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Federal Reserve Bank

OF DALLAS
ROBERT

D. M C T E E R , J R .

DALLAS, TEXAS
75265-590 6

PRESIDEN T
AND CHIEF EX ECUTIVE O F F IC E R

June 1, 1994

Notice 94-57

TO:

The Chief Executive Officer of each
member bank and others concerned in
the Eleventh Federal Reserve District
SUBJECT

Request for Comments on Proposed
Amendments to the Risk-based
Capital Guidelines
DETAILS

The Board of Governors of the Federal Reserve System is requesting
public comment on a proposal that would amend the Federal Res e r v e ’s risk-based
capital guidelines for state member banks and bank holding companies to
recognize the risk-reducing benefits of netting arrangements. This proposal
was issued jointly with the Office of the Comptroller of the Currency, which
is seeking comment on a similar amendment to its capital guidelines for
national banks.
Under the proposed amendment, institutions would be permitted to
net, for risk-based capital purposes, the current exposures of interest and
exchange rate contracts subject to qualifying bilateral netting contracts.
The proposed amendment would allow state member banks and bank holding
companies to net positive and negative mark-to-market values of rate contracts
in determining the current exposure portion of the credit equivalent amount of
such contracts to be included in risk-weighted assets.
This proposal is based on a proposed revision to the Basle Accord
that would allow the recognition of such netting arrangements.
The Board must receive comments by
be addressed to William W. Wiles, Secretary,
Reserve System, 20th Street and Constitution
20551. All comments should refer to Docket

June 20, 1994. Comments should
Board of Governors of the Federal
Avenue, N.W., Washington, D.C.
No. R-0837.

ATTACHMENT

A copy of the joint notice (Federal Reserve System Docket No.
R-0837) is attached.

For additional copies, bankers and others are encouraged to use one of the following toll-free numbers in contacting the Federal Reserve Bank of Dallas:
Dallas Office (800) 333-4460; El Paso Branch Intrastale (800) 592-1631, Interstate (800) 351-1012; Houston Branch Intrastate (800) 392-4162,
Interstate (800) 221-0363; San Antonio Branch Intrastate (800) 292-5810.

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)

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2

-

MORE INFORMATION
For more information, please contact Dorsey Davis at (214) 922-6051.
For additional copies of this B a n k ’s notice, please contact the Public Affairs
Department at (214) 922-5254.
Sincerely yours,

DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Part 3
Docket No. 94-08
RIN 1557—AB14
FEDERAL RESERVE SYSTEM
12 CFR Parts 208 and 225
Docket No. R-0837
Risk-Based Capital Standards; Bilateral Netting Requirements

AGENCIES:

Office of the Comptroller of the Currency (OCC),

Department of the Treasury; and Board of Governors of the Federal
Reserve System (Board).
ACTION:

Notice of proposed rulemaking.

SUMMARY:

The OCC and the Board (the banking agencies) are

proposing to amend their risk-based capital standards to
recognize the risk reducing benefits of netting arrangements.
Under the proposal, institutions regulated by the OCC and the
Federal Reserve would be permitted to net, for risk-based capital
purposes, interest and exchange rate contracts (rate contracts)
subject to legally enforceable bilateral netting contracts that
meet certain criteria.

The OCC and the Board are proposing these

amendments on the basis of proposed revisions to the Basle Accord
which would permit the recognition of such netting arrangements.
The effect of the proposed amendments would be to allow banks and
bank holding companies regulated by the OCC and the Federal
Reserve (banking organizations, institutions) to net positive and
negative mark-to-market values of rate contracts in determining
the current exposure portion of the credit equivalent amount of
such contracts to be included in risk-weighted assets.

2
DATES:

Comments must be received by June 20, 1994.

ADDRESSES:

Interested parties are invited to submit written

comments to either or both of the banking agencies.

All comments

will be shared by the banking agencies.
OCC:

Written comments should be submitted to Docket

No. 94-08, Communications Division, Ninth Floor, Office of the
Comptroller of the Currency, 250 E Street, S.W., Washington, D.C.
20219.

Attention:

Karen Carter.

Comments will be available for

inspection and photocopying at that address.
Board of Governors:

Comments, which should refer to

Docket No. R-0837, may be mailed to Mr. William W. Wiles,
Secretary, Board of Governors of the Federal Reserve System, 20th
Street and Constitution Avenue, N.W., Washington, D.C. 20551; or
delivered to Room B-2223, Eccles Building, between 8:45 a.m. and
5:15 p.m. weekdays.

Comments may be inspected in Room MP-500

between 9:00 a.m. and 5:00 p.m. weekdays, except as provided in
section 261.8 of the Board's Rules Regarding Availability of
Information, 12 CFR 261.8.

FOR FURTHER INFORMATION CONTACT:
OCC:

For issues relating to netting and the

calculation of risk-based capital ratios, Roger Tufts, Senior
Economic Advisor (202/874-5070), Office of the Chief National
Bank Examiner.

For legal issues, Eugene Cantor, Senior Attorney,

Securities, Investments, and Fiduciary Practices (202/874-5210),
or Ronald Shimabukuro, Senior Attorney, Bank Operations and Asset

Division (202/874-4460), Office of the Comptroller of the
Currency, 250 E Street, S.W., Washington, D.C. 20219.
Board of Governors:

Roger Cole, Deputy Associate

Director (202/452-2618), Norah Barger, Manager (202/452-2402),
Robert Motyka, Supervisory Financial Analyst (202/452-3621),
Barbara Bouchard, Senior Financial Analyst (202/452-3072),
Division of Banking Supervision and Regulation; or Stephanie
Martin, Senior Attorney (202/452-3198), Legal Division.

For the

hearing impaired only. Telecommunications Device for the Deaf,
Dorothea Thompson (202/452-3544).
SUPPLEMENTARY INFORMATION:
A. Background
The international risk-based capital standards (Basle
Accord)1 include a framework for calculating risk-weighted
assets by assigning assets and off-balance sheet items, including
interest and exchange rate contracts, to broad risk categories
based primarily on credit risk.

The OCC and the Federal Reserve

both adopted in 1989 similar frameworks to assess the capital
adequacy of the banking organizations under their supervision.
Banking organizations must hold capital against their overall
credit risk, that is, generally, against the risk that a loss
x
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.

4
will be incurred if a counterparty defaults on a transaction.
Under the risk-based capital framework, off-balance
sheet items are incorporated into risk-weighted assets by first
determining the on-balance sheet credit equivalent amounts for
the items and then assigning the credit equivalent amounts to the
appropriate risk category according to the obligor, or if
relevant, the guarantor or the nature of the collateral.

For

many types of off-balance sheet transactions, the on-balance
sheet credit equivalent amount is determined by multiplying the
face amount of the item by a credit conversion factor.

For

interest and exchange rate contracts however, credit equivalent
amounts are determined by summing two amounts:

the current

exposure and the estimated potential future exposure.2
The current exposure (sometimes referred to as
replacement cost) of a contract is derived from its market value.
In most instances the initial market value of a contract is
zero.3

A banking organization should mark-to-market all of its

rate contracts to reflect the current market value of the

2
Exchange rate contracts with an original maturity of 14
calendar days or less and instruments traded on exchanges that
require daily payment of variation margin are excluded from the
risk-based ratio calculations.
3
An options contract has a positive value at inception,
which reflects the premium paid by the purchaser. The value of
the option may be reduced due to market movements but it cannot
become negative. Therefore, unless an option has zero value,
the purchaser of the option contract will always have some credit
exposure, which may be greater than or less than the original
purchase price, and the seller of the option contract will never
have credit exposure.

contracts in light of changes in the market price of the
contracts or in the underlying interest or exchange rates.
Unless the market value of a contract is zero, one party will
always have a positive mark-to-market value for the contract,
while the other party (counterparty) will have a negative markto-market value.
An institution holding a contract with a positive markto-market value is Hin-the-money," that is, it would have the
right to receive payment from the counterparty if the contract
were terminated.

Thus, an institution that is in-the-money on a

contract is exposed to counterparty credit risk, since the
counterparty could fail to make the expected payment.

The

potential loss is equal to the cost of replacing the terminated
contract with a new contract that would generate the same
expected cash flows under the existing market conditions.
Therefore, the in-the-money institution's current exposure on the
contract is equal to the market value of the contract.
An institution holding a contract with a negative markto-market value, on the other hand, is wout-of-the-money" on that
contract, that is, if the contract were terminated, the
institution would have an obligation to pay the counterparty.
The institution with the negative mark-to-market value has no
counterparty credit exposure because it is not entitled to any
payment from the counterparty in the case of counterparty
default.

Consequently, a contract with a negative market value

is assigned a current exposure of zero.

A current exposure of

6

zero is also assigned to a contract with a market value of zero,
since neither party would suffer a loss in the event of contract
termination.

In summary, the current exposure of a rate contract

equals either the positive market value of the contract or zero.
The second part of the credit equivalent amount for
rate contracts, the estimated potential future exposure (often
referred to as the add-on), is an amount that represents the
potential future credit exposure of a contract over its remaining
life.

This exposure is calculated by multiplying the notional

principal amount of the underlying contract by a credit
conversion factor that is determined by the remaining maturity of
the contract and the type of contract.*

The potential future

credit exposure is calculated for all contracts, regardless of
whether the mark-to-market value is zero, positive, or negative.
The potential future exposure is added to the current
exposure to arrive at a credit equivalent amount.5

Each credit

*For interest rate contracts with a remaining maturity of
one year or less, the factor is 0% and for those with a remaining
maturity of over one year, the factor is .5%. For exchange rate
contracts with a remaining maturity of one year or less, the
factor is 1% and for those with a remaining maturity of over one
year, the factor is 5%.
Because exchange rate contracts involve an exchange of
principal upon maturity and are generally more volatile, they
carry a higher conversion factor. No potential future credit
exposure is calculated for single-currency interest-rate swaps in
which payments are made based on two floating indices (basis
swaps).
*This method of determining credit equivalent amounts for
rate contracts is known as the current exposure method, which is
used by most international banks. The Basle Accord permits,
subject to each country's discretion, an alternative method for
determining the credit equivalent amount known as the original

equivalent amount is then assigned to the appropriate risk
category, according to the counterparty or, if relevant, the
guarantor or the nature of the collateral.

The maximum risk

weight applied to such rate contracts is 50 percent.
B. Matting and Current Risk-Based Capital Treatment
The OCC, the Board, and the Basle Supervisors'
Committee have long recognized the importance and encouraged the
use of netting contracts as a means of improving interbank
efficiency and reducing counterparty credit exposure.

Netting

contracts are increasingly being used by institutions engaging in
rate contracts.

Often referred to as master netting contracts,

these arrangements typically provide for both payment and close­
out netting.

Payment netting provisions permit an institution to

make payments to a counterparty on a net basis by offsetting
payments it is obligated to make with payments

it is entitled

receive and, thus, to reduce its costs arising

to

out of payment

settlements.
Close-out netting provisions permit the netting of
credit exposures if a counterparty defaults or

upon the

occurrence of another event such as insolvency

or bankruptcy.

If

such an event occurs, all outstanding contracts subject to the

exposure method. Under this method, the capital charge is
derived by multiplying the notional principal amount of the
contract by a credit conversion factor, which varies according to
the original maturity of the contract and whether it is an
interest or exchange rate contract. The conversion factors,
which are greater than those used under the current exposure
method, make no distinction between current exposure and
potential future exposure.

8
close-out provisions are terminated and accelerated, and their
market values are determined.

The positive and negative market

values are then netted, or set off, against each other to arrive
at a single net exposure to be paid by one party to the other
upon final resolution of the default or other event.
The potential for close-out netting provisions to
reduce counterparty credit risk, by limiting an institution's
obligation to the net credit exposure, depends upon the legal
enforceability of the netting contract, particularly in
insolvency or bankruptcy.6

In this regard, the Basle Accord

noted that while close-out netting could reduce credit risk
exposure associated with rate contracts, the legal status of
close-out netting in many of the G-10 countries was uncertain and
insufficiently developed to support a reduced capital charge for
such contracts.7

There was particular concern that a bank's

credit exposure to a counterparty was not reduced if liquidators
of a failed counterparty might assert the right to "cherry-pick,"
that is, demand performance on those contracts that are favorable
®The primary criterion for determining whether a particular
netting contract should be recognized in the risk-based capital
framework is the enforceability of that netting contract in
insolvency or bankruptcy.
In addition, the netting contract as
well as the individual contracts subject to the netting contract
must be legally valid' and enforceable under non-insolvency or
non-bankruptcy law, as is the case with all contracts.
7
While payment netting provisions can reduce costs and the
credit risk arising out of daily settlements with a counterparty,
such provisions are not relevant to the risk-based capital
framework since they do not in any way affect the counterparty's
gross obligations.

and reject contracts that are unfavorable to the defaulting
party.
Concern over "cherry-picking" led the Basle
Supervisors' Committee to limit the recognition of netting in the
Basle Accord.

The only type of netting that was considered to

genuinely reduce counterparty credit risk at the time the Accord
was endorsed was netting accomplished by novation.8 Under
legally enforceable netting by novation "cherry-picking" cannot
occur and, thus, counterparty risk is genuinely reduced.

The

Accord stated that the Basle Supervisors' Committee would
continue to monitor and assess the effectiveness of other forms
of netting to determine if close-out netting provisions could be
recognized for risk-based capital purposes.
The OCC and the Board's risk-based capital standards
provide for the same treatment of rate contracts as the Basle
Accord, but require that banking organizations use the current
exposure method.

The banking agencies, in adopting their

standards, generally stated they would work with the Basle
Supervisors' Committee in its continuing efforts with regard to
the recognition of netting provisions for capital purposes.
8
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. Parties to the novation
contract, in effect, offset their obligations to make payments on
individual transactions subject to the novation contract with
their right to receive payments on other transactions subject to
the contract.

10
C. Basis Supervisors* committee Proposal
Since the Basle Accord was adopted, a number of studies
have confirmed that close-out netting provisions can serve to
reduce counterparty risk.

In response to the conclusions of

these studies, as well as to industry support for greater
acceptance of netting contracts under the risk-based capital
framework, the Basle Supervisors' Committee issued a consultative
paper on April 30, 1993, proposing an expanded recognition of
netting arrangements in the Basle Accord.9 Under the proposal,
for purposes of determining the current exposure of rate
contracts subject to legally enforceable bilateral close-out
netting provisions (that is, close-out netting provisions with a
single counterparty), an institution could net the contracts'
positive and negative mark-to-market values.
Specifically, the Basle proposal states that a banking
organization would be able to net rate contracts subject to a
legally valid bilateral netting contract for risk-based capital
purposes if it satisfied the appropriate national supervisor(s)
that:
(1) in the event of a counterparty's failure to perform
due to default, bankruptcy or liquidation, the banking
organization's claim (or obligation) would be to
®The paper is entitled "The Prudential Supervision of
Netting, Market Risks and Interest Rate Risk." The section
applicable to netting is subtitled "The Supervisory Recognition
of Netting for Capital Adequacy Purposes." This paper is
available for review through the banking agencies' Freedom of
Information Offices (FOIA) or through public information offices
at the Federal Reserve Banks or OCC District Offices.

receive (or pay) only the net value of the sun of
unrealized gains and losses on included transactions;
(2) it has obtained written and reasoned legal opinions
stating that in the event of legal challenge, the
netting would be upheld in all relevant jurisdictions;
and
(3) it has procedures in place to ensure that the
netting arrangements are kept under review in light of
changes in relevant law.
The Basle Supervisors' Committee agreed that if a
national supervisor is satisfied that a bilateral netting
contract meets these minimum criteria, the netting contract may
be recognized for risk-based capital purposes without raising
safety and soundness concerns.

The Basle Supervisors'

Committee's proposal includes a footnote stating that if any of
the relevant supervisors is dissatisfied with the status of the
enforceability of a netting contract under its laws, the netting
contract would not be recognized for risk-based capital purposes
by either counterparty.
In addition, the Basle Supervisors' Committee is
proposing that any netting contract that includes a walkaway
clause be disqualified as an acceptable netting contract for
risk-based capital purposes.

A walkaway clause is a provision in

a netting contract that permits the non-defaulting counterparty
to make only limited payments, or no payments at all, to the
defaulter or the estate of the defaulter even if the defaulter is

12
a net creditor under the contract.
Under the proposal, a banking organization would
calculate one current exposure under each qualifying bilateral
netting contract.

The current exposure would be determined by

adding together (netting) the positive and negative market values
for all individual interest rate and exchange rate contracts
subject to the netting contract.

If the net market value is

positive, that value would equal the current exposure.

If the

net market value is negative or zero, the current exposure would
be zero.

The add-on for potential future credit exposure would

be determined by calculating individual potential future
exposures for each underlying contract subject to the netting
contract in accordance with the procedure already in place in the
Basle Accord.1
0

A banking organization would then add together

the potential future credit exposure (always a positive value) of
each individual contract subject to the netting contract to
arrive at the total potential future exposure it has under those
contracts with the counterparty.

The total potential future

exposure would be added to the net current exposure to arrive at
one credit equivalent amount that would be assigned to the
appropriate risk category.
1 Under the proposal, a banking organization could net in
0
this manner for risk-based capital purposes if it uses, as all
U.S. banking organizations are required to use, the current
exposure method for calculating credit equivalent amounts of rate
contracts. Organizations using the original exposure method
would use revised conversion factors until market risk-related
capital requirements are implemented, at which time the original
exposure method will no longer be available for netted
transactions.

13
D. Th« Banking Agencies' Proposal
The OCC and the Board concur with the Basle
Supervisors' Committee's determination that the legal status of
close-out netting provisions has developed sufficiently to
support the expanded recognition of such provisions for riskbased capital purposes.

Therefore, the banking agencies are

proposing to amend their respective risk-based capital standards
in a manner consistent with the Basle Supervisors' Committee's
proposed revision to the Basle Accord.

The banking agencies'

proposed amendments would allow banking organizations regulated
by the OCC and the Federal Reserve to 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 netting
contract.
The banking agencies' proposed amendments would add
provisions to their standards setting forth criteria for a
qualifying bilateral netting contract and an explanation of how
the credit equivalent amount should be calculated for such
contracts.

The risk-based capital treatment of an individual

contract that is not subject to a qualifying bilateral netting
contract would remain unchanged.
For interest and exchange rate contracts that are
subject to a qualifying bilateral netting contract under the
proposed standards, the credit equivalent amount would equal the
sum of (i) the current exposure of the netting contract and (ii)

14
the total of the add-ons for all individual contracts subject to
the netting contract.

(As with all contracts, mark-to-market

values for netted contracts would be measured in dollars,
regardless of the currency specified in the contract.)

The

*current exposure of the bilateral netting contract would be
determined by adding together all positive and negative mark-tomarket values of the individual contracts subject to the
bilateral netting contract.1
1

The current exposure would equal

the sum of the market values if that sum is positive, or zero if
the sum of the market values is zero or negative.

The potential

future exposure (add-on) for each individual contract subject to
the bilateral netting contract would be calculated in the same
manner as for non-netted contracts.

These individual potential

future exposures would then be added together to arrive at one
total add-on amount.
The proposed amendments provide that a banking
organization may net, for risk-based capital purposes, interest
and exchange rate contracts only under a written bilateral
netting contract that creates a single legal obligation covering
all included individual rate contracts and that does not contain
u For regulatory capital purposes, the agencies would expect
that institutions would normally calculate the current exposure
of a bilateral netting contract by consistently including all
contracts covered by that netting contract.
In the event a
netting contract covers transactions that are normally excluded
from 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— institutions may elect to
consistently either include or exclude all mark-to-market values
of such transactions when determining net current exposures.

15
a walkaway clause.

In addition, if a counterparty fails to

perform due to default, insolvency, bankruptcy, liquidation or
similar circumstances, the banking organization must have a claim
to receive a payment, or an obligation to make a payment, for
only the net amount of the sum of the positive and negative
market values on included individual contracts.
The banking agencies' proposal requires that a banking
organization obtain a written and reasoned legal opinion(s),
representing that an organization's claim or obligation, in the
event of a legal challenge, including one resulting from default,
insolvency, bankruptcy, or similar circumstances, would be found
by the relevant court and administrative authorities to be the
net sum of all positive and negative market values of contracts
included in the bilateral netting contract.1
2
normally would cover:

The legal opinion

(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

1 The Financial Accounting Standards Board (FASB) has issued
2
Interpretation No. 39 (FIN 39) relating to the "Offsetting of
Amounts Related to Certain Contracts." FIN 39 generally provides
that assets and liabilities meeting specified criteria may be
netted under generally accepted accounting principles (GAAP).
However, FIN 39 does not specifically require a written and
reasoned legal opinion regarding the enforceability of the
netting contract in bankruptcy and other circumstances.
Therefore, under this proposal a banking organization might be
able to net certain contracts in accordance with FIN 39 for GAAP
reporting purposes, but not be able to net those contracts for
risk-based capital purposes.

16
contracts covered by the bilateral netting contract; and (iii)
the law that governs the netting contract.

The multiple

jurisdiction requirement is designed to ensure that the netting
contract would be upheld in any jurisdiction where the contract
would likely be enforced or whose law would likely be applied in
an enforcement action, as well as the jurisdiction where the
counterparty's assets reside.
A legal opinion could be prepared by either an outside
law firm or in-house counsel.

If a banking organization obtained

an opinion on the enforceability of a bilateral netting contract
that covered a variety of underlying contracts, it generally
would not need a legal opinion for each individual underlying
contract that is subject to the netting contract, so long as the
individual underlying contracts were of the type contemplated by
the legal opinion covering the netting contract.
The complexity of the legal opinions will vary
according to the extent and nature of the organization's
involvement in rate contracts.

For instance, a banking

organization that is active in the international financial
markets may need opinions covering multiple foreign jurisdictions
as well as domestic law.

The banking agencies expect that in

many cases a legal opinion will focus on whether a contractual
choice of law would be recognized in the event of default,
insolvency, bankruptcy or similar circumstances in a particular
jurisdiction rather than whether the jurisdiction recognizes
netting.

For example, a U.S. institution might engage in

17
interest rate swaps with a non-U.S. institution under a netting
contract that includes a provision that the contract will be
governed by U.S. law.

In this case the U.S. institution should

obtain a legal opinion as to whether the netting would be upheld
in the U.S. and whether the foreign courts would honor the choice
of U.S. law in default or in an insolvency, bankruptcy, or
similar proceeding.
For a banking organization that engages solely in
domestic rate contracts, the process of obtaining a legal opinion
may be much simpler.

For example, for an institution that is an

end-user of a relatively small volume of domestic rate contracts,
the standard contracts used by the dealer bank may already have
been subject to the mandated legal review.

In this case the end-

user institution may obtain a copy of the opinion covering the
standard dealer contracts, supported by the bank's own legal
opinion.
The proposed amendments require a banking organization
to establish procedures to ensure that the legal characteristics
of netting contracts are kept under review in the light of
possible changes in relevant law.

This review would apply to any

conditions that, according to the required legal opinions, are a
prerequisite for the enforceability of the netting contract, as
well as to any adverse changes in the law.
As with all of the provisions of the risk-based capital
standards, a banking organization must maintain in its files
documentation adequate to support any particular risk-based

18
capital treatment.

In the case of a bilateral netting contract,

a banking organization must maintain in its files documentation
adequate to support the bilateral netting contract.

In

particular, this documentation should demonstrate that the
bilateral netting contract would be honored in all relevant
jurisdictions as set forth in this rule.

Typically, these

documents would include a copy of the bilateral netting contract,
legal opinions and any related English translations.
The banking agencies would have the discretion to
disqualify any or all contracts from netting treatment for riskbased capital purposes if the bilateral netting contract,
individual contracts, or associated legal opinions do not meet
the requirements set out in the applicable standards.

In the

event of such a disqualification, the affected individual
contracts subject to the bilateral netting contract would be
treated as individual non-netted contracts under the standards.
As a general matter, relevant legal provisions for
banking organizations in the U.S. make it clear that netting
contracts with close-out provisions enable such organizations to
setoff included individual transactions and reduce the
obligations to a single net amount in the event of default,
insolvency, bankruptcy, liquidation or similar circumstances.
The banking agencies' proposal provides that netting
by novation arrangements would not be grandfathered under the
standards if such arrangements do not meet all of the
requirements proposed for qualifying bilateral netting contracts.

19
Although netting by novation would continue to be recognized
under the proposed standards, institutions may not have the legal
opinions or procedures in place that would be required by the
proposed amendments.

The banking agencies believe that holding

all bilateral netting contracts to the same standards will
promote certainty as to the legal enforceability of the contracts
and decrease the risks faced by counterparties in the event of a
default.
E. Request for Comment
The banking agencies are seeking comment on all aspects
of their proposed amendments to the risk-based capital standards.
In addition, the agencies note that under current risk-based
capital standards for individual contracts, the degree to which
collateral is recognized in assigning the appropriate risk weight
is based on the market value of the collateral in relation to the
credit equivalent amount of the rate contract.

The agencies are

seeking comment on the nature of collateral arrangements and the
extent to which collateral might be recognized in bilateral
netting contracts, particularly taking into account legal
implications of collateral arrangements (e.g., whether the
collateral pledged for an individual transaction would be
available to cover the net counterparty exposure in the event of
legal challenge) and procedural difficulties in monitoring
collateral levels.
Regulatory Flexibility Act Analysis
Pursuant to section 605(b) of the Regulatory

20
Flexibility Act, the banking agencies hereby certify that this
proposed rule will not have a significant impact on a substantial
number of small business entities.

Accordingly, a regulatory

flexibility analysis is not required.
The banking agencies believe that a small institution
is more likely than a large institution to enter into relatively
uncomplicated transactions under standard bilateral netting
contracts and may need only to review a legal opinion that has
already been obtained by its counterparties.
Executive Order 12866
It has been determined that this proposal is not a
significant regulatory action as defined in Executive Order
12866.
Paperwork Reduction Act
The Federal Reserve has determined that its proposed
amendments, if adopted, would not increase the regulatory
paperwork burden of banking organizations pursuant to the
provisions of the Paperwork Reduction Act (44 U.S.C. 3501 et
sea.).

The OCC has determined that there are no reporting or

recordkeeping requirements in its proposed amendments;
accordingly, the provisions of the Paperwork Reduction Act do not
apply.
List of Subjects
12 CFR Part 3
Administrative practice and procedure, Capital,
National banks, Reporting and recordkeeping requirements, Risk.

21
12 CFR Part 208
Accounting, Agriculture, Banks, banking, Branches,
Capital adequacy, Confidential business information, Currency,
Reporting and recordkeeping requirements, Securities, State
member banks.
12 CFR Part 225
Administrative practice and procedure, Banks, banking,
Capital adequacy, Holding companies, Reporting and recordkeeping
requirements, Securities.

COMPTROLLER OF THE CURRENCY

AUTHORITY AND ISSUANCE:
For the reasons set out in the preamble, appendix A to
part 3 of title 12, chapter I of the Code of Federal Regulations
is proposed to be amended as set forth below.

PART 3— MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES
1.

The authority citation for part 3 is revised to

read as follows:
AUTHORITY:

12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note,

1831n note, 3907 and 3909.
2.

In appendix A, paragraph (c)(15) of section 1 is

removed, paragraphs (c)(16) through (c)(28) are redesignated as
paragraphs (c)(15) through (c)(27), and a new paragraph (c)(28)
is added to read as follows:

22
APPENDIX A— RISK-BASED CAPITAL GUIDELINES
* *

*

*

*

Section 1. Purpose. Applicability of Guidelines, and Definitions.
* * * * *
(c) * * *
(28) Walkawav clause means a provision in a bilateral
netting contract that permits a nondefaulting counterparty to
make a lower payment than it would make otherwise under the
bilateral netting contract, or no payment at all, to a defaulter
or the estate of a defaulter, even if a defaulter or the estate
of a defaulter is a net creditor under the bilateral netting
contract.
3.

In appendix A, paragraph (b)(5) of section 3 is

revised to read as follows:
Section 3. Risk Categories/Weights for On-Balance Sheet Assets
and Off-Balance Sheet Items
* * * * *
(b) * * *
(5) Off-Balance Sheet Contracts— Interest Rate and
Foreign Exchange Rate Contracts.
(i) Calculation of credit equivalent amounts.

The credit

equivalent amount of an off-balance sheet interest rate or
foreign exchange rate contract is equal to the sum of the current
credit exposure (also referred to as the replacement cost) and
the potential future credit exposure of the off-balance sheet
rate contract.

The calculation of credit equivalent amounts must

23
be measured in U.S. dollars, regardless of the currency or
currencies specified in the off-balance sheet rate contract.
(A) Current credit exposure. The current credit
exposure for a single off-balance sheet rate contract is
determined by the mark-to-market value of the off-balance sheet
rate contract.

If the mark-to-market value is positive, then the

current exposure is equal to that mark-to-market value.

If the

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

However, in determining its current credit

exposure for multiple off-balance sheet rate contracts executed
with a single counterparty, a bank may net positive and negative
mark-to-market values of off-balance sheet rate contracts if
subject to a bilateral netting contract as provided by section
3(b)(5)(ii) of this appendix A.

If the net mark-to-market value

is positive, then the current credit exposure is equal to that
net mark-to-market value.

If the net mark-to-market value is

zero or negative, then the current exposure is zero.
(B) Potential future credit exposure.

The potential

future credit exposure on an off-balance sheet rate contract,
including contracts with negative mark-to-market values, is
estimated by multiplying the notional principal1 * by one of the
8

1 *For purposes of calculating potential future credit
8
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.

24
following credit conversion factors, as appropriate:1
8

Remaining Maturity

One year or less. . . .
Over one year ........

Interest Rate
Contracts
(Percents)

Foreign Exchange Rate
Contracts
(Percents)
1.0
5.0

(ii) Off-balance sheet rate contracts subject to bilateral
netting contracts.

In determining its current credit exposure

for multiple off-balance sheet rate contracts executed with a
single counterparty, a bank may net off-balance sheet rate
contracts subject to a bilateral netting contract by offsetting
positive and negative mark-to-market values, provided that:
(A) The bilateral netting contract is in writing;
(B) The bilateral netting contract creates a single
legal obligation for all individual off-balance sheet rate
contracts covered by the bilateral netting contract, and
provides, in effect, that the bank would have a single claim or
obligation either to receive or pay only the net amount of the
sum of the positive and negative mark-to-market values on the
individual off-balance sheet contracts covered by the bilateral
netting contract in the event that a counterparty, or a
counterparty to whom the bilateral netting contract has been
validly assigned, fails to perform due to any of the following
1 No potential future credit exposure is calculated for
9
single currency interest rate swaps in which payments are made
based upon two floating rate indices, so-called floating/floating
or basis swaps; the credit equivalent amount is measured solely
on the basis of the current credit exposure.

25
events:

default, insolvency, bankruptcy, or other similar

circumstances.
(C) The bank obtains a written and reasoned legal
opinion(s) that represents that in the event of a legal
challenge, including one resulting from default, insolvency,
bankruptcy, or similar circumstances, the relevant court and
administrative authorities would find the bank's exposure to be
the net amount under:
(I) The law of the jurisdiction in which the
counterparty is chartered or the equivalent location in the case
of noncorporate entities, and if a branch of the counterparty is
involved, then also under the law of the jurisdiction in which
the branch is located;
(II) The law that governs the individual off-balance
sheet rate contracts covered by the bilateral netting contract;
and
(III) The law that governs the bilateral netting
contract;
(D) The bank establishes and maintains procedures to
monitor possible changes in relevant law and to ensure that the
bilateral netting contract continues to satisfy the requirements
of this section; and
(E) The bank maintains in its files documentation
adequate to support the netting of an off-balance sheet rate

26
contract.1 a
9
(F)

The bilateral netting contract is not subject to a

walkaway clause.
(iii) Risk weighting.

Once the bank determines the credit

equivalent amount for an off-balance sheet rate contract, that
amount is assigned to the risk weight category appropriate to the
counterparty, or, if relevant, the nature of any collateral or
guarantee.

However, the maximum weight that will be applied to

the credit equivalent amount of such off-balance sheet rate
contracts is 50 percent.
(iv) Exceptions.

The following off-balance sheet rate contracts

are not subject to the above calculation, and therefore, are not
considered part of the denominator of a national bank's riskbased capital ratio:
(A) A foreign exchange rate contract with an original
maturity of 14 calendar days or less; and
(B) Any interest rate or foreign exchange rate contract
that is traded on an exchange requiring the daily payment of any
variations in the market value of the contract.

1,
9 By netting individual off-balance sheet rate contracts for
the purpose of calculating its credit equivalent amount, a bank
represents that documentation adequate to support the netting of
an off-balance sheet rate contract is in the bank's files and
available for inspection by the OCC. Upon determination by the
OCC that a bank's files are inadequate or that a bilateral
netting contract may not be legally enforceable under any one of
the bodies of law described in section 3 (b)(5)(ii)(C)(I) through
(III) of this appendix A, the underlying individual off-balance
sheet rate contracts may not be netted for the purposes of this
section.

27
* * * * *
3.

The table title and the introductory text to Table

3 are revised to read as follows:
TABLE 3— TREATMENT OF INTEREST RATE AND FOREIGN EXCHANGE RATE
CONTRACTS
The current exposure method is used to calculate the
credit equivalent amounts of these off-balance sheet rate
contracts.

These amounts are assigned a risk weight appropriate

to the obligor or any collateral or guarantee.
maximum risk weight is limited to 50 percent.

However, the
Multiple off-

balance sheet rate contracts with a single counterparty may be
netted if those contracts are subject to a qualifying bilateral
netting contract.
* * * * *

28

This signature page relates to the joint Notice of
Proposed Rulemaking titled Risk-Based Capital Standards;
Bilateral Netting Requirements, Office of the Comptroller of the
Currency, Department of the Treasury, Docket Number [94-08

Office of the Comptroller of the Currency

A/
/W

i
'
----

JZate

Eugene A ./Ludwig
Comptroller o£ the Currency

].

29

FEDERAL RESERVE SYSTEM

AUTHORITY AMD ISSUANCE:
For the reasons set out in the preamble, part 208

of

chapter II of title 12 of the Code of Federal Regulations is
proposed to be amended as set forth below.

PART 208— MEMBERSHIP OF STATE BANKING INSTITUTIONS

IN THE

FEDERAL RESERVE SYSTEM (REGULATION H)
1.

The authority citation for part 208 continues to

read as follows:
AUTHORITY:

12 U.S.C. 36, 248(a) and (c), 321-338a, 371d, 461,

481-486, 601, 611, 1814, 1823(j), 1828(0), 18310, 1831p-l, 3105,
3310, 3331-3351 and 3906-3909; 15 U.S.C. 78b, 781(b), 781(g),
781(i), 78o-4(c)(5), 78q, 78q-l and 78w; 31 U.S.C. 5318.

2.

Appendix A to part 208 is amended by revising

section III.E.2.; section III.E.3.; section III.E.5.; the last
sentence of Attachment IV; and Attachment V to read as follows:

APPENDIX A TO PART 208— CAPITAL ADEQUACY GUIDELINES FOR STATE
MEMBER BANKS:
* *

RISK-BASED MEASURE

* * *

III. Procedures for Computing Weighted Risk Assets and OffBalance Sheet Items

30
*

*

*

*

*

E. Interest Rate and Foreign Exchange Rate Contracts
*

*

*

*

*

2.

calculation of credit equivalent amounts.

credit equivalent amount of an off-balance sheet rate contract
that is not subject to a qualifying bilateral netting contract in
accordance with section III.E.5. of this appendix A is equal to
the sum of (i) the current exposure (sometimes referred to as the
replacement cost) of the contract and (ii) an estimate of the
potential future credit exposure over the remaining life of the
contract.
The current exposure is determined by the mark-tomarket value of the contract.

If the mark-to-market value is

positive, then the current exposure is equal to that mark-tomarket value.

If the mark-to-market value is zero or negative,

then the current exposure is zero.

Mark-to-market values are

measured in dollars, regardless of the currency or currencies
specified in the contract and should reflect changes in both
interest rates and counterparty credit quality.
The potential future credit exposure on a contract,
including contracts with negative mark-to-market values, is
estimated by multiplying the notional principal amount of the
contract by one of the following credit conversion factors, as
appropriate:

The

31
[in percent]
Interest
rate
contracts

Remaining Maturity
..

Over one year ........... ..

0
0.5

Exchange
rate
contracts
1.0
5.0

Examples of the calculation of credit equivalent
amounts for these instruments are contained in Attachment V of
this appendix A.
Because exchange rate contracts involve an exchange of
principal upon maturity, and exchange rates are generally more
volatile than interest rates, higher conversion factors have been
established for foreign exchange rate contracts than for interest
rate contracts.
No potential future credit exposure is calculated for
single currency interest rate swaps in which payments are made
based upon two floating rate indices, so-called floating/floating
or basis swaps; the credit exposure on these contracts is
evaluated solely on the basis of their mark-to-market values.
3.

Risk weights. Once the credit equivalent amount for

interest rate and exchange rate instruments has been determined,
that amottat is assigned to the risk weight category appropriate
to the counterparty, or, if relevant, the guarantor or the nature
of any collateral.*9 However, the maximum weight that will be
*
9For interest and exchange rate contracts, sufficiency of
collateral or guaranties is determined by the market value of the
collateral or the amount of the guarantee in relation to the
credit equivalent amount. Collateral and guarantees are subject

32
applied to the credit equivalent amount of such instruments is 50
percent.
* * * * *

5.

Netting.

For purposes of this appendix A, netting

refers to the offsetting of positive and negative mark-to-market
values when determining a current exposure to be used in the
calculation of a credit equivalent amount.

Any legally

enforceable form of bilateral netting (that is, netting with a
single counterparty) of 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, insolvency, bankruptcy, 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,
liquidation or similar circumstances, the relevant court and

to the same provisions noted under section III.B. of this
appendix A.

33
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.
A contract containing a walkaway clause is not eligible
for netting for purposes of calculating the credit equivalent
amount.5
0
By netting individual contracts for the purpose of

5 For purposes of this section, a walkaway clause means a
0
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.

34
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 Federal Reserve.

Upon determination by the

Federal Reserve 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 (b)(i) through (iii) above,
underlying individual contracts may be treated as though they
were not subject to the netting contract.
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

exposure on all individual contracts subject to the netting
contract.
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.
For each individual contract included in the netting
contract, the potential future credit exposure is estimated in

35
accordance with section E.2. of this appendix A.5
1
Examples of the calculation of credit equivalent
amounts for these types of contracts are contained in Attachment
V of this appendix A.
*

*

*

*

*

ATTACHMENT IV— CREDIT CONVERSION FACTORS FOR OFF-BALANCE SHEET
ITEMS FOR STATE MEMBER BANKS
* * * * *
*

* * Qualifying netting by novation contracts and other

qualifying bilateral netting contracts may be recognized.
* * * * *

5 For purposes of calculating potential future credit
1
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.

36

Attachment T— CALCULATION OF CREDIT EQUIVALENT AMOUNTS FOR INTEREST RATE AND FOREIGN EXCHANGE RATE RELATED
TRANSACTIONS FOR STATE MEMBER BANKS

+

Potential Exposure

Type of Contract
(Remaining Maturity)

Notional
principal

x

Potential
exposure

-

Current Exposure

Potential
exposure

Mark-tomarket

(dollars)

value1

Credit
equivalent
amount

Current
exposure
(dollars)2

(dollars)

conversion

(1) 120-day forward
foreign exchange... .

3,000,000

.01

30,000

100,000

(2) 120-day forward
foreign exchange... .

6,000,000

.01

60,000

-120,000

(3) 3-year single
currency fixed/floating
interest rate swap..
10,000,000

.005

50,000

200,000

(*) 3-year single
currency fixed/floating
interest rate swap..
10,000,000

.005

50,000

-250,000

0

50,000

(5) 7-year cross-currency
floating/floating
interest rate awap.. 20,000,000

.05

1,000,000

-1,300,000

0

1,000,000

TOTAL

100,000

0

200,000

1,210,000

300,000

150,000

60,000

250,000

1,510,000

If contracts (1) through (5) above are subject to a qualifying bilateral netting contract, than the
following eppliea:
Mark-to-market
value
(from above)

Potential Exposure
(dollars)
(from above)
(1)

50,000
60,000

-120,000

(3)

50,000

200,000

(*)

50,000

-250,000

(5)

1,000,000

-1,300,000

TOTAL

1,210,000

Credit
Equivalent
amount

100,000

(2)

Current Exposure
(dollars)

-1,370,000
+

TTEese nuoDara ara purely tor illustration.
2Tha larger of sero or a positive mark-to-market value.

0

1,210,000

37

FEDERAL RESERVE SYSTEM
AUTHORITY AMD ISSUANCE
For the reasons set out in the joint Notice of Proposed
Rulemaking, part 225 of chapter II of title 12 of the Code of
Federal Regulations is proposed to be amended as set forth below:

PART 225— BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL
(REGULATION Y)
1.

The authority citation for part 225 continues to

read as follows:
AUTHORITY:

12 U.S.C. 1817(j)(13), 1818(b), 1828(0), 1831i,

1843(c)(8), 1844(b), 1972(1), 3106, 3108, 3310, 3331-3351, 3907,
and 3909.
2.

Appendix A to part 225 is amended by revising

section III.E.2., section III.E.3.; section III.E.5.; the last
sentence of Attachment IV; and Attachment V to read as follows:
APPENDIX A TO PART 225— CAPITAL ADEQUACY GUIDELINES FOR BANK
HOLDING COMPANIES:

RISK-BASED MEASURE

* * * * *
III. PROCEDURES FOR COMPUTING WEIGHTED RISK ASSETS AND OFFBALANCE SHEET ITEMS
* * * * *
E.
* * * * *

Interest Rate and Foreign Exchange Rate Contracts

38
2.

Calculation of credit equivalent amounts.

credit equivalent amount of an off-balance sheet rate contract
that is not subject to a qualifying bilateral netting contract in
accordance with section III.E.5. of this appendix A is equal to
the sum of (i) the current exposure (sometimes referred to as the
replacement cost) of the contract and (ii) an estimate of the
potential future credit exposure over the remaining life of the
contract.
The current exposure is determined by the mark-tomarket value of the contract.

If the mark-to-market value is

positive, then the current exposure is equal to that mark-tomarket value.

If the mark-to-market value is zero or negative,

then the current exposure is zero.

Mark-to-market values are

measured in dollars, regardless of the currency or currencies
specified in the contract and should reflect changes in both
interest rates and counterparty credit quality.
The potential future credit exposure on a contract,
including contracts with negative mark-to-market values, is
estimated by multiplying the notional principal amount of the
contract by one of the following credit conversion factors, as
appropriate:
[in percent]

Remaining Maturity
One year or less ........ . .
Over one year ........... ,

Interest
rate
contracts
0
0.5

Exchange
rate
contracts
1.0
5.0

The

39
Examples of the calculation of credit equivalent
amounts for these instruments are contained in Attachment V of
this appendix A.
Because exchange rate contracts involve an exchange of
principal upon maturity, and exchange rates are generally more
volatile than interest rates, higher conversion factors have been
established for foreign exchange contracts than for interest rate
contracts.
No potential future credit exposure is calculated for
single currency interest rate swaps in which payments are made
based upon two floating rate indices, so-called floating/floating
or basis swaps; the credit exposure on these contracts is
evaluated solely on the basis of their mark-to-market values.
3.

Risk weights. Once the credit equivalent amount for

interest rate and exchange rate instruments has been determined,
that amount is assigned to the risk weight category appropriate
to the counterparty, or, if relevant, the guarantor or the nature
of any collateral.5
3

However, the maximum weight that will be

applied to the credit equivalent amount of such instruments is 50
percent.
* * * * *
5.

Netting.

For purposes of this appendix A, netting

5 For interest and exchange rate contracts, sufficiency of
3
collateral or guaranties is determined by the market value of the
collateral or the amount of the guarantee in relation to the
credit equivalent amount. Collateral and guarantees are subject
to the same provisions noted under section III.B. of this
appendix A.

refers to the offsetting of positive and negative mark-to-market
values when determining a current exposure to be used in the
calculation of a credit equivalent amount.

Any legally

enforceable form of bilateral netting (that is, netting with a
single counterparty) of 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
organization 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, insolvency, bankruptcy, or similar circumstances.
(b) The banking organization obtains a written and
reasoned legal opinion(s) representing that, in the event of
a legal challenge, including one resulting from default,
insolvency, bankruptcy, or similar circumstances, the
relevant court and administrative authorities would find the
organization'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

41
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 banking organization establishes and maintains
procedures to ensure that the legal characteristics of
netting contracts are kept under review in the light of
possible changes in relevant law.
(d) The banking organization 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.
A contract containing a walkaway clause is not eligible
for netting for purposes of calculating the credit equivalent
amount.5
4
By netting individual contracts for the purpose of
calculating its credit equivalent amount, a banking organization
represents that it has met the requirements of this appendix A
and all the appropriate documents are in the organization's files
and available for inspection by the Federal Reserve.

Upon

determination by the Federal Reserve that a banking
organization's files are inadequate or that a netting contract

5
*For purposes of this section, a walkaway clause means a
provision in a netting contract that permits a non-defaulting
counterparty to make lower payments than it would make otherwise
under the contract, or no payment at all, to a defaulter or the
estate of a defaulter, even if a defaulter or the estate of a
defaulter is a net creditor under the contract.

42
may not be legally enforceable under any one of the bodies of law
described in (b)(i) through (iii) above, underlying individual
contracts may be treated as though they were not subject to the
netting contract.
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

exposure on all individual contracts subject to the netting
contract.
The current exposure of the netting contract is
determined by summing all positive and negative mark-to-market
values of the individual transactions 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.
For each individual contract included in the netting
contract, the potential future credit exposure is estimated in
accordance with section E.2. of this appendix A.5
5
Examples of the calculation of credit equivalent
amounts for these types of contracts are contained in Attachment
“ For purposes of calculating potential future credit
exposure for foreign exchange contracts and other similar
contracts in which notional principal is equivalent to cash
flows, total notional principal is defined as the net receipts to
each party falling due on each value date in each currency.

43
V of this appendix A.
* * * * *
ATTACHMENT IV— CREDIT CONVERSION FACTORS FOR OFF-BALANCE SHEET
ITEMS FOR BANK HOLDING COMPANIES
* * * * *
*

* * Qualifying netting by novation contracts and other

qualifying bilateral netting contracts may be recognized.
* * * * *

44

Attachment V — CALCULATION OF CREDIT EQUIVALENT AMOUNTS FOR INTEREST RATE AND FOREIGN EXCHANGE RATE RELATED
TRANSACTIONS FOR BANK BOLDING COMPANIES

Current Exposure

Potential Exposure

Type of Contract
(Remaining Maturity)

Notional
principal
(dollars)

x

Potential
exposure
conversion

Potential
exposure
(dollars)

■

+

Mark-tomarket
valual

Credit
equivalent
amount

Current
1
exposure
(dollars)2

(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 single
currency fixed/floating
interest rata swap..
10,000,000

.005

50,000

200,000

200,000

250,000

(*) 3-year single
currency fixed/floating
interest rate swap..
10,000,000

.005

50,000

-250,000

0

50,000

(5) 7-year cross-currency
floating/floating
interest rate awap..
20,000,000

.05

1,000,000

-1,300,000

0

1,000,000

300,000

1,510,000

1,210,000

TOTAL

If contracts (1) through (5) above are subject to e qualifying bilateral netting contract, than the
following applies:
Mark-to-market
value
(from above)

Potential Exposure
(dollars)
(from above)
(1)

50,000
60,000

-120,000

(3)

50,000

200,000

(*>

50,000

-250,000

(5)

1,000,000

1,300,000

TOTAL

1,210,000

Credit
equivalent
amount

100,000

(2)

Current Exposure
(dollars)

-1,370,000
+

Ilhese numbers are purely tor illustration.
2Tha larger of zero or a positive mark-to-market value.

0

1,210,000

45

Board of Governors of the Federal Reserve System,
May 17, 1994.

[signed)

W. Wiles?

William W. Wiles,
Secretary of the Board.
[FR Doc. 94-00000 Filed 00-00-94; 8:45 am]
BILLING CODE 6210-01-P