Capital Adequacy: Calculation of Credit Equivalent Amounts of Off-Balance Sheet Contracts

Federal RegisterSep 1, 1994

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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 3

[Docket No. 94-13]

RIN 1557-AB14

Capital Adequacy: Calculation of Credit Equivalent Amounts of

Off-Balance Sheet Contracts

AGENCY: Office of the Comptroller of the Currency, Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: The Office of the Comptroller of the Currency (OCC) is

proposing to amend its risk-based capital guidelines for national

banks. This proposed rule would revise and expand the set of off-

balance sheet credit conversion factors used to calculate the potential

future exposure of derivative contracts and permit banks to net

multiple derivative contracts that are subject to a qualifying

bilateral netting contract when calculating the potential future credit

exposure.

This proposed rule is based on the July 15, 1994, proposed

revisions to the Agreement on International Convergence of Capital

Measurement and Capital Standards of July 1988 (Basle Accord). The

effect of this proposed rule would be twofold. First, long-dated

interest rate and foreign exchange rate contracts would be subject to

new higher off-balance sheet credit conversion factors and new

conversion factors would be established specifically for derivative

contracts related to equities, precious metals, and other commodities.

Second, national banks generally would recognize a reduction in

potential future credit exposure for multiple derivative contracts

subject to a qualifying bilateral netting contract.

DATES: Comments must be received on or before October 21, 1994.

ADDRESSES: Comments may be submitted to Docket Number 94-13,

Communications Division, Ninth floor, Office of the Comptroller of the

Currency, 250 E Street, SW., Washington, DC 20219. Comments will be

available for inspection and photocopying at that address.

FOR FURTHER INFORMATION CONTACT: Roger Tufts, Senior Economic Advisor,

Office of the Chief National Bank Examiner, (202) 874-5070; or Ronald

Shimabukuro, Senior Attorney, Bank Operations and Assets Division,

(202) 874-4460, Office of the Comptroller of the Currency.

SUPPLEMENTARY INFORMATION:

I. Background

The Basle Accord\1\ established the international risk-based

capital standards and set forth a framework for measuring capital

adequacy under which risk-weighted assets are calculated by assigning

assets and off-balance-sheet items to broad categories based primarily

on their credit risk, that is, the risk that a loss will be incurred

due to an obligor or counterparty default on a transaction.\2\ Off-

balance-sheet contracts are incorporated into risk-weighted assets by

converting each item into a credit equivalent amount, which is then

assigned to the appropriate credit risk category according to the

identity of the obligor or counterparty, or if relevant, the guarantor

or the nature of the collateral.

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\1\The Basle Accord was proposed by the Basle Committee on

Banking Supervision (Basle Supervisors' Committee and endorsed by

the central bank governors of the Group of Ten (G-10) countries in

July 1988. The Basle Supervisors' Committee (BSC) is comprised of

representatives of the central banks and supervisory authorities

from the G-10 countries (Belgium, Canada, France, Germany, Italy,

Japan Netherlands, Sweden, Switzerland, the United Kingdom, and the

United States) and Luxembourg.

\2\Other types of risks, such as market risks, generally are not

addressed by the risk-based capital framework.

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The credit equivalent amount of an interest rate or foreign

exchange rate contract (rate contract) is determined by adding together

the current replacement cost (current credit exposure) and an estimate

of the possible increases in future replacement cost, in view of the

volatility of the current credit exposure over the remaining life of

the contract (potential future credit exposure--also referred to as the

add-on). Each credit equivalent amount is then assigned to the

appropriate risk category. The maximum risk weight applied to rate

contracts is 50 percent.\3\

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\3\Exchange rate contracts with an original maturity of 14

calendar days or less and instruments traded on exchanges that

require daily payment of variation margin are excluded from the

risk-based capital ratio calculations.

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A. Current Credit Exposure

Under the risk-based capital guidelines, the current credit

exposure of a rate contract with a positive mark-to-market value is

equal to the mark-to-market value.\4\ If the mark-to-market value is

zero or negative, then there is no replacement cost associated with the

rate contract and the current credit exposure is zero. The sum of

current credit exposures for a defined set of rate contracts is

referred to as the gross current credit exposure for that set of rate

contracts.

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\4\The loss to a bank from a counterparty's default on a rate

contract is the cost of replacing the cash flows specified by the

rate contract. The mark-to-market value is the present value of the

net cash flows specified by the rate contract, calculated on the

basis of current market interest and foreign exchange rates.

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As initially adopted in July 1988, the Basle Accord required banks

to determine the current credit exposure individually for every rate

contract. Generally, banks were not permitted to offset, that is, net,

positive and negative mark-to-market values of multiple rate contracts

with a single counterparty to determine a single current credit

exposure relative to that counterparty.\5\ In April 1993 the BSC

proposed a revision to the Basle Accord that would permit banks to net

positive and negative mark-to-market values of rate contracts subject

to a qualifying, legally enforceable, bilateral netting contract.

Pursuant to the April 1993 BSC netting proposal, banks with qualifying

bilateral netting contracts could replace the gross current credit

exposure of a set of rate contracts covered by the bilateral netting

contracts with a single net current credit exposure for purposes of

calculating the credit equivalent amount. If the net market value is

positive, then that market value equals the current credit exposure for

the rate contracts under a bilateral netting contract. If the net

market value is zero or negative, then the current credit exposure is

zero.

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\5\Netting by novation, however, was recognized. Netting by

novation is accomplished under a written bilateral contract

providing that any obligation to deliver a given currency on a given

date is automatically amalgamated with all other obligations for the

same currency and value date. The previously existing contracts are

extinguished and a new contract, for the single net amount, is

legally substituted for the amalgamated gross obligations.

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On May 20, 1994, the OCC and the Board of Governors of the Federal

Reserve System (FRB) issued a joint notice of proposed rulemaking to

amend their respective risk-based capital guidelines in accordance with

the April 1993 BSC netting proposal.\6\ See 59 FR 26456 (May 20, 1994).

Generally, under the May 1994 joint OCC/FRB proposed rule, a bilateral

netting contract would be recognized for risk-based capital purposes

only if the bilateral netting contract is legally enforceable. The May

1994 joint OCC/FRB proposed rule is consistent with the April 1993 BSC

netting proposal which was adopted in final form on July 1994. The

April 1993 BSC netting proposal is discussed in detail in the May 1994

joint OCC/FRB proposed rule.

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\6\The Office of Thrift Supervision issued a similar netting

proposal on June 14, 1994 and the Federal Deposit Insurance

Corporation issued its netting proposal on July 25, 1994.

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B. Potential Future Credit Exposure

The second part of the credit equivalent amount, the add-on for

potential future credit exposure, is an estimate of the additional

credit exposure that may arise over the remaining life of the rate

contract as a result of fluctuations in prices or rates. Such changes

may increase the market value of the rate contract in the future and,

therefore, increase the cost of replacing it if the counterparty

subsequently defaults.

The add-on for potential future credit exposure is calculated by

multiplying the notional principal amount\7\ of the underlying rate

contract by a credit conversion factor that is determined by the

remaining maturity of the rate contract and the type of rate contract.

The current credit conversion factors used to calculate potential

future credit exposure, referred to as the credit conversion factor

matrix, is as follows:

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\7\The notional principal amount, or value, is a reference

amount of money used to calculate payment streams between the

counterparties. Principal amounts generally are not exchanged in

single-currency interest rate swaps, but generally are exchanged in

foreign exchange contacts (including cross-currency interest rate

swaps).

Table 1.--Current Credit Conversion Factor Matrix

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Interest Exchange

rate rate

Remaining maturity contracts contracts

(percent) (percent)

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One year or less.............................. 0.0 1.0

Over one year................................. 0.5 5.0

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These credit conversion factors were determined through simulation

studies that estimated the potential volatility of interest and

exchange rates and analyzed the implications of movements in those

rates for the replacement costs of various types of interest rate and

exchange rate contracts. The simulation studies were conducted only on

interest rate and foreign exchange rate contracts, because at the time

the Basle Accord was being developed, activity in the derivatives

market was for the most part limited to these types of transactions.

The simulation studies produced distributions of potential replacement

costs over the remaining life of matched pairs of rate contracts.\8\

Potential future credit exposure was then defined in terms of

confidence limits derived from these distributions. The credit

conversion factors were intended to be a compromise between precision,

on the one hand, and complexity and burden, on the other.\9\

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\8\A matched pair is a pair of contracts with identical terms,

where the bank the buyer of one contract and the seller of the other

contract.

\9\The methodology upon which the statistical analyses were

based is described in detail in a technical working paper entitled

``Potential Credit Exposure on Interest Rate and Foreign Exchange

Rate Related Instruments.'' This paper is available upon request

from the OCC's Communications Division.

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The add-on for potential future credit exposure is calculated for

all rate contracts, regardless of whether the market value is zero,

positive, or negative, or whether the current credit exposure is

calculated on a gross or net basis. Neither the April 1993 BSC netting

proposal nor the May 1994 joint OCC/FRB proposed rule to recognize

qualifying bilateral netting contracts for the calculation of the

current credit exposure affects the calculation of the potential future

credit exposure, which would continue to be calculated on a gross

basis. Under the April 1993 BSC netting proposal, this means that an

add-on for potential future credit exposure is calculated separately

for each individual rate contract covered by the bilateral netting

contract and then these individual future credit exposures are added

together to arrive at a gross add-on for potential future credit

exposure. The gross add-on for potential future credit exposure would

then be added to the net current credit exposure to arrive at one

credit equivalent amount for all of the rate contracts subject to the

bilateral netting contract.

When initially adopted, the Basle Accord noted that the credit

conversion factors in the add-on conversion factor matrix were

provisional and would be subject to revision if volatility levels or

market conditions changed.

II. Basle Proposals for the Treatment of Potential Future Credit

Exposure

Since the original Basle Accord was adopted, the derivatives market

has grown and broadened. The use of certain types of derivative

contracts not specifically addressed in the Basle Accord--notably

equity, precious metals, and commodity-linked transactions\10\--has

become much more widespread. As a result of continued review of the

method for calculating the add-on for potential future credit exposure,

in July 1994 the BSC issued a consultative paper which contained two

proposals.\11\ The first proposal would expand the matrix of add-on

credit conversion factors used to calculate potential future credit

exposure to take into account innovations in the derivatives market.

The second proposal represents an extension of the April 1993 BSC

netting proposal and would recognize reductions in the potential future

credit exposure of derivative contracts that result from entering into

bilateral netting contracts. The consultation period for the July 1994

BSC proposal is scheduled to end on October 10, 1994.

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\10\In general terms, these are off-balance-sheet transactions

that have a return, or a portion of their return, linked to the

price of a particular equity, precious metals, or commodity or to an

index of equity, precious metals, or commodity prices.

\11\The proposals are contained in a paper from the FSC entitled

``The Capital Adequacy Treatment of the Credit Risk Associated with

Certain Off-Balance Sheet Items'' that is available upon request

from the Communications Division of the OCC.

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A. Expansion of Add-On Credit Conversion Factor Matrix

A recent BSC study of the add-on for potential future credit

exposure indicated that the current add-on credit conversion factors

used to calculate the add-on amount may produce insufficient capital

for certain types of derivative instruments, in particular, long-dated

interest rate contracts, commodity contracts, and equity-index

contracts. The BSC study indicated that the current add-on credit

conversion factors do not adequately address the full range of contract

structures and the timing of cash flows. The BSC study also showed that

the credit conversion factors used by many banks to calculate potential

future credit exposure for equity, precious metals, and commodity

contracts could result in insufficient capital coverage in view of the

volatility of the indices or prices on the underlying assets from which

these contracts derive their value.\12\

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\12\While equity, precious metals, and commodity contracts were

not explicitly covered by the original Basle Accord, as the use of

such contracts became more prevalent, many G-10 banking supervisors,

including U.S. banking supervisors, have informally permitted

institutions to apply the conversion factors for exchange rate

contracts to these types of transactions pending development of a

more appropriate treatment.

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The BSC study concluded that it was not appropriate to address

these problems with a significant departure from the existing

methodology used in the Basle Accord. The BSC decided that it would be

appropriate to preserve the credit conversion factors existing in the

Basle Accord and add new credit conversion factors. Consequently, the

revision proposed by the BSC retains the existing credit conversion

factors for interest and exchange rate contracts, but applies new

higher credit conversion factors to such rate contracts with remaining

maturities of five years and over.\13\ The BSC proposal also proposes

credit conversion factors specifically applicable to equity, precious

metals, and commodity contracts. The new credit conversion factors were

determined on the basis of simulation studies that used the same

general approach that generated the original add-on credit conversion

factors.\14\

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\13\The conversion factors for rate contracts with remaining

maturities of one to five years are currently applied to contracts

with a remaining maturity of over one year.

\14\The methodology and results of the statistical analyses are

summarized in a paper entitled ``The Calculation of Add-Ons for

Derivative Contracts: the `Expanded Matrix' Approach'' and is

available upon request from the Communications Division of the OCC.

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The proposed credit conversion factor matrix is set forth below:

Table 2.--Credit Conversion Factor Matrix\1\

[Percent]

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Foreign

Interest exchange Precious Other

Remaining maturity rate rate and Equity\2\ metals commodities

gold

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Less than one year............................. 0.0 1.0 6.0 7.0 12.0

One to five years.............................. 0.5 5.0 8.0 7.0 12.0

Over five years................................ 1.5 7.5 10.0 8.0 15.0

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\1\For derivative contracts with multiple exchanges of principal, the conversion factors are to be multiplied by

the number of remaining payments in the derivative contract.

\2\For derivative contracts that automatically reset to zero value following a payment, the remaining maturity

is set equal to the time until the next payment.

Gold is included within the foreign exchange rate column because

the price volatility of gold has been found to be comparable to the

foreign exchange rate volatility of major currencies. In addition, the

BSC determined that gold's role as a financial asset distinguishes it

from other precious metals. The proposed credit conversion factor

matrix is designed to accommodate the different structures of

derivative contracts, as well as the observed disparities in the

volatilities of the associated indices or prices of the underlying

assets.

Two footnotes are attached to the credit conversion factor matrix

to address two particular derivative contract structures. The first

relates to derivative contracts with multiple exchanges of principal.

Because the level of potential future credit exposure rises generally

in proportion to the number of remaining exchanges of principal, the

credit conversion factors are multiplied by the number of remaining

payments (exchanges of principal) in the derivative contract. This

treatment is intended to ensure that the full level of potential future

credit exposure is covered adequately. The second footnote applies to

equity contracts that automatically reset to zero each time a payment

is made. The credit risk associated with these equity contracts is

similar to that of a series of shorter contracts beginning and ending

at each reset date. For this type of equity contract the remaining

maturity is equal to the time remaining until the next payment.

While the capital charges resulting from the application of the new

proposed credit conversion factors may not provide complete coverage

for risks associated with any single derivative contract, the BSC

believes the credit conversion factors will provide a reasonable level

of prudential coverage for derivative contracts on a portfolio basis.

Like the original credit conversion factor matrix, the proposed

expanded credit conversion factor matrix provides a reasonable balance

between precision, complexity, and burden.

B. Recognition of the Effects of Netting

The simulation studies used by the BSC to generate the credit

conversion factors for potential future credit exposure analyzed the

implications of underlying rate and price movements on the current

credit exposure of derivative contracts without taking into account

reductions in credit exposure that could result from legally

enforceable bilateral netting contracts. Thus, the credit conversion

factors are most appropriately applied to non-netted derivative

contracts, and when applied to derivative contracts subject to a

legally enforceable bilateral netting contract, they could in some

cases overstate the potential future credit exposure.

Comments on the April 1993 BSC netting proposal, as well as further

research conducted by the BSC, have suggested that bilateral netting

contracts can reduce not only a bank's current credit exposure for the

transactions subject to the bilateral netting contracts, but also the

potential future credit exposure for those transactions.\15\ The July

1994 BSC proposal reflects these conclusions and proposes to

incorporate into the calculation of the add-on for potential future

credit exposure a method for recognizing the risk-reducing effects of

qualifying bilateral netting contracts. Under the July 1994 BSC

proposal, banks could recognize these effects only for transactions

subject to legally enforceable bilateral netting contracts that meet

the requirements of netting for current credit exposure as set forth in

the April 1993 BSC netting proposal.

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\15\While current credit exposure is intended to cover an

organization's credit exposure at one point in time, potential

future credit exposure provides an estimate of possible increases in

future replacement cost, in view of the volatility of current credit

exposure over the remaining life of the contract. The greater the

tendency of the current credit exposure to fluctuate over time, the

greater the add-on for potential future credit exposure should be to

cover possible fluctuations.

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Depending on market conditions and the characteristics of a bank's

derivative portfolio, bilateral netting contracts can have substantial

effects on the bank's potential future credit exposure to multiple

derivative contracts it has entered into with a single counterparty.

Should the counterparty default at some future date, the bank's credit

exposure would be limited to the net amount the counterparty owes on

the date of default, rather than the gross current credit exposure of

the included derivative contracts. By entering into a bilateral netting

contract, a bank may reduce not only its current credit exposure, but

possibly its future credit exposure as well. Nevertheless, while in

many circumstances a bilateral netting contract can reduce the

potential future credit exposure to a single counterparty portfolio,

this is not always the case.\16\

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\16\For purposes of this discussion, a single counterparty

portfolio refers to a set of contracts with a single counterparty.

This should be distinguished from a bank's global portfolio, which

refers to all of the contracts in the bank's derivatives portfolio

that are subject to qualifying bilateral netting contracts.

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The most important factors influencing whether a bilateral netting

contract will have an effect on the potential future credit exposure of

a single counterparty portfolio are the volatilities of the current

credit exposure to the counterparty on both a gross and net basis.\17\

The volatilities of net current credit exposure and gross current

credit exposure of a single counterparty portfolio may not necessarily

be the same. Volatility of gross current credit exposure is influenced

primarily by the fluctuations of the market values of positively valued

derivative contracts. On the other hand, volatility of the net current

credit exposure is influenced by the fluctuations of the market values

of all derivative contracts within a single counterparty portfolio. In

those cases where net current credit exposure has a tendency to

fluctuate more over time than gross current credit exposure, a

bilateral netting contract will not reduce the potential future credit

exposure. However, in those situations where net current credit

exposure has a tendency to fluctuate less over time than gross current

credit exposure, a bilateral netting contract can reduce the potential

future credit exposure.

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\17\Volatility in this discussion is the tendency of the market

value of a derivative contract to vary or fluctuate over time. A

highly volatile portfolio would have a tendency to fluctuate

significantly over short periods of time. One of the most important

factors influencing a portfolio's volatility is the correlation of

the derivative contracts within the portfolio, that is, the degree

to which the derivative contracts in the portfolio respond similarly

to changing market conditions.

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Net current credit exposure is likely to be less volatile relative

to the volatility of gross current credit exposure when the single

counterparty portfolio of derivative contracts as a whole is more

diverse than the subset of positively valued derivative contracts. When

a bilateral netting contract is applied to a diversified single

counterparty portfolio and the positively valued derivative contracts

within that portfolio as a group are less diversified than the overall

portfolio, then the effect of the bilateral netting contract will

likely be to reduce the potential future credit exposure of the single

counterparty portfolio.

The BSC has studied and analyzed several alternatives for taking

into account the effects of netting when calculating the capital charge

for potential future credit exposure. In particular, the BSC reviewed

one general method proposed by commenters to the April 1993 BSC netting

proposal. This method would reduce the amount of the add-on for

potential future credit exposure by multiplying the calculated gross

add-on by the ratio of a single counterparty portfolio's net current

credit exposure to the gross current credit exposure. This is called

the net-to-gross ratio (NGR). The NGR is used as a proxy for the risk-

reducing effects of the bilateral netting contract on the potential

future credit exposure. The more diversified a single counterparty

portfolio, the lower the net current credit exposure tends to be

relative to gross current credit exposure.

This method is incorporated into the July 1994 BSC proposal.

However, given that there are portfolio-specific situations in which

the NGR does not provide a good indication of these effects, the July

1994 BSC proposal gives only partial weight to the effects of the NGR

on the add-on for potential future credit exposure. The proposed method

would calculate a weighted average of two amounts. The first amount is

the add-on as it is currently calculated (Agross). The second

amount is Agross multiplied by the NGR. This calculation results

in a reduced add-on (Anet) for derivative contracts subject to a

qualifying bilateral netting contract. The weights contained in the

proposed rule are 0.5 and 0.5, respectively, for (1) Agross, and

(2) NGR times Agross.

The formula is:

Anet=0.5 x Agross+(0.5 x NGR x Agross).

For example, a bank with a gross current credit exposure of

$500,000, a net current credit exposure of $300,000, and a gross add-on

for potential future credit exposure of $1,200,000, would have an NGR

of 0.6 ($300,000/$500,000) and would calculate Anet as follows:

Anet=0.5 x $1,200,000+(0.5 x 0.6 x $1,200,000)

Anet=$960,000

For banks with an NGR of 50 percent, the effect of this treatment

would be to permit a reduction in the amount of the add-on by 25

percent. The BSC believes that most dealer banks are likely to have an

NGR in the vicinity of 50 percent.

The July 1994 BSC proposal does not specify whether the NGR should

be calculated on a counterparty-by-counterparty basis or on an

aggregate basis for all transactions subject to qualifying, legally

enforceable bilateral netting contracts. The July 1994 BSC proposal

requests comment on whether the choice of method could bias the results

and whether there is a significant difference in calculation burden

between the two methods.

The July 1994 BSC proposal also acknowledges that simulations using

banks' internal models for measuring credit risk exposure would most

likely produce the most accurate determination of the effect of

bilateral netting contracts on potential future credit exposures. The

July 1994 BSC proposal states that the use of such models would be

considered at some future date.

III. The OCC Proposal

In light of the July 1994 BSC proposal, the OCC believes that it is

appropriate to seek public comment on proposed revisions to the

calculation of the add-on for potential future credit exposure for

derivative contracts. Therefore, the OCC is proposing to (1) Amend its

risk-based capital guidelines for national banks to expand the matrix

of credit conversion factors and (2) change the calculation of the add-

on for potential future credit exposure when the derivative contracts

are subject to a qualifying bilateral netting contract. It is important

to note that the second part of the proposed rule is contingent on the

adoption of a final rule to the May 1994 joint OCC/FRB proposed rule to

recognize qualifying bilateral netting contracts. With regard to the

portion of this proposed rule to expand the credit conversion factor

matrix, the OCC is proposing to adopt the same credit conversion

factors set forth in the July 1994 BSC proposal. The OCC believes that

the existing credit conversion factors applicable to long-dated

transactions may not provide sufficient capital for the risks

associated with those types of contracts. The OCC also believes that

the credit conversion factors for foreign exchange rate contracts are

significantly too low for equity, precious metals, and commodity

derivative contracts due to the volatility of the associated indices

and the prices on the underlying assets.\18\

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\18\Similar to the July 1994 BSC proposal, this proposed rule

specifies that for equity contracts that automatically reset to zero

value following a payment, the remaining maturity is set equal to

the time remaining until the next payment. Also, for contracts with

multiple exchanges of principal, the conversion factors are to be

multiplied by the number of remaining payments in the contract.

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The OCC is proposing the same weighted average formula as the July

1994 BSC proposal to calculate a reduction in the add-on for potential

future credit exposure for derivative contracts subject to qualifying

bilateral netting contracts. The OCC believes that there may be several

advantages with this formula. First, the formula uses bank-specific

information to calculate the NGR. The NGR is simple to calculate and

uses readily available information. The OCC believes the use of the

averaging factor of 0.5 is an important aspect of the proposed formula

because it means the add-on for potential future credit exposure can

never be reduced to zero and banks will always hold some capital

against derivative contracts, even in those instances where the net

current exposure is zero.

The OCC is seeking comment on all aspects of this proposed rule.

1. As with the July 1994 BSC proposal, the OCC seeks comment on

whether the NGR should be calculated on a counterparty-by-counterparty

basis, or on a global basis for all derivative contracts subject to a

qualifying bilateral netting contract. The OCC's proposed regulatory

language would require the calculation of a separate NGR for each

counterparty with which it has a qualifying netting contract. However,

the OCC also is seeking comment as to which method of calculating the

NGR would be most efficient and appropriate for banks with numerous

qualifying bilateral netting contracts. The OCC notes that some

preliminary findings indicate that a global NGR may be less burdensome

to apply, but counterparty specific NGRs may provide a more accurate

indication of the credit risk associated with each counterparty.

2. The OCC is also seeking comment on the appropriate weights to

apply to the two components of the weighted average--Agross and

NGR x Agross. The proposed values (both set equal to 0.5) allow

only a partial reduction in the add-on, even when the NGR equals zero.

Are there other weights, which sum to a value of 1, that better reflect

the potential risk of a set of netted contracts and which ensure that

an appropriate level of capital is held for this risk of a potential

future exposure? Empirical evidence to support any suggested changes to

the weights used in the calculation would be appreciated.

Regulatory Flexibility Act

Pursuant to section 605(b) of the Regulatory Flexibility Act, the

OCC hereby certifies that this proposed rule will not have a

significant impact on a substantial number of small business entities.

Accordingly, a regulatory flexibility analysis is not required. The OCC

believes that, while some banks with limited derivative portfolios may

experience an increase in capital charges, for most small banks the

proposal will have little or no affect since small banks typically have

a limited derivatives portfolio. For banks with more developed

portfolios the overall affect of the proposal will likely be to reduce

regulatory burden and a decrease in the capital charge for certain

derivative contracts.

Executive Order 12866

It has been determined that this proposal is not a significant

regulatory action as defined in Executive Order 12866.

List of Subjects in 12 CFR Part 3

Administrative practice and procedure, Capital, National banks,

Reporting and recordkeeping requirements, Risk.

Authority and Issuance

For the reasons set out in the preamble, appendix A to part 3 of

title 12, chapter 1 of the Code of Federal Regulations is proposed to

be amended as set forth below.

PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES

1. The authority citation for part 3 continues to read as follows:

Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n

note, 3907 and 3909.

2. In appendix A, section 3, paragraph (a)(3)(ii) is revised, the

fourth sentence in the introductory text of paragraph (b) which begins

with ``Second,'' is revised, and paragraph (b)(5), as proposed to be

revised at 59 FR 26460 (May 20, 1994) is revised, to read as follows:

Appendix A to Part 3--Risk-Based Capital Guidelines

* * * * *

Section 3. Risk Categories/Weights for On-Balance Sheet Assets and

Off-Balance Sheet Items

* * * * *

(a) * * *

(3) * * *

(ii) The credit equivalent amount of derivative contracts

calculated in accordance with section 3(b)(5) of this appendix A, that

do not qualify for inclusion in a lower risk category.

* * * * *

(b) * * * Second, the resulting credit equivalent amount is then

assigned to the proper risk category using the criteria regarding

obligors, guarantors, and collateral listed in section 3(a) of this

appendix A. Collateral and guarantees are applied to the face amount

of an off-balance sheet item, not the credit equivalent amount of

such an off-balance sheet item; however, with respect to derivative

contracts under section 3(b)(5) of this appendix A, collateral and

guarantees are applied to the credit equivalent amount of such

derivative contracts. * * *

* * * * *

(5) Derivative contracts--(i) Calculation of credit equivalent

amounts. The credit equivalent amount of a derivative contract

equals the sum of the current credit exposure and the potential

future credit exposure of the derivative contract. The calculation

of credit equivalent amounts must be measured in U.S. dollars,

regardless of the currency or currencies specified in the derivative

contract.

(A) Current credit exposure. The current credit exposure for a

single derivative contract is determined by the mark-to-market value

of the derivative contract. If the mark-to-market value is positive,

then the current credit exposure is equal to that mark-to-market

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

current exposure is zero. The current credit exposure for multiple

contracts executed with a single counterparty and subject to a

qualifying bilateral netting contract is determined as provided by

section 3(b)(5)(ii) of this appendix A.

(B) Potential future credit exposure. The potential future

credit exposure on a derivative contract, including a derivative

contract with negative mark-to-market value, is calculated by

multiplying the notional principal18a of the derivative

contract by one of the credit conversion factors in Table A

(Conversion Factor Matrix) of this appendix A, as appropriate.\19\

The potential future credit exposure for multiple derivative

contracts executed with a single counterparty and subject to a

qualifying bilateral netting contract is determined as provided by

section 3(b)(5)(ii)(A)(2) of this appendix A.

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\1\8aFor purposes of caluclating either the potential future

credit exposure under section 3(b)(5)(i)(B) of this appendix A or

the gross potential future credit exposure under section

3(b)(5)(ii)(A)(2) of this appendix A for foreign exchange contracts

and other similar contracts in which the notional principal is

equivalent to the cash flows, total notional principal is the net

receipts to each party falling due on each value date in each

currency.

\19\No potential future credit exposure is calculated for single

currency interest rate swaps in which payments are made based upon

two floating rate indices, so-called floating/floating or basis

swaps; the credit equivalent amount is measured solely on the basis

of the current credit exposure.

Table A.--Conversion Factor Matrix\1\