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Financial Institution Letters


[Federal Register: December 28, 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: Final rule.

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SUMMARY: The FDIC is amending its risk-based capital standards to 
recognize the risk-reducing benefits of qualifying bilateral netting 
contracts. This final rule implements a recent revision to the Basle 
Accord permitting the recognition of such netting arrangements. The 
effect of the final rule is that state nonmember banks (banks) may net 
positive and negative mark-to-market values of interest and exchange 
rate contracts in determining the current exposure portion of the 
credit equivalent amount of such contracts to be included in risk-
weighted assets.

EFFECTIVE DATE: December 28, 1994.

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, N.W., 
Washington, D.C. 20429; Jeffrey M. Kopchik, Counsel, (202/898-3872), 
Christopher Curtis, Senior Counsel, (202/898-3728), FDIC, Legal 
Division, 550 17th Street, N.W., Washington, D.C., 20429; Linda L. 
Stamp, Counsel, (202/736-0161), Legal Division, 1717 H Street, N.W., 
Washington, D.C. 20429.

SUPPLEMENTARY INFORMATION:

Background

    The Basle Accord1 established a risk-based capital framework 
which was implemented in the United States by the FDIC in 1989. Under 
this framework, off-balance-sheet interest rate and exchange rate 
contracts (rate contracts) are incorporated into risk weighted assets 
by converting each contract into a credit equivalent amount. This 
amount is then assigned to the appropriate credit risk category 
according to the identity of the obligor or counterparty or, if 
relevant, the guarantor or the nature of the collateral. The credit 
equivalent amount of an interest or exchange rate contract can be 
assigned to a maximum credit risk category of 50 percent.
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    \1\The Basle Accord is a risk-based framework that was proposed 
by the Basle 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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    The credit equivalent amount of a rate contract is determined by 
adding together the current replacement cost (current exposure) and an 
estimate of the possible increase in future replacement cost in view of 
the volatility of the current exposure over the remaining life of the 
contract (potential future exposure, also referred to as the add-
on).2
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    \2\This method of determining credit equivalent amounts for rate 
contracts is identified in the Basle Accord as the current exposure 
method, which is used by most international banks.
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    For risk-based capital purposes, a rate contract with a positive 
mark-to-market value has a current exposure equal to that market value. 
If the mark-to-market value of a rate contract is zero or negative, 
then there is no replacement cost associated with the contract and the 
current exposure is zero. The original Basle Accord and FDIC standards 
provided that current exposure would be determined individually for 
each rate contract entered into by a bank; banks generally were not 
permitted to offset, that is, net, positive and negative market values 
of multiple rate contracts with a single counterparty to determine one 
current credit exposure relative to that counterparty.3
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    \3\It was noted in the Accord that the legal enforceability of 
certain netting arrangements was unclear in some jurisdictions. 
However, the legal status of netting by novation was determined to 
be settled and this limited type of netting was recognized. Netting 
by novation is accomplished under a written bilateral contract 
providing that any obligation to deliver a given currency on a given 
date is automatically amalgamated with all other obligations for the 
same currency and value date. The previously existing contracts are 
extinguished and a new contract, for the single net amount, is 
legally substituted for the amalgamated gross obligations.
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    In April 1993 the Basle Supervisors' Committee proposed a revision 
to the Basle Accord, endorsed by the G-10 Governors in July 1994, that 
permits banks to net positive and negative market values of rate 
contracts subject to a qualifying, legally enforceable, bilateral 
netting arrangement. Under the revision, banks with qualifying netting 
arrangements are permitted to calculate a single net current exposure 
for purposes of determining the credit equivalent amount for the 
included contracts.4 If the net market value of the contracts 
included in such a netting arrangement is positive, then that market 
value equals the current exposure for the netting contract. If the net 
market value is zero or negative, then the current exposure is zero.
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    \4\The revision to the Accord notes that national supervisors 
must be satisfied about the legal enforceability of a netting 
arrangement under the laws of each jurisdiction relevant to the 
arrangement. The Accord continues, if any supervisor is dissatisfied 
about enforceability under its laws, the netting arrangement does 
not satisfy this condition and neither counterparty may obtain 
supervisory benefit.
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The FDIC's Proposal

    On May 20, 1994, the Board of Governors of the Federal Reserve 
System (Federal Reserve) and the Office of the Comptroller of the 
Currency (OCC) issued a joint proposal to amend their respective risk-
based capital standards (59 FR 26456) in accordance with the Basle 
Supervisors' Committee's April 1993 proposal. The Office of Thrift 
Supervision (OTS) issued a similar netting proposal on June 14, 1994 
(59 FR 30538) and the FDIC issued its netting proposal on July 25, 1994 
(59 FR 37726). (Collectively, the FDIC, Federal Reserve, OCC and OTS 
are referred to as the banking agencies.) The banking agencies each 
proposed that for capital purposes the organizations under their 
supervision could net the positive and negative market values of 
interest and exchange rate contracts subject to a qualifying, legally 
enforceable, bilateral netting contract to calculate one current 
exposure for that master netting contract.
    The banking agencies' proposals provided that the net current 
exposure would be determined by adding together all positive and 
negative market values of individual contracts subject to the netting 
contract. The net current exposure would equal the sum of the market 
values if that sum is a positive value, or zero if the sum of the 
market values is zero or a negative value. The proposals did not alter 
the calculation method for potential future exposure.5
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    \5\Potential future exposure is estimated by multiplying the 
effective notional amount of a contract by a credit conversion 
factor which is based on the type of contract and the remaining 
maturity of the contract. Under the FDIC's proposal, a potential 
future exposure amount would be calculated for each individual 
contract subject to the netting contract. The individual potential 
future exposures would then be added together to arrive at one total 
add-on amount.
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    Under the banking agencies' proposals, institutions would be able 
to net for risk-based capital purposes only with a written bilateral 
netting contract that creates a single legal obligation covering all 
included individual rate contracts and does not contain a walkaway 
clause.6 The proposals required an institution to obtain a written 
and reasoned legal opinion(s) stating that under the master netting 
contract the institution would have a claim to receive, or an 
obligation to pay, only the net amount of the sum of the positive and 
negative market values of included individual contracts if a 
counterparty failed to perform due to default, insolvency, bankruptcy, 
liquidation, or similar circumstances.
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    \6\A walkaway clause is a provision in a netting contract that 
permits a non-defaulting counterparty to make lower payments than it 
would make otherwise under the contract, or no payment at all, to a 
defaulter or to the estate of a defaulter, even if the defaulter or 
the estate of the defaulter is a net creditor under the contract.
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    The banking agencies' proposals indicated that the legal opinion 
must normally cover: (i) The law of the jurisdiction in which the 
counterparty is chartered, or the equivalent location in the case of 
noncorporate entities, and if a branch of the counterparty is involved, 
the law of the jurisdiction in which the branch is located; (ii) the 
law that governs the individual contracts covered by the netting 
contract; and (iii) the law that governs the netting contract.
    The banking agencies' proposals provided that an institution must 
maintain in its files documentation adequate to support the bilateral 
netting contract. Documentation would typically include a copy of the 
bilateral netting contract, legal opinions and any related 
translations. In addition, the proposals required an institution to 
establish and maintain procedures to ensure that the legal 
characteristics of netting contracts would be kept under review.
    Under the proposals, the banking agencies could disqualify any or 
all contracts from netting treatment for risk-based capital purposes if 
the requirements of the proposals were not satisfied. In the event of 
disqualification, the affected contracts would be treated as though 
they were not subject to the master netting contract. The proposals 
indicated that outstanding netting by novation arrangements would not 
be grandfathered, that is, such arrangements would have to meet all of 
the proposed requirements for qualifying bilateral netting contracts.
    The proposals requested general comments as well as specific 
comments on the nature of collateral arrangements and the extent to 
which collateral might be recognized in conjunction with bilateral 
netting contracts.

Comments Received

    The banking agencies together received twenty-two public comments 
on their proposed amendments. Since all the comment letters were shared 
by the banking agencies, all of them will be discussed herein. Twelve 
of the commenters were banks, thrifts, and bank and thrift holding 
companies and five were industry trade associations and organizations. 
In addition, there were two comments from foreign financial 
institutions and three comments from law firms. All commenters 
supported the expanded recognition of bilateral netting contracts for 
risk-based capital purposes. Several commenters encouraged recognition 
of such contracts as quickly as possible. Many of the commenters 
concurred with one of the principal underlying tenets of the proposals, 
that is, that legally enforceable bilateral netting contracts can 
provide an efficient and desirable means for institutions to reduce or 
control credit exposure. A few commenters noted that, in their view, 
the recognition of bilateral netting contracts would create an 
incentive for market participants to use such arrangements and would 
encourage lawmakers to clarify the legal status of netting arrangements 
in their jurisdictions. One commenter noted that the expanded 
recognition of bilateral netting contracts would help keep U.S. banking 
organizations competitive in global derivatives markets.
    While generally expressing their endorsement for the expanded 
recognition of bilateral netting contracts, nearly all commenters 
offered suggestions or requested clarification regarding details of the 
proposals. In particular, the commenters raised issues concerning 
specifics of the required legal opinions, the treatment of collateral, 
and the grandfathering of walkaway clauses and novation agreements.

Legal Opinions

    Almost all commenters addressed the proposed requirement that 
institutions obtain legal opinions concluding that their bilateral 
netting contracts would be enforceable in all relevant jurisdictions. 
Commenters did not object to the general requirement that they secure 
legal opinions, rather they raised a number of questions about the form 
and substance of an acceptable opinion.
Form
    Several commenters requested clarification as to the specific form 
of the legal opinion. Commenters wanted to know if a memorandum of law 
would satisfy the requirement or if a legal opinion would be required. 
They questioned whether a memorandum or opinion could be addressed to, 
or obtained by, an industry group, and whether a generic opinion or 
memorandum relating to a standardized netting contract would satisfy 
the legal opinion requirement.
    Several commenters suggested that an opinion secured on behalf of 
the banking industry by an organization should be sufficient so long as 
the individual institution's counsel concurs with the opinion and 
concludes that the opinion applies directly to the institution's 
specific netting contract and to the individual contracts subject to 
it. A few commenters requested confirmation that legal opinions would 
not have to follow a predetermined format.
Scope
    Several commenters identified two possible interpretations of the 
proposed language with regard to the scope of the legal opinions. They 
asked the banking agencies to clarify whether the opinions would be 
required to discuss only whether all relevant jurisdictions would 
recognize the contractual choice of law or whether they must also 
discuss the enforceability of netting in bankruptcy or other instances 
of default. One commenter suggested deleting the requirement for a 
choice of law analysis.
    A number of commenters objected to the proposed requirement that 
the legal opinion for a multibranch netting contract (that is, a 
netting contract between multinational banks that includes contracts 
with branches of the parties located in various jurisdictions) address 
the enforceability of netting under the law of the jurisdiction where 
each branch is located. These commenters stated that it should be 
sufficient for the legal opinion to conclude that netting would be 
enforced in the jurisdiction of the counterparty's home office if the 
master netting contract provides that all transactions are considered 
obligations of the home office and the branch jurisdictions recognize 
that provision.
Severability
    Several commenters expressed concern about the proposed treatment 
for netting contracts that include contracts with branches in 
jurisdictions where the enforceability of netting is unclear. In such 
circumstances, commenters asserted, unenforceability or uncertainty in 
one jurisdiction should not invalidate the entire netting contract for 
risk-based capital netting treatment. These commenters contended that, 
to the extent supported by legal opinions, contracts with branches of a 
counterparty in jurisdictions that recognize netting arrangements 
should be netted and contracts with branches in jurisdictions where the 
enforceability of netting is not supported by legal opinions should, 
for risk-based capital purposes, be severed, or removed, from the 
master netting contract and treated as though they were not subject to 
that contract. These commenters noted that this treatment should only 
be available to the extent it is supported by legal opinion.
Conclusions
    The proposals required a legal opinion to conclude that ``relevant 
court and administrative authorities would find'' the netting to be 
effective. Many commenters that discussed this aspect of the proposals 
expressed concern that this standard was too high. They suggested, 
instead, that the opinions be required to conclude that netting 
``should'' be effective.
    A few commenters requested clarification regarding the proposed 
requirement that the netting contract must create a single legal 
obligation.

Collateral

    Twelve commenters addressed the proposals' specific request for 
comment on the nature of collateral and the extent to which collateral 
might be recognized in conjunction with bilateral netting contracts. 
All of these commenters believed collateral should be recognized as a 
means of reducing credit exposure. A few commenters noted that 
collateral arrangements are increasingly being used with derivative 
transactions.
    Several commenters stated that for netting contracts that call for 
the use of collateral, the amount of required collateral is determined 
from the net mark-to-market value of the master netting contract. A few 
commenters added that mark-to-market collateral often is used in 
conjunction with a collateral ``add-on'' based on such things as the 
notional amount of the underlying contracts, the maturities of the 
contracts, the credit quality of the counterparty, and volatility 
levels.
    A number of commenters offered their opinions as to how collateral 
should be recognized for risk-based capital purposes. Some suggested 
that the existing method of recognizing collateral for purposes of 
assigning credit equivalent amounts to risk categories is applicable to 
derivative transactions as well. Other commenters expressed the view 
that collateral should be recognized when assigning risk weights to the 
extent it is legally available to cover the total credit exposure for 
the bilateral netting contract in the event of default and that this 
availability should be addressed in the legal opinions.
    Several other commenters suggested separating the net current 
exposure and potential future exposure of bilateral netting contracts 
for determining collateral coverage and appropriate risk weights. One 
commenter favored recognizing collateral for capital purposes by 
allowing an institution to offset net current exposure by the amount of 
the collateral to further reduce the credit equivalent amount.
    Two commenters requested clarification that contracts subject to 
qualifying netting contracts could be eligible for a zero percent risk 
weight if the transaction is properly collateralized in accordance with 
the Federal Reserve's collateralized transactions rule.7
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    \7\In December 1992, the Federal Reserve issued an amendment to 
its risk-based capital guidelines permitting certain collateralized 
transactions to qualify for a zero percent risk weight (57 FR 62180, 
December 30, 1992). In order to qualify for a zero percent risk 
weight, an institution must maintain a positive margin of qualifying 
collateral at all times. Thus, the collateral arrangement should 
provide for immediate liquidation of the claim in the event that a 
positive margin of collateral is not maintained. The OCC has issued 
a similar proposal (58 FR 43822, August 18, 1993).
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Walkaway Clauses

    Several commenters addressed the proposed prohibition against 
walkaway clauses in contracts qualifying for netting for risk-based 
capital purposes. While most of these commenters agreed that, 
ultimately, walkaway clauses should be eliminated from master netting 
contracts, they favored a phase-out period, during which outstanding 
bilateral netting contracts containing walkaway clauses could qualify 
for capital netting treatment. Several commenters contended that if a 
defaulter is a net debtor under the contract, the existence of a 
walkaway clause would not affect the amount owed to the non-defaulting 
creditor.

Novation

    A few commenters expressed concern that the banking agencies' 
proposals did not grandfather outstanding novation agreements. These 
commenters suggested a phase-in period during which novation agreements 
would not be required to be supported by legal opinions.

Other Issues

    One commenter requested greater detail on the nature and extent of 
examination review procedures. Two commenters stated that in some 
situations obtaining translations might be burdensome. Another 
commenter suggested assurance that the agencies would not disqualify 
netting contracts in an unreasonable manner.
    Approximately one-half of the commenters expressed concern that the 
banking agencies' proposals specifically were limited to interest rate 
and exchange rate contracts. All of these opposed limiting the range of 
products that could be included under qualifying netting contracts. In 
this regard, one commenter noted that where there is sufficient legal 
support confirming the enforceability of cross-product netting it 
should be recognized for capital purposes.
    A number of commenters used the proposal as an opportunity to 
discuss the manner in which the add-on for potential future exposure is 
calculated. They suggested netting contracts should be recognized not 
only as a way to reduce the current exposure to a counterparty, but 
also the effects of such netting contracts should be taken into account 
to reduce the amount of capital organizations must hold against the 
potential future exposure to the counterparty.

Final Rule

    After considering the public comments received and further 
deliberating the issues involved, the FDIC has determined to adopt a 
final rule recognizing, for capital purposes, qualifying bilateral 
netting contracts. This final rule is substantially the same as 
proposed.

Legal opinions

Form
    The final rule requires that banks obtain a written and reasoned 
legal opinion(s) concluding that the netting contract is enforceable in 
all relevant jurisdictions. This requirement is aimed at ensuring there 
is a substantial legal basis supporting the legal enforceability of a 
netting contract before reducing a bank's capital requirement based on 
that netting contract. A legal opinion, as that phrase is commonly 
understood by the legal community in the United States, can provide 
such a legal basis. A memorandum of law may be an acceptable 
alternative as long as it addresses all of the relevant issues in a 
credible manner.
    As discussed in the proposal, the legal opinion may be prepared by 
either an outside law firm or a bank's in-house counsel. The salient 
requirements for an acceptable legal opinion are that it: (i) Addresses 
all relevant jurisdictions; and (ii) concludes with a high degree of 
certainty that in the event of a legal challenge the bank's claim or 
obligation would be determined by the relevant court or administrative 
authority to be the net sum of the positive and negative mark-to-market 
values of all individual contracts subject to the bilateral netting 
contract. The subject matter and complexity of required legal opinions 
will vary.
    To some extent, banks may use general, standardized opinions to 
help support the legal enforceability of their bilateral netting 
contracts. For example, a bank may have obtained a memorandum of law 
addressing the enforceability of netting provisions in a particular 
foreign jurisdiction. This opinion may be used as the basis for 
recognizing netting generally in that jurisdiction. However, with 
regard to an individual master netting contract, the general opinion 
would need to be supplemented by an opinion that addresses issues such 
as the enforceability of the underlying contracts, choice of law, and 
severability.
    For example, the FDIC does not believe that a generic opinion 
prepared for a trade association with respect to the effectiveness of 
netting under the standard form agreement issued by the trade 
association, by itself is adequate to support a netting contract. Banks 
using such general opinions would need to supplement them with a review 
of the terms of the specific netting contract that the bank is 
executing.
Scope
    With regard to the scope of the legal opinions, that is, what areas 
of analysis must be covered, the FDIC is of the opinion that legal 
opinions must address the validity and enforceability of the entire 
netting contract. The opinion must conclude that under the applicable 
state or other jurisdictional law the netting contract is a legal, 
valid, and binding contract, enforceable in accordance with its terms, 
even in the event of insolvency, bankruptcy, or similar proceedings. 
Opinions provided on the law of jurisdictions outside of the U.S. 
should include a discussion and conclusion that netting provisions do 
not violate the public policy or the law of that jurisdiction.
    The FDIC has further determined that one of the most critical 
aspects of a qualifying netting contract is the contract's 
enforceability in any jurisdiction whose law would likely be applied in 
an enforcement action, as well as the jurisdiction where the 
counterparty's assets reside. In this regard, and in light of the 
policy in some countries to liquidate branches of foreign banking 
organizations independent of the head office, the FDIC is retaining its 
proposed requirement that legal opinions address the netting contract's 
enforceability under: (i) The law of the jurisdiction in which the 
counterparty is chartered, or the equivalent location in the case of 
noncorporate entities, and if a branch of the counterparty is involved, 
the law of the jurisdiction in which the branch is located; (ii) the 
law that governs the individual contracts subject to the bilateral 
netting contract; and (iii) the law that governs the netting contract.
Severability
    The FDIC recognizes that for some multibranch netting contracts a 
bank may not be able to obtain a legal opinion(s) concluding that 
netting would be enforceable in every jurisdiction where branches 
covered under the master netting contract are located. The FDIC concurs 
with commenters that in such situations it may be inefficient to 
require banks to renegotiate netting contracts to ensure they cover 
only those jurisdictions where netting is clearly enforceable. The FDIC 
has determined that, in certain circumstances for capital purposes, 
banks may use master bilateral netting contracts that include contracts 
with branches across all jurisdictions. Banks should calculate their 
net current exposure for the contracts in those jurisdictions where 
netting clearly is enforceable as supported by legal opinion(s). The 
remaining contracts subject to the netting contract should be severed 
from the netting contract and treated as though they were not subject 
to the netting contract for capital and credit purposes. This approach 
of essentially dividing contracts subject to the netting contact into 
two categories--those that may clearly be netted and those that may 
not--is acceptable provided that the bank's legal opinions conclude 
that the contracts that do not qualify for netting treatment are 
legally severable from the master netting contract and that such 
severance will not undermine the enforceability of the netting contract 
for the remaining qualifying contracts.
Conclusions
    The FDIC has retained the proposed language that legal opinions 
must represent that netting would be enforceable in all relevant 
jurisdictions. In response to commenters' assertions that the standard 
for this type of legal opinion is too high, the FDIC notes that use of 
the word ``would'' in the capital rules does not necessarily mean that 
the legal opinions must also use the word ``would'' or that 
enforceability must be determined to be an absolute certainty. The 
intent, rather, is for banks to secure a legal opinion concluding that 
there is a high degree of certainty that the netting contract will 
survive a legal challenge in any applicable jurisdiction. The degree of 
certainty should be apparent from the reasoning set out in the opinion.
    The FDIC notes that the requirement for legal opinions to conclude 
that netting contracts must create a single legal obligation applies 
only to those individual contracts that are covered by, and included 
under, the netting contract for capital purposes. As discussed above, a 
netting contract may include individual contracts that do not qualify 
for netting treatment, provided that these individual contracts are 
legally severable from the contracts to be netted for capital purposes.

Collateral

    The final rule permits, subject to certain conditions, banks to 
take into account qualifying collateral when assigning the credit 
equivalent amount of a netting contract to the appropriate risk weight 
category in accordance with the procedures and requirements currently 
set forth in the FDIC's risk-based capital standards. The FDIC has 
added language to the final rule clarifying that collateral must be 
legally available to cover the credit exposure of the netting contract 
in the event of default. For example, the collateral may not be pledged 
solely against one individual contract subject to the master netting 
contract. The legal availability of the collateral must be addressed in 
the legal opinions.

Walkaway Clauses

    The FDIC has considered the suggestion made by some commenters of a 
phase-out period for outstanding contracts with walkaway clauses. The 
FDIC continues to believe that walkaway clauses do not reduce credit 
risk. Accordingly, the final rule retains the provision that bilateral 
netting contracts with walkaway clauses are not eligible for netting 
treatment for risk-based capital purposes and does not provide for a 
phase-out period.

Novation

    The proposal required all netting contracts, including netting by 
novation agreements, to be supported by written legal opinions. The 
FDIC does not agree with commenters that a grandfathering period for 
outstanding novation agreements is needed. Rather, the FDIC continues 
to believe that all netting contracts must be held to the same 
standards in order to promote certainty as to the legal enforceability 
of the contracts and to decrease the risks faced by counterparties in 
the event of default. Under the final rule, a netting by novation 
agreement must meet the requirements for a qualifying bilateral netting 
contract.

Other Issues

    The FDIC has considered all of the other issues raised by 
commenters. With regard to documentation, the FDIC reiterates that, as 
with all provisions of risk-based capital, a bank must maintain in its 
files appropriate documentation to support any particular capital 
treatment including netting of rate contracts. Appropriate 
documentation typically would include a copy of the bilateral netting 
contract, supporting legal opinions, and any related translations. The 
documentation should be available to examiners for their review.
    The FDIC recognizes commenters' concerns that the proposed rules 
were limited specifically to interest and exchange rate contracts. The 
FDIC notes that both the Basle Accord and its risk-based capital 
standards currently do not address derivatives contracts other than 
rate contracts. This final rule does not attempt to go beyond the scope 
of the existing risk-based capital framework and applies only to 
netting contracts encompassing interest rate and foreign exchange rate 
contracts. The FDIC, however, notes that the Basle Supervisors' 
Committee issued a proposal for public comment in July 1994 to amend 
the Basle Accord which explicitly would set forth the risk-based 
capital treatment for other types of derivative transactions, such as 
commodity, precious metal, and equity contracts. In this regard, the 
Federal Reserve, the OCC, and the FDIC issued similar proposals, based 
on the Basle Supervisors' Committee proposal, to amend their risk-based 
capital standards (59 FR 43508, August 24, 1994; 59 FR 45243, September 
1, 1994; and 59 FR 52714, October 19, 1994, respectively). The OTS 
intends to issue a similar proposal in the near future.
    Until the Basle Accord has been revised and the FDIC's risk-based 
capital rules have been amended to encompass commodity, precious metal, 
and equity derivative contracts, the FDIC will permit banks to apply 
the following treatment, rather than automatically disqualifying from 
capital netting treatment an entire netting contract that includes non-
rate-related transactions. In determining the current exposure of 
otherwise qualifying netting contracts that include non-rate-related 
contracts, banks will be permitted to net the positive and negative 
mark-to-market values of the included interest and exchange rate 
contracts, while severing the non-rate-related contracts and treating 
them as though they were not subject to the master netting contract. 
(This treatment is similar to the treatment applied to a netting 
contract that includes contracts in jurisdictions where the 
enforceability of netting is not supported by legal opinion. Legal 
opinions are not required to support severability of non-rate-related 
contracts.)
    The FDIC notes that the regulatory language with regard to the 
calculation of potential future exposure remains essentially the same 
as that proposed. The FDIC has clarified an underlying premise of the 
current exposure method for calculating credit exposure as set forth in 
the Basle Accord, that is, the add-on for potential future exposure 
must be calculated based on the effective, rather than the apparent, 
notional principal amount and the notional amount the bank uses will be 
subject to examiner review.8
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    \8\The notional amount is, generally, a stated reference amount 
of money used to calculate payment streams between the 
counterparties. In the event that the effect of the notional amount 
is leveraged or enhanced by the structure of the transaction, banks 
must use the actual, or effective, notional amount when determining 
potential future exposure. For example, a stated notional amount of 
one million dollars with payments calculated at 2X Libor, would have 
an effective notional amount of two million dollars.
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    Finally, in its Notice of Proposed Rulemaking, the FDIC described 
its transfer and enforcement powers with respect to ``qualified 
financial contracts'' under section 11(e) of the FDI Act. (59 FR 37229-
30). Having received no comments on that subject, the FDIC reaffirms 
its position as stated in the Notice of Proposed Rulemaking.

Regulatory Flexibility Act Analysis

    Pursuant to section 605(b) of the Regulatory Flexibility Act, the 
FDIC hereby certifies that this final rule will not have a significant 
impact on a substantial number of small business entities. Accordingly, 
a regulatory flexibility analysis is not required.

Paperwork Reduction Act and Regulatory Burden

    The FDIC has determined that this final rule will not increase the 
regulatory paperwork burden of banks pursuant to the provisions of the 
Paperwork Reduction Act (44 U.S.C. 3501 et seq.).
    Section 302 of the Riegle Community Development and Regulatory 
Improvement Act of 1994 (Pub. L. 103-325, 108 Stat. 2160) provides that 
the federal banking agencies must consider the administrative burdens 
and benefits of any new regulation that imposes additional requirements 
on insured depository institutions. Section 302 also requires such a 
rule to take effect on the first day of the calendar quarter following 
final publication of the rule, unless the agency, for good cause, 
determines an earlier effective date is appropriate.
    The new capital rule imposes certain requirements on banks that 
wish to net the current exposures of their rate contracts for purposes 
of calculating their risk-based capital requirements. However, the FDIC 
expects that such banks would adhere to these requirements in any event 
as part of prudent business practices. Any burden of complying with the 
requirements of netting under a legally enforceable netting contract 
and obtaining the necessary legal opinions should be outweighed by the 
benefits associated with a lower capital requirement. The new rule will 
not affect banks that do not wish to net for capital purposes. For 
these reasons, the FDIC has determined that the rule is to be effective 
on the date published, and banks will be permitted to take advantage of 
netting in their year-end statements, if they so desire.

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 amends 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. Appendix A to part 325 is amended by revising section II.E.1 
introductory text, Section II.E.1.(a) and (b) and the undesignated 
paragraph after section II.E.1.(b) preceding the table; revising the 
first paragraph of section II.E.2.; removing the last two sentences of 
the second paragraph of section 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 II.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. To calculate the credit equivalent amount of 
its off-balance sheet interest rate and foreign exchange rate 
instruments, a bank should, for each contract, sum:
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    (a) The mark-to-market value (positive values only) of the 
contact (that is, its current credit exposure or replacement cost); 
and
    (b) An estimate of the potential future increase in credit 
exposure over the remaining life of the instrument.
    For risk based capital purposes, potential credit exposure on a 
contract is determined by multiplying the notional principal amount 
of the contract, including contracts with negative mark-to-market 
values, by the appropriate credit conversion factor. Banks should, 
subject to examiner review, use the effective rather than the 
apparent or stated notional amount in this calculation.40 The 
conversion factors are:
---------------------------------------------------------------------------

    \4\0The notional amount is, generally, a stated reference amount 
of money used to calculate payment streams between the 
counterparties. In the event that the effect of the notional amount 
is leveraged or enhanced by the structure of the transaction, 
institutions must use the actual, or effective, notional amount when 
determining potential future exposure. For example, a stated 
notional amount of one million dollars with payments calculated at 
2X Libor, would have an effective notional amount of two million 
dollars.
---------------------------------------------------------------------------

* * * * *
    2. Risk Weights for Interest Rate and Foreign Exchange Rate 
Contracts. Once the credit equivalent amount for an interest rate 
and foreign exchange rate instrument has been determined, that 
amount generally should be assigned to a risk weight category 
according to the identity of the counterparty or, if relevant, the 
nature of any collateral or guarantees. Collateral held against a 
netting contract is not recognized for capital purposes unless it is 
legally available for all contracts included in the netting 
contract. However, the maximum risk weight that will be applied to 
the credit equivalent amount of such instruments is 50 percent.
* * * * *
    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 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.41
---------------------------------------------------------------------------

    \4\1For 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.
---------------------------------------------------------------------------

    (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 exposures 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 contracts 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.42
---------------------------------------------------------------------------

    \4\2For 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.
---------------------------------------------------------------------------

    (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 removing 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 in their place two new sentences and by adding new 
Table IV to read as follows:
* * * * *

Table III.--Credit Conversion Factors for Off-Balance Sheet Items

* * * * *

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 exposure. 
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                       +          Current          =                   
                                exposure   ----------------------------   exposure   --------------             
 Type of contract (remaining --------------                            --------------                  Credit   
          maturity)             Notional     Conversion     Potential                    Current     equivalent 
                                principal      factor       exposure      Mark-to-      exposure       amount   
                                (dollars)                   (dollars)   market value    (dollars)               
----------------------------------------------------------------------------------------------------------------
(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             0        60,000
(3) 3-year interest rate                                                                                        
 swap.......................    10,000,000          .005        50,000       200,000       200,000       250,000
(4) 3-year interest rate                                                                                        
 swap.......................    10,000,000          .005        50,000      -250,000             0        50,000
(5) 7-year foreign exchange                                                                                     
 swap.......................    20,000,000           .05     1,000,000    -1,300,000             0     1,000,000
      Total.................  ............  ............     1,210,000  ............       300,000     1,510,000
----------------------------------------------------------------------------------------------------------------

    If contracts (1) through (5) above are subject to a qualifying 
bilateral netting contract, then the following applies:

                                                                        
------------------------------------------------------------------------
                         Potential                                      
                          future           Net current          Credit  
                      exposure (from       exposure\1\        equivalent
                          above)                                amount  
------------------------------------------------------------------------
(1).................          50,000                                    
(2).................          60,000                                    
(3).................          50,000                                    
(4).................          50,000                                    
(5).................       1,000,000                                    
                     ---------------------------------------------------
      Total.........       1,210,000  +              0  =      1,210,000
------------------------------------------------------------------------
\1\The total of the mark-to-market values from above is -1,370,000.     
  Since this is a negative amount, the net current exposure is zero.    

* * * * *
    By order of the Board of Directors.

    Dated at Washington, DC, this 20th day of December, 1994.

Federal Deposit Insurance Corporation.
Robert E. Feldman,
Acting Executive Secretary.
[FR Doc. 94-31826 Filed 12-27-94; 8:45 am]
BILLING CODE 6714-01-P
Last Updated 07/17/1999 communications@fdic.gov