[Federal Register Volume 59, Number 169 (Thursday, September 1, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-21642]
[[Page Unknown]]
[Federal Register: September 1, 1994]
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DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Part 3
[Docket No. 94-13]
RIN 1557-AB14
Capital Adequacy: Calculation of Credit Equivalent Amounts of
Off-Balance Sheet Contracts
AGENCY: Office of the Comptroller of the Currency, Treasury.
ACTION: Notice of proposed rulemaking.
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SUMMARY: The Office of the Comptroller of the Currency (OCC) is
proposing to amend its risk-based capital guidelines for national
banks. This proposed rule would revise and expand the set of off-
balance sheet credit conversion factors used to calculate the potential
future exposure of derivative contracts and permit banks to net
multiple derivative contracts that are subject to a qualifying
bilateral netting contract when calculating the potential future credit
exposure.
This proposed rule is based on the July 15, 1994, proposed
revisions to the Agreement on International Convergence of Capital
Measurement and Capital Standards of July 1988 (Basle Accord). The
effect of this proposed rule would be twofold. First, long-dated
interest rate and foreign exchange rate contracts would be subject to
new higher off-balance sheet credit conversion factors and new
conversion factors would be established specifically for derivative
contracts related to equities, precious metals, and other commodities.
Second, national banks generally would recognize a reduction in
potential future credit exposure for multiple derivative contracts
subject to a qualifying bilateral netting contract.
DATES: Comments must be received on or before October 21, 1994.
ADDRESSES: Comments may be submitted to Docket Number 94-13,
Communications Division, Ninth floor, Office of the Comptroller of the
Currency, 250 E Street, SW., Washington, DC 20219. Comments will be
available for inspection and photocopying at that address.
FOR FURTHER INFORMATION CONTACT: Roger Tufts, Senior Economic Advisor,
Office of the Chief National Bank Examiner, (202) 874-5070; or Ronald
Shimabukuro, Senior Attorney, Bank Operations and Assets Division,
(202) 874-4460, Office of the Comptroller of the Currency.
SUPPLEMENTARY INFORMATION:
I. Background
The Basle Accord\1\ established the international risk-based
capital standards and set forth a framework for measuring capital
adequacy under which risk-weighted assets are calculated by assigning
assets and off-balance-sheet items to broad categories based primarily
on their credit risk, that is, the risk that a loss will be incurred
due to an obligor or counterparty default on a transaction.\2\ Off-
balance-sheet contracts are incorporated into risk-weighted assets by
converting each item into a credit equivalent amount, which is then
assigned to the appropriate credit risk category according to the
identity of the obligor or counterparty, or if relevant, the guarantor
or the nature of the collateral.
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\1\The Basle Accord 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 (BSC) 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.
\2\Other types of risks, such as market risks, generally are not
addressed by the risk-based capital framework.
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The credit equivalent amount of an interest rate or foreign
exchange rate contract (rate contract) is determined by adding together
the current replacement cost (current credit exposure) and an estimate
of the possible increases in future replacement cost, in view of the
volatility of the current credit exposure over the remaining life of
the contract (potential future credit exposure--also referred to as the
add-on). Each credit equivalent amount is then assigned to the
appropriate risk category. The maximum risk weight applied to rate
contracts is 50 percent.\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 capital ratio calculations.
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A. Current Credit Exposure
Under the risk-based capital guidelines, the current credit
exposure of a rate contract with a positive mark-to-market value is
equal to the mark-to-market value.\4\ If the mark-to-market value is
zero or negative, then there is no replacement cost associated with the
rate contract and the current credit exposure is zero. The sum of
current credit exposures for a defined set of rate contracts is
referred to as the gross current credit exposure for that set of rate
contracts.
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\4\The loss to a bank from a counterparty's default on a rate
contract is the cost of replacing the cash flows specified by the
rate contract. The mark-to-market value is the present value of the
net cash flows specified by the rate contract, calculated on the
basis of current market interest and foreign exchange rates.
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As initially adopted in July 1988, the Basle Accord required banks
to determine the current credit exposure individually for every rate
contract. Generally, banks were not permitted to offset, that is, net,
positive and negative mark-to-market values of multiple rate contracts
with a single counterparty to determine a single current credit
exposure relative to that counterparty.\5\ In April 1993 the BSC
proposed a revision to the Basle Accord that would permit banks to net
positive and negative mark-to-market values of rate contracts subject
to a qualifying, legally enforceable, bilateral netting contract.
Pursuant to the April 1993 BSC netting proposal, banks with qualifying
bilateral netting contracts could replace the gross current credit
exposure of a set of rate contracts covered by the bilateral netting
contracts with a single net current credit exposure for purposes of
calculating the credit equivalent amount. If the net market value is
positive, then that market value equals the current credit exposure for
the rate contracts under a bilateral netting contract. If the net
market value is zero or negative, then the current credit exposure is
zero.
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\5\Netting by novation, however, 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, is
legally substituted for the amalgamated gross obligations.
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On May 20, 1994, the OCC and the Board of Governors of the Federal
Reserve System (FRB) issued a joint notice of proposed rulemaking to
amend their respective risk-based capital guidelines in accordance with
the April 1993 BSC netting proposal.\6\ See 59 FR 26456 (May 20, 1994).
Generally, under the May 1994 joint OCC/FRB proposed rule, a bilateral
netting contract would be recognized for risk-based capital purposes
only if the bilateral netting contract is legally enforceable. The May
1994 joint OCC/FRB proposed rule is consistent with the April 1993 BSC
netting proposal which was adopted in final form on July 1994. The
April 1993 BSC netting proposal is discussed in detail in the May 1994
joint OCC/FRB proposed rule.
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\6\The Office of Thrift Supervision issued a similar netting
proposal on June 14, 1994 and the Federal Deposit Insurance
Corporation issued its netting proposal on July 25, 1994.
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B. Potential Future Credit Exposure
The second part of the credit equivalent amount, the add-on for
potential future credit exposure, is an estimate of the additional
credit exposure that may arise over the remaining life of the rate
contract as a result of fluctuations in prices or rates. Such changes
may increase the market value of the rate contract in the future and,
therefore, increase the cost of replacing it if the counterparty
subsequently defaults.
The add-on for potential future credit exposure is calculated by
multiplying the notional principal amount\7\ of the underlying rate
contract by a credit conversion factor that is determined by the
remaining maturity of the rate contract and the type of rate contract.
The current credit conversion factors used to calculate potential
future credit exposure, referred to as the credit conversion factor
matrix, is as follows:
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\7\The notional principal amount, or value, is a reference
amount of money used to calculate payment streams between the
counterparties. Principal amounts generally are not exchanged in
single-currency interest rate swaps, but generally are exchanged in
foreign exchange contacts (including cross-currency interest rate
swaps).
Table 1.--Current Credit Conversion Factor Matrix
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Interest Exchange
rate rate
Remaining maturity contracts contracts
(percent) (percent)
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One year or less.............................. 0.0 1.0
Over one year................................. 0.5 5.0
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These credit conversion factors were determined through simulation
studies that estimated the potential volatility of interest and
exchange rates and analyzed the implications of movements in those
rates for the replacement costs of various types of interest rate and
exchange rate contracts. The simulation studies were conducted only on
interest rate and foreign exchange rate contracts, because at the time
the Basle Accord was being developed, activity in the derivatives
market was for the most part limited to these types of transactions.
The simulation studies produced distributions of potential replacement
costs over the remaining life of matched pairs of rate contracts.\8\
Potential future credit exposure was then defined in terms of
confidence limits derived from these distributions. The credit
conversion factors were intended to be a compromise between precision,
on the one hand, and complexity and burden, on the other.\9\
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\8\A matched pair is a pair of contracts with identical terms,
where the bank the buyer of one contract and the seller of the other
contract.
\9\The methodology upon which the statistical analyses were
based is described in detail in a technical working paper entitled
``Potential Credit Exposure on Interest Rate and Foreign Exchange
Rate Related Instruments.'' This paper is available upon request
from the OCC's Communications Division.
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The add-on for potential future credit exposure is calculated for
all rate contracts, regardless of whether the market value is zero,
positive, or negative, or whether the current credit exposure is
calculated on a gross or net basis. Neither the April 1993 BSC netting
proposal nor the May 1994 joint OCC/FRB proposed rule to recognize
qualifying bilateral netting contracts for the calculation of the
current credit exposure affects the calculation of the potential future
credit exposure, which would continue to be calculated on a gross
basis. Under the April 1993 BSC netting proposal, this means that an
add-on for potential future credit exposure is calculated separately
for each individual rate contract covered by the bilateral netting
contract and then these individual future credit exposures are added
together to arrive at a gross add-on for potential future credit
exposure. The gross add-on for potential future credit exposure would
then be added to the net current credit exposure to arrive at one
credit equivalent amount for all of the rate contracts subject to the
bilateral netting contract.
When initially adopted, the Basle Accord noted that the credit
conversion factors in the add-on conversion factor matrix were
provisional and would be subject to revision if volatility levels or
market conditions changed.
II. Basle Proposals for the Treatment of Potential Future Credit
Exposure
Since the original Basle Accord was adopted, the derivatives market
has grown and broadened. The use of certain types of derivative
contracts not specifically addressed in the Basle Accord--notably
equity, precious metals, and commodity-linked transactions\10\--has
become much more widespread. As a result of continued review of the
method for calculating the add-on for potential future credit exposure,
in July 1994 the BSC issued a consultative paper which contained two
proposals.\11\ The first proposal would expand the matrix of add-on
credit conversion factors used to calculate potential future credit
exposure to take into account innovations in the derivatives market.
The second proposal represents an extension of the April 1993 BSC
netting proposal and would recognize reductions in the potential future
credit exposure of derivative contracts that result from entering into
bilateral netting contracts. The consultation period for the July 1994
BSC proposal is scheduled to end on October 10, 1994.
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\10\In general terms, these are off-balance-sheet transactions
that have a return, or a portion of their return, linked to the
price of a particular equity, precious metals, or commodity or to an
index of equity, precious metals, or commodity prices.
\11\The proposals are contained in a paper from the FSC entitled
``The Capital Adequacy Treatment of the Credit Risk Associated with
Certain Off-Balance Sheet Items'' that is available upon request
from the Communications Division of the OCC.
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A. Expansion of Add-On Credit Conversion Factor Matrix
A recent BSC study of the add-on for potential future credit
exposure indicated that the current add-on credit conversion factors
used to calculate the add-on amount may produce insufficient capital
for certain types of derivative instruments, in particular, long-dated
interest rate contracts, commodity contracts, and equity-index
contracts. The BSC study indicated that the current add-on credit
conversion factors do not adequately address the full range of contract
structures and the timing of cash flows. The BSC study also showed that
the credit conversion factors used by many banks to calculate potential
future credit exposure for equity, precious metals, and commodity
contracts could result in insufficient capital coverage in view of the
volatility of the indices or prices on the underlying assets from which
these contracts derive their value.\12\
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\12\While equity, precious metals, and commodity contracts were
not explicitly covered by the original Basle Accord, as the use of
such contracts became more prevalent, many G-10 banking supervisors,
including U.S. banking supervisors, have informally permitted
institutions to apply the conversion factors for exchange rate
contracts to these types of transactions pending development of a
more appropriate treatment.
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The BSC study concluded that it was not appropriate to address
these problems with a significant departure from the existing
methodology used in the Basle Accord. The BSC decided that it would be
appropriate to preserve the credit conversion factors existing in the
Basle Accord and add new credit conversion factors. Consequently, the
revision proposed by the BSC retains the existing credit conversion
factors for interest and exchange rate contracts, but applies new
higher credit conversion factors to such rate contracts with remaining
maturities of five years and over.\13\ The BSC proposal also proposes
credit conversion factors specifically applicable to equity, precious
metals, and commodity contracts. The new credit conversion factors were
determined on the basis of simulation studies that used the same
general approach that generated the original add-on credit conversion
factors.\14\
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\13\The conversion factors for rate contracts with remaining
maturities of one to five years are currently applied to contracts
with a remaining maturity of over one year.
\14\The methodology and results of the statistical analyses are
summarized in a paper entitled ``The Calculation of Add-Ons for
Derivative Contracts: the `Expanded Matrix' Approach'' and is
available upon request from the Communications Division of the OCC.
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The proposed credit conversion factor matrix is set forth below:
Table 2.--Credit Conversion Factor Matrix\1\
[Percent]
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Foreign
Interest exchange Precious Other
Remaining maturity rate rate and Equity\2\ metals commodities
gold
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Less than one year............................. 0.0 1.0 6.0 7.0 12.0
One to five years.............................. 0.5 5.0 8.0 7.0 12.0
Over five years................................ 1.5 7.5 10.0 8.0 15.0
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\1\For derivative contracts with multiple exchanges of principal, the conversion factors are to be multiplied by
the number of remaining payments in the derivative contract.
\2\For derivative contracts that automatically reset to zero value following a payment, the remaining maturity
is set equal to the time until the next payment.
Gold is included within the foreign exchange rate column because
the price volatility of gold has been found to be comparable to the
foreign exchange rate volatility of major currencies. In addition, the
BSC determined that gold's role as a financial asset distinguishes it
from other precious metals. The proposed credit conversion factor
matrix is designed to accommodate the different structures of
derivative contracts, as well as the observed disparities in the
volatilities of the associated indices or prices of the underlying
assets.
Two footnotes are attached to the credit conversion factor matrix
to address two particular derivative contract structures. The first
relates to derivative contracts with multiple exchanges of principal.
Because the level of potential future credit exposure rises generally
in proportion to the number of remaining exchanges of principal, the
credit conversion factors are multiplied by the number of remaining
payments (exchanges of principal) in the derivative contract. This
treatment is intended to ensure that the full level of potential future
credit exposure is covered adequately. The second footnote applies to
equity contracts that automatically reset to zero each time a payment
is made. The credit risk associated with these equity contracts is
similar to that of a series of shorter contracts beginning and ending
at each reset date. For this type of equity contract the remaining
maturity is equal to the time remaining until the next payment.
While the capital charges resulting from the application of the new
proposed credit conversion factors may not provide complete coverage
for risks associated with any single derivative contract, the BSC
believes the credit conversion factors will provide a reasonable level
of prudential coverage for derivative contracts on a portfolio basis.
Like the original credit conversion factor matrix, the proposed
expanded credit conversion factor matrix provides a reasonable balance
between precision, complexity, and burden.
B. Recognition of the Effects of Netting
The simulation studies used by the BSC to generate the credit
conversion factors for potential future credit exposure analyzed the
implications of underlying rate and price movements on the current
credit exposure of derivative contracts without taking into account
reductions in credit exposure that could result from legally
enforceable bilateral netting contracts. Thus, the credit conversion
factors are most appropriately applied to non-netted derivative
contracts, and when applied to derivative contracts subject to a
legally enforceable bilateral netting contract, they could in some
cases overstate the potential future credit exposure.
Comments on the April 1993 BSC netting proposal, as well as further
research conducted by the BSC, have suggested that bilateral netting
contracts can reduce not only a bank's current credit exposure for the
transactions subject to the bilateral netting contracts, but also the
potential future credit exposure for those transactions.\15\ The July
1994 BSC proposal reflects these conclusions and proposes to
incorporate into the calculation of the add-on for potential future
credit exposure a method for recognizing the risk-reducing effects of
qualifying bilateral netting contracts. Under the July 1994 BSC
proposal, banks could recognize these effects only for transactions
subject to legally enforceable bilateral netting contracts that meet
the requirements of netting for current credit exposure as set forth in
the April 1993 BSC netting proposal.
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\15\While current credit exposure is intended to cover an
organization's credit exposure at one point in time, potential
future credit exposure provides an estimate of possible increases in
future replacement cost, in view of the volatility of current credit
exposure over the remaining life of the contract. The greater the
tendency of the current credit exposure to fluctuate over time, the
greater the add-on for potential future credit exposure should be to
cover possible fluctuations.
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Depending on market conditions and the characteristics of a bank's
derivative portfolio, bilateral netting contracts can have substantial
effects on the bank's potential future credit exposure to multiple
derivative contracts it has entered into with a single counterparty.
Should the counterparty default at some future date, the bank's credit
exposure would be limited to the net amount the counterparty owes on
the date of default, rather than the gross current credit exposure of
the included derivative contracts. By entering into a bilateral netting
contract, a bank may reduce not only its current credit exposure, but
possibly its future credit exposure as well. Nevertheless, while in
many circumstances a bilateral netting contract can reduce the
potential future credit exposure to a single counterparty portfolio,
this is not always the case.\16\
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\16\For purposes of this discussion, a single counterparty
portfolio refers to a set of contracts with a single counterparty.
This should be distinguished from a bank's global portfolio, which
refers to all of the contracts in the bank's derivatives portfolio
that are subject to qualifying bilateral netting contracts.
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The most important factors influencing whether a bilateral netting
contract will have an effect on the potential future credit exposure of
a single counterparty portfolio are the volatilities of the current
credit exposure to the counterparty on both a gross and net basis.\17\
The volatilities of net current credit exposure and gross current
credit exposure of a single counterparty portfolio may not necessarily
be the same. Volatility of gross current credit exposure is influenced
primarily by the fluctuations of the market values of positively valued
derivative contracts. On the other hand, volatility of the net current
credit exposure is influenced by the fluctuations of the market values
of all derivative contracts within a single counterparty portfolio. In
those cases where net current credit exposure has a tendency to
fluctuate more over time than gross current credit exposure, a
bilateral netting contract will not reduce the potential future credit
exposure. However, in those situations where net current credit
exposure has a tendency to fluctuate less over time than gross current
credit exposure, a bilateral netting contract can reduce the potential
future credit exposure.
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\17\Volatility in this discussion is the tendency of the market
value of a derivative contract to vary or fluctuate over time. A
highly volatile portfolio would have a tendency to fluctuate
significantly over short periods of time. One of the most important
factors influencing a portfolio's volatility is the correlation of
the derivative contracts within the portfolio, that is, the degree
to which the derivative contracts in the portfolio respond similarly
to changing market conditions.
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Net current credit exposure is likely to be less volatile relative
to the volatility of gross current credit exposure when the single
counterparty portfolio of derivative contracts as a whole is more
diverse than the subset of positively valued derivative contracts. When
a bilateral netting contract is applied to a diversified single
counterparty portfolio and the positively valued derivative contracts
within that portfolio as a group are less diversified than the overall
portfolio, then the effect of the bilateral netting contract will
likely be to reduce the potential future credit exposure of the single
counterparty portfolio.
The BSC has studied and analyzed several alternatives for taking
into account the effects of netting when calculating the capital charge
for potential future credit exposure. In particular, the BSC reviewed
one general method proposed by commenters to the April 1993 BSC netting
proposal. This method would reduce the amount of the add-on for
potential future credit exposure by multiplying the calculated gross
add-on by the ratio of a single counterparty portfolio's net current
credit exposure to the gross current credit exposure. This is called
the net-to-gross ratio (NGR). The NGR is used as a proxy for the risk-
reducing effects of the bilateral netting contract on the potential
future credit exposure. The more diversified a single counterparty
portfolio, the lower the net current credit exposure tends to be
relative to gross current credit exposure.
This method is incorporated into the July 1994 BSC proposal.
However, given that there are portfolio-specific situations in which
the NGR does not provide a good indication of these effects, the July
1994 BSC proposal gives only partial weight to the effects of the NGR
on the add-on for potential future credit exposure. The proposed method
would calculate a weighted average of two amounts. The first amount is
the add-on as it is currently calculated (Agross). The second
amount is Agross multiplied by the NGR. This calculation results
in a reduced add-on (Anet) for derivative contracts subject to a
qualifying bilateral netting contract. The weights contained in the
proposed rule are 0.5 and 0.5, respectively, for (1) Agross, and
(2) NGR times Agross.
The formula is:
Anet=0.5 x Agross+(0.5 x NGR x Agross).
For example, a bank with a gross current credit exposure of
$500,000, a net current credit exposure of $300,000, and a gross add-on
for potential future credit exposure of $1,200,000, would have an NGR
of 0.6 ($300,000/$500,000) and would calculate Anet as follows:
Anet=0.5 x $1,200,000+(0.5 x 0.6 x $1,200,000)
Anet=$960,000
For banks with an NGR of 50 percent, the effect of this treatment
would be to permit a reduction in the amount of the add-on by 25
percent. The BSC believes that most dealer banks are likely to have an
NGR in the vicinity of 50 percent.
The July 1994 BSC proposal does not specify whether the NGR should
be calculated on a counterparty-by-counterparty basis or on an
aggregate basis for all transactions subject to qualifying, legally
enforceable bilateral netting contracts. The July 1994 BSC proposal
requests comment on whether the choice of method could bias the results
and whether there is a significant difference in calculation burden
between the two methods.
The July 1994 BSC proposal also acknowledges that simulations using
banks' internal models for measuring credit risk exposure would most
likely produce the most accurate determination of the effect of
bilateral netting contracts on potential future credit exposures. The
July 1994 BSC proposal states that the use of such models would be
considered at some future date.
III. The OCC Proposal
In light of the July 1994 BSC proposal, the OCC believes that it is
appropriate to seek public comment on proposed revisions to the
calculation of the add-on for potential future credit exposure for
derivative contracts. Therefore, the OCC is proposing to (1) Amend its
risk-based capital guidelines for national banks to expand the matrix
of credit conversion factors and (2) change the calculation of the add-
on for potential future credit exposure when the derivative contracts
are subject to a qualifying bilateral netting contract. It is important
to note that the second part of the proposed rule is contingent on the
adoption of a final rule to the May 1994 joint OCC/FRB proposed rule to
recognize qualifying bilateral netting contracts. With regard to the
portion of this proposed rule to expand the credit conversion factor
matrix, the OCC is proposing to adopt the same credit conversion
factors set forth in the July 1994 BSC proposal. The OCC believes that
the existing credit conversion factors applicable to long-dated
transactions may not provide sufficient capital for the risks
associated with those types of contracts. The OCC also believes that
the credit conversion factors for foreign exchange rate contracts are
significantly too low for equity, precious metals, and commodity
derivative contracts due to the volatility of the associated indices
and the prices on the underlying assets.\18\
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\18\Similar to the July 1994 BSC proposal, this proposed rule
specifies that for equity contracts that automatically reset to zero
value following a payment, the remaining maturity is set equal to
the time remaining until the next payment. Also, for contracts with
multiple exchanges of principal, the conversion factors are to be
multiplied by the number of remaining payments in the contract.
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The OCC is proposing the same weighted average formula as the July
1994 BSC proposal to calculate a reduction in the add-on for potential
future credit exposure for derivative contracts subject to qualifying
bilateral netting contracts. The OCC believes that there may be several
advantages with this formula. First, the formula uses bank-specific
information to calculate the NGR. The NGR is simple to calculate and
uses readily available information. The OCC believes the use of the
averaging factor of 0.5 is an important aspect of the proposed formula
because it means the add-on for potential future credit exposure can
never be reduced to zero and banks will always hold some capital
against derivative contracts, even in those instances where the net
current exposure is zero.
The OCC is seeking comment on all aspects of this proposed rule.
1. As with the July 1994 BSC proposal, the OCC seeks comment on
whether the NGR should be calculated on a counterparty-by-counterparty
basis, or on a global basis for all derivative contracts subject to a
qualifying bilateral netting contract. The OCC's proposed regulatory
language would require the calculation of a separate NGR for each
counterparty with which it has a qualifying netting contract. However,
the OCC also is seeking comment as to which method of calculating the
NGR would be most efficient and appropriate for banks with numerous
qualifying bilateral netting contracts. The OCC notes that some
preliminary findings indicate that a global NGR may be less burdensome
to apply, but counterparty specific NGRs may provide a more accurate
indication of the credit risk associated with each counterparty.
2. The OCC is also seeking comment on the appropriate weights to
apply to the two components of the weighted average--Agross and
NGR x Agross. The proposed values (both set equal to 0.5) allow
only a partial reduction in the add-on, even when the NGR equals zero.
Are there other weights, which sum to a value of 1, that better reflect
the potential risk of a set of netted contracts and which ensure that
an appropriate level of capital is held for this risk of a potential
future exposure? Empirical evidence to support any suggested changes to
the weights used in the calculation would be appreciated.
Regulatory Flexibility Act
Pursuant to section 605(b) of the Regulatory Flexibility Act, the
OCC 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 OCC
believes that, while some banks with limited derivative portfolios may
experience an increase in capital charges, for most small banks the
proposal will have little or no affect since small banks typically have
a limited derivatives portfolio. For banks with more developed
portfolios the overall affect of the proposal will likely be to reduce
regulatory burden and a decrease in the capital charge for certain
derivative contracts.
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 3
Administrative practice and procedure, Capital, National banks,
Reporting and recordkeeping requirements, Risk.
Authority and Issuance
For the reasons set out in the preamble, appendix A to part 3 of
title 12, chapter 1 of the Code of Federal Regulations is proposed to
be amended as set forth below.
PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES
1. The authority citation for part 3 continues 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, section 3, paragraph (a)(3)(ii) is revised, the
fourth sentence in the introductory text of paragraph (b) which begins
with ``Second,'' is revised, and paragraph (b)(5), as proposed to be
revised at 59 FR 26460 (May 20, 1994) is revised, to read as follows:
Appendix A to Part 3--Risk-Based Capital Guidelines
* * * * *
Section 3. Risk Categories/Weights for On-Balance Sheet Assets and
Off-Balance Sheet Items
* * * * *
(a) * * *
(3) * * *
(ii) The credit equivalent amount of derivative contracts
calculated in accordance with section 3(b)(5) of this appendix A, that
do not qualify for inclusion in a lower risk category.
* * * * *
(b) * * * Second, the resulting credit equivalent amount is then
assigned to the proper risk category using the criteria regarding
obligors, guarantors, and collateral listed in section 3(a) of this
appendix A. Collateral and guarantees are applied to the face amount
of an off-balance sheet item, not the credit equivalent amount of
such an off-balance sheet item; however, with respect to derivative
contracts under section 3(b)(5) of this appendix A, collateral and
guarantees are applied to the credit equivalent amount of such
derivative contracts. * * *
* * * * *
(5) Derivative contracts--(i) Calculation of credit equivalent
amounts. The credit equivalent amount of a derivative contract
equals the sum of the current credit exposure and the potential
future credit exposure of the derivative contract. The calculation
of credit equivalent amounts must be measured in U.S. dollars,
regardless of the currency or currencies specified in the derivative
contract.
(A) Current credit exposure. The current credit exposure for a
single derivative contract is determined by the mark-to-market value
of the derivative 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. The current credit exposure for multiple
contracts executed with a single counterparty and subject to a
qualifying bilateral netting contract is determined as provided by
section 3(b)(5)(ii) of this appendix A.
(B) Potential future credit exposure. The potential future
credit exposure on a derivative contract, including a derivative
contract with negative mark-to-market value, is calculated by
multiplying the notional principal18a of the derivative
contract by one of the credit conversion factors in Table A
(Conversion Factor Matrix) of this appendix A, as appropriate.\19\
The potential future credit exposure for multiple derivative
contracts executed with a single counterparty and subject to a
qualifying bilateral netting contract is determined as provided by
section 3(b)(5)(ii)(A)(2) of this appendix A.
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\1\8aFor purposes of caluclating either the potential future
credit exposure under section 3(b)(5)(i)(B) of this appendix A or
the gross potential future credit exposure under section
3(b)(5)(ii)(A)(2) of this appendix A for foreign exchange contracts
and other similar contracts in which the notional principal is
equivalent to the cash flows, total notional principal is the net
receipts to each party falling due on each value date in each
currency.
\19\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.
Table A.--Conversion Factor Matrix\1\
[Percent]
----------------------------------------------------------------------------------------------------------------
Foreign
Interest exchange Precious Other
Remaining maturity rate rate and Equity\2\ metals commodities
gold
----------------------------------------------------------------------------------------------------------------
Less than one year............................. 0.0 1.0 6.0 7.0 12.0
One to five years.............................. 0.5 5.0 8.0 7.0 12.0
Over five years................................ 1.5 7.5 10.0 8.0 15.0
----------------------------------------------------------------------------------------------------------------
\1\For derivative contracts with multiple exchanges of principal, the conversion factors are to be multiplied by
the number of remaining payments in the derivative contract.
\2\For derivative contracts that automatically reset to zero value following a payment, the remaining maturity
is set equal to the time until the next payment.
(ii) Derivative contracts subject to a bilateral netting
contract--(A) Netting Calculation. The credit equivalent amount for
multiple derivative contracts executed with a single counterparty
and subject to a qualifying bilateral netting contract as provided
by section (3)(b)(5)(ii)(B) of this appendix A is calculated by
adding the net current credit exposure and the adjusted sum of the
potential future credit exposure for all of the derivative contracts
subject to the bilateral netting contract.
(1) The net current credit exposure. The net current credit
exposure is the net sum of all positive and negative mark-to-market
values of the individual derivative contracts subject to the
bilateral netting contract. If the net sum of the mark-to-market
value is positive, then the net current credit exposure is equal to
that net sum of the mark-to-market value. If the net sum of the
mark-to-market value is zero or negative, then the net current
credit exposure is zero.
(2) Adjusted sum of the estimates of the potential future credit
exposure. The adjusted sum of the potential future credit exposure
is calculated as: Anet = 0.5 x Agross +
(0.5 x NGR x Agross), where Anet is the adjusted sum of
the potential future credit exposure, Agross is the gross
potential future credit exposure, and NGR is the net to gross ratio.
The NGR is the ratio of the net current credit exposure to the gross
current credit exposure. The gross potential future credit exposure
(Agross) is the sum of the potential future credit exposure (as
determined under section 3(b)(5)(i)(B) of this appendix A) for each
individual derivative contract subject to the bilateral netting
contract. In calculating the net gross ratio (NGR), the gross
current credit exposure is equal to the sum of the current credit
exposures (as determined under section 3(b)(5)(i)(A) of this
appendix A) of all individual derivative contracts subject to the
bilateral netting contract.
(B) Qualifying Bilateral Netting Contract. In determining the
current credit exposure for multiple derivative contracts executed
with a single counterparty, a bank may net derivative 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 derivative contracts covered by the
bilateral netting contract, and provides, in effect, that the bank
would have a single claim or obligation either to receive or to pay
only the net amount of the sum of the positive and negative mark-to-
market values on the individual derivative contracts covered by the
bilateral netting contract in the event that a counterparty, or a
counterparty to whom the bilateral netting contract has been
assigned, fails to perform due to any of the following events--
default, insolvency, bankruptcy, or other similar circumstances.
(3) The bank 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 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 of the jurisdiction that governs the individual
derivative contracts covered by the bilateral netting contract; and
(iii) The law of the jurisdiction that governs the bilateral
netting contract;
(4) 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 requirement of this
section.
(5) The bank maintains in its files documentation adequate to
support the netting of a derivative contract.19a
---------------------------------------------------------------------------
\1\9aBy netting individual derivative contracts for the purpose
of calculating its credit equivalent amount, a bank represents that
documentation adequate to support the netting of a derivativ
contract is in 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 in
any one of the bodies of law described in section 3(b)(5)(ii)(B)(3)
(i) through (iii) of this appendix A the underlying derivative
contracts may not be netted for the purposes of this section.
---------------------------------------------------------------------------
(6) The bilateral netting contract is not subject to a walkaway
clause.
(iii) Risk weighting. Once the bank determines the credit
equivalent amount for a derivative contract, 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 derivative contract is 50 percent.
(iv) Exceptions. The following derivative contracts are not
subject to the above calculation, and therefore, are not considered
part of the denominator of a national bank's risk-based capital
ratio:
(A) Exchange rate contracts with an original maturity of 14
calendar days or less; and
(B) Any interest rate or exchange rate contract that is traded
on an exchange requiring the daily payment of any variations in the
market value of the contract.
* * * * *
3. Table 3, at the end of appendix A, is revised to read as
follows:
Table 3.--Treatment of Derivative Contracts
The current exposure method is used to calculate the credit
equivalent amounts of derivative 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 derivative contracts with a single counterparty may be netted
if those contracts are subject to a qualifying bilateral netting
contract.
Table A.--Conversion Factor Matrix\1\
[Percent]
----------------------------------------------------------------------------------------------------------------
Foreign
Interest exchange Precious Other
Remaining maturity rate rate and Equity\2\ metals commodities
gold
----------------------------------------------------------------------------------------------------------------
Less than one year............................. 0.0 1.0 6.0 7.0 12.0
One to five years.............................. 0.5 5.0 8.0 7.0 12.0
Over five years................................ 1.5 7.5 10.0 8.0 15.0
----------------------------------------------------------------------------------------------------------------
\1\For derivative contracts with multiple exchanges of principal, the conversion factors are to be multiplied by
the number of remaining payments in the derivative contract.
\2\For derivative contracts that automatically reset to zero value following a payment, the remaining maturity
is set equal to the time until the next payment.
The following derivative contracts will be excluded:
Exchange rate contracts with an original maturity of 14
calendar days or less; and
Derivative contracts traded on exchanges and subject to
daily margin requirements.
Dated: August 24, 1994.
Stephen R. Steinbrink,
Acting Comptroller of the Currency.
[FR Doc. 94-21642 Filed 8-31-94; 8:45 am]
BILLING CODE 4810-33-P
