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Federal R eserve Bank
OF DALLAS
ROBERT
D. M c T E E R , J R .
S e n tp m h e r Q
1Q Q 4
O C p iC llIU C l
p re s id e n t
AND CHIEF EX ECU TIV E O F F IC E R
± yy*t
y ,
Da l l a s ,
texas
75265-5906
Notice 94-95
TO:
The Chief Executive Officer of each
m em ber bank and others concerned in
the Eleventh Federal Reserve District
SUBJECT
Request for Public Comment on a
Proposed Amendment to the Risk-based
Capital Guidelines
DETAILS
The Board of Governors of the Federal Reserve System has requested public
comment on a proposed amendment to the Board’s risk-based capital guidelines for state
m em ber banks and bank holding companies regarding the treatm ent of derivative
contracts.
The proposal would
1.
Revise and expand the set of conversion factors used to calculate the
potential future exposure of derivative contracts; and
2.
Recognize effects of netting arrangements in the calculation of potential
future exposure for derivative contracts subject to qualifying bilateral
netting arrangements.
The proposal is based on consultative proposals issued by the Basle Supervi
sors’ Committee on July 15, 1994.
The first part of the proposal would apply new higher conversion factors to
long-dated interest and exchange rate contracts (that is, those with a remaining maturity
of five years or more). The second part of the proposal builds upon the Board’s pending
proposal (and is contingent upon the adoption of a final amendment) to recognize
qualifying, legally enforceable bilateral netting arrangements in the calculation of current
exposure.
F or 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 Intrastate (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)
- 2 -
The Board must receive comments by October 21, 1994. Comments should
be addressed to William W. Wiles, Secretary, Board of Governors of the Federal
Reserve System, 20th Street and Constitution Avenue, N.W., Washington, D.C. 20551.
All comments should refer to Docket No. R-0845.
ATTACHMENT
A copy of the Board’s notice as it appears on pages 43508-17, Vol. 59, No.
163, of the Federal Register dated August 24, 1994, is attached.
MORE INFORMATION
For more information, please contact Dorsey Davis at (214) 922-6051. For
additional copies of this Bank’s notice, please contact the Public Affairs D epartm ent at
(214) 922-5254.
Sincerely yours,
PROPOSAL TO REVISE THE
RISK-BASED CAPITAL
GUIDELINES
(DOCKET R-0845)
43508
Federal Register / Vol. 59, No. 163 / W ednesday, August 24, 1994 / Proposed Rules
FEDERAL RESERVE SYSTEM
12 CFR Parts 208 and 225
[R egulations H an d Y; D ocket No. R-0845)
Capital; Capital Adequacy Guidelines
AGENCY: Board of Governors of the
Federal Reserve System.
ACTION: Notice of Proposed Rulemaking.
SUMMARY: The Board of Governors of the
Federal Reserve System is proposing to
amend its risk-based capital guidelines
for state member banks and bank
holding companies. The proposal would
revise and expand the set of conversion
factors used to calculate the potential
future exposure of derivative contracts
and recognize effects of netting
arrangements in the calculation of
potential future exposure for derivative
contracts subject to qualifying bilateral
netting arrangements.
The Board is proposing these
amendments on the basis of proposed
revisions to the Basle Accord
announced on July 15,1994. The effect
of the proposed amendments would be
twofold. First, long-dated interest rate
and exchange rate contracts would be
subject to new higher conversion factors
and new conversion factors would be
set forth that specifically apply to
derivative contracts related to equities,
precious metals, and other commodities.
Second, institutions w ould be permitted
to recognize a reduction in potential
future exposure for transactions subject
to qualifying bilateral netting
arrangements.
DATES: Comments m ust be received on
or before October 21,1994.
ADDRESSES: Comments should refer to
docket No. R-0845 and may be mailed
to William W. Wiles, Secretary, Board of
Governors of the Federal Reserve
System, 20th Street and Constitution
Avenue, N.W., W ashington, D.C. 20551.
Comments may also be delivered to
Room B-2222 of the Eccles Building
between 8:45 a.m. and 5:15 p.m.
weekdays, or to the guard station in the
Eccles Building courtyard on 20th
Street, N.W. (between Constitution
Avenue and C Street) at any time.
Comments may be inspected in Room
MP-500 of the Martin Building between
9:00 a.m. and 5:00 p.m. weekdays,
except as provided in 12 CFR 261.8 of
the Board’s Rules regarding availability
of information.
FOR FURTHER INFORMATION CONTACT:
Roger Cole, Deputy Associate Director
(202/452-2618), Norah Barger, Manager
(202/452-2402), Robert Motyka,
Supervisory Financial Analyst (202/4523621), Barbara Bouchard, Senior
Financial Analyst (202/452-3072),
Federal Register / Vol. 59, No. 163 / W ednesday, August 24, 1994 / Proposed Rules
possible loss equal to the mark-tomarket value.4 For risk-based capital
purposes, if the mark-to-market value is
zero or negative, then there is no
replacement cost associated w ith the
contract and the current exposure is
zero. The sum of current exposures for
SUPPLEMENTARY INFORMATION:
a defined set of contracts is sometimes
referred to as the gross current exposure
I. Background
for that set of contracts.
The international risk-based capital
The Basle Accord, as endorsed in
standards (the Basle A ccord)1 set forth
1988, provided that current exposure
a framework for measuring capital
would be determined individually for
adequacy under which risk-weighted
every rate contract entered into by a
assets are calculated by assigning assets
banking organization. Generally,
and off-balance-sheet items to broad
institutions were not perm itted to offset,
categories based primarily on their
that is, net, positive and negative markcredit risk, that is, the risk that a loss
to-market values of multiple rate
will be incurred due to an obligor or
contracts with a single counterparty to
counterparty default on a transaction.2
determine one current exposure relative
Off-balance-sheet transactions are
to that counterparty.5 In April 1993 the
incorporated into risk-weighted assets
Basle Supervisors’ Committee (BSC)
by converting each item into a credit
proposed a revision to the Basle Accord,
equivalent amount which is then
endorsed by the G-10 Governors in July
assigned to the appropriate credit risk
1994, that permits institutions to net
category according to the identity of the
positive and negative mark-to-market
obligor or counterparty, or if relevant,
values of rate contracts subject to a
the guarantor or the nature of the
qualifying, legally enforceable, bilateral
collateral.
netting arrangement. Under the revision
The credit equivalent am ount of an
to the Accord, institutions with
interest rate or exchange rate contract
qualifying netting arrangements could
(rate contract) is determined by adding
replace the gross current exposure of a
together the current replacement cost
set of contracts included in such an
(current exposure) and an estimate of
arrangement with a single net current
the possible increases in future
exposure for purposes of calculating the
replacement cost, in view of the
credit equivalent amount for the
volatility of the current exposure over
included contracts. If the net market
the remaining life of the contract
value is positive, then that market value
(potential future exposure, also referred
equals the current exposure for the
to as the add-on). Each credit equivalent netting contract. If the net market value
amount is then assigned to the
is zero or negative, then the current
appropriate risk category generally
exposure is zero.
based on the identity of the
On May 20,1994, the Board and the
counterparty. The maximum risk weight Office of the Comptroller of the
applied to interest rate or exchange rate
Currency (OCC) issued a joint proposal
contracts is 50 percent.3
to amend their respective risk-based
capital guidelines in accordance with
A. Current Exposure
the BSC April 1993 proposal.6
A banking organization that has a rate Generally, under the proposal, a
contract with a positive mark-to-market
bilateral netting arrangement w ould be
value has a current exposure to a
recognized for risk-based capital
Division of Banking Supervision and
Regulation; or Stephanie Martin, Senior
Attorney (202/452-3198), Legal
Division. For the hearing impaired only.
Telecommunication Device for the Deaf,
Dorothea Thompson (202/452-3544).
1The Basle Accord was proposed by the Basle
Committee on Banking Supervision (Basle
Supervisors’ Committee, BSC) 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. In January 1989 the Federal Reserve
Board adopted a similar framework to be used by
state member banks and bank holding companies.
2Other types of risks, such as market risks,
generally are not addressed by the risk-based
framework.
3 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 capital ratio calculations.
4The loss to a banking organization from a
counterparty’s default on a rate contract is the cost
of replacing the cash flows specified by the
contract. The mark-to-market value is the present
value of the net cash flows specified by the
contract, calculated on the basis of current market
interest and exchange rates.
5 Netting by novation, however, 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.
‘ The Office of Thrift Supervision issued a similar
netting proposal on June 14, 1994 and the Federal
Deposit Insurance Corporation issued its netting .
proposal on July 25,1994.
43509
purposes only if the netting arrangement
is legally enforceable. The institution
would have to have a legal opinion(s) to
this effect. The joint Federal Reserve/
OCC proposal is consistent w ith the
final July 1994 change to the Basle
Accord. (A detailed discussion of the
BSC proposal and the Board/OCC
proposed amendment to their risk-based
capital guidelines can be found at 59 FR
26456, May 20,1994.)
B. Potential Future Exposure
The second part of the credit
equivalent amount, potential future
exposure, is an estimate of the
additional exposure that may arise over
the remaining life of the contract as a
result of fluctuations in prices or rates.
Such changes may increase the market
value of the contract in the future and,
therefore, increase the cost of replacing
it if the counterparty subsequently
defaults.
The add-on for potential future
exposure is estimated by multiplying
the notional principal am o unt7 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 existing set
of conversion factors used to calculate
potential future exposure, referred to as
the add-on matrix, is as follows:
Remaining maturity
One year or less ......
Over one y ear..........
Interest
rate con
tracts (in
percent)
Exchange
rate con
tracts (in
percent)
0
0.5
1.0
5.0
The conversion factors were
determined through simulation studies
that estimated the potential volatility of
interest and exchange rates and
analyzed the implications of movements
in those rates for the replacement costs
of various types of interest rate and
exchange rate contracts. The simulation
studies were conducted only on interest
rate and foreign exchange rate contracts,
because at the time the Accord was
being developed activity in the
derivatives market was for the most part
limited to these types of transactions.
The analysis produced probability
distributions of potential replacement
costs over the remaining life of matched
pairs of rate contracts.8 Potential future
7 The notional principal amount, or value, is a
reference amount of money used to calculate
payment streams between the counterparties.
Principal amounts generally are not exchanged in
single-currency interest rate swaps, but generally
are exchanged in foreign exchange contacts
(including cross-currency interest rate swaps).
8 A matched pair is a pair of contracts with
identical terms, with the banking organization the
Continued
43510
,
Federal Register / Vol. 59, No. 163 / W ednesday, August 2 4 1994 / Proposed Rules
exposure was then defined in terms of
confidence limits for these distributions.
The conversion factors were intended to
be a compromise between precision, on
the one hand, and complexity and
burden, on the other.9
The add-on for potential future
exposure is calculated for all contracts,
regardless of w hether the market value
is zero, positive, or negative, or whether
the current exposure is calculated on a
gross or net basis. The add-on will
always be either a positive number or
zero. The recent revision to the Basle
Accord to recognize netting for the
calculation of current exposure does not
affect the calculation of potential future
exposure, which generally continues to
be calculated on a gross basis. This
means that an add-on for potential
future exposure is calculated separately
for each individual contract subject to
the netting arrangement and then these
individual future exposures are added
together to arrive at a gross add-on for
potential future exposure. For contracts
subject to a qualifying bilateral netting
arrangement jn accordance with the
newly adopted Accord changes, the
gross add-on for potential future
exposure would be added to the net
current exposure to arrive at one credit
equivalent am ount for the contracts
subject to the netting arrangement.
The original Basle Accord noted that
the credit conversion factors in the add
on matrix were provisional and would
be subject to revision if volatility levels
or market conditions changed.
II. Basle Proposals for the Treatment of
Potential Future Exposure
Since the original Accord was
adopted, the derivatives market has
grown and broadened. The use of
certain types of derivative instruments
not specifically addressed in the
Accord—notably commodity, precious
metals, and equity-linked
transactions 10—has become much more
widespread. As a result of continued
review of the m ethod for calculating the
add-on for potential future exposure, in
July 1994 the BSC issued two proposals
for public consultation.1 The first
1
proposal would expand the matrix of
add-on factors used to calculate
potential future exposure to take into
account innovations in the derivatives
m arket The second proposal would
recognize reductions in the potential
future exposure of derivative contracts
that result from entering into bilateral
netting arrangements. The second
proposal is an extension of the recent
revision to the Accord recognizing
bilateral netting arrangements for
purposes of calculating current
exposure and would formally extend the
recognition of netting arrangements to
equity, precious metals and other
commodity derivative contracts. The
consultation period for these BSC
proposals is scheduled to end on
October 10, 1994.
certain types of derivative instruments,
in particular, long-dated interest rate
contracts, commodity contracts, and
equity-index contracts. The BSC review
indicated that the current add-on factors
do not adequately address the full range
of contract structures and the timing of
cash flows. The review also showed that
the conversion factors many institutions
are using to calculate potential futu re'
exposure for commodity, precious
metais, and equity contracts could result
in insufficient capita! coverage in view
of the volatility of the indices or prices
on the underlying assets from which
these contracts derive their value.
The BSC concluded that it was not
appropriate to address these problems
with a significant departure from the
existing methodology used in the
Accord. The BSC decided that it would
be appropriate to preserve the
conversion factors existing in the
Accord and add new conversion factors.
Consequently, the revision proposed by
the BSC retains the existing conversion
factors for interest and exchange rate
contracts but applies new higher
conversion factors to such contracts
with remaining maturities of five years
and over.13 The proposal also introduces
conversion factors specifically
applicable to commodity, precious
metals, and equity contracts. The new
conversion factors were determined on
the basis of simulation studies that used
A. Expansion o f A dd-on Matrix
the same general approach that
A recently concluded BSC review of
the add-on for potential future exposure generated the original add-on
indicated that the current add-on factors conversion factors.14
The proposed matrix is set forth
used to calculate the add-on amount
below:
may produce insufficient capital for
C o n v e r s i o n F a c t o r M a t r ix *
[Amounts in percent]
Interest rate
Residual maturity
Less than one y e a r ...................................................................... ..................
One to five y e a r s ........................... ........................ ........................................
Five years or m o r e ____
_ .......... ...............................................
Foreign ex
change and
gold
0.0%
0.5%
1.5%
1.0%
5.0%
7.5%
Equity**
6.0%
8.0%
10.0%
Precious
m etals, ex
cept gold
7.0%
7.0%
8.0%
Other com
modities
12.0%
12.0%
.15.0%
'For contracts with multiple exchanges oJ principal, the factors are to be multiplied by the number of remaining paym ents In the contract.
**For contracts that automatically reset to zero value lotlowing a paym ent, the remaining maturity is set equal to the time rem aning until the
next payment.
buyer of one oi the contracts aud the seller of the
other.
’ The methodology upon which the statistical
analyses were based is described in detail in a
technical working paper entitled "Potential Credit
Exposure on Interest Rate and Foreign Exchange
Rate Related Instruments.” This paper is available
upon request from the Board's Freedom of
Iri formation Office.
toin genera] terms, these are off-balance-sheet
transactions that have a return, or • portion of their
return, linked to the price of a particular
commodity, precious metal, or equity or to an index factors for exchange rate contracts to these types of
transactions pending development of a more
-of commodity, precions metal, or equity prices.
appropriate treatment.
1
1 The proposals are contained In a paper from the
BSC entitled "The Capital Adequacy Treatment of
1 The conversion factors for rate contracts with
3
-the Credit Risk Associated with Certain Off-Balance remaining maturities of one to five yean ate
Sheet Items** that is available upon request from the currently applied <0 contracts with a remaining
maturity of over one year.
Board's Freedom of Information Office.
13While commodity, precious metals, and equity
“ The methodology end results of the statistical
contracts were sot explicitly covered by the original analyses are summwiced is ■ paper entitled "The
Calculation of Add-Ons for Derivative Contract*:
Accord, as the use of such contracts became more
prevalent, many G-10 hanking supervisors,
the "Expended Matrix’*Approach" that is available
including U.S. banking supervisors, have informally upon request from the Board’s Freedom of
information Office.
permitted institutions to apply the conversion
Federal Register / Vol. 59, No. 163 / W ednesday, August 24, 1994 / Proposed Rules
Gold is included within the foreign
exchange column because the price
volatility of gold has been found to be
comparable to the exchange rate
volatility of major currencies. In
addition, the BSC determined that
gold’s role as a financial asset
distinguishes it from other precious
metals. The proposed matrix is designed
to accommodate the different structures
of contracts, as well as the observed
disparities in the volatilities of the
associated indices or prices of the
underlying assets.
Two footnotes are attached to the
matrix to address two particular
contract structures. The first relates to
contracts with multiple exchanges of
principal. Since the level of potential
future exposure rises generally in
proportion to the number of remaining
exchanges, the conversion factors are to
be multiplied by the number of
remaining payments (that is, exchanges
of principal) in the contract. This
treatment is intended to ensure that the
full level of potential future exposure is
adequately covered. The second
footnote applies to equity contracts that
automatically reset to zero each time a
payment is made. The credit risk
associated with these contracts is
similar to that of a series of shorter
contracts beginning and ending at each
reset date. For this type of equity
contract the remaining maturity is set
equal to the time remaining until the
next payment.
While the capital charges resulting
from the application of the new
proposed conversion factors may not
provide complete coverage for risks
associated with any single contract, the
BSC believes the factors will provide a
reasonable level of prudential coverage
for derivative contracts on a portfolio
basis. Like the original matrix, the
proposed expanded matrix is designed
to provide a reasonable balance between
precision, and complexity and burden.
B. Recognition o f the Effects of Netting
The simulation studies used to
generate the conversion factors for
potential future exposure analyzed the
implications of underlying rate and
price movements on the current
exposure of contracts w ithout taking
into account reductions in exposure that
could result from legally enforceable
netting arrangements. Thus, the
conversion factors are most
appropriately applied to non-netted
contracts, and when applied to legally
enforceable netted contracts, they could
in some cases, overstate the potential
future exposure.
Comments provided during the
consultative process of revising the
Basle Accord to recognize qualifying
bilateral netting arrangements and
further research conducted by the BSC,
have suggested that netting
arrangements can reduce not only a
banking organization’s current exposure
for the transactions subject to the
netting arrangement, but also its
potential future exposure for those
transactions.1
5
As a result, in July 1994 the BSC
issued a proposal to incorporate into the
calculation of the add-on for potential
future exposure a method for
recognizing the risk-reducing effects of
qualifying netting arrangements. Under
the proposal, institutions could
recognize these effects only for
transactions subject to legally
enforceable bilateral netting
arrangements that meet the
requirements of netting for current
exposure as set forth in the recent
revision to the Accord.
Depending on market conditions and
the characteristics of a banking
organization’s derivative portfolio,
netting arrangements can have
substantial effects on the organization’s
potential future exposure to multiple
derivative contracts it has entered into
with a single counterparty. Should the
counterparty default at some future
date, the institution’s exposure would
be limited to the net amount the
counterparty owes on the date of default
rather than the gross current exposure of
the included contracts. By entering into
a netting arrangement a bank may
reduce not only its current exposure,
but possibly its future exposure as well.
Nevertheless, while in many
circumstances a netting arrangement
can reduce the potential future exposure
of a counterparty portfolio, this is not
always the case.16
The most important factors
influencing whether a netting
arrangement will have an effect on
potential future exposure are the
volatilities of the current exposure to
the counterparty on both a gross and net
basis.17 The volatilities of net current
15While current exposure is intended to cover an
organization’s credit exposure at one point in time,
potential future exposure provides an estimate of
possible increases in future replacement cost, in
view of the volatility of current exposure over the
remaining life of the contract. The greater the
tendency of the current exposure to fluctuate over
time, the greater the add-on for potential future
exposure should be to cover possible fluctuations.
16For purposes of this discussion, a portfolio
refers to a set of contracts with a single
counterparty. A banking organization’s global
portfolio refers to all of the contracts in the
institution’s total derivatives portfolio that are
subject to qualifying netting arrangements.
17 Volatility in this discussion is the tendency of
the market value of a contract to vary or fluctuate
over time. A highly volatile portfolio would have
43511
exposure and gross current exposure of
the portfolio may not necessarily be the
same. Volatility of gross current
exposure is influenced primarily by the
fluctuations of the market values of
positively valued contracts. Volatility of
net current exposure on the other hand,
is influenced by the fluctuations of the
market values of all contracts within the
portfolio. In those cases where net
current exposure has a tendency to
fluctuate more over time than gross
current exposure, a netting arrangement
wilLnot reduce the potential future
exposure. However, in those situations
where net current exposure has a
tendency to fluctuate less over time than
gross current exposure, a netting
arrangement can reduce the potential
future exposure.
Net current exposure is likely to be
less volatile relative to the volatility of
gross current exposure when the
portfolio of contracts as a whole is more
diverse than the subset of positively
valued contracts. When a netting
arrangement is applied to a diversified
portfolio and the positively valued
contracts within the portfolio as a group
are less diversified than the overall
portfolio, then the effect of the netting
arrangement will likely be to reduce the
potential future exposure of the
portfolio.
The BSC has studied and analyzed
several alternatives for taking into
account the effects of netting when
calculating the capital charge for
potential future exposure. In particular,
the BSC reviewed one general method
proposed by commenters to the April
1993 netting proposal. This method
would reduce the amount of the add-on
for potential future exposure by
multiplying the calculated gross add-on
by the ratio of the portfolio’s net current
exposure to gross current exposure (the
net-to-gross ratio or NGR). The NGR is
used as a proxy for the risk-reducing
effects of the netting arrangement on the
potential future exposure. The more
diversified the portfolio, the lower the
net current exposure tends to be relative
to gross current exposure.
The BSC incorporated this method
into its proposal. However, given that
there are portfolio-specific situations in
which the NGR does not provide a good
indication of these effects, the BSC
proposal gives only partial weight to the
effects of the NGR on the add-on for
potential future exposure. The proposed
method would average the amount of
a tendency to fluctuate significantly over short
periods of time. One of the most important factors
influencing a portfolio’s volatility is the correlation
of the contracts within the portfolio, that is, the
degree to which the contracts in the portfolio
respond similarly to changing market conditions.
43512
Federal Register / Vol. 59, No. 163 / W ednesday, August 24, 1994 / Proposed Rules
the add-on as currently calculated
(Agro,) and the same am ount m ultiplied
by the NGR to arrive at a reduced add
on (A„<.,) for contracts subject to
qualifying netting arrangements in
accordance with the requirements set
forth in the recently revised Accord.
This formula is expressed as:
A net—5
■
E N 'G R x A J .
For example, a bank with a gross current
exposure of 500,000, a net current
exposure of 300,000, and a gross add-on
for potential future exposure of
1.200,000, would have an NGR of .6
(300,000/500,000) and would calculate
A w as follows:
.5(l,2C!:.000+(.6xl,200,000))
Anc.=9ft0,000
For banking organizations with an NGR
of 50 percent, the effect of this treatment
would be to permit a reduction in the
amount of the add-on by 25 percent.
The BSC believes that most dealer banks
are likely to have an NGR in the vicinity
of 50 percent.
The BSC propos'al does not specify
whether the NGR should be calculated
on a counterparty-by-counterpartv basis
or on an aggregate basis for all
transactions subject to qualifying,
legally enforceable netting
arrangements. The proposal requests
comment on w hether the choice of
method could bias the results and
whether there is a significant difference
in calculation burden between the two
methods.
The BSC proposal also acknowledges
that simulations using institutions’
internal models for measuring credit
risk exposure would most likely
produce the most accurate
determination of the effect of n e t t i n g
arrangements on potential future
exposures. The proposal states that the
use of such models would be considered
at some future date.
III. The Board Proposal
In light of the BSC proposal, the
Board believes that it is appropriate to
seek comment on proposed revisions to
the calculation of the add-on for
potential future exposure for derivative
contracts. Therefore, the Board is
proposing to amend its risk-based
capital guidelines for state member
banks and bank holding companies to
expand the matrix of conversion factors,
and to permit institutions that make use
of qualifying netting arrangements to
recognize the effects of those netting
arrangements in the calculation of the
add-on for potential future exposure.
The second part of the proposed
amendment is contingent on the
adoption of a final am endm ent to the
Board's risk-based capital guidelines to
recognize bilateral close-out netting
applied separately to adjust the add-on
arrangements and would formally
for potential future exposure for each
extend this recognition to commodity,
netting arrangement. The Board notes
precious metals, and equity derivative
that some preliminary findings indicate
contracts.
that a global NGR may be less
With regard to the portion of the
burdensome to apply since the same
proposal to exm nd the conversion
NGR would be used for each
factor matrix, the Board is proposing the counterparty with a netting
same conversion factors set forth in the
arrangement, but counterparty specific
BSC proposal. The Board agrees with
NGRs may provide a more accurate
the BSC that the existing conversion
indication of the credit risk associated
factors applicable to long-dated
with each counterparty.
transactions do not provide sufficient
Regulatory Flexibility Act Analysis
capital for the risks associated with
those types of contracts. The Board also
The Board does not believe that
agrees with the BSC that the conversion
adoption of this proposal would have »
factors for foreign exchange transactions significant economic impact on a
are significantly too low for commodity, substantial number of small business
precious metals, and equity derivative
entities (in this case, small banking
contracts due to the volatility of the
organizations), in accord with the spirit
associated indices and the prices on the and purposes of the Regulatory
underlying assets.1
8
Flexibility Act (5 U.S.C 601 et seq.) In
The Board is proposing the same
this regard, while some small
formula as the BSC proposal to calculate institutions with limited derivative
a reduction in the add-on for potential
portfolios may experience an increase in
future exposure for contracts subject to
capita! charges, for most of these
qualifying netting contracts. The Board
institutions the proposal w'ill have no
recognizes several advantages w ith this
effect. For institutions with more
formula. First, the formula uses bankdeveloped derivative portfolios the
specific information to calculate the
overall affect of the proposal will likely
NGR. The NGR is simple to calculate
be to reduce regulatory burden and the
and uses readily available information.
capital charge for certain transactions.
The Board believes the use of the
In addition, because the risk-based
averaging factor of 0.5 is an important
capital standards generally do not apply
aspect of the proposed formula because
to bank holding companies with
it means the add-on for potential future
consolidated assets of less than S150
exposure can never be reduced to zero
million, this proposal will not affect
and banking organizations w ill always
such companies.
hold some capital against derivative
contracts, even in those instances where Paperw ork Reduction Act
the net current exposure is zero.
The Federal Reserve has determined
The Board is seeking comment on all
that its proposed amendments, if
aspects of this proposal. As mentioned
adopted, would not increase the
earlier, the BSC proposal seeks
regulatory paperwork burden of banking
comment on w hether the NGR should
organizations pursuant to the provisions
be calculated on a counterparry-byof the Paperwork Reduction Act (44
counterparty basis, or on a global basis
U.S.C. 3501 et. seq.).
for all contracts subject to qualifying
bilateral netting arrangements. The
List of Subjects
Eoard's proposed regulatory language
12 CFR Part 208
would require the calculation of a
separate NGR for each counterparty
Accounting, Agriculture, Banks,
with which it has a qualifying netting
banking. Capital adequacy, Confidential
contract. However, the Board is also
seeking comment as to which method of business information, Currency, Federal
Reserve System, Reporting and
calculating the NGR would be most
efficient and appropriate for institutions recordkeeping requirements, Securities,
State member banks.
with numerous qualifying bilateral
netting arrangements. With either
72 CFR Part 225
calculation method the NGR would be
Administratix’e practice and
procedure, Banks, banking, Capital
,h Similar to the BSC proposal, the Board's
proposed amendment specifies that for equity
adequacy, Federal Reserve System,
contracts that automatically reset to zero value
Holding companies, Reporting and
following a payment, the remaining maturity is set
recordkeeping requirements, Securities.
equal to the time remaining until the next paym ent
Also, for contracts with multiple exchanges of
principal, the conversion factors are to be
multiplied by the number of remaining payments in
the contract.
For the reasons set forth in the
preamble, the Board proposes to amend
12 CFR parts 208 and 225 as follows.
Federal Register / Vol. 59, No. 163 / W ednesday, A ugust 24, 1994 / Proposed Rules
PART 208—MEMBERSHIP OF STATE
BANKING INSTITUTIONS IN THE
FEDERAL RESERVE SYSTEM
(REGULATION H)
1. The authority citation for part 208
is revised to read as follows:
Authority: 12 U.S.C. 36. 248(a), 248(c),
321-338a. 371d, 461, 481-486, 601, 611,
1814. 1823(j), 1828(o). 1831o, 1 8 3 1 p - l, 3105,
3310, 3331-3351 a n d 390C-3909; 15 U.S.C.
78b. 781(b), 781(g), 78l(i), 78o-4(c)(5), 78q,
78q-l a n d 78w; 31 U.S.C. 5318.
2- A ppendix A to part 208 is amended
by revising the last paragraph in section
1II.C.3. and footnote 40 in the
introductory text of section ILLD. to read
as follows:
Appendix A to Part 208— Capital Adequacy
G uidelines for State Member Banks: RiskBased M easure
*
*
111 *
*
*
*
*
*
C. * * *
3. * * *
C redit e q u iv a len t a m o unts o f derivative
contracts involving stand ard risk obligors
(that is. obligors w hose loans o r debt
securities w o uld be assigned to the 100
percent risk category) are in clu d e d in th e 50
percent category, u nless they are hacked by
collateral or guarantees that allow th em to be
placed in a low er risk category.
3. Appendix A to part 208 is amended
by revising the section III.E. heading
a n d section IILE.1. to read as follows:
111. * * *
E. Derivative C o ntracts (Interest Rate,
Exchange Rate, C om m odity (including
precious m etals), a n d E quity C ontracts)
1. Scope, (a) C redit e q u iv a len t a m o u n ts are
co m p u ted for e ac h o f the fallow ing offbalance-sheet d erivative oontracts:
I. Interest Rate C ontracts
A. Single c u rren cy interest rate sw aps.
B. Basis sw aps.
C. Forw ard rate agreem ents.
D. Interest rate o p tio n s p u rc h ased (in cluding
caps, collars, a n d floors purchased).
E. Any o ther in stru m e n t that gives rise to
sim ilar cred it risks (in clu d in g w henissued securities a n d forward deposits
accepted).
43513
treated in the sam e w ay as o th er derivative
contracts.
*
*
*
*
*
4. In appendix A to part 208, section
III.K.2. and section III.E.3., as those
sections were proposed to be revised at
59 FR 26461, May 20, 1994, are revised
to read as follows:
*
*
*
*
*
111.
*
*
*
E ***
.
2.
Calculation o f credit equivalent
amounts, (a) T h e credit equ ivalent a m o u n t of
a derivative c o n tract th at is co t subject to a
qualifying b ilateral netting contract in
a ccordance w ith section IH.E.3. o f this
a p p en d ix A is equal to the sum of (i) the
II. Exchange Rate C ontracts
cu rren t exp osure (som etim es referred co as
the replacem ent cost) o f th e contract a n d (ii)
A. Cross-currency interest rate sw aps.
an estim ate o f the p otential future credit
B. Forw ard foreign exchange contracts.
exposure o ver th e rem ain ing life of th e
C. C urrency o p tio n s purchased.
contract.
D. Any o th er in stru m e n t th at gives rise to
(b) T he c u rren t exposure is d ete rm in e d by
sim ilar c re d it risks.
the m ark-to-m arket v alue of the contract. Lf
III. C om m odity (includin g preciou s metal) or
the m ark-to-m arket v alue is positive, th en the
Equity Derivative Contracts
cu rrent expo su re is equal to that m ark-to
A. C om m odity o r e q u ity linked sw aps.
m arket value. If the m ark-to-m arket value is
B. C om m odity o r e quity linked o ptio ns
zero or negative, th en the cu rren t expo su re is
purchased.
zero. M ark-to-m arket values are m ea su re d in
C. Forw ard c om m od ity or equity linked
dollars, regardless o f the currency or
contracts.
currencies specified in the contract and
D. Any oth er in stru m e n t that gives rise to
shou ld reflect changes in b oth u nd erlyin g
sim ilar c red it risks.
rates, prices, a n d ind ices, a n d c o unterparty
(b) Exchange rate c o ntracts w ith an original credit quality.
m aturity o f fou rteen cale n d ar day s or less
(c) T he po ten tial future credit ex posure of
a contract, in clu d in g contracts w ith negative
and derivative c o ntracts trad ed on exchanges
m ark-to-m arket values, is estim ated by
that require daily p a y m ent o f variation
m u ltip lyin g the notional prin cip al a m o u n t of
m argin m ay be e x clu d e d from the risk-based
the contract by on e of the follow ing credit
ratio calculation. O v er-the-cou nter options
conversion factors, as appropriate:
purchased, how ever, are in clu d e d and
C onversion F actor Matrix *
[Amounts in percent]
Residual maturity
Less than one vear .......................................
One to five years___
Five vears or more
Interest rate
Exchange
rate and
gold
0.0
0.5
1.5
1.0
5.0
7.5
Equity**
6.0
8.0
10.0
Precious
metals ex
cept gold
Other com
modities
7.0
7.0
8.0
12.0
12.0
15.0
' For contracts with multiple exchanges of principal, the tactors are to be multiplied by the number of remaining payments in the contract.
* For contracts that reset to zero value following a payment, the remaining maturity is set equal to the time until the next payment.
*
(d) No potential future exposure is
calculated for single currency interest rate
sw aps in w h ic h p ay m en ts are m a d e based
upon two floating rate indices (so called
floating/floating o r basis swaps); the credit
exposure on these contracts is evaluated
solely on the basis o f th eir m ark-to-m arket
values.
(e) T he Board notes that the conversion
factors set forth above, w h ic h are based on
observed volatilities of the p articular types of
instrum ents, are subject to review and
m odification in lig h t o f changing volatilities
or m arket conditions.
3.
Netting, (a) For pu rposes o f this
append ix A, netUng refers to the offsetting of
positive a n d negative m ark-to-m arket values
w hen determ in ing a cu rren t ex posure to be
used in the calculation o f a cred it equivalent
am ount. Any legally enforceable form of
bilateral netting (that is, netting w ith a single
counterparty) o f derivative contracts is
recognized for pu rp o ses of calculating the
credit equiv alent a m o u n t prov ided that:
(1) The netting is a ccom plished u n d e r a
w ritten n etting contract that creates a single
legal obligation, covering all in clu d e d
ind iv id u al co&tracts, w ith th e effect that the
bank w o u ld hav e a c laim o r obligation to
receive or pay, respectively, o nly the n e t
a m oun t of the sum o f the positive and
negative m ark-to-m arket values on in clu d ed
in div idual contracts in the event that a
counterparty, or a co unterparty to w h o m the
contract has been validly assigned, fails to
perform d u e to a n y o f the follow ing events:
default, insolvency, bankruptcy, or sim ilar
circum stances.
(2) T he bank ob tains a w ritten and
reasoned legal opinion(s) rep resenting th at in
the e v e n t of a legal challenge, inclu d in g one
resulting from default, insolvency.
w The sufficiency of collateral and guarantees for
off-balance-sheet items is determined by the market
value of the collateral or the amount of the
guarantee in relation to the face am ount of the item,
except for derivative contracts, for w hich this
determination is generally made in relation to the
credit equivalent amount. Collateral and guarantees
are subject to the same'provi&ions noted under
section IU.B of this appendix A.
43514
Federal Register / Vol. 59, No. 163 / W ednesday, August 24, 1994 / Proposed Rules
liquidation o r sim ilar circum stances, the
relevant cou rt a n d adm inistrativ e authorities
w ould find th e b a n k ’s exposure to be such a
net am ou nt u nder:
(i) the law o f the jurisdiction in w hich the
co unterparty is c h artered or the equivalent
location in th e case of noncorporate entities,
and if a b ranch o f th e c o unterparty is
involved, th en also u n d e r the law of the
jurisdiction in w h ic h th e 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.
(3) T he b ank e stablish es a n d m aintains
procedures to e n su re th at the legal
characteristics of n e ttin g contracts are kept
u n d e r review in th e light of possible changes
in relevant law.
(4) T he ban k m ain tain s in its files
d ocum entation a d equate to s upp ort the
netting o f rate contracts, includ ing a copy of
the bilateral n ettin g c o ntract a nd necessary
legal opinions.
(b) A contract conta in in g a walkaw ay
clause is not eligible for netting for purposes
of calculating th e credit equivalent am ou nt.4V
(c) By netting in d iv id u a l contracts for the
p u rpose o f c alculating its credit equivalent
am ount, a b a n k re p rese n ts that it has m et the
requirem ents of th is a p p en d ix A and all the
app ropriate d o c u m e n ts are in the bank's files
and available for inspection by the Federal
Reserve. U pon d eterm inatio n by the Federal
Reserve that a b a n k ’s files are inadequate or
that a netting contract may not be legally
enforceable u n d e r any one of the bodies of
law described in section Ill.E.3.(a)(2) (i)
through (iii) of th is a p p en d ix A, underlying
individual contracts m ay be treated as though
they w ere n ot subject to the netting contract.
(d) T he credit e qu ivalen t am ou nt of
derivative co ntracts that are subject to a
qualifying bilateral netting contract is
calculated by a d d in g (i) the net current
e xposure for the n etting contract and (ii) the
sum of the e stim ates of potential future
exposure for all in d iv id u a l contracts subject
to the netting contract, adjusted to take into
account the effects o f th e netting contract.
(e) T he net c u rren t exposure is the sum of
all positive and negative mark-to-market
values of th e in d iv id u a l contracts subject to
the netting contract. If the net sum of the
m ark-to-m arket v alues is positive, th en the
net current ex p o su re is equal to that sum . If
the net su m of th e m ark-to-m arket values is
zero or negative, th en the net current
exposure is zero.
(f) T he sum of th e estim ates of potential
future exposure for all individu al contracts
subject to th e n ettin g contract ( A grOs 0 ,
adjusted to reflect th e effects of the netting
contract ( A n c ,)> is d e te rm in e d through
application of a form ula. T h e form ula, w hich
em ploys the ratio of th e net current exposure
to the gross c u rren t ex posure (NGR), is
expressed as:
A n c t = - 5 ( A Er o s s + ( N G R x A gr<» s ) )
(g) Gross p oten tial fu ture exposure, or
AtfC is calculated by su m m in g the estim ates
m,
of potential future expo su re (determ ined in
accordance w ith section III.E.2. o f this
a p p en d ix A) for each in d iv id u a l contract
subject to the qualifying bilateral netting
contract.50 T he NGR is the ratio of the net
cu rren t exposure o f th e netting contract to
the gross c u rren t e x p o su re o f the netting
contract. T he gross cu rrent exposure is the
sum of the curren t ex p o su res o f all
individu al contracts subject to the netting
contract calculated in accordance with
section II1.E.2. of this a p p en d ix A. T he effect
of this treatm en t is th at Anc, is the average of
Atro^ a n d Agross ad ju sted by the NGR.
*
*
*
*
*
5. Appendix A to part 208 is amended
by revising section III.E.4. to read as
follows:
*
*
*
*
*
111. * * *
E. * * *
4. Fisk weights, (a) Once the credit
equivalent a m ou nt for a derivative contract,
or a group of derivative contracts subject to
a qualifying nettin g contract, has been
determ ined, that am o u n t is assigned to the
risk weight category ap prop riate to the
counterparty, or, if relevant, the g uarantor or
the n ature o f any co llateral.51 However, the
m axim um w eight th at w ill be applied to the
credit equivalent a m o u n t o f such contracts is
50 percent.
*
*
*
*
*
6. In appendix A to part 208, section
III.E.5., as that section was proposed to
be revised at 59 FR 26461, May 20,
1994, is revised to read as follows:
*
*
*
*
*
III. * * *
E. * * *
5. Avoidance o f double counting, (a) In
certain cases, cred it ex posures arising from
th e derivative c on tracts covered by these
g uid elines m ay already be reflected, in part,
on the balance sheet. To avoid double
counting su ch ex posures in the assessm ent of
capital adequacy and, perhaps, assigning
inapprop riate risk w eights, counterparty
credit exp osures arising from the types of
instru m ents covered by these g uidelines may
need to be ex clu d ed from balance sheet
assets in calculatin g b a n k s’ risk-based capital
ratios.
(b) Exam ples o f th e calculation of credit
equivalent am o u n ts for these types of
contracts are co n tain ed in A ttachm ent V of
th is a p p en d ix A.
*
*
*
*
*
7. In appendix A to part 208,
Attachment V, as that attachment was
proposed to be revised at 59 FR 26462,
May 20, 1994, is revised to read as
follows:
*
*
*
*
*
Attachment V— C alculation of C redit E quivalent Amounts for Derivative C ontracts
Potential exposure + Current exposure = Credit equivalent amount
Type of contract (remaining maturity)
(1) 120-day forward foreign exchange ...............
(2) fryeaj forward foreign exchange ..................
(3) 3-year interest rate swap ..............................
(4) 1-year oil sw ap.............................................
(5) 7-year interest rate sw ap ..............................
Total ........................................................
i
Notional prin
cipal (dollars)
5,000,000
6,000,000
10,000,000
10,000,000
20,000,000
Conversion
factor
01
.075
.005
.12
.05
Potential ex
posure (dol
lars)
Mark-to-market value
’ 50,000
450,000
50,000
1,200,000
1,000,000
100,000
-120,000
200,000
-250,000
-1,300,000
2.750,000
Current ex
posure (dol
lars)
100,000
0
200,000
0
0
150,000
450,000
250,000
1,200,000
1,000,000
300,000
3,050,000
If contracts (1) through (5) above are
subject to a qualifying bilateral netting
contract, then th e follow ing applies:
49 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 to
the estate of a defaulter, even if a defaulter or the
estate of a defaulter is a net creditor under the
contract.
• 1For purposes of calculating gross potential
M
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.
51 For derivative contracts, sufficiency of
collateral or guarantees is generally 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.
Federal Register / Vol. 59, No. 163 1 W ednesday, August 24, 1994 / Proposed Rules
Potential fu
ture expo
sure (from
above)
( 1 ) ..............................................................................................
(2) ...............- .............................................................................
2.750,000
Credit equiv
alent amount
Net Current
exposure1
50.000
450,000
50.000
1.200,000
1,000,000
Total................... ............. .............. .............................
43515
0
+
=
2,750,000
1The 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.
To recognize the effects of netting on potential future exposure the following formula applies: Anet=.5(Agross+(NGRxAgross.)
In the above example: NGR=0 (0/300,000)
Anet=.5(2,75Q,DOO+(Ox2,750,000))
Anet=1,375,000.
Credit equivalent amount 1,375,000+0=1,375,000.
If the net current exposure was a positive amount for example $200,000, the credit equivalent amount would be calculated as follows:
NGR=.67 (200,000/300,000)
AneJ=.5(2,750,000+(.67x2.750,000))
Anet=2,296,250.
Credit Equivalent amount: 2J?96,250+200,000=2,496,250.
*
*
*
*
*
PART 225—BANK HOLDING
COMPANIES AND CHANGE IN BANK
CONTROL (REGULATION Y)
III. * * *
E. Derivative Contracts (Interest Fate.
Exchange Bate. C om m odity (including
precious metals) and Equity Derivative
Contracts).
1. Scope, (a) Credit e q uiv alent am oun ts are
1. T he a u tho rity citation for p art 225
co n tin u es to read as follows:
co m p u ted for each of the follow ing offbalance-sheet derivative contracts:
Authority: 12 U.S.C. 1817{j)(13), 1818,
1831i, 1843(c)(8), 1844(b), 1972(1), 3106,
3108. 3310, 3331-3351, 3907, and 3-909.
I. Interest Rate C ontracts
Appendix A to part 2 2 5 is amended
by revising the last paragraph in section
III.C .3. and footnote 4 3 in the
introductory text of section I I I .D . to read
as follows:
2.
A ppendix A to Part 225— Capital Adequacy
G uidelines for Bank H olding Companies:
Risk-Based M easure
*
*
*
*
*
III. • * *
C. * * *
3. * * *
C redit equivalent a m ou nts of derivative
contracts involving sta n d ard risk obligors
(that is, obligors w hose loans o r debt
securities w o u ld be assigned to the 100
percent risk category) are in clu d e d in the 50
percent category, unless they are backed by
collateral or guarantees that allow them to be
placed in a low er risk category.
*
*
*
*
*
D . . . 43 * * *
*
*
*
*
*
3.
Appendix A to part 225 is amended
by revising the section UI.E. heading
and section I I I . E . l . to read as follows:
*
*
*
*
*
4 ’The sufficiency o f collateral and guarantees Cor
off-balance-sheet items is determined by die market
value of the collateral or the amount o f the
guarantee in relation to the face amount of the item,
except for derivative contracts, for which this
A. Single currency in terest rate swaps.
B. Basis sw aps.
C. Forw ard rate agreements.
D. Interest rate o ptio n s p u rc h ased (including
caps, collars, a n d floors purchased).
E. A ny o ther in stru m e n t th a t gives rise to
sim ilar credit risks {including w henissued securities a n d forw ard deposits
accepted).
treated in the sam e way as other derivative
contracts.
*
*
*
*
*
4. In appendix A to part 225, section
III.E.2. and section III.E.3., as those
sections were proposed to be revised at
59 FR 26463, May 20, 1994, are revised
to read as follows:
*
*
*
*
*
III. * ’ *
£. ***
2.
Calculation o f credit equivalent
am ounts, (a) T h e credit equivalent am o u n t of
a derivative contract that is n o t subject to a
qualifying bilateral netting contract in
accordance w ith section III.E.3. of this
a p p e n d ix A is equal to the sum of (i) the
current exposure (som etim es referred to as
II. Exchange Rate C ontracts
the replacem ent cost) o f the contract and (ii)
A. Cross-currency interest ra te swaps.
an estim ate of the potential future credit
B. Forw ard foreign exchange contracts.
exposure over the rem aining life o f the
C. C urrency options purchased.
contract.
D. A ny o th er in stru m e n t that gives rise to
(b) T h e c u rren t exposure is determ ined by
sim ilar c re d it risks.
the m ark-to-m arket value of th e contract. If
III. C om m odity (in clu ding p recious m etal) or
th e m ark-to-m arket v alue is positive, th en the
Equity D erivative C ontracts
c u rren t exposure is equal to th at m ark-to
m arket value. If the m ark-to-m arket value is
A. C om m odity o r equity link ed swaps.
B. C om m odity o r equity lin k e d o ptions
zero or negative, then the c u rren t exp osure is
purchased.
zero. Mark-to-market values a re m easured in
C. Forw ard co m m o d ity o r equity linked
dollars, regardless of th e c urrency or
contracts.
currencies specified in the contract a n d
D. A ny o th er instru m en t th at gives rise to
sh o u ld reflect changes in b oth und erlying
sim ilar credit risks.
rates a n d indices, a n d coun terp arty cred it
(b) E xchange rate contracts w ith an original quality.
(c) The p otential future credit exposure o f
m atu rity o f fourteen c ale n d ar days or less
a c o n tr a c t includ ing contracts w ith negative
a n d derivative contracts trad e d on exchanges
m ark-to-m arket values, is estim ated by
th at require daily p a y m e n t o f variation
m u ltip ly in g the notional p rin cip a l am o u n t of
m argin m ay be e x d u d e d from the risk-based
th e contract by one o f the follow ing credit
ratio calculation. O ver-the-counter o ptions
conversion factors, as appropriate:
pu rchased, how ever, are in clu d e d and
determination is generally m ade in relation to the
credit equivalent amount. Collateral and guarantees
are subject to tire same provisions noted tinder
section III.B of this Appendix A.
43516
Federal Register / Vol. 59, No. 163 / W ednesday, August 24, 1994 / Proposed Rules
C onversion F actor Matrix *
[Amounts in percent]
Residual maturity
Interest rate
Less than one year ..............................................................................
One to five years ..................................................................................
Five years or more ...............................................................................
Exchange
rate and
gold
0.0
0.5
1.5
Equity**
6.0
8.0
10.0
1.0
5.0
7.5
Precious
metals ex
cept gold
Other com
modities
7.0
7.0
8.0
12.0
12.0
15.0
’ For contracts with multiple exchanges of principal, the factors are to be multiplied by the number of remaining payments in the contract.
* For contracts that reset to zero value following a payment, the remaining matunty is set equal to the time until the next payment.
*
(d) No potential future exposure is
calculated for single currency in terest rate
sw aps in w h ic h p aym ents are m ad e based
u p o n tw o floating rate in dices (so called
floating/floating o r basis sw aps); the credit
exposure on these contracts is evaluated
solely on the basis of their m ark-to-m arket
values.
(e) T he Board notes that the conversion
factors set forth above, w h ic h are based on
observed volatilities of th e p a rtic u la r types of
instrum ents, are subject to review a n d
m odification in light of changing volatilities
or m arket conditions.
3.
Netting, (a) For p u rp o ses of this
append ix A, netting refers to the offsetting of
positive and negative m ark-to-m arket values
w hen determ ining a curren t e x po su re to be
used in the calculation of a credit equivalent
am ount. Any legally enforceable form of
bilateral n etting (that is, n etting w ith a single
counterparty) of derivative contracts is
recognized for p urposes of c alculatin g the
credit equivalent am o unt pro v id ed that:
(1) The netting is accom p lished u n d e r a
w ritten netting contract that creates a single
legal obligation, covering all in clu d e d
ind ividual contracts, w ith th e effect th at the
organization w ould have a claim or
obligation to receive or pay, respectively,
only the net am o unt of the sum of the
positive a n d negative m ark-to-m arket values
on inclu d ed ind ivid ual contracts in the event
that a counterparty, or a cou n te rp arty to
w hom the con tract has b een v alidly assigned,
fails to perform due to any of the follow ing
events: default, insolvency, b an kruptcy, or
sim ilar circum stances.
(2) T he banking organization ob tains a
written a n d reasoned legal opinion(s)
representing that in the event of a legal
challenge, in clu d in g o ne resulting from
default, insolvency, liq uidation or sim ilar
circum stances, the relevant court and
adm inistrativ e authorities w o u ld find the
organization’s exposure to be such a net
am ount under;
(i) the law o f the jurisdiction in w h ic h the
co unterparty is chartered or the equivalen t
location in th e case of noncorpo rate entities,
and if a b ranch of the c o u nterp arty is
involved, th en also u n d e r the law of the
jurisdiction in w h ic h the b ranch is located;
(ii) the law that governs the in d iv id u a l
contracts covered by the n etting contract; and
(iii) the law that governs the netting
contract.
(3) T he banking organization establishes
and m ain tain s procedures to e n su re th at the
legal characteristics of n etting co ntracts are
kept u n d e r review in th e light o f possible
changes in relevant law.
(4) T he banking organization m ain tain s in
its files do cu m en tation adequate to su ppo rt
the netting o f rate contracts, in clu d in g a copy
of the bilateral n etting contract a n d necessary
legal opinions.
(b) A contract c o n tain ing a w alkaw ay
clause is not eligible for n etting for purpo ses
of calculating the credit equivalent a m ou nt.53
(c) By netting in div idual contracts for the
purpose of calculating its credit e q uiv alent
am ount, a banking organization rep resents
that it has m et the requirem ents o f this
append ix A a n d all the approp riate
docum ents are in the o rg anization's files and
available for inspection by the Federal
Reserve. U pon determ ination by th e Federal
Reserve that a banking organ ization ’s files are
inadequate or that a n etting contract m ay not
be legally enforceable u n d e r any one of the
bodies of law described in section
III.E.3.(a)(2) (i) throu gh (iii) of this a p p en d ix
A, underlyin g in div id u al co ntracts m ay be
treated as though they were not subject to the
netting contract.
(d) T he credit equivalen t a m ou nt of
derivative contracts that are subject to a
qualifying bilateral netting c ontract is
calculated by adding (i) the net curren t
exposure for the netting contract a n d (ii) the
sum of the estim ates o f potential future
exposure for all in div id u al contracts subject
to the netting contract, adjusted to take into
account the effects of the n etting contract.
(e) T he net current exposure is th e su m of
all positive and negative m ark-to-m arket
values of the in div idual contracts subject to
the netting contract. If the net su m o f the
mark-to-m arket values is positive, th e n the
net current exposure is equal to that sum . If
the net sum of the m ark-to-m arket values is
zero o r negative, th en the net c u rren t
exposure is zero.
(f) T h e su m o f the estim ates of potential
future exposure for all ind iv id u al contracts
subject to the netting contract (Ap o u ),
adjusted to reflect the effects o f the netting
contract (A,*,), is d eterm ined through
application of a formula. T he form ula, w hich
em ploys the ratio of the net curren t exposure
to the gross current e xposure (NGR), is
expressed as:
Anct= *5(Agross+(NGRxAgrovs))
’■'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 to
the estate of a defaulter, even if a defaulter or the
estate of a defaulter is a net creditor under the
contract.
(g) Gross potential future exposure, or
AfIO„ , is calculated by sum m in g the estim ates
of potential future exposure (determ ined in
accordance w ith section III.E.2. o f this
app en d ix A) for each indiv id u al contract
subject to th e qualifying bilateral netting
contract.54 T he NGR is the ratio o f the net
current exposure of the netting contract to
the gross cu rrent exposure o f the netting
contract. T h e gross current expo su re is the
sum of the curren t exposures of all
in div idual contracts subject to th e netting
contract calculated in accordance w ith section I1I.E.2. of this a p p en d ix A. T he effect
of this treatm ent is that A„« is the average of
A gross and Apross adjusted by th e NGR.
*
*
*
*
*
5. Appendix A to part 225 is amended
by revising section III.E.4. to read as
follows:
*
*
*
*
*
III. * * *
E. * * *
4. Fisk weights, (a) O nce the credit
equivalent a m oun t for a derivative contract,
or a group of derivative contracts subject to
a qualifying netting contract, has been
determ ined, that a m ou nt is assigned to the
risk weight category app ropriate to the
counterparty, or, if relevant, the g uarantor or
the nature of any collateral.55 H ow ever, the
m axim um w eight that w ill be a p p lie d to the
credit equivalent am o u n t o f su c h c ontracts is
50 percent.
*
*
*
*
*
6. In appendix A to part 225, section
II1.E.5., as that section was proposed to
be revised at 59 FR 26463, May 20,
1994, is revised to read as follows:
*
*
*
*
*
III. * * *
E * * *
5. Avoidance o f double counting, (a) In
certain cases, credit exposures arising from
the derivative contracts covered by these
guidelines m ay already be reflected, in part,
34For purposes of calculating gross 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.
35 For derivative contracts, sufficiency of
collateral or guarantees is generally 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.
Federal Register / Vol. 59, No. 163 / W ednesday, August 24, 1994 / Proposed Rules
on the balance sheet. To avoid double
counting s u c h e x p o su res in the assessm ent of
capital adequ acy a n d , perhaps, assigning
inappro priate risk weights, cou nterparty
credit exposures arising from the types of
instru m ents covered by these g uid elines m ay
need to be e x clu d e d from balance sheet
7. In a p p e n d ix A to part 225, A ttachm ent
V, as that attach m en t w as propo sed to be
revised at 59 FR 26464, M ay 20,199 4, is
revised to read as follows:
assets in calculatin g b a n k s’ risk-based capital
ratios.
(b) E xam ples o f th e c alculation o f credit
equivalent a m o u n ts for these types of
contracts are c o n ta in ed in A ttachm ent V o f
th is a p p en d ix A.
*
‘ *
A t t a c h m e n t V — C a l c u l a t io n
of
*
C
*
r e d it
43517
*
*
*
*
*
*
E q u iv a l e n t A m o u n t s
for
D e r iv a t iv e C o n t r a c t s
Potential Exposure + Current Exposure = Credit Equivalent Amount
Type of contract (remaining maturity)
(1) 120-day forward foreign exchange................
(2) 6-year forward foreign exchange..................
(3) 3-year interest rate sw ap..............................
(4) 1-year oil sw ap.............................................
(5) 7-year interest rate sw ap ..............................
Notional prin
cipal (dollars)
5,000,000
6,000,000
10,000,000
10,000,000
20,000,000
Conversion
factor
.01
.075
.005
.12
.05
Total ........................................................
Potential ex
posure (dol
lars)
Mark-to-market value
50,000
450,000
50,000
1,200,000
1,000,000
100,000
-120,000
200,000
-250,000
-1,300,000
Current ex
posure (dol
lars)
150,000
450,000
250,000
1,200,000
1,000,000
300,000
2,750,000
100,000
0
200,000
0
0
3,050,000
If contracts (1) through (5) above are
subject to a qualifying bilateral netting
contract, th en the follow ing applies:
Potential fu
ture expo
sure (from
above)
(1)
(2)
(3)
(4)
(5)
..........................................................................................
...............................................................................................
...............................................................................................
...............................................................................................
...............................................................................................
50.000
450,000
50.000
1,200,000
1,000,000
Total .................................................................................
2,750,000
Credit Equiv
alent Amount
Net current
exposure1
+
0
=
2,750,000
1The 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.
To recognize the effects of netting on potential future exposure the following formula applies: Anet=.5(Agross+(NGRxAgross).
In the above example: NGR=0 (0/300,000)
Anet=.5(2,750,000+(0x2,750,000))
Anet=1,375,000.
Credit equivalent amount: 1,375,000+0=1,375,000.
If the net current exposure was a positive amount, for example, $200,000, the credit equivalent amount would be calculated as follows:
NGR=.67 (200,000/300,000)
Anet=.5(2,750,000+(.67x2,750,000))
Anet=2,296,250.
Credit equivalent amount: 2,296,250+200,000=2,496,250.
*
*
*
*
*
By the order o f the Board o f Governors of
th e Federal Reserve System , August 16,1994.
W illiam W. W iles,
Secretary of the Board.
[FR Doc.94-20506 Filed 8-23-94 8:45am]
BILLING CODE 6210-01-P
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