Standardized Approach for Calculating the Exposure Amount of Derivative Contracts

Federal RegisterJan 24, 2020

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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Parts 3 and 32

[Docket ID OCC-2018-0030]

RIN 1557-AE44

FEDERAL RESERVE SYSTEM

12 CFR Part 217

[Docket No. R-1629]

RIN 7100-AF22

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Parts 324 and 327

RIN 3064-AE80

Standardized Approach for Calculating the Exposure Amount of Derivative Contracts

AGENCY:

The Office of the Comptroller of the Currency, Treasury; the Board of Governors of the Federal Reserve System; and the Federal Deposit Insurance Corporation.

ACTION:

Final rule.

SUMMARY:

The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation are issuing a final rule to implement a new approach—the standardized approach for counterparty credit risk (SA-CCR)—for calculating the exposure amount of derivative contracts under these agencies' regulatory capital rule. Under the final rule, an advanced approaches banking organization may use SA-CCR or the internal models methodology to calculate its advanced approaches total risk-weighted assets, and must use SA-CCR, instead of the current exposure methodology, to calculate its standardized total risk-weighted assets. A non-advanced approaches banking organization may use the current exposure methodology or SA-CCR to calculate its standardized total risk-weighted assets. The final rule also implements SA-CCR in other aspects of the capital rule. Notably, the final rule requires an advanced approaches banking organization to use SA-CCR to determine the exposure amount of derivative contracts included in the banking organization's total leverage exposure, the denominator of the supplementary leverage ratio. In addition, the final rule incorporates SA-CCR into the cleared transactions framework and makes other amendments, generally with respect to cleared transactions.

DATES:

Effective date:

April 1, 2020.

Mandatory compliance date:

January 1, 2022, for advanced approaches banking organizations.

FOR FURTHER INFORMATION CONTACT:

OCC:

Margot Schwadron, Director or Guowei Zhang, Risk Expert, Capital Policy, (202) 649-7106; Kevin Korzeniewski, Counsel, or Ron Shimabukuro, Senior Counsel, Chief Counsel's Office, (202) 649-5490; or, for persons who are deaf or hearing impaired, TTY, (202) 649-5597.

Board:

Constance M. Horsley, Deputy Associate Director, (202) 452-5239; David Lynch, Deputy Associate Director, (202) 452-2081; Elizabeth MacDonald, Manager, (202) 475-6316; Michael Pykhtin, Manager, (202) 912-4312; Mark Handzlik, Lead Financial Institutions Policy Analyst, (202) 475-6636; Sara Saab, Senior Financial Institutions Policy Analyst II, (202) 872-4936; or Cecily Boggs, Senior Financial Institutions Policy Analyst II, (202) 530-6209; Division of Supervision and Regulation; or Mark Buresh, Senior Counsel, (202) 452-5270; Gillian Burgess, Senior Counsel (202) 736-5564; or Andrew Hartlage, Counsel, (202) 452-6483; Legal Division, Board of Governors of the Federal Reserve System, 20th and C Streets NW, Washington, DC 20551. For the hearing impaired only, Telecommunication Device for the Deaf, (202) 263-4869.

FDIC:

Bobby R. Bean, Associate Director,

bbean@fdic.gov;

Irina Leonova, Senior Policy Analyst,

ileonova@fdic.gov;

Peter Yen, Senior Policy Analyst,

pyen@fdic.gov,

Capital Markets Branch, Division of Risk Management Supervision, (202) 898-6888; or Michael Phillips, Counsel,

mphillips@fdic.gov;

Catherine Wood, Counsel,

cawood@fdic.gov;

Supervision Branch, Legal Division, Federal Deposit Insurance Corporation, 550 17th Street NW, Washington, DC 20429.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction and Overview of the Proposal

A. Overview of Derivative Contracts

B. The Basel Committee Standard on SA-CCR

C. Overview of the Proposal

II. Overview of the Final Rule

A. Scope and Application of the Final Rule

B. Effective Date and Compliance Deadline

C. Final Rule's Interaction With Agency Requirements and Other Proposals

III. Mechanics of the Standardized Approach for Counterparty Credit Risk

A. Exposure Amount

B. Definition of Netting Sets and Treatment of Financial Collateral

C. Replacement Cost

D. Potential Future Exposure

IV. Revisions to the Cleared Transactions Framework

A. Trade Exposure Amount

B. Treatment of Default Fund Contributions

V. Revisions to the Supplementary Leverage Ratio

VI. Technical Amendments

A. Receivables Due From a QCCP

B. Treatment of Client Financial Collateral Held by a CCP

C. Clearing Member Exposure When CCP Performance Is Not Guaranteed

D. Bankruptcy Remoteness of Collateral

E. Adjusted Collateral Haircuts for Derivative Contracts

F. OCC Revisions to Lending Limits

G. Other Clarifications and Technical Amendments From the Proposal to the Final Rule

VII. Impact of the Final Rule

VIII. Regulatory Analyses

A. Paperwork Reduction Act

B. Regulatory Flexibility Act

C. Plain Language

D. Riegle Community Development and Regulatory Improvement Act of 1994

E. OCC Unfunded Mandates Reform Act of 1995 Determination

F. The Congressional Review Act

I. Introduction and Overview of the Proposal

A. Overview of Derivative Contracts

In general, derivative contracts represent agreements between parties either to make or receive payments or to buy or sell an underlying asset on a certain date (or dates) in the future. Parties generally use derivative contracts to mitigate risk, although such transactions may serve other purposes. For example, an interest rate derivative contract allows a party to manage the risk associated with a change in interest rates, while a commodity derivative contract allows a party to fix commodity prices in the future and thereby minimize any exposure attributable to unfavorable movements in those prices.

The value of a derivative contract, and thus a party's exposure to its counterparty, changes over the life of the contract based on movements in the value of the reference rates, assets, indicators or indices underlying the contract (reference exposures). A party with a positive current exposure expects to receive a payment or other beneficial transfer from the counterparty and is considered to be “in the money.” A party that is in the money is subject to the risk that the counterparty will default on its obligations and fail to pay the amount owed under the transaction, which is referred to as counterparty credit risk. In contrast, a party with a zero or negative current exposure does not expect to receive a payment or beneficial transfer from the counterparty

and is considered to be “at the money” or “out of the money.” A party that has no current exposure to counterparty credit risk may have exposure to counterparty credit risk in the future if the derivative contract becomes “in the money.”

Parties to a derivative contract often exchange collateral to mitigate counterparty credit risk. If a counterparty defaults, the non-defaulting party can sell the collateral to offset its exposure. In the derivatives context, collateral may include variation margin and initial margin (also known as independent collateral). Parties exchange variation margin on a periodic basis during the term of a derivative contract, as typically specified in a variation margin agreement or by regulation.

Variation margin offsets changes in the market value of a derivative contract and thereby covers the potential loss arising from the default of a counterparty. Variation margin may not always be sufficient to cover a party's positive exposure (

e.g.,

due to delays in receiving collateral), and thus parties may exchange initial margin. Parties typically exchange initial margin at the outset of the derivative contract and in amounts that are expected to reduce the likelihood of a positive exposure amount for the derivative contract in the event of the counterparty's default, resulting in overcollateralization.

See, e.g.,

12 CFR part 45 (OCC); 12 CFR part 237 (Board); and 12 CFR part 349 (FDIC).

To facilitate the exchange of collateral, parties may enter into variation margin agreements that typically provide for a threshold amount and a minimum transfer amount. The threshold amount is the maximum amount by which the market value of the derivative contract can change before a party must collect or post variation margin (in other words, the threshold amount specifies an acceptable amount of under-collateralization). The minimum transfer amount is the smallest amount of collateral that a party must transfer when it is required to exchange collateral under the variation margin agreement. Parties generally apply a discount (also known as a haircut) to non-cash collateral to account for a potential reduction in the value of the collateral during the period between the last exchange of collateral before the close out of the derivative contract (as in the case of default of the counterparty) and replacement of the contract on the market. This period is known as the margin period of risk (MPOR).

Two parties often will enter into a large number of derivative contracts together. In such cases, the parties may enter into a netting agreement to allow for the offsetting of the derivative contracts under the agreement in the event that one of the parties default and to streamline certain aspects of the transactions, including the exchange of collateral. Netting multiple contracts against each other can substantially reduce the exposure if one of the parties were to default. A netting set reflects those derivative contracts that are subject to the same master netting agreement.

“Qualifying master netting agreement” is defined in §§ _.2 and _.3(d) of the capital rule.

See

12 CFR 3.2 and 3.3(d) (OCC); 12 CFR 217.2 and 217.3(d) (Board); and 12 CFR 324.2 and 324.3(d) (FDIC).

Parties to a derivative contract may also clear their derivative contract through a central counterparty (CCP). The use of central clearing is designed to reduce the risk of engaging in derivative transactions through the multilateral netting of exposures, establishment and enforcement of collateral requirements, and the promotion of market transparency. A party engages with a CCP either as a clearing member or as a clearing member client. A clearing member is a member of, or a direct participant in, a CCP that has authority to enter into transactions with the CCP. A clearing member may act as a financial intermediary with respect to the clearing member client and either take one position with the client and an offsetting position with the CCP (the principal model of clearing) or guarantee the performance of the clearing member client to the CCP (the agency model of clearing). With respect to the latter type of clearing, the clearing member generally is responsible for fulfilling initial and variation margin calls from the CCP on behalf of its client, irrespective of the client's ability to post such collateral.

The capital rule of the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Board), and the Federal Deposit Insurance Corporation (FDIC) (together, the agencies) requires a banking organization to hold regulatory capital based on the exposure amount of its derivative contracts.

The capital rule prescribes different approaches for measuring the exposure amount of derivative contracts based on the size and risk profile of a banking organization. All banking organizations are currently required to use the current exposure method (CEM) to determine the exposure amount of a derivative contract for purposes of calculating standardized total risk-weighted assets.

Certain large banking organizations may use CEM or the internal models methodology (IMM) to determine the exposure amount of a derivative contract for advanced approaches risk-weighted assets. In contrast to CEM, IMM is an internal-models-based approach that requires supervisory approval. The capital rule also requires certain large banking organizations to meet a supplementary leverage ratio, measured as the banking organization's tier 1 capital relative to its total leverage exposure.

The total leverage exposure measure captures both on- and off-balance sheet assets, including the exposure amount of a banking organization's derivative contracts as determined under CEM.

12 CFR part 3 (OCC); 12 CFR part 217 (Board); 12 CFR part 324 (FDIC). The agencies have codified the capital rule in different parts of title 12 of the CFR, but the internal structure of the sections within each agency's rule are identical. All references to sections in the capital rule or the proposal are intended to refer to the corresponding sections in the capital rule of each agency. Banking organizations subject to the agencies' capital rule include national banks, state member banks, insured state nonmember banks, savings associations, and top-tier bank holding companies and savings and loan holding companies domiciled in the United States, but exclude banking organizations subject to the Board's Small Bank Holding Company and Savings and Loan Holding Company Policy Statement (12 CFR part 225, appendix C), and certain savings and loan holding companies that are substantially engaged in insurance underwriting or commercial activities or that are estate trusts, and bank holding companies and savings and loan holding companies that are employee stock ownership plans. The agencies recently adopted a final rule to implement a community bank leverage ratio framework that is applicable, on an optional basis to depository institutions and depository institution holding companies with less than $10 billion in total consolidated assets and that meet certain other criteria. Such banking organizations that opt into the community bank leverage ratio framework will be deemed compliant with the capital rule's generally applicable requirements and are not required to calculate risk-based capital ratios.

See

84 FR 61776 (November 13, 2019).

CEM and IMM are also applied in other parts of the capital rule. For example, advanced approaches banking organizations must use CEM to determine the exposure amount of derivative contracts included in total leverage exposure, the denominator of the supplementary leverage ratio. In addition, the capital rule incorporates CEM into the cleared transactions framework and makes other amendments, generally with respect to cleared transactions.

See

section II.C. of this

SUPPLEMENTARY INFORMATION

for further discussion.

See infra

note 23. Banking organizations subject to Category I, Category II, or Category III standards are subject to the supplementary leverage ratio.

See

12 CFR 3.10(c)(4) (OCC); 12 CFR 217.10(c)(4) (Board); and 12 CFR 324.10(c)(4) (FDIC).

B. The Basel Committee Standard on SA-CCR

In 2014, the Basel Committee on Banking Supervision released a new approach for calculating the exposure amount of a derivative contract called the standardized approach for counterparty credit risk (SA-CCR) (the Basel Committee standard).

Under the Basel Committee standard, a banking organization calculates the exposure amount of its derivative contracts at the netting set level, meaning, those contracts that the standard permits to be netted against each other because they are subject to the same qualifying master netting agreement (QMNA), which must meet certain operational requirements.

The exposure amount of a derivative contract not subject to a QMNA is calculated individually, and thus the derivative contract constitutes a netting set of one.

See

“The standardized approach for measuring counterparty credit risk exposures,” Basel Committee on Banking Supervision (March 2014, rev. April 2014),

https://www.bis.org/publ/bcbs279.pdf.

See e.g. supra

note 2.

The exposure amount of each netting set is equal to an alpha factor of 1.4 multiplied by the sum of the replacement cost of the netting set and the potential future exposure (PFE) of the netting set:

exposure amount

= 1.4 * (replacement cost + PFE)

For netting sets that are not subject to a variation margin agreement, replacement cost reflects a banking organization's current on-balance-sheet credit exposure to its counterparty measured as the maximum of the fair value of the derivative contracts within the netting set less the applicable collateral or zero. For netting sets that are subject to a variation margin agreement, the replacement cost of a netting set reflects the maximum possible unsecured exposure amount of the netting set that would not trigger a variation margin call. For the replacement cost calculation, a banking organization recognizes the collateral amount on a dollar-for-dollar basis, subject to any applicable haircuts.

PFE reflects a measure of potential changes in a banking organization's counterparty exposure for a netting set over a specified period. The PFE calculation allows a banking organization to fully or partially offset derivative contracts within the same netting set that share similar risk factors, based on the concept of hedging sets. Under the Basel Committee standard, derivative contracts form a hedging set if they share the same primary risk factor, and therefore, are within the same asset class—interest rate, exchange rate, credit, equity, or commodities. As derivatives within the same asset class are highly correlated and thus have an economic relationship,

under the Basel Committee standard, derivative contracts within the same hedging set may be able to fully or partially offset each other.

Derivative contracts within the same asset class share the same primary risk factor, which implies a closer alignment between all of the underlying risk factors and a higher correlation factor. For a directional portfolio, greater alignment between the risk factors would result in a more concentrated risk, leading to a higher exposure amount. For a balanced portfolio, greater alignment between the risk factors would result in more offsetting of risk, leading to a lower exposure amount.

To obtain the PFE for each netting set, a banking organization sums the adjusted derivative contract amount of all hedging sets within the netting set using an asset-class specific aggregation formula and multiples that amount by the PFE multiplier. The PFE multiplier decreases exponentially from a value of one as the value of the financial collateral held by the banking organization exceeds the net fair value of the derivative contracts within the netting set, subject to a floor of five percent. Thus, the PFE multiplier accounts for both over-collateralization and the negative fair value amount of the derivative contracts within the netting set.

For purposes of calculating the hedging set amount, a banking organization calculates the adjusted notional amount of a derivative contract and multiplies that amount by a corresponding supervisory factor, maturity factor, and supervisory delta to determine a conservative estimate of effective expected positive exposure (EEPE), assuming zero fair value and zero collateral.

The Basel Committee standard uses supervisory factors that reflect the volatilities observed in the derivatives markets during the financial crisis. The supervisory factors reflect the potential variability of the primary risk factor of the derivative contract over a one-year horizon. The maturity factor scales down the default one-year risk horizon of the supervisory factor to the risk horizon appropriate for the derivative contract. For the supervisory delta adjustment, a banking organization applies a positive sign to the derivative contract amount if the derivative contract is long the risk factor and a negative sign if the derivative contract is short the risk factor. A derivative contract is long the primary risk factor if the fair value of the instrument increases when the value of the primary risk factor increases. A derivative contract is short the primary risk factor if the fair value of the instrument decreases when the value of the primary risk factor increases. The assumptions of zero fair value and zero collateral allow for recognition of offsetting and diversification benefits between derivative contracts that share similar risk factors (

i.e.,

long and short derivative contracts within the same hedging set could fully or partially offset one another).

Under IMM, an advanced approaches banking organization uses its own internal models to determine the exposure amount of its derivative contracts. The exposure amount under IMM is calculated as the product of the EEPE for a netting set, which is the time-weighted average of the effective expected exposures (EE) profile over a one-year horizon, and an alpha factor. For the purposes of regulatory capital calculations, the resulting exposure amount is treated as a loan equivalent exposure, which is the amount effectively loaned by the banking organization to the counterparty under the derivative contract. A banking organization arrives at the exposure amount by first determining the EE profile for each netting set. In general, EE profile is determined by computing exposure distributions over a set of future dates using Monte Carlo simulations, and the expectation of exposure at each date is the simple average of all positive Monte Carlo simulated exposures for each date. The expiration of short-term trades can cause the EE profile to decrease, even though a banking organization is likely to replace short-term trades with new trades (

i.e.,

rollover). To account for rollover, a banking organization converts the EE profile for each netting set into an effective EE profile by applying a nondecreasing constraint to the corresponding EE profile over the first year. The nondecreasing constraint prevents the effective EE profile from declining with time by replacing the EE amount at a given future date with the maximum of the EE amounts across this and all prior simulation dates. The EEPE for a netting set is the time-weighted average of the effective EE profile over a one-year horizon. EEPE would be the appropriate loan equivalent exposure in a credit risk capital calculation if the following assumptions were true: There is no concentration risk, systematic market risk, and wrong-way risk (

i.e.,

the size of an exposure is positively correlated with the counterparty's probability of default). However, these conditions nearly never exist with respect to a derivative contract. Thus, to account for these risks, IMM requires a banking organization to multiply EEPE by 1.4.

C. Overview of the Proposal

On October 30, 2018, the agencies published a notice of proposed rulemaking (proposal) to implement SA-CCR

in order to provide important improvements to risk sensitivity and calibration relative to CEM.

In particular, the implementation of SA-CCR is responsive to concerns that CEM has not kept pace with certain market practices that have been adopted, particularly by large banking organizations that are

active in the derivatives market.

The agencies also proposed SA-CCR to provide a method that is less complex and involves less discretion than IMM, which allows banking organizations to use their own internal models to determine the exposure amount of their derivative contracts.

Although IMM is more risk-sensitive than CEM, IMM is significantly more complex and requires prior supervisory approval.

The agencies based the core elements of the proposal on the Basel Committee SA-CCR standard.

See

83 FR 64660 (December 17, 2018).

The

Supplementary Information

set forth in the proposal includes a description of CEM.

See id.

at 64664.

The agencies initially adopted CEM in 1989.

See

54 FR 4168 (January 27, 1989) (Board and OCC); 54 FR 11500 (March 21, 1989) (FDIC). The last significant update to CEM was in 1995.

See

60 FR 46170 (September 5, 1995).

The

Supplementary Information

set forth in the proposal includes a description of IMM.

See

83 FR at 64665.

See

12 CFR 3.122 (OCC); 12 CFR 217.122 (Board); and 12 CFR 324.122 (FDIC).

See supra

note 7.

The agencies received approximately 58 comments on the proposal from interested parties, including banking organizations, trade groups, members of Congress, and advocacy organizations. Banking organizations and trade groups offered widespread support for the implementation of SA-CCR although they also suggested modifications to various components of the proposal largely to address concerns regarding its calibration. Commenters who supported the proposal also expressed concerns with its proposed implementation schedule and potential interaction with certain other U.S. laws and regulations. Other commenters, including some commercial entities that use derivative contracts to manage risks arising from their business operations (commercial end-users), opposed the proposal or elements of the proposal. Specifically, these commenters expressed concern that the proposal could indirectly increase the fees they pay to enter into derivative transactions to manage commercial risks in order to help offset the regulatory capital costs of such derivative contracts for banking organizations. The commenters asserted that any such effect would be in contravention of separate public policy objectives designed to support the ability of commercial end-users to engage in derivative transactions for risk-management purposes.

By contrast, other commenters that opposed the proposal expressed concerns that it could reduce capital held against derivative contracts.

See, e.g.,

The Commodity Exchange Act and the Securities Exchange Act of 1934, as amended by sections 731 and 764, respectively, of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376, 1703-12, 1784-96 (2010), require the agencies to, in establishing capital and margin requirements for non-cleared swaps, provide an exemption for certain types of counterparties (

e.g.,

counterparties that are not financial entities and are using swaps to hedge or mitigate commercial risks) from the mandatory clearing requirement.

See

7 U.S.C. 6s(e)(3)(C); 15 U.S.C. 78o-10(e)(3)(C);

See also

section III.D.4. of this

Supplementary Information

Commenters also criticized the proposal's approach to the recognition of collateral provided to support a derivative contract for purposes of the supplementary leverage ratio. In response to commenters' concerns, and consistent with changes to the Basel Committee leverage ratio standard that occurred during the comment period, the final rule allows for greater recognition of collateral in the calculation of total leverage exposure relating to client-cleared derivative contracts.

See

“Leverage ratio treatment of client cleared derivatives,” Basel Committee on Banking Supervision, June 2019,

https://www.bis.org/bcbs/publ/d467.pdf. See also

section V of this

Supplementary Information

II. Overview of the Final Rule

Figure 1 below provides a high-level overview of SA-CCR under the Final Rule.

A counterparty's maximum exposure to a netting set subject to a varation margin agreement equals the threshold amount plus minimum transfer amount.

Net independent collateral amount (NICA), as described in section III. B of this

Supplementary Information

Figure 1—Overview of SA-CCR Under the Final Rule

Purpose

• The final rule implements the standardized approach for counterparty-credit risk, in a manner consistent with the core elements of the Basel Committee standard.

• A banking organization uses SA-CCR (either on a mandatory or an optional basis) to determine the capital requirements for its derivative contracts.

SA-CCR Mechanics

Under the final rule, a banking organization using SA-CCR determines the exposure amount for a netting set of derivative contracts as follows:

Exposure amount = alpha factor × (replacement cost + potential future exposure)

Key Elements of the SA-CCR Formula

Replacement Cost

The

replacement cost

of a derivative contract reflects the amount that it would cost a banking organization to replace the derivative contract if the counterparty were to immediately default. Under SA-CCR, replacement cost is based on the fair value of a derivative contract under U.S. GAAP, with adjustments to reflect the exchange of collateral for margined transactions.

For un-margined transactions:

max

{

−

0},

where

replacement cost (RC) equals the maximum of the fair value of the derivative contract (after excluding any valuation adjustments) (V) less the net amount of any collateral (C) received from the counterparty and zero.

For margined transactions:

max

{

−

C; TH

MTA

−

NICA;

0},

where

replacement cost equals the maximum of (1) the sum of the fair values (after excluding any valuation adjustments) of the derivative contracts within the netting set less the net amount of collateral applicable to such derivative contracts; (2) the counterparty's maximum exposure to the netting set under the variation margin agreement (TH + MTA),

less the net collateral amount applicable to such derivative contracts (NICA

); or (3) zero.

Potential Future Exposure

The

potential future exposure

of a derivative contract reflects the possibility of changes in the value of the derivative contract over a specified period. Under SA-CCR, the potential future exposure amount is based on the notional amount and maturity of the derivative contract, volatilities observed during the financial crisis for different classes of derivative contracts (

i.e.,

interest rate, exchange rate, credit, equity, and commodity), the exchange of collateral, and full or partial offsetting among derivative contracts that share an economic relationship.

PFE = multiplier × aggregated amount, where

the PFE multiplier decreases exponentially from a value of 1 to recognize the amount of any excess collateral and the negative fair values of derivative contracts within the netting set. The aggregated amount accounts for full or partial offsetting among derivative contracts within a hedging set that share an economic relationship, as well as observed volatilities in the reference asset, the maturity of the derivative contract, and the correlation between the derivative contract and the reference exposure (

i.e.,

long or short).

Alpha Factor

The

alpha factor

is a measure of conservatism that is designed to address risks that are not directly captured under SA-CCR, and to ensure that the capital requirement for a derivative contract under SA-CCR is generally not lower than the one produced under IMM.

For most derivative contracts, the alpha factor equals 1.4; however, no alpha factor applies to derivative contracts with commercial end-user counterparties.

A. Scope and Application of the Final Rule

1. Scoping Criteria

The capital rule provides two methodologies for determining total risk-weighted assets: The standardized approach, which applies to all banking organizations, and the advanced approaches, which apply only to “advanced approaches banking organizations,” (or banking organizations subject to Category I or Category II standards)

as defined under the capital rule.

Both the standardized approach and the advanced approaches require a banking organization to determine the exposure amount for derivative contracts transacted through a central counterparty (

i.e.,

cleared transactions) and derivative contracts that are not cleared transactions (

i.e.,

noncleared derivative contracts, otherwise known as over-the-counter derivative contracts).

As part of the cleared transactions framework, a banking organization also must determine the risk-weighted asset amounts of any contributions or commitments it may have to mutualized loss sharing agreements with central counterparties (

i.e.,

default fund contributions).

The agencies recently adopted a final rule to revise the criteria for determining the applicability of regulatory capital and liquidity requirements for large U.S. and foreign banking organizations (tailoring final rule). Under the tailoring final rule, an advanced approaches banking organization means a banking organization subject to Category I or Category II standards. Category I standards apply to U.S. global systemically important bank holding companies (U.S. GSIBs) and their depository institution subsidiaries, as identified based on the methodology in the Board's U.S. GSIB surcharge rule. Category II standards apply to banking organizations that are not subject to Category I standards and that have $700 billion or more in total consolidated assets or $75 billion or more in cross-jurisdictional activity and to their depository institution subsidiaries. Category III standards apply to banking organizations that are not subject to Category I or II standards and that have $250 billion or more in total consolidated assets or $75 billion or more in any of nonbank assets, weighted short-term wholesale funding, or off-balance-sheet exposure. Category III standards also apply to depository institution subsidiaries of any holding company subject to Category III standards. Category IV standards apply to banking organizations with total consolidated assets of $100 billion or more, and their depositiory institution subsidiaries, that do not meet any of the criteria for a higher category of standards.

See

“Changes to Applicabiltiy Thresholds for Regulatory Capital and Liquidity Requirements,” 84 FR 59230 (November 1, 2019).

Standardized total risk-weighted assets serve as a floor for advanced approaches total risk-weighted assets. Advanced approaches banking organizations must therefore calculate total risk-weighted assets under both approaches and use the result that produces a more binding capital requirement. Total risk-weighted assets are the denominator of the risk-based capital ratios; regulatory capital is the numerator.

Under the standardized approach, the risk-weighted asset amount for a derivative contract currently is the product of the exposure amount of the derivative contract calculated under CEM and the risk weight for the type of counterparty as set forth in the capital rule.

See generally

12 CFR 3.35 (OCC); 12 CFR 217.35 (Board); and 12 CFR 324.35 (FDIC). Under the advanced approaches, the risk-weighted asset amount for a derivative contract currently is derived using either CEM or the internal models methodology, which multiplies the exposure amount (or exposure at default amount) of the derivative contract by a models-based formula that uses risk parameters determined by a banking organization's internal methodologies.

See generally

12 CFR 3.132 (OCC); 12 CFR 217.132 (Board); and 12 CFR 324.132 (FDIC).

See

12 CFR 3.35(d) and 3.133(d) (OCC); 12 CFR 217.35(d) and 217.133(d) (Board); and 12 CFR 324.35(d) and 324.133(d) (FDIC).

The proposal would have replaced CEM with SA-CCR in the capital rule for advanced approaches banking organizations. Thus, for purposes of the advanced approaches, an advanced approaches banking organization would have been required to use either SA-CCR or IMM to calculate the exposure amount of its noncleared and cleared derivative contracts and to use SA-CCR to determine the risk-weighted asset amount of its default fund contributions. For purposes of the standardized approach, an advanced approaches banking organization would have been required to use SA-CCR (instead of CEM) to calculate the exposure amount of its noncleared and cleared derivative contracts and to determine the risk-weighted asset amount of its default fund contributions. The proposal also would have revised the total leverage exposure measure of the supplementary leverage ratio by replacing CEM with a modified version of SA-CCR.

Banking organizations that are not advanced approaches banking organizations

would have had to choose either CEM or SA-CCR to calculate the exposure amount of

noncleared and cleared derivative contracts and to determine the risk-weighted asset amount of default fund contributions under the standardized approach.

Under this final rule, banking organizations that are not advanced approaches banking organizations (

i.e.,

banking organizations subject to Category III or Category IV standards) are permitted to choose either CEM or SA-CCR for purposes of determining standardized risk-weighted assets.

See supra

note 23.

Some commenters raised concerns with the proposal's use of multiple methods—CEM, SA-CCR, and IMM—to determine the exposure amount of derivative contracts. Specifically, commenters stated that including multiple approaches for calculating the exposure amount of derivative contracts in the capital rule creates regulatory burden and increases the potential for competitive inequalities. The commenters asked the agencies to adopt one methodology that all banking organizations would be required to use to determine the exposure amount of derivative contracts or, short of that, to allow all banking organizations (

i.e.,

both advanced approaches and non-advanced approaches banking organizations) to elect to use any approach—CEM, SA-CCR, or IMM—to determine the exposure amount for all derivative contracts, as long as the approach is permitted or required under any of the agencies' rules to calculate the exposure amount of derivative contracts. Other commenters, however, supported allowing advanced approaches banking organizations the option to use IMM for noncleared and cleared derivative contracts to facilitate closer alignment with internal risk-management practices of banking organizations because, according to the commenters, SA-CCR may not adapt dynamically to changes in market conditions.

Some commenters also requested changes to the applicability criteria for a particular methodology under the capital rule. Specifically, commenters asked the agencies to allow advanced approaches banking organizations to use IMM to calculate the exposure amount of derivative contracts under the standardized approach. Some of these commenters also asked the agencies to tailor the application of SA-CCR based on the composition of a banking organization's derivatives portfolio, rather than solely based on whether the banking organization meets the definition of an advanced approaches banking organization.

Limiting all banking organizations to a single methodology would be inconsistent with the agencies' efforts to tailor the application of the capital rule to the risk profiles of banking organizations.

In particular, while SA-CCR offers several improvements to the regulatory capital treatment for derivative contracts relative to CEM, it also requires internal systems enhancements and other operational modifications that could be particularly burdensome for smaller, less complex banking organizations. Moreover, allowing banking organizations to use IMM for purposes of determining standardized total risk-weighted assets would be inconsistent with an intended purpose of the standardized approach, which is to serve as a floor to model-derived outcomes under the advanced approaches.

See id.

The proposal to require advanced approaches banking organizations to use either SA-CCR or IMM to determine the exposure amount of their noncleared and cleared derivative contracts under the advanced approaches provides meaningful flexibility, promotes consistency for banking organizations that have substantial operations in multiple jurisdictions, and facilitates regulatory reporting and the supervisory assessment of an advanced approaches banking organization's capital management program. An approach that tailors the applicability of SA-CCR based solely on the composition of a banking organization's derivatives portfolio, as suggested by commenters, would be inconsistent with these objectives.

Consistent with the proposal, the final rule includes CEM, SA-CCR, and IMM as methodologies for banking organizations to use to determine the exposure amount of derivative contracts and prescribes which approach a banking organization must use based on the category of standards applicable to the banking organization.

As under the capital rule currently, the final rule does not permit advanced approaches banking organizations to use IMM to calculate the exposure amount of derivative contracts under the standardized approach.

Id.

Under the final rule and as reflected further in Table 1, an advanced approaches banking organization generally may use SA-CCR or IMM for purposes of determining advanced approaches total risk-weighted assets,

and must use SA-CCR for purposes of determining standardized total risk-weighted assets as well as the supplementary leverage ratio. A non-advanced approaches banking organization may continue to use CEM or elect to use SA-CCR for purposes of the standardized approach and supplementary leverage ratio (as applicable).

Where a banking organization has the option to choose among the approaches applicable to such banking organization under the capital rule, it must use the same approach for all purposes. As discussed in section II.C of this

Supplementary Information

, the agencies will continue to consider the extent to which SA-CCR should be incorporated into areas of the regulatory framework that are not addressed under this final rule in the context of separate rulemakings.

As reflected in Table 1, an advanced approaches banking organization must use SA-CCR to determine its exposure to default fund contributions under the advanced approaches.

The tailoring final rule revised the scope of applicability of the supplementary leverage ratio, such that it applies to U.S. and foreign banking organizations subject to Category I, Category II, or Category III standards.

See supra

notes 5 and 23. The use of SA-CCR for purposes of the supplementary leverage ratio is discussed in greater detail in section V of this

Supplementary Information

Table 1—Scope and Applicability of the Final Rule

Noncleared derivative contracts

Cleared transactions framework

Default fund contribution

Advanced approaches banking organizations, advanced approaches total risk-weighted assets

Option to use SA-CCR or IMM

Must use the same approach selected for purposes of noncleared derivative contracts

Must use SA-CCR.

Advanced approaches banking organizations, total risk-weighted assets under the standardized approach

Must use SA-CCR

Must use SA-CCR.

Non-advanced approaches banking organizations, total risk-weighted assets under the standardized approach

Option to use CEM or SA-CCR

Must use the same approach selected for purposes of noncleared derivative contracts

Must use the same approach selected for purposes of noncleared derivative contracts.

Advanced approaches banking organizations, supplementary leverage ratio

Must use SA-CCR to determine the exposure amount of derivative contracts for total leverage exposure.

Banking organizations subject to Category III capital standards, supplementary leverage ratio

Option to use CEM or SA-CCR to determine the exposure amount of derivative contracts for total leverage exposure. A banking organization must use the same approach, CEM or SA-CCR, for purposes of both standardized total risk-weighted assets and the supplementary leverage ratio.

2. Applicability to Certain Derivative Contracts

The proposal would have required a banking organization to calculate the exposure amount for all derivative contracts to which the banking organization has an exposure. Commenters raised concerns regarding the treatment of certain derivative contracts under the proposal. Specifically, several commenters asked the agencies to exclude from banking organizations' regulatory capital calculations derivative contracts with commercial end-user counterparties, while other commenters suggested that the final rule should exclude physically settled forward contracts. Other commenters requested that the agencies allow advanced approaches banking organizations to continue to use CEM to calculate the exposure amount of their derivative contracts with commercial end-user counterparties.

Excluding certain derivative contracts from the application of the capital rule, as suggested by commenters, would exclude a material source of credit risk from a banking organization's regulatory capital requirements. Moreover, requiring a banking organization to use the same approach for its entire derivative portfolio when calculating either its standardized or advanced approaches total risk-weighted assets promotes consistency in the regulatory capital treatment of derivative contracts, and facilitates the supervisory assessment of a banking organization's capital management program.

Therefore, consistent with the proposal, the final rule does not provide an exclusion for specific types of derivative contracts nor does it permit the use of different methodologies based on the type of derivative contract or counterparty.

The final rule does not revise the FR Y-15 report to reflect SA-CCR, as discussed further in section II.C of this

Supplementary Information

3. Application to New Derivative Contracts and Immaterial Exposures

Under the current capital rule, an advanced approaches banking organization can use CEM for a period of 180 days for material portfolios of new derivative contracts and without time limitations for immaterial portfolios of new derivative contracts to satisfy the requirement that the total exposure amount calculated under IMM must be at least equal to the greater of the expected positive exposure amount under either the modelled stress scenario or the modelled un-stressed scenario multiplied by 1.4.

Some commenters noted that the proposal did not replace CEM with SA-CCR for these purposes and suggested providing advanced approaches banking organizations the option to consider SA-CCR, in place of CEM, to satisfy the same conservatism requirements. The agencies recognize that an advanced approaches banking organization may need time to develop systems and collect sufficient data to appropriately model the exposure amount for material portfolios of new derivatives under IMM. Therefore, under the final rule, an advanced approaches banking organization that elects to use IMM to calculate the exposure amount of its derivative contracts under the advanced approaches may use SA-CCR for a period of 180 days for material portfolios of new derivative contracts and for immaterial portfolios of such contracts without time limitations.

This treatment is consistent with the current capital rule.

See

12 CFR 3.132(d)(10) (OCC); 12 CFR 217.132(d)(10) (Board); and 12 CFR 324.132(d)(10) (FDIC).

Similar to CEM, as a standardized framework, SA-CCR is designed to produce sufficiently conservative exposure amounts, compared to those calculated under IMM, that satisfy the conservatism requirement under § __.132(d)(10)(i). The final rule also makes similar conforming changes elsewhere in § __.132(d) and (e) to incorporate SA-CCR in the place of CEM.

B. Effective Date and Compliance Deadline

The proposal included a transition period, until July 1, 2020, by which time all advanced approaches banking organizations would have been required to implement SA-CCR; however, both advanced approaches and non-advanced approaches banking organizations would have been able to adopt SA-CCR as of the effective date of the final rule.

Several commenters asked the agencies to delay adoption of the final rule. Specifically, some of these commenters asked that the agencies delay adoption until completion of a comprehensive study on the effect of the proposal, including the effect of SA-CCR on commercial end-user counterparties. Other commenters also asked the agencies to delay adoption of SA-CCR, or alternatively, the mandatory compliance date, in order to align its implementation with potential forthcoming changes to the U.S. regulatory capital framework that might be implemented through separate rulemakings.

These commenters expressed concern that the interaction between SA-CCR and related aspects of the U.S. regulatory capital framework could result in increased capital requirements for banking organizations that are not reflective of underlying risk. In addition, some of these commenters specifically urged the agencies to pair the adoption of SA-CCR with the implementation of the Basel Committee's revised comprehensive approach for securities financing transactions.

These commenters argued that banking organizations could use derivative transactions as a substitute for securities financing

transactions and, therefore, adopting SA-CCR without implementing the revised comprehensive approach for securities financing transactions could lead to further concentration in the derivatives market and decreases in the liquidity of the securities financing transactions market. Alternatively, other commenters urged the agencies to set the mandatory compliance date as of January 2022 to align with other anticipated changes to the U.S. regulatory capital framework, and supported allowing banking organizations to adopt SA-CCR or portions of SA-CCR as early as the issuance of the final rule.

For example, the commenters noted potential changes to the regulatory framework as a result of the Basel Committee's December 2017 release.

See

“Basel III: Finalising post-crisis reforms,” Basel Committee on Banking Supervision, December 2017,

https://www.bis.org/bcbs/publ/d424.pdf.

Id.

Additionally, several commenters asked the agencies to align U.S. implementation of SA-CCR with its implementation schedule in other jurisdictions, so as not to disadvantage U.S. banking organizations and their U.S. clients relative to foreign firms. These commenters argued that a mandatory compliance date of January 2022 would ensure internationally consistent implementation of SA-CCR across jurisdictions and allow banking organizations ample time to implement SA-CCR for purposes of both existing regulatory capital requirements and any anticipated forthcoming changes to the U.S. regulatory capital framework. Other commenters suggested extending the mandatory compliance date to January 2022 for banking organizations that use CEM currently and do not have extensive derivatives portfolios.

Conversely, several commenters asked the agencies to adopt the proposal as a final rule without delay and to retain the proposed July 2020 mandatory compliance date. Of these, some commenters suggested that the effective date for implementation of SA-CCR should be earlier than July 2020 for the entirety or portions of the SA-CCR rule. These commenters also asked the agencies to provide interim relief through a reduction in risk weights for certain financial products, such as options, if the implementation of SA-CCR is delayed.

The agencies anticipate that the final rule will not materially change the amount of capital in the banking system, and that any change in a particular banking organization's capital requirements, through either an increase or a decrease in regulatory capital, would reflect the enhanced risk sensitivity of SA-CCR relative to CEM, as well as market conditions.

In addition, SA-CCR provides important improvements to risk sensitivity and calibration relative to CEM and is responsive to concerns that CEM has not kept pace with market practices used by large banking organizations that are active in the derivatives market. Therefore, the agencies are not delaying adoption of the final rule. The agencies intend to monitor the implementation of SA-CCR as part of their ongoing assessment of the effectiveness of the overall U.S. regulatory capital framework to determine whether there are opportunities to reduce burden and improve its efficiency in a manner that continues to support the safety and soundness of banking organizations and U.S. financial stability.

The estimated impact of the final rule is described in greater detail in section VII of this

SUPPLEMENTARY INFORMATION

However, the agencies recognize that the implementation of SA-CCR requires advanced approaches banking organizations to augment existing systems or develop new ones, as all such banking organizations must adopt SA-CCR for the standardized approach even if they plan to continue using IMM under the advanced approaches. Accordingly, the final rule includes a mandatory compliance date for advanced approaches banking organizations of January 1, 2022, to permit these banking organizations additional time to adjust their systems, as needed, to implement SA-CCR. The final rule also includes an effective date shortly after publication that permits any banking organization to elect to adopt SA-CCR prior to the mandatory compliance date. For this reason, the agencies do not believe that it is necessary to provide any interim adjustments to the current framework.

Advanced approaches and non-advanced approaches banking organizations that adopt SA-CCR prior to the mandatory compliance date must notify their appropriate Federal supervisor. Non-advanced approaches banking organizations that adopt SA-CCR after the mandatory compliance date also must notify their appropriate Federal supervisor. As the final rule does not allow banking organizations to use SA-CCR for a material subset of derivative exposures under either the standardized or advanced approaches, a banking organization cannot early adopt SA-CCR on a partial basis.

In addition, the technical revisions in the final rule, as described in section VI of this

Supplementary Information

, are effective as of the effective date of the final rule.

The final rule allows banking organizations that elect to use SA-CCR to continue to use method 1 or method 2 under CEM to calculate the risk-weighted asset amount for default fund contributions until January 1, 2022.

See

section IV.B. of this

Supplementary Information

for a more detailed discussion on the treatment of default fund contributions under the final rule.

C. Final Rule's Interaction With Agency Requirements and Other Proposals

The implementation of SA-CCR affects other parts of the regulatory framework. Commenters asked that the agencies clarify the interaction between SA-CCR and other existing aspects of the framework that would be affected by the adoption of SA-CCR, including the FDIC's deposit insurance assessment methodology, the Banking Organization Systemic Risk Report (FR Y-15), the stress test projections in the Board's Comprehensive Capital Analysis and Review (CCAR) process, and the OCC's lending limits. Commenters also asked that the agencies clarify the interaction between SA-CCR and potential future revisions to the U.S. regulatory capital framework, including potential implementation of the December 2017 Basel Committee release,

Basel III: Finalising post-crisis reforms

(Basel III finalization standard),

and the Board's stress capital buffer proposal.

See supra

note 35.

1. FDIC Deposit Insurance Assessment Methodology

Some commenters noted that the adoption of SA-CCR could affect the FDIC assessment methodology. In response to this comment, the FDIC notes that a lack of historical data on derivative exposure using SA-CCR makes the FDIC unable to incorporate the SA-CCR methodology into the deposit insurance assessment pricing methodology for highly complex institutions

upon the effective date of this rule. The FDIC plans to review derivative exposure data reported using SA-CCR, and then consider options for addressing the use of SA-CCR in the deposit insurance assessment system. In the meantime, for purposes of reporting counterparty exposures on Schedule RC-O, memorandum items 14 and 15,

highly complex institutions must continue to calculate derivative exposures using CEM (as set forth in 12 CFR 324.34(b) under the final rule), but without any reduction for collateral other than cash collateral that is all or part of variation margin and that satisfies the requirements of 12 CFR 324.10(c)(4)(ii)(C)(1)(ii) and (iii) and 324.10(c)(4)(ii)(C)(3)-(7) (as amended under the final rule). Similarly, highly complex institutions must continue to report the exposure amount associated with securities financing transactions, including cleared transactions that are securities financing transactions, using the standardized approach set forth in 12 CFR 324.37(b) or (c) (as amended under the final rule). The FDIC is making technical amendments to its assessment regulations to update cross-references to CEM and cash collateral requirements in 12 CFR part 324.

A “highly complex institution” is defined as: (1) An insured depository institution (IDI) (excluding a credit card bank) that has had $50 billion or more in total assets for at least four consecutive quarters that either is controlled by a U.S. parent holding company that has had $500 billion or more in total assets for four consecutive quarters, or is controlled by one or more intermediate U.S. parent holding companies that are controlled by a U.S. holding company that has had $500 billion or more in assets for four consecutive quarters; or (2) a processing bank or trust company. A processing bank or trust company is an IDI whose last three years' non-lending interest income, fiduciary revenues, and investment banking fees, combined, exceed 50 percent of total revenues (and its last three years fiduciary revenues are non-zero), whose total fiduciary assets total $500 billion or more and whose total assets for at least four consecutive quarters have been $10 billion or more.

See

12 CFR 327.8(g) and (s).

2. The Banking Organization Systemic Risk Report (FR Y-15)

Some commenters noted that the adoption of SA-CCR could affect reporting on the Banking Organization Systemic Risk Report (FR Y-15), which must be filed by U.S. bank holding companies and certain savings and loan holding companies with $100 billion or more in total consolidated assets and foreign banking organizations with $100 billion or more in combined U.S. assets.

In particular, these commenters requested that the agencies exclude the alpha factor from the exposure amount calculation under SA-CCR for purposes of the interconnectedness indicator under the FR Y-15. The Board expects to address the use of SA-CCR for purposes of the FR Y-15 in a separate process. Until such time, banking organizations that must report the FR Y-15 should continue to use CEM to determine the potential future exposure of their derivative contracts for purposes of completing line 11(b) of Schedule B, consistent with the current instructions to the form.

See

Reporting Form FR Y-15, Instructions for Preparation of Banking Organization Systemic Risk Report (reissued December 2016). The Board recently finalized modifications the reporting panel and certain substantive requirements of Form FR Y-15 in connection with the tailoring final rule adopted by the agencies.

See

84 FR 59032 (November 1, 2019) (Board-only final rule to establish risk-based categories for determining prudential standards to large U.S. and foreign banking organizations (Board-only tailoring final rule));

see also supra

note 23.

3. Stress Test Projections in CCAR

Commenters asked the Board to clarify how the implementation of SA-CCR will interact with the supervisory stress-testing program. In particular, some commenters asked the Board to clarify when a banking organization must incorporate SA-CCR into any stress test projections made for purposes of the Comprehensive Capital Analysis and Review (CCAR) exercise relative to the timing of its implementation for regulatory capital purposes. Consistent with past capital planning practice, the Board expects to make revisions so as to not require a banking organization to use SA-CCR for purposes of the CCAR exercise prior to adopting SA-CCR to calculate its risk-based and supplementary leverage capital requirements (as applicable) under the capital rule. To promote comparability of stress test results across banking organizations, for the 2020 stress test cycle all banking organizations would continue to use CEM for the CCAR exercise. However, a banking organization that has elected to adopt SA-CCR in 2020 would be required to use SA-CCR for the CCAR exercise beginning with the 2021 stress test cycle, and those who adopt in 2021 must use SA-CCR for the CCAR exercise beginning with 2022 stress test cycle.

Finally, a banking organization that does not adopt SA-CCR until the mandatory compliance date in 2022 would not be required to use SA-CCR for the CCAR exercise until the 2023 and all subsequent stress test cycles. Prior to the time of adoption in stress testing, the Board expects to update the Form FR Y-14 to implement these changes and to provide any necessary information on how to incorporate SA-CCR into a banking organization's stress test results.

For banking organizations subject to Category IV supervisory stress test requirements, 2022 is an on-cycle year.

Banking organizations that report information on the FR Y-14 under SA-CCR must do so for all schedules, including DFAST and CCAR. The anticipated standards described in this section would apply equally for purposes of DFAST and CCAR.

Commenters also suggested aligning certain aspects of the CCAR exercise with SA-CCR. Specifically, commenters asked the Board to revise the CCAR methodology for estimating losses under the largest single counterparty default scenario to distinguish between margined and unmargined counterparty relationships in a manner consistent with SA-CCR. The methodologies for measuring counterparty exposure under SA-CCR and supervisory stress testing are designed to capture different types of risks. In particular, the largest single counterparty default exercise seeks to ensure that a banking organization can absorb losses associated with the default of any counterparty, in addition to losses associated with adverse economic conditions, in an environment of economic uncertainty. The Board regularly reviews its stress testing models, and will continue to evaluate the appropriateness of assumptions related to the largest counterparty default component.

4. Swap Margin Rule

Commenters noted that the agencies' margin and capital requirements for covered swap entities rule (swap margin rule) uses a methodology similar to CEM to quantify initial margin requirements for non-cleared swaps and non-cleared security-based swaps.

This final rule does not affect the swap margin rule or the calculation of appropriate margin and, therefore, the implementation of SA-CCR will not require a banking organization to change the way it complies with those requirements.

See supra

note 17.

5. OCC Lending Limits

In the proposal, the OCC proposed to revise its lending limit rule at 12 CFR part 32, to update cross-references to CEM in the standardized approach and to permit SA-CCR as an option for calculation of exposures under lending limits. Commenters generally supported the OCC's proposal to align measurement of counterparty credit risk across regulatory requirements. The OCC agrees with the commenters and therefore the final rule adopts revisions to the lending limits rule as proposed.

6. Single Counterparty Credit Limit (SCCL)

As noted in the proposal, the Board's single counterparty credit limit (SCCL) rule authorizes a banking organization subject to the SCCL to use any methodology that such a banking organization is authorized to use under the capital rule to determine the credit exposure associated with a derivative contract for purposes of the SCCL rule.

Thus, as under the proposal, as of the mandatory compliance date for SA-CCR, to determine the credit exposure associated with a derivative contract under the SCCL rule, an advanced approaches banking organization must use SA-CCR or IMM and a banking organization subject to Category III standards, which include the SCCL rule, must use whichever of CEM or SA-CCR

that it uses to calculate its standardized total risk-weighted assets.

See

83 FR 38460 (August 6, 2018). The Board-only tailoring final rule revised the scope of applicability of the SCCL rule, such that it applies to U.S. and foreign banking organizations subject to Category I, II, or III standards, as applicable, and foreign banking organizations with global consolidated assets of $250 billion or more.

See supra

note 41.

7. Potential Future Revisions to the Agencies' Rules

Commenters requested additional information on the interaction of SA-CCR with other potential revisions that the agencies may make to their respective regulatory capital rules. Potential revisions identified by commenters included the implementation of the Basel III finalization standard and the Board's proposal to integrate the capital rule and CCAR and stress test rules published in April 2018.

In addition, the proposed net stable funding ratio rule would cross-reference netting provisions of the agencies' supplementary leverage ratio that are amended under the final rule.

The agencies will consider the calibration and operation of SA-CCR for purposes of any such potential revisions through the rulemaking process.

See

83 FR 18160 (April 25, 2018).

See

81 FR 35124 (June 1, 2016).

III. Mechanics of the Standardized Approach for Counterparty Credit Risk

A. Exposure Amount

Under the proposal, the exposure amount of a netting set would have been equal to an alpha factor of 1.4 multiplied by the sum of the replacement cost of the netting set and the PFE of the netting set. The purposes of the alpha factor were to address certain risks that are not captured under SA-CCR and to ensure that exposure amounts produced under SA-CCR generally would not be lower than those under IMM, in support of its use as a broadly applicable and standardized methodology. In addition, the proposal would have set the exposure amount at zero for a netting set that consists of only sold options in which the counterparty to the options paid the premiums up front and that the options within the netting set are not subject to a variation margin agreement.

Commenters stated that the proposal would increase the exposure amount of derivative contracts with commercial end-users, relative to CEM, because commercial end-users often have directional, unmargined derivative portfolios, which would not receive the benefits of collateral recognition and netting under SA-CCR in the form of a reduction to the replacement cost and PFE amounts. As a result, commenters expressed concern that banking organizations would pass the costs of higher capital to commercial end-users in the form of higher fees or, alternatively, that banking organizations could be less willing to engage in derivative contracts with commercial end-users who may lack the capability and scale to provide financial collateral recognized under the capital rule. Commenters also expressed concern that any increase in hedging costs for commercial end-users could have an adverse impact on the broader economy.

Commenters generally suggested that the agencies address these issues through changes to the alpha factor, either by removing it for all derivative contracts with commercial end-user counterparties, or only for such contracts that are unmargined. Commenters asserted that providing relief for derivative contracts with commercial end-user counterparties would not undermine the goals of the proposal because these transactions comprise a small percentage of outstanding derivatives and may present less risk than other directional, unmargined derivatives. In support of this assertion, commenters argued that commercial end-users typically provide collateral that is not recognized as financial collateral under the capital rule but nonetheless reduces the counterparty credit risk of the underlying transaction.

Commenters also argued that removing or reducing the alpha factor for such derivative contracts would be consistent with congressional and regulatory efforts designed to facilitate the ability of such counterparties to enter into derivative contracts to manage commercial risks.

The types of collateral that commercial end-users provide that do not qualify as financial collateral under the capital rule are discussed in further detail in section III.B. of this

SUPPLEMENTARY INFORMATION

See supra

note 17.

Some commenters argued that applying the alpha factor to derivative contracts with commercial end-user counterparties is misaligned with the risks that the alpha factor was intended to address under IMM, such as wrong-way risk.

Some commenters recommended reducing the alpha factor to 0.65 for derivative contracts with investment grade commercial end-user counterparties, or with non-investment grade commercial end-user counterparties that are supported by a letter of credit or provide a first-priority lien on assets that do not present wrong-way risk with respect to the underlying derivative contract. These commenters argued that reducing the alpha factor to 0.65 would improve risk sensitivity and more closely align with the treatment of investment-grade corporate exposures under the revised Basel III finalization standard.

Wrong way risk means that the size of an exposure is positively correlated with the counterparty's probability of default—that is, the exposure amount of the derivative contract increases as the counterparty's probability of default increases.

See supra

note 3555.

The agencies recognize that derivative contracts between banking organizations and commercial end-users may include credit risk mitigants that do not qualify as financial collateral under the capital rule.

In addition, and in contrast to derivative contracts with financial end-users, derivative contracts with commercial end-users have heightened potential to present right-way risk.

The final rule removes the alpha factor from the exposure amount formula for derivative contracts with commercial end-user counterparties. The agencies intend for this treatment to better align with the counterparty credit risk presented by such exposures due to the presence of credit risk mitigants and the potential for such transactions to present right-way risk. In particular, the agencies recognize that derivative exposures to commercial end-user counterparties may be less likely to present the types of risks that the alpha factor was designed to address, as discussed previously, and therefore believe that removing the alpha factor for such exposures improves the calibration of SA-CCR. The agencies note that this approach also may mitigate the concerns of commenters regarding the potential effects of the proposal relative to congressional and other regulatory actions designed to mitigate the effect that post-crisis derivatives market reforms have on the ability of these parties to enter into derivative contracts to manage commercial risks. The agencies intend to monitor the implementation of SA-CCR as part of their ongoing assessment of the effectiveness of the overall U.S. regulatory capital framework to determine whether there are opportunities to improve the ability of commercial end-users to enter into derivative contracts with banking organizations in a manner that continues to support the safety and soundness of banking organizations and U.S. financial stability.

Under § _.2 of the capital rule, financial collateral means cash or liquid and readily marketable securities, in which a banking organization has a perfected first-priority security interest in the collateral.

See

12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); and 12 CFR 324.2 (FDIC).

Right way risk means that the size of an exposure is negatively correlated with the counterparty's probability of default—that is, the exposure amount of the derivative contract decreases as the counterparty's probability of default increases.

Beyond the concerns related to commercial end-users, commenters

recommended other changes to the alpha factor. Several commenters suggested removing the alpha factor from the SA-CCR methodology altogether, whereas other commenters suggested that the alpha factor should apply only to the PFE component. Some commenters supported reducing or eliminating the alpha factor as it applies to all or a subset of derivative contracts.

Commenters that recommended removing the alpha factor argued that the rationale for adopting the alpha factor for purposes of IMM does not apply in the context of SA-CCR because, in contrast to IMM, SA-CCR is a non-modelled approach and does not require an adjustment to account for model risk. Similarly, other commenters noted that the alpha factor is less meaningful in the United States because, under the capital rule, the standardized approach serves as a floor to the advanced approaches for total risk-weighted assets. Some of these commenters also stated that the potential elimination of the advanced approaches in connection with the U.S. implementation of the Basel III finalization standard would eliminate use of IMM and undermine the need for the alpha factor. Other commenters argued that because IMM incorporates relatively higher stressed-volatility inputs while the supervisory factors under SA-CCR are static, attempts to have SA-CCR yield a more conservative exposure amount than IMM in all cases could result in SA-CCR producing excessive capital requirements that are disconnected from the actual risk of the underlying exposures. Alternatively, other commenters recommended only applying the alpha factor to PFE. These commenters argued that applying the alpha factor to replacement cost would be inappropriate as the fair value of on-balance sheet derivatives are not subject to model uncertainty.

Commenters that supported reducing the alpha factor recommended revising the calibration to reflect the derivatives market reforms that followed the financial crisis, such as mandatory clearing requirements promulgated by the Commodity Futures Trading Commission (CFTC)

and the swap margin rule.

Of these, some commenters supported applying a lower alpha factor to heavily over-collateralized portfolios in order to provide greater collateral recognition.

See

17 CFR part 50.

See supra

note 17.

Additionally, some commenters expressed concern that the alpha factor could adversely affect custody banking organizations. In particular, the commenters asserted that custody banking organizations do not maintain large portfolios of derivative contracts across a broad range of tenors (

i.e.,

the amount of time remaining before the end date of the derivative contract) and asset classes and that the foreign exchange derivative portfolio of a custody banking organization is intended to serve the investment needs of the custody banking organization's clients rather than to take on economic risk.

In contrast, some commenters who supported the alpha factor suggested that concerns regarding its impact on the exposure amount calculated under SA-CCR are overstated. Specifically, these commenters argued that banking organizations have incentives to minimize estimates of risk for regulatory capital purposes and that internal models failed to account properly for risk during the crisis and have been criticized in analyses conducted since then. In addition, these commenters stated that although SA-CCR uses estimates of volatility for individual positions that are based on observed, crisis period volatilities, greater recognition of netting and margin under SA-CCR may fully offset any conservatism resulting from the use of updated volatility estimates.

As noted in the proposal, the alpha factor helps to instill an appropriate level of conservatism and further support the use of SA-CCR as a broadly applicable and standardized methodology. Additionally, the alpha factor serves to capture certain risks (

e.g.,

wrong-way risk, non-granular risk exposures, etc.) that are not fully reflected under either IMM or SA-CCR. Adopting commenters' recommendations could reduce the efficacy of SA-CCR as a standardized approach that serves a floor to internal models-based approaches. For large, internationally active banking organizations, consistency with the Basel Committee standard also helps to reduce operational burden and minimize any incentives such banking organizations may have to book activities in legal entities located in jurisdictions that provide relatively more favorable regulatory capital treatment.

Accordingly, the final rule incorporates an alpha factor of 1.4 in the exposure amount formula, except as it applies to derivative contracts with commercial end-user counterparties for which the alpha factor is removed under the final rule. The exposure amount formulas are represented as follows:

exposure amount

= 1.4 * (

replacement cost

PFE

However, for a derivative contract with a commercial end-user counterparty, the exposure amount is represented as follows:

exposure amount

= (

replacement cost

PFE

To operationalize the exposure amount formula for derivative contracts with commercial end-user counterparties, the final rule provides a definition of commercial end-user. Under the final rule, a commercial end-user means a company that is using derivatives to hedge or mitigate commercial risk, and is not a financial entity listed in section 2(h)(7)(C)(i)(I) through (VIII) of the Commodity Exchange Act

or is not a financial entity listed in section 3C(g)(3)(A)(i) through (viii) of the Securities Exchange Act.

The definition also includes an entity that qualifies for the exemption from clearing under section 2(h)(7)(A) of the Commodity Exchange Act by virtue of section 2(h)(7)(D) of the Commodity Exchange Act, including entities that are exempted from the definition of financial entity under section 2(h)(7)(C)(iii) of the Commodity Exchange Act;

or qualifies for the exemption from clearing under section 3C(g)(1) of the Securities Exchange Act by virtue of section 3C(g)(4) of the Securities Exchange Act.

Including these entities within the commercial end-user definition permits affiliates that hedge commercial risks on behalf of a parent entity that is not a financial entity to qualify as a commercial end-user, which would accommodate business organizations that hedge commercial risks through transactions conducted by affiliates rather than directly by the parent company. Overall, the definition covers commercial end-users and generally excludes financial entities.

7 U.S.C. 2(h)(7)(C)(i)(I) through (VIII). The commercial end-user definition also applies to transactions with affiliates of entities that enter into derivative contracts on behalf of those entities that meet the criteria under section 2(h)(7)(D) of the Commodity Exchange Act.

15 U.S.C. 78c-3(g)(3)(A)(i) through (viii).

7 U.S.C. 2(h)(7)(A), (C)(iii), and (D).

15 U.S.C. 78c-3(g)(1) and (4).

This definition has the advantage of being generally consistent with other regulations promulgated by the agencies, including the swap margin rule.

Referencing provisions of the Commodities Exchange Act or Securities Exchange Act promotes consistency with other regulations and offers a significant compliance benefit to

institutions subject to the final rule.

In addition, in the swap margin rule context, the agencies observed that differences in risk profiles justified distinguishing between financial end-users and non-financial end-users, on the grounds that financial firms present a higher level of risk than other types of counterparties and are more likely to default during a period of financial stress, thus posing greater risk to the safety and soundness of the counterparty and systemic risk.

While some commenters requested an exemption for entities that was slightly narrower or broader than the definition the agencies are adopting in the final rule, as noted above, the distinction drawn by this definition is appropriate to differentiate derivative transactions that have the potential to present right-way risk from those that do not.

See supra

note 17.

The definition of a commercial end-user in the final rule does not extend to an organization exempted by the CFTC pursuant to section 2(h)(7)(C)(ii) of the Commodity Exchange Act (7 U.S.C. 2(h)(7)(C)(ii)) or exempted by the Securities and Exchange Commission pursuant to section 3C(g)(3)(B) of the Securities Exchange Act of 1934 (15 U.S.C. 78c-3(g)(3)(B)).

See

80 FR 74839, 74853 (April 1, 2016).

Id.

Other commenters asked the agencies to clarify that the proposal would apply an exposure amount of zero to sold options in which the counterparty to the options has paid the premiums up front and that are not subject to a variation margin agreement. Consistent with the proposal, under the final rule, an exposure amount of zero applies to sold options that are not subject to a variation margin agreement and for which the counterparty has paid the premiums up front.

This treatment is appropriate because the counterparty to the option has no future payment obligation under the derivative contract and the banking organization, as the option seller, has no exposure to counterparty credit risk.

See

§ _.132(c)(5)(iii) of the final rule.

B. Definition of Netting Sets and Treatment of Financial Collateral

Under the capital rule, a netting set is currently defined as a group of transactions with a single counterparty that are subject to a qualifying master netting agreement (QMNA) or a qualifying cross-product master netting agreement. The proposal would have revised the definition of netting set to mean either one derivative contract between a banking organization and a single counterparty, or a group of derivative contracts between a banking organization and a single counterparty that are subject to the same qualifying master netting agreement or the same qualifying cross-product master netting agreement. The proposal would have allowed a banking organization to calculate the exposure amount of multiple derivative contracts under the same netting set so long as each derivative contract is subject to the same QMNA.

Some commenters raised concerns with the proposal's reliance on netting to reduce exposure amounts on a point-in-time basis instead of on a dynamic basis and suggested revising the proposal to account for situations that may arise during stress periods that could disrupt the availability of netting. As an example, the commenters noted that during the financial crisis some banking organizations requested to novate their “in-the-money” derivative contracts with another counterparty, while leaving the banking organization's “out-of-the-money” positions with the initial counterparty. The agencies believe it is appropriate to allow for the netting of derivative contracts under SA-CCR on a point-in-time basis, as allowing for netting on a point-in-time basis under SA-CCR is consistent with U.S. generally accepted accounting principles (U.S. GAAP) and facilitates implementation of the final rule. The capital rule relies significantly on banking organizations' U.S. GAAP balance sheets and thus requires banking organizations to determine capital ratios on a point-in-time basis. The risks related to stress events identified by the commenters may be further addressed in the context of stress testing and resolution planning. Thus, the agencies are adopting as final the netting treatment under the proposal, with the exception of the availability of netting among collateralized-to-market and settled-to-market derivative contracts, which is discussed below in section III.D.4. of this

SUPPLEMENTARY INFORMATION

Under the final rule, a group of derivative contracts subject to the same QMNA are part of the same netting set.

In general, a QMNA means a netting agreement that permits a banking organization to terminate, close-out on a net basis, and promptly liquidate or set off collateral upon an event of default of the counterparty.

To qualify as a QMNA, the netting agreement must satisfy certain operational requirements under § _.3 of the capital rule.

The definition of netting set also clarifies that a netting set can be composed of a single derivative contract and retains certain components of the definition that are specific to IMM.

See supra

note 2. In 2017, the agencies adopted a final rule that requires GSIBs and the U.S. operations of foreign GSIBs to amend their qualified financial contracts to prevent their immediate cancellation or termination if such a banking organization enters bankruptcy or a resolution process. Qualified financial contracts include derivative contracts, securities lending, and short-term funding transactions such as repurchase agreements. Under the 2017 final rule, the agencies revised the definition of QMNA under the capital rule such that qualified financial contracts could be subject to a QMNA (notwithstanding other operational requirements).

See

82 FR 42882 (September 12, 2017).

See supra

note 2.

Some commenters expressed concern that the proposed definition of netting set could inadvertently affect the treatment for repo-style transactions under other provisions of the capital rule. The proposed definition was intended to reflect that under SA-CCR a banking organization would determine the exposure amount for a derivative contract at the netting set level, which would have included a single derivative contract. However, to address the commenters' concern, the agencies have revised the definition of netting set under the final rule to mean a group of transactions with a single counterparty that are subject to a QMNA and, with respect to derivative contracts only, also includes a single derivative contract between a banking organization and a counterparty.

With respect to repo-style transactions, this definition is consistent with the current capital rule.

Consistent with the current definition of netting set, for purposes of the internal models methodology in § _.132(d) of the capital rule, netting set also includes a qualifying cross-product master netting agreement.

See

12 CFR 3.132(d) (OCC); 12 CFR 217.132(d) (Board); and 12 CFR 324.132(d) (FDIC).

The proposal set forth definitions for variation margin, variation margin amount, independent collateral, and net independent collateral amount. The proposal would have defined variation margin as financial collateral that is subject to a collateral agreement and provided by one party to its counterparty to meet the performance of the first party's obligations under one or more derivative contracts between the parties as a result of a change in value of such obligations since the last exchange of such collateral. The variation margin amount would have been equal to the fair value amount of the variation margin that a counterparty to a netting set has posted to a banking organization less the fair value amount of the variation margin posted by the banking organization to the counterparty.

The proposal would have required the variation margin amount to be adjusted by the existing standard supervisory haircuts under § _.132(b)(2)(ii)(A)(

) of the capital rule. The standard supervisory haircuts reflect potential

future changes in the value of the financial collateral by adjusting for any potential decrease in the value of the financial collateral received by a banking organization and any potential increase in the value of the financial collateral posted by the banking organization over supervisory-provided holding periods. The standard supervisory haircuts are based on a ten-business-day holding period, and the capital rule requires a banking organization to adjust, as applicable, the standard supervisory haircuts to align with the associated derivative contract (or repo-style transaction) according to the formula in § _.132(b)(2)(ii)(A)(4).

As described in section III.D. of this

SUPPLEMENTARY INFORMATION

, the final rule applies a five-day holding period for the purpose of the margin period of risk to all derivative contracts subject to a variation margin agreement that are client-facing derivative transactions, as defined in the final rule, regardless of the method the banking organization uses to calculate the exposure amount of the derivative contract. As described in section VI.E. of this

SUPPLEMENTARY INFORMATION

, the collateral haircuts for such transactions similarly reflect a five-business-day holding period under the final rule.

The proposal would have defined independent collateral as financial collateral, other than variation margin, that is subject to a collateral agreement, or in which a banking organization has a perfected, first-priority security interest or, outside of the United States, the legal equivalent thereof (with the exception of cash on deposit and notwithstanding the prior security interest of any custodial agent or any prior security interest granted to a CCP in connection with collateral posted to that CCP), and the amount of which does not change directly in response to the change in value of the derivative contract or contracts that the financial collateral secures.

Net independent collateral amount would have been defined as the fair value amount of the independent collateral that a counterparty to a netting set has posted to a banking organization less the fair value amount of the independent collateral posted by the banking organization to the counterparty, excluding such amounts held in a bankruptcy-remote manner,

or posted to a qualifying central counterparty (QCCP)

and held in conformance with the operational requirements in § _.3 of the capital rule. As with the variation margin amount, the independent collateral amount would have been subject to the standard supervisory haircuts under § _.132(b)(2)(ii)(A)(

) of the capital rule.

“Bankruptcy remote” is defined in § _.2 of the capital rule.

See

12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); and 12 CFR 324.2 (FDIC).

“Qualifying central counterparty” is defined in § _.2 of the capital rule.

See

12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); and 12 CFR 324.2 (FDIC).

The agencies did not receive comment on the proposed definitions of variation margin, variation margin amount, independent collateral, and independent collateral amount. Several commenters, however, advocated for recognition of alternative collateral arrangements under SA-CCR to address the potential impact of the proposal on derivative contracts with certain counterparties, including commercial end-users. As noted above, the commenters argued that SA-CCR could unduly increase capital requirements for derivative exposures to commercial end-user counterparties because they often do not provide collateral in the form of cash or liquid and readily marketable securities. Commenters stated that companies, including commercial end-users, regularly use alternative security arrangements, such as liens on assets, a letter of credit, or a parent company guarantee, to offset the counterparty credit risk of their derivative contracts, and that banking organizations should be able to recognize the credit risk-mitigating benefits of such arrangements under SA-CCR.

In support of their recommendation, commenters noted that a line of credit functions similarly to the exchange of margin because the line of credit is available to be drawn upon by the banking organization in advance of default as the counterparty's creditworthiness deteriorates. Moreover, the line of credit can be structured so that its amount may increase over the life of the derivative contract based on certain credit quality metrics. Commenters added that common industry practice allows banking organizations to accept these forms of collateral from counterparties and to reflect their credit risk-mitigating benefits when they calculate the exposure amount under IMM. Commenters also argued that derivative contracts with commercial end-users may present right-way risk for banking organizations, in contrast to derivative contracts with financial institution counterparties, and that this feature of these transactions supports recognition of alternative forms of collateral.

The capital rule only recognizes certain forms of collateral that qualify as “financial collateral,” as defined under the rule.

In general, the items that qualify as financial collateral under the capital rule exhibit sufficient liquidity and asset quality to serve as credit risk mitigants for risk-based capital purposes. Consistent with the capital rule, the final rule does not recognize the alternative collateral arrangements suggested by commenters. Liens and asset pledges, by contrast, may not be rapidly available to support losses in an event of default because the assets they attach to can be illiquid and thus difficult to value and sell for cash after enforcement of a security interest in the collateral or foreclosure, which is inconsistent with the principle that derivatives should be able to be closed out easily and quickly in an event of default.

In addition, recognizing letters of credit would add significant complexity to the capital rule. In particular, recognition of letters of credit as financial collateral would require the introduction of appropriate qualification criteria, as well as a framework for considering the counterparty credit risk of institutions providing the letters of credit. The agencies also believe that the removal of the alpha factor for derivative contract exposures to commercial end-users helps to address commenters' concerns that the proposal would have resulted in unduly high risk-weighted asset amounts for derivative contracts with commercial end-user counterparties.

See supra

note 52.

The Board and OCC issued the capital rule as a joint final rule on October 11, 2013 (78 FR 62018) and the FDIC issued the capital rule as a substantially identical interim final rule on September 10, 2013 (78 FR 53340). In April 14, 2014, the FDIC issued the interim final rule as a final rule with no substantive changes (79 FR 20754).

Accordingly, the agencies are adopting without change the proposed definitions for variation margin, independent collateral, variation margin amount, and independent collateral amount, as well as the proposed application of the standard supervisory haircuts under the capital rule.

C. Replacement Cost

The proposal would have provided separate formulas to determine replacement cost that apply depending on whether the counterparty to a banking organization is required to post variation margin. Specifically, the replacement cost for a netting set that is not subject to a variation margin agreement would have equaled the greater of (1) the sum of the fair values (after excluding any valuation adjustments) of the derivative contracts within the netting set, less the net independent collateral amount applicable to such derivative contracts, or (2) zero.

Replacement cost is calculated based on the assumption that the counterparty has defaulted. Therefore, this calculation cannot include valuation adjustments based on counterparty's credit quality,

such as CVA, which reflect the discounted present value of losses if the counterparty were to default in the future.

For a netting set that is subject to a variation margin agreement where the counterparty is required to post variation margin, replacement cost would have equaled the greater of (1) the sum of the fair values (after excluding any valuation adjustments) of the derivative contracts within the netting set, less the sum of the net independent collateral amount and the variation margin amount applicable to such derivative contracts; (2) the sum of the variation margin threshold and the minimum transfer amount applicable to the derivative contracts within the netting set, less the net independent collateral amount applicable to such derivative contracts; or (3) zero. As noted in the proposal, the formula to determine the replacement cost of a netting set subject to a variation margin agreement would have accounted for the maximum possible unsecured exposure amount of the netting set that would not trigger a variation margin call. For example, a netting set with a high variation margin threshold has a higher replacement cost compared to an equivalent netting set with a lower variation margin threshold. Therefore, the proposal would have provided definitions for variation margin threshold and the minimum transfer amount.

Under the proposal, the variation margin threshold would have meant the maximum amount of a banking organization's credit exposure to its counterparty that, if exceeded, would require the counterparty to post variation margin to the banking organization. The minimum transfer amount would have meant the smallest amount of variation margin that may be transferred between counterparties to a netting set. The proposal included this treatment to address transactions for which the variation margin agreement includes a variation margin threshold that is set at a level high enough to make the netting set effectively unmargined. In such a case, the variation margin threshold would result in an inappropriately high replacement cost, because it is not reflective of the risk associated with the derivative contract but rather the terms of the variation margin agreement. To address this issue, the proposal would have provided that the exposure amount of a netting set subject to a variation margin agreement could not exceed the exposure amount of the same netting set calculated as if the netting set were not subject to a variation margin agreement.

There could be a situation unrelated to the value of the variation margin threshold in which the exposure amount of a margined netting set is greater than the exposure amount of an equivalent unmargined netting set. For example, in the case of a margined netting set composed of short-term transactions with a residual maturity of ten business days or less, the risk horizon equals the MPOR, which under the final rule is set to a minimum floor of ten business days. The risk horizon for an equivalent unmargined netting set also is set to ten business days because this is the floor for the remaining maturity of such a netting set. However, the maturity factor for the margined netting set is greater than the one for the equivalent unmargined netting set because of the application of a factor of 1.5 to margined derivative contracts. In such an instance, the exposure amount of a margined netting set is more than the exposure amount of an equivalent unmargined netting set by a factor of 1.5, thus triggering the cap. In addition, in the case of margin disputes, the MPOR of a margined netting set is doubled, which could further increase the exposure amount of a margined netting set comprised of short-term transactions with a residual maturity of ten business days or less above an equivalent unmargined netting set. The agencies believe, however, that such instances rarely occur and thus would have minimal effect on banking organizations' regulatory capital. Therefore, the final rule limits the exposure amount of a margined netting set to no more than the exposure amount of an equivalent unmargined netting set. However, the agencies expect to monitor the application of this treatment under the final rule.

In addition, the proposal would have provided adjustments for determining the replacement cost of a netting set that is subject to multiple variation margin agreements or a hybrid netting set, which is a netting set composed of at least one derivative contract subject to a variation margin agreement under which the counterparty must post variation margin and at least one derivative contract that is not subject to such a variation margin agreement, and for multiple netting sets subject to a single variation margin agreement.

Some commenters supported the proposed replacement cost calculation and, in particular, the cap based on the margin exposure threshold and minimum transfer amount. The commenters argued that the unmargined exposure amount more accurately reflects the exposure amount for short-dated trades subject to a higher MPOR, as the close-out period reflected in MPOR cannot be increased beyond the maturity of the transactions. Other commenters advocated subtracting incurred CVA from the exposure amount of a netting set. In support of their recommendation, the commenters noted that IMM allows incurred CVA to be subtracted from EAD, and that the agencies previously extended such treatment to advanced approaches banking organizations that use CEM to calculate advanced approaches risk-weighted assets.

The final rule adopts the proposed replacement cost formulas and related definitions, with one modification. The agencies recognize that in determining the fair value of a derivative on a banking organization's balance sheet, the recognized CVA on the netting set of OTC derivative contracts is intended to reflect the credit quality of the counterparty. The final rule permits advanced approaches banking organizations to reduce EAD, calculated according to SA-CCR, by the recognized CVA on the balance sheet, for the purposes of calculating advanced approaches total risk-weighted assets. This treatment is consistent with the recognition of CVA under CEM as it applies to advanced approaches banking organizations that use CEM for purposes of determining advanced approaches total risk-weighted assets.

See

80 FR 41409 (July 15, 2015).

The final rule otherwise adopts without change the proposed replacement cost formulas and related definitions, as well as the proposed treatment to cap the exposure amount for a margined netting set at the maximum exposure amount for an unmargined, but otherwise identical, netting set.

Under § _.132(c)(6)(ii) of the final rule, the replacement cost of a netting set that is not subject to a variation margin agreement is represented as follows:

replacement cost

max

{

−

; 0},

Where:

V is the fair values (after excluding any valuation adjustments) of the derivative contracts within the netting set; and

C is the net independent collateral amount applicable to such derivative contracts.

The same requirement applies to a netting set that is subject to a variation margin agreement under which the counterparty is not required to post variation margin. For such a netting set, C also includes the negative amount of the variation margin that the banking organization posted to the counterparty (thus increasing replacement cost).

For netting sets subject to a variation margin agreement under which the counterparty must post variation margin, the replacement cost formula is provided under § _.132(c)(6)(i) of the final rule and is represented as follows:

replacement cost

max

{

−

;

VMT

MTA

−

NICA

; 0},

Where:

V is the fair values (after excluding any valuation adjustments) of the derivative contracts within the netting set;

C is the sum of the net independent collateral amount and the variation margin amount applicable to such derivative contracts;

VMT is the variation margin threshold applicable to the derivative contracts within the netting set; and

MTA is the minimum transfer amount applicable to the derivative contracts within the netting set.

NICA is the net independent collateral amount applicable to such derivative contracts.

For a netting set that is subject to multiple variation margin agreements, or a hybrid netting set, a banking organization must determine replacement cost using the methodology described in § _.132(c)(11)(i) of the final rule. Under this paragraph, a banking organization must use the standard replacement cost formula (described in § _.132(c)(6)(i) for a netting set subject to a variation margin agreement), except that the variation margin threshold equals the sum of the variation margin thresholds of all the variation margin agreements within the netting set and the minimum transfer amount equals the sum of the minimum transfer amounts of all the variation margin agreements within the netting set.

For multiple netting sets subject to a single variation margin agreement, a banking organization must assign a single replacement cost to the multiple netting sets according to the following formula, as provided under § _.132(c)(10)(i) of the final rule:

Replacement Cost

max{

max

{

; 0}−

max

{

; 0}; 0} +

max

{Σ

min

{

; 0}−

min

{

; 0}; 0},

Where:

NS is each netting set subject to the variation margin agreement MA;

is the sum of the fair values (after excluding any valuation adjustments) of the derivative contracts within the netting set NS; and

is the sum of the net independent collateral amount and the variation margin amount applicable to the derivative contracts within the netting sets subject to the single variation margin agreement.

The component

max{

max

{

; 0}−

max

{

; 0}; 0} reflects the exposure amount produced by netting sets that have current positive market value. Variation margin and independent collateral collected from the counterparty to the transaction can offset the current positive market value of these netting sets (

i.e.,

this component contributes to replacement cost only in instances when C

is positive). However, netting sets that have current negative market value are not allowed to offset the exposure amount. The component

max

{Σ

min

{

; 0}−

min

{

; 0}; 0} reflects the exposure amount produced when the banking organization posts variation margin and independent collateral to its counterparty (

i.e.,

this component contributes to replacement cost only in instances when C

is negative).

D. Potential Future Exposure

Under the proposal, the PFE for a netting set would have equaled the product of the PFE multiplier and the aggregated amount. To determine the aggregated amount, a banking organization would have been required to determine the hedging set amounts for the derivative contracts within a netting set, where a hedging set is comprised of derivative contracts that share similar risk factors based on asset class (

i.e.,

interest rate, exchange rate, credit, equity, and commodity). The aggregated amount would have equaled the sum of all hedging set amounts within a netting set.

Under the proposal, a banking organization would have used a two-step process to determine the hedging set amount for an asset class. First, a banking organization would have determined the composition of a hedging set using the asset class definitions set forth in the proposal. Second, the banking organization would have determined hedging set amount using asset class specific formulas. The hedging set amount formulas require a banking organization to determine an adjusted derivative contract amount for each derivative contract, and to aggregate those amounts to arrive at the hedging set amount for an asset class.

Section III.D.1. of this

SUPPLEMENTARY INFORMATION

discusses the methodology for determining the composition of a hedging set using the asset class distinctions set forth in the final rule. Section III.D.2. of this

SUPPLEMENTARY INFORMATION

discusses the methodology for determining the adjusted derivative contract amount for each derivative contract. Section III.D.3. of this

SUPPLEMENTARY INFORMATION

discusses the PFE multiplier. Section III.D.4. of this

SUPPLEMENTARY INFORMATION

discusses the PFE calculation for nonstandard margin agreements.

The final rule adopts the formula for determining PFE as proposed. Under § _.132(c)(7) of the final rule, the PFE of a netting set equals the product of the PFE multiplier and the aggregated amount. The final rule defines the aggregated amount as the sum of all hedging set amounts within the netting set. This formula is represented in the final rule as follows:

PFE

PFE multiplier

aggregated amount,

Where aggregated amount is the sum of each hedging set amount within the netting set.

1. Hedging Set Amounts

Under the proposal, a banking organization would have determined the hedging set amount by asset class. To specify each asset class, the proposal would have maintained the existing definitions in the capital rule for interest rate, exchange rate, credit, equity, and commodity derivative contracts. The proposal would have provided hedging set definitions for each asset class and sought comment on an alternative approach for the definition and treatment of exchange rate derivative contracts to recognize the economic relationships of exchange rate chains (

i.e.,

when more than one currency pair can offset the risk of another). For example, a Yen/Dollar forward contract and a Dollar/Euro forward contract, taken together, may be economically equivalent, with properly set notional amounts, to a Yen/Euro forward contract when they are subject to the same QMNA. The proposal also would have included separate treatments for volatility derivative contracts and basis derivative contracts.

Some commenters recommended that the agencies revise the definitions for interest rate, exchange rate, equity, and commodity derivative contracts for SA-CCR. In particular, the commenters noted that there could be instances in which the existing definitions in the capital rule are not aligned with the primary risk factor for a derivative contract, and therefore would differ from the classifications used under SA-CCR. To address this concern, commenters requested allowing banking organizations to use the primary risk factor for the derivative contract instead of one based on the asset class definitions set forth in the proposal.

The final rule maintains the definitions of interest rate, exchange rate, equity, and commodity derivative contracts, as the definitions are largely aligned with existing derivative products and market practices. In addition to being sufficiently broad to capture the various types of derivative contracts, the existing asset class definitions are well-established, well-understood, and generally have functioned as intended in the capital rule. The final rule preserves the ability of the primary Federal regulator to address derivative contracts with multiple risk factors by requiring them to be included in multiple hedging sets under § _.132(c)(2)(iii)(H).

The Board is the primary Federal regulator for bank holding companies, savings and loan holding companies, intermediate holding companies of foreign banks, and state member banks; the OCC is the primary Federal regulator for all national banks

and Federal savings associations; and the FDIC is the primary Federal regulatory for all state nonmember banks and savings associations.

Some commenters supported the alternative treatment for recognizing the economic relationships of exchange rate chains described in the proposal, but only if modified to address any potential overstatement in the exposure amounts produced when creating separate hedging sets for each foreign currency. The agencies believe that the alternative treatment described in the proposal, if modified to incorporate correlation parameters as suggested by commenters, would add a level of complexity to the alternative treatment that would make it inappropriate for use in a standardized framework that is intended for potential implementation by all banking organizations. The agencies further believe that the alternative treatment described in the proposal, if modified to require the maximum of long or short risk positions, would not add meaningful risk sensitivity by not taking into account the correlations between currency risk factors. Therefore, the agencies are adopting as final the asset class and hedging set definitions as proposed.

To determine each hedging set amount, a banking organization first must group into separate hedging sets derivative contracts that share similar risk factors based on the following asset classes: Interest rate, exchange rate, credit, equity, and commodity. Basis derivative contracts and volatility derivative contracts require separate hedging sets. A banking organization then must determine each hedging set amount using asset-class specific formulas that allow for full or partial offsetting. If the risk of a derivative contract materially depends on more than one risk factor, whether interest rate, exchange rate, credit, equity, or commodity risk factor, a banking organization's primary Federal regulator may require the banking organization to include the derivative contract in each appropriate hedging set. Under the final rule, the hedging set amount of a hedging set composed of a single derivative contract equals the absolute value of the adjusted derivative contract amount of the derivative contract.

Section _.132(c)(2)(iii) of the final rule provides the respective hedging set definitions. As noted, an exchange rate hedging set means all exchange rate derivative contracts within a netting set that reference the same currency pair. Thus, there could be as many exchange rate hedging sets within a netting set as distinct currency pairs referenced by the exchange rate derivative contracts. An interest rate hedging set means all interest rate derivative contracts within a netting set that reference the same reference currency. Thus, there could be as many interest rate hedging sets in a netting set as distinct currencies referenced by the interest rate derivative contracts in the netting set. A credit hedging set would mean all credit derivative contracts within a netting set. Similarly, an equity hedging set means all equity derivative contracts within a netting set. Consequently, there could be at most one equity hedging set and one credit hedging set within a netting set. A commodity hedging set means all commodity derivative contracts within a netting set that reference one of the following commodity categories: Energy, metal, agricultural, or other commodities. Therefore, there could be no more than four commodity derivative contract hedging sets within a netting set.

Consistent with the proposal, the final rule sets forth separate treatments for volatility derivative contracts and basis derivative contracts. A basis derivative contract is a non-foreign exchange derivative contract (

i.e.,

the contract is denominated in a single currency) in which the cash flows of the derivative contract depend on the difference between two risk factors that are attributable solely to one of the following derivative asset classes: Interest rate, credit, equity, or commodity. A basis derivative contract hedging set means all basis derivative contracts within a netting set that reference the same pair of risk factors and are denominated in the same currency. In contrast, a volatility derivative contract means a derivative contract in which the payoff of the derivative contract explicitly depends on a measure of volatility for the underlying risk factor of the derivative contract. Examples of volatility derivative contracts include variance and volatility swaps and options on realized or implied volatility. A volatility derivative contract hedging set means all volatility derivative contracts within a netting set that reference one of interest rate, exchange rate, credit, equity, or commodity risk factors, separated according to the requirements under § _.132(c)(2)(iii)(A)-(E) of the final rule.

a. Interest Rate Derivative Contracts

Under the proposal, the hedging set amount for a hedging set of interest rate derivative contracts would have recognized that interest rate derivative contracts with close tenors (

i.e.,

the amount of time remaining before the end date of the derivative contract) are generally highly correlated, and thus would have provided a greater offset relative to interest rate derivative contracts that do not have close tenors. In particular, the proposed formula for determining the hedging set amount for interest rate derivative contracts would have permitted full offsetting within a tenor category and partial offsetting across tenor categories, with tenor categories of less than one year, between one and five years, and more than five years. The proposal would have applied a correlation factor of 70 percent across adjacent tenor categories and a correlation factor of 30 percent across nonadjacent tenor categories. The tenor of a derivative contract would have been based on the period between the present date and the end date of the derivative contract, where end date would have meant the last date of the period referenced by the derivative contract, or if the derivative contract references another instrument, the period referenced by the underlying instrument.

Some commenters asked the agencies to allow banking organizations to recognize interest rate derivative contracts within the same QMNA as belonging to the same interest rate hedging set, even if such derivative contracts reference different currencies. According to the commenters, such an approach would allow banking organizations to recognize the diversification benefits of multi-currency interest rate derivative portfolios. Some of these commenters also suggested potential ways to implement this approach. Under one approach, a banking organization would calculate the maximum exposure for the interest rate derivative contracts within the QMNA under two scenarios using a single-factor model. The first scenario would receive a correlation factor of zero percent across interest rate exposures in different currencies, while the second scenario would receive a correlation factor of 70 percent. The former scenario would produce the largest amount for portfolios balanced across net short and net long currency exposures, while the latter scenario would produce the largest amount for portfolios that primarily consist of net long or net short currency positions. The second approach would use a single-factor model to aggregate interest rate derivative contracts per currency type to recognize correlations across currencies. Alternatively, other commenters stated that yield curve correlations across major currencies could be used to establish correlation

factors for interest rate derivative contracts that reference different currencies. These commenters noted that the Basel Committee's standard on minimum capital requirements for market risk incorporates a correlation parameter to reflect diversification benefits across multi-currency interest rate portfolios.

These commenters also stated that studies regarding the Basel Committee standard suggest that, by not recognizing any hedging or diversification benefits across currencies, the proposed method to calculate the hedging set amount for interest rate derivatives under SA-CCR is overly conservative. Other commenters criticized the proposal as not providing a sufficient justification for the requirement that interest rate hedging sets must be settled in the same currency to be included within the same hedging set, in contrast to the proposed treatment for credit, commodity, and equity derivative contracts.

See

“Minimum capital requirements for market risk,” Basel Committee on Banking Supervision (January 2019, rev. February 2019),

https://www.bis.org/bcbs/publ/d457.pdf.

The fact that a set of derivative contracts are subject to the same QMNA is not determinative of whether hedging benefits across derivative contracts actually exist. Interest rates in different currencies can move in different directions, rendering correlations unstable. In addition, adopting the commenters' recommendations could add significant complexity to the final rule. The agencies therefore are adopting as final the proposed treatment for determining the hedging set amount of interest rate derivative contracts. Under § _.132(c)(8)(i) of the final rule, a banking organization must calculate the hedging set amount for interest rate derivative contracts according to the following formula:

ER24JA20.002

Where:

AddOn

equals the sum of the adjusted derivative contract amounts within the hedging set with an end date of less than one year from the present date;

AddOn

equals the sum of the adjusted derivative contract amounts within the hedging set with an end date of one to five years from the present date; and

AddOn

equals the sum of the adjusted derivative contract amounts within the hedging set with an end date of more than five years from the present date.

Consistent with the proposal, the final rule also includes a simpler formula that does not provide an offset across tenor categories. Under this approach, the hedging set amount for interest rate derivative contracts equals the sum of the absolute amounts of each tenor category, which is the sum of the adjusted derivative contract amounts within each respective tenor category. The simpler formula always results in a more conservative measure of the hedging set amount for interest rate derivative contracts of different tenor categories, but may be less burdensome for banking organizations with smaller interest rate derivative contract portfolios. A banking organization may use this simpler formula for some or all of its interest rate derivative contracts.

b. Exchange Rate Derivative Contracts

Exchange rate derivative contracts that reference the same currency pair generally are driven by the same market factor (

i.e.,

the exchange spot rate between these currencies) and thus are highly correlated. Therefore, under the proposal, the formula for determining the hedging set amount for exchange rate derivative contracts would have allowed for full offsetting within the exchange rate derivative contract hedging set. The agencies did not receive comment regarding the formula for determining the hedging set amount for exchange rate derivative contracts, and are adopting it as proposed. Under § _.132(c)(8)(ii) of the final rule, the hedging set amount for exchange rate derivative contracts equals the absolute value of the sum of the adjusted derivative contract amounts within the hedging set.

c. Credit Derivative Contracts and Equity Derivative Contracts

Under the proposal, a banking organization would have used the same formula to determine the hedging set amount for both its credit derivative contracts and equity derivative contracts. The formula would allow full offsetting for credit or equity contracts that reference the same entity, and partial offsetting when aggregating across distinct reference entities. In addition, the proposal would have provided supervisory correlation parameters for credit derivative contracts and equity derivative contracts based on whether the derivative contract referenced a single-name entity or an index.

A single-name derivative would have received a correlation factor of 50 percent, while an index derivative contract would have received a correlation factor of 80 percent to reflect partial diversification of idiosyncratic risk within an index. As noted in the proposal, the pairwise correlation between two entities is the product of the corresponding correlation factors, so that the pairwise correlation between two single-name derivatives is 25 percent, between one single-name and one index derivative is 40 percent, and between two index derivatives is 64 percent. The application of a higher correlation factor does not necessarily result in a higher exposure amount because the proposal generally would have yielded a lower exposure amount for balanced portfolios relative to directional portfolios.

Several commenters asked the agencies to allow banking organizations to decompose indices within credit and equity asset classes to reflect the exposure of highly correlated net long and short positions within an index. Under § _.132(c)(5)(vi) of the final rule, a banking organization may elect to decompose indices within credit and equity asset classes, such that a banking organization would treat each component of the index as a separate single-name derivative contract. Thus, under this election, a banking organization would apply the SA-CCR methodology to each component of the index as if it were a separate single-name derivative contract instead of applying the SA-CCR methodology to

the index derivative contract. This approach provides enhanced risk sensitivity to the SA-CCR framework by allowing for recognition of the hedging benefits provided by the components of an index. In addition, this approach is similar to other aspects of the capital rule.

The agencies will monitor the application of the decomposition approach, including the correlation assumptions between an index and its components, to ensure that the approach is functioning as intended.

See e.g.,

12 CFR 3.53 (OCC); 12 CFR 217.53 (Board); and 12 CFR 324.53 (FDIC).

Under the final rule, a banking organization must determine the hedging set amount for its credit and equity derivative contracts set forth in § _.132(c)(8)(iii) of the final rule, as follows:

ER24JA20.003

Where:

is each reference entity within the hedging set;

is the number of reference entities within the hedging set;

AddOn

(

Ref

) equals the sum of the adjusted derivative contract amounts for all derivative contracts within the hedging set that reference reference entity

; and

equals the applicable supervisory correlation factor, as provided in Table 2.

d. Commodity Derivative Contracts

The proposal would have required a banking organization to determine the hedging set amount for commodity derivative contracts based on the following four commodity categories: Energy, metal, agricultural and other. The proposal would have permitted full offsetting for all derivative contracts within the same commodity category (

i.e.,

within a hedging set) that reference the same commodity type, and partial offsetting for all derivative contracts within the same commodity category that reference different commodity types.

Under the proposal, a commodity type would have referred to a specific commodity within one of the four commodity categories. Additionally, the proposal would not have provided separate supervisory factors for different commodity types within the energy commodity category.

For example, under the proposal, a hedging set could have been composed of crude oil derivative contracts and electricity derivative contracts, with each subject to the same supervisory factor. A banking organization would have been able to fully offset all crude oil derivative contracts against each other and all electricity derivative contracts against each other (as they reference the same commodity type). In addition, a banking organization would not have been able to offset commodity derivative contracts that are included in different commodity categories (

i.e.,

a forward contract on crude oil cannot hedge a forward contract on corn).

See

section III.D.2.b. of this

SUPPLEMENTARY INFORMATION

for a more detailed discussion on supervisory factors under the final rule.

Several commenters asked the agencies to clarify the offsetting treatment among the different types of contracts within the energy category (

e.g.,

electricity and oil/gas derivative contracts). Some commenters asked the agencies to allow banking organizations to decompose derivative contracts that reference commodity indices, such that a banking organization would treat each component of the index as a separate single-name derivative contract.

Consistent with the proposal, the final rule permits full offsetting for all derivative contracts within a hedging set that reference the same commodity type, and partial offsetting for all derivative contracts within a hedging set that reference different commodity types within the same commodity category.

This treatment applies consistently to each of the four commodity categories, including energy. For example, electricity derivative contracts within the same hedging set may fully offset each other, whereas electricity derivative contracts and non-electricity derivate contracts (

e.g.,

oil derivative contracts) within the same hedging set may only partially offset each other because they are different commodity types within the same commodity category.

The final rule provides separate supervisory factors for electricity derivative contracts and other types of commodity derivative contracts within the energy category as discussed further in section III.D.2.b.iii. of this

SUPPLEMENTARY INFORMATION

In an attempt to appropriately balance risk sensitivity with operational burden, consistent with the proposal, the final rule allows banking organizations to recognize commodity types without regard to characteristics such as location or quality. For example, a banking organization may recognize crude oil as a commodity type, and would not need to distinguish further between West Texas Intermediate and Saudi Light crude oil.

In response to comments, § _.132(c)(5)(vi) of the final rule allows a banking organization to elect to decompose commodity indices, such that a banking organization would treat each component of the index as a separate, single-name derivative contract. Thus, under this election, a banking organization would apply the SA-CCR methodology to each component of the index as if it were a separate, single-name derivative contract, instead of applying the SA-CCR methodology to the index derivative contract. This approach provides enhanced risk sensitivity to the SA-CCR framework by allowing for better recognition of hedging benefits provided by the components of an index. In addition, this approach is similar to other aspects of the capital rule.

See supra

note 80.

The agencies recognize that specifying separate commodity types is operationally difficult; indeed, it is likely infeasible to sufficiently specify all relevant distinctions between commodity types in order to capture all basis risk. Therefore, the agencies will monitor the commodity-type distinctions made within the industry for purposes of both the full offset treatment for commodity derivative contracts of the same type and the decomposition approach for commodity indices, to ensure that they are being applied and functioning as intended.

Consistent with the proposal, a banking organization must assign a derivative contract to the “other” commodity category if the derivative contract does not meet the criteria for the energy, metal or agricultural commodity categories.

The hedging set amount for commodity derivative contracts would

be determined under § _.132(c)(8)(iv) of the final rule, as follows:

ER24JA20.004

Where:

is each commodity type within the hedging set;

is the number of commodity types within the hedging set;

AddOn(Type

) equals the sum of the adjusted derivative contract amounts for all derivative contracts within the hedging set that reference commodity type

; and

ρ equals the applicable supervisory correlation factor, as provided in Table 2 of the preamble.

2. Adjusted Derivative Contract Amount

Under the proposal, the adjusted derivative contract amount would have represented a conservative estimate of effective expected positive exposure (EEPE)

for a netting set consisting of a single derivative contract, assuming zero market value and zero collateral, that is either positive (if a long position) or negative (if a short position). A banking organization would have calculated the adjusted derivative contract amount as a product of four components: The adjusted notional amount, the applicable supervisory factor, the applicable supervisory delta adjustment, and the applicable maturity factor. The adjusted derivative contact amount for each asset class would have been aggregated under the hedging set amount formulas for each asset class, as described above. The agencies received no comments on this aspect of the proposal, and are finalizing the formula for determining the adjusted derivative contract amount as proposed under § _.132(c)(9) of the final rule.

See supra

note 10.

The formula to determine the adjusted derivative contract amount is represented as follows:

adjusted derivative contract amount = d

* δ

Where:

is the adjusted notional amount;

is the applicable supervisory delta adjustment;

is the applicable maturity factor; and

is the applicable supervisory factor.

The adjusted notional amount accounts for the size of the derivative contract and reflects the attributes of the most common derivative contracts in each asset class. The supervisory factor converts the adjusted notional amount of the derivative contract into an EEPE based on the measured volatility specific to each asset class over a one-year horizon.

The supervisory delta adjustment accounts for the sensitivity of a derivative contract (scaled to unit size) to the underlying primary risk factor, including the correct sign (positive or negative) to account for the direction of the derivative contract amount relative to the primary risk factor.

Finally, the maturity factor scales down, if necessary, the derivative contract amount from the standard one-year horizon used for supervisory factor calibration to the risk horizon relevant for a given contract.

Specifically, the supervisory factors are intended to reflect the EEPE of a single at-the-money linear trade of unit size, zero market value and one-year maturity referencing a given risk factor in the absence of collateral.

See supra

note 10.

Sensitivity of a derivative contract to a risk factor is the ratio of the change in the market value of the derivative contract caused by a small change in the risk factor to the value of the change in the risk factor. In a linear derivative contract, the payoff of the derivative contract moves at a constant rate with the change in the value of the underlying risk factor. In a nonlinear contract, the payoff of the derivative contract does not move at a constant rate with the change in the value of the underlying risk factor. The sensitivity is positive if the derivative contract is long the risk factor and negative if the derivative contract is short the risk factor.

a. Adjusted Notional Amount

i. Interest Rate and Credit Derivative Contracts

Under the proposal, a banking organization would have applied the same formula to interest rate derivative contracts and credit derivative contracts to arrive at the adjusted notional amount. For such contracts, the adjusted notional amount would have equaled the product of the notional amount of the derivative contract, as measured in U.S. dollars, using the exchange rate on the date of the calculation, and the supervisory duration. The supervisory duration would have incorporated measures of the number of business days from the present day until the start date for the derivative contract (

), and the number of business days from the present day until the end date for the derivative contract (

Some commenters argued that the standard notional definition would not produce reasonably accurate exposure estimates of a banking organization's closeout risk for all types of derivative contracts. These commenters recommended allowing banking organizations to use internal methodologies to determine the adjusted notional amount for derivative contracts that are not specifically covered under the formulas and methodologies set forth in the proposal.

The final rule maintains the formulas and methodologies for determining the adjusted notional amount for interest rate and credit derivative contracts, as generally one of these will be applicable for most derivative contracts. However, the agencies recognize that such approaches may not be applicable to all types of derivative contracts, and that a different approach may be necessary to determine the adjusted notional amount of a derivative contract. In such a case, a banking organization must consult with its primary Federal regulator prior to using an alternative approach to the formulas or methodologies set forth in the final rule.

Some commenters suggested revising the proposal to provide a separate measure of

for fixed-to-floating interest rate derivative contracts where the floating rate is determined at the beginning of the reset period and paid at the end, defined as the time period until the earliest reset date, measured in years.

According to the commenters, the proposal could overestimate the duration for such derivative contracts, as it would include the time period for which the floating rate (and, therefore, the floating leg payment) is captured in the supervisory duration. The commenters also noted that such

treatment could significantly affect the adjusted notional amount for a short-dated interest rate derivative portfolio.

Other commenters recommended changes to the measure of

for basis derivative contracts, for which the floating rates on the reference exposure are set at the beginning of the payment period. Some of these commenters recommended measuring

as the period (in years) as the earliest reset date of the two floating-rate components of the contract, if the reset dates are different.

The treatment recommended by the commenters cannot be made applicable to all interest rate derivatives; for example, it would not be appropriate for in arrears swaps, in which the rate is set at the end of the reset period instead of the beginning, and for forward rate agreements. In addition, adopting the commenters' recommendations could add significant complexity to the final rule because it would require additional parameters in the adjusted notional amount formula that would be used only in certain circumstances. Such an approach would create additional burden for banking organizations that adopt SA-CCR and could adversely affect the agencies' ability to use SA-CCR to assess comparability across banking organizations. The agencies therefore are adopting as final the proposed treatment for determining the adjusted notional amount of interest rate and credit derivative contracts.

Some commenters requested changes to address forward-settling mortgage-backed securities traded in the to-be-announced (TBA) market. Specifically, these commenters asked the agencies to recalibrate the adjusted notional amount for TBA derivative contracts to account for the term of the mortgage loans underlying the securities. Other commenters recommended measuring

for TBA derivative contracts as the time-weighted average term of the mortgages underlying the securities. In response to commenter concerns, the agencies are clarifying that for an interest rate derivative contract or credit derivative contract that is a variable notional swap, including mortgage-backed securities traded in the TBA market, the notional amount is equal to the time-weighted average of the contractual notional amounts of such a swap over the remaining life of the swap.

Other commenters recommended measuring the adjusted notional amount for basis derivative contracts as the product of the absolute value of the spread between the two underlying risk factors (positive or negative) and the number of units. According to these commenters, such an approach would better reflect the risk of such transactions because SA-CCR requires the use of floating notional values, and the notional value may change after execution based on increases or decreases in the spread. The commenters also argued that such an approach would be consistent with guidance released by the CFTC regarding the notional amount for locational basis derivative contracts.

The final rule does not incorporate the commenters' suggestion, as the purpose of the proposed treatment is to obtain the absolute volatility of the contract price, which is related to each risk factor rather than the spread.

See

CFTC, Division of Swap Dealer and Intermediary Oversight, FAQs About Swap Entities (Oct. 12, 2012), at 1.

The final rule adopts without change the proposed treatment for determining the adjusted notional amount for credit and interest rate derivative contracts. Under § _.132(c)(9)(ii)(A) of the final rule, the adjusted notional amount for such contracts equals the product of the notional amount of the derivative contract, as measured in U.S. dollars using the exchange rate on the date of the calculation, and the supervisory duration. The formula to determine the supervisory duration is as follows:

ER24JA20.005

Where:

is the number of business days from the present day until the start date for the derivative contract, or zero if the start date has already passed; and

is the number of business days from the present day until the end date for the derivative contract.

A banking organization must calculate the supervisory duration for the period that starts at

and ends at

where

equals the number of business days between the present date and the start date for the derivative contract, or zero if the start date has passed, and

equals the number of business days from the present date until the end date for the derivative contract. The supervisory duration recognizes that interest rate derivative contracts and credit derivative contracts with a longer tenor have a greater degree of variability than an identical derivative contract with a shorter tenor for the same change in the underlying risk factor (interest rate or credit spread), and is based on the assumption of a continuous stream of equal payments and a constant continuously compounded interest rate of 5 percent. The exponential function provides discounting for

and

at 5 percent continuously compounded. In all cases, the supervisory duration is floored at ten business days (or 0.04, based on an average of 250 business days per year).

For an interest rate derivative contract or a credit derivative contract that is a variable notional swap, the notional amount equals the time-weighted average of the contract notional amounts of such a swap over the remaining life of the swap. For an interest rate derivative contract or a credit derivative contract that is a leveraged swap, in which the notional amounts of all legs of the derivative contract are divided by a factor and all rates of the derivative contract are multiplied by the same factor, the notional amount equals the notional amount of an equivalent unleveraged swap.

ii. Exchange Rate Derivative Contracts

Under the proposal, the adjusted notional amount for an exchange rate derivative contract would have equaled the notional amount of the non-U.S. denominated currency leg of the derivative contract, as measured in U.S. dollars using the exchange rate on the date of the calculation. In general, the non-U.S. dollar denominated currency leg is the source of exchange rate volatility. If both legs of the exchange rate derivative contract are denominated in currencies other than U.S. dollars, the adjusted notional amount of the derivative contract would have been the largest leg of the derivative contract, measured in U.S. dollars. For an exchange rate derivative contract with multiple exchanges of principal, the notional amount would have equaled

the notional amount of the derivative contract multiplied by the number of exchanges of principal under the derivative contract. The agencies received no comments on the proposed adjusted notional amount for exchange rate derivative contracts, and are adopting it as final under § _.132(c)(9)(ii)(B) of the final rule.

iii. Equity and Commodity Derivative Contracts

Under the proposal, a banking organization would have applied the same single-factor formula to equity derivative contracts and commodity derivative contracts. For such contracts, the adjusted notional amount would have equaled the product of the fair value of one unit of the reference instrument underlying the derivative contract and the number of such units referenced by the derivative contract. By design, the proposed treatment would have reflected the current price of the underlying reference instrument. For example, if a banking organization has a derivative contract that references 15,000 pounds of frozen concentrated orange juice currently priced at $0.0005 a pound then the adjusted notional amount would be $7.50. For an equity derivative contract or a commodity derivative contract that is a volatility derivative contract, a banking organization would have been required to replace the unit price with the underlying volatility referenced by the volatility derivative contract and replace the number of units with the notional amount of the volatility derivative contract. By design, the proposed treatment would have reflected that the payoff of a volatility derivative contract generally is determined based on a notional amount and the realized or implied volatility (or variance) referenced by the derivative contract and not necessarily the unit price of the underlying reference instrument. The agencies received no comments on the proposed adjusted notional amount for equity and commodity derivative contracts, including instances in which such a contract is a volatility derivative contract, and are adopting it without change under § _.132(c)(9)(ii)(C) of the final rule.

b. Supervisory Factor

i. Credit Derivative Contracts

In contrast to the Basel Committee standard, the proposal would not have provided for the use of credit ratings to determine the supervisory factor for credit derivative contracts due to section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which prohibits the use of credit ratings in Federal regulations.

As an alternative, the proposal would have introduced an approach that satisfies section 939A of the Dodd-Frank Act while allowing for a level of granularity among the supervisory factors applicable to single-name credit derivatives that would have been generally consistent with the Basel Committee standard.

Under the proposal for single-name credit derivative contracts, investment grade derivative contracts would have received a supervisory factor of 0.5 percent, speculative grade derivative contracts would have received a supervisory factor of 1.3 percent, and sub-speculative grade derivative contracts would have received a supervisory factor of 6.0 percent. For credit derivative contracts that reference an index, investment grade derivative contracts would have received 0.38 percent and speculative grade derivative contracts would have received 1.06 percent. The proposal would have revised the capital rule to include definitions for speculative grade and sub-speculative grade (the capital rule already includes a definition for investment grade). The agencies received several comments on the supervisory factors for credit derivative contracts, but no comments on the proposed definitions of speculative grade and sub-speculative grade.

See

Public Law 111-203, 124 Stat. 1376 (2010), section 939A. This provision is codified as part of the Securities Exchange Act of 1934 at 15 U.S.C. 78o-7.

Specifically, the supervisory factors in the Basel Committee's SA-CCR standard are as follows (in percent): AAA and AA-0.38, A-0.42; BBB-0.54; BB-1.06; B-1.6; CCC-6.0.

Several commenters encouraged the agencies to reconsider the proposed methodology for determining the supervisory factors for single-name credit derivative contracts. As an alternative, the commenters recommended an approach that maps probability of default (PD) bands to the credit rating categories and the corresponding supervisory factors set forth in the Basel Committee standard for single-name credit derivatives, consistent with the approach used to assign a counterparty risk weight under the simple CVA approach in the advanced approaches.

According to the commenters, this approach would more closely align with the granularity and the supervisory factors provided under the Basel Committee standard, while meeting the requirements of section 939A of the Dodd-Frank Act. Alternatively, if the agencies declined to adopt the PD band-based approach for purposes of the final rule, the commenters suggested lowering the proposed supervisory factor for investment grade single-name credit derivatives from 0.5 percent to 0.46 percent, to eliminate the impact of rounding (to the nearest tenth) that was conducted for purposes of the proposal. Other commenters suggested aligning the supervisory factor for investment grade single-name credit derivatives to the lowest supervisory factor under the Basel Committee standard, 0.38 percent, based on the view that the most creditworthy issuers in the United States are no more prone to default than the most creditworthy issuers in other jurisdictions.

See

12 CFR 3.132(e)(5) (OCC); 12 CFR 217.132(e)(5) (Board); and 12 CFR 324.132(e)(5) (FDIC).

SA-CCR is a standardized approach, and the use of PD bands to assign supervisory factors to single-name credit derivatives would require the use of internal models, which generally are not appropriate for a standardized approach that is intended to be implementable by banking organizations of all sizes. In addition, providing such treatment as an option in SA-CCR could introduce more risk sensitivity solely for more sophisticated banking organizations that currently determine PD for purposes of the advanced approaches, and potentially provide a competitive advantage to such firms and adversely affect the use of SA-CCR to assess comparability across banking organizations. In addition, lowering the supervisory factor for single-name investment grade credit derivatives to 0.38 percent would fail to recognize the meaningful differences in the risks captured by the investment grade category under the proposal and the final rule, relative to the category and supervisory factor that correspond solely to an AAA credit rating under the Basel Committee standard. In response to comments, however, the final rule applies a 0.46 percent supervisory factor to investment grade single-name credit derivative contracts. This change will enhance the precision and risk sensitivity of the final rule, without introducing undue complexity or materially affecting the amount of regulatory capital a banking organization must hold for such derivative contracts relative to the proposal.

Therefore, the final rule adopts the supervisory factors for credit derivative contracts, as proposed, with one modification to the supervisory factor for investment grade single-name credit derivative contracts as described above. In addition, the final rule maintains the current definition of investment grade

in the capital rule, and adopts the proposed definitions for “speculative grade” and “sub-speculative grade.” The supervisory factors are reflected in Table 2 of this

SUPPLEMENTARY INFORMATION

The investment grade category generally captures single-name credit derivative contracts consistent with the three highest supervisory factor categories under the Basel Committee standard. The capital rule defines investment grade to mean that the entity to which the banking organization is exposed through a loan or security, or the reference entity with respect to a credit derivative contract, has adequate capacity to meet financial commitments for the projected life of the asset or exposure. Such an entity or reference entity has adequate capacity to meet financial commitments, as the risk of its default is low and the full and timely repayment of principal is expected.

“Investment grade” is defined in § _.2 of the capital rule.

See

12 CFR 3.2 (OCC); 12 CFR 217.2 (Board); and 12 CFR 324.2 (FDIC).

The speculative grade category generally captures single-name credit derivative contracts consistent with the next two lower supervisory factor categories under the Basel Committee standard. The final rule defines the term speculative grade to mean that the reference entity has adequate capacity to meet financial commitments in the near term, but is vulnerable to adverse economic conditions, such that should economic conditions deteriorate, the reference entity would present elevated default risk. The sub-speculative grade category corresponds to the lowest supervisory factor category under the Basel Committee standard, with the term sub-speculative grade defined under the final rule to mean that the reference entity depends on favorable economic conditions to meet its financial commitments, such that should economic conditions deteriorate, the reference entity likely would default on its financial commitments. Each of these categories includes exposures that perform largely in accordance with the performance criteria that define each category under the final rule, and therefore result in capital requirements that are broadly equivalent to those resulting from application of the supervisory factors under the Basel Committee standard.

An empirical analysis for the supervisory factors applied to the investment grade and speculative grade categories is set forth in the

SUPPLEMENTARY INFORMATION

section of the proposal.

See

83 FR 64660, 64675 (December 17, 2018).

The agencies expect that banking organizations would conduct their own due diligence to determine the appropriate category for a single-name credit derivative, in view of the performance criteria in the definitions for each category under the final rule. A banking organization may consider the credit rating for a single-name credit derivative in making that determination as part of a multi-factor analysis. In addition, the agencies expect a banking organization to have and retain support for its analysis and assignment of the respective credit categories.

ii. Equity Derivative Contracts

Under the proposal, single-name equity derivative contracts would have received a supervisory factor of 32 percent and equity derivative contracts that reference an index would have received a supervisory factor of 20 percent. The agencies received several comments regarding the proposed supervisory factors for equity derivative contracts. In general, the commenters recommended various approaches to distinguish among the risks of single-name equity derivative contracts and thereby provide additional granularity in the supervisory factors that correspond to such exposures. The approaches offered by the commenters would distinguish among (1) investment grade and non-investment grade issuers; (2) issuers in advanced and emerging markets; (3) issuers with large market capitalizations and those with small market capitalizations; and (4) issuers in different industry sectors. Some of the approaches suggested by commenters align with the Basel Committee market risk standa

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