark-to-market values on included
individual contracts in the event that a counterparty, or a
counterparty to whom the contract has been validly assigned, fails to
perform due to any of the following events: default, bankruptcy,
liquidation, or similar circumstances.
(b) The bank obtains a written and reasoned legal opinion(s)
representing that in the event of a legal challenge, including one
resulting from a failure to perform due to default, insolvency,
bankruptcy or similar circumstances, the relevant court and
administrative authorities would find the bank's exposure to be such a
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 contracts covered by the
netting contract; and
(iii) the law that governs the netting contract.
(c) The bank establishes and maintains procedures to ensure that
the legal characteristics of netting contracts are kept under review in
the light of possible changes in relevant law.
(d) The bank maintains in its files documentation adequate to
support the netting of rate contracts, including a copy of the
bilateral netting contract and necessary legal opinions.
(2) A contract containing a walkaway clause is not eligible for
netting for purposes of calculating the credit equivalent
amount.40
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\4\0For purposes of this section, a walkaway clause means 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 a defaulter or the estate of a
defaulter is a net creditor under the contract.
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(3) By netting individual contracts for the purpose of calculating
its credit equivalent amount, a bank represents that it has met the
requirements of this appendix A and all the appropriate documents are
in the bank's files and available for inspection by the FDIC. Upon
determination by the FDIC that a bank's files are inadequate or that a
netting contract may not be legally enforceable under any one of the
bodies of law described in paragraphs (b)(i) through (iii) of this
section, underlying individual contracts may be treated as though they
were not subject to the netting contract.
(4) The credit equivalent amount of rate contracts that are subject
to a qualifying bilateral netting contract is calculated by adding (i)
the current exposure of the netting contract and (ii) the sum of the
estimates of the potential future credit exposure on all individual
contracts subject to the netting contract.
(5) The current exposure of the netting contract is determined by
summing all positive and negative mark-to-market values of the
individual transactions included in the netting contract. If the net
sum of the mark-to-market values is positive, then the current exposure
of the netting contract is equal to that sum. If the net sum of the
mark-to-market values is zero or negative, then the current exposure of
the netting contract is zero.
(6) For each individual contract included in the netting contract,
the potential future credit exposure is estimated in accordance with
section II.E.1. of this appendix A.41
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\4\1For 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.
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(7) Examples of the calculation of credit equivalent amounts for
these types of contracts are contained in Table IV.
* * * * *
3. Appendix A to part 325 is amended by revising the last three
sentences of the last paragraph under the heading ``Credit Conversion
for Interest Rate and Foreign Exchange Rate Related Contracts'' in
Table III and adding new Table IV to read as follows:
* * * * *
III. * * *
Credit Conversion for Interest Rate and Foreign Exchange Rate Related
Contracts
* * * * *
* * * In the event a netting contract covers transactions that are
normally not included in 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--an institution may elect to consistently
either include or exclude all mark-to-market values of such
transactions when determining a net current exposures. Multiple
contracts with the same counterparty may be netted for risk-based
capital purposes pursuant to section II.E.3. of this appendix.
Table IV.--Calculation of Credit Equivalent Amounts for Interest Rate and Foreign Exchange Rate Related Transactions for State Nonmember Banks
--------------------------------------------------------------------------------------------------------------------------------------------------------
Potential exposure Current Exposure
----------------------------------------------------------------------------------- Credit
Type of contract(remaining maturity) Notional Potential Potential Mark-to- Current equivalent
principal x exposure = exposure market exposure amount
(dollars) conversion (dollars) value\1\ (dollars)\2\
--------------------------------------------------------------------------------------------------------------------------------------------------------
(1) 120-day forward foreign exchange.................... 5,000,000 .01 50,000 100,000 100,000 150,000
(2) 120-day forward foreign exchange.................... 6,000,000 .01 60,000 -120,000 ............ 60,000
(3) 3-year single currency fixed/floating interest rate
swap................................................... 10,000,000 .005 50,000 200,000 200,000 250,000
(4) 3-year single currency fixed/floating interest rate
swap................................................... 10,000,000 .005 50,000 -250,000 ............ 50,000
(5) 7-year cross-currency floating/floating interest
rate swap.............................................. 20,000,000 .05 1,000,000 -1,300,000 ............ 1,000,000
-----------------------------------------------------------------------------------------------
Total............................................. ........... .. ........... ........... 1,210,000 ........... 300,000 1,510,000
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If contracts (1) through (5) above are subject to a qualifying
bilateral netting contract, then the following applies:
----------------------------------------------------------------------------------------------------------------
Potential
exposure Mark-to-market Current Credit
(dollars) value (from exposure equivalent
(from above) above) (dollars) amount
----------------------------------------------------------------------------------------------------------------
(1)............................................. 50,000 100,000
(2)............................................. 60,000 -20,000
(3)............................................. 50,000 200,000
(4)............................................. 50,000 -250,000
(5)............................................. 1,000,000 -1,300,000
---------------------------------------------------------------
Total..................................... 1,210,000 -1,370,000 .............. 1,210,000
----------------------------------------------------------------------------------------------------------------
\1\These numbers are purely for illustration.
\2\The larger of zero or a positive mark-to-market value.
By order of the Board of Directors.
Dated at Washington, D.C. this 8th day of June, 1994.
Federal Deposit Insurance Corporation.
Robert E. Feldman
Acting Executive Secretary.
[FR Doc. 94-17762 Filed 7-22-94; 8:45 am]
BILLING CODE 6714-01-P
