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.