Skip to main content
U.S. flag
An official website of the United States government
Dot gov
The .gov means it’s official.
Federal government websites often end in .gov or .mil. Before sharing sensitive information, make sure you’re on a federal government site.
Https
The site is secure.
The https:// ensures that you are connecting to the official website and that any information you provide is encrypted and transmitted securely.

[Federal Register: December 28, 1994]



 

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



 

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 325


 

RIN 3064-AB42


 

 

Risk-Based Capital Standards; Bilateral Netting Requirements


 

AGENCY: Federal Deposit Insurance Corporation (FDIC or Corporation).


 

ACTION: Final rule.


 

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


 

SUMMARY: The FDIC is amending its risk-based capital standards to

recognize the risk-reducing benefits of qualifying bilateral netting

contracts. This final rule implements a recent revision to the Basle

Accord permitting the recognition of such netting arrangements. The

effect of the final rule is that state nonmember banks (banks) may net

positive and negative mark-to-market values of interest and exchange

rate contracts in determining the current exposure portion of the

credit equivalent amount of such contracts to be included in risk-

weighted assets.


 

EFFECTIVE DATE: December 28, 1994.


 

FOR FURTHER INFORMATION CONTACT: William A. Stark, Assistant Director,

(202/898-6972), Curtis Wong, Capital Markets Specialist, (202/898-

7327), Division of Supervision, FDIC, 550 17th Street, N.W.,

Washington, D.C. 20429; Jeffrey M. Kopchik, Counsel, (202/898-3872),

Christopher Curtis, Senior Counsel, (202/898-3728), FDIC, Legal

Division, 550 17th Street, N.W., Washington, D.C., 20429; Linda L.

Stamp, Counsel, (202/736-0161), Legal Division, 1717 H Street, N.W.,

Washington, D.C. 20429.


 

SUPPLEMENTARY INFORMATION:


 

Background


 

The Basle Accord1 established a risk-based capital framework

which was implemented in the United States by the FDIC in 1989. Under

this framework, off-balance-sheet interest rate and exchange rate

contracts (rate contracts) are incorporated into risk weighted assets

by converting each contract into a credit equivalent amount. This

amount is then assigned to the appropriate credit risk category

according to the identity of the obligor or counterparty or, if

relevant, the guarantor or the nature of the collateral. The credit

equivalent amount of an interest or exchange rate contract can be

assigned to a maximum credit risk category of 50 percent.

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


 

\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 a rate contract is determined by

adding together the current replacement cost (current exposure) and an

estimate of the possible increase in future replacement cost in view of

the volatility of the current exposure over the remaining life of the

contract (potential future exposure, also referred to as the add-

on).2

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


 

\2\This method of determining credit equivalent amounts for rate

contracts is identified in the Basle Accord as the current exposure

method, which is used by most international banks.

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


 

For risk-based capital purposes, a rate contract with a positive

mark-to-market value has a current exposure equal to that market value.

If the mark-to-market value of a rate contract is zero or negative,

then there is no replacement cost associated with the contract and the

current exposure is zero. The original Basle Accord and FDIC standards

provided that current exposure would be determined individually for

each rate contract entered into by a bank; banks generally were not

permitted to offset, that is, net, positive and negative market values

of multiple rate contracts with a single counterparty to determine one

current credit exposure relative to that counterparty.3

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


 

\3\It was noted in the Accord that the legal enforceability of

certain netting arrangements was unclear in some jurisdictions.

However, the legal status of netting by novation was determined to

be settled and this limited type of netting was recognized. Netting

by novation is accomplished under a written bilateral contract

providing that any obligation to deliver a given currency on a given

date is automatically amalgamated with all other obligations for the

same currency and value date. The previously existing contracts are

extinguished and a new contract, for the single net amount, is

legally substituted for the amalgamated gross obligations.

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


 

In April 1993 the Basle Supervisors' Committee proposed a revision

to the Basle Accord, endorsed by the G-10 Governors in July 1994, that

permits banks to net positive and negative market values of rate

contracts subject to a qualifying, legally enforceable, bilateral

netting arrangement. Under the revision, banks with qualifying netting

arrangements are permitted to calculate a single net current exposure

for purposes of determining the credit equivalent amount for the

included contracts.4 If the net market value of the contracts

included in such a netting arrangement is positive, then that market

value equals the current exposure for the netting contract. If the net

market value is zero or negative, then the current exposure is zero.

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


 

\4\The revision to the Accord notes that national supervisors

must be satisfied about the legal enforceability of a netting

arrangement under the laws of each jurisdiction relevant to the

arrangement. The Accord continues, if any supervisor is dissatisfied

about enforceability under its laws, the netting arrangement does

not satisfy this condition and neither counterparty may obtain

supervisory benefit.

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


 

The FDIC's Proposal


 

On May 20, 1994, the Board of Governors of the Federal Reserve

System (Federal Reserve) and the Office of the Comptroller of the

Currency (OCC) issued a joint proposal to amend their respective risk-

based capital standards (59 FR 26456) in accordance with the Basle

Supervisors' Committee's April 1993 proposal. The Office of Thrift

Supervision (OTS) issued a similar netting proposal on June 14, 1994

(59 FR 30538) and the FDIC issued its netting proposal on July 25, 1994

(59 FR 37726). (Collectively, the FDIC, Federal Reserve, OCC and OTS

are referred to as the banking agencies.) The banking agencies each

proposed that for capital purposes the organizations under their

supervision could net the positive and negative market values of

interest and exchange rate contracts subject to a qualifying, legally

enforceable, bilateral netting contract to calculate one current

exposure for that master netting contract.

The banking agencies' proposals provided that the net current

exposure would be determined by adding together all positive and

negative market values of individual contracts subject to the netting

contract. The net current exposure would equal the sum of the market

values if that sum is a positive value, or zero if the sum of the

market values is zero or a negative value. The proposals did not alter

the calculation method for potential future exposure.5

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


 

\5\Potential future exposure is estimated by multiplying the

effective notional amount of a contract by a credit conversion

factor which is based on the type of contract and the remaining

maturity of the contract. Under the FDIC's proposal, a potential

future exposure amount would be calculated for each individual

contract subject to the netting contract. The individual potential

future exposures would then be added together to arrive at one total

add-on amount.

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


 

Under the banking agencies' proposals, institutions would be able

to net for risk-based capital purposes only with a written bilateral

netting contract that creates a single legal obligation covering all

included individual rate contracts and does not contain a walkaway

clause.6 The proposals required an institution to obtain a written

and reasoned legal opinion(s) stating that under the master netting

contract the institution would have a claim to receive, or an

obligation to pay, only the net amount of the sum of the positive and

negative market values of included individual contracts if a

counterparty failed to perform due to default, insolvency, bankruptcy,

liquidation, or similar circumstances.

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


 

\6\A walkaway clause is a provision in a netting contract that

permits a non-defaulting counterparty to make lower payments than it

would make otherwise under the contract, or no payment at all, to a

defaulter or to the estate of a defaulter, even if the defaulter or

the estate of the defaulter is a net creditor under the contract.

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


 

The banking agencies' proposals indicated that the legal opinion

must normally cover: (i) The law of the jurisdiction in which the

counterparty is chartered, or the equivalent location in the case of

noncorporate entities, and if a branch of the counterparty is involved,

the law of the jurisdiction in which the branch is located; (ii) the

law that governs the individual contracts covered by the netting

contract; and (iii) the law that governs the netting contract.

The banking agencies' proposals provided that an institution must

maintain in its files documentation adequate to support the bilateral

netting contract. Documentation would typically include a copy of the

bilateral netting contract, legal opinions and any related

translations. In addition, the proposals required an institution to

establish and maintain procedures to ensure that the legal

characteristics of netting contracts would be kept under review.

Under the proposals, the banking agencies could disqualify any or

all contracts from netting treatment for risk-based capital purposes if

the requirements of the proposals were not satisfied. In the event of

disqualification, the affected contracts would be treated as though

they were not subject to the master netting contract. The proposals

indicated that outstanding netting by novation arrangements would not

be grandfathered, that is, such arrangements would have to meet all of

the proposed requirements for qualifying bilateral netting contracts.

The proposals requested general comments as well as specific

comments on the nature of collateral arrangements and the extent to

which collateral might be recognized in conjunction with bilateral

netting contracts.


 

Comments Received


 

The banking agencies together received twenty-two public comments

on their proposed amendments. Since all the comment letters were shared

by the banking agencies, all of them will be discussed herein. Twelve

of the commenters were banks, thrifts, and bank and thrift holding

companies and five were industry trade associations and organizations.

In addition, there were two comments from foreign financial

institutions and three comments from law firms. All commenters

supported the expanded recognition of bilateral netting contracts for

risk-based capital purposes. Several commenters encouraged recognition

of such contracts as quickly as possible. Many of the commenters

concurred with one of the principal underlying tenets of the proposals,

that is, that legally enforceable bilateral netting contracts can

provide an efficient and desirable means for institutions to reduce or

control credit exposure. A few commenters noted that, in their view,

the recognition of bilateral netting contracts would create an

incentive for market participants to use such arrangements and would

encourage lawmakers to clarify the legal status of netting arrangements

in their jurisdictions. One commenter noted that the expanded

recognition of bilateral netting contracts would help keep U.S. banking

organizations competitive in global derivatives markets.

While generally expressing their endorsement for the expanded

recognition of bilateral netting contracts, nearly all commenters

offered suggestions or requested clarification regarding details of the

proposals. In particular, the commenters raised issues concerning

specifics of the required legal opinions, the treatment of collateral,

and the grandfathering of walkaway clauses and novation agreements.


 

Legal Opinions


 

Almost all commenters addressed the proposed requirement that

institutions obtain legal opinions concluding that their bilateral

netting contracts would be enforceable in all relevant jurisdictions.

Commenters did not object to the general requirement that they secure

legal opinions, rather they raised a number of questions about the form

and substance of an acceptable opinion.

Form

Several commenters requested clarification as to the specific form

of the legal opinion. Commenters wanted to know if a memorandum of law

would satisfy the requirement or if a legal opinion would be required.

They questioned whether a memorandum or opinion could be addressed to,

or obtained by, an industry group, and whether a generic opinion or

memorandum relating to a standardized netting contract would satisfy

the legal opinion requirement.

Several commenters suggested that an opinion secured on behalf of

the banking industry by an organization should be sufficient so long as

the individual institution's counsel concurs with the opinion and

concludes that the opinion applies directly to the institution's

specific netting contract and to the individual contracts subject to

it. A few commenters requested confirmation that legal opinions would

not have to follow a predetermined format.

Scope

Several commenters identified two possible interpretations of the

proposed language with regard to the scope of the legal opinions. They

asked the banking agencies to clarify whether the opinions would be

required to discuss only whether all relevant jurisdictions would

recognize the contractual choice of law or whether they must also

discuss the enforceability of netting in bankruptcy or other instances

of default. One commenter suggested deleting the requirement for a

choice of law analysis.

A number of commenters objected to the proposed requirement that

the legal opinion for a multibranch netting contract (that is, a

netting contract between multinational banks that includes contracts

with branches of the parties located in various jurisdictions) address

the enforceability of netting under the law of the jurisdiction where

each branch is located. These commenters stated that it should be

sufficient for the legal opinion to conclude that netting would be

enforced in the jurisdiction of the counterparty's home office if the

master netting contract provides that all transactions are considered

obligations of the home office and the branch jurisdictions recognize

that provision.

Severability

Several commenters expressed concern about the proposed treatment

for netting contracts that include contracts with branches in

jurisdictions where the enforceability of netting is unclear. In such

circumstances, commenters asserted, unenforceability or uncertainty in

one jurisdiction should not invalidate the entire netting contract for

risk-based capital netting treatment. These commenters contended that,

to the extent supported by legal opinions, contracts with branches of a

counterparty in jurisdictions that recognize netting arrangements

should be netted and contracts with branches in jurisdictions where the

enforceability of netting is not supported by legal opinions should,

for risk-based capital purposes, be severed, or removed, from the

master netting contract and treated as though they were not subject to

that contract. These commenters noted that this treatment should only

be available to the extent it is supported by legal opinion.

Conclusions

The proposals required a legal opinion to conclude that ``relevant

court and administrative authorities would find'' the netting to be

effective. Many commenters that discussed this aspect of the proposals

expressed concern that this standard was too high. They suggested,

instead, that the opinions be required to conclude that netting

``should'' be effective.

A few commenters requested clarification regarding the proposed

requirement that the netting contract must create a single legal

obligation.


 

Collateral


 

Twelve commenters addressed the proposals' specific request for

comment on the nature of collateral and the extent to which collateral

might be recognized in conjunction with bilateral netting contracts.

All of these commenters believed collateral should be recognized as a

means of reducing credit exposure. A few commenters noted that

collateral arrangements are increasingly being used with derivative

transactions.

Several commenters stated that for netting contracts that call for

the use of collateral, the amount of required collateral is determined

from the net mark-to-market value of the master netting contract. A few

commenters added that mark-to-market collateral often is used in

conjunction with a collateral ``add-on'' based on such things as the

notional amount of the underlying contracts, the maturities of the

contracts, the credit quality of the counterparty, and volatility

levels.

A number of commenters offered their opinions as to how collateral

should be recognized for risk-based capital purposes. Some suggested

that the existing method of recognizing collateral for purposes of

assigning credit equivalent amounts to risk categories is applicable to

derivative transactions as well. Other commenters expressed the view

that collateral should be recognized when assigning risk weights to the

extent it is legally available to cover the total credit exposure for

the bilateral netting contract in the event of default and that this

availability should be addressed in the legal opinions.

Several other commenters suggested separating the net current

exposure and potential future exposure of bilateral netting contracts

for determining collateral coverage and appropriate risk weights. One

commenter favored recognizing collateral for capital purposes by

allowing an institution to offset net current exposure by the amount of

the collateral to further reduce the credit equivalent amount.

Two commenters requested clarification that contracts subject to

qualifying netting contracts could be eligible for a zero percent risk

weight if the transaction is properly collateralized in accordance with

the Federal Reserve's collateralized transactions rule.7

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


 

\7\In December 1992, the Federal Reserve issued an amendment to

its risk-based capital guidelines permitting certain collateralized

transactions to qualify for a zero percent risk weight (57 FR 62180,

December 30, 1992). In order to qualify for a zero percent risk

weight, an institution must maintain a positive margin of qualifying

collateral at all times. Thus, the collateral arrangement should

provide for immediate liquidation of the claim in the event that a

positive margin of collateral is not maintained. The OCC has issued

a similar proposal (58 FR 43822, August 18, 1993).

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


 

Walkaway Clauses


 

Several commenters addressed the proposed prohibition against

walkaway clauses in contracts qualifying for netting for risk-based

capital purposes. While most of these commenters agreed that,

ultimately, walkaway clauses should be eliminated from master netting

contracts, they favored a phase-out period, during which outstanding

bilateral netting contracts containing walkaway clauses could qualify

for capital netting treatment. Several commenters contended that if a

defaulter is a net debtor under the contract, the existence of a

walkaway clause would not affect the amount owed to the non-defaulting

creditor.


 

Novation


 

A few commenters expressed concern that the banking agencies'

proposals did not grandfather outstanding novation agreements. These

commenters suggested a phase-in period during which novation agreements

would not be required to be supported by legal opinions.


 

Other Issues


 

One commenter requested greater detail on the nature and extent of

examination review procedures. Two commenters stated that in some

situations obtaining translations might be burdensome. Another

commenter suggested assurance that the agencies would not disqualify

netting contracts in an unreasonable manner.

Approximately one-half of the commenters expressed concern that the

banking agencies' proposals specifically were limited to interest rate

and exchange rate contracts. All of these opposed limiting the range of

products that could be included under qualifying netting contracts. In

this regard, one commenter noted that where there is sufficient legal

support confirming the enforceability of cross-product netting it

should be recognized for capital purposes.

A number of commenters used the proposal as an opportunity to

discuss the manner in which the add-on for potential future exposure is

calculated. They suggested netting contracts should be recognized not

only as a way to reduce the current exposure to a counterparty, but

also the effects of such netting contracts should be taken into account

to reduce the amount of capital organizations must hold against the

potential future exposure to the counterparty.


 

Final Rule


 

After considering the public comments received and further

deliberating the issues involved, the FDIC has determined to adopt a

final rule recognizing, for capital purposes, qualifying bilateral

netting contracts. This final rule is substantially the same as

proposed.


 

Legal opinions


 

Form

The final rule requires that banks obtain a written and reasoned

legal opinion(s) concluding that the netting contract is enforceable in

all relevant jurisdictions. This requirement is aimed at ensuring there

is a substantial legal basis supporting the legal enforceability of a

netting contract before reducing a bank's capital requirement based on

that netting contract. A legal opinion, as that phrase is commonly

understood by the legal community in the United States, can provide

such a legal basis. A memorandum of law may be an acceptable

alternative as long as it addresses all of the relevant issues in a

credible manner.

As discussed in the proposal, the legal opinion may be prepared by

either an outside law firm or a bank's in-house counsel. The salient

requirements for an acceptable legal opinion are that it: (i) Addresses

all relevant jurisdictions; and (ii) concludes with a high degree of

certainty that in the event of a legal challenge the bank's claim or

obligation would be determined by the relevant court or administrative

authority to be the net sum of the positive and negative mark-to-market

values of all individual contracts subject to the bilateral netting

contract. The subject matter and complexity of required legal opinions

will vary.

To some extent, banks may use general, standardized opinions to

help support the legal enforceability of their bilateral netting

contracts. For example, a bank may have obtained a memorandum of law

addressing the enforceability of netting provisions in a particular

foreign jurisdiction. This opinion may be used as the basis for

recognizing netting generally in that jurisdiction. However, with

regard to an individual master netting contract, the general opinion

would need to be supplemented by an opinion that addresses issues such

as the enforceability of the underlying contracts, choice of law, and

severability.

For example, the FDIC does not believe that a generic opinion

prepared for a trade association with respect to the effectiveness of

netting under the standard form agreement issued by the trade

association, by itself is adequate to support a netting contract. Banks

using such general opinions would need to supplement them with a review

of the terms of the specific netting contract that the bank is

executing.

Scope

With regard to the scope of the legal opinions, that is, what areas

of analysis must be covered, the FDIC is of the opinion that legal

opinions must address the validity and enforceability of the entire

netting contract. The opinion must conclude that under the applicable

state or other jurisdictional law the netting contract is a legal,

valid, and binding contract, enforceable in accordance with its terms,

even in the event of insolvency, bankruptcy, or similar proceedings.

Opinions provided on the law of jurisdictions outside of the U.S.

should include a discussion and conclusion that netting provisions do

not violate the public policy or the law of that jurisdiction.

The FDIC has further determined that one of the most critical

aspects of a qualifying netting contract is the contract's

enforceability in any jurisdiction whose law would likely be applied in

an enforcement action, as well as the jurisdiction where the

counterparty's assets reside. In this regard, and in light of the

policy in some countries to liquidate branches of foreign banking

organizations independent of the head office, the FDIC is retaining its

proposed requirement that legal opinions address the netting contract's

enforceability under: (i) The law of the jurisdiction in which the

counterparty is chartered, or the equivalent location in the case of

noncorporate entities, and if a branch of the counterparty is involved,

the law of the jurisdiction in which the branch is located; (ii) the

law that governs the individual contracts subject to the bilateral

netting contract; and (iii) the law that governs the netting contract.

Severability

The FDIC recognizes that for some multibranch netting contracts a

bank may not be able to obtain a legal opinion(s) concluding that

netting would be enforceable in every jurisdiction where branches

covered under the master netting contract are located. The FDIC concurs

with commenters that in such situations it may be inefficient to

require banks to renegotiate netting contracts to ensure they cover

only those jurisdictions where netting is clearly enforceable. The FDIC

has determined that, in certain circumstances for capital purposes,

banks may use master bilateral netting contracts that include contracts

with branches across all jurisdictions. Banks should calculate their

net current exposure for the contracts in those jurisdictions where

netting clearly is enforceable as supported by legal opinion(s). The

remaining contracts subject to the netting contract should be severed

from the netting contract and treated as though they were not subject

to the netting contract for capital and credit purposes. This approach

of essentially dividing contracts subject to the netting contact into

two categories--those that may clearly be netted and those that may

not--is acceptable provided that the bank's legal opinions conclude

that the contracts that do not qualify for netting treatment are

legally severable from the master netting contract and that such

severance will not undermine the enforceability of the netting contract

for the remaining qualifying contracts.

Conclusions

The FDIC has retained the proposed language that legal opinions

must represent that netting would be enforceable in all relevant

jurisdictions. In response to commenters' assertions that the standard

for this type of legal opinion is too high, the FDIC notes that use of

the word ``would'' in the capital rules does not necessarily mean that

the legal opinions must also use the word ``would'' or that

enforceability must be determined to be an absolute certainty. The

intent, rather, is for banks to secure a legal opinion concluding that

there is a high degree of certainty that the netting contract will

survive a legal challenge in any applicable jurisdiction. The degree of

certainty should be apparent from the reasoning set out in the opinion.

The FDIC notes that the requirement for legal opinions to conclude

that netting contracts must create a single legal obligation applies

only to those individual contracts that are covered by, and included

under, the netting contract for capital purposes. As discussed above, a

netting contract may include individual contracts that do not qualify

for netting treatment, provided that these individual contracts are

legally severable from the contracts to be netted for capital purposes.


 

Collateral


 

The final rule permits, subject to certain conditions, banks to

take into account qualifying collateral when assigning the credit

equivalent amount of a netting contract to the appropriate risk weight

category in accordance with the procedures and requirements currently

set forth in the FDIC's risk-based capital standards. The FDIC has

added language to the final rule clarifying that collateral must be

legally available to cover the credit exposure of the netting contract

in the event of default. For example, the collateral may not be pledged

solely against one individual contract subject to the master netting

contract. The legal availability of the collateral must be addressed in

the legal opinions.


 

Walkaway Clauses


 

The FDIC has considered the suggestion made by some commenters of a

phase-out period for outstanding contracts with walkaway clauses. The

FDIC continues to believe that walkaway clauses do not reduce credit

risk. Accordingly, the final rule retains the provision that bilateral

netting contracts with walkaway clauses are not eligible for netting

treatment for risk-based capital purposes and does not provide for a

phase-out period.


 

Novation


 

The proposal required all netting contracts, including netting by

novation agreements, to be supported by written legal opinions. The

FDIC does not agree with commenters that a grandfathering period for

outstanding novation agreements is needed. Rather, the FDIC continues

to believe that all netting contracts must be held to the same

standards in order to promote certainty as to the legal enforceability

of the contracts and to decrease the risks faced by counterparties in

the event of default. Under the final rule, a netting by novation

agreement must meet the requirements for a qualifying bilateral netting

contract.


 

Other Issues


 

The FDIC has considered all of the other issues raised by

commenters. With regard to documentation, the FDIC reiterates that, as

with all provisions of risk-based capital, a bank must maintain in its

files appropriate documentation to support any particular capital

treatment including netting of rate contracts. Appropriate

documentation typically would include a copy of the bilateral netting

contract, supporting legal opinions, and any related translations. The

documentation should be available to examiners for their review.

The FDIC recognizes commenters' concerns that the proposed rules

were limited specifically to interest and exchange rate contracts. The

FDIC notes that both the Basle Accord and its risk-based capital

standards currently do not address derivatives contracts other than

rate contracts. This final rule does not attempt to go beyond the scope

of the existing risk-based capital framework and applies only to

netting contracts encompassing interest rate and foreign exchange rate

contracts. The FDIC, however, notes that the Basle Supervisors'

Committee issued a proposal for public comment in July 1994 to amend

the Basle Accord which explicitly would set forth the risk-based

capital treatment for other types of derivative transactions, such as

commodity, precious metal, and equity contracts. In this regard, the

Federal Reserve, the OCC, and the FDIC issued similar proposals, based

on the Basle Supervisors' Committee proposal, to amend their risk-based

capital standards (59 FR 43508, August 24, 1994; 59 FR 45243, September

1, 1994; and 59 FR 52714, October 19, 1994, respectively). The OTS

intends to issue a similar proposal in the near future.

Until the Basle Accord has been revised and the FDIC's risk-based

capital rules have been amended to encompass commodity, precious metal,

and equity derivative contracts, the FDIC will permit banks to apply

the following treatment, rather than automatically disqualifying from

capital netting treatment an entire netting contract that includes non-

rate-related transactions. In determining the current exposure of

otherwise qualifying netting contracts that include non-rate-related

contracts, banks will be permitted to net the positive and negative

mark-to-market values of the included interest and exchange rate

contracts, while severing the non-rate-related contracts and treating

them as though they were not subject to the master netting contract.

(This treatment is similar to the treatment applied to a netting

contract that includes contracts in jurisdictions where the

enforceability of netting is not supported by legal opinion. Legal

opinions are not required to support severability of non-rate-related

contracts.)

The FDIC notes that the regulatory language with regard to the

calculation of potential future exposure remains essentially the same

as that proposed. The FDIC has clarified an underlying premise of the

current exposure method for calculating credit exposure as set forth in

the Basle Accord, that is, the add-on for potential future exposure

must be calculated based on the effective, rather than the apparent,

notional principal amount and the notional amount the bank uses will be

subject to examiner review.8

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


 

\8\The notional amount is, generally, a stated reference amount

of money used to calculate payment streams between the

counterparties. In the event that the effect of the notional amount

is leveraged or enhanced by the structure of the transaction, banks

must use the actual, or effective, notional amount when determining

potential future exposure. For example, a stated notional amount of

one million dollars with payments calculated at 2X Libor, would have

an effective notional amount of two million dollars.

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


 

Finally, in its Notice of Proposed Rulemaking, the FDIC described

its transfer and enforcement powers with respect to ``qualified

financial contracts'' under section 11(e) of the FDI Act. (59 FR 37229-

30). Having received no comments on that subject, the FDIC reaffirms

its position as stated in the Notice of Proposed Rulemaking.


 

Regulatory Flexibility Act Analysis


 

Pursuant to section 605(b) of the Regulatory Flexibility Act, the

FDIC hereby certifies that this final rule will not have a significant

impact on a substantial number of small business entities. Accordingly,

a regulatory flexibility analysis is not required.


 

Paperwork Reduction Act and Regulatory Burden


 

The FDIC has determined that this final rule will not increase the

regulatory paperwork burden of banks pursuant to the provisions of the

Paperwork Reduction Act (44 U.S.C. 3501 et seq.).

Section 302 of the Riegle Community Development and Regulatory

Improvement Act of 1994 (Pub. L. 103-325, 108 Stat. 2160) provides that

the federal banking agencies must consider the administrative burdens

and benefits of any new regulation that imposes additional requirements

on insured depository institutions. Section 302 also requires such a

rule to take effect on the first day of the calendar quarter following

final publication of the rule, unless the agency, for good cause,

determines an earlier effective date is appropriate.

The new capital rule imposes certain requirements on banks that

wish to net the current exposures of their rate contracts for purposes

of calculating their risk-based capital requirements. However, the FDIC

expects that such banks would adhere to these requirements in any event

as part of prudent business practices. Any burden of complying with the

requirements of netting under a legally enforceable netting contract

and obtaining the necessary legal opinions should be outweighed by the

benefits associated with a lower capital requirement. The new rule will

not affect banks that do not wish to net for capital purposes. For

these reasons, the FDIC has determined that the rule is to be effective

on the date published, and banks will be permitted to take advantage of

netting in their year-end statements, if they so desire.


 

List of Subjects in 12 CFR Part 325


 

Bank deposit insurance, Banks, banking, Capital adequacy, Reporting

and recordkeeping requirements, Savings associations, State nonmember

banks.


 

For the reasons set out in the preamble, the Board of Directors of

the FDIC amends 12 CFR part 325 as follows:


 

PART 325--CAPITAL MAINTENANCE


 

1. The authority citation for part 325 continues to read as

follows:


 

Authority: 12 U.S.C. 1815(a), 1815(b), 1816, 1818(a), 1818(b),

1818(c), 1818(t), 1819(Tenth), 1828(c), 1828(d), 1828(i), 1828(n),

1828(o), 1831o, 3907, 3909; Pub.L. 102-233, 105 Stat. 1761, 1789,

1790 (12 U.S.C. 1831n note) Pub.L. 102-242, 105 Stat. 2236, 2355,

2386 (12 U.S.C. 1828 note).


 

2. Appendix A to part 325 is amended by revising section II.E.1

introductory text, Section II.E.1.(a) and (b) and the undesignated

paragraph after section II.E.1.(b) preceding the table; revising the

first paragraph of section II.E.2.; removing the last two sentences of

the second paragraph of section II.E.2; and adding new II.E.3. to read

as follows:


 

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


 

* * * * *

II. * * *

E. * * *

1. Credit Equivalent Amounts for Interest Rate and Foreign

Exchange Rate Contracts. The credit equivalent amount of an off-

balance sheet rate contract that is not subject to a qualifying

bilateral netting contract in accordance with section II.E.3. of

this appendix A is equal to the sum of (i) the current exposure

(which is equal to the mark-to-market value39 and is sometimes

referred to as the replacement cost) of the contract; and (ii) an

estimate of the potential future credit exposure over the remaining

life of the contract. To calculate the credit equivalent amount of

its off-balance sheet interest rate and foreign exchange rate

instruments, a bank should, for each contract, sum:

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


 

\3\9Mark-to-market values should be measured in dollars,

regardless of the currency or currencies specified in the contract,

and should reflect changes in both interest (or foreign exchange)

rates and in counterparty credit quality.

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


 

(a) The mark-to-market value (positive values only) of the

contact (that is, its current credit exposure or replacement cost);

and

(b) An estimate of the potential future increase in credit

exposure over the remaining life of the instrument.

For risk based capital purposes, potential credit exposure on a

contract is determined by multiplying the notional principal amount

of the contract, including contracts with negative mark-to-market

values, by the appropriate credit conversion factor. Banks should,

subject to examiner review, use the effective rather than the

apparent or stated notional amount in this calculation.40 The

conversion factors are:

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


 

\4\0The notional amount is, generally, a stated reference amount

of money used to calculate payment streams between the

counterparties. In the event that the effect of the notional amount

is leveraged or enhanced by the structure of the transaction,

institutions must use the actual, or effective, notional amount when

determining potential future exposure. For example, a stated

notional amount of one million dollars with payments calculated at

2X Libor, would have an effective notional amount of two million

dollars.

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


 

* * * * *

2. Risk Weights for Interest Rate and Foreign Exchange Rate

Contracts. Once the credit equivalent amount for an interest rate

and foreign exchange rate instrument has been determined, that

amount generally should be assigned to a risk weight category

according to the identity of the counterparty or, if relevant, the

nature of any collateral or guarantees. Collateral held against a

netting contract is not recognized for capital purposes unless it is

legally available for all contracts included in the netting

contract. However, the maximum risk weight that will be applied to

the credit equivalent amount of such instruments is 50 percent.

* * * * *

3. Netting. (1) For purposes of this appendix A, netting refers

to the offsetting of positive and negative mark-to-market values

when determining a current exposure to be used in the calculation of

a credit equivalent amount. Any legally enforceable form of

bilateral netting of rate contracts is recognized for purposes of

calculating the credit equivalent amount provided that:

(a) The netting is accomplished under a written netting contract

that creates a single legal obligation, covering all included

individual contracts, with the effect that the bank would have a

claim or obligation to receive or pay, respectively, only the net

amount of the sum of the positive and negative mark-to-market values

on included individual contracts in the event that a counterparty,

or a counterparty to whom the contract has been validly assigned,

fails to perform due to any of the following events: default,

bankruptcy, liquidation, or similar circumstances.

(b) The bank obtains a written and reasoned legal opinion(s)

representing that in the event of a legal challenge, including one

resulting from default, insolvency, bankruptcy or similar

circumstances, the relevant court and administrative authorities

would find the bank's exposure to be such a net amount under:

(i) The law of the jurisdiction in which the counterparty is

chartered or the equivalent location in the case of noncorporate

entities and, if a branch of the counterparty is involved, then also

under the law of the jurisdiction in which the branch is located;

(ii) The law that governs the individual contracts covered by

the netting contract; and

(iii) The law that governs the netting contract.

(c) The bank establishes and maintains procedures to ensure that

the legal characteristics of netting contracts are kept under review

in the light of possible changes in relevant law.

(d) The bank maintains in its files documentation adequate to

support the netting of rate contracts, including a copy of the

bilateral netting contract and necessary legal opinions.

(2) A contract containing a walkaway clause is not eligible for

netting for purposes of calculating the credit equivalent

amount.41

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


 

\4\1For purposes of this section, a walkaway clause means a

provision in a netting contract that permits a non-defaulting

counterparty to make lower payments than it would make otherwise

under the contract, or no payment at all, to a defaulter or to the

estate of a defaulter, even if a defaulter or the estate of a

defaulter is a net creditor under the contract.

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


 

(3) By netting individual contracts for the purpose of

calculating its credit equivalent amount, a bank represents that it

has met the requirements of this appendix A and all the appropriate

documents are in the bank's files and available for inspection by

the FDIC. Upon determination by the FDIC that a bank's files are

inadequate or that a netting contract may not be legally enforceable

under any one of the bodies of law described in paragraphs (b)(i)

through (iii) of this section, underlying individual contracts may

be treated as though they were not subject to the netting contract.

(4) The credit equivalent amount of rate contracts that are

subject to a qualifying bilateral netting contract is calculated by

adding (i) the current exposure of the netting contract and (ii) the

sum of the estimates of the potential future credit exposures on all

individual contracts subject to the netting contract.

(5) The current exposure of the netting contract is determined

by summing all positive and negative mark-to-market values of the

individual contracts included in the netting contract. If the net

sum of the mark-to-market values is positive, then the current

exposure of the netting contract is equal to that sum. If the net

sum of the mark-to-market values is zero or negative, then the

current exposure of the netting contract is zero.

(6) For each individual contract included in the netting

contract, the potential future credit exposure is estimated in

accordance with section II.E.1. of this appendix A.42

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


 

\4\2For purposes of calculating potential future credit exposure

for foreign exchange contracts and other similar contracts in which

notional principal is equivalent to cash flows, total notional

principal is defined as the net receipts to each party falling due

on each value date in each currency.

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


 

(7) Examples of the calculation of credit equivalent amounts for

these types of contracts are contained in Table IV.

* * * * *

3. Appendix A to part 325 is amended by removing the last three

sentences of the last paragraph under the heading ``Credit Conversion

for Interest Rate and Foreign Exchange Rate Related Contracts'' in

Table III and adding in their place two new sentences and by adding new

Table IV to read as follows:

* * * * *


 

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


 

* * * * *


 

Credit Conversion for Interest Rate and Foreign Exchange Rate

Related Contracts


 

* * * * *

* * * In the event a netting contract covers transactions that

are normally not included in the risk-based ratio calculation--for

example, exchange rate contracts with an original maturity of

fourteen calendar days or less or instruments traded on exchanges

that require daily payment of variation margin--an institution may

elect to consistently either include or exclude all mark-to-market

values of such transactions when determining a net current exposure.

Multiple contracts with the same counterparty may be netted for

risk-based capital purposes pursuant to section II.E.3. of this

appendix.


 

Table IV--Calculation of Credit Equivalent Amounts for Interest Rate and Foreign Exchange Rate Related

Transactions for State Nonmember Banks

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

Potential + Current =

exposure ---------------------------- exposure --------------

Type of contract (remaining -------------- -------------- Credit

maturity) Notional Conversion Potential Current equivalent

principal factor exposure Mark-to- exposure amount

(dollars) (dollars) market value (dollars)

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

(1) 120-day forward foreign

exchange................... 5,000,000 .01 50,000 100,000 100,000 150,000

(2) 120-day forward foreign

exchange................... 6,000,000 .01 60,000 -120,000 0 60,000

(3) 3-year interest rate

swap....................... 10,000,000 .005 50,000 200,000 200,000 250,000

(4) 3-year interest rate

swap....................... 10,000,000 .005 50,000 -250,000 0 50,000

(5) 7-year foreign exchange

swap....................... 20,000,000 .05 1,000,000 -1,300,000 0 1,000,000

Total................. ............ ............ 1,210,000 ............ 300,000 1,510,000

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


 

If contracts (1) through (5) above are subject to a qualifying

bilateral netting contract, then the following applies:


 

 

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

Potential

future Net current Credit

exposure (from exposure\1\ equivalent

above) amount

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

(1)................. 50,000

(2)................. 60,000

(3)................. 50,000

(4)................. 50,000

(5)................. 1,000,000

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

Total......... 1,210,000 + 0 = 1,210,000

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

\1\The total of the mark-to-market values from above is -1,370,000.

Since this is a negative amount, the net current exposure is zero.


 

* * * * *

By order of the Board of Directors.


 

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


 

Federal Deposit Insurance Corporation.

Robert E. Feldman,

Acting Executive Secretary.

[FR Doc. 94-31826 Filed 12-27-94; 8:45 am]

BILLING CODE 6714-01-P