Risk-Based Capital Guidelines: Collateralized Transactions

DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 3

[Docket No. 94-25]

RIN 1557-AB14

Risk-Based Capital Guidelines: Collateralized Transactions

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

ACTION: Final rule.

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

this final rule to amend the risk-based capital guidelines to lower the

risk weight from 20 percent to zero percent for securities lending,

repurchase agreement transactions, certain collateralized letters of

credit, and other collateralized on- and off-balance sheet credit

exposures. This final rule is needed to ensure that the risk weight

assigned to transactions collateralized with cash or government

securities more accurately reflects the minimal operational risk and

the near absence of credit risk those transactions present. In

addition, this amendment is intended to eliminate the disparity in the

risk-based capital treatment of collateralized transactions in

international markets, enabling national banks to compete more

effectively with foreign banks, and achieves consistency with the

capital rules applied to state-chartered banks that are members of the

Federal Reserve System, and their holding companies.

EFFECTIVE DATE: December 31, 1994.

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

Office of the Chief National Bank Examiner, (202) 874-5070; Tom Rollo,

National Bank Examiner, Office of the Chief National Bank Examiner,

(202) 874-5070; Ronald Shimabukuro, Senior Attorney, Legislative and

Regulatory Activities, (202) 874-4460; or Elizabeth Milor, Financial

Economist, Economic and Regulatory Policy Analysis (202) 874-5220;

Office of the Comptroller of the Currency, Washington, DC 20219.

SUPPLEMENTARY INFORMATION:

Background and Purpose

The OCC adopted its risk-based capital guidelines in 1989 to

implement the International Convergence of Capital Measurement and

Capital Standards of July 1988, as reported by the Basle Committee on

Banking Supervision (Basle Accord). See 54 FR 4168 (January 27, 1989).

These guidelines, developed in cooperation with the Federal Deposit

Insurance Corporation (FDIC) and the Federal Reserve Board (FRB),

provide minimum capital requirements that vary primarily on the basis

of the credit risk profiles of the assets and off-balance sheet

activities of banks.

Under the present OCC risk-based capital guidelines, all

transactions collateralized by cash or government securities issued by

OECD\1\ countries are risk weighted at 20 percent.\2\ However, some

transactions collateralized with cash or near-cash assets expose banks

to significantly less credit risk than other similar transactions. The

purpose of this final rule is to amend the risk-based capital

guidelines to lower the risk weight from 20 percent to zero percent for

certain collateralized transactions that have little or no credit risk

and only minimal operational risk. This will have a beneficial effect

on banks by lowering the required capital on certain low-risk

transactions.

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\1\Organization for Economic Cooperation and Development (OECD).

Under the risk-based capital guidelines, OECD countries include

countries that are full members of the OECD plus countries that have

concluded special lending arrangements with the International

Monetary Fund (IMF) associated with the IMF's General Arrangements

to Borrow. 12 CFR part 3, appendix A, section 1(c)(16).

\2\Specifically, 12 CFR part 3, appendix A, section 3(a)(2)

assigns a 20 percent risk weight for:

(1) That portion of assets collateralized by the current market

value of securities issued or guaranteed by the United States

Government or its agencies, or the central government of an OECD

country;

(2) That portion of assets collateralized by the current market

value of securities issued or guaranteed by United States

Government-sponsored agencies;

(3) That portion of assets collateralized by the current market

value of securities issued by official multilateral lending

institutions of regional development institutions in which the

United States is a shareholder or contributing member; and

(4) Assets collateralized by cash held in a segregated deposit

account by the reporting national bank.

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Proposal

The OCC published a notice of proposed rulemaking (NPRM) on August

18, 1993 (58 FR 43822) soliciting comment on whether to permit certain

transactions collateralized by cash or OECD government securities to

qualify for the zero percent risk-weight category. Specifically, the

OCC proposed that securities lending and repurchase agreement

transactions, and certain collateralized letters of credit be included

in the zero percent risk-weight category. After carefully considering

the comments received, the OCC is issuing this final rule adopting the

NPRM and including additional collateralized on- and off-balance sheet

exposures in the zero percent risk-weight category.

Discussion

In developing the risk-based capital guidelines, the FRB, FDIC and

OCC (banking agencies) initially proposed assigning transactions

collateralized by cash or OECD government securities to a 10 percent

risk-weight category. See 53 FR 8550, 8553 (March 15, 1988). Under the

Basle Accord, signatory countries have some latitude in assigning risk

weights to claims collateralized by cash or OECD government securities.

Specifically, paragraph 39 of the Basle Accord provides:

In view of the varying practices among banks in different

countries for taking collateral and different experiences of the

stability of physical or financial collateral values, it has not

been found possible to develop a basis for recognising collateral

generally in the weighting system. The more limited recognition of

collateral will apply only to loans secured against cash or against

securities issued by OECD central governments and specified

multilateral development banks. These will attract the weight given

to the collateral (i.e. a zero or a low weight).

When the banking agencies adopted the final risk-based capital

guidelines, they eliminated the 10 percent risk-weight category in the

interest of simplicity. See 54 FR 4168 (January 27, 1989). To limit the

types of claims qualifying for the zero percent risk-weight category,

the banking agencies assigned claims collateralized by cash and OECD

central government securities, including securities unconditionally

guaranteed by the U.S. government, to the lowest non-zero risk weight,

which is 20 percent. See 54 FR 4173, 4174 (January 27, 1989).

Comments

The comment period for the NPRM closed on September 17, 1993.

Twenty-four comments were received. The commenters represented a

diverse group of banking interests consisting of 14 banks and bank

holding companies, one banking subsidiary, four bankers' associations

or trade groups, one federally sponsored agency, and four other

interested parties. All commenters generally supported reducing both

the risk weight applied to the transactions included in the NPRM and

the proposed collateral margin requirement. Most commenters also

supported extending the zero percent risk weight to a broader range of

transactions.

The OCC invited comment on all aspects of the NPRM and posed four

specific questions. The questions and the responses follow.

Question 1: Should additional requirements be established to ensure

that only very low-risk transactions are assigned to the zero percent

risk-weight category? For example, should the zero percent risk weight

be available only to institutions that have appropriate management and

operating systems in place?

Eleven commenters addressed this question, all indicating that they

consider additional regulatory requirements unnecessary. Most

commenters expressed the view that operating systems are best

supervised through the examination process. One commenter thought that

new requirements were not needed, because of the new annual audit

requirement established under the Federal Deposit Insurance Corporation

Improvement Act of 1991 (FDICIA) (Pub. L. 102-242).

Question 2: Should the OCC establish a specific minimum positive

margin required for collateralized transactions to qualify for the zero

percent risk weight for those credit exposures with market values that

experience normal volatility? Should the OCC require that national

banks maintain margins in excess of this minimum for those exposures

with more volatile market values?

A number of commenters indicated that the OCC should not establish

a specific margin requirement under the risk-based capital guidelines.

Eleven commenters cited the proposed daily mark-to-market and positive

collateral margin requirements as sufficient for ensuring safety and

soundness. The majority of these commenters stated that specific

regulatory requirements could disrupt normal market operations, because

the collateral margins are negotiated as part of the contract for many

collateralized transactions. Two commenters stated that the Federal

Financial Institutions Examination Council (FFIEC) guidelines provide

adequate guidance for banks participating in the securities lending

markets.\3\ Four commenters suggested that, instead of establishing a

collateral margin requirement, the OCC should use pro rata risk

weighting, assigning only that portion of a transaction that has

sufficient collateral to the zero percent risk-weight category.

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\3\These guidelines were issued to national banks by the OCC in

Banking Circular 196, dated May 7, 1985.

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Question 3: For some securities lending transactions, banks

indemnify their clients against losses that could occur if the market

value of the lent security exceeds that of the collateral provided.

Should the OCC permit transactions with indemnification agreements that

cover additional losses to qualify for the zero percent risk weight?

Four commenters supported excluding from the zero percent risk

weight those collateralized transactions where a bank indemnifies a

client against losses other than those arising from collateral

shortages caused by changes in market values. However, most commenters

suggested that indemnification agreements that cover additional losses

should not exclude a collateralized transaction from the zero percent

risk-weight category. Four commenters supported allowing the zero

percent risk weight for transactions in which a bank indemnifies its

client against all losses, if the client continuously maintains a

positive collateral margin with the bank or its agent, or if a bank

acts only as agent in a transaction.

Question 4: At this time, the OCC believes that this proposal would

apply only to securities lending transactions, repurchase agreements,

and certain collateralized financial guarantees. The OCC invites

comment as to whether, in the current market place, there are other

collateralized transactions that expose banks to minimal risk that have

contracts structured to meet the collateral requirements of this

proposal. The OCC is specifically interested in comments concerning (a)

bank participation in collateralized markets for swap agreements and

(b) bank issued collateralized letters of credit other than financial

guarantees.

Eighteen commenters supported including all transactions

collateralized with Treasury securities in the zero percent risk-weight

category. Seven commenters supported including collateralized swap

agreements, and three commenters supported extending the zero percent

risk weight to all collateralized letters of credit. One commenter

suggested that the OCC should assign all affiliate transactions,

regardless of collateral, to the zero percent risk weight, because such

transactions expose banks to the same insignificant credit risk as the

collateralized transactions mentioned in the NPRM.

In addition to the questions presented in the NPRM, the commenters

raised other significant issues. Two commenters mentioned that some

otherwise qualifying collateralized transactions involving foreign

jurisdictions would not qualify for the zero percent risk weight under

the NPRM. For example, the NPRM discussed a requirement that a bank

receiving collateral in the form of OECD government securities must

have a perfected interest in those securities. If a bank counterparty

operates in a foreign jurisdiction, these commenters noted that it may

not be possible to obtain a perfected security interest for that

transaction.

Two commenters recommended that transactions collateralized with

either irrevocable letters of credit or government agency securities

should be eligible for the zero percent risk-weight category, because

these types of collateral provide the same degree of protection as

government securities.

Twelve commenters urged the OCC to modify the NPRM to parallel that

of the FRB, in order to maintain parity of capital treatment for

collateralized transactions.

After careful consideration of all the comments received, the OCC

adopts this final rule to permit national banks to assign to the zero

percent risk-weight category the off-balance sheet transactions

proposed in the NPRM. These off-balance sheet transactions include

securities lending and repurchase agreement transactions,

collateralized letters of credit that serve as financial guarantees,

and certain collateralized credit exposures arising from off-balance

sheet transactions. In addition, based on the comments received, the

final rule allows national banks to include in the zero percent risk-

weight category certain loans and other on-balance sheet credit

exposures that are collateralized fully by cash or OECD government

securities.

To qualify for a zero percent risk weight, the credit exposure must

satisfy the following criteria:

(1) The bank's counterparty must maintain a positive collateral

margin relative to the amount of the bank's exposure to that

counterparty;

(2) The collateral either must be cash or securities issued or

guaranteed by OECD central governments or U.S. government agencies;

(3) The bank must maintain control over the collateral. Cash

collateral must be held on deposit by the bank or by a third-party for

the account of the bank. OECD government securities posted by a

counterparty must be held by the bank or by a third-party acting on

behalf of the bank; and

(4) Where the bank is acting as agent for a customer in a

transaction involving the lending or sale of securities, and the

transaction is collateralized by cash or OECD government securities

delivered to the bank, then (a) any bank indemnification is limited to

no more than the difference between the market value of the securities

and the collateral received, and (b) any reinvestment risk associated

with that collateral is borne by the customer.

Collateral

Collateralized transactions differ from other types of transactions

in that the bank's credit exposure is supported by a pledge of

collateral. The degree of protection afforded by the collateral depends

on the quality of the collateral and the legal effectiveness of the

pledge.

This final rule limits the types of qualifying collateral to cash

(both domestic and foreign currency) and OECD government securities.

This limitation preserves the quality of the collateral because both

cash and OECD government securities are liquid and readily marketable.

With respect to the legal effectiveness of the pledge of collateral,

this final rule requires that the bank must maintain control over the

collateral. This requirement is different from the NPRM. First, this

final rule does not require a bank to obtain a perfected security

interest for OECD government securities pledged as collateral. This

change was made in response to the comment that the perfection of a

security interest may not be possible in certain transactions involving

foreign jurisdictions. While the OCC believes that a perfected security

interest generally should be obtained when possible, the OCC has

considered this issue and shares the commenter's concern. As a result

this final rule does not require the bank to obtain a perfected

security interest in the collateral.

Second, the OCC believes that safe and sound banking practice

requires that a bank exercise control over the collateral in order to

protect the interest of the bank. If the collateral consists of cash,

then the cash must be held on deposit by the bank or by a third-party

for the account of the bank. To qualify for a zero percent risk weight,

a third-party collateral arrangement must adequately insulate the bank

from the credit exposure, and not introduce other significant risks.

Similarly, if the collateral consists of OECD government

securities, then the bank must maintain control of the OECD government

securities. In some instances, a bank may want to maintain actual

possession over the OECD government securities. This final rule,

however, makes clear that a third party, acting on behalf of the bank,

may hold and administer the collateral for the bank.

A national bank may assign to the zero percent risk-weight category

only those credit exposures for which the bank's counterparty maintains

a positive collateral margin. In addition, if any component of a

collateralized transaction is denominated in foreign exchange, then

fluctuations in exchange rates also could result in changes in market

value. Therefore, to qualify for the zero percent risk-weight category,

a bank must ensure that its counterparty maintains a positive

collateral margin with respect to fluctuations in interest rates,

foreign exchange rates, or other market factors.

Bank Indemnification

This final rule clarifies an issue raised by the commenters. Where

a bank is acting as agent for a customer in a securities lending

transaction, the transaction qualifies for the zero percent risk-weight

category provided that the bank's indemnification is limited. Under

this final rule, any indemnification extended by a bank must be limited

to no more than the difference between the market value of the

securities lent and the market value of the collateral received, and

any reinvestment risk associated with the collateral (either cash or

OECD government securities) must be borne by the customer.

International Comparability of Capital Standards

In re-examining the capital treatment of transactions

collateralized with cash and OECD government securities, the OCC noted

that most foreign supervisors subscribing to the Basle Agreement assign

the zero percent risk weight to transactions collateralized with cash

or OECD government securities. Reassigning these transactions to the

zero percent risk-weight category under U.S. standards eliminates the

disparate capital treatment.

Effective Date

Section 302 of the Riegle Community Development and Regulatory

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

provides that the federal banking agencies must consider the

administrative burdens and benefits of any new regulations that impose

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. Similarly, the Administrative Procedure Act requires a 30-

day delayed effective date, unless the rule either relieves a

restriction or the agency finds good cause. 5 U.S.C. 553(d)(1) and (3).

This final rule amend the risk-based capital guidelines to lower

the risk weight from 20 percent to zero percent for certain

transactions collateralized with cash or government securities. This

final rule revises the risk weights to more accurately reflect the

minimal operational risks of these transactions, corrects the disparity

in the risk-based capital treatment of collateralized transactions in

international markets, and provides consistency with the capital rules

applied to state-chartered banks that are members of the Federal

Reserve System, and their holding companies. The OCC believes that

these benefits far outweigh any burden of complying with the

requirements of this final rule. For these reasons, the OCC determines

that, pursuant to section 302 of RCDRIA and 5 U.S.C. 553(d)(1) and (3),

there is sufficient good cause to provide for an effective date of

December 31, 1994. A year-end effective date allows banks to take

advantage of this final rule for the first quarter of the new calendar

year. Delay in implementation of this final rule, to the next calendar

quarter would be unnecessary and contrary to the public interest

because compliance would be more difficult and costly, and could

require additional accounting adjustments and disclosures.

Regulatory Flexibility Act

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

hereby certified that this final rule will not have a significant

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

a regulatory flexibility analysis is not required.

This final rule benefits all national banks by assigning to the

zero percent risk-weight category certain collateralized transactions,

and by promoting competitive equality with other financial

institutions. While the exact volume of collateralized transactions is

unknown, the OCC believes that assigning these types of collateralized

transactions to the zero percent risk-weight category will not

significantly impact national banks, regardless of size.

Executive Order 12866

The OCC has determined that this final rule is not a significant

regulatory action under Executive Order 12866.

List of Subjects in 12 CFR Part 3

Administrative practice and procedure, Capital, National banks,

Reporting and recordkeeping requirements, Risk.

Authority and Issuance

For the reasons set out in the preamble, appendix A of title 12,

chapter I, part 3 of the Code of Federal Regulations is amended as set

forth below.

PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES

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

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

note, 3907, and 3909.

2. In appendix A to part 3, section 3 is amended by adding a new

paragraph (a)(1)(viii), revising paragraph (a)(2)(iv), removing

(a)(2)(xii), and redesignating paragraph (a)(2)(xiii) as (a)(2)(xii) to

read as follows:

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

* * * * *

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

Off-Balance Sheet Items.

* * * * *

(a) * * *

(1) * * *

(viii) That portion of assets and off-balance sheet transactions

collateralized by cash or securities issued or directly and

unconditionally guaranteed by the United States Government or its

agencies, or the central government of an OECD country, provided

that:9a

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\9\aAssets and off-balance sheet transactions collateralized by

securities issued or guaranteed by the United States Government or

its agencies, or the central government of an OECD country include,

but are not limited to, securities lending transactions, repurchase

agreements, collateralized letters of credit, such as reinsurance

letters of credit, and other similar financial guarantees. Swaps,

forwards, futures, and options transactions are also eligible, if

they meet the collateral requirements. However, the OCC may at its

discretion require that certain collateralized transactions be risk

weighted at 20 percent if they involve more than minimal risk.

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(A) The bank maintains control over the collateral:

(1) If the collateral consists of cash, the cash must be held on

deposit by the bank or by a third-party for the account of the bank;

(2) If the collateral consists of OECD government securities,

then the OECD government securities must be held by the bank or by a

third-party acting on behalf of the bank;

(B) The bank maintains a daily positive margin of collateral

fully taking into account any change in the market value of the

collateral held as security;

(C) Where the bank is acting as a customer's agent in a

transaction involving the loan or sale of securities that is

collateralized by cash or OECD government securities delivered to

the bank, any obligation by the bank to indemnify the customer is

limited to no more than the difference between the market value of

the securities lent and the market value of the collateral received,

and any reinvestment risk associated with the collateral is borne by

the customer; and

(D) The transaction involves no more than minimal risk.

(2) * * *

(iv) That portion of assets collateralized by cash or by

securities issued or directly and unconditionally guaranteed by the

United States Government or its agencies, or the central government

of an OECD country, that does not qualify for the zero percent risk-

weight category.

* * * * *

Dated: December 21, 1994.

Eugene A. Ludwig,

Comptroller of the Currency.

[FR Doc. 94-31729 Filed 12-27-94; 8:45 am]

BILLING CODE 4810-33-P