[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