Full text of Federal Reserve Bank of New York Circulars : 10731. Treatment of Derivative Contracts

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FEDERAL RESERVE BANK
OF NEW YORK

[

Circular No. 10731
September 2, 1994

"I

J

TREATMENT OF DERIVATIVE CONTRACTS
Proposal to Amend the Board’s Risk-Based Capital Guidelines
Comments Invited by October 21

To All State Member Banks and Bank Holding Companies
in the Second Federal Reserve District; and Others Concerned:

Following is the text of a statement issued by the Board of Governors of the Federal Reserve
System:
The Federal Reserve Board has requested public comment on a proposed amendment to the Board’s
risk-based capital guidelines for state member banks and bank holding companies regarding the
treatment of derivative contracts.
Comment is requested by October 21, 1994.
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 Supervisors’ Committee (BSC)
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.

Printed on the following pages is the text of the proposal, as published in the F ederal R egister
of August 4. Comments thereon should be submitted by October 21, 1994, and may be sent to the
Board of Governors, as indicated in the notice, or to our Banking Studies Department.




W il l ia m J. M c D o n o u g h ,

P resident.

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Federal Register / Vol. 59, No. 163 / Wednesday, August 24, 1994 / Proposed Rules
FEDERAL RESERVE SYSTEM
12CFR Parts 208 and 225
[Regulations H and Y; Docket No. R-0845]

Capital; Capital Adequacy Guidelines
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.

AGENCY:

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 would be permitted
to recognize a reduction in potential
future exposure for transactions subject
to qualifying bilateral netting
arrangements.
DATES:

Comments must 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., Washington, 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),

/ 073/
Federal Register / Vol. 59, No. 163 / Wednesday, August 24, 1994 / Proposed Rules
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).
SUPPLEMENTARY INFORMATION:

I. Background
The international risk-based capital
standards (the Basle A ccord)1 set forth
a framework for measuring capital
adequacy under which risk-weighted
assets are calculated by assigning assets
and off-balance-sheet items to broad
categories based prim arily on their
credit risk, that is, the risk that a loss
will be incurred due to an obligor or
counterparty default on a transaction.12
Off-balance-sheet transactions are
incorporated into risk-weighted assets
by converting each item into a credit
equivalent am ount w hich is then
assigned to the appropriate credit risk
category according to the identity of the
obligor or counterparty, or if relevant,
the guarantor or the nature of the
collateral.
The credit equivalent am ount of an
interest rate or exchange rate contract
(rate contract) isjdetermined by adding
together the current replacem ent cost
(current exposure) and an estimate of
the possible increases in future
replacement cost, in view of the
volatility of the current exposure over
the remaining life of the contract
(potential future exposure, also referred
to as the add-on). Each credit equivalent
amount is then assigned to the
appropriate risk category generally
based on the identity of the
counterparty. The maximum risk weight
applied to interest rate or exchange rate
contracts is 50 percent.3
A. Current Exposure
A banking organization that has a rate
contract with a positive mark-to-market
value has a current exposure to a
1T he B asle A ccord w as p rop osed by th e B asle
C om m ittee o n B an k in g S u p e r v isio n (B asle
S up ervisors' C om m ittee, BSC) an d en d o rsed b y the
central bank governors o f th e G roup o f T en (G-10)
cou n tries in July 1988. T h e B a sle S u p e r v is o r s ’
C om m ittee is co m p rise d o f re p r ese n ta tiv es o f th e
central banks an d su p er v iso ry a u th o r itie s from the
G -10 co u n trie s (B elgiu m , C anada, F rance, G erm any,
Italy, Japan, N eth erlan d s, S w e d e n , S w itz e r la n d , the
U n ited K ingd om , an d the U n ited S tates) an d
L uxem bourg. In January 1989 th e F ed eral R eserve
Board a d o p ted a sim ila r fram ew ork to be u se d by
state m em b er banks and bank h o ld in g co m p a n ies.

2 Other types of risks, such as market risks,
generally are not addressed by the risk-based
framework.
3 Exchange rate contracts w ith an origin al
m atu rity o f 14 calen d ar d ays or le ss and
in stru m en ts traded on ex c h a n g es that requ ire d a ily
p aym en t o f variation m argin are e x c lu d e d from the
risk-based cap ital ratio ca lcu la tio n s.




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
a defined set of contracts is sometimes
referred to as the gross current exposure
for that set of contracts.
The Basle Accord, as endorsed in
1988, provided that current exposure
would be determined individually for
every rate contract entered into by a
banking organization. Generally,
institutions were not perm itted to offset,
that is, net, positive and negative markto-market values of m ultiple rate
contracts wdth a single counterparty to
determine one current exposure relative
to that counterparty.5 In April 1993 the
Basle Supervisors’ Committee (BSC)
proposed a revision to the Basle Accord,
endorsed by the G-10 Governors in July
1994, that permits institutions to net
positive and negative mark-to-market
values of rate contracts subject to a
qualifying, legally enforceable, bilateral
netting arrangement. Under the revision
to the Accord, institutions with
qualifying netting arrangements could
replace the gross current exposure of a
set of contracts included in such an
arrangement w ith a single net current
exposure for purposes of calculating the
credit equivalent amount for the
included contracts. If the net market
value is positive, then that market value
equals the current exposure for the
netting contract. If the net market value
is zero or negative, then the current
exposure is zero.
On May 20,1994, the Board and the
Office of the Comptroller of the
Currency (OCC) issued a joint proposal
to amend their respective risk-based
capital guidelines in accordance with
the BSC April 1993 proposal.6
Generally, under the proposal, a
bilateral netting arrangement would be
recognized for risk-based capital
4 T he lo ss to a b a n k in g o rg a n iza tio n from a
cou n terp arty’s d efa u lt on a rate co n tra ct is th e co st
o f rep la cin g th e ca sh flo w s s p e c ifie d b y the
contract. T h e m ark-to-m arket v a lu e is th e p resen t
v a lu e o f th e net ca sh flo w s s p e c ifie d b y the
contract, ca lcu la ted o n th e b a sis o f current m arket
interest an d ex c h a n g e rates.
s N ettin g b y n o v a tio n , h o w ev er, w a s re co g n ized .
N ettin g by n o v a tio n is a c c o m p lis h e d u n d er a
w ritten b ilateral con tract p ro v id in g that an y
ob lig a tio n to d eliv er a g iv e n cu rren cy o n a g iv e n
date is a u to m a tica lly a m algam ated w ith a ll oth er
o b lig a tio n s for th e sa m e curren cy a n d v a lu e date.
T h e p rev io u sly e x istin g con tracts are e x tin g u is h e d
and a n ew con tract, for the sin g le net a m o u n t, is
leg a lly su b stitu ted for th e a m algam ated gross
ob ligations.
6 T he O ffice o f Thrift S u p er v isio n is s u e d a sim ila r
n ettin g p ro p o sa l o n June 1 4 ,1 9 9 4 an d th e F ed eral
D ep o sit Insu ran ce C orporation is s u e d its n ettin g
p rop osal o n July 2 5 , 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 with 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 m ultiplying
the notional principal am ount7 of the
underlying contract by a credit
conversion factor that is determ ined 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 e a r..........

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 T h e n o tio n a l p rin cip a l a m o u n t, or v a lu e .i s a
referen ce am ou n t o f m o n ey u se d to ca lcu la te
p a y m en t stream s b etw een the co u n terp a rties.
P rin cip a l a m o u n ts gen era lly are not ex c h a n g ed in
sin g le-cu rren cy in terest rate sw a p s, but g en era lly
are ex c h a n g ed in foreign ex c h a n g e co n ta cts
(in clu d in g cross-cu rrency in terest rate sw a p s).
8 A m a tch ed pair is a pair o f co n tra cts w ith
id en tica l term s, w ith th e b ank ing o rg a n iza tio n the
Continued

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Federal Register / Vol. 59, No. 163 / Wednesday, August 24, 1-994 / Proposed Rules

exposure was them 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 end
burden, on the other.9
The add-on for potential future
exposure is calculated for all contracts,
regardless of whether the market value
is zero, positive, or negative, or whether
the current exposure is calculated on a
gross or net basis. The add-on w ill
always be either a positive number or
zero. The recent revision to the Basle
Accord to recognize netting for die
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 in 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 amount 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. Basie Proposals for the Treatment o f
Potential F u to n 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
transactions10*—has become much more
widespread. As a result of continued
review of the method for calculating the
add-on for potential future exposure, in
July 1994 the BSC issued two proposals
for public consultation.11 The first
proposal would expand the matrix of
add-on factors used to calculate
potential future exposure to take into
account innovations in the derivatives
market. 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 o f derivative instruments,
in particular, long-dated interest rate
contracts, commodity contracts, and
equity-index contracts. The BSC review
indicated drat the current add-on factors
do not adequately address the full range
of contract structures and die timing o f
cash flows. The review also showed that
the conversion factors many institutions
are using to calculate potential future
exposure for commodity, precious
metals, and equity contracts could result
in insufficient capital coverage in view
of die volatility of the indices or prices
on the underlying assets from which
these contracts derive their value.12
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
he 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 rdte
contracts hut 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
A. E x p a n sio n o f A d d -o n M atrix
the basis n f simulation studies that used
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
used to calculate the add-on amount
The proposed matrix is set forth
below:
may produce insufficient capital for
Conversion Factor Matrix*
[Amounts in percent]

Residual maturity
Less than one year ......„...... „..........................................................
One to five years................- ............................................................
Five years or more ............................. - ............................................

Interest rate

Foreign ex­
change and
gdld

0.0%
0.5%
15%

1.0%
5.0%
7.5%

Equity**
6.0%
8.0%
to.o%

Precious
com­
metals, ex­ Other
cept gold . 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 automatically reset to zero value following a payment, the remaining maturity is set equal to the time remaining until the
next payment

buyer o f one of the contracts and the seller of the
other.
9The m ethodology upon w hich the statistical
analyses w ere based is described in detail in a
technical working paper entlfied “Potential Credit
Exposure on Interest Rate and Foreign Exchange
Rate Related Instrum ents.” This paper is available
-upon request from the Board's Freedom of
Information Office.
10
In general terms, these are off-balance-sheet
transactions that have a.return. or a portion of their
return, linked to the price o f a particular




com m odity, precious m etal, or equity or to an index
of com m odity, precious m etal, or equity prices.
11 The proposal* are contained in a paper from the
BSC entitled ‘T h e Capital Adequacy Treatment of
the Credit R isk A ssociated w ith Certain Off-Balance
Sheet Item s” that is available upon request from the
Board's Freedom ttflnform ation Office.
12 W hile com m odity, precious m etals, and equity
contracts w ere not exp licitly covered by the original
Accord, as d ie use of su ch contracts becam e more
prevalent, many^G-10 banking supervisors,
including U .5. banking supervisors,-have informally
permitted institutions to apply the conversion

factors for exchange rate contracts to these types of
transactions pending developm ent of a m ore
appropriate treatment.
13 The conversion factois for Tate contracts w ith
rem aining m aturities of one to five years are
currently applied Uxcontracta w ith a remaining
maturity oil over one year.
14The m ethodology and results.of the statistical
analyses are sum m arized in a paper entitled “The
Calculation of Add-Ons for Derivative-Contracts:
th e "Expanded Matrix” Approach" tbaMs available
upon request from the Board's Freedom of
Information Office.

Federal Register / Vol. 59, No. 163 / Wednesday, August 24, 1994 / Proposed Rules
Gold is included w ithin 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 m ultiple exchanges of
principal. Since the level of potential
future exposure rises generally in
proportion to the num ber of remaining
exchanges, the conversion factors are to
be m ultiplied by the num ber 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 tim e 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 m aturity 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 of 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 without 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.13*15
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 m ethod 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 m ultiple
derivative contracts it has entered into
w ith 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 im portant 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
13 W h ile current ex p o su r e is in ten d ed to co v er an
org a n iza tio n 's cred it ex p o su r e at o n e p o in t in tim e ,
p o ten tia l future ex p o su r e p ro v id es a n estim a te o f
p o ss ib le in crea ses in future rep la cem en t co st, in ^
v ie w o f th e v o la tility o f current ex p o su r e o v er th e
rem a in in g life o f the con tract. T h e greater th e
te n d e n c y o f the current e x p o su r e to flu ctu a te o v er
tim e , th e greater the a d d -o n for p o ten tia l future
ex p o su r e sh o u ld be to c o v e r p o ss ib le flu ctu a tio n s.
16 For p u rp o ses o f th is d is c u ss io n , a p o rtfo lio
refers to a set o f con tracts w ith a sin g le
cou n terp arty. A b ank ing o rg a n iz a tio n ’s glo b a l
p ortfo lio refers to all o f th e co n tra cts in th e
in s titu tio n ’s total d eriv a tiv es p o rtfo lio that are
sub ject to q u a lify in g n ettin g arrangem ents.
17 V o la tility in th is d is c u ss io n is th e te n d e n c y o f
th e m arket v a lu e o f a co n tra ct to vary or flu ctu a te
o v er tim e. A h ig h ly v o la tile p o rtfo lio w o u ld 'h a v e

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 w ithin the
portfolio. In those cases where net
current exposure has a tendency to
fluctuate more over time than gross
current exposure, a netting arrangement
will not 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 w ithin 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 am ount 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
w hich 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 te n d e n c y to flu ctu a te s ig n ific a n tly o v er short
p e r io d s o f tim e. O ne o f th e m o st im portant factors
in flu e n c in g a p o rtfo lio ’s v o la tility is th e correlation
o f th e con tracts w ith in th e p o rtfo lio , that is, th e
d eg ree to w h ic h th e co n tra cts in th e p o rtfo lio
re sp o n d sim ila rly to ch a n g in g m arket co n d itio n s.

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Federal Register / Vol. 59, No. 163 / Wednesday, August 24, 1994 / Proposed Rules

recognize bilateral (dose-out netting
arrangements and w ould formally
extend this recognition to commodity,
precious metals, and equity derivative
contracts.
With regard to the portion of the
proposal to expand the conversion
factor matrix, the Board is proposing the
same conversion factors set forth in the
BSC proposal. The Board agrees w ith
the BSC that the existing conversion
factors applicable to long-dated
transactions do not provide sufficient
capital for the risks associated with
those types of contracts. The Board also
agrees w ith the BSC that the conversion
factors for foreign exchange transactions
are significantly too low for commodity,
precious metals, and equity derivative
contracts due to the volatility of the
associated indices and the prices on the
underlying assets.18
The Board is proposing the same
formula as the BSC proposal to calculate
a reduction in the add-on for potential
future exposure for contracts subject to
qualifying netting contracts. The Board
recognizes several advantages w ith this
formula. First, the formula uses bankspecific information to calculate the
NGR. The NGR is simple to calculate
and uses readily available information.
The Board believes the use of the
averaging factor of 0.5 is an im portant
aspect of the proposed formula because
it means the add-on for potential future
exposure can never be reduced to zero
and banking organizations w ill always
hold some capital against derivative
contracts, even in those instances where
the net current exposure is zero.
The Board is seeking comment on all
aspects of this proposal. As mentioned
earlier, the BSC proposal seeks
comment on w hether the NGR should
be calculated on a counterparty-by­
counterparty basis, or on a global basis
for all contracts subject to qualifying
III. The Board Proposal
bilateral netting arrangements. The
Board’s proposed regulatory language
In light of the BSC proposal, the
would
require the calculation of a
Board believes that it is appropriate to
separate NGR for each counterparty
seek comment on proposed revisions to
with which it has a qualifying netting
the calculation of the add-on for
contract. However, the Board is also
potential future exposure for derivative
seeking comment as to w hich method of
contracts. Therefore, the Board is
calculating the NGR would be most
proposing to amend its risk-based
efficient and appropriate for institutions
capital guidelines for state member
with num erous qualifying bilateral
banks and bank holding com panies to
expand the matrix of conversion factors, netting arrangements. With either
and to perm it institutions that make use calculation method the NGR would be
of qualifying netting arrangem ents to
" 'S im ilar to th e B SC p ro p o sa l, th e B o a rd ’s
recognize the effects of those netting
p rop osed a m en d m en t s p e c ifie s that for eq u ity
arrangements in the calculation of the
con tracts that a u to m a tica lly reset to zero v a lu e
add-on for potential future exposure.
fo llo w in g a p a y m en t, th e re m a in in g m a tu rity is set
equal to th e tim e rem a in in g u n til th e n ex t p a y m en t.
The second part of the proposed
A lso, for co n tra cts w ith m u ltip le e x c h a n g e s o f
am endm ent is contingent on the
p rin cip a l, th e co n v er sio n factors are to be
adoption of a final am endm ent to the
m u ltip lie d by th e num b er o f r e m a in in g p a y m en ts in
the
contract.
Board’s risk-based capital guidelines to

the add-on as currently calculated
(Agross) and the same am ount m ultiplied
by the NGR to arrive at a reduced add­
on (Ane») for contracts subject to
qualifying netting arrangem ents in
accordance w ith the requirem ents set
forth in the recently revised Accord.
This formula is expressed as:
A net—-5(Agross+(NGRxAgross)).
For example, a bank w ith 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„et as follows:
.5(1,200,000+1.6x1,200,000))
Anct=960,000
For banking organizations w ith 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 proposal does not specify
whether the NGR should be calculated
on a counterparty-by-counterparty basis
or on an aggregate basis for all
transactions subject to qualifying,
legally enforceable netting
arrangements. The proposal requests
com m ent on w hether the choice of
m ethod could bias the results and
w hether there is a significant difference
in calculation burden between the two
methods.
The BSC proposal also acknowledges
that sim ulations using institutions’
internal models for m easuring credit
risk exposure would most likely
produce the most accurate
determ ination of the effect of netting
arrangements on potential future
exposures. The proposal states that the
use of such models would be considered
at some future date.




applied separately to adjust th e add-on
for potential future exposure for each
netting arrangement. The Board notes
that some preliminary findings indicate
that a global NGR may be less
burdensome to apply since the same
NGR w ould be used for each
counterparty with a netting
arrangement, but counterparty specific
NGRs may provide a more accurate
indication of the credit risk associated
with each counterparty.
Regulatory Flexibility Act Analysis
The Board does not believe that
adoption of this proposal w ould have a
significant economic impact on a
substantial num ber of small business
entities (in this case, small banking
organizations), in accord with the spirit
and purposes of the Regulatory
Flexibility Act (5 U.S^C 601 etseq.). In
this regard, while some small
institutions with limited derivative
portfolios may experience an increase in
capital charges, for most of these
institutions the proposal w ill have no
effect. For institutions with more
developed derivative portfolios the
overall affect of the proposal will likely
be to reduce regulatory burden and the
capital charge for certain transactions.
In addition, because the risk-based
capital standards generally do not apply
to bank holding companies w ith
consolidated assets o f less than $150
million, this proposal will not affect
such -companies.
Paperw ork Reduction Act
The Federal Reserve has determ ined
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. seq.).
List of Subjects
12 CFE Fart 208
Accounting, Agriculture, Banks,
banking, Capital adequacy, Confidential
business information, Currency, Federal
Reserve System, Reporting and
recordkeeping requirements, Securities,
State member banks.
12 CFE Part 225
Adm inistrative practice and
procedure, Banks, banking, Capital
adequacy, Federal Reserve System,
Holding companies, Reporting and
recordkeeping requirements, Securities,
For the reasons set forth in the
preamble, the Board proposes to amend
12 CFR parts 208 and 225 as follows.

/6 7 3 /
Federal Register / Vol. 59, No. 163 / Wednesday, August 24, 1994 / Proposed Rides
PART 208—MEMBERSHIP OF STATE
BANKING INSTITUTIONS IN THE
FEDERAL RESERVE SYSTEM
(REGULATION H)

HI . * *
E. Derivative-Contracts (Interest Rate,
Exchange Rate, Commodity (including
precious metals), and Equity Contracts)
1. S c o p e . (a) Credit equivalent amounts are
computed for each of the following offbalance-sheet derivative contracts:

43513

treated in the same way as other derivative
contracts.
*
*
*
*
*

4. In appendix A to part 208, section
III.E.2. and section IH.E.3., as those
sections were proposed to he revised at
59 FR 26461, May 20,1994, are revised
I. Interest Rate Contracts
to read as follows:
A. Single currency interest rate swaps.
*
*
*
*
*
B. Basis swaps.
111.*
*
*
C. Forward rate agreements.
E. * * *
D. Interest rate options purchased (including
2.
Calculation of credit equivalent
caps, collars, and floors purchased).
amounts, (a) The credit equivalent amount of
E. Any other instrument that gives rise to
a derivative contract that is not subject to a
similar credit risks (including whenqualifying bilateral netting contract in
issued securities, and forward deposits
accordance with section IH.E.3. of this
accepted).
appendix A is equal to the sum of (i) the
II. Exchange Rate Contracts
current exposure'(sometimes referred to as
Appendix A to Part 208 —Capital Adequacy
A. Cross-currency interest rate swaps.
the replacement cost) of the contract and (ii)
Guidelines for State Member Banks: RiskB. Forward foreign exchange contracts.
an estimate of the potential future credit
Based Measure
exposure over the remaining life of the
C. Currency options purchased.
*
*
*
*
*
contract.
^
D. Any other instrument that gives rise to
III. * * *
similar credit risks/
(b) The current exposure is determined by
C. * * *
III. Commodity (including precious metal) or the mark-to-market value of the contract. If
3. * * *
the mark-to-market value is positive,, then the
Credit equivalent amounts of derivative
Equity Derivative Contracts
current exposure is equal to that mark-to
contracts involving standard risk obligors
A. Commodity or equity linked swaps.
market value. If the mark-to-market value is
(that is, obligors whose loans or debt
B. Commodity or equity linked options
zero or negative, then the current exposure is
securities would be assigned to the 100
purchased.
zero. Mark-to-market values are measured in
percent risk category) are included in the 50
C. Forward commodity or equity linked
dollars, regardless .of the currency or
percent category, unless they are backed fey
contracts.
collateral or guarantees that allow them to be
currencies specified in the contact and
D.
Any
other
instrument
that
gives
rise
to
placed in a lower risk category.
should reflect changes in both underlying
similar credit risks.
*
•*
*
*
*
rates, prices, and indices, and counterparty
(b)
Exchange rale contracts with an originalcredit quality.
j-j * * * 40 * * *
maturity of fourteen calendar days or less
(c) The potential future credit exposure of
*
*
*
*
*
and derivative contracts traded on exchanges a contract, including contracts with negative
3.
A ppendix A to part 208 is amendedthat require daily payment of variation
mark-to-market values, is estimated by
by revising the section III.E. heading
margin may be excluded from the risk-based
multiplying the notional principal amount of
and section IILE.1. to read as follows:
ratio calculation. Over-the-counter options
the contract by one of the following credit
conversion factors, as appropriate:
purchased, however, are included and
1. T he authority citation for part 208
is revised to read as follows:
Authority: 12 U.S.C. 36. 248(a), 248(c),
321-338a, 37ld,461,481-486, 601, 611,
1814,1823(j), T828(o), 1831o, 1831p-l, 3105,
3310, 3331-3351 and 3906-3909; 15 U.S.C.
78b, 781(b), 781(g), 78l(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 the last paragraph in section
III.C.3. and footnote 40 in the
introductory text of section III.D. to read
as follows:

C onversion Factor M atrix *
[Amounts in percent]
Residual maturity

i Interest rate

Less than one year
.. „................... .... .................................... .
One to five years .................................... - .......................................
Five years or more ................................ .................................. ....... „. i

Exchange
rate and
gold

G.O
0.5
1.5

1.0
5.0
7.5

Equity**
6.0
8.0 :
10.0

Precious
com­
metals ex- ' Other
modities
ceptgold
7.0
70
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 maturity is set equal to the time until "toe next payment.
(d) No potential future 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.
(e) The Board notes that the conversion
factors set forth above, which are based on
observed volatilities of the particular types of
instruments, are subject to review and
modification in light of changing volatilities
or market conditions.40*

3.
Netting, (a) For purposes of this
appendix A, netting refers to the offsetting of
positive and nogHtTvemark-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 derivative contracts is
recognized for purposes of calculating the
credit equivalent amount provided that:
(1)
The netting is accomplished under a
written netting contract (that creates a single
legal obligation, covering all included
individual iCOBbacts, with the effect that the

bank would haven 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, foils to
perform due to any ofthe following events:
default, insolvency, bankruptcy,>or similar
circumstances.
(2)
The bank obtains a written and
reasoned legal opiniott(s) representing that in
the -event of a legal challenge, including one
resulting from default, insolvency.

40 T h e s u ffic ie n c y o f co lla tera l an d gu aran tees for
o ff-b alan ce-sh eet ite m s i s d eterm in ed b y th e market
v a lu e o f th e co lla tera l or th e am ou n t o f th e

guarantee i n re la tio n r e th e fa c e a m o u n t o f t h e item ,
e x c e p t fa r d eriv a tiv e-co n tra c ts, f o r -w hich th is
d eterm in a tio n is g en er a lly m a d e in rela tio n to the

cr e d it e q u iv a le n t am ount.■CoUateral a n d gu aran tees
are su b ject to t h e sa m e p r o v is io n s n o te d u n d er
s e c tio n in.B o f th is a p p e n d ix A.




/O 0 /
43514

F ed eral R egister / Vol. 59, No. 163 / W ednesday, August 24, 1994 / Proposed Rules

liq u id a tio n o r s im ila r c ir c u m s ta n c e s , th e
r e le v a n t c o u r t a n d a d m in is tr a tiv e a u th o r itie s
w o u ld fin d t h e b a n k ’s e x p o s u r e to b e s u c h a
n et am ou n t under:
(i) th e la w o f t h e j u r is d ic tio n in w h ic h th e
c o u n te r p a r ty is c h a r te r e d o r th e e q u iv a le n t
lo c a tio n in t h e c a s e o f n o n c o r p o r a te e n t itie s ,
a n d i f a b r a n c h o f t h e c o u n te r p a r ty is
in v o lv e d , t h e n a ls o u n d e r t h e la w o f th e
ju r is d ic tio n in w h ic h t h e b ra n ch is lo c a te d ;
(ii) th e la w th a t g o v e r n s th e in d iv id u a l
c o n tr a c ts c o v e r e d b y t h e n e ttin g co n tra ct; a n d
(iii) th e la w th a t g o v e r n s th e n e ttin g
co n tra ct.
(3) T h e b a n k e s t a b lis h e s a n d m a in ta in s
p r o c e d u r e s to e n s u r e th a t th e leg a l
c h a r a c te r is tic s o f n e t tin g c o n tr a c ts are k e p t
u n d e r r e v ie w in th e lig h t o f p o s s ib le c h a n g e s
in r e le v a n t la w .
(4) T h e b a n k m a in t a in s in its file s
d o c u m e n t a t io n a d e q u a te to su p p o r t th e
n e ttin g o f rate c o n tr a c ts , in c lu d in g a c o p y o f
th e b ila te r a l n e t tin g c o n tr a c t a n d n e c e s s a r y
le g a l o p in io n s .
(b) A c o n tr a c t c o n t a in in g a w a lk a w a y
c la u s e is n o t e lig ib le fo r n e ttin g for p u r p o se s
o f c a lc u la t in g t h e c r e d it e q u iv a le n t a m o u n t.49
(c) B y n e t tin g in d iv id u a l c o n tr a c ts for th e
p u r p o s e o f c a lc u la t in g it s c r e d it e q u iv a le n t
a m o u n t, a b a n k r e p r e s e n ts th a t it h a s m e t th e
r e q u ir e m e n ts o f t h is a p p e n d ix A a n d a ll t h e
a p p r o p r ia te d o c u m e n t s a re in th e b a n k ’s f ile s
a n d a v a ila b le for in s p e c t io n b y th e F ed e r a l
R e se r v e . U p o n d e te r m in a tio n b y th e F ed era l
R e se r v e th a t a b a n k ’s f ile s a re in a d e q u a te or
th a t a n e ttin g c o n tr a c t m a y n o t b e le g a lly
e n fo r c e a b le u n d e r a n y o n e o f th e b o d ie s o f
la w d e s c r ib e d in s e c t io n I1I.E.3.(a)(2) (i)
th r o u g h (iii) o f t h is a p p e n d ix A . u n d e r ly in g
in d iv id u a l c o n tr a c ts m a y b e tr ea ted a s th o u g h
t h e y w e r e n o t s u b je c t to t h e n e ttin g co n tra ct.
(d) T h e c r e d it e q u iv a le n t a m o u n t o f
d e r iv a tiv e c o n tr a c ts th a t a re su b je c t to a
q u a lify in g b ila te r a l n e t tin g co n tr a c t is
c a lc u la te d b y a d d in g (i) t h e n e t cu rren t
e x p o s u r e fo r th e n e t tin g c o n tr a c t a n d (ii) th e
su m o f th e e s tim a te s o f p o te n tia l futu re

e x p o s u r e for a ll in d iv id u a l c o n tr a c ts su b je c t
to th e n e ttin g c o n tr a c t, a d ju s te d to take in to
a c c o u n t th e e f fe c ts o f t h e n e ttin g co n tra ct.
(e) T h e n e t c u r r e n t e x p o s u r e is th e su m o f
a ll p o s it iv e a n d n e g a tiv e m a rk -to-m ark et
v a lu e s o f t h e in d iv id u a l c o n tr a c ts su b je c t to
th e n e ttin g c o n tr a c t. If t h e n e t s u m o f th e
m a rk -to -m a rk et v a lu e s i s p o s it iv e , th e n th e
n e t cu r r e n t e x p o s u r e is e q u a l to that su m . If
th e n e t s u m o f th e m a rk -to -m a rk et v a lu e s is
z e r o or n e g a tiv e , t h e n t h e n e t cu rren t
e x p o s u r e is zer o .
(f) T h e s u m o f th e e s tim a te s o f p o te n tia l
fu tu re e x p o s u r e fo r a ll in d iv id u a l c o n tr a c ts
su b je c t to t h e n e ttin g c o n tr a c t (A gro»s),
a d ju s te d to r e fle c t t h e e f fe c ts o f th e n e ttin g
c o n tr a c t (A nci), is d e te r m in e d th r o u g h
a p p lic a tio n o f a fo r m u la . T h e fo rm u la , w h ic h
e m p lo y s t h e ra tio o f t h e n e t cu rren t e x p o s u r e
to th e g r o s s c u r r e n t e x p o s u r e (NGR), is
e x p r e s s e d as:
Ancf= *5 (Agross+ ( NGRXA gross))
(g) G ro ss p o te n t ia l fu tu r e e x p o s u r e , or
Agross, is c a lc u la t e d b y s u m m in g th e e s tim a te s
o f p o te n tia l fu tu r e e x p o s u r e (d e te r m in e d in
a c c o r d a n c e w it h s e c t io n II1.E.2. o f t h is
a p p e n d ix A ) for e a c h in d iv id u a l co n tra ct
su b je c t to th e q u a lify in g b ila te r a l n e ttin g
c o n tr a c t.50 T h e N G R is t h e ra tio o f th e n et
cu r r e n t e x p o s u r e o f t h e n e ttin g co n tr a c t to
th e g r o s s c u r r e n t e x p o s u r e o f th e n e ttin g
c o n tr a c t. T h e g r o s s c u r r e n t e x p o s u r e is th e
s u m o f th e c u r r e n t e x p o s u r e s o f all
in d iv id u a l c o n tr a c ts su b je c t to th e n e ttin g
c o n tr a c t c a lc u la t e d in a c c o r d a n c e w ith
s e c tio n III.E.2. o f t h is a p p e n d ix A . T h e e ffe c t
o f t h is tr e a tm e n t is th a t And is th e a v era g e o f
Agross a n d Agross a d ju s te d b y th e NGR.
♦

*

*

*

4. B isk w eig h ts, (a) O n c e t h e c r e d it
e q u iv a le n t a m o u n t fo r a d e r iv a tiv e c o n tr a c t,
or a g r o u p o f d e r iv a tiv e c o n tr a c ts su b je c t to
a q u a lify in g n e t tin g c o n tr a c t, h a s b e e n
d e te r m in e d , th a t a m o u n t is a s s ig n e d to th e
r isk w e ig h t c a te g o r y a p p r o p r ia te to th e
c o u n te r p a r ty , o r, i f r e le v a n t, th e g u a r a n to r or
t h e n a tu re o f a n y c o lla t e r a l.51 H o w e v e r , th e
m a x im u m w e ig h t th a t w i l l b e a p p lie d to th e
c r e d it e q u iv a le n t a m o u n t o f s u c h c o n tr a c ts is
5 0 p e r c e n t.

*

*

*

*

*

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. A v o id a n c e o f d o u b le cou n tin g , (a) In
c e r ta in c a s e s , c r e d it e x p o s u r e s a r is in g from
th e d e r iv a tiv e c o n tr a c ts c o v e r e d b y th e s e
g u id e lin e s m a y a lr e a d y b e r e fle c te d , in part,
o n th e b a la n c e s h e e t. T o a v o id d o u b le
c o u n tin g s u c h e x p o s u r e s in th e a s s e s s m e n t o f
c a p ita l a d e q u a c y a n d , p e r h a p s, a s s ig n in g
in a p p r o p r ia te r isk w e ig h t s , co u n te r p a r ty
c r e d it e x p o s u r e s a r is in g from th e t y p e s o f
in s tr u m e n ts c o v e r e d b y t h e s e g u id e lin e s m a y
n e e d to b e e x c lu d e d fro m b a la n c e s h e e t
a s s e ts in c a lc u la t in g b a n k s ’ r isk -b a se d c a p ita l
ra tio s.
(b)
E x a m p le s o f t h e c a lc u la t io n o f c r e d it
e q u iv a le n t a m o u n ts for th e s e ty p e s o f
c o n tr a c ts are c o n t a in e d in A tta c h m e n t V o f
th is a p p e n d ix A .

*

*

*

*

*

*

5.
A ppendix A to part 208 is amended 7. In appendix A to part 208,
Attachment V, as that attachment was
by revising section III.E.4. to read as
proposed to be revised at 59 FR 26462,
follows: '
May 20,1994, is revised to read as
*
*
*
*
*
follows:
III. * * *
E. * * *

A t t a c h m e n t V — C a l c u l a t io n o f C r e d it E q u iv a l e n t A m o u n t s fo r 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)
(2)
(3)
(4)
(5)

120-day forward foreign exchange ...............
6-year forward foreign exchange ..................
3-year interest rate s w a p ..............................
1-year oil sw ap..............................................
7-year interest rate swap ..............................
Total .........................................................

Notional prin­
cipal (dollars)
5,000,000
6 ,000,006
10,000,000
10,000,000
20,000,000

Conversion
factor
01
.075
.005
.12
.05

Potential ex­
posure (dol­
lars)

Mark-to-mar­
ket 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 c o n tr a c ts (1) th r o u g h (5) a b o v e are
su b je c t to a q u a lify in g b ila te r a l n e ttin g
c o n tr a c t, th e n th e f o llo w in g a p p lie s:

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.




v,For 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.

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 m.B. of this
appendix A.

/ C

f a /

Federal Register / Vol. 59, No. 163 7 Wednesday, August 24, 1994 / Proposed Rules
Potential fu­
ture expo­
sure (from
above)

(5) ...............- ...............................................................................

50.000
450,000
50.000
1,200,000
1,000,000

Total — ............................................................................. •

2,750,000

( 1 ) .................................................................... ...........................
(2) ................................................................................................

Net Current
exposure1

+

0

43515

Credit equiv­
alent amount

=

2,750,000

1 The total of the mark-to-market values from above is -1,370,000. Since this is a negative amount, the net current exposure is zero.
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(2,75G,O0O+{Ox2,75O,OOO))
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.

*

*

*

*

*

PART 225—BANK HOLDING
COMPANIES AND CHANGE IN BANK
CONTROL (REGULATION Y)
1. T h e a u th o r ity c it a tio n for part 2 2 5
c o n t in u e s to rea d a s fo llo w s :

Authority: 1 2 U .S .C . 1 8 1 7 (j)(1 3 ), 1 8 1 8 ,
1 8 3 1 i, 1 8 4 3 (c )(8 ), 1 8 4 4 (b ), 1 9 7 2 (1 ), 3 1 0 6 ,
3 1 0 8 , 3 3 1 0 , 3 3 3 1 -3 3 5 1 , 3 9 0 7 , an d 3909.

2. A ppendix A to part 225 is amended
by revising the last paragraph in section
III.C.3. and footnote 43 in the
introductory text of section III.D. to read
as follows:

HI * « *
E. Derivative Contracts (Interest Rate,
Exchange Rate, Commodity (including
precious metals) and Equity Derivative
Contracts).
1. Scope, (a) Credit equivalent amounts are

computed for each of the following offbalance-sheet derivative contracts:
I. Interest Kate Contracts
A. Single currency interest rate swaps.
B. Basis swaps.
C. Forward rate agreements.
D. Interest rate options purchased (including
caps, collars, and floors purchased).
E. Any other instrument that gives rise to
similar credit risks (including whenissued securities and forward deposits
accepted).
II. Exchange Rate Contracts
A. Cross-currency interest rate swaps.
B. Forward foreign exchange contracts.
C. Currency options purchased.
D. Any other instrument that gives rise to
similar credit risks.
III. Commodity (including precious metal) or
Equity Derivative Contracts
A. Commodity or equity linked swaps.

treated in the same 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:
*
*
*
*
*
HI * * *
E.

* * *

Calculation of credit equivalent
amounts, (a) The credit equivalent amount of

2.

a derivative contract that is not subject to a
qualifying bilateral netting contract in
accordance with section III.E.3. of this
appendix A is equal to the sum of (i) the
Appendix A to Part 225—Capital Adequacy
current exposure (sometimes referred to as
Guidelines lor Bank Holding Companies:
the replacement cost) of the contract and (ii)
Risk-Based Measure
an estimate of the potential future credit
*
*
*
*
*
exposure over the remaining life of the
III. * * *
contract.
C .* * *
(b) The current exposure is determined by
3. * * *
the mark-to-market value of the contract. If
C r e d it e q u iv a le n t a m o u n ts o f d e r iv a tiv e
the mark-to-market value is positive, then the
c o n tr a c ts in v o lv in g s ta n d a r d risk o b lig o r s
current exposure is equal to that mark-to
(th a t is , o b lig o r s w h o s e lo a n s o r d eb t
market value. If the mark-to-market value is
s e c u r itie s w o u ld b e a s s ig n e d to t h e 1O0
B. C o m m o d ity or e q u ity lin k e d o p tio n s
zero or negative, then the current exposure is
p e r c e n t risk c a te g o r y ) a re in c lu d e d in th e 50
purchased.
zero. Mark-to-market values are measured in
p e r c e n t c a te g o r y , u n le s s t h e y are b a c k e d b y
C. Forward commodity or equity linked
dollars, regardless of the currency or
c o lla te r a l o r g u a r a n te e s th a t a llo w th e m to b e
contracts.
currencies specified in the contract and
p la c e d in a lo w e r r isk ca te g o r y .
D. Any other instrument that gives rise to
should reflect changes in both underlying
*
*
*
*
*
similar credit risks.
rates and indices, and counterparty credit
***43 * * *
(b)
Exchange rate contracts with an originalquality.
*
*
*
*
*
(c) The potential future credit exposure of
maturity of fourteen calendar days or less
3.
Appendix A to part 225 is amendedand derivative contracts traded on exchanges a contract, including contracts with negative
mark-to-market values, is estimated by
that require daily payment of variation
by revising the section III.E. heading
margin may be excluded from the risk-based
multiplying the notional principal amount of
and section III.E.l. to read as follows:
ratio calculation. Over-the-counter options
the contract by one of the following credit
*
*
*
*
*
purchased, however, are included and
conversion factors, as appropriate:

The snfficiency o f collateral and guarantees far
off-balance-sheet item s is determ ined by the market
value o fth e collateral or the amount o f the
guarantee in relation to the face amount o f the item,
except for derivative contracts, for w hich this




determination is generally m ade in relation to the
credit equivalent amount. Collateral and guarantees
are subject to the same provisions noted under
section III.B of this A ppendix A.

/ O

43516

W

Federal Register / Vol. 59, No. 163 / Wednesday, August 24, 1994 / Proposed Rules
Conversion Factor Matrix *
[Amounts in percent]
Residual maturity

Interest rate

Less than one year ...............................................................................
One to live years...................................................................................
Five years or more .................................................................................

Exchange
rate and
gold

0.0
0.5
1.5

Equity**

1.0
5.0
7.5

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 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 maturity is set equal to the time until the next payment.
(d) N o p o te n tia l fu tu r e e x p o s u r e is
c a lc u la te d for s in g le c u r r e n c y in te r e s t rate
s w a p s in w h ic h p a y m e n ts are m a d e b a se d
u p o n t w o flo a tin g rate in d ic e s (s o c a lle d
flo a tin g /flo a tin g or b a s is s w a p s ); t h e c r e d it
e x p o s u r e o n t h e s e c o n tr a c ts is e v a lu a t e d
s o le ly o n th e b a s is o f th e ir m a r k -to -m a r k e t
v a lu e s.
(e) T h e B o a rd n o te s th a t th e c o n v e r s io n
fa cto rs s e t forth a b o v e , w h ic h are b a s e d o n
o b se r v e d v o la t ilit ie s o f th e p a r tic u la r ty p e s o f
in str u m e n ts , are su b je c t to r e v ie w a n d
m o d ific a tio n in lig h t o f c h a n g in g v o la t ilit ie s
or m ark et c o n d itio n s .
3.
N ettin g , (a) F o r p u r p o s e s o f t h is
a p p e n d ix A , n e ttin g refers to t h e o ffs e tt in g o f
p o s itiv e a n d n e g a tiv e m a rk -to -m a rk et v a lu e s
w h e n d e te r m in in g a c u r r e n t e x p o s u r e to b e
u s e d in th e c a lc u la t io n o f a c r e d it e q u iv a le n t
a m o u n t. A n y le g a lly e n f o r c e a b le fo rm o f
b ila te r a l n e ttin g (th a t is , n e ttin g w it h a s in g le
co u n te r p a r ty ) o f d e r iv a tiv e c o n tr a c ts is
r e c o g n iz e d for p u r p o s e s o f c a lc u la t in g th e
c r e d it e q u iv a le n t a m o u n t p r o v id e d that:
(1) T h e n e ttin g is a c c o m p lis h e d u n d e r a
w r itte n n e ttin g c o n tr a c t th a t c r e a te s a s in g le
leg a l o b lig a tio n , c o v e r in g a ll in c lu d e d
in d iv id u a l c o n tr a c ts, w it h th e e ffe c t th a t th e
o r g a n iz a tio n w o u ld h a v e a c la im o r
o b lig a tio n to r e c e iv e o r p a y , r e s p e c t iv e ly ,
o n ly th e n e t a m o u n t o f th e s u m o f t h e
p o s it iv e a n d n e g a tiv e m a r k -to -m a r k e t v a lu e s
o n in c lu d e d in d iv id u a l c o n tr a c ts in t h e e v e n t
that a c o u n te r p a r ty , o r a c o u n te r p a r ty to
w h o m t h e c o n tr a c t h a s b e e n v a lid ly a s s ig n e d ,
fa ils to p e r fo r m d u e to a n y o f t h e f o llo w in g
e v e n ts: d e fa u lt, in s o lv e n c y , b a n k r u p tc y , or
s im ila r c ir c u m s ta n c e s .
(2) T h e b a n k in g o r g a n iz a tio n o b ta in s a
w r itte n a n d r e a s o n e d le g a l o p in io n ( s )
r e p r e s e n tin g th a t in th e e v e n t o f a le g a l
c h a lle n g e , in c lu d in g o n e r e s u ltin g fro m
d e fa u lt, in s o lv e n c y , liq u id a tio n or s im ila r
c ir c u m s ta n c e s , th e r e le v a n t c o u r t a n d
a d m in is tr a tiv e a u th o r itie s w o u ld f in d th e
o r g a n iz a tio n ’s e x p o s u r e to b e s u c h a n e t
a m o u n t u n d er:
(i) th e la w o f th e j u r is d ic tio n in w h ic h th e
c o u n te r p a r ty is ch a r te r e d o r th e e q u iv a le n t
lo c a tio n in th e c a s e o f n o n c o r p o r a te e n t itie s ,
a n d if a b r a n c h o f th e c o u n te r p a r ty is
in v o lv e d , t h e n a ls o u n d e r t h e la w o f th e
ju r is d ic tio n in w h ic h th e b r a n c h is lo c a te d ;
(ii) th e la w th a t g o v e r n s t h e in d iv id u a l
c o n tr a c ts c o v e r e d b y th e n e ttin g c o n tr a c t; a n d
(iii) th e la w th a t g o v e r n s th e n e t tin g
c o n tra ct.
(3) T h e b a n k in g o r g a n iz a tio n e s t a b lis h e s
a n d m a in ta in s p r o c e d u r e s to e n s u r e th a t th e
le g a l c h a r a c te r is tic s o f n e t tin g c o n tr a c ts are
k e p t u n d e r r e v ie w in th e lig h t o f p o s s ib le
c h a n g e s in r e le v a n t la w .




(4)
T h e b a n k in g o r g a n iz a tio n m a in t a in s in
its f ile s d o c u m e n ta tio n a d e q u a te to su p p o r t
th e n e ttin g o f rate c o n tr a c ts, in c lu d in g a c o p y
o f th e b ila te r a l n e ttin g c o n tr a c t a n d n e c e s s a r y
leg a l o p in io n s .
(b) A c o n tr a c t c o n t a in in g a w a lk a w a y
c la u s e is n o t e lig ib le for n e ttin g for p u r p o s e s
o f c a lc u la tin g th e c r e d it e q u iv a le n t a m o u n t .53
(c) B y n e ttin g in d iv id u a l c o n tr a c ts fo r th e
p u r p o se o f c a lc u la t in g its c r e d it e q u iv a le n t
a m o u n t, a b a n k in g o r g a n iz a tio n r e p r e s e n ts
tha t it h a s m e t th e r e q u ir e m e n ts o f th is
a p p e n d ix A a n d a ll th e a p p r o p r ia te
d o c u m e n ts are in th e o r g a n iz a tio n ’s f ile s a n d
a v a ila b le for in s p e c t io n b y th e F e d e r a l
R eserv e. U p o n d e te r m in a tio n b y th e F e d e r a l
R e se r v e th a t a b a n k in g o r g a n iz a tio n ’s f ile s are
in a d e q u a te or th a t a n e ttin g c o n tr a c t m a y n o t
b e le g a lly e n fo r c e a b le u n d e r a n y o n e o f th e
b o d ie s o f la w d e s c r ib e d in s e c tio n
111.E.3.(a)(2) (i) th r o u g h (iii) o f t h is a p p e n d ix
A , u n d e r ly in g in d iv id u a l c o n tr a c ts m a y b e
trea ted a s th o u g h th e y w e r e n o t s u b je c t to th e
n e ttin g c o n tr a c t.
(d) T h e c r e d it e q u iv a le n t a m o u n t o f
d e r iv a tiv e c o n tr a c ts th at are su b je c t to a
q u a lify in g b ila te r a l n e ttin g c o n tr a c t is
c a lc u la te d b y a d d in g (i) th e n e t c u r r e n t
e x p o s u r e for th e n e ttin g c o n tr a c t a n d (ii) th e
su m o f th e e s tim a te s o f p o te n tia l fu tu r e
e x p o s u r e for a ll in d iv id u a l c o n tr a c ts su b je c t
to th e n e ttin g c o n tr a c t, a d ju s te d to ta k e in to
a c c o u n t th e e ffe c ts o f th e n e ttin g c o n tr a c t.
(e) T h e n e t cu r r e n t e x p o s u r e is t h e s u m o f
a ll p o s it iv e a n d n e g a tiv e m a r k -to -m a rk et
v a lu e s o f th e in d iv id u a l c o n tr a c ts s u b je c t to
th e n e ttin g c o n tr a c t. If th e n e t s u m o f th e
m a rk -to -m a rk et v a lu e s is p o s it iv e , t h e n th e
n et cu r r e n t e x p o s u r e is e q u a l to th a t su m . If
th e n e t s u m o f th e m a rk -to -m a rk et v a lu e s is
z e r o or n e g a tiv e , th e n th e n e t c u r r e n t
e x p o s u r e is zer o .
(f) T h e s u m o f th e e s tim a te s o f p o te n tia l
fu tu re e x p o s u r e for a ll in d iv id u a l c o n tr a c ts
su b je c t to t h e n e ttin g c o n tr a c t (Agr0ss),
a d ju s te d to r e fle c t th e e ffe c ts o f th e n e ttin g
co n tr a c t (Anei), is d e te r m in e d th r o u g h
a p p lic a tio n o f a fo rm u la . T h e fo r m u la , w h ic h
e m p lo y s th e ra tio o f th e n e t cu r r e n t e x p o s u r e
to th e g r o s s cu r r e n t e x p o s u r e (N G R ), is
e x p r e s s e d as:
Anct= *5 (A gr0ss+ (N G R xA gr0ss))
33 For p u r p o ses o f th is se c tio n , a w a lk a w a y c la u se
m ean s a p r o v isio n in a n ettin g co n tra ct that p erm its
a n on -d efa u ltin g cou n terp arty to m ak e lo w er
p aym en ts th a n it w o u ld m ak e o th e r w is e u n d er th e
con tract, or n o p a y m en t at a ll, to a d efa u lter or to
the estate o f a d efau lter, e v e n if a d efa u lter or th e
estate o f a d efa u lter is a n et cred ito r u n d er the
contract.

(g)
G ross p o te n tia l fu tu r e e x p o s u r e , or
Agross, is c a lc u la te d b y s u m m in g th e e s tim a te s
o f p o te n tia l fu tu r e e x p o s u r e (d e te r m in e d in
a c c o r d a n c e w it h s e c tio n III.E.2. o f th is
a p p e n d ix A ) for e a c h in d iv id u a l c o n tr a c t
s u b je c t to th e q u a lify in g b ila te r a l n e ttin g
c o n tr a c t.54 T h e N G R is th e r a tio o f t h e n e t
cu r r e n t e x p o s u r e o f th e n e ttin g c o n tr a c t to
th e g r o s s c u r r e n t e x p o s u r e o f t h e n e ttin g
c o n tra ct. T h e g r o s s c u r r e n t e x p o s u r e is th e
su m o f th e c u r r e n t e x p o s u r e s o f a ll
in d iv id u a l c o n tr a c ts su b je c t to t h e n e ttin g
c o n tr a c t c a lc u la t e d in a c c o r d a n c e w it h
s e c tio n 1I1.E.2. o f t h is a p p e n d ix A . T h e effe c t
o f t h is trea tm e n t is th at A n« is th e a v e r a g e o f
A gross a n d A gr0ss a d ju s te d b y th e N G R .
*
*
*
*
*

5. Appendix A to part 225 is amended
by revising section III.E.4. to read as
follows:
*
*
*
*
*
III. * * *

E. * * *
4. R isk w eigh ts, (a) O n c e th e c r e d it
e q u iv a le n t a m o u n t for a d e r iv a tiv e c o n tr a c t,
or a g r o u p o f d e r iv a tiv e c o n tr a c ts su b je c t to
a q u a lify in g n e ttin g c o n tr a c t, h a s b e e n
d e te r m in e d , th a t a m o u n t is a s s ig n e d to th e
risk w e ig h t c a te g o r y a p p r o p r ia te to th e
c o u n te r p a r ty , or, i f r e le v a n t, th e g u a r a n to r or
th e n a tu r e o f a n y c o lla te r a l.55 H o w e v e r , th e
m a x im u m w e ig h t th at w i l l b e a p p lie d to th e
c r e d it e q u iv a le n t a m o u n t o f s u c h c o n tr a c ts is
5 0 p e r c e n t.

*

*
*
*
*
6. In appendix A to part 225, section
III.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. A v o id a n c e o f d o u b le cou n tin g , (a) In
c e r ta in c a s e s , c r e d it e x p o s u r e s a r is in g from
th e d e r iv a tiv e c o n tr a c ts c o v e r e d b y t h e s e
g u id e lin e s m a y a lr e a d y b e r e fle c te d , in part, *3
54 For p u r p o ses o f ca lcu la tin g gross p o ten tia l
future cred it ex p o su r e for foreign ex c h a n g e
con tracts a n d oth er sim ila r co n tra cts in w h ic h
n o tio n a l p rin cip a l is eq u iv a le n t to ca sh flo w s , total
n o tio n a l p rin cip a l is d efin ed as th e n et re ceip ts to
ea ch party fa llin g d u e o n ea c h v a lu e d ate in ea ch
cu rren cy.
33 For d eriv a tiv e co n tra cts, s u ffic ie n c y o f
co lla tera l or gu aran tees is g en er a lly d eterm in ed by
th e m arket v a lu e o f th e co lla tera l or th e a m o u n t o f
th e gu arantee in rela tio n to th e cred it eq u iv a le n t
a m o u n t. C ollateral an d gu aran tees are su b ject to th e
sa m e p ro v isio n s n o ted u n d er s e c tio n III.B. o f th is
a p p e n d ix A.

Federal Register / Vol. 59, No. 163 / Wednesday, August 24, 1994 / Proposed Rules
o n th e b a la n c e s h e e t. T o a v o id d o u b le
c o u n tin g s u c h e x p o s u r e s in th e a s s e s s m e n t o f
c a p ita l a d e q u a c y a n d , p e r h a p s, a s s ig n in g
in a p p r o p r ia te risk w e ig h t s , c o u n te r p a r ty
c r e d it e x p o s u r e s a r is in g fro m t h e ty p e s o f
in str u m e n ts c o v e r e d b y t h e s e g u id e lin e s m a y
n e e d to b e e x c lu d e d fro m b a la n c e s h e e t

a s s e ts in c a lc u la t in g b a n k s ’ r isk -b a se d c a p ita l
ra tio s.
(b)
E x a m p le s o f t h e c a lc u la t io n o f cr e d it
e q u iv a le n t a m o u n ts for t h e s e ty p e s o f
c o n tr a c ts are c o n t a in e d in A tta c h m e n t V o f
th is a p p e n d ix A .
it

it

it

ic

43517

7.
In a p p e n d ix A to part 2 2 5 , A tta c h m e n t
V , a s th a t a tta c h m e n t w a s p r o p o s e d to be
r e v is e d at 5 9 FR 2 6 4 6 4 , M a y 2 0 ,1 9 9 4 , is
r e v is e d to rea d as fo llo w s :
*
*
*
*
*

ic

A t t a c h m e n t V — C a l c u l a t io n o f C r e d it E q u iv a l e n t A m o u n t s f o r 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)
(2)
(3)
(4)
(5)

120-day forward foreign exchange ................
6-year forward foreign exchange ..................
3-year interest rate s w a p..............................
1-year oil sw ap..............................................
7-year interest rate s w a p ..............................

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-mar­
ket 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 co n tr a c ts (1) th r o u g h (5) a b o v e are
su b je c t to a q u a lify in g b ila te r a l n e ttin g
c o n tr a c t, th e n th e f o llo w in g a p p lie s:

Potential fu­
ture expo­
sure (from
above)
(D
(2)
(3)
(4)
(5)

..... ...........................................................................................
................................................................................................
................................................................................................
................................................................................................
................................................................................................

50,000
450,000
50,000
1,200,000
1,000,000

T otal...................................................................................

2,750,000

Net current
exposure1

+

0

Credit Equiv­
alent Amount

=

2,750,000

1 The total of the mark-to-market values from above is -1,370,000. Since this is a negative amount, the net current exposure is zero.
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.*

*

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B y th e o r d e r o f th e B o a r d o f G o v e r n o r s o f
th e F e d e r a l R e s e r v e S y s te m , A u g u s t 1 6 ,1 9 9 4 .

William W. Wiles,
S e c re ta ry o f th e B oard.
[FR D o c .9 4 - 2 0 5 0 6 F ile d 8 -2 3 -9 4 8 :4 5 a m ]
BILLING CODE 6210-01-P