Risk-Based Capital Standards; Bilateral Netting Requirements

DEPARTMENT OF THE TREASURY

12 CFR Part 3

[Docket No. 94-24]

RIN 1557-AB14

Office of Thrift Supervision

12 CFR Part 567

[Docket No. 94-258]

RIN 1550-AA75

Risk-Based Capital Standards; Bilateral Netting Requirements

AGENCIES: Office of the Comptroller of the Currency (OCC), Department

of the Treasury and the Office of Thrift Supervision (OTS), Department

of the Treasury.

ACTION: Final rule.

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SUMMARY: The OCC and the OTS (the banking agencies) are amending their

respective risk-based capital standards to recognize the risk-reducing

benefits of qualifying bilateral netting contracts. On December 7,

1994, the Board of Governors of the Federal Reserve System (Board)

issued a similar final rule. 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 banks, thrifts and

savings associations (institutions or banking 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:

OCC: For issues relating to netting and the calculation of risk-

based capital ratios, Roger Tufts, Senior Economic Advisor (202/874-

5070), Office of the Chief National Bank Examiner. For legal issues,

Eugene H. Cantor, Senior Attorney, Securities & Corporate Practices

(202/874-5210), or Ronald Shimabukuro, Senior Attorney, Legislative and

Regulatory Activities Division (202/874-4460), Office of the

Comptroller of the Currency, 250 E Street, SW., Washington, DC 20219.

OTS: John F. Connolly, Senior Program Manager, Capital Policy (202/

906-6465); Vicki Hawkins-Jones, Senior Attorney (202/906-7034),

Regulations and Legislation Division, Office of Thrift Supervision,

1700 G Street, NW., Washington, DC 20552.

SUPPLEMENTARY INFORMATION:

Background

The Basle Accord\1\ established a risk-based capital framework

which was implemented in the United States by the banking agencies 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

weight 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 Accord Committee on Banking Supervison (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 U.S. banking

agency standards provided that current exposure would be determined

individually for each rate contract entered into by an institution;

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 Basle 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 qualifying

netting arrangements 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 Basle 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 Basle 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 Banking Agencies' Proposals

On May 20, 1994, the OCC issued a joint proposal with the Board to

amend their respective risk-based capital standards (59 FR 26456) in

accordance with the Basle Supervisors' Committee's April 1993 proposal.

The OTS and the Federal Deposit Insurance Corporation (FDIC) issued

their parallel netting proposals on June 14, 1994 (59 FR 30538) and

July 25, 1994 (59 FR 37726), respectively. The banking agencies each

proposed that for capital purposes the institutions under their

supervision 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 master netting contract.

The proposals 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.\5\

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\5\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 proposals, 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 proposals, 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.\6\ The proposals

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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\6\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 proposals 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 proposals 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

proposals required an institution to establish and maintain procedures

to ensure that the legal characteristics of netting contracts would be

kept under review.

Under the proposals, the banking agencies could disqualify any or

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

the requirements of the proposals 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 proposals

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 proposals 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. On December 7, 1994, the Board which worked with the

banking agencies on the proposal, issued its version of the final rule

in 59 FR 62987 (December 7, 1994).

Comments Received

The banking agencies together received 21 public comments on their

proposed amendments. Thirteen comments were from banks, thrifts, and

bank and thrift holding companies 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 proposals, 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 institutions 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 institution 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 the banking agencies to clarify 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 proposals 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 proposals

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 proposals' 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 collateralized transactions rule proposed by the OCC in August

1993, when it is issued as a final rule. \7\

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\7\In August 1993, the OCC issued a proposed amendment to its

risk-based capital guidelines permitting certain collateralized

transactions to qualify for a zero percent risk weight (58 FR 43822,

August 18, 1993). In order to qualify for a zero percent risk

weight, an institution would need to maintain a positive margin of

qualifying collateral at all times. The collateral arrangement

should provide for immediate liquidation of the claim in the event

that a positive margin of collateral is not maintained. The Board

issued a final rule with similar provisions in December 1992 (57 FR

62180, December 30, 1992).

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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 banking agencies'

proposals 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 banking agencies would not

disqualify netting contracts in an unreasonable manner.

Approximately one-half of the commenters expressed concern that the

banking agencies' proposals specifically were 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 it

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 institutions 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 banking agencies are 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 affirms the usual and customary industry practice by

providing that institutions obtain a written and reasoned legal

opinion(s) concluding that the netting contract is enforceable in all

relevant jurisdictions. The legal opinion provisions of the final rule

are aimed at ensuring there is a substantial legal basis supporting the

legal enforceability of a netting contract before reducing a banking

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

legal opinion, as that phrase is commonly understood by the legal

community in the United States, can provide such a legal basis. A

memorandum of law may be consistent with prudent banking practices

provided it addresses all of the relevant issues in a credible manner

and represents that netting is enforceable in all relevant

jurisdictions.

As discussed in the proposals, legal opinions on bilateral netting

contracts are prepared by either an outside law firm or an

institution's in-house counsel, and need to (i) address all relevant

jurisdictions, and (ii) conclude with a high degree of certainty that

in the event of a legal challenge the banking institution'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.

Institutions sometimes use general, standardized opinions to help

support the legal enforceability of their bilateral netting contracts.

For example, a banking institution 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 memorandum of law

is supplemented by an opinion that addresses issues such as the

enforceability of the underlying contracts, choice of law, and

severability.

For example, 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 generally

inadequate to support a netting contract. Banking institutions

supplement the generic opinion 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, institutions

following prudent banking practices insure that legal opinions address

the validity and enforceability of the entire netting contract. This

generally involves a legal conclusion 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.

A critical aspect of a qualified 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

institutions independent of the head office, prudent banking practices

include ensuring 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 banking agencies recognize that for some multibranch netting

contracts an institution 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 banking agencies concur with commenters that in such situations it

may be inefficient for institutions to renegotiate netting contracts to

ensure they cover only those jurisdictions where netting is clearly

enforceable. 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 are 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 consistent with prudent banking

practices provided that the banking institution'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 banking agencies have retained the proposed language concerning

legal opinions, which is consistent with the prudent industry practice

of obtaining legal opinions representing that netting is enforceable in

all relevant jurisdictions. In response to commenters' assertions that

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

agencies note 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 institutions to continue

to secure a legal opinion indicating with a high degree of certainty

that a 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.

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. Legal opinions obtained by banking

institutions under this final rule will address only those individual

contracts that are covered by, and included under, the netting contract

for capital purposes, e.g., not severed contracts.

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, 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. Examples of such contracts

include 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.

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 each banking agencies' risk-based capital standards. The

banking agencies have 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 banking agencies have considered the suggestion made by some

commenters of a phase-out period for outstanding contracts with

walkaway clauses. The banking agencies continue 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

banking agencies do not agree with commenters that a grandfathering

period for outstanding novation agreements is needed. Rather, the

banking agencies continue 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 banking agencies have considered all of the other issues raised

by commenters. With regard to documentation, the banking agencies

reiterate that, as with all provisions of risk-based capital, a banking

institution 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 banking agencies recognize commenters' concerns that the

proposed rule was limited specifically to interest and exchange rate

contracts. The banking agencies note that both the Basle Accord and

their risk-based capital standards 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 banking agencies, however, note

that the Basle Supervisors' Committee issued a proposal for public

comment in July 1994 to amend the Basle Accord which 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 OCC issued a similar proposal, based on

the Basle Supervisors' Committee proposal, to amend its risk-based

capital standards (59 FR 45243, September 1, 1994).\8\ The OTS intends

to issue a similar proposal in the near future.

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\8\The Board and the FDIC have issued similar proposed rules (59

FR 43508, August 24, 1994 and 59 FR 52714, October 19, 1994,

respectively).

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Until the Basle Accord has been revised and the banking agencies'

risk-based capital rules have been amended to encompass commodity,

precious metal, and equity derivative contracts, the banking agencies,

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 banking agencies note that the regulatory language with regard

to the calculation of potential future exposure remains essentially the

same as that proposed. The banking agencies have 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. For example, a stated

notional amount of one million dollars with payments calculated at

2X Libor, would have an effective notional amount of two million

dollars.

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Regulatory Flexibility Act Analysis

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

banking agencies hereby certify 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.

Executive Order 12866

The OCC and the OTS have determined that this final rule is not a

significant regulatory action as defined in Executive Order 12866.

Effective Date

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 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 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. This final rule

will not affect institutions that do not wish to net for capital

purposes. For these reasons, the banking agencies have determined that

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

December 31, 1994. A year-end effective date allows banking

institutions to take advantage of netting in their year-end statements,

if they so desire. 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.

List of Subjects

12 CFR Part 3

Administrative practice and procedure, Capital, National banks,

Reporting and recordkeeping requirements, Risk.

12 CFR Part 567

Capital, Reporting and recordkeeping requirements, Savings

associations.

Comptroller of the Currency

12 CFR Chapter I

Authority and Issuance

For the reasons set out in the preamble, part 3 of title 12,

chapter I 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 is revised 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, paragraph (c)(15) of section 1 is

removed, paragraphs (c)(16) through (c)(29) are redesignated as

paragraphs (c)(15) through (c)(28), and a new paragraph (c)(29) is

added to read as follows:

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

Section 1. Purpose, Applicability of Guidelines, and Definitions.

* * * * *

(c) * * *

(29) Walkaway clause means a provision in a bilateral netting

contract that permits a nondefaulting counterparty to make a lower

payment than it would make otherwise under the bilateral netting

contract, or no payment at all, to a defaulter or the estate of a

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

net creditor under the bilateral netting contract.

* * * * *

3. In appendix A, paragraph (b)(5) of section 3 is revised to read

as follows:

* * * * *

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

Off-Balance Sheet Items.

* * * * *

(b) * * *

(5) Off-balance sheet contracts--interest rate and foreign

exchange rate contracts. (i) Calculation of credit equivalent

amount. The credit equivalent amount of an off-balance sheet

interest rate or foreign exchange rate contract equals the sum of

the current credit exposure (also referred to as the replacement

cost) and the potential future credit exposure of the off-balance

sheet rate contract. The calculation of credit equivalent amounts is

measured in U.S. dollars, regardless of the currency or currencies

specified in the off-balance sheet rate contract.

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

single off-balance sheet rate contract is determined by the mark-to-

market value of the off-balance sheet rate contract. If the mark-to-

market value is positive, then the current exposure equals that

mark-to-market value. If the mark-to-market value is zero or

negative, the current exposure is zero. However, in determining its

current credit exposure for multiple off-balance sheet rate

contracts executed with a single counterparty, a bank may net

positive and negative mark-to-market values of off-balance sheet

rate contracts if subject to a bilateral netting contract as

provided by section 3(b)(5)(ii) of this appendix A. If the net mark-

to-market value is positive, the current credit exposure equals that

net mark-to-market value. If the net mark-to-market value is zero or

negative, the current exposure is zero.

(B) Potential future credit exposure. The potential future

credit exposure of an off-balance sheet rate contract, including a

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

multiplying the notional principal\19\ by a credit conversion

factor. Banks, subject to examiner review, should use the effective

rather than the apparent or stated notional amount in this

calculation. The credit conversion factors are:\20\

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

\19\For purposes of calculating 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.

\20\No potential future credit exposure is calculated for single

currency interest rate swaps in which payments are made based upon

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

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

of the current credit exposure.

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

Foreign

Interest exchange

Remaining maturity rate rate

contracts contracts

(percents) (percents)

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

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

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

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

(ii) Off-balance sheet rate contracts subject to bilateral

netting contracts. In determining its current credit exposure for

multiple off-balance sheet rate contracts executed with a single

counterparty, a bank may net off-balance sheet rate contracts

subject to a bilateral netting contract by offsetting positive and

negative mark-to-market values, provided that:

(A) The bilateral netting contract is in writing;

(B) The bilateral netting contract is not subject to a walkaway

clause;

(C) The bilateral netting contract creates a single legal

obligation for all individual off-balance sheet rate contracts

covered by the bilateral netting contract. In effect, the bilateral

netting contract provides that the bank has a single claim or

obligation either to receive or pay only the net amount of the sum

of the positive and negative mark-to-market values on the individual

off-balance sheet contracts covered by the bilateral netting

contract. The single legal obligation for the net amount is

operative in the event that a counterparty, or a counterparty to

whom the bilateral netting contract has been validly assigned, fails

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

bankruptcy, or other similar circumstances;

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

representing, with a high degree of certainty, that in the event of

a legal challenge, including one resulting from default, insolvency,

bankruptcy, or similar circumstances, the relevant court and

administrative authorities would find the bank's exposure to be the

net amount 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, then also

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

(II) The law that governs the individual off-balance sheet rate

contracts covered by the bilateral netting contract; and

(III) The law that governs the bilateral netting contract;

(E) The bank establishes and maintains procedures to monitor

possible changes in relevant law and to ensure that the bilateral

netting contract continues to satisfy the requirements of this

section; and

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

support the netting of an off-balance sheet rate contract.\21\

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

\21\By netting individual off-balance sheet rate contracts for

the purpose of calculating its credit equivalent amount, a bank

represents that documentation adequate to support the netting of an

off-balance sheet rate contract is in the bank's files and available

for inspection by the OCC. Upon determination by the OCC that a

bank's files are inadequate or that a bilateral netting contract may

not be legally enforceable under any one of the bodies of law

described in sections 3(b)(5)(ii)(D) (I) through (III) of this

appendix A, the underlying individual off-balance sheet rate

contracts may not be netted for the purpose of this section.

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

(iii) Risk weighting. Once the bank determines the credit

equivalent amount for an off-balance sheet rate contract, it assigns

that amount to the counterparty's appropriate risk weight category

or, if relevant, to the nature of any collateral or guarantee.

Collateral held against a netting contract is not recognized for

capital purposes unless it is legally available for all contracts

included in the netting contract. However, the maximum risk weight

for the credit equivalent amount of such an off-balance sheet rate

contract is 50 percent.

(iv) Exceptions. The following off-balance sheet rate contracts

are not subject to the above calculation, and therefore, are not

part of the denominator of a national bank's risk-based capital

ratio:

(A) A foreign exchange rate contract with an original maturity

of 14 calendar days or less; and

(B) Any interest rate or foreign exchange rate contract that is

traded on an exchange requiring the daily payment of any variations

in the market value of the contract.

* * * * *

4. The table title and the introductory text to Table 3 to appendix

A are revised to read as follows:

* * * * *

Table 3--Treatment of Interest Rate and Foreign Exchange Rate Contracts

The current exposure method is used to calculate the credit

equivalent amounts of these off-balance sheet rate contracts. These

amounts are assigned a risk weight appropriate to the obligor or any

collateral or guarantee. However, the maximum risk weight is limited

to 50 percent. Multiple off-balance sheet rate contracts with a

single counterparty may be netted if those contracts are subject to

a qualifying bilateral netting contract.

* * * * *

Office of Thrift Supervision

12 CFR Chapter V

Authority and Issuance

For the reasons set out in the preamble, part 567, of chapter V,

title 12 of the Code of Federal Regulations is amended as set forth

below:

SUBCHAPTER D--REGULATIONS APPLICABLE TO ALL SAVINGS ASSOCIATIONS

1. The authority citation for part 567 continues to read as

follows:

Authority: 12 U.S.C. 1462, 1462a, 1463, 1464, 1467a, 1828

(note).

2. Section 567.6 is amended by revising paragraph (a)(2)(v) to read

as follows:

Sec. 567.6 Risk-based capital credit risk-weight categories.

(a) * * *

(2) * * *

(v) Off-balance sheet contracts; interest-rate and foreign exchange

rate contracts (Group E)--(A) Calculation of credit equivalent amounts.

The credit equivalent amount of an off-balance sheet interest rate or

foreign exchange rate contract that is not subject to a qualifying

bilateral netting contract in accordance with paragraph (a)(2)(v)(B) of

this section is equal to the sum of the current credit exposure, i.e.,

the replacement cost of the contract, and the potential future credit

exposure of the off-balance sheet rate contract. The calculation of

credit equivalent amounts is measured in U.S. dollars, regardless of

the currency or currencies specified in the off-balance sheet rate

contract.

(1) Current credit exposure. The current credit exposure of an off-

balance sheet rate contract is determined by the mark-to-market value

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

current credit exposure equals that mark-to-market value. If the mark-

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

In determining its current credit exposure for multiple off-balance

sheet rate contracts executed with a single counterparty, a savings

association may net positive and negative mark-to-market values of off-

balance sheet rate contracts if subject to a bilateral netting contract

as provided in paragraph (a)(2)(v)(B) of this section.

(2) Potential future credit exposure. The potential future credit

exposure of an off-balance sheet rate contract, including a contract

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

notional principal\9\ by a credit conversion factor. Savings

associations, subject to examiner review, should use the effective

rather than the apparent or stated notional amount in this calculation.

The conversion factors are:\10\

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

\9\For purposes of calculating 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.

\10\No potential future credit exposure is calculated for single

currency interest rate swaps in which payments are made based upon

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

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

of the current credit exposure.

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

Foreign

Interest exchange

Remaining maturity rate rate

contracts contracts

(percents) (percents)

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

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

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

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

(B) Off-balance sheet rate contracts subject to bilateral netting

contracts. In determining its current credit exposure for multiple off-

balance sheet rate contracts executed with a single counterparty, a

savings association may net off-balance sheet rate contracts subject to

a bilateral netting contract by offsetting positive and negative mark-

to-market values, provided that:

(1) The bilateral netting contract is in writing;

(2) The bilateral netting contract creates a single legal

obligation for all individual off-balance sheet rate contracts covered

by the bilateral netting contract. In effect, the bilateral netting

contract provides that the savings association has a single claim or

obligation either to receive or pay only the net amount of the sum of

the positive and negative mark-to-market values on the individual off-

balance sheet rate contracts covered by the bilateral netting contract.

The single legal obligation for the net amount is operative in the

event that a counterparty, or a counterparty to whom the bilateral

netting contract has been validly assigned, fails to perform due to any

of the following events: default, insolvency, bankruptcy, or other

similar circumstances;

(3) The savings association obtains a written and reasoned legal

opinion(s) representing, with a high degree of certainty, that in the

event of a legal challenge, including one resulting from default,

insolvency, bankruptcy or similar circumstances, the relevant court and

administrative authorities would find the savings association's

exposure to be the net amount 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, then also

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

(ii) The law that governs the individual off-balance sheet rate

contracts covered by the bilateral netting contract; and

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

(4) The savings association establishes and maintains procedures to

monitor possible changes in relevant law and to ensure that the

bilateral netting contract continues to satisfy the requirements of

this section; and

(5) The savings association maintains in its files documentation

adequate to support the netting of an off-balance sheet rate

contract.\11\

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

\11\By netting individual off-balance sheet rate contracts for

the purpose of calculating its credit equivalent amount, a savings

association represents that documentation adequate to support the

netting of an off-balance sheet rate contract is in the savings

association's files and available for inspection by the OTS. Upon

determination by the OTS that a savings association's files are

inadequate or that a bilateral netting contract may not be legally

enforceable under any one of the bodies of law described in

paragraphs (a)(2)(v)(B)(3) (i) through (iii) of this section, the

underlying individual off-balance sheet rate contracts may not be

netted for the purposes of this section.

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

(C) Walkaway clause. A bilateral netting contract that contains a

walkaway clause is not eligible for netting for purposes of calculating

the current credit exposure amount. The term ``walkaway clause'' means

a provision in a bilateral netting contract that permits a

nondefaulting counterparty to make a lower payment than it would make

otherwise under the bilateral netting contract, or no payment at all,

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

the estate of the defaulter is a net creditor under the bilateral

netting contract.

(D) Risk weighting. Once the savings association determines the

credit equivalent amount for an off-balance sheet rate contract, that

amount is assigned to the risk-weight category appropriate to the

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

guarantee. Collateral held against a netting contract is not recognized

for capital purposes unless it is legally available for all contracts

included in the netting contract. However, the maximum risk weight for

the credit equivalent amount of such off-balance sheet rate contracts

is 50 percent.

(E) Exceptions. The following off-balance sheet rate contracts are

not subject to the above calculation, and therefore, are not part of

the denominator of a savings association's risk-based capital ratio:

(1) A foreign exchange rate contract with an original maturity of

14 calendar days or less; and

(2) Any interest rate or foreign exchange rate contract that is

traded on an exchange requiring the daily payment of any variations in

the market value of the contract.

* * * * *

Dated: December 7, 1994.

Eugene A. Ludwig,

Comptroller of the Currency.

Dated: December 1, 1994.

Jonathan L. Fiechter,

Acting Director, Office of Thrift Supervision.

[FR Doc. 94-31730 Filed 12-27-94; 8:45 am]

BILLING CODE 4810-33-P AND 6720-01-P