Capital; Capital Adequacy Guidelines

Federal RegisterDec 7, 1994

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FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

[Regulations H and Y; Docket No. R-0837]

Capital; Capital Adequacy Guidelines

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Final rule.

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SUMMARY: The Board of Governors of the Federal Reserve System (Board)

is amending its risk-based capital guidelines to recognize the risk-

reducing benefits of qualifying bilateral netting contracts. This final

rule implements a recent revision to the Basle Accord permitting the

recognition of such netting arrangements. The effect of the final rule

is that state member banks and bank holding companies (banking

organizations, institutions) may net positive and negative mark-to-

market values of interest and exchange rate contracts in determining

the current exposure portion of the credit equivalent amount of such

contracts to be included in risk-weighted assets.

EFFECTIVE DATE: December 31, 1994.

FOR FURTHER INFORMATION CONTACT: Roger Cole, Deputy Associate Director

(202/452-2618), Norah Barger, Manager (202/452-2402), Robert Motyka,

Supervisory Financial Analyst (202)/452-3621), Barbara Bouchard,

Supervisory Financial Analyst (202/452-3072), Division of Banking

Supervision and Regulation; or Stephanie Martin, Senior Attorney (202/

452-3198), Legal Division. For the hearing impaired only,

Telecommunications Device for the Deaf, Dorothea Thompson (202/452-

3544), 20th and C Streets, N.W., Washington, D.C. 20551.

SUPPLEMENTARY INFORMATION:

Background

The Basle Accord1 established a risk-based capital framework

which was implemented for state member banks and bank holding companies

by the Board in 1989. Under this framework, off-balance-sheet interest

rate and exchange rate contracts (rate contracts) are incorporated into

risk weighted assets by converting each contract into a credit

equivalent amount. This amount is then assigned to the appropriate

credit risk category according to the identity of the obligor or

counterparty or, if relevant, the guarantor or the nature of the

collateral. The credit equivalent amount of an interest or exchange

rate contract can be assigned to a maximum credit risk category of 50

percent.

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\1\The Basle Accord is a risk-based framework that 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 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.

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The credit equivalent amount of a rate contract is determined by

adding together the current replacement cost (current exposure) and an

estimate of the possible increase 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).2

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\2\This method of determining credit equivalent amounts for rate

contracts is identified in the Basle Accord as the current exposure

method, which is used by most international banks.

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For risk-based capital purposes, a rate contract with a positive

mark-to-market value has a current exposure equal to that market value.

If the mark-to-market value of a rate contract is zero or negative,

then there is no replacement cost associated with the contract and the

current exposure is zero. The original Basle Accord and the Board's

guidelines provided that current exposure would be determined

individually for each rate contract entered into by a banking

organization; institutions generally were not permitted to offset, that

is, net, positive and negative market values of multiple rate contracts

with a single counterparty to determine one current credit exposure

relative to that counterparty.3

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\3\It was noted in the Accord that the legal enforceability of

certain netting arrangements was unclear in some jurisdictions. The

legal status of netting by novation, however, was determined to be

settled and this limited type of netting 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, in

effect, legally replaces the amalgamated gross obligations.

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In April 1993 the Basle Supervisors' Committee proposed a revision

to the Basle Accord, endorsed by the G-10 Governors in July 1994, that

permits institutions to net positive and negative market values of rate

contracts subject to a qualifying, legally enforceable, bilateral

netting arrangement. Under the revision, institutions with a qualifying

netting arrangement may calculate a single net current exposure for

purposes of determining the credit equivalent amount for the included

contracts.4 If the net market value of the contracts included in

such a netting arrangement 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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\4\The revision to the Accord notes that national supervisors

must be satisfied about the legal enforceability of a netting

arrangement under the laws of each jurisdiction relevant to the

arrangement. The Accord also states that, if any supervisor is

dissatisfied about enforceability under its own laws, the netting

arrangement does not satisfy this condition and neither counterparty

may obtain supervisory benefit.

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The Board's Proposal

On May 20, 1994, the Board and the Office of the Comptroller of the

Currency (OCC) issued a joint proposal to amend their respective risk-

based capital standards (59 FR 26456) in accordance with the Basle

Supervisors' Committee's April 1993 proposal.5 The joint proposal

provided that for capital purposes institutions regulated by the Board

and the OCC could net the positive and negative market values of

interest and exchange rate contracts subject to a qualifying, legally

enforceable, bilateral netting contract to calculate one current

exposure for that netting contract (sometimes referred to as the master

netting contract).

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\5\The Office of Thrift Supervision (OTS) issued a similar

netting proposal on June 14, 1994 and the Federal Deposit Insurance

Corporation (FDIC) issued its netting proposal on July 25, 1994.

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The proposal provided that the net current exposure would be

determined by adding together all positive and negative market values

of individual contracts subject to the netting contract. The net

current exposure would equal the sum of the market values if that sum

is a positive value, or zero if the sum of the market values is zero or

a negative value. The proposals did not alter the calculation method

for potential future exposure.\6\

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\6\Potential future exposure is estimated by multiplying the

effective notional amount of a contract by a credit conversion

factor which is based on the type of contract and the remaining

maturity of the contract. Under the Board/OCC proposal, a potential

future exposure amount would be calculated for each individual

contract subject to the netting contract. The individual potential

future exposures would then be added together to arrive at one total

add-on amount.

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Under the proposal, institutions would be able to net for risk-

based capital purposes only with a written bilateral netting contract

that creates a single legal obligation covering all included individual

rate contracts and does not contain a walkaway clause.\7\ The proposal

required an institution to obtain a written and reasoned legal

opinion(s) stating that under the master netting contract the

institution would have a claim to receive, or an obligation to pay,

only the net amount of the sum of the positive and negative market

values of included individual contracts if a counterparty failed to

perform due to default, insolvency, bankruptcy, liquidation, or similar

circumstances.

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\7\A walkaway clause is a provision in a netting contract that

permits a non-defaulting counterparty to make lower payments than it

would make otherwise under the contract, or no payment at all, to a

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

the estate of the defaulter is a net creditor under the contract.

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The proposal indicated that the legal opinion must normally cover:

(i) The law of the jurisdiction in which the counterparty is chartered,

or the equivalent location in the case of noncorporate entities, and if

a branch of the counterparty is involved, the law of the jurisdiction

in which the branch is located; (ii) the law that governs the

individual contracts covered by the netting contract; and (iii) the law

that governs the netting contract.

The proposal provided that an institution must maintain in its

files documentation adequate to support the bilateral netting contract.

Documentation would typically include a copy of the bilateral netting

contract, legal opinions and any related translations. In addition, the

proposal required an institution to establish and maintain procedures

to ensure that the legal characteristics of netting contracts would be

kept under review.

Under the proposal, the Federal Reserve could disqualify any or all

contracts from netting treatment for risk-based capital purposes if the

requirements of the proposal were not satisfied. In the event of

disqualification, the affected contracts would be treated as though

they were not subject to the master netting contract. The proposal

indicated that outstanding netting by novation arrangements would not

be grandfathered, that is, such arrangements would have to meet all of

the proposed requirements for qualifying bilateral netting contracts.

The proposal requested general comments as well as specific

comments on the nature of collateral arrangements and the extent to

which collateral might be recognized in conjunction with bilateral

netting contracts.

Comments Received

The Board received nineteen public comments on the proposed

amendment. Eleven comments were from banking organizations and five

were from industry trade associations and organizations. In addition,

there were three comments from law firms. All commenters supported the

expanded recognition of bilateral netting contracts for risk-based

capital purposes. Several commenters encouraged recognition of such

contracts as quickly as possible. Many of the commenters concurred with

one of the principal underlying tenets of the proposal, that is, that

legally enforceable bilateral netting contracts can provide an

efficient and desirable means for institutions to reduce or control

credit exposure. A few commenters noted that, in their view, the

recognition of bilateral netting contracts would create an incentive

for market participants to use such arrangements and would encourage

lawmakers to clarify the legal status of netting arrangements in their

jurisdictions. One commenter noted that the expanded recognition of

bilateral netting contracts would help keep U.S. banking organizations

competitive in global derivatives markets.

While generally expressing their endorsement for the expanded

recognition of bilateral netting contracts, nearly all commenters

offered suggestions or requested clarification regarding details of the

proposals. In particular, the commenters raised issues concerning

specifics of the required legal opinions, the treatment of collateral,

and the grandfathering of walkaway clauses and novation agreements.

Legal Opinions

Almost all commenters addressed the proposed requirement that

institutions obtain legal opinions concluding that their bilateral

netting contracts would be enforceable in all relevant jurisdictions.

Commenters did not object to the general requirement that they secure

legal opinions, rather they raised a number of questions about the form

and substance of an acceptable opinion.

Form. Several commenters requested clarification as to the specific

form of the legal opinion. Commenters wanted to know if a memorandum of

law would satisfy the requirement or if a legal opinion would be

required. They questioned whether a memorandum or opinion could be

addressed to, or obtained by, an industry group, and whether a generic

opinion or memorandum relating to a standardized netting contract would

satisfy the legal opinion requirement.

Several commenters suggested that an opinion secured on behalf of

the banking industry by an organization should be sufficient so long as

the individual institution's counsel concurs with the opinion and

concludes that the opinion applies directly to the institution's

specific netting contract and to the individual contracts subject to

it. A few commenters requested confirmation that legal opinions would

not have to follow a predetermined format.

Scope. Several commenters identified two possible interpretations

of the proposed language with regard to the scope of the legal

opinions. They asked for clarification as to whether the opinions would

be required to discuss only whether all relevant jurisdictions would

recognize the contractual choice of law, or whether they must also

discuss the enforceability of netting in bankruptcy or other instances

of default. One commenter suggested deleting the requirement for a

choice of law analysis.

A number of commenters objected to the proposed requirement that

the legal opinion for a multibranch netting contract (that is, a

netting contract between multinational banks that includes contracts

with branches of the parties located in various jurisdictions) address

the enforceability of netting under the law of the jurisdiction where

each branch is located. These commenters stated that it should be

sufficient for the legal opinion to conclude that netting would be

enforced in the jurisdiction of the counterparty's home office if the

master netting contract provides that all transactions are considered

obligations of the home office and the branch jurisdictions recognize

that provision.

Severability. Several commenters expressed concern about the

proposed treatment for netting contracts that include contracts with

branches in jurisdictions where the enforceability of netting is

unclear. In such circumstances, commenters asserted, unenforceability

or uncertainty in one jurisdiction should not invalidate the entire

netting contract for risk-based capital netting treatment. These

commenters contended that contracts with branches of a counterparty in

jurisdictions that recognize netting arrangements should be netted and

contracts with branches in jurisdictions where the enforceability of

netting is not supported by legal opinions should, for risk-based

capital purposes, be severed, or removed from the master netting

contract and treated as though they were not subject to that contract.

These commenters noted that this treatment should only be available to

the extent it is supported by legal opinion.

Conclusions. The proposal required a legal opinion to conclude that

``relevant court and administrative authorities would find'' the

netting to be effective. Many commenters that discussed this aspect of

the proposal expressed concern that this standard was too high. They

suggested, instead, that the opinions be required to conclude that

netting ``should'' be effective.

A few commenters requested clarification regarding the proposed

requirement that the netting contract must create a single legal

obligation.

Collateral

Twelve commenters addressed the proposal's specific request for

comment on the nature of collateral and the extent to which collateral

might be recognized in conjunction with bilateral netting contracts.

All of these commenters believed collateral should be recognized as a

means of reducing credit exposure. A few commenters noted that

collateral arrangements are increasingly being used with derivative

transactions.

Several commenters stated that for netting contracts that call for

the use of collateral, the amount of required collateral is determined

from the net mark-to-market value of the master netting contract. A few

commenters added that mark-to-market collateral often is used in

conjunction with a collateral ``add-on'' based on such things as the

notional amount of the underlying contracts, the maturities of the

contracts, the credit quality of the counterparty, and volatility

levels.

A number of commenters offered their opinions as to how collateral

should be recognized for risk-based capital purposes. Some suggested

that the existing method of recognizing collateral for purposes of

assigning credit equivalent amounts to risk categories is applicable to

derivative transactions as well. Other commenters expressed the view

that collateral should be recognized when assigning risk weights to the

extent it is legally available to cover the total credit exposure for

the bilateral netting contract in the event of default and that this

availability should be addressed in the legal opinions.

Several other commenters suggested separating the net current

exposure and potential future exposure of bilateral netting contracts

for determining collateral coverage and appropriate risk weights. One

commenter favored recognizing collateral for capital purposes by

allowing an institution to offset net current exposure by the amount of

the collateral to further reduce the credit equivalent amount.

Two commenters requested clarification that contracts subject to

qualifying netting contracts could be eligible for a zero percent risk

weight if the transaction is properly collateralized in accordance with

the Board's collateralized transactions rule.8

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\8\In December 1992 the Board issued an amendment to its risk-

based capital guidelines permitting certain collateralized

transactions to qualify for a zero percent risk weight (57 FR 62180,

December 30, 1992). In order to qualify for a zero percent risk

weight, an institution must maintain a positive margin of qualifying

collateral at all times. Thus, the collateral arrangement should

provide for immediate liquidation of the claim in the event that a

positive margin of collateral is not maintained. The OCC has issued

a similar proposal (58 FR 43822, August 18, 1993).

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Walkaway Clauses

Several commenters addressed the proposed prohibition against

walkaway clauses in contracts qualifying for netting for risk-based

capital purposes. While most of these commenters agreed that,

ultimately, walkaway clauses should be eliminated from master netting

contracts, they favored a phase-out period, during which outstanding

bilateral netting contracts containing walkaway clauses could qualify

for capital netting treatment. Several commenters contended that if a

defaulter is a net debtor under the contract, the existence of a

walkaway clause would not affect the amount owed to the non-defaulting

creditor.

Novation

A few commenters expressed concern that the proposal did not

grandfather outstanding novation agreements. These commenters suggested

a phase-in period during which novation agreements would not be

required to be supported by legal opinions.

Other Issues

One commenter requested greater detail on the nature and extent of

examination review procedures. Two commenters stated that in some

situations obtaining translations might be burdensome. Another

commenter suggested assurance that the Federal Reserve would not

disqualify netting contracts in an unreasonable manner.

Approximately one-half of the commenters expressed concern that the

proposal specifically was limited to interest rate and exchange rate

contracts. All of these opposed limiting the range of products that

could be included under qualifying netting contracts. In this regard,

one commenter noted that where there is sufficient legal support

confirming the enforceability of cross-product netting, such netting

should be recognized for capital purposes.

A number of commenters used the proposal as an opportunity to

discuss the manner in which the add-on for potential future exposure is

calculated. They suggested netting contracts should be recognized not

only as a way to reduce the current exposure to a counterparty, but

also the effects of such netting contracts should be taken into account

to reduce the amount of capital organizations must hold against the

potential future exposure to the counterparty.

Final Rule

After considering the public comments received and further

deliberating the issues involved, the Board is adopting a final rule

recognizing, for capital purposes, qualifying bilateral netting

contracts. This final rule is substantially the same as proposed.

Legal Opinions

Form. The final rule requires that institutions obtain a written

and reasoned legal opinion(s) concluding that the netting contract is

enforceable in all relevant jurisdictions. This requirement is aimed at

ensuring there is a substantial legal basis supporting the legal

enforceability of a netting contract before reducing a banking

organization's capital requirement based on that netting contract. A

legal opinion, as generally recognized by the legal community in the

United States, can provide such a legal basis. A memorandum of law may

be an acceptable alternative as long as it addresses all of the

relevant issues in a credible manner.

As discussed in the proposal, the legal opinions may be prepared by

either an outside law firm or an institution's in-house counsel. The

salient requirements for an acceptable legal opinion are that it: (i)

Addresses all relevant jurisdictions; and (ii) concludes with a high

degree of certainty that in the event of a legal challenge the banking

organization's claim or obligation would be determined by the relevant

court or administrative authority to be the net sum of the positive and

negative mark-to-market values of all individual contracts subject to

the bilateral netting contract. The subject matter and complexity of

required legal opinions will vary.

To some extent, institutions may use general, standardized opinions

to help support the legal enforceability of their bilateral netting

contracts. For example, a banking organization may have obtained a

memorandum of law addressing the enforceability of netting provisions

in a particular foreign jurisdiction. This opinion may be used as the

basis for recognizing netting generally in that jurisdiction. However,

with regard to an individual master netting contract, the general

opinion would need to be supplemented by an opinion that addresses

issues such as the enforceability of the underlying contracts, choice

of law, and severability.

For example, the Board does not believe that a generic opinion

prepared for a trade association with respect to the effectiveness of

netting under the standard form agreement issued by the trade

association, by itself, is adequate to support a netting contract.

Banking organizations using such general opinions would need to

supplement them with a review of the terms of the specific netting

contract that the institution is executing.

Scope. With regard to the scope of the legal opinions, that is,

what areas of analysis must be covered, the Board is of the opinion

that legal opinions must address the validity and enforceability of the

entire netting contract. The opinion must conclude that under the

applicable state or other jurisdictional law the netting contract is a

legal, valid, and binding contract, enforceable in accordance with its

terms, even in the event of insolvency, bankruptcy, or similar

proceedings. Opinions provided on the law of jurisdictions outside of

the U.S. should include a discussion and conclusion that netting

provisions do not violate the public policy or the law of that

jurisdiction.

The Board has further determined that one of the most critical

aspects of a qualifying netting contract is the contract's

enforceability in any jurisdiction whose law would likely be applied in

an enforcement action, as well as the jurisdiction where the

counterparty's assets reside. In this regard, and in light of the

policy in some countries to liquidate branches of foreign banking

organizations independent of the head office, the Board is retaining

its proposed requirement that legal opinions address the netting

contract's enforceability under: (i) The law of the jurisdiction in

which the counterparty is chartered, or the equivalent location in the

case of noncorporate entities, and if a branch of the counterparty is

involved, the law of the jurisdiction in which the branch is located;

(ii) the law that governs the individual contracts subject to the

bilateral netting contract; and (iii) the law that governs the netting

contract.

Severability. The Board recognizes that for some multibranch

netting contracts an organization may not be able to obtain a legal

opinion(s) concluding that netting would be enforceable in every

jurisdiction where branches covered under the master netting contract

are located. The Board concurs with commenters that in such situations

it may be inefficient to require institutions to renegotiate netting

contracts to ensure they cover only those jurisdictions where netting

is clearly enforceable. The Board has determined that, in certain

circumstances for capital purposes, banking institutions may use master

bilateral netting contracts that include contracts with branches across

all jurisdictions. Banking institutions should calculate their net

current exposure for the contracts in those jurisdictions where netting

clearly is enforceable as supported by legal opinion(s). The remaining

contracts subject to the netting contract should be severed from the

netting contract and treated as though they were not subject to the

netting contract for capital and credit purposes. This approach of

essentially dividing contracts subject to the netting contact into two

categories--those that clearly may be netted and those that may not--is

acceptable provided that the banking organization's legal opinions

conclude that the contracts that do not qualify for netting treatment

are legally severable from the master netting contract and that such

severance will not undermine the enforceability of the netting contract

for the remaining qualifying contracts.

Conclusions. The Board has retained the proposed language that

legal opinions must represent that netting would be enforceable in all

relevant jurisdictions. In response to commenters' assertions that the

standard for this type of legal opinion is too high, the Board notes

that use of the word ``would'' in the capital rules does not

necessarily mean that the legal opinions must also use the word

``would'' or that enforceability must be determined to be an absolute

certainty. The intent, rather, is for banking organizations to secure a

legal opinion concluding that there is a high degree of certainty that

the netting contract will survive a legal challenge in any applicable

jurisdiction. The degree of certainty should be apparent from the

reasoning set out in the opinion.

The Board notes that the requirement for legal opinions to conclude

that netting contracts must create a single legal obligation applies

only to those individual contracts that are covered by, and included

under, the netting contract for capital purposes. As discussed above, a

netting contract may include individual contracts that do not qualify

for netting treatment, provided that these individual contracts are

legally severable from the contracts to be netted for capital purposes.

Institutions generally must include all contracts covered by a

qualifying netting contract in calculating the current exposure of that

netting contract. In the event a netting contract covers transactions

that are normally excluded from the risk-based ratio calculation--for

example, exchange rate contracts with an original maturity of fourteen

calendar days or less or instruments traded on exchanges that require

daily payment of variation margin--an institution may choose to either

include or exclude all mark-to-market values of such contracts when

determining net current exposure, but this choice must be followed

consistently.

Collateral

The final rule permits, subject to certain conditions, institutions

to take into account qualifying collateral when assigning the credit

equivalent amount of a netting contract to the appropriate risk weight

category in accordance with the procedures and requirements currently

set forth in the Board's risk-based capital guidelines. The Board has

added language to the final rule clarifying that collateral must be

legally available to cover the credit exposure of the netting contract

in the event of default. For example, the collateral may not be pledged

solely against one individual contract subject to the master netting

contract. The legal availability of the collateral must be addressed in

the legal opinions.

Walkaway Clauses

The Board has considered the suggestion made by some commenters of

a phase-out period for outstanding contracts with walkaway clauses. The

Board continues to believe that walkaway clauses do not reduce credit

risk. Accordingly, the final rule retains the provision that bilateral

netting contracts with walkaway clauses are not eligible for netting

treatment for risk-based capital purposes and does not provide for a

phase-out period.

Novation

The proposal required all netting contracts, including netting by

novation agreements, to be supported by written legal opinions. The

Board does not agree with commenters that a grandfathering period for

outstanding novation agreements is needed. Rather, the Board continues

to believe that all netting contracts must be held to the same

standards in order to promote certainty as to the legal enforceability

of the contracts and to decrease the risks faced by counterparties in

the event of default. Under the final rule, a netting by novation

agreement must meet the requirements for a qualifying bilateral netting

contract.

Other Issues

The Board has considered all of the other issues raised by

commenters. With regard to documentation, the Board reiterates that, as

with all provisions of risk-based capital, a banking organization must

maintain in its files appropriate documentation to support any

particular capital treatment including netting of rate contracts.

Appropriate documentation typically would include a copy of the

bilateral netting contract, supporting legal opinions, and any related

translations. The documentation should be available to examiners for

their review.

The Board recognizes commenters' concerns that the proposed rule

was limited specifically to interest and exchange rate contracts. The

Board notes that both the Basle Accord and the Board's risk-based

capital guidelines currently do not address derivatives contracts other

than rate contracts. This final rule does not attempt to go beyond the

scope of the existing risk-based capital framework and applies only to

netting contracts encompassing interest rate and foreign exchange rate

contracts. The Board, however, notes that the Basle Supervisors'

Committee issued a proposal for public comment in July 1994 to amend

the Basle Accord that explicitly would set forth the risk-based capital

treatment for other types of derivative transactions, such as

commodity, precious metal, and equity contracts. In this regard, the

Board issued a similar proposal, based on the Basle Supervisors'

Committee proposal, to amend its risk-based capital guidelines (59 FR

43508, August 24, 1994).

Until the Basle Accord has been revised and the Board's risk-based

capital rules have been amended to encompass commodity, precious metal,

and equity derivative contracts, the Board, rather than automatically

disqualifying from capital netting treatment an entire netting contract

that includes non-rate-related transactions, will permit institutions

to apply the following treatment. In determining the current exposure

of otherwise qualifying netting contracts that include non-rate-related

contracts, institutions will be permitted to net the positive and

negative mark-to-market values of the included interest and exchange

rate contracts, while severing the non-rate-related contracts and

treating them for risk-based capital purposes as individual contracts

that are not subject to the master netting contract. (This treatment is

similar to the treatment applied to a netting contract that includes

contracts in jurisdictions where the enforceability of netting is not

supported by legal opinion. With non-rate-related contracts, however,

legal opinions on severability are not required.)

The Board notes that the regulatory language with regard to the

calculation of potential future exposure remains essentially the same

as that proposed. The Board has clarified an underlying premise of the

current exposure method for calculating credit exposure as set forth in

the Basle Accord, that is, the add-on for potential future exposure

must be calculated based on the effective, rather than the apparent,

notional principal amount and the notional amount an institution uses

will be subject to examiner review.9

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\9\The notional amount is, generally, a stated reference amount

of money used to calculate payment streams between the

counterparties. In the event that the effect of the notional amount

is leveraged or enhanced by the structure of the transaction,

institutions must use the actual, or effective, notional amount when

determining potential future exposure.

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Regulatory Flexibility Act Analysis

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

Board hereby certifies that this final rule will not have a significant

impact on a substantial number of small business entities. Accordingly,

a regulatory flexibility analysis is not required.

Paperwork Reduction Act and Regulatory Burden

The Board has determined that this final rule will not increase the

regulatory paperwork burden of banking organizations pursuant to the

provisions of the Paperwork Reduction Act (44 U.S.C. 3501 et seq.).

Section 302 of the Riegle Community Development and Regulatory

Improvement Act of 1994 (Pub. L. 103-325, 108 Stat. 2160) provides that

the federal banking agencies must consider the administrative burdens

and benefits of any new regulation that imposes additional requirements

on insured depository institutions. Section 302 also requires such a

rule to take effect on the first day of the calendar quarter following

final publication of the rule, unless the agency, for good cause,

determines an earlier effective date is appropriate.

The new capital rule imposes certain requirements on depository

institutions that wish to net the current exposures of their rate

contracts for purposes of calculating their risk-based capital

requirements. For these institutions, any burden of complying with the

requirements of netting under a legally enforceable netting contract

and obtaining the necessary legal opinions should be outweighed by the

benefits associated with a lower capital requirement. The new rule will

not affect institutions that do not wish to net for capital purposes.

For these reasons, the Board has determined that an effective date of

December 31, 1994 is appropriate, in order to allow banking

organizations to take advantage of netting in their year-end

statements, if they so desire. For these same reasons, in accordance

with 5 U.S.C. 553(d)(3) the Board finds there is good cause not to

follow the 30-day notice requirements of 5 U.S.C. 553(d) and to make

the rule effective on December 31, 1994.

List of Subjects

12 CFR Part 208

Accounting, Agriculture, Banks, banking, Branches, Capital

adequacy, Confidential business information, Crime, Currency, Federal

Reserve System, Mortgages, Reporting and recordkeeping requirements,

Securities, State member banks.

12 CFR Part 225

Administrative practice and procedure, Banks, banking, Capital

adequacy, Federal Reserve System, Holding companies, Reporting and

recordkeeping requirements, Securities.

Authority and Issuance

For the reasons set out in the preamble, parts 208 and 225 of

chapter II of title 12 of the Code of Federal Regulations are amended

as set forth below.

PART 208--MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL

RESERVE SYSTEM (REGULATION H)

1. The authority citation for part 208 is revised to read as

follows:

Authority: 12 U.S.C. 36, 248(a) and 248(c), 321-338a, 371d, 461,

481-486, 601, 611, 1814, 1823(j), 1828(o), 1831o, 1831p-1, 3105,

3310, 3331-3351 and 3906-3909; 15 U.S.C. 78b, 78l(b), 78l(g),

78l(i), 78o-4(c)(5), 78q, 78q-1 and 78w; 31 U.S.C. 5318.

2. Appendix A to part 208 is amended by revising:

a. Section III.E.2.;

b. Section III.E.3;

c. Section III.E.5.;

d. The last heading and two subsequent paragraphs of Attachment IV;

and

e. Attachment V.

The revisions read as follows:

Appendix A to Part 208--Capital Adequacy Guidelines for State Member

Banks: Risk-Based Measure

* * * * *

III. * * *

E. * * *

12. Calculation of credit equivalent amounts. a. The credit

equivalent amount of an off-balance-sheet rate contract that is not

subject to a qualifying bilateral netting contract in accordance

with section III.E.5. of this appendix A is equal to the sum of (i)

the current exposure (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.

b. 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 that mark-to-market value. If the mark-to-

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

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

currency or currencies specified in the contract, and should reflect

changes in the relevant rates, as well as counterparty credit

quality.

c. The potential future credit exposure of a contract, including

a contract with a negative mark-to-market value, is estimated by

multiplying the notional principal amount of the contract by a

credit conversion factor. Banks should, subject to examiner review,

use the effective rather than the apparent or stated notional amount

in this calculation. The conversion factors are:

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

Interest Exchange

rate rate

Remaining maturity contracts contracts

(percent) (percent)

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

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

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

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

d. Examples of the calculation of credit equivalent amounts for

these instruments are contained in Attachment V of this appendix A.

e. Because exchange rate contracts involve an exchange of

principal upon maturity, and exchange rates are generally more

volatile than interest rates, higher conversion factors have been

established for foreign exchange rate contracts than for interest

rate contracts.

f. 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 exposure on these contracts is evaluated solely on

the basis of their mark-to-market values.

3. Risk weights. Once the credit equivalent amount for an

interest rate or exchange rate contract has been determined, that

amount is assigned to the risk weight category appropriate to the

counterparty, or, if relevant, to the guarantor or the nature of any

collateral.49 However, the maximum weight that will be applied

to the credit equivalent amount of such instruments is 50 percent.

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\4\9For interest and exchange rate contracts, sufficiency of

collateral or guarantees is determined by the market value of the

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

equivalent amount. Collateral and guarantees are subject to the same

provisions noted under section III.B. of this appendix A. Collateral

held against a netting contract is not recognized for capital

purposes unless it is legally available to support the single legal

obligation created by the netting contract.

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* * * * *

5. Netting. a. For purposes of this appendix A, netting refers

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

the determination of 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 rate contracts is recognized for purposes of

calculating the credit equivalent amount provided that:

i. The netting is accomplished under a written netting contract

that creates a single legal obligation, covering all included

individual contracts, with the effect that the bank would have a

claim to receive, or obligation to pay, only the net amount of the

sum of the positive and negative mark-to-market values on included

individual contracts in the event that a counterparty, or a

counterparty to whom the contract has been validly assigned, fails

to perform due to any of the following events: Default, insolvency,

liquidation, or similar circumstances.

ii. The bank obtains a written and reasoned legal opinion(s)

representing that in the event of a legal challenge--including one

resulting from default, insolvency, liquidation, or similar

circumstances--the relevant court and administrative authorities

would find the bank's exposure to be such a net amount under:

1. The law of the jurisdiction in which the counterparty is

chartered or the equivalent location in the case of noncorporate

entities, and if a branch of the counterparty is involved, then also

under the law of the jurisdiction in which the branch is located;

2. The law that governs the individual contracts covered by the

netting contract; and

3. The law that governs the netting contract.

iii. The bank establishes and maintains procedures to ensure

that the legal characteristics of netting contracts are kept under

review in the light of possible changes in relevant law.

iv. The bank maintains in its files documentation adequate to

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

bilateral netting contract and necessary legal opinions.

b. A contract containing a walkaway clause is not eligible for

netting for purposes of calculating the credit equivalent

amount.50

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\5\0A walkaway clause is a provision in a netting contract that

permits a non-defaulting counterparty to make lower payments than it

would make otherwise under the contract, or no payment at all, to a

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

the estate of the defaulter is a net creditor under the contract.

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c. 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 Federal Reserve. The Federal Reserve may determine that a bank's

files are inadequate or that a netting contract, or any of its

underlying individual contracts, may not be legally enforceable

under any one of the bodies of law described in paragraph 5.a.ii.1.

through 5.a.ii.3. of section III of this appendix A. If such a

determination is made, the netting contract may be disqualified from

recognition for risk-based capital purposes or underlying individual

contracts may be treated as though they are not subject to the

netting contract.

d. The credit equivalent amount of rate contracts that are

subject to a qualifying bilateral netting contract is calculated by

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

the sum of the estimates of the potential future credit exposures on

all individual contracts subject to the netting contract, estimated

in accordance with section III.E.2. of this appendix A.51

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\5\1For purposes of calculating potential future credit exposure

to a netting counterparty 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

falling due on each value date in each currency. The reason for this

is that offsetting contracts in the same currency maturing on the

same date will have lower potential future exposure as well as lower

current exposure.

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e. The current exposure of the netting contract is determined by

summing all positive and negative mark-to-market values of the

individual contracts included in the netting contract. If the net

sum of the mark-to-market values is positive, then the current

exposure of the netting contract is equal to that sum. If the net

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

current exposure of the netting contract is zero. The Federal

Reserve may determine that a netting contract qualifies for risk-

based capital netting treatment even though certain individual

contracts may not qualify. In such instances, the nonqualifying

contracts should be treated as individual contracts that are not

subject to the netting contract.

f. In the event a netting contract covers contracts that are

normally excluded from the risk-based ratio calculation--for

example, exchange rate contracts with an original maturity of

fourteen calendar days or less, or instruments traded on exchanges

that require daily payment of variation margin--an institution may

elect to consistently either include or exclude all mark-to-market

values of such contracts when determining net current exposure.

g. An example of the calculation of the credit equivalent amount

for rate contracts subject to a qualifying netting contract is

contained in Attachment V of this appendix A.

* * * * *

Attachment IV--Credit Conversion Factors for Off-Balance-Sheet Items

for State Member Banks

* * * * *

Credit Conversion for Interest Rate and Exchange Rate Contracts

1. The credit equivalent amount of a rate contract is the sum of

the current credit exposure of the contract and an estimate of

potential future increases in credit exposure. The current exposure

is the positive mark-to-market value of the contract (or zero if the

mark-to-market value is zero or negative). For rate contracts that

are subject to a qualifying bilateral netting contract the current

exposure is, generally, the net sum of the positive and negative

mark-to-market values of the contracts included in the netting

contract (or zero if the net sum of the mark-to-market values is

zero or negative). The potential future exposure is calculated by

multiplying the effective notional amount of a contract by one of

the following credit conversion factors, as appropriate:

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

Interest Exchange

rate rate

Remaining maturity contracts contracts

(percent) (percent)

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

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

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

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

2. No potential future exposure is calculated for single

currency interest rate swaps in which payments are made based upon

two floating indices, that is, so called floating/floating or basis

swaps. The credit exposure on these contracts is evaluated solely on

the basis of their mark-to-market value. Exchange rate contracts

with an original maturity of fourteen days or less are excluded.

Instruments traded on exchanges that require daily payment of

variation margin are also excluded.

Attachment V--Calculation of Credit Equivalent Amounts for Interest Rate and Exchange Rate-Related Transactions

for State Member Banks

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

Potential + Current = Credit

exposure ------------------------------ exposure ------------- equivalent

Type of contract ---------------- ---------------- amount

(remaining maturity) Notional Conversion Potential Current ---------------

principal factor exposure Mark-to-market exposure

(dollars) (dollars) value (dollars)

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

(1) 120-day forward

foreign exchange.... 5,000,000 .01 50,000 100,000 100,000 150,000

(2) 120-day forward

foreign exchange.... 6,000,000 .01 60,000 -120,000 0 60,000

(3) 3-year single-

currency interest-

rate swap........... 10,000,000 .005 50,000 200,000 200,000 250,000

(4) 3-year single-

currency fixed/

floating interest-

rate swap........... 10,000,000 .005 50,000 -250,000 0 50,000

(5) 7-year cross-

currency floating/

floating interest-

rate swap........... 20,000,000 .05 1,000,000 -1,300,000 0 1,000,000

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

Total.......... .............. ............ 1,210,000 .............. 300,000 1,510,000

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

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\1\ = equivalent

above) amount

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

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

(2)...................................... 60,000

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

(4)...................................... 50,000

(5)...................................... 1,000,0000

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

Total.............................. 1,210,000 ........... 0 ........... 1,210,000

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

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

current exposure is zero.

* * * * *

PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL

(REGULATION Y)

1. The authority citation for part 225 is revised to read as

follows:

Authority: 12 U.S.C. 1817(j)(13), 1818, 1831i, 1831p-1,

1843(c)(8), 1844(b), 1972(1), 3106, 3108, 3310, 3331-3351, 3907, and

3909.

2. Appendix A to part 225 is amended by revising:

a. Section III.E.2.;

b. Section III.E.3.;

c. Section III.E.5.;

d. The last heading and subsequent two paragraphs of Attachment IV;

and

e. Attachment V.

The revisions read as follows:

Appendix A to Part 225--Capital Adequacy Guidelines for Bank Holding

Companies: Risk-Based Measure

* * * * *

III. * * *

E. * * *

2. Calculation of credit equivalent amounts. a. The credit

equivalent amount of an off-balance sheet rate contract that is not

subject to a qualifying bilateral netting contract in accordance

with section III.E.5. of this appendix A is equal to the sum of (i)

the current exposure (sometimes referred to as the replacement cost)

of the contract; and an (ii) estimate of the potential future credit

exposure over the remaining life of the contract.

b. 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 that mark-to-market value. If the mark-to-

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

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

currency or currencies specified in the contract, and should reflect

changes in the relevant rates, as well as counterparty credit

quality.

c. The potential future credit exposure of a contract, including

a contract with a negative mark-to-market value, is estimated by

multiplying the notional principal amount of the contract by a

credit conversion factors. Banking organizations should, subject to

examiner review, use the effective rather than the apparent or

stated notional amount in this calculation. The conversion factors

are:

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

Interest Exchange

rate rate

Remaining maturity contracts contracts

(percent) (percent)

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

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

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

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

d. Examples of the calculation of credit equivalent amounts for

these instruments are contained in Attachment V of this appendix A.

e. Because exchange rate contracts involve an exchange of

principal upon maturity, and exchange rates are generally more

volatile than interest rates, higher conversion factors have been

established for exchange rate contracts than for interest rate

contracts.

f. 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 exposure on these contracts is evaluated solely on

the basis of their mark-to-market values.

3. Risk weights. Once the credit equivalent amount for an

interest rate or exchange rate contract has been determined, that

amount is assigned to the risk weight category appropriate to the

counterparty or, if relevant, to the guarantor or the nature of any

collateral.53 However, the maximum weight that will be applied

to the credit equivalent amount of such instruments is 50 percent.

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

\5\3 For interest and exchange rate contracts, sufficiency of

collateral or guarantees is determined by the market value of the

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

equivalent amount. Collateral and guarantees are subject to the same

provisions noted under section III.B. of this appendix A. Collateral

held against a netting contract is not recognized for capital

purposes unless it is legally available to support the single legal

obligation created by the netting contract.

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

* * * * *

5. Netting. a. For purposes of this appendix A, netting refers

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

the determination of 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 rate contracts is recognized for purposes of

calculating the credit equivalent amount provided that:

i. The netting is accomplished under a written netting contract

that creates a single legal obligation, covering all included

individual contracts, with the effect that the organization would

have a claim to receive, or obligation to receive or pay, only the

net amount of the sum of the positive and negative mark-to-market

values on included individual contracts in the event that a

counterparty, or a counterparty to whom the contract has been

validly assigned, fails to perform due to any of the following

events: default, bankruptcy, liquidation, or similar circumstances.

ii. The banking organization obtains a written and reasoned

legal opinion(s) representing that in the event of a legal

challenge--including one resulting from default, bankruptcy,

liquidation, or similar circumstances--the relevant court and

administrative authorities would find the banking organization's

exposure to be such a net amount under:

1. The law of the jurisdiction in which the counterparty is

chartered or the equivalent location in the case of noncorporate

entities, and if a branch of the counterparty is involved, then also

under the law of the jurisdiction in which the branch is located;

2. The law that governs the individual contracts covered by the

netting contract; and

3. The law that governs the netting contract.

iii. The banking organization establishes and maintains

procedures to ensure that the legal characteristics of netting

contracts are kept under review in the light of possible changes in

relevant law.

iv. The banking organization maintains in its files

documentation adequate to support the netting of rate contracts,

including a copy of the bilateral netting contract and necessary

legal opinions.

b. A contract containing a walkaway clause is not eligible for

netting for purposes of calculating the credit equivalent

amount.54

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

\5\4A walkaway clause is a provision in a netting contract that

permits a non-defaulting counterparty to make lower payments than it

would make otherwise under the contract, or no payment at all, to a

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

the estate of the defaulter is a net creditor under the contract.

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

c. By netting individual contracts for the purpose of

calculating its credit equivalent amount, a banking organization

represents that it has met the requirements of this appendix A and

all the appropriate documents are in the organization's files and

available for inspection by the Federal Reserve. The Federal Reserve

may determine that a banking organization's files are inadequate or

that a netting contract, or any of its underlying individual

contracts, may not be legally enforceable under any one of the

bodies of law described in paragraph 5.a.ii.1. through 5.a.ii.3. of

section III of this appendix A. If such a determination is made, the

netting contract may be disqualified from recognition for risk-based

capital purposes or underlying individual contracts may be treated

as though they are not subject to the netting contract.

d. The credit equivalent amount of rate contracts that are

subject to a qualifying bilateral netting contract is calculated by

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

the sum of the estimates of the potential future credit exposures on

all individual contracts subject to the netting contract, estimated

in accordance with section III.E.2. of this appendix A.55

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\5\5For purposes of calculating potential future credit exposure