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Financial Institution Letters 




Division of Supervision
Classification Number
6300 (I)(S)

Date
August 15 , 1996

MEMORANDUM SYSTEM
Issuing Office
DOS/OCM

Contact
William A.  Stark, x86972
Curtis Wong, x87327

Notice

Memorandum
X

TO:       Regional Directors

FROM:     Nicholas J. Ketcha Jr.
          Director

SUBJECT:  Supervisory Guidance for Credit Derivatives

1.  Purpose.  To provide preliminary examination guidance for the supervisory analysis and treatment of
credit derivatives at insured financial institutions.  Credit derivatives are relatively new instruments in the
marketplace, thus the examination guidance and capital treatment that follows is general in nature and
will be refined in the future.  This memorandum provides an overview of credit derivatives and presents
a framework for analyzing the risks incurred by insured institutions that use these off-balance sheet
instruments.

Credit derivatives are financial instruments used to assume or lay off credit risk, sometimes only to a
limited extent.  Depository institutions are increasingly employing these off-balance sheet instruments
either as end-users that purchase credit protection from or provide credit protection to counterparties,
or as dealers intermediating such protection.  This guidance stresses the need for examiners to ensure that
depository institutions  using credit derivatives for such purposes as risk management, yield enhancement,
reduction of credit concentrations, or diversification of overall risk have established sound risk
management policies and procedures.

The analytical techniques used to manage credit derivatives may provide new insights into credit risk and
its management.  Currently, U.S. banking supervisors, as well as banking supervisors abroad, are
analyzing credit derivatives in order to develop appropriate supervisory policies.  The discussions with
the other U.S. and international banking regulators may result in revised or additional guidance on the
appropriate supervisory treatment of credit derivatives. 

2.  Background.  Credit derivatives are off-balance sheet arrangements that allow one party (the
"beneficiary") to transfer the credit risk of a "reference asset" to another party (the "guarantor").   The
beneficiary often actually owns the reference asset but the guarantor does not need to purchase the
reference asset directly to assume the associated credit risk.  Credit derivative transactions, however, 
unlike traditional guarantee arrangements, often are documented using master agreements developed by
the International Swaps and Derivatives Association (ISDA) in a manner similar to swaps or options.

Under some credit derivative arrangements, the beneficiary may pay the total return on a reference asset,
including any appreciation in the asset's price, to a guarantor in exchange for a spread over funding costs
plus any depreciation in the value of the reference asset (a "total rate-of-return swap").  Alternatively,
a beneficiary may pay a fee to the guarantor in exchange for a guarantee against any loss that may occur
if the reference asset defaults (a "credit default swap").  These two structures are the most prevalent types
of credit derivatives and are described in greater detail in the Appendix.

The credit derivative market has been evolving rapidly, and credit derivative structures are likely to take
on new forms.  For example, very recently a market has developed for put options on specific corporate
bonds or loans.  While the payoffs of these puts are expressed in terms of a strike price, rather than a
default event, if the strike price is sufficiently high, credit risk effectively could be transferred to the writer
of the put from the buyer of the put.  

3. Supervisory Policy.  In reviewing credit derivatives, examiners should consider the credit risk
associated with the reference asset as the primary risk, as they do for loan participations or guarantees. 
A depository institution providing credit protection through a credit derivative can become as exposed
to the credit risk of the reference asset as it would if the asset were on its own balance sheet.  Thus, for
supervisory purposes, the exposure generally should be treated as if it were a letter of credit or other 
off-balance sheet guarantee.  This treatment would apply, for example, in determining an institution's overall
credit exposure to a borrower for purposes of evaluating concentrations of credit.  The institution's
overall exposure should include exposure it assumes by acting as a guarantor in a credit derivative
transaction where the borrower is the obligor of the reference asset.  

In addition, depository institutions providing credit protection through a credit derivative should hold
capital against their exposure to the reference asset.  This broad principle holds for all credit derivatives,
but must be modified somewhat for credit derivative contracts that incorporate periodic payments for
depreciation or appreciation such as most total rate of return swaps.  For these credit derivatives, the
guarantor can deduct the amount of depreciation paid to the beneficiary (net of any amounts paid by the
beneficiary for appreciation) from the notional amount of the contract in determining the amount of
reference exposure subject to a capital charge.

In some cases, such as total rate of return swaps, both the guarantor and the beneficiary are exposed to
the credit risk of the counterparty, which for derivative contracts generally is measured as the replacement 
cost of the credit derivative transaction plus an add-on for the potential future exposure of the derivative
to market price changes, i.e., the credit risk measurement generally employed for derivative contracts. 
For banks acting as dealers that have matching offsetting positions, the counterparty risk could be the
primary risk to which the dealer banks are exposed from credit derivative transactions.  

In reviewing a credit derivative entered into by a beneficiary depository institution, the examiner should
review the organization's credit exposure to the guarantor, as well as to the reference asset -- if the asset
is actually owned by the beneficiary.  The degree to which a credit derivative, unlike most other credit
guarantee arrangements, transfers the credit risk of an underlying asset from the beneficiary to the
guarantor may be uncertain or limited.  The degree of risk transference depends upon the terms of the
transaction.  For example, some credit derivatives are structured so that a payout only occurs when a pre-defined 
event of default or a downgrade below a pre-specified credit rating occurs.  Others may require
a payment only when a defined default event occurs and a pre-determined materiality (or loss) threshold
is exceeded.  Default payments themselves may be based upon an average of dealer prices for the
reference asset during some period of time after default using a pre-specified sampling procedure or may
be specified in advance as a set percentage of the notional amount of the reference asset.  Finally, the term
of many credit derivative transactions is shorter than the maturity of the underlying asset and, thus,
provides only temporary credit protection to the beneficiary.

Examiners must ascertain whether the amount of credit protection a beneficiary receives by entering into
a credit derivative is sufficient to warrant treatment of the derivative as a guarantee for regulatory capital
and other supervisory purposes.  Only those arrangements that provide virtually complete credit
protection to the underlying asset will be considered effective guarantees for purposes of asset
classification and risk-based capital calculations.  On the other hand, if the amount of credit risk
transferred by the beneficiary is severely limited or uncertain, then the limited credit protection the
derivative provides the beneficiary should not be taken into account for these purposes.  

In this regard, examiners should carefully review credit derivative transactions in which the reference
asset is not identical to the asset actually owned by the beneficiary depository institution.  In order to
determine that the derivative contract provides effective credit protection, the examiner must be satisfied
that the reference asset is an appropriate proxy for the loan or other asset whose credit exposure the
depository institution intends to offset.  In making this determination, examiners should consider, among
other factors, whether the reference asset and owned asset have the same obligor and seniority in
bankruptcy and whether both contain mutual cross-default provisions.

The supervisory and regulatory treatment that is currently outlined will continue to be reviewed to ensure
the appropriate treatment for credit derivatives transactions.  Such a review will take into consideration
the potential offsetting of credit exposures within the portfolio and how the proposed market risk capital
rules would be applied to credit derivative transactions once they become effective.

An institution should not enter into credit derivative transactions unless its management has the ability
to understand and manage the credit and other risks associated with these instruments in a safe and sound
manner.  Accordingly, examiners should determine the appropriateness of these instruments on an
institution-by-institution basis.  Such a determination should take into account management's expertise
in evaluating such instruments; the adequacy of relevant policies, including position limits; and the quality
of the institution's relevant information systems and internal controls.

4.  Action Required.  This document should be distributed to all examiners.  Examiners should contact
their regional capital markets specialists when encountering off-balance sheet credit derivatives or on-balance 
sheet credit linked notes.

If you have any questions on the supervisory or capital issues related to credit derivatives, please contact
William A. Stark,  Assistant Director (202/898-6972), or Miguel D. Browne, Deputy Assistant Director
(202/898-6789).  Questions concerning the accounting treatment for these products may  be addressed
to Stephen G. Pfeifer, Examination Specialist (202/898-8904).


Attachments


Transmittal No.  96-066.                             Appendix


               Supervisory and Accounting Guidance 
                  Relating to Credit Derivatives


I.  Description of Credit Derivatives

The most widely used types of credit derivatives to date are credit default swaps and total rate-of-return
(TROR) swaps.  While the timing and structure of the cash flows associated with credit default and
TROR swaps differ, the economic substance of both arrangements is that they seek to transfer the credit
risk on the asset(s) referenced in the transaction.

The use of credit derivatives may allow a depository institution to mitigate its concentration to a
particular borrower or industry without severing the customer relationship.  In addition, organizations
that are approaching established in-house limits on counterparty credit exposure could continue to
originate loans to a particular industry and use credit derivatives to transfer the credit risk to a third party. 
Furthermore, institutions may use credit derivatives to diversify their portfolios by assuming credit
exposures to different borrowers or industries without actually purchasing the underlying assets. 
Nonbank institutions may serve as counterparties to credit derivative transactions with banks in order to
gain access to the commercial bank loan market.  These institutions either do not lend or do not have the
ability to administer a loan portfolio.

                       Credit Default Swaps
The purpose of a credit default swap, as its name suggests, is to provide protection against credit losses
associated with a default on a specified reference asset.  The swap purchaser, i.e., the beneficiary, "swaps"
the credit risk with the provider of the swap, i.e., the guarantor.  While the transaction is called a "swap,"
it is very similar to a guarantee or financial standby letter of credit.

In a credit default swap, illustrated in Figure 1, the beneficiary (Bank A) agrees to pay to the guarantor
(Bank B) a fee typically amounting to a certain number of basis points on the par value of the reference
asset either quarterly or annually.  In return, the guarantor agrees to pay the beneficiary an agreed upon,
market-based, post-default amount or a predetermined fixed percentage of the value of the reference asset
if there is a default.  The guarantor makes no payment until there is a default.  A default is strictly defined
in the contract to include, for example, bankruptcy, insolvency, or payment default, and the event of
default itself must be publicly verifiable.  In some instances, the guarantor is not obliged to make any
payments to the beneficiary until a pre-established amount of loss has been exceeded in conjunction with
a default event; this is often referred to as a materiality threshold.






























The swap is terminated if the reference asset defaults prior to the maturity of the swap.  The amount
owed by the guarantor is the difference between the reference asset's initial principal (or notional) amount
and the actual market value of the defaulted, reference asset.  The methodology for establishing the 
post-default market value of the reference asset should be set out in the contract.  Often, the market value of
the defaulted reference asset may be determined by sampling dealer quotes.  The guarantor may have the
option to purchase the defaulted, underlying asset and pursue a workout with the borrower directly, an
action it may take if it believes that the "true" value of the reference asset is higher than that determined
by the swap pricing mechanism.  Alternatively, the swap may call for a fixed payment in the event of
default, for example, 15 percent of the notional value of the reference asset.


                    Total Rate-of-Return Swap
In a total rate-of-return (TROR) swap, illustrated in Figure 2, the beneficiary (Bank A) agrees to pay the
guarantor (Bank B) the "total return" on the reference asset, which consists of all contractual payments,
as well as any appreciation in the market value of the reference asset.  To complete the swap
arrangement, the guarantor agrees to pay LIBOR plus a spread and any depreciation to the beneficiary. 
The guarantor in a TROR swap could be viewed as having synthetic ownership of the reference asset
since it bears the risks and rewards of ownership over the term of the swap. 

























At each payment exchange date (including when the swap matures) -- or upon default, at which point the
swap may terminate -- any depreciation or appreciation in the amortized value of the reference asset is
calculated as the difference between the notional principal balance of the reference asset and  the "dealer
price."  The dealer price is generally determined either by referring to a market quotation source or by
polling a  group of dealers and reflects changes in the credit profile of the reference obligor and reference
asset.

If the dealer price is less than the notional amount (i.e., the hypothetical original price of the reference
asset) of the contract, then the guarantor must pay the difference to the beneficiary, absorbing any loss
caused by a decline in the credit quality of the reference asset.   Thus, a TROR swap differs from a
standard direct credit substitute in that the guarantor is guaranteeing not only against default of the
reference obligor, but also against a deterioration in that obligor's credit quality, which can occur even
if there is no default. 




II.  Supervisory Issues Relating to Credit Derivatives
    Risk-Based Capital Treatment

For purposes of risk-based capital, credit derivatives generally are to be treated as off-balance sheet direct
credit substitutes.  The notional amount of the contract should be converted at 100 percent to determine
the credit equivalent amount to be included in risk weighted assets of the guarantor.  A depository
institution providing a guarantee through a credit derivative transaction should assign its credit exposure
to the risk category appropriate to the obligor of the reference asset or, if relevant, the nature of the
collateral.  On the other hand, a depository institution that owns the underlying asset upon which effective
credit protection has been acquired through a credit derivative may assign the unamortized portion of the
underlying asset to the risk category appropriate to the guarantor, e.g., the 20 percent risk category if
the guarantor is an OECD bank. 

Whether the credit derivative is considered an eligible guarantee for purposes of risk-based capital
depends upon the degree of credit protection actually provided.  As explained earlier, the amount of
credit protection actually provided by a credit derivative may be limited depending upon the terms of the
arrangement.  In this regard, for example, a relatively restrictive definition of a default event or a
materiality threshold that requires a comparably high percentage of loss to occur before the guarantor
is obliged to pay could effectively limit the amount of credit risk actually transferred in the transaction. 
If the terms of the credit derivative arrangement significantly limit the degree of risk transference, then
the beneficiary bank cannot reduce the risk weight of the "protected" asset to that of the guarantor bank. 
On the other hand, even if the transfer of credit risk is limited, a depository institution providing credit
protection through a credit derivative must hold capital against the underlying exposure while it is
exposed to the credit risk of the reference asset.

Depository institutions providing a guarantee through a credit derivative may mitigate the credit risk
associated with the transaction by entering into an offsetting credit derivative with another counterparty,
a so-called "back-to-back" position.  Organizations that have entered into such a position may treat the
first credit derivative as guaranteed by the offsetting transaction for risk-based capital purposes. 
Accordingly, the notional amount of the first credit derivative may be assigned to the risk category
appropriate to the counterparty providing credit protection through the offsetting credit derivative
arrangement, e.g., the 20 percent risk category if the counterparty is an OECD bank. 

In some instances, the reference asset in the credit derivative transaction may not be identical to the
underlying asset for which the beneficiary has acquired credit protection.  For example, a credit derivative
used to offset the credit exposure of a loan to a corporate customer may use a publicly-traded corporate
bond of the customer as the reference asset, whose credit quality serves as a proxy for the on-balance
sheet loan.  In such a case, the underlying asset will still generally be considered guaranteed for capital
purposes as long as both the underlying asset and the reference asset are obligations of the same legal
entity and have the same level of seniority in bankruptcy.  In addition, depository institutions offsetting
credit exposure in this manner would be obligated to demonstrate to examiners that there is a high degree
of correlation between the two instruments; the reference instrument is a reasonable and sufficiently liquid
proxy for the underlying asset so that the instruments can be reasonably expected to behave in a similar
manner in the event of default; and, at a minimum, are subject to mutual cross-default provisions.  A
depository institution that uses a credit derivative, which is based on a reference asset that differs from
the protected underlying asset, must document the credit derivative being used to offset credit risk and
must link it directly to the asset or assets whose credit risk the transaction is designed to offset.  The
documentation and the effectiveness of the credit derivative transaction are subject to examiner review. 
Depository institutions providing credit protection through such arrangements must hold capital against
the risk exposures that are assumed.

Some credit derivative transactions provide credit protection for a group or basket of reference assets
and call for the guarantor to absorb losses on only the first asset in the group that defaults.  Once the first
asset in the group defaults, the credit protection for the remaining assets covered by the credit derivative
ceases.  If examiners determine that the credit risk for the basket of assets has effectively been transferred
to the guarantor and the beneficiary depository institution owns all of the reference assets included in the
basket, then the beneficiary may assign the asset with the smallest dollar amount in the group -- if less
than or equal to the notional amount of the credit derivative -- to the risk category appropriate to the
guarantor.  Conversely, a depository institution extending credit protection through a credit derivative
on a basket of assets must assign the contract's notional amount of credit exposure to the highest risk
category appropriate to the assets in the basket.

                    Other Supervisory Issues
The decision to treat credit derivatives as guarantees could have significant supervisory implications for
the way examiners treat concentration risk, classified assets, the adequacy of the allowance for loan and
lease losses (ALLL), and transactions involving affiliates.  Examples of how credit derivatives that
effectively transfer credit risk could affect supervisory procedures are discussed below.

                        Credit Exposure
For internal credit risk management purposes, banks are encouraged to develop policies to determine how
credit derivative activity will be used to manage credit exposures.  For example, a bank's internal credit
policies may set forth situations in which it is appropriate to reduce credit exposure to an underlying
obligor through credit derivative transactions.  Such policies need to address when credit exposure is
effectively reduced and how all credit exposures will be monitored, including those resulting from credit
derivative activities.

For supervisory purposes, a concentration of credit generally exists when a bank's loans and other
exposures -- e.g., fed funds sold, securities, and letters of credit -- to a single obligor, geographic area,
or industry exceed certain thresholds of  the bank's Tier 1 capital.  Examiners should not consider a
bank's asset concentration to a particular borrower reduced because of the existence of a non-government
guarantee on one of the borrower's loans because the underlying concentration to the borrower still
exists.  However, examiners should consider how the bank manages the concentration, which could
include the use of non-governmental guarantees.  Asset concentrations are to be listed in the examination
report to highlight that the ultimate risk to the bank stems from these concentrations, although the
associated credit risk may be mitigated by the existence of non-governmental guarantees.  

Any non-government guarantee should be included with other exposures to the guarantor to determine
if there is an asset concentration with respect to the guarantor.  Thus, the use of credit derivatives will
increase the beneficiary's concentration exposure to the guarantor without reducing concentration risk
of the underlying borrower.  Similarly, a guarantor bank's exposure to all reference assets will be included
in its overall credit exposure to the reference obligor.  

                         Classification
The criteria used to classify assets are primarily based upon the degree of risk and the likelihood of
repayment as well as on the assets' potential effect on the bank's safety and soundness.  When evaluating
the quality of a loan, examiners should review the overall financial condition of the borrower; the
borrower's credit history; any secondary sources of repayment, such as guarantees; and other factors. 
The primary focus in the review of a loan's quality is the primary source of repayment.  The assessment
of the credit quality of a troubled loan, however, should take into account support provided by a
financially responsible guarantor.

The protection provided on an underlying asset by a credit derivative from a financially responsible
guarantor may be sufficient to preclude classification of the underlying asset, or reduce the severity of
classification.  Sufficiency depends upon the extent of credit protection that is provided.  In order for a
credit derivative to be considered a guarantee for purposes of determining the classification of assets, the
credit risk must be transferred from the beneficiary to the financially responsible guarantor; the financially
responsible guarantor must have both the financial capacity and willingness to provide support for the
credit; the guarantee (i.e., the credit derivative contract) must be legally enforceable; and the guarantee
must provide support for repayment of the indebtedness, in whole or in part, during the remaining term
of the underlying asset.  

However, credit derivatives tend to have a shorter maturity than the underlying asset being protected. 
Furthermore, there is uncertainty as to whether the credit derivative will be renewed once it matures. 
Thus, examiners need to consider the term of the credit derivative relative to the maturity of the protected
underlying asset, the probability that the protected underlying asset will default while the guarantee is in
force, as well as whether the credit risk has actually been transferred, when determining whether to
classify an underlying asset protected by a credit derivative.  In general, the beneficiary depository
institution continues to be exposed to the credit risk of the classified underlying asset when the maturity
of the credit derivative is shorter than the underlying asset.  Thus, in situations of a maturity mismatch,
the presumption may be against a diminution of the severity of the classification of the underlying asset.

For guarantor depository institutions, examiners should review the credit quality of individual reference
assets in derivative contracts in the same manner as other credit instruments, such as standby letters of
credit.  Thus, examiners should evaluate a credit derivative, in which a depository institution provides
credit protection, based upon the overall financial condition and resources of the reference obligor; the
obligor's credit history; and any secondary sources of repayment, such as collateral.



              Allowance for Loan and Lease Losses
In accordance with the Interagency Policy Statement on the Allowance for Loan and Lease Losses
(ALLL), institutions must maintain an ALLL at a level that is adequate to absorb estimated credit losses
associated with the loan and lease portfolio.  FDIC staff continues to review accounting issues related
to credit derivatives and reserving practices and may issue additional guidance upon completion of this
review or when more definitive guidance is provided by accounting authorities.  Likewise, consideration
will be given to improving disclosures in regulatory reports to improve the transparency of credit
derivatives and their effects on the credit quality of the loan portfolio, particularly if the market for credit
derivatives grows significantly.

               Transactions Involving Affiliates
Although examiners have not seen credit derivative transactions involving two or more legal entities
within the same bank holding company, the possibility of such transactions exists.  Transactions between
or involving affiliates raise important supervisory issues, especially whether such arrangements are
effective guarantees of affiliate obligations, or transfers of assets and their related credit exposure
between affiliates.  Thus, depository institutions should carefully consider existing supervisory guidance
on interaffiliate transactions before entering into credit derivative arrangements involving affiliates,
particularly when substantially the same objectives could be met using traditional guarantee instruments.


III.  Accounting and Regulatory Reporting 
    Treatment for Credit Derivatives

The instructions to the Reports of Condition and Income ("Call Report") do not contain explicit
accounting guidance on credit derivatives at this time.  Furthermore, there is no authoritative accounting
guidance under GAAP that directly applies to credit derivatives.  Accordingly, as a matter of sound
practice, depository institutions entering into credit derivative transactions should have a written
accounting policy that has been approved by senior management for credit derivatives and any asset (e.g.,
a loan or security) for which protection has been purchased.  Depository institutions are strongly
encouraged to consult with their outside accountants to ensure appropriate accounting practices in this
area.   Nevertheless, institutions' accounting practices are subject to examiner review and criticism.

Pending any authoritative guidance from the accounting profession, banks should report credit derivatives
in the Call Report in accordance with the following instructions.  Beneficiary depository institutions that
purchase credit protection on an asset through a credit derivative should continue to report the amount
and nature of the underlying asset for regulatory reporting purposes, without regard to the credit
derivative transaction.  That is, all underlying assets should be reported in the category appropriate for
that transaction and obligor.  Furthermore, the underlying asset should be reported as past due or
nonaccrual, as appropriate, in Schedule RC-N in the Call Report, regardless of the existence of an
associated credit derivative transaction.  Amounts receivable under a credit derivative contract should
not be reported as an adjustment to the ALLL.

The notional amount of all credit derivatives entered into by beneficiary depository institutions should
be reported in Schedule RC-L, item 13, "All other off-balance-sheet assets," of the Call Report. 
Furthermore, institutions may report the amount of credit derivatives that provide effective protection
for their past due and nonaccrual assets in "Optional Narrative Statement Concerning the Amounts
Reported in the Reports of Condition and Income" or in Schedule RI-E, item 9, "Other explanations." 


In Schedule RC-R, items 4 through 7, column A, the carrying value of all specifically identified underlying
assets that are effectively guaranteed through credit derivative transactions may be assigned to the risk
category of the guarantor or obligor, whichever is lower.  However, for underlying assets that are
reported as available-for-sale securities the amortized cost rather than the carrying value (i.e. fair value)
should be assigned to a risk category. 

Banks that extend credit protection through credit derivatives (guarantors) should reflect all liabilities for
expected losses arising from these contracts in their financial statements promptly.  In addition, guarantor
banks should report in the Call Report the notional amount of the credit derivatives in Schedule RC-L,
item 12, "All other off-balance sheet liabilities," and the credit equivalent amounts of these contracts in
Schedule RC-R, items 4 through 7, column B.  In Schedule RC-R, credit equivalent amounts of their
credit derivatives may be reported in the risk category of the reference asset obligor or any guarantor,
whichever is lower.  For example, a bank that assumes the credit risk of a corporate bond through a credit
derivative would assign the exposure to the 100 percent risk category.  However, if the bank laid off the
corporate bond's credit risk by purchasing a credit derivative from another OECD bank, the exposure
may instead be assigned to the 20 percent risk category.

For Call Report purposes, the notional value of credit derivatives transactions should not be reported as
interest rate, foreign exchange, commodity, or equity derivative transactions in Schedules RC-L and RC-R.  
Institutions that have been reporting credit derivatives as such derivative transaction in the Call
Report do not have to amend past reports.

Last Updated 07/17/1999 communications@fdic.gov