Capital; Capital Adequacy Guidelines

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 325

RIN 3064-AB43

Capital; Capital Adequacy Guidelines

AGENCY: Federal Deposit Insurance Corporation (FDIC or Corporation).

ACTION: Notice of proposed rulemaking.

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SUMMARY: The FDIC is proposing to amend its risk-based capital

guidelines for state nonmember banks. The proposal would revise and

expand the set of conversion factors used to calculate the potential

future exposure of derivative contracts and recognize effects of

netting arrangements in the calculation of potential future exposure

for derivative contracts subject to qualifying bilateral netting

arrangements.

The FDIC is proposing these amendments on the basis of proposed

revisions to the Basle Accord announced on July 15, 1994. The effect of

the proposed amendments would be twofold. First, long-dated interest

rate and exchange rate contracts would be subject to new higher

conversion factors and new conversion factors would be set forth that

specifically apply to derivative contracts related to equities,

precious metals, and other commodities. Second, institutions would be

permitted to recognize a reduction in potential future exposure for

transactions subject to qualifying bilateral netting arrangements.

DATES: Comments must be received on or before December 5, 1994.

ADDRESSES: Send comments to Robert E. Feldman, Acting Executive

Secretary, Federal Deposit Insurance Corporation, 550 17th Street,

N.W., Washington, D.C. 20429. Comments may be hand delivered to room F-

402, 1776 F Street, N.W., Washington, D.C., on business days between

8:30 a.m. and 5:00 p.m. [Fax number: (202) 898-3838.] Comments may be

inspected at the FDIC's Reading Room, room 7118, 550 17th Street, N.W.,

Washington, D.C. between 9:00 a.m. and 4:30 p.m. on business days.

FOR FURTHER INFORMATION CONTACT: William A. Stark, Assistant Director,

(202) 898-6972, Division of Supervision, FDIC; Sharon K. Lee, Chief,

Capital Markets Policy and Training, (202) 898-6789, Division of

Supervision, FDIC; Jeffrey M. Kopchik, Counsel, (202) 898-3872, Legal

Division, FDIC, 550 17th Street, N.W., Washington, D.C. 20429.

SUPPLEMENTARY INFORMATION:

I. Background

The international risk-based capital standards (the Basle Accord or

Accord)\1\ set forth a framework for measuring capital adequacy under

which risk-weighted assets are calculated by assigning assets and off-

balance-sheet items to broad categories based 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

transactions 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, BSC) and endorsed

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

in July 1988. The Basle Supervisors' Committee is comprised of

representatives of the central banks and supervisory authorities

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

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

United States) and Luxembourg.

In January 1989 the FDIC Board adopted a similar framework to be

used by state nonmember banks.

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

addressed by the risk-based framework.

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The credit equivalent amount of an interest rate or exchange rate

contract (rate contract) is determined by adding together the current

replacement cost (current exposure) and an estimate of the possible

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

current exposure over the remaining life of the contract (potential

future exposure, also referred to as the add-on). Each credit

equivalent amount is then assigned to the appropriate risk category

generally based on identity of the counterparty. The maximum risk

weight applied to interest rate or exchange 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 Exposure

A state nonmember bank that has a rate contract with a positive

mark-to-market value has a current exposure or a possible loss equal to

the mark-to-market value.\4\ For risk-based capital purposes, if the

mark-to-market value is zero or negative, then there is no replacement

cost associated with the contract and the current exposure is zero. The

sum of current exposures for a defined set of contracts is sometimes

referred to as the gross current exposure for that set of contracts.

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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

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

cash flows specified by the contract, calculated on the basis of

current market interest and exchange rates.

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The Accord, as endorsed in 1988, provided that current exposure

would be determined individually for every rate contract entered into

by a banking organization. Generally, institutions were not permitted

to offset, that is, net, positive and negative mark-to-market values of

multiple rate contracts with a single counterparty\5\ to determine one

current exposure relative to that counterparty. In April 1993 the BSC

proposed a revision to the Accord, endorsed by the G-10 Governors in

July 1994, that permits institutions to net positive and negative mark-

to-market values of rate contracts subject to a qualifying, legally

enforceable, bilateral netting arrangement. Under the revision to the

Accord, institutions with qualifying netting arrangements could replace

the gross current exposure of a set of contracts included in such an

arrangement with a single net current exposure for purposes of

calculating the credit equivalent amount for the included contracts. If

the net market value is positive, then that market value equals the

current exposure for the netting contract. If the net market value is

zero or negative, then the current exposure is zero.

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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 July 25, 1994, the FDIC issued a notice of proposed rulemaking

to amend its risk-based capital guidelines in accordance with the BSC

April 1993 proposal. 59 FR 37726, July 25, 1994.\6\ Generally, under

the proposal, a bilateral netting arrangement would be recognized for

risk-based capital purposes only if the netting arrangement is legally

enforceable. The bank would have to have a legal opinion(s) to this

effect. That proposal is consistent with the final July 1994 change to

the Accord.

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\6\The Board of Governors of the Federal Reserve System and the

Office of the Comptroller of the Currency issued a similar joint

netting proposal on May 20, 1994 and the OTS issued its netting

proposal on June 14, 1994.

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B. Potential Future Exposure

The second part of the credit equivalent amount, potential future

exposure, is an estimate of the additional exposure that may arise over

the remaining life of the contract as a result of fluctuations in

prices or rates. Such changes may increase the market value of the

contract in the future and, therefore, increase the cost of replacing

it if the counterparty subsequently defaults.

The add-on for potential future exposure is estimated by

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

by a credit conversion factor that is determined by the remaining

maturity of the contract and the type of contract. The existing set of

conversion factors used to calculate potential future exposure,

referred to as the add-on matrix, is as follows:

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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).

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Interest Exchange

rate rate

Remaining maturity contracts contracts

(percent) (percent)

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One year or less.................................. 0 1.0

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

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The conversion factors were determined through simulation studies

that estimated the potential volatility of interest and exchange rates

and analyzed the implications of movements in those rates for the

replacement costs of various types of interest rate and exchange rate

contracts. The simulation studies were conducted only on rate

contracts, because at the time the Accord was being developed activity

in the derivatives market was for the most part limited to these types

of transactions. The analysis produced probability distributions of

potential replacement costs over the remaining life of matched pairs of

rate contracts.\8\ Potential future exposure was then defined in terms

of confidence limits for these distributions. The conversion factors

were intended to be a compromise between precision, on the one hand,

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

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

with the bank the buyer of one of the contracts and the seller of

the other.

\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 FDIC's Reading Room by calling (202) 898-8785.

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

contracts, regardless of whether the market value is zero, positive, or

negative, or whether the current exposure is calculated on a gross or

net basis. The add-on will always be either a positive number or zero.

The recent revision to the Accord to recognize netting for the

calculation of current exposure does not affect the calculation of

potential future exposure, which generally continues to be calculated

on a gross basis. This means that an add-on for potential future

exposure is calculated separately for each individual contract subject

to the netting arrangement and then these individual future exposures

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

exposure. For contracts subject to a qualifying bilateral netting

arrangement in accordance with the newly adopted Accord changes, the

gross add-on for potential future exposure would be added to the net

current exposure to arrive at one credit equivalent amount for the

contracts subject to the netting arrangement.

The original Basle Accord noted that the credit conversion factors

in the add-on matrix were provisional and would be subject to revision

if volatility levels or market conditions changed.

II. Basle Proposals for the Treatment of Potential Future Exposure

Since the original Accord was adopted, the derivatives market has

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

not specifically addressed in the Accord--notably commodity, precious

metal, and equity-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 exposure, in July 1994 the

BSC issued two proposals for public consultation.\11\ The first

proposal would expand the matrix of add-on factors used to calculate

potential future exposure to take into account innovations in the

derivatives market. The second proposal would recognize reductions in

the potential future exposure of derivative contracts that result from

entering into bilateral netting arrangements. The second proposal is an

extension of the recent revision to the Accord recognizing bilateral

netting arrangements for purposes of calculating current exposure and

would formally extend the recognition of netting arrangements to

equity, precious metals and other commodity derivative contracts. The

consultation period for these BSC proposals is scheduled to end on

October 10, 1994.

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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 commodity, precious metal, or equity or to an

index of commodity, precious metal or equity prices.

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

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

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

from FDIC's Reading Room by calling (202) 898--8785.

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A. Expansion of Add-On Matrix

A recently concluded BSC review of the add-on for potential future

exposure indicated that the current add-on factors used to calculate

the potential future exposure 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 review indicated that the current add-on factors do

not adequately address the full range of contract structures and the

timing of cash flows. The review also showed that the conversion

factors many institutions are using to calculate potential future

exposure for commodity, precious metal, and equity 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 commodity, precious metal, and equity contracts were

not explicity covered by the original Accord, as the use of such

contracts became more prevalent, many G-10 bank 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 concluded that it was not appropriate to address these

problems with a significant departure from the existing methodology

used in the Accord. The BSC decided that it would be appropriate to

preserve the conversion factors existing in the Accord and add new

conversion factors. Consequently, the revision proposed by the BSC

retains the existing conversion factors for rate contracts but applies

new higher conversion factors to such contracts with remaining

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

conversion factors specifically applicable to commodity, precious

metal, and equity contracts. The new conversion factors were determined

on the basis of simulation studies that used the same general approach

that generated the original add-on 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 any

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'' which is

available upon request from the FDIC's Reading Room by calling (202)

898-8785.

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The proposed matrix is set forth below:

Conversion Factor Matrix*

[Numbers in percent]

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Precious

Interest Foreign metals, Other

Residual maturity rate exchange Equity** except commododities

and gold 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

Five years or more................................... 1.5 7.5 10.0 8.0 15.0

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*For contracts with multiple exchanges of principal, the factors are to be multiplied by the number of remaining

payments in the contract.

**For contracts that automatically reset to zero value following a payment, the remaining maturity is set equal

to the time remaining until the next payment.

Gold is included within the foreign exchange column because the

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

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

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

other precious metals. The proposed matrix is designed to accommodate

the different structures of contracts, as well as the observed

disparities in the volatilities of the associated indices or prices of

the underlying assets.

Two footnotes are attached to the matrix to address two particular

contract structures. The first relates to contracts with multiple

exchanges of principal. Since the level of potential future exposure

rises generally in proportion to the number of remaining exchanges, the

conversion factors are to be multiplied by the number of remaining

payments (that is, exchanges of principal) in the contract. This

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

exposure is adequately covered. The second footnote applies to equity

contracts that automatically reset to zero each time a payment is made.

The credit risk associated with these contracts is similar to that of a

series of shorter contracts beginning and ending at each reset date.

For this type of equity contract the remaining maturity is set equal to

the time remaining until the next payment.

While the capital charges resulting from the application of the new

proposed conversion factors may not provide complete coverage for risks

associated with any single contract, the BSC believes the factors will

provide a reasonable level of prudential coverage for derivative

contracts on a portfolio basis. Like the original matrix, the proposed

expanded matrix is designed to provide a reasonable balance between

precision, and complexity and burden.

B. Recognition of the Effects of Netting

The simulation studies used to generate the conversion factors for

potential future exposure analyzed the implications of underlying rate

and price movements on the current exposure of contracts without taking

into account reductions in exposure that could result from legally

enforceable netting arrangements. Thus, the conversion factors are most

appropriately applied to non-netted contracts, and when applied to

legally enforceable netted contracts, they could in some cases,

overstate the potential future exposure.

Comments provided during the consultative process of revising the

Basle Accord to recognize qualifying bilateral netting arrangements and

further research conducted by the BSC, have suggested that netting

arrangements can reduce not only a banking organization's current

exposure for the transactions subject to the netting arrangement, but

also its potential future exposure for those transactions.\15\

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\15\While current exposure is intended to cover an

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

future exposure provides an estimate of possible increases in future

replacement cost, in view of the volatility of current exposure over

the remaining life of the contract. The greater the tendency of the

current exposure to fluctuate over time, the greater the add-on for

potential future exposure should be to cover expected fluctuations.

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As a result, in July 1994 the BSC issued a proposal to incorporate

into the calculation of the add-on for potential future exposure a

method for recognizing the risk-reducing effects of qualifying netting

arrangements. Under the proposal, institutions could recognize these

effects only for transactions subject to legally enforceable bilateral

netting arrangements that meet the requirements of netting for current

exposure as set forth in the recent amendment to the Accord.

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

derivative portfolio, netting arrangements can have substantial effects

on a bank's potential future exposure to multiple derivative contracts

it has entered into with a single counterparty. Should the counterparty

default at some future date, the bank's exposure would be limited to

the net amount the counterparty owes on the date of default rather than

the gross current exposure of the included contracts. By entering into

a netting arrangement, a bank may reduce not only its current exposure,

but also its future exposure as well. Nevertheless, while in many

circumstances a netting arrangement can reduce the potential future

exposure of a counterparty portfolio, this is not always the case.\16\

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\16\For purposes of this discussion, a portfolio refers to a set

of contracts with a single counterparty. A bank's global portfolio

refers to all of the contracts in the institution's derivatives

portfolio that are subject to qualifying netting arrangements.

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The most important factors influencing whether a netting

arrangement will have an effect on potential future exposure are the

volatilities of the current exposure to the counterparty on both a

gross and net basis.\17\ The volatilities of net current exposure and

gross current exposure of the portfolio may not necessarily be the

same. Volatility of gross current exposure is influenced primarily by

the fluctuations of the market values of positively valued contracts.

Volatility of net current exposure on the other hand, is influenced by

the fluctuations of the market values of all contracts within the

portfolio. In those cases where net current exposure has a tendency to

fluctuate more over time than gross current exposure, a netting

arrangement will not reduce the potential future exposure. However, in

those situations where net current exposure has a tendency to fluctuate

less over time than gross current exposure, a netting arrangement can

reduce the potential future exposure.

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

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

volatile portfolio would have a tendency to fluctuate significantly

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

influencing a portfolio's volatility is the correlation of the

contracts within the portfolio, that is, the degree to which the

contracts in the portfolio respond similarly to changing market

conditions.

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Net current exposure is likely to be less volatile relative to the

volatility of gross current exposure when the portfolio of contracts as

a whole is more diverse than the subset of positively valued contracts.

When a netting arrangement is applied to a diversified portfolio and

the positively valued contracts within the portfolio as a group are

less diversified than the overall portfolio, then the effect of the

netting arrangement will be to reduce the potential future exposure for

the portfolio.

The BSC has studied and analyzed several alternatives for taking

into account the effects of netting when calculating the capital charge

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

general method proposed by commenters to the April 1993 netting

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

potential future exposure by multiplying the calculated gross add-on by

the ratio of the portfolio's net current exposure to gross current

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

for the risk-reducing effects of the netting arrangement on the

potential future exposure. The more diversified the portfolio, the

lower the net current exposure tends to be relative to gross current

exposure.

The BSC incorporated this method into its proposal. However, given

that there are portfolio-specific situations in which the NGR does not

provide a good indication of these effects, the BSC proposal gives only

partial weight to the effects of the NGR on the add-on for potential

future exposure. The proposed method would average the amount of the

add-on as currently calculated (Agross) and the same amount

multiplied by the NGR to arrive at a reduced add-on (Anet) for

contracts subject to qualifying netting arrangements in accordance with

the requirements set forth in the recently amended Accord. This formula

is expressed as:

Anet = .5(Agross + (NGR * Agross)).

For example, a bank with a gross current exposure of 500,000, a net

current exposure of 300,000, and a gross add-on for potential future

exposure of 1,200,000, would have an NGR of .6 (300,000/500,000) and

would calculate Anet as follows:

.5(1,200,000 + (.6 * 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 BSC proposal does not specify whether the NGR should be

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

basis for all transactions subject to qualifying, legally enforceable

netting arrangements. The proposal requests 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 BSC proposal also acknowledges that simulations using bank's

internal models for measuring credit risk exposure would most likely

produce the most accurate determination of the effect of netting

arrangements on potential future exposures. The proposal states that

the use of such models would be considered at some future date.

C. The FDIC Proposal

In light of the BSC proposal, the FDIC believes that it is

appropriate to seek comment on proposed revisions to the calculation of

the add-on for potential future exposure for derivative contracts.

Therefore, the FDIC is proposing to amend its risk-based capital

guidelines for state nonmember banks to expand the matrix of conversion

factors, and to permit institutions that make use of qualifying netting

arrangements to recognize the effects of those netting arrangements in

the calculation of the add-on for potential future exposure. The second

part of the proposed amendment is contingent on the adoption of a final

amendment to the FDIC's risk-based capital guidelines to recognize

bilateral close-out netting arrangements and would formally extend this

recognition to commodity, precious metals, and equity derivative

contracts.

With regard to the portion of the proposal to expand the conversion

factor matrix, the FDIC is proposing the same conversion factors set

forth in the BSC proposal. The FDIC agrees with the BSC that the

existing conversion factors applicable to long-dated transactions do

not provide sufficient capital for the risks associated with those

types of contracts. The FDIC also agrees with the BSC that the

conversion factors for foreign exchange transactions are significantly

too low for commodity, precious metal, and equity contracts due to the

volatility of the associated indices or the prices on the underlying

assets.\18\

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\18\Similar to the BSC proposal, the FDIC's proposed amendment

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 FDIC is proposing the same formula as the BSC proposal to

calculate a reduction in the add-on for potential future exposure for

contracts subject to qualifying netting contracts. The FDIC recognizes

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 FDIC 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

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 FDIC is seeking comment on all aspects of this proposal. As

mentioned earlier, the BSC proposal seeks comment on whether the NGR

should be calculated on a counterparty-by-counterparty basis, or on a

global basis for all contracts subject to qualifying bilateral netting

arrangements. The FDIC'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 FDIC is also seeking comment

as to which method of calculating the NGR would be most efficient and

appropriate for institutions with numerous qualifying bilateral netting

arrangements. With either calculation method the NGR would be applied

separately to adjust the add-on for potential future exposure for each

netting arrangement. The FDIC notes that some preliminary findings

indicate that a global NGR may be less burdensome to apply since the

same NGR would be used for each counterparty with a netting

arrangement, but counterparty specific NGRs may provide a more accurate

indication of the credit risk associated with each counterparty.

Regulatory Flexibility Act Analysis

The FDIC does not believe that adoption of this proposal would have

a significant economic impact on a substantial number of small business

entities (in this case, small banks), in accord with the spirit and

purposes of the Regulatory Flexibility Act (5 U.S.C 601 et. seq.). In

this regard, while some small banks with limited derivative portfolios

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

overall effect of the proposal will be to reduce regulatory burden and

to reduce the capital charge for certain transactions.

Paperwork Reduction Act

The FDIC has determined that its proposed amendments, if adopted,

would not increase the regulatory paperwork burden of state nonmember

banks pursuant to the provisions of the paperwork Reduction Act (44

U.S.C. 3501 et. seq.).

List of Subjects in 12 CFR Part 325

Bank deposit insurance, Banks, banking, Capital adequacy, Reporting

and recordkeeping requirements, Savings associations, State nonmember

banks.

For the reasons set forth in the preamble, the Board of Directors

of the FDIC proposes to amend 12 CFR part 325 as follows:

PART 325--CAPITAL MAINTENANCE

1. The authority citation for part 325 continues to read as

follows:

Authority: 12 U.S.C. 1815(a), 1815(b), 1816, 1818(a), 1818(b),

1818(c), 1818(t), 1819 (Tenth), 1828(c), 1828(d), 1828(i), 1828(n),

1828(o), 1831o, 3907, 3909; Pub. L. 102-233, 105 Stat. 1761, 1789,

1790 (12 U.S.C. 1831n note) Pub. L. 102-242, 105 Stat. 2236, 2355,

2386 (12 U.S.C. 1828 note).

2. In appendix A to part 325, section II is amended by:

a. Revising the last sentence in section II.C. Category 3;

b. Redesignating footnotes 36 through 40 as footnotes 37 through

41;

c. Adding new footnote 35 at the end of the introductory text of

section II.D.; and

d. Revising the heading and the introductory text of section

II.E. (preceding paragraph E.1.) to read as follows:

APPENDIX A TO PART 325--STATEMENT OF POLICY ON RISK-BASED CAPITAL

* * * * *

II. * * *

C. * * *

Category 3 * * * In addition, the credit equivalent amount of

derivative contracts that do not qualify for a lower risk weight are

assigned to the 50 percent risk category.

* * * * *

D. * * *\35\ * * *

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\35\The sufficiency of collateral and guarantees for off-

balance-sheet items is determined by the market value of the

collateral or the amount of the guarantee in relation to the face

amount of the item, except for derivative contracts, for which this

determination is generally made in relation to the credit equivalent

amount. Collateral and guarantees are subject to the same provisions

noted under section II.B.

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* * * * *

E. Derivative Contracts (Interest Rate, Exchange Rate, Commodity and

Equity Derivative Contracts)

Credit equivalent amounts are computed for each of the following

off-balance-sheet derivative contracts:

Interest Rate Contracts

(1) Single currency interest rate swaps.

(2) Basis swaps

(3) Forward rate agreements.

(4) Interest rate options (including caps, collars, and floors

purchased).

(5) Any other instrument that gives rise to similar credit risks

(including when-issued securities and forward deposits accepted).

Exchange Rate Contracts

(1) Cross-currency interest rate swaps.

(2) Forward foreign exchange contracts.

(3) Currency options purchased.

(4) Any other instrument that gives rise to similar credit

risks.

Commodity (including precious metal) or Equity Derivative Contracts

(1) Commodity or equity linked swaps.

(2) Commodity or equity linked options purchased.

(3) Forward commodity or equity linked contracts.

(4) Any other instrument that gives rise to similar credit

risks.

Exchange rate contracts with an original maturity of fourteen

calendar days or less and derivative contracts traded on exchanges

that require daily payment of variation margin may be excluded from

the risk-based ratio calculation. Over-the-counter options

purchased, however, are included and treated in the same way as

other derivative contracts.

* * * * *

3. In Appendix A to part 325, section II.E.1., as that section

was proposed to be revised at 59 FR 37726, July 25, 1994, is revised

to read as follows:

II. * * *

E. * * *

1. Credit Equivalent Amounts for Derivative Contracts. The

credit equivalent amount of a derivative contract that is not

subject to a qualifying bilateral netting contract in accordance

with section II.E.3. of this appendix A is equal to the sum of (i)

the current exposure (which is equal to the mark-to-market

value,\41\ if positive, and is sometimes referred to as the

replacement cost) of the contract and (ii) an estimate of the

potential future credit exposure over the remaining life of the

contract.

---------------------------------------------------------------------------

\41\Mark-to-market values are measured in dollars, regardless of

the currency or currencies specified in the contract and should

reflect changes in both underlying rates, prices and indices, and

counterparty credit quality.

---------------------------------------------------------------------------

The current exposure is determined by the mark-to-market value

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

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

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

zero.

The potential future credit exposure of a contract, including

contracts with negative mark-to-market values, is estimated by

multiplying the notional principal amount of the contract by one of

the following credit conversion factors, as appropriate:

Conversion Factor MatrixA

[Numbers in percent]

------------------------------------------------------------------------

Precious

Residual Interest Exchange metals, Other

maturity rate rate and EquityB except commodities

gold gold

------------------------------------------------------------------------

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

Five years or

more.......... 1.5 7.5 10.0 8.0 15.0

------------------------------------------------------------------------

AFor contracts with multiple exchanges of principal, the factors are to

be multiplied by the number of remaining payments in the contract.

BFor contracts that reset to zero value following a payment, the

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

No potential future exposure is calculated for single currency

interest rate swaps in which payments are made based upon two

floating rate indices (so called floating/floating or basis swaps);

the credit exposure on these contracts is evaluated solely on the

basis of their mark-to-market values.

4. In Appendix A to part 325, section II.E.2, as that section

was proposed to be revised at 59 FR 37726, July 25, 1994, is revised

to read as follows:

II. * * *

E. * * *

2. Risk Weights and Avoidance of Double Counting. Once the

credit equivalent amount for a derivative contract, or a group of

derivative contracts, has been determined, that amount is assigned

to the risk category appropriate to the counterparty, or, if

relevant, the guarantor or the nature of any collateral. However,

the maximum weight that will be applied to the credit equivalent

amount of such contracts is 50 percent.

In certain cases, credit exposures arising from the derivative

contracts covered by these guidelines may already be reflected, in

part, on the balance sheet. To avoid double counting such exposures

in the assessment of capital adequacy and, perhaps, assigning

inappropriate risk weights, counterparty credit exposures arising

from the types of instruments covered by these guidelines may need

to be excluded from balance sheet assets in calculating banks' risk-

based capital ratios.

The FDIC notes that the conversion factors set forth in section

II.E.1. of appendix A, which are based on observed volatilities of

the particular types of instruments, are subject to review and

modification in light of changing volatilities or market conditions.

Examples of the calculation of credit equivalent amounts for

these types of contracts are contained in table IV of this appendix

A.

5. In Appendix A to part 325, section II.E.3, as that section

was proposed to be added at 59 FR 37726, July 25, 1994, is revised

to read as follows:

II. * * *

E. * * *

3. Netting. For purposes of this appendix A, netting refers to

the offsetting of positive and negative mark-to-market values when

determining a current exposure to be used in the calculation of a

credit equivalent amount. Any legally enforceable form of bilateral

netting (that is, netting with a single counterparty) of derivative

contracts is recognized for purposes of calculating the credit

equivalent amount provided that:

* * * * *

(d) The bank maintains in its files documentation adequate to

support the netting of derivative contracts, including a copy of the

bilateral netting contract and necessary legal opinions.

A contract containing a walkaway clause is not eligible for

netting for purposes of calculating the credit equivalent

amount.\42\

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\42\For purposes of this section, a walkaway clause means a

provision in a netting contract that permits a non-defaulting

counterparty to make lower payments than it would make otherwise

under the contract, or no payments at all, to a defaulter or to the

estate of a defaulter, even if a defaulter or the estate of a

defaulter is a net creditor under the contract.

---------------------------------------------------------------------------

By netting individual contracts for the purpose of calculating

its credit equivalent amount, a bank represents that it has met the

requirements of this appendix A and all the appropriate documents

are in the bank's files and available for inspection by the FDIC.

Upon determination by the FDIC that a bank's files are inadequate or

that a netting contract may not be legally enforceable under any one

of the bodies of law described in paragraphs (b) (i) through (iii)

of this section, underlying individual contracts may be treated as

though they were not subject to the netting contract.

The credit equivalent amount of derivative contracts that are

subject to a qualifying bilateral netting contract is calculated by

adding (i) the net current exposure of the netting contract and (ii)

the sum of the estimates of potential future exposure for all

individual contracts subject to the netting contract, adjusted to

take into account the effects of the netting contract.

The net current exposure is the sum of all positive and negative

mark-to-market values of the individual contracts subject to the

netting contract. If the net sum of the mark-to-market values is

positive, then the net current exposure is equal to that sum. If the

net sum of the mark-to-market values is zero or negative, then the

net current exposure is zero.

The sum of the estimates of potential future exposure for all

individual contracts subject to the netting contract (Agross),

adjusted to reflect the effects of the netting contract (Anet),

is determined through application of a formula. The formula, which

employs the ratio of the net current to the gross current exposure

(NGR), is expressed as:

Anet = .5(Agross + (NGR * Agross))

Gross potential future exposure, or Agross, is calculated

by summing the estimates of potential future exposure (determined in

accordance with section II.E.1. of this appendix A) for each

individual contract subject to the qualifying bilateral netting

contract.\43\ The NGR is determined as the ratio of the net current

exposure of the netting contract to the gross current exposure of

the netting contract. The gross current exposure is the sum of the

current exposures of all individual contracts subject to the netting

contract calculated in accordance with section II.E.1. of this

appendix A. The effect of this treatment is that Anet is the

average of Agross and Agross adjusted by the NGR.

---------------------------------------------------------------------------

\43\For purposes of calculating gross potential future credit

exposure for foreign exchange contracts and other similar contracts

in which notional principal is equivalent to cash flows, total

notional principal is defined as the net receipts to each party

falling due on each value date in each currency.

---------------------------------------------------------------------------

6. In Appendix A to part 325, the chart in Table III and its

heading, as that section was proposed to be amended at 59 FR 37726,

July 25, 1994, is revised to read as follows:

Table III. * * *

* * * * *

Credit Conversion for Derivative Contracts

* * * * *

Conversion Factor MatrixA

[Numbers in percent]

------------------------------------------------------------------------

Residual Interest Exchange Precious Other

maturity rate rate EquityB metals commodities

------------------------------------------------------------------------

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

Five years or

more.......... 1.5 7.5 10.0 8.0 15.0

------------------------------------------------------------------------

AFor contracts with multiple exchanges of principal, the factors are to

be multiplied by the number of remaining payments in the contract.

BFor contracts that reset to zero value following a payment, the

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

* * * * *

6. In Appendix A to part 325, Table IV, as that table was proposed

to be added at 59 FR 37726, July 25, 1994, is revised to read as

follows:

Table IV.--Calculation of Credit Equivalent Amounts for Derivative Contracts

----------------------------------------------------------------------------------------------------------------

Potential exposure + = Credit equivalent amount

----------------------------------------------- ---------------------------------------------------

Notional Current Potential Market-to Current Credit

Type of contract (remaining principal exposure Exposure market exposure equivalent

maturity) (dollars) (dollars) value (dollars) amount

----------------------------------------------------------------------------------------------------------------

(1) 120-Day Forward Foreign

Exchange........................ 5,000,000 .01 50,000 100,000 100,000 150,000

(2) 6-Year Forward Foreign

Exchange........................ 6,000,000 .075 450,000 -120,000 0 450,000

(3) 3-Year Interest Rate Swap.... 10,000,000 .005 50,000 200,000 200,000 250,000

(4) 1-Year Oil Swap.............. 10,000,000 .12 1,200,000 -250,000 0 1,200,000

(5) 7-Year Interest Rate Swap.... 20,000,000 .015 300,000 -1,300,000 0 300,000

------------------------------------------------------------------------------

Total...................... ........... ............ 2,050,000 ........... 300,000 2,350,000

----------------------------------------------------------------------------------------------------------------

If contracts (1) through (5) above are subject to a qualifying

bilateral netting contract, then the following applies:

------------------------------------------------------------------------

Potential

future Net current Credit

exposure (from exposure* equivalent

above) amount

------------------------------------------------------------------------

(1).................. 50,000

(2).................. 450,000

(3).................. 50,000

(4).................. 1,200,000

(5).................. 300,000

----------------

Total.......... 2,050,000 + 0 = 2,050,000

------------------------------------------------------------------------

*The total of the mark-to-market values from above is -1,370,000. Since

this is a negative amount, the net current exposure is zero.

To recognize the effects of netting on potential future

exposure, the following formula applies:

Anet = .5 (Agross + (NGR * Agross))

In the above example:

NGR = 0 (0/300,000)

Anet = .5 (2,050,000 + (0 * 2,050,000))

Anet = 1,025,000

Credit Equivalent Amount: 1,025,000 + 0 = 1,025,000

If the net current exposure was a positive amount, for example,

$200,000, the credit equivalent amount would be calculated as

follows:

NGR = .67 (200,000/300,000)

Anet = .5(2,050,000 + (.67 * 2,050,000))

Anet = 1,711,750

Credit Equivalent Amount: 1,711,750 + 200,000 = 1,911,750

By order of the Board of Directors.

Dated at Washington, D.C. this 27 day of September, 1994.

Federal Deposit Insurance Corporation

Robert E. Feldman,

Acting Executive Secretary.

[FR Doc. 94-25662 Filed 10-18-94; 8:45 am]

BILLING CODE 6714-01-P