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Home > News & Events > Financial Institution Letters




Financial Institution Letters


[Federal Register: September 5, 1995 (Volume 60, Number 171)]
[Rules and Regulations]               
[Page 46169-46185]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]



[[Page 46169]]

_______________________________________________________________________

Part IV

Department of the Treasury



Office of the Comptroller of the Currency



12 CFR Part 3

Federal Reserve System



12 CFR Parts 208 and 225

Federal Deposit Insurance Corporation



12 CFR Part 325



_______________________________________________________________________



Risk-Based Capital Standards: Derivative Transactions; Final Rule


[[Page 46170]]


DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 3

[Docket No. 95-20]
RIN 1557-AB14

FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

[Regulations H and Y; Docket No. R-0845]

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 325

RIN 3064-AB43

 
Risk-Based Capital Standards: Derivative Transactions

AGENCIES: Office of the Comptroller of the Currency (OCC), Department 
of the Treasury; Board of Governors of the Federal Reserve System 
(Board); and Federal Deposit Insurance Corporation (FDIC).

ACTION: Final rule.

-----------------------------------------------------------------------

SUMMARY: The OCC, the Board, and the FDIC (the banking agencies) are 
amending their respective risk-based capital standards for banks and 
bank holding companies (banking organizations, institutions). This 
final rule implements a recent revision to the Basle Accord revising 
and expanding the set of conversion factors used to calculate the 
potential future exposure of derivative contracts and recognizing the 
effects of netting arrangements in the calculation of potential future 
exposure for derivative contracts subject to qualifying bilateral 
netting arrangements. The effect of this final rule is threefold. 
First, long-dated interest rate and exchange rate contracts are subject 
to higher conversion factors and new conversion factors are set forth 
that specifically apply to derivative contracts related to equities, 
precious metals, and other commodities. Second, institutions are 
permitted to recognize a reduction in potential future credit exposure 
for transactions subject to qualifying bilateral netting arrangements. 
Third, derivative contracts related to equities, precious metals and 
other commodities may be recognized in bilateral netting arrangements 
for risk-based capital purposes.

EFFECTIVE DATE: October 1, 1995.

FOR FURTHER INFORMATION CONTACT: OCC: For issues relating to netting 
and the calculation of risk-based capital ratios, Roger Tufts, Senior 
Economic Advisor (202/874-5070), Office of the Chief National Bank 
Examiner. For legal issues, Eugene H. Cantor, Senior Attorney, 
Securities and Corporate Practices (202/874-5210), or Ronald 
Shimabukuro, Senior Attorney, Legislative and Regulatory Activities 
Division (202/874-5090), Office of the Comptroller of the Currency, 250 
E Street, S.W., Washington, D.C. 20219.
    Board: Roger Cole, Deputy Associate Director (202/452-2618), Norah 
Barger, Manager (202/452-2402), Robert Motyka, Supervisory Financial 
Analyst (202)/452-3621), Barbara Bouchard, Supervisory Financial 
Analyst (202/452-3072), Division of Banking Supervision and Regulation; 
or Stephanie Martin, Senior Attorney (202/452-3198), Legal Division. 
For the Hearing Impaired only, Telecommunications Device for the Deaf, 
Dorothea Thompson (202/452-3544), 20th and C Streets, N.W., Washington, 
D.C. 20551.
    FDIC: William A. Stark, Assistant Director, (202/898-6972), Curtis 
Wong, Capital Markets Specialist, (202/898-7327), Division of 
Supervision, or Jeffrey M. Kopchik, Counsel, (202/898-3872), Legal 
Division, FDIC, 550 17th St., N.W., Washington, D.C. 20429.

SUPPLEMENTARY INFORMATION:

I. Background

    The Basle Accord1 established a risk-based capital framework 
for assessing capital adequacy that was implemented in the United 
States by the banking agencies in 1989. Under this framework, off-
balance-sheet transactions are incorporated into the risk-based 
structure by converting each item into a credit equivalent amount that 
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 collateral.

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

    The credit equivalent amount of an off-balance-sheet interest rate 
or exchange rate contract (rate contract) is determined by adding 
together the current replacement cost (current exposure) of the 
contract and an estimate of the possible increase in future replacement 
cost (potential future exposure, also referred to as the add-on) in 
view of the volatility of the current exposure of the contract. The 
maximum risk category for rate contracts is 50 percent.2

    \2\Exchange rate contracts with an original maturity of 14 
calendar days or less and instruments traded on exchanges that 
require daily receipt and payment of cash variation margin are 
excluded from the risk-based capital ratio calculations.
---------------------------------------------------------------------------

Current Exposure

    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 is zero or negative, then the current 
exposure is zero. The sum of current exposures for a defined set of 
contracts is sometimes referred to as the gross current exposure for 
that set of contracts. When they were initially issued, the Basle 
Accord and the banking agencies' risk-based capital standards provided, 
generally, that current exposure would be determined individually for 
each rate contract entered into by a banking organization.
    In July 1994 the Basle Accord was revised to permit institutions to 
net, that is, offset, positive and negative mark-to-market values of 
rate contracts entered into with a single counterparty subject to a 
qualifying, legally enforceable, bilateral netting arrangement. 
Effective at year-end 1994, the banking agencies each amended, in a 
uniform manner, their risk-based capital standards to implement the 
revision to the Accord.3 Accordingly, U.S. banking organizations 
with qualifying, legally enforceable, bilateral netting arrangements 
may replace the gross current exposure of a set of contracts included 
in such an arrangement with a single net current exposure for purposes 
of determining the credit equivalent amount for the included contracts.

    \3\The Board issued its amendment on December 7, 1994 (59 FR 
62987), the OCC and FDIC issued their amendments on December 28, 
1994 (59 FR 66645 for the OCC final rule and 59 FR 66656 for the 
FDIC final rule).
---------------------------------------------------------------------------

Potential Future Exposure

    The potential future exposure portion of the credit equivalent 
amount for rate contracts is an estimate of the additional credit 
exposure that may arise as a result of fluctuations in prices or rates. 
The add-on for potential future exposure is estimated by multiplying 
the notional principal amount4 of the contract by a credit 
conversion factor that is determined by the remaining maturity of the 
contract and the type of 

[[Page 46171]]
contract. The original conversion factors in the Basle Accord and the 
banking agencies' risk-based capital standards are set forth in the 
following matrix:

    \4\The notional principal amount is a reference amount of money 
used to calculate payment streams between counterparties.

------------------------------------------------------------------------
                                                     Interest   Exchange
                Remaining maturity                   rate (in   rate (in
                                                     percent)   percent)
------------------------------------------------------------------------
One year or less..................................          0        1.0
Over one year.....................................        0.5        5.0
------------------------------------------------------------------------

    An individual add-on for potential future exposure is calculated 
for all rate contracts regardless of whether the market value is zero, 
positive, or negative, or whether the current exposure is calculated on 
a gross or net basis. The banking agencies' recent amendments to expand 
the recognition of bilateral netting arrangements did not revise the 
calculation of the add-on for potential future exposure. Accordingly, 
an add-on is calculated separately for each individual contract subject 
to a qualifying bilateral netting arrangement. These individual 
potential future exposures are added together to arrive at a gross add-
on amount. The gross add-on amount is added to the net current exposure 
to determine one credit equivalent amount for the contracts subject to 
the qualifying bilateral netting arrangement.
    Commenters to the Basle proposal to expand the recognition of 
bilateral netting arrangements urged regulators to also recognize 
reductions in potential future credit exposure arising from such 
arrangements. They also commented that commodity and equity derivative 
transactions should be eligible for netting for risk-based capital 
purposes. Accordingly, in July 1994 the Basle Supervisors Committee 
proposed revisions to the Basle Accord regarding the risk-based capital 
treatment of derivative transactions.5 Under the proposed 
revision, the matrix of conversion factors used to calculate potential 
future exposure would be expanded to take into account innovations in 
the derivatives markets. Specifically, the Basle Committee proposed 
that higher conversion factors be added to address long-dated 
transactions (that is, contracts with remaining maturities over five 
years) and new conversion factors be added to explicitly cover certain 
types of derivatives transactions not directly mentioned by the Accord 
when it was endorsed in 1988. These include commodity-, precious metal-
, and equity-linked derivative transactions.6 The proposed 
revision also would have formally extended the recognition of 
qualifying bilateral netting arrangements to commodity, precious metal, 
and equity derivative contracts so that these types of transactions 
could be netted when determining current exposure for the netting 
contract. In addition, the proposed revision set forth a formula for 
institutions to employ in recognizing reductions in the potential 
future exposure of derivatives contracts that can result from entering 
into qualifying bilateral netting arrangements.

    \5\The proposed revisions are contained in a document entitled 
``The capital adequacy treatment of the credit risk associated with 
certain off-balance-sheet items'' that is available upon request 
from the Board's or OCC's Freedom of Information Offices or the 
FDIC's Office of the Executive Secretary.
    \6\In general terms, these are off-balance-sheet derivative 
contracts that have a return, or a portion of their return, linked 
to the price or an index of prices for a particular commodity, 
precious metal, or equity. These types of transactions were not 
specifically addressed in the 1988 Accord (or in the banking 
agencies' original risk-based capital standards) because they were 
not prevalent in the derivatives markets at that time.
---------------------------------------------------------------------------

II. The Agencies' Proposals

    After the Basle Supervisors Committee issued its proposed revisions 
to the Basle Accord, the banking agencies each issued for public 
comment proposals to amend their respective risk-based capital 
standards based on the international proposal.7 The agencies' 
proposed conversion factor matrix is set forth below:

    \7\The Board issued its proposal on August 24, 1994 (59 FR 
43508), the OCC issued its proposal on September 1, 1994 (59 FR 
45243), and the FDIC issued its proposal on October 19, 1994 (59 FR 
52714).

                                           Conversion Factor Matrix\1\                                          
                                              [Amounts in percent]                                              
----------------------------------------------------------------------------------------------------------------
                                                                Foreign                   Precious              
               Residual maturity                   Interest     exchange    Equity\2\     metals,       Other   
                                                     rate       and gold                except gold  commodities
----------------------------------------------------------------------------------------------------------------
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
Five years or more.............................          1.5          7.5         10.0          8.0         15.0
----------------------------------------------------------------------------------------------------------------
\1\For contracts with multiple exchanges of principal, the factors are to be multiplied by the number of        
  remaining payments in the contract.                                                                           
\2\For contracts that automatically reset to zero 
value following a payment, the remaining maturity 
is set equal to the time remaining until the next payment.                                                                 

    The proposed matrix was designed to accommodate a variety of 
contracts and was intended to provide a reasonable balance between 
precision, on the one hand, and complexity and burden, on the other.
    The agencies also proposed the same methodology as the Basle 
Supervisors Committee to calculate a reduction in the add-on amount for 
contacts subject to qualifying bilateral netting arrangements. Under 
the agencies' proposals, institutions would apply the following 
formula8 to adjust the amount of the add-on for potential future 
exposure:

    \8\This formula may also be expressed as: Anet = (1-
P)Agross + P(NGR  x  Agross) [P or policy factor = 0.5].
---------------------------------------------------------------------------

Anet = 0.5(Agross +(NGR x Agross))
    Where Anet is the adjusted add-on for all contracts subject to 
the netting arrangement, Agross is the amount of the add-on as 
calculated under the current agency standards, and NGR is the ratio of 
the net current exposure of the set of contracts included in the 
netting arrangement to the gross current exposure of those contracts. 
The proposals would have given partial credit to the effect of the NGR 
by applying a weighted averaging factor of 0.5.
    Under the proposals, institutions would calculate a separate NGR 
for each counterparty with which it has a qualifying bilateral netting 
contract. The proposals requested general comments as well as specific 
comment as to whether the NGR should be calculated on a counterparty-
by-counterparty basis or on an aggregate basis for all contracts 
subject to qualifying bilateral netting arrangements.

[[Page 46172]]


III. Comments Received

    The banking agencies together received nineteen public comments on 
their proposed amendments. Fifteen of the commenters were banks and 
bank holding companies and four were industry trade associations and 
other organizations. Commenters generally supported the proposed 
amendments, in particular the recognition of the effects of bilateral 
netting arrangements in the calculation of potential future exposure, 
and several urged adoption of the amendments as soon as possible. 
Commenters offered suggestions and opinions on several aspects of the 
proposals including the conversion factors, the formula for recognizing 
potential future exposure, ways of calculating the NGR, and recognizing 
additional risk-reducing techniques.

Expanded Matrix

    Over one half of the commenters addressed the proposed expanded 
conversion factor matrix. Of these commenters, most indicated the 
proposed factors were generally reasonable and acceptable. Several 
commenters discussed the underlying assumptions used in the simulation 
models for arriving at the proposed factors for commodity transactions 
and expressed concern that the conversion factors for certain commodity 
derivative transactions were too high. One commenter suggested the 
conversion factor for commodity contracts across all time bands should 
be twelve percent. Another commenter expressed the view that the 
proposed conversion factor for interest rate contracts with remaining 
maturities greater than five years (1.5 percent) was an excessive 
increment over the current 0.5 percent conversion factor for interest 
rate contracts with remaining maturities greater than one year. This 
commenter suggested an additional time band for interest rate contracts 
with five to eight years remaining maturity and a corresponding 
conversion factor of 1.0 percent. Another commenter suggested there 
should be no capital charge for potential future exposure for commodity 
contracts based on two floating indices.
    One commenter supported continuing the existing time band of ``one 
year or less'' as opposed to the proposed time band of ``less than one 
year.'' Two commenters expressed the view that the proposed time band 
for contracts with remaining maturities greater than five years was 
unnecessary. One commenter suggested adding a time band and appropriate 
conversion factors for contracts with remaining maturities between one 
and two years.
    Several commenters discussed the matrix footnotes. One suggested 
extending the footnote applicable to equity contracts with automatic 
reset features following a payment to any derivative contract with 
effective early termination or periodic reset features. With regard to 
the footnote pertaining to contracts with multiple exchanges of 
principal, one commenter requested further clarification on the types 
of contracts included, while another expressed the view that 
multiplying the conversion factor by the number of remaining payments 
in a contract was too conservative. A few commenters recommended 
clarification as to the appropriate capital treatment when transactions 
are leveraged or enhanced by a stated multiple.

Netting and Potential Future Exposure

    A number of commenters discussed the proposed formula for 
recognizing the effects of bilateral netting arrangements in the 
calculation of potential future exposure. Most of these commenters 
supported the use of the NGR as a reasonable proxy to estimate the 
risk-reducing benefits of netting arrangements. Several commenters 
supported giving full weight to the NGR or, alternatively, weighting 
the NGR with a higher averaging factor than the proposed 0.5 factor. 
Another commenter offered a revised formula that would weight the 
netting portion of the formula by two and divide the entire formula by 
three. This commenter stated the revised formula would effectively 
reduce the credit equivalent amount and place greater emphasis on the 
portion of the formula affected by a netting arrangement. One commenter 
suggested that net credit risk should be the basis for the add-on 
amount.
    Several commenters addressed the proposal's specific request for 
comment on whether the NGR should be calculated on a counterparty-by-
counterparty basis or on an aggregate basis across all portfolios 
eligible for capital netting treatment. A few commenters supported a 
counterparty-by-counterparty NGR as providing a more accurate 
indication of credit risks. Other commenters preferred an aggregate 
NGR, characterizing an aggregate NGR as less burdensome to calculate. 
Two commenters suggested applying a single NGR to all counterparties 
within each risk weight classification.

Other Comments

    Several commenters encouraged recognizing other risk reducing 
techniques such as margin and collateral agreements, frequent 
settlement of mark-to-market values, and periodic resetting of terms 
and early termination agreements. One commenter suggested there should 
be no capital charge for potential future exposure when current 
exposure is less than a certain level (e.g., negative $1 million). One 
commenter suggested using negative net mark-to-market values to offset 
potential future exposure. A few commenters supported the use of 
internal systems to calculate capital requirements and recommended 
continued monitoring of developments in the banking industry.

IV. Final Rule

    After consideration of the comments received and further 
deliberation on the issues involved, the banking agencies have 
determined to adopt a final rule that is substantially the same as 
proposed. The final rule amends the matrix of conversion factors used 
to calculate potential future exposure and permits institutions to 
recognize the effects of qualifying bilateral netting arrangements in 
the calculation of potential future exposure. The final rule is 
consistent with a revision to the Basle Accord announced by the Basle 
Supervisors Committee in April 1995.9

    \9\The revision to the Basle Accord is in an annex with the 
heading ``Forwards, swaps, purchased options and similar derivative 
contracts'' that was issued along with the Basle Supervisors 
Committee's consultative proposal on Market Risk on April 12, 1995. 
This document is available upon request from the Board's and OCC's 
Freedom of Information Offices and the FDIC's Office of the 
Executive Secretary.
---------------------------------------------------------------------------

Expanded Matrix

    The banking agencies believe that the proposed conversion factors 
generally provide a reasonable measure of potential future exposure for 
long-dated interest rate and exchange rate contracts and for other 
derivative instruments not addressed in the original Accord. In 
addition, the banking agencies believe that the proposed matrix 
adequately accommodates a variety of contracts and appropriately 
provides a reasonable balance between precision, and complexity and 
burden. The agencies, however, have taken into consideration issues 
raised by commenters regarding the simulation methods used to arrive at 
the conversion factors for other commodities. After additional 
simulation analysis, the agencies have concluded that the conversion 
factor for other commodity transactions with maturities of one year or 
less should be lowered from 12 percent to 10 percent. Any off-balance-
sheet derivative contract not explicitly covered by the expanded matrix 
is subject to the add-on conversion factors for other 

[[Page 46173]]
commodities. Furthermore, in response to commenters' concerns, the 
banking agencies have revised the proposed time band of ``less than one 
year'' to ``one year or less'' to maintain consistency with the 
existing time bands for remaining maturity.
    The proposed matrix included a footnote applicable to equity 
contracts that automatically reset market value to zero following a 
payment. Under the proposal, the remaining maturity of such contracts 
would be the time until the next payment. Several commenters asserted 
this treatment should extend to a wider range of contacts. The agencies 
have determined that for contracts structured to settle outstanding 
exposure to zero following specified payment dates and where the terms 
of the contract are reset so that the market value of the contract is 
zero on these dates, the remaining maturity may be set equal to the 
time until the next reset date. However, the agencies believe that a 
long-dated interest rate swap, with, for example, a six-month zero 
reset provision, represents a greater risk than an interest rate swap 
that terminates after six months. The final rule provides that the 
minimum add-on conversion factor for interest rate contacts with 
remaining maturities of greater than one year is 0.5 percent.
    Under the final rule, which is identical to the proposal in this 
regard, gold derivative contracts are accorded the same conversion 
factors as exchange rate contracts. However, while exchange rate 
contracts with original maturities of fourteen calendar days or less 
may be excluded from the risk-based ratio calculation,10 gold 
contracts with such original maturities are to be included.

    \10\Exchange rate contracts with original maturities of 14 
calendar days or less are normally excluded from the risk-based 
capital ratio. When such contracts are included in a bilateral 
netting arrangement, however, the institution may elect consistently 
either to include or exclude all mark-to-market values of those 
contracts when determining net current exposure. These contracts 
should continue to be excluded when determining potential future 
exposure.
---------------------------------------------------------------------------

    Finally, the agencies note that the conversion factors are to be 
regarded as provisional and may be subject to amendment as a result of 
changes in the volatility of rates and prices.

 Netting and Potential Future Exposure

    The final rule adopts, in substantially the same form, the proposed 
methodology for reducing potential future exposure for contracts 
subject to qualifying bilateral netting arrangements. The agencies have 
considered the argument presented by several commenters that the 
proposed formula did not give sufficient recognition to reductions in 
credit risk resulting from participating in qualifying netting 
arrangements. These commenters suggested giving full weight to the NGR 
or, alternatively, that it be weighted at 90 percent. The agencies 
believe that only partial weight should be given to the NGR as it is 
neither a precise, nor a stable indicator of future changes in net 
exposure relative to changes in gross exposure. The agencies agree, to 
a limited extent, with commenters that a 0.5 averaging factor (referred 
to as the policy or P factor) may not sufficiently recognize reductions 
in potential future exposure resulting from qualifying bilateral 
netting arrangements and have determined that the P factor should be 
raised to 0.6. This weight represents an appropriate compromise between 
recognizing effects of bilateral netting arrangements in calculating 
the add-on and providing a cushion against additional exposure that may 
arise as a result of fluctuations in prices or rates. The formula 
adopted by the agencies is expressed as:

Anet=(0.4 x Agross)+0.6(NGR x Agross)

    The agencies have also considered comments discussing whether the 
NGR should be calculated on a counterparty-by-counterparty basis (that 
is, an individual NGR for each bilateral netting contract) or on an 
aggregate basis for all contracts subject to legally enforceable 
netting arrangements. The agencies have determined that an institution 
may elect to calculate separate NGRs for each of its bilateral netting 
arrangements or an aggregate NGR so long as the method chosen is used 
consistently and is subject to examiner review.
    Regardless of the method employed by an institution to calculate 
its NGR(s), the NGR should be applied separately and individually to 
each of the institution's bilateral netting arrangements. If an 
institution calculates an NGR for each bilateral netting arrangement, 
then it should use a different NGR when determining the potential 
future exposure for each bilateral netting arrangement. If an 
institution aggregates its net and gross replacement costs across all 
bilateral netting contracts to determine a single NGR, then it should 
use the same NGR when determining the potential future exposure for 
each bilateral netting arrangement.
    Institutions with equity, precious metal, and other commodity 
contracts included in bilateral netting contracts should now include 
those types of transactions when determining the net current exposure 
for the bilateral netting contract and when determining potential 
future exposure in accordance with this final rule.
    The final rule permits, subject to certain conditions, institutions 
to take into account qualifying collateral when assigning the credit 
equivalent amount of a netting arrangement to the appropriate risk 
category in accordance with the procedures and requirements currently 
set forth in each agency's risk-based capital standards.
    Finally, the agencies note that the methodology for recognizing the 
effects of qualifying bilateral netting arrangements is subject to 
review and revision as determined to be appropriate.

V. Regulatory Flexibility Act Analysis

    Pursuant to section 605(b) of the Regulatory Flexibility Act, the 
agencies do not believe that this final rule will have a significant 
impact on a substantial number of small business entities in accord 
with the spirit and purposes of the Regulatory Flexibility Act (5 
U.S.C. 601 et seq.). In this regard, while some institutions with 
limited derivative portfolios may experience an increase in capital 
charges, for most of these institutions the final rule will have no 
effect. For institutions with more developed derivative portfolios, the 
overall effect of the rule will likely be to reduce regulatory burden 
and decrease the capital charge for certain derivative transactions. In 
addition, because the risk-based capital standards generally do not 
apply to bank holding companies with consolidated assets of less than 
$150 million, this final rule will not affect such companies.

VI. Paperwork Reduction Act and Regulatory Burden

    The agencies have determined that this final rule will not increase 
the regulatory paperwork burden of banking organizations 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. As noted above, the rule may result 
in higher capital charges for some institutions and lower charges for 
others, but any additional paperwork or recordkeeping burden should be 
minimal. The rule provides a more accurate measure of risks related to 
derivative contracts and the capital required to cover those risks. 

[[Page 46174]]

    Section 302 also requires such a rule to become effective on the 
first day of the calendar quarter following publication of the rule, 
unless the agency, for good cause, determines an earlier effective date 
is appropriate. Accordingly, the agencies have determined that an 
effective date of October 1, 1995 is appropriate.

VII. OCC Executive Order 12866

    It has been determined that this final rule is not a significant 
regulatory action as defined in Executive Order 12866.

VIII. OCC Unfunded Mandates Act of 1995

    Section 202 of the Unfunded Mandates Act of 1995 (Unfunded Mandates 
Act) (signed into law on March 22, 1995) requires that certain agencies 
prepare a budgetary impact statement before promulgating a rule that 
includes a federal mandate that may result in the expenditure by state, 
local, and tribal governments, in the aggregate, or by the private 
sector, of $100 million or more in any one year. If a budgetary impact 
statement is required, section 205 of the Unfunded Mandates Act also 
requires the agency to identify and consider a reasonable number of 
regulatory alternatives before promulgating a rule. The OCC has 
determined that this joint agency final rule will not result in 
expenditures by state, local and tribal governments, or by the private 
sector, of more than $100 million in any one year. Accordingly, the OCC 
has not prepared a budgetary impact statement or specifically addressed 
the regulatory alternatives considered.
    As discussed in the preamble, this joint agency final rule amends 
the risk-based capital guidelines to (1) revise and expand the credit 
conversion factors used to calculate the potential future credit 
exposure for derivative contracts and long-dated interest rate and 
foreign exchange rate contracts and (2) permit banks to net multiple 
derivative contracts subject to a qualifying bilateral netting contract 
when calculating the potential future credit exposure. While the impact 
of this final rule on any particular national bank will depend on the 
composition of its derivatives portfolio, the OCC believes that this 
final rule generally will have little or no impact on most banks since 
most banks have limited derivative portfolios. For those banks with 
more developed derivatives portfolios, the OCC believes that the effect 
of this final rule will likely be a decrease in the capital 
requirements for certain derivative contracts.

List of Subjects

12 CFR Part 3

    Administrative practice and procedure, Capital, National banks, 
Reporting and recordkeeping requirements, Risk.

12 CFR Part 208

    Accounting, Agriculture, Banks, banking, Confidential business 
information, Crime, Currency, Federal Reserve System, Flood insurance, 
Mortgages, Reporting and recordkeeping requirements, Securities.

12 CFR Part 225

    Administrative practice and procedure, Banks, banking, Federal 
Reserve System, Holding companies, Reporting and recordkeeping 
requirements, Securities.

12 CFR Part 325

    Bank deposit insurance, Banks, banking, Capital adequacy, Reporting 
and recordkeeping requirements, Savings associations, State nonmember 
banks.
Authority and Issuance

OFFICE OF THE COMPTROLLER OF THE CURRENCY

12 CFR CHAPTER I

    For the reasons set out in the joint preamble, appendix A to part 3 
of title 12, chapter 1 of the Code of Federal Regulations is amended as 
set forth below.

PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES

    1. The authority citation for part 3 continues to read as follows:

    Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n 
note, 1835, 3907, and 3909.

    2. In appendix A, to part 3, section 1 is revised by redesignating 
paragraphs (c)(10) through (c)(30) as paragraphs (c)(11) through 
(c)(31) and adding new paragraph (c)(10) to read as follows:

Appendix A to Part 3--Risk-Based Capital Guidelines

Section 1. Purpose, Applicability of Guidelines, and Definitions.

* * * * *
    (c) *  * *
    (10) Derivative contract means generally a financial contract 
whose value is derived from the values of one or more underlying 
assets, reference rates or indexes of asset values. Derivative 
contracts include interest rate, foreign exchange rate, equity, 
precious metals and commodity contracts, or any other instrument 
that poses similar credit risks.
* * * * *
    3. In appendix A, to part 3, section 3 is amended:
    a. By revising paragraph (a)(1)(viii);
    b. In paragraph (a)(3)(ii) by removing the words ``interest rate 
and exchange rate contracts,'' and adding in their place the words 
``derivative contracts,''; and
    c. In paragraph (b) by revising the introductory text and 
paragraph (b)(5).
    The revisions read as follows:
* * * * *

Section 3. Risk Categories/Weights for On-Balance Sheet Assets and 
Off-Balance Sheet Items.

* * * * *
    (a) * * *
    (1) * * *
    (viii) That portion of assets and off-balance sheet 
transactions9a collateralized by cash or securities issued or 
directly and unconditionally guaranteed by the United States 
Government or its agencies, or the central government of an OECD 
country, provided that:9b

    \9a\See footnote 22 in section 3(b)(5)(iii) of this appendix A 
(collateral held against derivative contracts).
    \9b\Assets and off-balance sheet transactions collateralized by 
securities issued or guaranteed by the United States Government or 
its agencies, or the central government of an OECD country include, 
but are not limited to, securities lending transactions, repurchase 
agreements, collateralized letters of credit, such as reinsurance 
letters of credit, and other similar financial guarantees. Swaps, 
forwards, futures, and options transactions are also eligible, if 
they meet the collateral requirements. However, the OCC may at its 
discretion require that certain collateralized transactions be risk 
weighted at 20 percent if they involve more than a minimal risk.
---------------------------------------------------------------------------

* * * * *
    (b) Off-Balance Sheet Activities. The risk weight assigned to an 
off-balance sheet item is determined by a two-step process. First, 
the face amount of the off-balance sheet item is multiplied by the 
appropriate credit conversion factor specified in this section. This 
calculation translates the face amount of an off-balance sheet item 
into an on-balance sheet credit equivalent amount. 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; however, with respect to derivative contracts under section 
3(b)(5) of this appendix A, collateral and guarantees are applied to 
the credit equivalent amounts of such derivative contracts. The 
following are the credit conversion factors and the off-balance 
sheet items to which they apply.
* * * * *
    (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. 

[[Page 46175]]

    (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 equals that mark-to-market value. 
If the mark-to-market is zero or negative, then the current credit 
exposure is zero. The current 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) of this appendix A.
    (B) Potential future credit exposure. The potential future 
credit exposure for a single derivative contract, including a 
derivative contract with negative mark-to-market value, is 
calculated by multiplying the notional principal19 of the 
derivative contract by one of the credit conversion factors in Table 
A--Conversion Factor Matrix of this appendix A, for the appropriate 
category.20 The potential future credit exposure for gold 
contracts shall be calculated using the foreign exchange rate 
conversion factors. For any derivative contract that does not fall 
within one of the specified categories in Table A--Conversion Factor 
Matrix of this appendix A, the potential future credit exposure 
shall be calculated using the other commodity conversion factors. 
Subject to examiner review, banks should use the effective rather 
than the apparent or stated notional amount in calculating the 
potential future credit exposure. The potential future credit 
exposure for multiple derivatives 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) of this appendix 
A.

    \19\For purposes of calculating 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.
    \20\No potential future credit exposure is calculated for single 
currency interest rate swaps in which payments are made based upon 
two floating 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\                                      
----------------------------------------------------------------------------------------------------------------
                                                                Foreign                                         
                                                   Interest     exchange                  Precious      Other   
             Remaining maturity\2\                   rate       rate and    Equity\2\      metals     commodity 
                                                                  gold                                          
----------------------------------------------------------------------------------------------------------------
 One year or less..............................          0.0          1.0          6.0          7.0         10.0
Over 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 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  
  equals the time until the next payment. However, interest rate contracts with remaining maturities of greater 
  than one year shall be subject to a minimum conversion factor of 0.5 percent.                                 

    (ii) Derivative contracts subject to a qualifying 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 
derivative contracts subject to the qualifying bilateral netting 
contract.
    (1) 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 a qualifying 
bilateral netting contract. If the net sum of the mark-to-market 
value is positive, then the net current credit exposure equals 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 potential future credit exposure. The 
adjusted sum of the potential future credit exposure is calculated as:

Anet=0.4 x Agross+(0.6 x NGR x Agross)

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. 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 qualifying bilateral netting contract. The 
NGR is the ratio of the net current credit exposure to the gross 
current credit exposure. In calculating the NGR, the gross current 
credit exposure equals the sum of the positive current credit 
exposures (as determined under section 3(b)(5)(i)(A) of this 
appendix A) of all individual derivative contracts subject to the 
qualifying 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 qualifying bilateral netting contract by offsetting 
positive and negative mark-to-market values, provided that:
    (1) The qualifying bilateral netting contract is in writing.
    (2) The qualifying bilateral netting contract is not subject to 
a walkaway clause.
    (3) The qualifying bilateral netting contract creates a single 
legal obligation for all individual derivative contracts covered by 
the qualifying bilateral netting contract. In effect, the qualifying 
bilateral netting contract must provide 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 qualifying 
bilateral netting contract. The single legal obligation for the net 
amount is operative in the event that a counterparty, or a 
counterparty to whom the qualifying bilateral netting contract has 
been assigned, fails to perform due to any of the following events: 
default, insolvency, bankruptcy, or other similar circumstances.
    (4) The bank obtains a written and reasoned legal opinion(s) 
that represents, with a high degree of certainty, that in the event 
of a legal challenge, including one resulting from default, 
insolvency, bankruptcy, or similar circumstances, the relevant court 
and administrative authorities would find the bank's exposure to be 
the net amount under:
    (i) The law of the jurisdiction in which the counterparty is 
chartered or the equivalent location in the case of noncorporate 
entities, and if a branch of the counterparty is involved, then also 
under the law of the jurisdiction in which the branch is located;
    (ii) The law 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 qualifying 
bilateral netting contract.
    (5) The bank establishes and maintains procedures to monitor 
possible changes in relevant law and to ensure that the qualifying 
bilateral netting contract continues to satisfy the requirement of 
this section.
    (6) The bank maintains in its files documentation adequate to 
support the netting of a derivative contract.\21\

    \21\By 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 set of derivative 
contract is in the bank's files and available for inspection by the 
OCC. Upon determination by the OCC that a bank's files are 
inadequate or that a qualifying 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. 

[[Page 46176]]

---------------------------------------------------------------------------

    (iii) Risk weighting. Once the bank determines the credit 
equivalent amount for a derivative contract or a set of derivative 
contracts subject to a qualifying bilateral netting contract, the 
bank assigns that amount to the risk weight category appropriate to 
the counterparty, or, if relevant, the nature of any collateral or 
guarantee.\22\ However, the maximum weight that will be applied to 
the credit equivalent amount of such derivative contract(s) is 50 
percent.

    \22\Derivative contracts are an exception to the general rule of 
applying collateral and guarantees to the face value of off-balance 
sheet items. The sufficiency of collateral and guarantees is 
determined on the basis of the credit equivalent amount of 
derivative contracts. However, collateral and guarantees held 
against a qualifying bilateral netting contract is not recognized 
for capital purposes unless it is legally available for all 
contracts included in the qualifying bilateral netting contract.
---------------------------------------------------------------------------

    (iv) Exceptions. The following derivative contracts are not 
subject to the above calculation, and therefore, are not part of the 
denominator of a national bank's risk-based capital ratio:
    (A) An exchange rate contract with an original maturity of 14 
calendar days or less;\23\ and

    \23\Notwithstanding section 3(b)(5)(B) of this appendix A, gold 
contracts do not qualify for this exception.
---------------------------------------------------------------------------

    (B) A derivative contract that is traded on an exchange 
requiring the daily payment of any variations in the market value of 
the contract.
* * * * *

    4. Table 3, at the end of appendix A, is revised to read as 
follows:
* * * * *
Table 3--Treatment of Derivative Contracts

    1. 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.

                                           Conversion Factor Matrix\1\                                          
                                                    [Percent]                                                   
----------------------------------------------------------------------------------------------------------------
                                                                Foreign                                         
                                                   Interest     exchange                  Precious      Other   
             Remaining maturity\2\                   rate       rate and    Equity\2\      metals     commodity 
                                                                  gold                                          
----------------------------------------------------------------------------------------------------------------
One year or less...............................          0.0          1.0          6.0          7.0         10.0
Over 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 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  
  equals the time until the next payment. However, interest rate contracts with remaining maturities of greater 
  than one year shall be subject to a minimum conversion factor of 0.5 percent.                                 

    2. The following derivative contracts will be excluded:
    a. Exchange rate contract with an original maturity of 14 
calendar days or less; and
    b. Derivative contract traded on exchanges and subject to daily 
margin requirements.

    Dated: August 24, 1995.
Eugene A. Ludwig,
Comptroller of the Currency.
FEDERAL RESERVE SYSTEM

12 CFR CHAPTER II

    For the reasons set out in the joint preamble, the Board of 
Governors of the Federal Reserve System amends 12 CFR parts 208 and 225 
as set forth below.

PART 208--MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL 
RESERVE SYSTEM (REGULATION H)

    1. The authority citation for part 208 continues to read as 
follows:

    Authority: 12 U.S.C. 36, 248(a), 248(c), 321-338a, 371d, 461, 
481-486, 601, 611, 1814, 1823(j), 1828(o), 1831o, 1831p-1, 3105, 
3310, 3331-3351, and 3906-3909; 15 U.S.C. 78b, 78l(b), 78l(g), 
78l(i), 78o-4(c)(5), 78q, 78q-1 and 78w; 31 U.S.C. 5318; 42 U.S.C. 
4012a, 4104a, 4104b.

    2. In part 208, appendix A is amended by revising the last 
paragraph of section III.C.3. and footnote 40 in the introductory text 
of section III.D. to read as follows:

Appendix A to Part 208--Capital Adequacy Guidelines for State Member 
Banks: Risk-Based Measure

* * * * *

III. * * *

    C. * * *
    3. * * *
    Credit equivalent amounts of derivative contracts involving 
standard risk obligors (that is, obligors whose loans or debt 
securities would be assigned to the 100 percent risk category) are 
included in the 50 percent category, unless they are backed by 
collateral or guarantees that allow them to be placed in a lower 
risk category.
* * * * *
    D. * * * 40 * * *

    \40\The sufficiency of collateral and guarantees for off-
balance-sheet items is determined by the market value of the 
collateral or the amount of the guarantee in relation to the face 
amount of the item, except for derivative contracts, for which this 
determination is generally made in relation to the credit equivalent 
amount. Collateral and guarantees are subject to the same provisions 
noted under section III.B. of this appendix A.
---------------------------------------------------------------------------

* * * * *
    3. In part 208, appendix A is amended by revising the section 
III.E. heading and section III.E. to read as follows:
* * * * *

III. * * *

    E. Derivative Contracts (Interest Rate, Exchange Rate, 
Commodity-- (including precious metals) and Equity-Linked Contracts)
    1. Scope. Credit equivalent amounts are computed for each of the 
following off-balance-sheet derivative contracts:
    a. Interest Rate Contracts. These include single currency 
interest rate swaps, basis swaps, forward rate agreements, interest 
rate options purchased (including caps, collars, and floors 
purchased), and any other instrument linked to interest rates that 
gives rise to similar credit risks (including when-issued securities 
and forward deposits accepted).
    b. Exchange Rate Contracts. These include cross-currency 
interest rate swaps, forward foreign exchange contracts, currency 
options purchased, and any other instrument linked to exchange rates 
that gives rise to similar credit risks.
    c. Equity Derivative Contracts. These include equity-linked 
swaps, equity-linked options purchased, forward equity-linked 
contracts, and any other instrument linked to equities that gives 
rise to similar credit risks.
    d. Commodity (including precious metal) Derivative Contracts. 
These include commodity-linked swaps, commodity-linked options 
purchased, forward commodity-linked contracts, and any other 
instrument 

[[Page 46177]]
linked to commodities that gives rise to similar credit risks.
    e. Exceptions. Exchange rate contracts with an original maturity 
of fourteen or fewer calendar days and derivative contracts traded 
on exchanges that require daily receipt and payment of cash 
variation margin may be excluded from the risk-based ratio 
calculation. Gold contracts are accorded the same treatment as 
exchange rate contracts except that gold contracts with an original 
maturity of fourteen or fewer calendar days are included in the 
risk-based ratio calculation. Over-the-counter options purchased are 
included and treated in the same way as other derivative contracts.
    2. Calculation of credit equivalent amounts. a. The credit 
equivalent amount of a derivative contract that is not subject to a 
qualifying bilateral netting contract in accordance with section 
III.E.3. of this appendix A is equal to the sum of (i) the current 
exposure (sometimes referred to as the replacement cost) of the 
contract; and (ii) an estimate of the potential future credit 
exposure of the contract.
    b. The current exposure is determined by the mark-to-market 
value of the contract. If the mark-to-market value is positive, then 
the current 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. Mark-to-market values are measured in dollars, regardless 
of the currency or currencies specified in the contract, and should 
reflect changes in underlying rates, prices, and indices, as well as 
counterparty credit quality.
    c. The potential future credit exposure of a contract, including 
a contract with a negative mark-to-market value, is estimated by 
multiplying the notional principal amount of the contract by a 
credit conversion factor. Banks should use, subject to examiner 
review, the effective rather than the apparent or stated notional 
amount in this calculation. The credit conversion factors are:

                                               Conversion Factors                                               
                                                  [In percent]                                                  
----------------------------------------------------------------------------------------------------------------
                                                                                         Commodity,             
                                                   Interest     Exchange                 excluding     Precious 
               Remaining maturity                    rate       rate and      Equity      precious     metals,  
                                                                  gold                     metals    except gold
----------------------------------------------------------------------------------------------------------------
One year or less...............................          0.0          1.0          6.0         10.0          7.0
Over one to five years.........................          0.5          5.0          8.0         12.0          7.0
Over five years................................          1.5          7.5         10.0         15.0          8.0
----------------------------------------------------------------------------------------------------------------

    d. For a contract that is structured such that on specified 
dates any outstanding exposure is settled and the terms are reset so 
that the market value of the contract is zero, the remaining 
maturity is equal to the time until the next reset date. For an 
interest rate contract with a remaining maturity of more than one 
year that meets these criteria, the minimum conversion factor is 0.5 
percent.
    e. For a contract with multiple exchanges of principal, the 
conversion factor is multiplied by the number of remaining payments 
in the contract. A derivative contract not included in the 
definitions of interest rate, exchange rate, equity, or commodity 
contracts as set forth in section III.E.1. of this appendix A, is 
subject to the same conversion factors as a commodity, excluding 
precious metals.
    f. No potential future exposure is calculated for a single 
currency interest rate swap in which payments are made based upon 
two floating rate indices (a so called floating/floating or basis 
swap); the credit exposure on such a contract is evaluated solely on 
the basis of the mark-to-market value.
    g. The Board notes that the conversion factors set forth above, 
which are based on observed volatilities of the particular types of 
instruments, are subject to review and modification in light of 
changing volatilities or market conditions.
    3. Netting. a. 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 (that is, netting with a single counterparty) of 
derivative contracts is recognized for purposes of calculating the 
credit equivalent amount provided that:
    i. 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 to receive, or obligation to pay, 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, insolvency, 
liquidation, or similar circumstances.
    ii. 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, liquidation, or similar 
circumstances--the relevant court and administrative authorities 
would find the bank's exposure to be the net amount under:
    1. 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;
    2. The law that governs the individual contracts covered by the 
netting contract; and
    3. The law that governs the netting contract.
    iii. 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.
    iv. The bank maintains in its files documentation adequate to 
support the netting of derivative contracts, including a copy of the 
bilateral netting contract and necessary legal opinions.
    b. A contract containing a walkaway clause is not eligible for 
netting for purposes of calculating the credit equivalent 
amount.49

    \49\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.
---------------------------------------------------------------------------

    c. A bank netting individual contracts for the purpose of 
calculating credit equivalent amounts of derivative contracts, 
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 Federal Reserve. The Federal Reserve may 
determine that a bank's files are inadequate or that a netting 
contract, or any of its underlying individual contracts, may not be 
legally enforceable under any one of the bodies of law described in 
section III.E.3.a.ii. of this appendix A. If such a determination is 
made, the netting contract may be disqualified from recognition for 
risk-based capital purposes or underlying individual contracts may 
be treated as though they are not subject to the netting contract.
    d. The credit equivalent amount of contracts that are subject to 
a qualifying bilateral netting contract is calculated by adding (i) 
the current exposure of the netting contract (net current exposure) 
and (ii) the sum of the estimates of potential future credit 
exposures on all individual contracts subject to the netting 
contract (gross potential future exposure) adjusted to reflect the 
effects of the netting contract.50

    \50\For purposes of calculating potential future credit exposure 
to a netting counterparty 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 
falling due on each value date in each currency.
    e. The net current exposure is the sum of 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 net current exposure is equal to that sum. If 
the net sum of the mark-to-market values is zero or negative, then 
the net current 

[[Page 46178]]
exposure is zero. The Federal Reserve may determine that a netting 
contract qualifies for risk-based capital netting treatment even 
though certain individual contracts included under the netting 
contract may not qualify. In such instances, the nonqualifying 
contracts should be treated as individual contracts that are not 
subject to the netting contract.
    f. Gross potential future exposure, or Agross is calculated 
by summing the estimates of potential future exposure (determined in 
accordance with section III.E.2 of this appendix A) for each 
individual contract subject to the qualifying bilateral netting 
contract.
    g. The effects of the bilateral netting contract on the gross 
potential future exposure are recognized through the application of 
a formula that results in an adjusted add-on amount (Anet). The 
formula, which employs the ratio of net current exposure to gross 
current exposure (NGR) is expressed as:

    Anet = (0.4 x Agross) + 0.6(NGR x Agross)

    h. The NGR may be calculated in accordance with either the 
counterparty-by-counterparty approach or the aggregate approach.
    i. Under the counterparty-by-counterparty approach, the NGR is 
the ratio of the net current exposure for a netting contract to the 
gross current exposure of the netting contract. The gross current 
exposure is the sum of the current exposures of all individual 
contracts subject to the netting contract calculated in accordance 
with section III.E.2. of this appendix A. Net negative mark-to-
market values for individual netting contracts with the same 
counterparty may not be used to offset net positive mark-to-market 
values for other netting contracts with that counterparty.
    ii. Under the aggregate approach, the NGR is the ratio of the 
sum of all of the net current exposures for qualifying bilateral 
netting contracts to the sum of all of the gross current exposures 
for those netting contracts (each gross current exposure is 
calculated in the same manner as in section III.E.3.h.i. of this 
appendix A). Net negative mark-to-market values for individual 
counterparties may not be used to offset net positive mark-to-market 
values for other counterparties.
    iii. A bank must consistently use either the counterparty-by-
counterparty approach or the aggregate approach to calculate the 
NGR. Regardless of the approach used, the NGR should be applied 
individually to each qualifying bilateral netting contract to 
determine the adjusted add-on for that netting contract.
    i. In the event a netting contract covers contracts that are 
normally excluded from the risk-based ratio calculation--for 
example, exchange rate contracts with an original maturity of 
fourteen or fewer calendar days or instruments traded on exchanges 
that require daily payment and receipt of cash variation margin--a 
bank may elect to either include or exclude all mark-to-market 
values of such contracts when determining net current exposure, 
provided the method chosen is applied consistently.
    4. Risk Weights. Once the credit equivalent amount for a 
derivative contract, or a group of derivative contracts subject to a 
qualifying bilateral netting contract, has been determined, that 
amount is assigned to the risk category appropriate to the 
counterparty, or, if relevant, the guarantor or the nature of any 
collateral.51 However, the maximum risk weight applicable to 
the credit equivalent amount of such contracts is 50 percent.

    \51\For derivative contracts, sufficiency of collateral or 
guarantees is generally determined by the market value of the 
collateral or the amount of the guarantee in relation to the credit 
equivalent amount. Collateral and guarantees are subject to the same 
provisions noted under section III.B. of this appendix A.
---------------------------------------------------------------------------

    5. Avoidance of double counting. a. In certain cases, credit 
exposures arising from the derivative contracts covered by section 
III.E. of this appendix A may already be reflected, in part, on the 
balance sheet. To avoid double counting such exposures in the 
assessment of capital adequacy and, perhaps, assigning inappropriate 
risk weights, counterparty credit exposures arising from the 
derivative instruments covered by these guidelines may need to be 
excluded from balance sheet assets in calculating a bank's risk-
based capital ratios.
    b. Examples of the calculation of credit equivalent amounts for 
contracts covered under this section III.E. are contained in 
Attachment V of this appendix A.
* * * * *
    4. In appendix A to part 208, Attachments IV and V are revised to 
read as follows:
* * * * *

Attachment IV--Credit Conversion Factors for Off-Balance-Sheet Items 
for State Member Banks

100 Percent Conversion Factor

    1. Direct credit substitutes. (These include general guarantees 
of indebtedness and all guarantee-type instruments, including 
standby letters of credit backing the financial obligations of other 
parties.)
    2. Risk participations in bankers acceptances and direct credit 
substitutes, such as standby letters of credit.
    3. Sale and repurchase agreements and assets sold with recourse 
that are not included on the balance sheet.
    4. Forward agreements to purchase assets, including financing 
facilities, on which drawdown is certain.
    5. Securities lent for which the bank is at risk.

50 Percent Conversion Factor

    1. Transaction-related contingencies. (These include bid-bonds, 
performance bonds, warranties, and standby letters of credit backing 
the nonfinancial performance of other parties.)
    2. Unused portions of commitments with an original maturity 
exceeding one year, including underwriting commitments and 
commercial credit lines.
    3. Revolving underwriting facilities (RUFs), note issuance 
facilities (NIFs), and similar arrangements.

20 Percent Conversion Factor

    Short-term, self-liquidating trade-related contingencies, 
including commercial letters of credit.

Zero Percent Conversion Factor

    Unused portions of commitments with an original maturity of one 
year or less, or which are unconditionally cancellable at any time, 
provided a separate credit decision is made before each drawing.

Credit Conversion for Derivative Contracts

    1. The credit equivalent amount of a derivative contract is the 
sum of the current credit exposure of the contract and an estimate 
of potential future increases in credit exposure. The current 
exposure is the positive mark-to-market value of the contract (or 
zero if the mark-to-market value is zero or negative). For 
derivative contracts that are subject to a qualifying bilateral 
netting contract, the current exposure is, generally, the net sum of 
the positive and negative mark-to-market values of the contracts 
included in the netting contract (or zero if the net sum of the 
mark-to-market values is zero or negative). The potential future 
exposure is calculated by multiplying the effective notional amount 
of a contract by one of the following credit conversion factors, as 
appropriate:

                                               Conversion Factors                                               
                                                  [In percent]                                                  
----------------------------------------------------------------------------------------------------------------
                                                                                         Commodity,             
                                                   Interest     Exchange                 excluding     Precious 
               Remaining maturity                    rate       rate and      Equity      precious     metals,  
                                                                  gold                     metals    except gold
----------------------------------------------------------------------------------------------------------------
One year or less...............................          0.0          1.0          6.0         10.0          7.0
Over one to five years.........................          0.5          5.0          8.0         12.0          7.0
Over five years................................          1.5          7.5         10.0         15.0          8.0
----------------------------------------------------------------------------------------------------------------


[[Page 46179]]


    For contracts subject to a qualifying bilateral netting 
contract, the potential future exposure is, generally, the sum of 
the individual potential future exposures for each contract included 
under the netting contract adjusted by the application of the 
following formula:

Anet=(0.4 x Agross)+0.6(NGR x Agross)

    NGR is the ratio of net current exposure to gross current 
exposure.
    2. No potential future exposure is calculated for single 
currency interest rate swaps in which payments are made based upon 
two floating indices, that is, so called floating/floating or basis 
swaps. The credit exposure on these contracts is evaluated solely on 
the basis of their mark-to-market value. Exchange rate contracts 
with an original maturity of fourteen days or fewer are excluded. 
Instruments traded on exchanges that require daily receipt and 
payment of cash variation margin are also excluded.

                  Attachment V--Calculating Credit Equivalent Amounts for Derivative Contracts                  
----------------------------------------------------------------------------------------------------------------
                                      Notional                 Potential                  Current       Credit  
         Type of contract            principal    Conversion    exposure     Mark-to-     exposure    equivalent
                                       amount       factor     (dollars)      market     (dollars)      amount  
----------------------------------------------------------------------------------------------------------------
(1) 120-day forward foreign                                                                                     
 exchange.........................    5,000,000         0.01       50,000      100,000      100,000      150,000
(2) 4-year forward foreign                                                                                      
 exchange.........................    6,000,000         0.05      300,000     -120,000            0      300,000
(3) 3-year single-currency fixed &                                                                              
 floating interest rate swap......   10,000,000        0.005       50,000      200,000      200,000      250,000
(4) 6-month oil swap..............   10,000,000         0.10    1,000,000     -250,000            0    1,000,000
(5) 7-year cross-currency floating                                                                              
 & floating interest rate swap....   20,000,000        0.075    1,500,000   -1,500,000            0    1,500,000
      Total.......................  ...........  ...........    2,900,000            +      300,000    3,200,000
----------------------------------------------------------------------------------------------------------------

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

------------------------------------------------------------------------
                                    Potential                   Credit  
             Contract                 future    Net current   equivalent
                                     exposure     exposure      amount  
------------------------------------------------------------------------
(1)..............................       50,000  ...........  ...........
(2)..............................      300,000  ...........  ...........
(3)..............................       50,000  ...........  ...........
(4)..............................    1,000,000  ...........  ...........
(5)..............................    1,500,000  ...........  ...........
      Total......................    2,900,000           +0    2,900,000
------------------------------------------------------------------------
Note: The total of the mark-to-market values from the first table is -  
  $1,370,000. Since this is a negative amount, the net current exposure 
  is zero.                                                              

    b. To recognize the effects of bilateral netting on potential 
future exposure the following formula applies:

Anet=(.4 x Agross)+.6(NGR x Agross)

    c. In the above example where the net current exposure is zero, 
the credit equivalent amount would be calculated as follows:

NGR=0=(0/300,000)
Anet=(0.4 x $2,900,000)+0.6 (0 x $2,900,000)
Anet=$1,160,000

    The credit equivalent amount is $1,160,000+0=$1,160,000.
    d. If the net current exposure was a positive number, for 
example $200,000, the credit equivalent amount would be calculated 
as follows:

NGR=.67=($200,000/$300,000)
Anet=(0.4 x $2,900,000)+0.6(.67 x $2,900,000)
Anet=$2,325,800.
    The credit equivalent amount would be 
$2,325,800+$200,000=$2,525,800.
* * * * *
PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL 
(REGULATION Y)

    1. The authority citation for part 225 continues to read as 
follows:

    Authority: 12 U.S.C. 1817(j)(13), 1818, 1828(o), 1831i, 1831p-1, 
1843(c)(8), 1844(b), 1972(1), 3106, 3108, 3310, 3331-3351, 3907, and 
3909.

    2. In part 225, appendix A is amended by revising the last 
paragraph of section III.C.3. and footnote 43 in the introductory text 
of section III.D. to read as follows:

Appendix A to Part 225--Capital Adequacy Guidelines for Bank 
Holding Companies: Risk-Based Measure

* * * * *
    III. * * *
    C. * * *
    3. * * *
    Credit equivalent amounts of derivative contracts involving 
standard risk obligors (that is, obligors whose loans or debt 
securities would be assigned to the 100 percent risk category) are 
included in the 50 percent category, unless they are backed by 
collateral or guarantees that allow them to be placed in a lower 
risk category.
* * * * *
    D. * * *43 * * *

    \43\The sufficiency of collateral and guarantees for off-
balance-sheet items is determined by the market value of the 
collateral or the amount of the guarantee in relation to the face 
amount of the item, except for derivative contracts, for which this 
determination is generally made in relation to the credit equivalent 
amount. Collateral and guarantees are subject to the same provisions 
noted under section III.B. of this appendix A.
---------------------------------------------------------------------------

* * * * *
    3. In part 225, appendix A is amended by revising the section 
III.E. heading and section III.E. to read as follows:
* * * * *
    III. * * *
    E. Derivative Contracts (Interest Rate, Exchange Rate, 
Commodity- (including 

[[Page 46180]]
precious metals) and Equity-Linked Contracts)
    1. Scope. Credit equivalent amounts are computed for each of the 
following off-balance-sheet derivative contracts:
    a. Interest Rate Contracts. These include single currency 
interest rate swaps, basis swaps, forward rate agreements, interest 
rate options purchased (including caps, collars, and floors 
purchased), and any other instrument linked to interest rates that 
gives rise to similar credit risks (including when-issued securities 
and forward deposits accepted).
    b. Exchange Rate Contracts. These include cross-currency 
interest rate swaps, forward foreign exchange contracts, currency 
options purchased, and any other instrument linked to exchange rates 
that gives rise to similar credit risks.
    c. Equity Derivative Contracts. These include equity-linked 
swaps, equity-linked options purchased, forward equity-linked 
contracts, and any other instrument linked to equities that gives 
rise to similar credit risks.
    d. Commodity (including precious metal) Derivative Contracts. 
These include commodity-linked swaps, commodity-linked options 
purchased, forward commodity-linked contracts, and any other 
instrument linked to commodities that gives rise to similar credit 
risks.
    e. Exceptions. Exchange rate contracts with an original maturity 
of fourteen or fewer calendar days and derivative contracts traded 
on exchanges that require daily receipt and payment of cash 
variation margin may be excluded from the risk-based ratio 
calculation. Gold contracts are accorded the same treatment as 
exchange rate contracts except that gold contracts with an original 
maturity of fourteen or fewer calendar days are included in the 
risk-based ratio calculation. Over-the-counter options purchased are 
included and treated in the same way as other derivative contracts.
    2. Calculation of credit equivalent amounts. a. The credit 
equivalent amount of a derivative contract that is not subject to a 
qualifying bilateral netting contract in accordance with section 
III.E.3. of this appendix A is equal to the sum of (i) the current 
exposure (sometimes referred to as the replacement cost) of the 
contract; and (ii) an estimate of the potential future credit 
exposure of the contract.
    b. The current exposure is determined by the mark-to-market 
value of the contract. If the mark-to-market value is positive, then 
the current 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. Mark-to-market values are measured in dollars, regardless 
of the currency or currencies specified in the contract and should 
reflect changes in underlying rates, prices, and indices, as well as 
counterparty credit quality.
    c. The potential future credit exposure of a contract, including 
a contract with a negative mark-to-market value, is estimated by 
multiplying the notional principal amount of the contract by a 
credit conversion factor. Banking organizations should use, subject 
to examiner review, the effective rather than the apparent or stated 
notional amount in this calculation. The credit conversion factors 
are:

                                               Conversion Factors                                               
                                                  [In percent]                                                  
----------------------------------------------------------------------------------------------------------------
                                                                                         Commodity,             
                                                   Interest     Exchange                 excluding     Precious 
               Remaining maturity                    rate       rate and      Equity      precious     metals,  
                                                                  gold                     metals    except gold
----------------------------------------------------------------------------------------------------------------
One year or less...............................          0.0          1.0          6.0         10.0          7.0
Over one to five years.........................          0.5          5.0          8.0         12.0          7.0
Over five years................................          1.5          7.5         10.0         15.0          8.0
----------------------------------------------------------------------------------------------------------------

    d. For a contract that is structured such that on specified 
dates any outstanding exposure is settled and the terms are reset so 
that the market value of the contract is zero, the remaining 
maturity is equal to the time until the next reset date. For an 
interest rate contract with a remaining maturity of more than one 
year that meets these criteria, the minimum conversion factor is 0.5 
percent.
    e. For a contract with multiple exchanges of principal, the 
conversion factor is multiplied by the number of remaining payments 
in the contract. A derivative contract not included in the 
definitions of interest rate, exchange rate, equity, or commodity 
contracts as set forth in section III.E.1. of this appendix A is 
subject to the same conversion factors as a commodity, excluding 
precious metals.
    f. No potential future exposure is calculated for a single 
currency interest rate swap in which payments are made based upon 
two floating rate indices (a so called floating/floating or basis 
swap); the credit exposure on such a contract is evaluated solely on 
the basis of the mark-to-market value.
    g. The Board notes that the conversion factors set forth above, 
which are based on observed volatilities of the particular types of 
instruments, are subject to review and modification in light of 
changing volatilities or market conditions.
    3. Netting. a. 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 (that is, netting with a single counterparty) of 
derivative contracts is recognized for purposes of calculating the 
credit equivalent amount provided that:
    i. 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 banking organization 
would have a claim to receive, or obligation to pay, 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, 
insolvency, liquidation, or similar circumstances.
    ii. The banking organization obtains a written and reasoned 
legal opinion(s) representing that in the event of a legal 
challenge--including one resulting from default, insolvency, 
liquidation, or similar circumstances--the relevant court and 
administrative authorities would find the banking organization's 
exposure to be the net amount under:
    1. 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;
    2. The law that governs the individual contracts covered by the 
netting contract; and
    3. The law that governs the netting contract.
    iii. The banking organization 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.
    iv. The banking organization maintains in its files 
documentation adequate to support the netting of derivative 
contracts, including a copy of the bilateral netting contract and 
necessary legal opinions.
    b. A contract containing a walkaway clause is not eligible for 
netting for purposes of calculating the credit equivalent 
amount.53

    \53\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.
---------------------------------------------------------------------------

    c. A banking organization netting individual contracts for the 
purpose of calculating credit equivalent amounts of derivative 
contracts represents that it has met the requirements of this 
appendix A and all the appropriate documents are in the banking 
organization's files and available for inspection by the Federal 
Reserve. The Federal Reserve may determine that a 

[[Page 46181]]
banking organization's files are inadequate or that a netting contract, 
or any of its underlying individual contracts, may not be legally 
enforceable under any one of the bodies of law described in section 
III.E.3.a.ii. of this appendix A. If such a determination is made, 
the netting contract may be disqualified from recognition for risk-
based capital purposes or underlying individual contracts may be 
treated as though they are not subject to the netting contract.
    d. The credit equivalent amount of contracts that are subject to 
a qualifying bilateral netting contract is calculated by adding (i) 
the current exposure of the netting contract (net current exposure) 
and (ii) the sum of the estimates of potential future credit 
exposures on all individual contracts subject to the netting 
contract (gross potential future exposure) adjusted to reflect the 
effects of the netting contract.54

    \54\For purposes of calculating potential future credit exposure 
to a netting counterparty 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 
falling due on each value date in each currency.
---------------------------------------------------------------------------

    e. The net current exposure is the sum of 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 net current exposure is equal to that sum. If 
the net sum of the mark-to-market values is zero or negative, then 
the net current exposure is zero. The Federal Reserve may determine 
that a netting contract qualifies for risk-based capital netting 
treatment even though certain individual contracts included under 
the netting contract may not qualify. In such instances, the 
nonqualifying contracts should be treated as individual contracts 
that are not subject to the netting contract.
    f. Gross potential future exposure, or Agross is calculated 
by summing the estimates of potential future exposure (determined in 
accordance with section III.E.2 of this appendix A) for each 
individual contract subject to the qualifying bilateral netting 
contract.
    g. The effects of the bilateral netting contract on the gross 
potential future exposure are recognized through the application of 
a formula that results in an adjusted add-on amount (Anet). The 
formula, which employs the ratio of net current exposure to gross 
current exposure (NGR), is expressed as:

Anet=(0.4 x Agross)+0.6(NGR x Agross)

    h. The NGR may be calculated in accordance with either the 
counterparty-by-counterparty approach or the aggregate approach.
    i. Under the counterparty-by-counterparty approach, the NGR is 
the ratio of the net current exposure for a netting contract to the 
gross current exposure of the netting contract. The gross current 
exposure is the sum of the current exposures of all individual 
contracts subject to the netting contract calculated in accordance 
with section III.E.2. of this appendix A. Net negative mark-to-
market values for individual netting contracts with the same 
counterparty may not be used to offset net positive mark-to-market 
values for other netting contracts with the same counterparty.
    ii. Under the aggregate approach, the NGR is the ratio of the 
sum of all of the net current exposures for qualifying bilateral 
netting contracts to the sum of all of the gross current exposures 
for those netting contracts (each gross current exposure is 
calculated in the same manner as in section III.E.3.h.i. of this 
appendix A). Net negative mark-to-market values for individual 
counterparties may not be used to offset net positive current 
exposures for other counterparties.
    iii. A banking organization must use consistently either the 
counterparty-by-counterparty approach or the aggregate approach to 
calculate the NGR. Regardless of the approach used, the NGR should 
be applied individually to each qualifying bilateral netting 
contract to determine the adjusted add-on for that netting contract.
    i. In the event a netting contract covers contracts that are 
normally excluded from the risk-based ratio calculation--for 
example, exchange rate contracts with an original maturity of 
fourteen or fewer calendar days or instruments traded on exchanges 
that require daily payment and receipt of cash variation margin--an 
institution may elect to either include or exclude all mark-to-
market values of such contracts when determining net current 
exposure, provided the method chosen is applied consistently.
    4. Risk Weights. Once the credit equivalent amount for a 
derivative contract, or a group of derivative contracts subject to a 
qualifying bilateral netting contract, has been determined, that 
amount is assigned to the risk category appropriate to the 
counterparty, or, if relevant, the guarantor or the nature of any 
collateral.55 However, the maximum risk weight applicable to 
the credit equivalent amount of such contracts is 50 percent.

    \55\For derivative contracts, sufficiency of collateral or 
guarantees is generally determined by the market value of the 
collateral or the amount of the guarantee in relation to the credit 
equivalent amount. Collateral and guarantees are subject to the same 
provisions noted under section III.B. of this appendix A.
---------------------------------------------------------------------------

    5. Avoidance of double counting. a. In certain cases, credit 
exposures arising from the derivative contracts covered by section 
III.E. of this appendix A may already be reflected, in part, on the 
balance sheet. To avoid double counting such exposures in the 
assessment of capital adequacy and, perhaps, assigning inappropriate 
risk weights, counterparty credit exposures arising from the 
derivative instruments covered by these guidelines may need to be 
excluded from balance sheet assets in calculating a banking 
organization's risk-based capital ratios.
    b. Examples of the calculation of credit equivalent amounts for 
contracts covered under this section III.E. are contained in 
Attachment V of this appendix A.
* * * * *
    4. In appendix A to part 225, Attachments IV and V are revised to 
read as follows:
* * * * *

Attachment IV--Credit Conversion Factors for Off-Balance-Sheet Items 
for Bank Holding Companies

100 Percent Conversion Factor

    1. Direct credit substitutes. (These include general guarantees 
of indebtedness and all guarantee-type instruments, including 
standby letters of credit backing the financial obligations of other 
parties.)
    2. Risk participations in bankers acceptances and direct credit 
substitutes, such as standby letters of credit.
    3. Sale and repurchase agreements and assets sold with recourse 
that are not included on the balance sheet.
    4. Forward agreements to purchase assets, including financing 
facilities, on which drawdown is certain.
    5. Securities lent for which the banking organization is at 
risk.

50 Percent Conversion Factor

    1. Transaction-related contingencies. (These include bid-bonds, 
performance bonds, warranties, and standby letters of credit backing 
the nonfinancial performance of other parties.)
    2. Unused portions of commitments with an original maturity 
exceeding one year, including underwriting commitments and 
commercial credit lines.
    3. Revolving underwriting facilities (RUFs), note issuance 
facilities (NIFs), and similar arrangements.

20 Percent Conversion Factor

    Short-term, self-liquidating trade-related contingencies, 
including commercial letters of credit.

Zero Percent Conversion Factor

    Unused portions of commitments with an original maturity of one 
year or less, or which are unconditionally cancellable at any time, 
provided a separate credit decision is made before each drawing.

Credit Conversion for Derivative Contracts

    1. The credit equivalent amount of a derivative contract is the 
sum of the current credit exposure of the contract and an estimate 
of potential future increases in credit exposure. The current 
exposure is the positive mark-to-market value of the contract (or 
zero if the mark-to-market value is zero or negative). For 
derivative contracts that are subject to a qualifying bilateral 
netting contract, the current exposure is, generally, the net sum of 
the positive and negative mark-to-market values of the contracts 
included in the netting contract (or zero if the net sum of the 
mark-to-market values is zero or negative). The potential future 
exposure is calculated by multiplying the effective notional amount 
of a contract by one of the following credit conversion factors, as 
appropriate:

                                                                                                                

[[Page 46182]]
                                               Conversion Factors                                               
                                                  [In percent]                                                  
----------------------------------------------------------------------------------------------------------------
                                                                                         Commodity,             
                                                   Interest     Exchange                 excluding     Precious 
               Remaining maturity                    rate       rate and      Equity      precious     metals,  
                                                                  gold                     metals    except gold
----------------------------------------------------------------------------------------------------------------
One year or less...............................          0.0          1.0          6.0         10.0          7.0
Over one to five years.........................          0.5          5.0          8.0         12.0          7.0
Over five years................................          1.5          7.5         10.0         15.0          8.0
----------------------------------------------------------------------------------------------------------------



    For contracts subject to a qualifying bilateral netting 
contract, the potential future exposure is, generally, the sum of 
the individual potential future exposures for each contract included 
under the netting contract adjusted by the application of the 
following formula:

Anet=(0.4 x Agross)+0.6(NGR x Agross)
    NGR is the ratio of net current exposure to gross current 
exposure.
    2. No potential future exposure is calculated for single 
currency interest rate swaps in which payments are made based upon 
two floating indices, that is, so called floating/floating or basis 
swaps. The credit exposure on these contracts is evaluated solely on 
the basis of their mark-to-market value. Exchange rate contracts 
with an original maturity of fourteen or fewer days are excluded. 
Instruments traded on exchanges that require daily receipt and 
payment of cash variation margin are also excluded.

                  Attachment V--Calculating Credit Equivalent Amounts for Derivative Contracts                  
----------------------------------------------------------------------------------------------------------------
                                      Notional                 Potential                  Current       Credit  
         Type of Contract            principal    Conversion    exposure     Mark-to-     exposure    equivalent
                                       amount       factor     (dollars)      market     (dollars)      amount  
----------------------------------------------------------------------------------------------------------------
(1) 120-day forward foreign                                                                                     
 exchange.........................    5,000,000          .01       50,000      100,000      100,000      150,000
(2) 4-year forward foreign                                                                                      
 exchange.........................    6,000,000          .05      300,000     -120,000            0      300,000
(3) 3-year single-currency fixed &                                                                              
 floating interest rate swap......   10,000,000         .005       50,000      200,000      200,000      250,000
(4) 6-month oil swap..............   10,000,000          .10    1,000,000     -250,000            0    1,000,000
(5) 7-year cross-currency floating                                                                              
 & floating interest rate swap....   20,000,000         .075    1,500,000   -1,500,000            0    1,500,000
      Total.......................  ...........  ...........    2,900,000            +      300,000    3,200,000
----------------------------------------------------------------------------------------------------------------

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

------------------------------------------------------------------------
                                    Potential                   Credit  
             Contract                 future    Net current   equivalent
                                     exposure     exposure      amount  
------------------------------------------------------------------------
(1)..............................       50,000  ...........  ...........
(2)..............................      300,000  ...........  ...........
(3)..............................       50,000  ...........  ...........
(4)..............................    1,000,000  ...........  ...........
(5)..............................    1,500,000  ...........  ...........
      Total......................    2,900,000           +0    2,900,000
------------------------------------------------------------------------
Note: The total of the mark-to-market values from the first table is-   
  $1,370,000. Since this is a negative amount the net current exposure  
  is zero.                                                              

    b. To recognize the effects of bilateral netting on potential 
future exposure the following formula applies:

Anet=(0.4 x Agross)+0.6(NGR x Agross)

    c. In the above example, where the net current exposure is zero, 
the credit equivalent amount would be calculated as follows:

NGR=0=(0/300,000)
Anet=(0.4 x $2,900,000)+.6(0 x $2,900,000)
Anet=$1,160,000

    The credit equivalent amount is $1,160,000+0=$1,160,000.
    d. If the net current exposure was a positive number, for 
example $200,000, the credit equivalent would be calculated as 
follows:

NGR=.67=($200,000/$300,000)
Anet=(0.4 x $2,900,000)+0.6(.67 x $2,900,000)
Anet=$2,325,800

    The credit equivalent amount would be 
$2,325,800+$200,000=$2,525,800.
* * * * *
    By order of the Board of Governors of the Federal Reserve 
System, August 25, 1995.
Jennifer J. Johnson,
Deputy Secretary of the Board.
FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR CHAPTER III

    For the reasons set forth in the joint 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, 1835, 3907, 3909, 4808; Pub. L. 102-233, 105 Stat. 
1761, 1789, 1790 (12 U.S.C. 1831n note) Pub. L. 102-242, 105 Stat. 
2236, 2355, 2386 (12 U.S.C. 1828 note).

    2. In appendix A to part 325, section II is amended by:
    a. Revising the last sentence in section II.C. Category 3;
    b. Redesignating footnotes 35 through 38 as footnotes 36 through 
39;
    c. Adding new footnote 35 at the end of the introductory text of 
section II.D.; and
    d. Revising section II.E. to read as follows:

[[Page 46183]]


Appendix A to Part 325--Statement of Policy on Risk-Based Capital

* * * * *
    II. * * *
    C. * * *
    Category 3 * * * In addition, the credit equivalent amount of 
derivative contracts that do not qualify for a lower risk weight are 
assigned to the 50 percent risk category.
* * * * *
    D. * * *35 * * *

    \35\The sufficiency of collateral and guarantees for off-
balance-sheet items is determined by the market value of the 
collateral or the amount of the guarantee in relation to the face 
amount of the item, except for derivative contracts, for which this 
determination is generally made in relation to the credit equivalent 
amount. Collateral and guarantees are subject to the same provisions 
noted under section II.B. of this appendix A.
---------------------------------------------------------------------------

* * * * *
    E. Derivative Contracts (Interest Rate, Exchange Rate, Commodity 
(including precious metal) and Equity Derivative Contracts)
    1. Credit equivalent amounts are computed for each of the 
following off-balance-sheet derivative contracts:
    (a) Interest Rate Contracts
    (i) Single currency interest rate swaps.
    (ii) Basis swaps.
    (iii) Forward rate agreements.
    (iv) Interest rate options purchased (including caps, collars, 
and floors purchased).
    (v) Any other instrument linked to interest rates that gives 
rise to similar credit risks (including when-issued securities and 
forward deposits accepted).
    (b) Exchange Rate Contracts
    (i) Cross-currency interest rate swaps.
    (ii) Forward foreign exchange contracts.
    (iii) Currency options purchased.
    (iv) Any other instrument linked to exchange rates that gives 
rise to similar credit risks.
    (c) Commodity (including precious metal) or Equity Derivative 
Contracts
    (i) Commodity- or equity-linked swaps.
    (ii) Commodity- or equity-linked options purchased.
    (iii) Forward commodity- or equity-linked contracts.
    (iv) Any other instrument linked to commodities or equities that 
gives rise to similar credit risks.
    2. Exchange rate contracts with an original maturity of 14 
calendar days or less and derivative contracts traded on exchanges 
that require daily receipt and payment of cash variation margin may 
be excluded from the risk-based ratio calculation. Gold contracts 
are accorded the same treatment as exchange rate contracts except 
gold contracts with an original maturity of 14 calendar days or less 
are included in the risk-based calculation. Over-the-counter options 
purchased are included and treated in the same way as other 
derivative contracts.
    3. Credit Equivalent Amounts for Derivative Contracts. (a) The 
credit equivalent amount of a derivative contract that is not 
subject to a qualifying bilateral netting contract in accordance 
with section II.E.5. of this appendix A is equal to the sum of:
    (i) The current exposure (which is equal to the mark-to-market 
value,40 if positive, and is sometimes referred to as the 
replacement cost) of the contract; and

    \40\Mark-to-market values are measured in dollars, regardless of 
the currency or currencies specified in the contract and should 
reflect changes in both underlying rates, prices and indices, and 
counterparty credit quality.
---------------------------------------------------------------------------

    (ii) An estimate of the potential future credit exposure.
    (b) The current exposure is determined by the mark-to-market 
value of the contract. If the mark-to-market value is positive, then 
the current 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.
    (c) The potential future credit exposure of a contract, 
including a contract with a negative mark-to-market value, is 
estimated by multiplying the notional principal amount of the 
contract by a credit conversion factor. Banks should, subject to 
examiner review, use the effective rather than the apparent or 
stated notional amount in this calculation. The credit conversion 
factors are:

                                            Conversion Factor Matrix                                            
----------------------------------------------------------------------------------------------------------------
                                                                Exchange                  Precious              
               Remaining maturity                  Interest     rate and      Equity      metals,       Other   
                                                     rate         gold                  except gold  commodities
----------------------------------------------------------------------------------------------------------------
One year or less...............................         0.0%         1.0%         6.0%         7.0%        10.0%
More than one year to five years...............         0.5%         5.0%         8.0%         7.0%        12.0%
More than five years...........................         1.5%         7.5%        10.0%         8.0%        15.0%
----------------------------------------------------------------------------------------------------------------

    (d) For contracts that are structured to settle outstanding 
exposure on specified dates and where the terms are reset such that 
the market value of the contract is zero on these specified dates, 
the remaining maturity is equal to the time until the next reset 
date. For interest rate contracts with remaining maturities of more 
than one year and that meet these criteria, the conversion factor is 
subject to a minimum value of 0.5 percent.
    (e) For contracts with multiple exchanges of principal, the 
conversion factors are to be multiplied by the number of remaining 
payments in the contract. Derivative contracts not explicitly 
covered by any of the columns of the conversion factor matrix are to 
be treated as ``other commodities.''
    (f) No potential future 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 exposure on these contracts is evaluated solely 
on the basis of their mark-to-market values.
    4. Risk Weights and Avoidance of Double Counting. (a) Once the 
credit equivalent amount for a derivative contract, or a group of 
derivative contracts subject to a qualifying bilateral netting 
agreement, has been determined, that amount is assigned to the risk 
category appropriate to the counterparty, or, if relevant, the 
guarantor or the nature of any collateral. However, the maximum 
weight that will be applied to the credit equivalent amount of such 
contracts is 50 percent.
    (b) In certain cases, credit exposures arising from the 
derivative contracts covered by these guidelines may already be 
reflected, in part, on the balance sheet. To avoid double counting 
such exposures in the assessment of capital adequacy and, perhaps, 
assigning inappropriate risk weights, counterparty credit exposures 
arising from the types of instruments covered by these guidelines 
may need to be excluded from balance sheet assets in calculating a 
bank's risk-based capital ratio.
    (c) The FDIC notes that the conversion factors set forth in 
section II.E.3. of appendix A, which are based on observed 
volatilities of the particular types of instruments, are subject to 
review and modification in light of changing volatilities or market 
conditions.
    (d) Examples of the calculation of credit equivalent amounts for 
these types of contracts are contained in Table IV of this appendix 
A.
    5. Netting. (a) 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 (that is, netting with a single counterparty) of 
derivative contracts is recognized for purposes of calculating the 
credit equivalent amount provided that:
    (i) 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 

[[Page 46184]]
perform due to default, bankruptcy, liquidation, or similar 
circumstances;
    (ii) 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:
    (1) 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;
    (2) The law that governs the individual contracts covered by the 
netting contract; and
    (3) The law that governs the netting contract.
    (iii) 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; and
    (iv) The bank maintains in its file documentation adequate to 
support the netting of derivative contracts, including a copy of the 
bilateral netting contract and necessary legal opinions.
    (b) A contract containing a walkaway clause is not eligible for 
netting for purposes of calculating the credit equivalent 
amount.41

    \41\For 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.
---------------------------------------------------------------------------

    (c) 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 (ii)(1) 
through (3) of section II.E.5.(a) of this appendix A, underlying 
individual contracts may be treated as though they were not subject 
to the netting contract.
    (d) The credit equivalent amount of derivative contracts that 
are subject to a qualifying bilateral netting contract is calculated 
by adding:
    (i) The net current exposure of the netting contract; and
    (ii) The sum of the estimates of potential future exposure for 
all individual contracts subject to the netting contract, adjusted 
to take into account the effects of the netting contract.42

    \42\For purposes of calculating potential future credit exposure 
for foreign exchange contracts and other similar contracts in which 
notional principal is equivalent to cash flows, total notional 
principal is defined as the net receipts to each party falling due 
on each value date in each currency.
---------------------------------------------------------------------------

    (e) The net current exposure is the sum of all positive and 
negative mark-to-market values of the individual contracts subject 
to the netting contract. If the net sum of the mark-to-market values 
is positive, then the net current exposure is equal to that sum. If 
the net sum of the mark-to-market values is zero or negative, then 
the net current exposure is zero.
    (f) The effects of the bilateral netting contract on the gross 
potential future exposure are recognized through application of a 
formula, resulting in an adjusted add-on amount (Anet). The 
formula, which employs the ratio of net current exposure to gross 
current exposure (NGR) is expressed as:

Anet=(0.4 x Agross)+0.6(NGR x Agross)

    The effect of this formula is that Anet is the weighted 
average of Agross, and Agross adjusted by the NGR.
    (g) The NGR may be calculated in either one of two ways--
referred to as the counterparty-by-counterparty approach and the 
aggregate approach.
    (i) Under the counterparty-by-counterparty approach, the NGR is 
the ratio of the net current exposure of the netting contract to the 
gross current exposure of the netting contract. The gross current 
exposure is the sum of the current exposures of all individual 
contracts subject to the netting contract calculated in accordance 
with section II.E. of this appendix A.
    (ii) Under the aggregate approach, the NGR is the ratio of the 
sum of all of the net current exposures for qualifying bilateral 
netting contracts to the sum of all of the gross current exposures 
for those netting contracts (each gross current exposure is 
calculated in the same manner as in section II.E.5.(g)(i) of this 
appendix A). Net negative mark-to-market values to individual 
counterparties cannot be used to offset net positive current 
exposures to other counterparties.
    (iii) A bank must use consistently either the counterparty-by-
counterparty approach or the aggregate approach to calculate the 
NGR. Regardless of the approach used, the NGR should be applied 
individually to each qualifying bilateral netting contract to 
determine the adjusted add-on for that netting contract.

    3. In appendix A to part 325, Table III is amended by:
    a. In the last sentence, removing ``II.E.3.'' and adding in its 
place ``II.E.5.''; and
    b. Revising the chart and its heading to read as follows:
Table III. * * *
* * * * *

Credit Conversion for Derivative Contracts

* * * * *

                                            Conversion Factor Matrix                                            
----------------------------------------------------------------------------------------------------------------
                                                                Exchange                  Precious              
               Remaining maturity                  Interest     rate and      Equity      metals,       Other   
                                                     rate         gold                  except gold  commodities
----------------------------------------------------------------------------------------------------------------
One year or less...............................         0.0%         1.0%         6.0%         7.0%        10.0%
More than one year to five years...............         0.5%         5.0%         8.0%         7.0%        12.0%
More than five years...........................         1.5%         7.5%        10.0%         8.0%        15.0%
----------------------------------------------------------------------------------------------------------------

* * * * *
    4. Appendix A to part 325, Table IV, is revised to read as follows:

                  Table IV.--Calculation of Credit Equivalent Amounts for Derivative Contracts                  
----------------------------------------------------------------------------------------------------------------
        Potential exposure               +         Current         =       Credit equivalent amount             
------------------------------------------------   exposure  ---------------------------------------    Credit  
                                      Notional  -------------  Potential     Mark-to      Current     equivalent
    Type of contract (remaining      principal    Conversion    exposure      market      exposure      amount  
             maturity)               (dollars)      factor     (dollars)      value      (dollars)              
----------------------------------------------------------------------------------------------------------------
(1) 120-Day Forward Foreign                                                                                     
 Exchange.........................    5,000,000          .01       50,000      100,000      100,000      150,000
(2) 4-Year Forward Foreign                                                                                      
 Exchange.........................    6,000,000          .05      300,000     -120,000            0      300,000
(3) 3-Year Single-Currency Fixed/                                                                               
 Floating Interest Rate Swap......   10,000,000         .005       50,000      200,000      200,000     250,000 

[[Page 46185]]
                                                                                                                
(4) 6-Month Oil Swap..............   10,000,000          .10    1,000,000     -250,000            0    1,000,000
(5) 7-Year Cross-Currency Floating/                                                                             
 Floating Interest Rate Swap......   20,000,000         .075    1,500,000   -1,500,000            0    1,500,000
      Total.......................  ...........  ...........    2,900,000  ...........      300,000    3,200,000
----------------------------------------------------------------------------------------------------------------


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

----------------------------------------------------------------------------------------------------------------
                                             Potential                                                          
                                               future                                                   Credit  
                                              exposure                  Net current                   equivalent
                                               (from                     exposure*                      amount  
                                               above)                                                           
----------------------------------------------------------------------------------------------------------------
(1).......................................       50,000                                                         
(2).......................................      300,000                                                         
(3).......................................       50,000                                                         
(4).......................................    1,000,000                                                         
(5).......................................    1,500,000                                                         
      Total...............................    2,900,000  +                        0  =                2,900,000 
----------------------------------------------------------------------------------------------------------------
*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.                                                                                     

    (2) To recognize the effects of netting on potential future 
exposure, the following formula applies:

Anet=(0.4 x Agross)+0.6(NGR x Agross)

    (3) In the above example:

NGR=0=(0/300,000)
Anet=(0.4 x 2,900,000)+0.6(0 x 2,900,000)
Anet=1,160,000

Credit Equivalent Amount: 1,160,000+0=1,160,000

    (4) If the net current exposure was a positive amount, for 
example, $200,000, the credit equivalent amount would be calculated 
as follows:

NGR=.67=(200,000/300,000)
Anet=(0.4 x 2,900,000)+0.6(.67 x 2,900,000)
Anet=2,325,800

Credit Equivalent Amount: 2,325,800+200,000=2,525,800

    By order of the Board of Directors.

    Dated at Washington, D.C. this 25th day of August, 1995.

Federal Deposit Insurance Corporation.
Jerry L. Langley,
Executive Secretary.
[FR Doc. 95-21608 Filed 9-1-95; 8:45 am]
BILLING CODE 4810-33-P, 6210-01-P, 6714-01-P
Last Updated 07/17/1999 communications@fdic.gov