Risk-Based Capital Standards: Derivative Transactions

SUMMARY: The OCC, the Board, and the FDIC (the banking agencies) are

amending their respective risk-based capital standards for banks and

bank holding companies (banking organizations, institutions). This

final rule implements a recent revision to the Basle Accord revising

and expanding the set of conversion factors used to calculate the

potential future exposure of derivative contracts and recognizing the

effects of netting arrangements in the calculation of potential future

exposure for derivative contracts subject to qualifying bilateral

netting arrangements. The effect of this final rule is threefold.

First, long-dated interest rate and exchange rate contracts are subject

to higher conversion factors and new conversion factors are set forth

that specifically apply to derivative contracts related to equities,

precious metals, and other commodities. Second, institutions are

permitted to recognize a reduction in potential future credit exposure

for transactions subject to qualifying bilateral netting arrangements.

Third, derivative contracts related to equities, precious metals and

other commodities may be recognized in bilateral netting arrangements

for risk-based capital purposes.

EFFECTIVE DATE: October 1, 1995.

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 and Corporate Practices (202/874-5210), or Ronald

Shimabukuro, Senior Attorney, Legislative and Regulatory Activities

Division (202/874-5090), Office of the Comptroller of the Currency, 250

E Street, S.W., Washington, D.C. 20219.

Board: 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.

FDIC: William A. Stark, Assistant Director, (202/898-6972), Curtis

Wong, Capital Markets Specialist, (202/898-7327), Division of

Supervision, or Jeffrey M. Kopchik, Counsel, (202/898-3872), Legal

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

SUPPLEMENTARY INFORMATION:

I. Background

The Basle Accord1 established a risk-based capital framework

for assessing capital adequacy that was implemented in the United

States by the banking agencies in 1989. Under this framework, off-

balance-sheet transactions are incorporated into the risk-based

structure by converting each item into a credit equivalent amount that

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 collateral.

\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 an off-balance-sheet interest rate

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

together the current replacement cost (current exposure) of the

contract and an estimate of the possible increase in future replacement

cost (potential future exposure, also referred to as the add-on) in

view of the volatility of the current exposure of the contract. The

maximum risk category for rate contracts is 50 percent.2

\2\Exchange rate contracts with an original maturity of 14

calendar days or less and instruments traded on exchanges that

require daily receipt and payment of cash variation margin are

excluded from the risk-based capital ratio calculations.

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Current Exposure

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 is zero or negative, then the current

exposure is zero. The sum of current exposures for a defined set of

contracts is sometimes referred to as the gross current exposure for

that set of contracts. When they were initially issued, the Basle

Accord and the banking agencies' risk-based capital standards provided,

generally, that current exposure would be determined individually for

each rate contract entered into by a banking organization.

In July 1994 the Basle Accord was revised to permit institutions to

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

rate contracts entered into with a single counterparty subject to a

qualifying, legally enforceable, bilateral netting arrangement.

Effective at year-end 1994, the banking agencies each amended, in a

uniform manner, their risk-based capital standards to implement the

revision to the Accord.3 Accordingly, U.S. banking organizations

with qualifying, legally enforceable, bilateral netting arrangements

may replace the gross current exposure of a set of contracts included

in such an arrangement with a single net current exposure for purposes

of determining the credit equivalent amount for the included contracts.

\3\The Board issued its amendment on December 7, 1994 (59 FR

62987), the OCC and FDIC issued their amendments on December 28,

1994 (59 FR 66645 for the OCC final rule and 59 FR 66656 for the

FDIC final rule).

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Potential Future Exposure

The potential future exposure portion of the credit equivalent

amount for rate contracts is an estimate of the additional credit

exposure that may arise as a result of fluctuations in prices or rates.

The add-on for potential future exposure is estimated by multiplying

the notional principal amount4 of the contract by a credit

conversion factor that is determined by the remaining maturity of the

contract and the type of

[[Page 46171]]

contract. The original conversion factors in the Basle Accord and the

banking agencies' risk-based capital standards are set forth in the

following matrix:

\4\The notional principal amount is a reference amount of money

used to calculate payment streams between counterparties.

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

Interest Exchange

Remaining maturity rate (in rate (in

percent) percent)

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

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

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

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

An individual add-on for potential future exposure is calculated

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

positive, or negative, or whether the current exposure is calculated on

a gross or net basis. The banking agencies' recent amendments to expand

the recognition of bilateral netting arrangements did not revise the

calculation of the add-on for potential future exposure. Accordingly,

an add-on is calculated separately for each individual contract subject

to a qualifying bilateral netting arrangement. These individual

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

on amount. The gross add-on amount is added to the net current exposure

to determine one credit equivalent amount for the contracts subject to

the qualifying bilateral netting arrangement.

Commenters to the Basle proposal to expand the recognition of

bilateral netting arrangements urged regulators to also recognize

reductions in potential future credit exposure arising from such

arrangements. They also commented that commodity and equity derivative

transactions should be eligible for netting for risk-based capital

purposes. Accordingly, in July 1994 the Basle Supervisors Committee

proposed revisions to the Basle Accord regarding the risk-based capital

treatment of derivative transactions.5 Under the proposed

revision, the matrix of conversion factors used to calculate potential

future exposure would be expanded to take into account innovations in

the derivatives markets. Specifically, the Basle Committee proposed

that higher conversion factors be added to address long-dated

transactions (that is, contracts with remaining maturities over five

years) and new conversion factors be added to explicitly cover certain

types of derivatives transactions not directly mentioned by the Accord

when it was endorsed in 1988. These include commodity-, precious metal-

, and equity-linked derivative transactions.6 The proposed

revision also would have formally extended the recognition of

qualifying bilateral netting arrangements to commodity, precious metal,

and equity derivative contracts so that these types of transactions

could be netted when determining current exposure for the netting

contract. In addition, the proposed revision set forth a formula for

institutions to employ in recognizing reductions in the potential

future exposure of derivatives contracts that can result from entering

into qualifying bilateral netting arrangements.

\5\The proposed revisions are contained in a document entitled

``The capital adequacy treatment of the credit risk associated with

certain off-balance-sheet items'' that is available upon request

from the Board's or OCC's Freedom of Information Offices or the

FDIC's Office of the Executive Secretary.

\6\In general terms, these are off-balance-sheet derivative

contracts that have a return, or a portion of their return, linked

to the price or an index of prices for a particular commodity,

precious metal, or equity. These types of transactions were not

specifically addressed in the 1988 Accord (or in the banking

agencies' original risk-based capital standards) because they were

not prevalent in the derivatives markets at that time.

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II. The Agencies' Proposals

After the Basle Supervisors Committee issued its proposed revisions

to the Basle Accord, the banking agencies each issued for public

comment proposals to amend their respective risk-based capital

standards based on the international proposal.7 The agencies'

proposed conversion factor matrix is set forth below:

\7\The Board issued its proposal on August 24, 1994 (59 FR

43508), the OCC issued its proposal on September 1, 1994 (59 FR

45243), and the FDIC issued its proposal on October 19, 1994 (59 FR

52714).

Conversion Factor Matrix\1\

[Amounts in percent]

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Foreign Precious

Residual maturity Interest exchange Equity\2\ metals, Other

rate and gold except gold commodities

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

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

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

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

remaining payments in the contract.

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

to the time remaining until the next payment.

The proposed matrix was designed to accommodate a variety of

contracts and was intended to provide a reasonable balance between

precision, on the one hand, and complexity and burden, on the other.

The agencies also proposed the same methodology as the Basle

Supervisors Committee to calculate a reduction in the add-on amount for

contacts subject to qualifying bilateral netting arrangements. Under

the agencies' proposals, institutions would apply the following

formula8 to adjust the amount of the add-on for potential future

exposure:

\8\This formula may also be expressed as: Anet = (1-

P)Agross + P(NGR x Agross) [P or policy factor = 0.5].

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

Where Anet is the adjusted add-on for all contracts subject to

the netting arrangement, Agross is the amount of the add-on as

calculated under the current agency standards, and NGR is the ratio of

the net current exposure of the set of contracts included in the

netting arrangement to the gross current exposure of those contracts.

The proposals would have given partial credit to the effect of the NGR

by applying a weighted averaging factor of 0.5.

Under the proposals, institutions would calculate a separate NGR

for each counterparty with which it has a qualifying bilateral netting

contract. The proposals requested general comments as well as specific

comment as to whether the NGR should be calculated on a counterparty-

by-counterparty basis or on an aggregate basis for all contracts

subject to qualifying bilateral netting arrangements.

[[Page 46172]]

III. Comments Received

The banking agencies together received nineteen public comments on

their proposed amendments. Fifteen of the commenters were banks and

bank holding companies and four were industry trade associations and

other organizations. Commenters generally supported the proposed

amendments, in particular the recognition of the effects of bilateral

netting arrangements in the calculation of potential future exposure,

and several urged adoption of the amendments as soon as possible.

Commenters offered suggestions and opinions on several aspects of the

proposals including the conversion factors, the formula for recognizing

potential future exposure, ways of calculating the NGR, and recognizing

additional risk-reducing techniques.

Expanded Matrix

Over one half of the commenters addressed the proposed expanded

conversion factor matrix. Of these commenters, most indicated the

proposed factors were generally reasonable and acceptable. Several

commenters discussed the underlying assumptions used in the simulation

models for arriving at the proposed factors for commodity transactions

and expressed concern that the conversion factors for certain commodity

derivative transactions were too high. One commenter suggested the

conversion factor for commodity contracts across all time bands should

be twelve percent. Another commenter expressed the view that the

proposed conversion factor for interest rate contracts with remaining

maturities greater than five years (1.5 percent) was an excessive

increment over the current 0.5 percent conversion factor for interest

rate contracts with remaining maturities greater than one year. This

commenter suggested an additional time band for interest rate contracts

with five to eight years remaining maturity and a corresponding

conversion factor of 1.0 percent. Another commenter suggested there

should be no capital charge for potential future exposure for commodity

contracts based on two floating indices.

One commenter supported continuing the existing time band of ``one

year or less'' as opposed to the proposed time band of ``less than one

year.'' Two commenters expressed the view that the proposed time band

for contracts with remaining maturities greater than five years was

unnecessary. One commenter suggested adding a time band and appropriate

conversion factors for contracts with remaining maturities between one

and two years.

Several commenters discussed the matrix footnotes. One suggested

extending the footnote applicable to equity contracts with automatic

reset features following a payment to any derivative contract with

effective early termination or periodic reset features. With regard to

the footnote pertaining to contracts with multiple exchanges of

principal, one commenter requested further clarification on the types

of contracts included, while another expressed the view that

multiplying the conversion factor by the number of remaining payments

in a contract was too conservative. A few commenters recommended

clarification as to the appropriate capital treatment when transactions

are leveraged or enhanced by a stated multiple.

Netting and Potential Future Exposure

A number of commenters discussed the proposed formula for

recognizing the effects of bilateral netting arrangements in the

calculation of potential future exposure. Most of these commenters

supported the use of the NGR as a reasonable proxy to estimate the

risk-reducing benefits of netting arrangements. Several commenters

supported giving full weight to the NGR or, alternatively, weighting

the NGR with a higher averaging factor than the proposed 0.5 factor.

Another commenter offered a revised formula that would weight the

netting portion of the formula by two and divide the entire formula by

three. This commenter stated the revised formula would effectively

reduce the credit equivalent amount and place greater emphasis on the

portion of the formula affected by a netting arrangement. One commenter

suggested that net credit risk should be the basis for the add-on

amount.

Several commenters addressed the proposal's specific request for

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

counterparty basis or on an aggregate basis across all portfolios

eligible for capital netting treatment. A few commenters supported a

counterparty-by-counterparty NGR as providing a more accurate

indication of credit risks. Other commenters preferred an aggregate

NGR, characterizing an aggregate NGR as less burdensome to calculate.

Two commenters suggested applying a single NGR to all counterparties

within each risk weight classification.

Other Comments

Several commenters encouraged recognizing other risk reducing

techniques such as margin and collateral agreements, frequent

settlement of mark-to-market values, and periodic resetting of terms

and early termination agreements. One commenter suggested there should

be no capital charge for potential future exposure when current

exposure is less than a certain level (e.g., negative $1 million). One

commenter suggested using negative net mark-to-market values to offset

potential future exposure. A few commenters supported the use of

internal systems to calculate capital requirements and recommended

continued monitoring of developments in the banking industry.

IV. Final Rule

After consideration of the comments received and further

deliberation on the issues involved, the banking agencies have

determined to adopt a final rule that is substantially the same as

proposed. The final rule amends the matrix of conversion factors used

to calculate potential future exposure and permits institutions to

recognize the effects of qualifying bilateral netting arrangements in

the calculation of potential future exposure. The final rule is

consistent with a revision to the Basle Accord announced by the Basle

Supervisors Committee in April 1995.9

\9\The revision to the Basle Accord is in an annex with the

heading ``Forwards, swaps, purchased options and similar derivative

contracts'' that was issued along with the Basle Supervisors

Committee's consultative proposal on Market Risk on April 12, 1995.

This document is available upon request from the Board's and OCC's

Freedom of Information Offices and the FDIC's Office of the

Executive Secretary.

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Expanded Matrix

The banking agencies believe that the proposed conversion factors

generally provide a reasonable measure of potential future exposure for

long-dated interest rate and exchange rate contracts and for other

derivative instruments not addressed in the original Accord. In

addition, the banking agencies believe that the proposed matrix

adequately accommodates a variety of contracts and appropriately

provides a reasonable balance between precision, and complexity and

burden. The agencies, however, have taken into consideration issues

raised by commenters regarding the simulation methods used to arrive at

the conversion factors for other commodities. After additional

simulation analysis, the agencies have concluded that the conversion

factor for other commodity transactions with maturities of one year or

less should be lowered from 12 percent to 10 percent. Any off-balance-

sheet derivative contract not explicitly covered by the expanded matrix

is subject to the add-on conversion factors for other

[[Page 46173]]

commodities. Furthermore, in response to commenters' concerns, the

banking agencies have revised the proposed time band of ``less than one

year'' to ``one year or less'' to maintain consistency with the

existing time bands for remaining maturity.

The proposed matrix included a footnote applicable to equity

contracts that automatically reset market value to zero following a

payment. Under the proposal, the remaining maturity of such contracts

would be the time until the next payment. Several commenters asserted

this treatment should extend to a wider range of contacts. The agencies

have determined that for contracts structured to settle outstanding

exposure to zero following specified payment dates and where the terms

of the contract are reset so that the market value of the contract is

zero on these dates, the remaining maturity may be set equal to the

time until the next reset date. However, the agencies believe that a

long-dated interest rate swap, with, for example, a six-month zero

reset provision, represents a greater risk than an interest rate swap

that terminates after six months. The final rule provides that the

minimum add-on conversion factor for interest rate contacts with

remaining maturities of greater than one year is 0.5 percent.

Under the final rule, which is identical to the proposal in this

regard, gold derivative contracts are accorded the same conversion

factors as exchange rate contracts. However, while exchange rate

contracts with original maturities of fourteen calendar days or less

may be excluded from the risk-based ratio calculation,10 gold

contracts with such original maturities are to be included.

\10\Exchange rate contracts with original maturities of 14

calendar days or less are normally excluded from the risk-based

capital ratio. When such contracts are included in a bilateral

netting arrangement, however, the institution may elect consistently

either to include or exclude all mark-to-market values of those

contracts when determining net current exposure. These contracts

should continue to be excluded when determining potential future

exposure.

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Finally, the agencies note that the conversion factors are to be

regarded as provisional and may be subject to amendment as a result of

changes in the volatility of rates and prices.

Netting and Potential Future Exposure

The final rule adopts, in substantially the same form, the proposed

methodology for reducing potential future exposure for contracts

subject to qualifying bilateral netting arrangements. The agencies have

considered the argument presented by several commenters that the

proposed formula did not give sufficient recognition to reductions in

credit risk resulting from participating in qualifying netting

arrangements. These commenters suggested giving full weight to the NGR

or, alternatively, that it be weighted at 90 percent. The agencies

believe that only partial weight should be given to the NGR as it is

neither a precise, nor a stable indicator of future changes in net

exposure relative to changes in gross exposure. The agencies agree, to

a limited extent, with commenters that a 0.5 averaging factor (referred

to as the policy or P factor) may not sufficiently recognize reductions

in potential future exposure resulting from qualifying bilateral

netting arrangements and have determined that the P factor should be

raised to 0.6. This weight represents an appropriate compromise between

recognizing effects of bilateral netting arrangements in calculating

the add-on and providing a cushion against additional exposure that may

arise as a result of fluctuations in prices or rates. The formula

adopted by the agencies is expressed as:

Anet=(0.4 x Agross)+0.6(NGR x Agross)

The agencies have also considered comments discussing whether the

NGR should be calculated on a counterparty-by-counterparty basis (that

is, an individual NGR for each bilateral netting contract) or on an

aggregate basis for all contracts subject to legally enforceable

netting arrangements. The agencies have determined that an institution

may elect to calculate separate NGRs for each of its bilateral netting

arrangements or an aggregate NGR so long as the method chosen is used

consistently and is subject to examiner review.

Regardless of the method employed by an institution to calculate

its NGR(s), the NGR should be applied separately and individually to

each of the institution's bilateral netting arrangements. If an

institution calculates an NGR for each bilateral netting arrangement,

then it should use a different NGR when determining the potential

future exposure for each bilateral netting arrangement. If an

institution aggregates its net and gross replacement costs across all

bilateral netting contracts to determine a single NGR, then it should

use the same NGR when determining the potential future exposure for

each bilateral netting arrangement.

Institutions with equity, precious metal, and other commodity

contracts included in bilateral netting contracts should now include

those types of transactions when determining the net current exposure

for the bilateral netting contract and when determining potential

future exposure in accordance with this final rule.

The final rule permits, subject to certain conditions, institutions

to take into account qualifying collateral when assigning the credit

equivalent amount of a netting arrangement to the appropriate risk

category in accordance with the procedures and requirements currently

set forth in each agency's risk-based capital standards.

Finally, the agencies note that the methodology for recognizing the

effects of qualifying bilateral netting arrangements is subject to

review and revision as determined to be appropriate.

V. Regulatory Flexibility Act Analysis

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

agencies do not believe that this final rule will have a significant

impact on a substantial number of small business entities in accord

with the spirit and purposes of the Regulatory Flexibility Act (5

U.S.C. 601 et seq.). In this regard, while some institutions with

limited derivative portfolios may experience an increase in capital

charges, for most of these institutions the final rule will have no

effect. For institutions with more developed derivative portfolios, the

overall effect of the rule will likely be to reduce regulatory burden

and decrease the capital charge for certain derivative transactions. In

addition, because the risk-based capital standards generally do not

apply to bank holding companies with consolidated assets of less than

$150 million, this final rule will not affect such companies.

VI. Paperwork Reduction Act and Regulatory Burden

The agencies have 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. As noted above, the rule may result

in higher capital charges for some institutions and lower charges for

others, but any additional paperwork or recordkeeping burden should be

minimal. The rule provides a more accurate measure of risks related to

derivative contracts and the capital required to cover those risks.

[[Page 46174]]

Section 302 also requires such a rule to become effective on the

first day of the calendar quarter following publication of the rule,

unless the agency, for good cause, determines an earlier effective date

is appropriate. Accordingly, the agencies have determined that an

effective date of October 1, 1995 is appropriate.

VII. OCC Executive Order 12866

It has been determined that this final rule is not a significant

regulatory action as defined in Executive Order 12866.

VIII. OCC Unfunded Mandates Act of 1995

Section 202 of the Unfunded Mandates Act of 1995 (Unfunded Mandates

Act) (signed into law on March 22, 1995) requires that certain agencies

prepare a budgetary impact statement before promulgating a rule that

includes a federal mandate that may result in the expenditure by state,

local, and tribal governments, in the aggregate, or by the private

sector, of $100 million or more in any one year. If a budgetary impact

statement is required, section 205 of the Unfunded Mandates Act also

requires the agency to identify and consider a reasonable number of

regulatory alternatives before promulgating a rule. The OCC has

determined that this joint agency final rule will not result in

expenditures by state, local and tribal governments, or by the private

sector, of more than $100 million in any one year. Accordingly, the OCC

has not prepared a budgetary impact statement or specifically addressed

the regulatory alternatives considered.

As discussed in the preamble, this joint agency final rule amends

the risk-based capital guidelines to (1) revise and expand the credit

conversion factors used to calculate the potential future credit

exposure for derivative contracts and long-dated interest rate and

foreign exchange rate contracts and (2) permit banks to net multiple

derivative contracts subject to a qualifying bilateral netting contract

when calculating the potential future credit exposure. While the impact

of this final rule on any particular national bank will depend on the

composition of its derivatives portfolio, the OCC believes that this

final rule generally will have little or no impact on most banks since

most banks have limited derivative portfolios. For those banks with

more developed derivatives portfolios, the OCC believes that the effect

of this final rule will likely be a decrease in the capital

requirements for certain derivative contracts.

List of Subjects

12 CFR Part 3

Administrative practice and procedure, Capital, National banks,

Reporting and recordkeeping requirements, Risk.

12 CFR Part 208

Accounting, Agriculture, Banks, banking, Confidential business

information, Crime, Currency, Federal Reserve System, Flood insurance,

Mortgages, Reporting and recordkeeping requirements, Securities.

12 CFR Part 225

Administrative practice and procedure, Banks, banking, Federal

Reserve System, Holding companies, Reporting and recordkeeping

requirements, Securities.

12 CFR Part 325

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

and recordkeeping requirements, Savings associations, State nonmember

banks.

Authority and Issuance

OFFICE OF THE COMPTROLLER OF THE CURRENCY

12 CFR CHAPTER I

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

of title 12, chapter 1 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, 1835, 3907, and 3909.

2. In appendix A, to part 3, section 1 is revised by redesignating

paragraphs (c)(10) through (c)(30) as paragraphs (c)(11) through

(c)(31) and adding new paragraph (c)(10) to read as follows:

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

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

* * * * *

(c) * * *

(10) Derivative contract means generally a financial contract

whose value is derived from the values of one or more underlying

assets, reference rates or indexes of asset values. Derivative

contracts include interest rate, foreign exchange rate, equity,

precious metals and commodity contracts, or any other instrument

that poses similar credit risks.

* * * * *

3. In appendix A, to part 3, section 3 is amended:

a. By revising paragraph (a)(1)(viii);

b. In paragraph (a)(3)(ii) by removing the words ``interest rate

and exchange rate contracts,'' and adding in their place the words

``derivative contracts,''; and

c. In paragraph (b) by revising the introductory text and

paragraph (b)(5).

The revisions read as follows:

* * * * *

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

transactions9a 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:9b

\9a\See footnote 22 in section 3(b)(5)(iii) of this appendix A

(collateral held against derivative contracts).

\9b\Assets 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 a minimal risk.

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* * * * *

(b) Off-Balance Sheet Activities. The risk weight assigned to an

off-balance sheet item is determined by a two-step process. First,

the face amount of the off-balance sheet item is multiplied by the

appropriate credit conversion factor specified in this section. This

calculation translates the face amount of an off-balance sheet item

into an on-balance sheet credit equivalent amount. Second, the

resulting credit equivalent amount is then assigned to the proper

risk category using the criteria regarding obligors, guarantors, and

collateral listed in section 3(a) of this appendix A. Collateral and

guarantees are applied to the face amount of an off-balance sheet

item; however, with respect to derivative contracts under section

3(b)(5) of this appendix A, collateral and guarantees are applied to

the credit equivalent amounts of such derivative contracts. The

following are the credit conversion factors and the off-balance

sheet items to which they apply.

* * * * *

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

amounts. The credit equivalent amount of a derivative contract

equals the sum of the current credit exposure and the potential

future credit exposure of the derivative contract. The calculation

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

regardless of the currency or currencies specified in the derivative

contract.

[[Page 46175]]

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

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

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

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

If the mark-to-market is zero or negative, then the current credit

exposure is zero. The current credit exposure for multiple

derivative contracts executed with a single counterparty and subject

to a qualifying bilateral netting contract is determined as provided

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

(B) Potential future credit exposure. The potential future

credit exposure for a single derivative contract, including a

derivative contract with negative mark-to-market value, is

calculated by multiplying the notional principal19 of the

derivative contract by one of the credit conversion factors in Table

A--Conversion Factor Matrix of this appendix A, for the appropriate

category.20 The potential future credit exposure for gold

contracts shall be calculated using the foreign exchange rate

conversion factors. For any derivative contract that does not fall

within one of the specified categories in Table A--Conversion Factor

Matrix of this appendix A, the potential future credit exposure

shall be calculated using the other commodity conversion factors.

Subject to examiner review, banks should use the effective rather

than the apparent or stated notional amount in calculating the

potential future credit exposure. The potential future credit

exposure for multiple derivatives contracts executed with a single

counterparty and subject to a qualifying bilateral netting contract

is determined as provided by section 3(b)(5)(ii)(A) of this appendix

A.

\19\For purposes of calculating either the potential future

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

the gross potential future credit exposure under section

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

and other similar contracts in which the notional principal is

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

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

currency.

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

currency interest rate swaps in which payments are made based upon

two floating indices, so-called floating/floating or basis swaps;

the credit equivalent amount is measured solely on the basis of the

current credit exposure.

Table A--Conversion Factor Matrix\1\

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

Foreign

Interest exchange Precious Other

Remaining maturity\2\ rate rate and Equity\2\ metals commodity

gold

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

One year or less.............................. 0.0 1.0 6.0 7.0 10.0

Over one to five years......................... 0.5 5.0 8.0 7.0 12.0

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

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

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

number of remaining payments in the derivative contract.

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

equals the time until the next payment. However, interest rate contracts with remaining maturities of greater

than one year shall be subject to a minimum conversion factor of 0.5 percent.

(ii) Derivative contracts subject to a qualifying bilateral

netting contract. (A) Netting calculation. The credit equivalent

amount for multiple derivative contracts executed with a single

counterparty and subject to a qualifying bilateral netting contract

as provided by section (3)(b)(5)(ii)(B) of this appendix A is

calculated by adding the net current credit exposure and the

adjusted sum of the potential future credit exposure for all

derivative contracts subject to the qualifying bilateral netting

contract.

(1) Net current credit exposure. The net current credit exposure

is the net sum of all positive and negative mark-to-market values of

the individual derivative contracts subject to a qualifying

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

value is positive, then the net current credit exposure equals that

net sum of the mark-to-market value. If the net sum of the mark-to-

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

exposure is zero.

(2) Adjusted sum of the potential future credit exposure. The

adjusted sum of the potential future credit exposure is calculated as:

Anet=0.4 x Agross+(0.6 x NGR x Agross)

Anet is the adjusted sum of the potential future credit

exposure, Agross is the gross potential future credit exposure,

and NGR is the net to gross ratio. Agross is the sum of the

potential future credit exposure (as determined under section

3(b)(5)(i)(B) of this appendix A) for each individual derivative

contract subject to the qualifying bilateral netting contract. The

NGR is the ratio of the net current credit exposure to the gross

current credit exposure. In calculating the NGR, the gross current

credit exposure equals the sum of the positive current credit

exposures (as determined under section 3(b)(5)(i)(A) of this

appendix A) of all individual derivative contracts subject to the

qualifying bilateral netting contract.

(B) Qualifying bilateral netting contract. In determining the

current credit exposure for multiple derivative contracts executed

with a single counterparty, a bank may net derivative contracts

subject to a qualifying bilateral netting contract by offsetting

positive and negative mark-to-market values, provided that:

(1) The qualifying bilateral netting contract is in writing.

(2) The qualifying bilateral netting contract is not subject to

a walkaway clause.

(3) The qualifying bilateral netting contract creates a single

legal obligation for all individual derivative contracts covered by

the qualifying bilateral netting contract. In effect, the qualifying

bilateral netting contract must provide that the bank would have a

single claim or obligation either to receive or to pay only the net

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

on the individual derivative contracts covered by the qualifying

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 qualifying bilateral netting contract has

been assigned, fails to perform due to any of the following events:

default, insolvency, bankruptcy, or other similar circumstances.

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

that represents, 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 of the jurisdiction that governs the individual

derivative contracts covered by the bilateral netting contract; and

(iii) The law of the jurisdiction that governs the qualifying

bilateral netting contract.

(5) The bank establishes and maintains procedures to monitor

possible changes in relevant law and to ensure that the qualifying

bilateral netting contract continues to satisfy the requirement of

this section.

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

support the netting of a derivative contract.\21\

\21\By netting individual derivative contracts for the purpose

of calculating its credit equivalent amount, a bank represents that

documentation adequate to support the netting of a set of derivative

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 qualifying bilateral netting contract may not

be legally enforceable in any one of the bodies of law described in

section 3(b)(5)(ii)(B)(3)(i) through (iii) of this appendix A, the

underlying derivative contracts may not be netted for the purposes

of this section.

[[Page 46176]]

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

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

equivalent amount for a derivative contract or a set of derivative

contracts subject to a qualifying bilateral netting contract, the

bank assigns that amount to the risk weight category appropriate to

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

guarantee.\22\ However, the maximum weight that will be applied to

the credit equivalent amount of such derivative contract(s) is 50

percent.

\22\Derivative contracts are an exception to the general rule of

applying collateral and guarantees to the face value of off-balance

sheet items. The sufficiency of collateral and guarantees is

determined on the basis of the credit equivalent amount of

derivative contracts. However, collateral and guarantees held

against a qualifying bilateral netting contract is not recognized

for capital purposes unless it is legally available for all

contracts included in the qualifying bilateral netting contract.

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

(iv) Exceptions. The following derivative 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) An exchange rate contract with an original maturity of 14

calendar days or less;\23\ and

\23\Notwithstanding section 3(b)(5)(B) of this appendix A, gold

contracts do not qualify for this exception.

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

(B) A derivative contract that is traded on an exchange

requiring the daily payment of any variations in the market value of

the contract.

* * * * *

4. Table 3, at the end of appendix A, is revised to read as

follows:

* * * * *

Table 3--Treatment of Derivative Contracts

1. The current exposure method is used to calculate the credit

equivalent amounts of derivative 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 derivative contracts with a single counterparty

may be netted if those contracts are subject to a qualifying

bilateral netting contract.

Conversion Factor Matrix\1\

[Percent]

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

Foreign

Interest exchange Precious Other

Remaining maturity\2\ rate rate and Equity\2\ metals commodity

gold

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

One year or less............................... 0.0 1.0 6.0 7.0 10.0

Over one to five years......................... 0.5 5.0 8.0 7.0 12.0

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

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

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

number of remaining payments in the derivative contract.

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

equals the time until the next payment. However, interest rate contracts with remaining maturities of greater

than one year shall be subject to a minimum conversion factor of 0.5 percent.

2. The following derivative contracts will be excluded:

a. Exchange rate contract with an original maturity of 14

calendar days or less; and

b. Derivative contract traded on exchanges and subject to daily

margin requirements.

Dated: August 24, 1995.

Eugene A. Ludwig,

Comptroller of the Currency.

FEDERAL RESERVE SYSTEM

12 CFR CHAPTER II

For the reasons set out in the joint preamble, the Board of

Governors of the Federal Reserve System amends 12 CFR parts 208 and 225

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 continues to read as

follows:

Authority: 12 U.S.C. 36, 248(a), 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; 42 U.S.C.

4012a, 4104a, 4104b.

2. In part 208, appendix A is amended by revising the last

paragraph of section III.C.3. and footnote 40 in the introductory text

of section III.D. to read as follows:

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

Banks: Risk-Based Measure

* * * * *

III. * * *

C. * * *

3. * * *

Credit equivalent amounts of derivative contracts involving

standard risk obligors (that is, obligors whose loans or debt

securities would be assigned to the 100 percent risk category) are

included in the 50 percent category, unless they are backed by

collateral or guarantees that allow them to be placed in a lower

risk category.

* * * * *

D. * * * 40 * * *

\40\The sufficiency of collateral and guarantees for off-

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

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

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

determination is generally made in relation to the credit equivalent

amount. Collateral and guarantees are subject to the same provisions

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

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

* * * * *

3. In part 208, appendix A is amended by revising the section

III.E. heading and section III.E. to read as follows:

* * * * *

III. * * *

E. Derivative Contracts (Interest Rate, Exchange Rate,

Commodity-- (including precious metals) and Equity-Linked Contracts)

1. Scope. Credit equivalent amounts are computed for each of the

following off-balance-sheet derivative contracts:

a. Interest Rate Contracts. These include single currency

interest rate swaps, basis swaps, forward rate agreements, interest

rate options purchased (including caps, collars, and floors

purchased), and any other instrument linked to interest rates that

gives rise to similar credit risks (including when-issued securities

and forward forward deposits accepted).

b. Exchange Rate Contracts. These include cross-currency

interest rate swaps, forward foreign exchange contracts, currency

options purchased, and any other instrument linked to exchange rates

that gives rise to similar credit risks.

c. Equity Derivative Contracts. These include equity-linked

swaps, equity-linked options purchased, forward equity-linked

contracts, and any other instrument linked to equities that gives

rise to similar credit risks.

d. Commodity (including precious metal) Derivative Contracts.

These include commodity-linked swaps, commodity-linked options

purchased, forward commodity-linked contracts, and any other

instrument

[[Page 46177]]

linked to commodities that gives rise to similar credit risks.

e. Exceptions. Exchange rate contracts with an original maturity

of fourteen or fewer calendar days and derivative contracts traded

on exchanges that require daily receipt and payment of cash

variation margin may be excluded from the risk-based ratio

calculation. Gold contracts are accorded the same treatment as

exchange rate contracts except that gold contracts with an original

maturity of fourteen or fewer calendar days are included in the

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

included and treated in the same way as other derivative contracts.

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

equivalent amount of a derivative contract that is not subject to a

qualifying bilateral netting contract in accordance with section

III.E.3. 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 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 equal to 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 underlying rates, prices, and indices, 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 use, subject to examiner

review, the effective rather than the apparent or stated notional

amount in this calculation. The credit conversion factors are:

Conversion Factors

[In percent]

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

Commodity,

Interest Exchange excluding Precious

Remaining maturity rate rate and Equity precious metals,

gold metals except gold

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

One year or less............................... 0.0 1.0 6.0 10.0 7.0

Over one to five years......................... 0.5 5.0 8.0 12.0 7.0

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

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

d. For a contract that is structured such that on specified

dates any outstanding exposure is settled and the terms are reset so

that the market value of the contract is zero, the remaining

maturity is equal to the time until the next reset date. For an

interest rate contract with a remaining maturity of more than one

year that meets these criteria, the minimum conversion factor is 0.5

percent.

e. For a contract with multiple exchanges of principal, the

conversion factor is multiplied by the number of remaining payments

in the contract. A derivative contract not included in the

definitions of interest rate, exchange rate, equity, or commodity

contracts as set forth in section III.E.1. of this appendix A, is

subject to the same conversion factors as a commodity, excluding

precious metals.

f. No potential future exposure is calculated for a single

currency interest rate swap in which payments are made based upon

two floating rate indices (a so called floating/floating or basis

swap); the credit exposure on such a contract is evaluated solely on

the basis of the mark-to-market value.

g. The Board notes that the conversion factors set forth above,

which are based on observed volatilities of the particular types of

instruments, are subject to review and modification in light of

changing volatilities or market conditions.

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

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

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

a credit equivalent amount. Any legally enforceable form of

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

derivative contracts is recognized for purposes of calculating the

credit equivalent amount provided that:

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 the 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 derivative 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.49

\49\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.

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

c. A bank netting individual contracts for the purpose of

calculating credit equivalent amounts of derivative contracts,

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

section III.E.3.a.ii. 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 contracts that are subject to

a qualifying bilateral netting contract is calculated by adding (i)

the current exposure of the netting contract (net current exposure)

and (ii) the sum of the estimates of potential future credit

exposures on all individual contracts subject to the netting

contract (gross potential future exposure) adjusted to reflect the

effects of the netting contract.50

\50\For 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.

e. The net current exposure is the sum of 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 net current exposure is equal to that sum. If

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

the net current

[[Page 46178]]

exposure is zero. The Federal Reserve may determine that a netting

contract qualifies for risk-based capital netting treatment even

though certain individual contracts included under the netting

contract may not qualify. In such instances, the nonqualifying

contracts should be treated as individual contracts that are not

subject to the netting contract.

f. Gross potential future exposure, or Agross is calculated

by summing the estimates of potential future exposure (determined in

accordance with section III.E.2 of this appendix A) for each

individual contract subject to the qualifying bilateral netting

contract.

g. The effects of the bilateral netting contract on the gross

potential future exposure are recognized through the application of

a formula that results in an adjusted add-on amount (Anet). The

formula, which employs the ratio of net current exposure to gross

current exposure (NGR) is expressed as:

Anet = (0.4 x Agross) + 0.6(NGR x Agross)

h. The NGR may be calculated in accordance with either the

counterparty-by-counterparty approach or the aggregate approach.

i. Under the counterparty-by-counterparty approach, the NGR is

the ratio of the net current exposure for a netting contract to the

gross current exposure of the netting contract. The gross current

exposure is the sum of the current exposures of all individual

contracts subject to the netting contract calculated in accordance

with section III.E.2. of this appendix A. Net negative mark-to-

market values for individual netting contracts with the same

counterparty may not be used to offset net positive mark-to-market

values for other netting contracts with that counterparty.

ii. Under the aggregate approach, the NGR is the ratio of the

sum of all of the net current exposures for qualifying bilateral

netting contracts to the sum of all of the gross current exposures

for those netting contracts (each gross current exposure is

calculated in the same manner as in section III.E.3.h.i. of this

appendix A). Net negative mark-to-market values for individual

counterparties may not be used to offset net positive mark-to-market

values for other counterparties.

iii. A bank must consistently use either the counterparty-by-

counterparty approach or the aggregate approach to calculate the

NGR. Regardless of the approach used, the NGR should be applied

individually to each qualifying bilateral netting contract to

determine the adjusted add-on for that netting contract.

i. 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 or fewer calendar days or instruments traded on exchanges

that require daily payment and receipt of cash variation margin--a

bank may elect to either include or exclude all mark-to-market

values of such contracts when determining net current exposure,

provided the method chosen is applied consistently.

4. Risk Weights. Once the credit equivalent amount for a

derivative contract, or a group of derivative contracts subject to a

qualifying bilateral netting contract, has been determined, that

amount is assigned to the risk category appropriate to the

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

collateral.51 However, the maximum risk weight applicable to

the credit equivalent amount of such contracts is 50 percent.

\51\For derivative contracts, sufficiency of collateral or

guarantees is generally 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.

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

5. Avoidance of double counting. a. In certain cases, credit

exposures arising from the derivative contracts covered by section

III.E. of this appendix A may already be reflected, in part, on the

balance sheet. To avoid double counting such exposures in the

assessment of capital adequacy and, perhaps, assigning inappropriate

risk weights, counterparty credit exposures arising from the

derivative instruments covered by these guidelines may need to be

excluded from balance sheet assets in calculating a bank's risk-

based capital ratios.

b. Examples of the calculation of credit equivalent amounts for

contracts covered under this section III.E. are contained in

Attachment V of this appendix A.

* * * * *

4. In appendix A to part 208, Attachments IV and V are revised to

read as follows:

* * * * *

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

for State Member Banks

100 Percent Conversion Factor

1. Direct credit substitutes. (These include general guarantees

of indebtedness and all guarantee-type instruments, including

standby letters of credit backing the financial obligations of other

parties.)

2. Risk participations in bankers acceptances and direct credit

substitutes, such as standby letters of credit.

3. Sale and repurchase agreements and assets sold with recourse

that are not included on the balance sheet.

4. Forward agreements to purchase assets, including financing

facilities, on which drawdown is certain.

5. Securities lent for which the bank is at risk.

50 Percent Conversion Factor

1. Transaction-related contingencies. (These include bid-bonds,

performance bonds, warranties, and standby letters of credit backing

the nonfinancial performance of other parties.)

2. Unused portions of commitments with an original maturity

exceeding one year, including underwriting commitments and

commercial credit lines.

3. Revolving underwriting facilities (RUFs), note issuance

facilities (NIFs), and similar arrangements.

20 Percent Conversion Factor

Short-term, self-liquidating trade-related contingencies,

including commercial letters of credit.

Zero Percent Conversion Factor

Unused portions of commitments with an original maturity of one

year or less, or which are unconditionally cancellable at any time,

provided a separate credit decision is made before each drawing.

Credit Conversion for Derivative Contracts

1. The credit equivalent amount of a derivative 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

derivative 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:

Conversion Factors

[In percent]

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

Commodity,

Interest Exchange excluding Precious

Remaining maturity rate rate and Equity precious metals,

gold metals except gold

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

One year or less............................... 0.0 1.0 6.0 10.0 7.0

Over one to five years......................... 0.5 5.0 8.0 12.0 7.0

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

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

[[Page 46179]]

For contracts subject to a qualifying bilateral netting

contract, the potential future exposure is, generally, the sum of

the individual potential future exposures for each contract included

under the netting contract adjusted by the application of the

following formula:

Anet=(0.4 x Agross)+0.6(NGR x Agross)

NGR is the ratio of net current exposure to gross current

exposure.

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 fewer are excluded.

Instruments traded on exchanges that require daily receipt and

payment of cash variation margin are also excluded.

Attachment V--Calculating Credit Equivalent Amounts for Derivative Contracts

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

Notional Potential Current Credit

Type of contract principal Conversion exposure Mark-to- exposure equivalent

amount factor (dollars) market (dollars) amount

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

(1) 120-day forward foreign

exchange......................... 5,000,000 0.01 50,000 100,000 100,000 150,000

(2) 4-year forward foreign

exchange......................... 6,000,000 0.05 300,000 -120,000 0 300,000

(3) 3-year single-currency fixed &

floating interest rate swap...... 10,000,000 0.005 50,000 200,000 200,000 250,000

(4) 6-month oil swap.............. 10,000,000 0.10 1,000,000 -250,000 0 1,000,000

(5) 7-year cross-currency floating

& floating interest rate swap.... 20,000,000 0.075 1,500,000 -1,500,000 0 1,500,000

Total....................... ........... ........... 2,900,000 + 300,000 3,200,000

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

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

qualifying bilateral netting contract, then the following applies:

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

Potential Credit

Contract future Net current equivalent

exposure exposure amount

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

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

(2).............................. 300,000 ........... ...........

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

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

(5).............................. 1,500,000 ........... ...........

Total...................... 2,900,000 +0 2,900,000

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

Note: The total of the mark-to-market values from the first table is -

$1,370,000. Since this is a negative amount, the net current exposure

is zero.

b. To recognize the effects of bilateral netting on potential

future exposure the following formula applies:

Anet=(.4 x Agross)+.6(NGR x Agross)

c. In the above example where the net current exposure is zero,

the credit equivalent amount would be calculated as follows:

NGR=0=(0/300,000)

Anet=(0.4 x $2,900,000)+0.6 (0 x $2,900,000)

Anet=$1,160,000

The credit equivalent amount is $1,160,000+0=$1,160,000.

d. If the net current exposure was a positive number, for

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

as follows:

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

Anet=(0.4 x $2,900,000)+0.6(.67 x $2,900,000)

Anet=$2,325,800.

The credit equivalent amount would be

$2,325,800+$200,000=$2,525,800.

* * * * *

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

(REGULATION Y)

1. The authority citation for part 225 continues to read as

follows:

Authority: 12 U.S.C. 1817(j)(13), 1818, 1828(o), 1831i, 1831p-1,

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

3909.

2. In part 225, appendix A is amended by revising the last

paragraph of section III.C.3. and footnote 43 in the introductory text

of section III.D. to read as follows:

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

Holding Companies: Risk-Based Measure

* * * * *

III. * * *

C. * * *

3. * * *

Credit equivalent amounts of derivative contracts involving

standard risk obligors (that is, obligors whose loans or debt

securities would be assigned to the 100 percent risk category) are

included in the 50 percent category, unless they are backed by

collateral or guarantees that allow them to be placed in a lower

risk category.

* * * * *

D. * * *43 * * *

\43\The sufficiency of collateral and guarantees for off-

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

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

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

determination is generally made in relation to the credit equivalent

amount. Collateral and guarantees are subject to the same provisions

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

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

* * * * *

3. In part 225, appendix A is amended by revising the section

III.E. heading and section III.E. to read as follows:

* * * * *

III. * * *

E. Derivative Contracts (Interest Rate, Exchange Rate,

Commodity- (including

[[Page 46180]]

precious metals) and Equity-Linked Contracts)

1. Scope. Credit equivalent amounts are computed for each of the

following off-balance-sheet derivative contracts:

a. Interest Rate Contracts. These include single currency

interest rate swaps, basis swaps, forward rate agreements, interest

rate options purchased (including caps, collars, and floors

purchased), and any other instrument linked to interest rates that

gives rise to similar credit risks (including when-issued securities

and forward forward deposits accepted).

b. Exchange Rate Contracts. These include cross-currency

interest rate swaps, forward foreign exchange contracts, currency

options purchased, and any other instrument linked to exchange rates

that gives rise to similar credit risks.

c. Equity Derivative Contracts. These include equity-linked

swaps, equity-linked options purchased, forward equity-linked

contracts, and any other instrument linked to equities that gives

rise to similar credit risks.

d. Commodity (including precious metal) Derivative Contracts.

These include commodity-linked swaps, commodity-linked options

purchased, forward commodity-linked contracts, and any other

instrument linked to commodities that gives rise to similar credit

risks.

e. Exceptions. Exchange rate contracts with an original maturity

of fourteen or fewer calendar days and derivative contracts traded

on exchanges that require daily receipt and payment of cash

variation margin may be excluded from the risk-based ratio

calculation. Gold contracts are accorded the same treatment as

exchange rate contracts except that gold contracts with an original

maturity of fourteen or fewer calendar days are included in the

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

included and treated in the same way as other derivative contracts.

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

equivalent amount of a derivative contract that is not subject to a

qualifying bilateral netting contract in accordance with section

III.E.3. 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 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 equal to 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 underlying rates, prices, and indices, 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. Banking organizations should use, subject

to examiner review, the effective rather than the apparent or stated

notional amount in this calculation. The credit conversion factors

are:

Conversion Factors

[In percent]

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

Commodity,

Interest Exchange excluding Precious

Remaining maturity rate rate and Equity precious metals,

gold metals except gold

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

One year or less............................... 0.0 1.0 6.0 10.0 7.0

Over one to five years......................... 0.5 5.0 8.0 12.0 7.0

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

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

d. For a contract that is structured such that on specified

dates any outstanding exposure is settled and the terms are reset so

that the market value of the contract is zero, the remaining

maturity is equal to the time until the next reset date. For an

interest rate contract with a remaining maturity of more than one

year that meets these criteria, the minimum conversion factor is 0.5

percent.

e. For a contract with multiple exchanges of principal, the

conversion factor is multiplied by the number of remaining payments

in the contract. A derivative contract not included in the

definitions of interest rate, exchange rate, equity, or commodity

contracts as set forth in section III.E.1. of this appendix A is

subject to the same conversion factors as a commodity, excluding

precious metals.

f. No potential future exposure is calculated for a single

currency interest rate swap in which payments are made based upon

two floating rate indices (a so called floating/floating or basis

swap); the credit exposure on such a contract is evaluated solely on

the basis of the mark-to-market value.

g. The Board notes that the conversion factors set forth above,

which are based on observed volatilities of the particular types of

instruments, are subject to review and modification in light of

changing volatilities or market conditions.

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

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

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

a credit equivalent amount. Any legally enforceable form of

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

derivative contracts is recognized for purposes of calculating the

credit equivalent amount provided that:

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 banking organization

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 banking organization 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 banking organization's

exposure to be the 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 derivative

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.53

\53\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.

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

c. A banking organization netting individual contracts for the

purpose of calculating credit equivalent amounts of derivative

contracts represents that it has met the requirements of this

appendix A and all the appropriate documents are in the banking

organization's files and available for inspection by the Federal

Reserve. The Federal Reserve may determine that a

[[Page 46181]]

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 section

III.E.3.a.ii. 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 contracts that are subject to

a qualifying bilateral netting contract is calculated by adding (i)

the current exposure of the netting contract (net current exposure)

and (ii) the sum of the estimates of potential future credit

exposures on all individual contracts subject to the netting

contract (gross potential future exposure) adjusted to reflect the

effects of the netting contract.54

\54\For 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.

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

e. The net current exposure is the sum of 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 net current exposure is equal to that sum. If

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

the net current exposure is zero. The Federal Reserve may determine

that a netting contract qualifies for risk-based capital netting

treatment even though certain individual contracts included under

the netting contract may not qualify. In such instances, the

nonqualifying contracts should be treated as individual contracts

that are not subject to the netting contract.

f. Gross potential future exposure, or Agross is calculated

by summing the estimates of potential future exposure (determined in

accordance with section III.E.2 of this appendix A) for each

individual contract subject to the qualifying bilateral netting

contract.

g. The effects of the bilateral netting contract on the gross

potential future exposure are recognized through the application of

a formula that results in an adjusted add-on amount (Anet). The

formula, which employs the ratio of net current exposure to gross

current exposure (NGR), is expressed as:

Anet=(0.4 x Agross)+0.6(NGR x Agross)

h. The NGR may be calculated in accordance with either the

counterparty-by-counterparty approach or the aggregate approach.

i. Under the counterparty-by-counterparty approach, the NGR is

the ratio of the net current exposure for a netting contract to the

gross current exposure of the netting contract. The gross current

exposure is the sum of the current exposures of all individual

contracts subject to the netting contract calculated in accordance

with section III.E.2. of this appendix A. Net negative mark-to-

market values for individual netting contracts with the same

counterparty may not be used to offset net positive mark-to-market

values for other netting contracts with the same counterparty.

ii. Under the aggregate approach, the NGR is the ratio of the

sum of all of the net current exposures for qualifying bilateral

netting contracts to the sum of all of the gross current exposures

for those netting contracts (each gross current exposure is

calculated in the same manner as in section III.E.3.h.i. of this

appendix A). Net negative mark-to-market values for individual

counterparties may not be used to offset net positive current

exposures for other counterparties.

iii. A banking organization must use consistently either the

counterparty-by-counterparty approach or the aggregate approach to

calculate the NGR. Regardless of the approach used, the NGR should

be applied individually to each qualifying bilateral netting

contract to determine the adjusted add-on for that netting contract.

i. 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 or fewer calendar days or instruments traded on exchanges

that require daily payment and receipt of cash variation margin--an

institution may elect to either include or exclude all mark-to-

market values of such contracts when determining net current

exposure, provided the method chosen is applied consistently.

4. Risk Weights. Once the credit equivalent amount for a

derivative contract, or a group of derivative contracts subject to a

qualifying bilateral netting contract, has been determined, that

amount is assigned to the risk category appropriate to the

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

collateral.55 However, the maximum risk weight applicable to

the credit equivalent amount of such contracts is 50 percent.

\55\For derivative contracts, sufficiency of collateral or

guarantees is generally 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.

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

5. Avoidance of double counting. a. In certain cases, credit

exposures arising from the derivative contracts covered by section

III.E. of this appendix A may already be reflected, in part, on the

balance sheet. To avoid double counting such exposures in the

assessment of capital adequacy and, perhaps, assigning inappropriate

risk weights, counterparty credit exposures arising from the

derivative instruments covered by these guidelines may need to be

excluded from balance sheet assets in calculating a banking

organization's risk-based capital ratios.

b. Examples of the calculation of credit equivalent amounts for

contracts covered under this section III.E. are contained in

Attachment V of this appendix A.

* * * * *

4. In appendix A to part 225, Attachments IV and V are revised to

read as follows:

* * * * *

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

for Bank Holding Companies

100 Percent Conversion Factor

1. Direct credit substitutes. (These include general guarantees

of indebtedness and all guarantee-type instruments, including

standby letters of credit backing the financial obligations of other

parties.)

2. Risk participations in bankers acceptances and direct credit

substitutes, such as standby letters of credit.

3. Sale and repurchase agreements and assets sold with recourse

that are not included on the balance sheet.

4. Forward agreements to purchase assets, including financing

facilities, on which drawdown is certain.

5. Securities lent for which the banking organization is at

risk.

50 Percent Conversion Factor

1. Transaction-related contingencies. (These include bid-bonds,

performance bonds, warranties, and standby letters of credit backing

the nonfinancial performance of other parties.)

2. Unused portions of commitments with an original maturity

exceeding one year, including underwriting commitments and

commercial credit lines.

3. Revolving underwriting facilities (RUFs), note issuance

facilities (NIFs), and similar arrangements.

20 Percent Conversion Factor

Short-term, self-liquidating trade-related contingencies,

including commercial letters of credit.

Zero Percent Conversion Factor

Unused portions of commitments with an original maturity of one

year or less, or which are unconditionally cancellable at any time,

provided a separate credit decision is made before each drawing.

Credit Conversion for Derivative Contracts

1. The credit equivalent amount of a derivative 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

derivative 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:

[[Page 46182]]

Conversion Factors

[In percent]

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

Commodity,

Interest Exchange excluding Precious

Remaining maturity rate rate and Equity precious metals,

gold metals except gold

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

One year or less............................... 0.0 1.0 6.0 10.0 7.0

Over one to five years......................... 0.5 5.0 8.0 12.0 7.0

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

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

For contracts subject to a qualifying bilateral netting

contract, the potential future exposure is, generally, the sum of

the individual potential future exposures for each contract included

under the netting contract adjusted by the application of the

following formula:

Anet=(0.4 x Agross)+0.6(NGR x Agross)

NGR is the ratio of net current exposure to gross current

exposure.

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 or fewer days are excluded.

Instruments traded on exchanges that require daily receipt and

payment of cash variation margin are also excluded.

Attachment V--Calculating Credit Equivalent Amounts for Derivative Contracts

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

Notional Potential Current Credit

Type of Contract principal Conversion exposure Mark-to- exposure equivalent

amount factor (dollars) market (dollars) amount

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

(1) 120-day forward foreign

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

(2) 4-year forward foreign

exchange......................... 6,000,000 .05 300,000 -120,000 0 300,000

(3) 3-year single-currency fixed &

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

(4) 6-month oil swap.............. 10,000,000 .10 1,000,000 -250,000 0 1,000,000

(5) 7-year cross-currency floating

& floating interest rate swap.... 20,000,000 .075 1,500,000 -1,500,000 0 1,500,000

Total....................... ........... ........... 2,900,000 + 300,000 3,200,000

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

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

qualifying bilateral netting contract, then the following applies:

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

Potential Credit

Contract future Net current equivalent

exposure exposure amount

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

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

(2).............................. 300,000 ........... ...........

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

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

(5).............................. 1,500,000 ........... ...........

Total...................... 2,900,000 +0 2,900,000

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

Note: The total of the mark-to-market values from the first table is-

$1,370,000. Since this is a negative amount the net current exposure

is zero.

b. To recognize the effects of bilateral netting on potential

future exposure the following formula applies:

Anet=(0.4 x Agross)+0.6(NGR x Agross)

c. In the above example, where the net current exposure is zero,

the credit equivalent amount would be calculated as follows:

NGR=0=(0/300,000)

Anet=(0.4 x $2,900,000)+.6(0 x $2,900,000)

Anet=$1,160,000

The credit equivalent amount is $1,160,000+0=$1,160,000.

d. If the net current exposure was a positive number, for

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

follows:

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

Anet=(0.4 x $2,900,000)+0.6(.67 x $2,900,000)

Anet=$2,325,800

The credit equivalent amount would be

$2,325,800+$200,000=$2,525,800.

* * * * *

By order of the Board of Governors of the Federal Reserve

System, August 25, 1995.

Jennifer J. Johnson,

Deputy Secretary of the Board.

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR CHAPTER III

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

Directors of the FDIC amends 12 CFR part 325 as follows:

PART 325--CAPITAL MAINTENANCE

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

follows:

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

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

1828(o), 1831o, 1835, 3907, 3909, 4808; Pub. L. 102-233, 105 Stat.

1761, 1789, 1790 (12 U.S.C. 1831n note) Pub. L. 102-242, 105 Stat.

2236, 2355, 2386 (12 U.S.C. 1828 note).

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

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

b. Redesignating footnotes 35 through 38 as footnotes 36 through

39;

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

section II.D.; and

d. Revising section II.E. to read as follows:

[[Page 46183]]

Appendix A to Part 325--Statement of Policy on Risk-Based Capital

* * * * *

II. * * *

C. * * *

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

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

assigned to the 50 percent risk category.

* * * * *

D. * * *35 * * *

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

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

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

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

determination is generally made in relation to the credit equivalent

amount. Collateral and guarantees are subject to the same provisions

noted under section II.B. of this appendix A.

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

* * * * *

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

(including precious metal) and Equity Derivative Contracts)

1. Credit equivalent amounts are computed for each of the

following off-balance-sheet derivative contracts:

(a) Interest Rate Contracts

(i) Single currency interest rate swaps.

(ii) Basis swaps.

(iii) Forward rate agreements.

(iv) Interest rate options purchased (including caps, collars,

and floors purchased).

(v) Any other instrument linked to interest rates that gives

rise to similar credit risks (including when-issued securities and

forward deposits accepted).

(b) Exchange Rate Contracts

(i) Cross-currency interest rate swaps.

(ii) Forward foreign exchange contracts.

(iii) Currency options purchased.

(iv) Any other instrument linked to exchange rates that gives

rise to similar credit risks.

(c) Commodity (including precious metal) or Equity Derivative

Contracts

(i) Commodity- or equity-linked swaps.

(ii) Commodity- or equity-linked options purchased.

(iii) Forward commodity- or equity-linked contracts.

(iv) Any other instrument linked to commodities or equities that

gives rise to similar credit risks.

2. Exchange rate contracts with an original maturity of 14

calendar days or less and derivative contracts traded on exchanges

that require daily receipt and payment of cash variation margin may

be excluded from the risk-based ratio calculation. Gold contracts

are accorded the same treatment as exchange rate contracts except

gold contracts with an original maturity of 14 calendar days or less

are included in the risk-based calculation. Over-the-counter options

purchased are included and treated in the same way as other

derivative contracts.

3. Credit Equivalent Amounts for Derivative Contracts. (a) The

credit equivalent amount of a derivative contract that is not

subject to a qualifying bilateral netting contract in accordance

with section II.E.5. of this appendix A is equal to the sum of:

(i) The current exposure (which is equal to the mark-to-market

value,40 if positive, and is sometimes referred to as the

replacement cost) of the contract; and

\40\Mark-to-market values are measured in dollars, regardless of

the currency or currencies specified in the contract and should

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

counterparty credit quality.

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

(ii) An estimate of the potential future credit exposure.

(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 equal to that mark-to-market value. If the

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

is zero.

(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 credit conversion

factors are:

Conversion Factor Matrix

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

Exchange Precious

Remaining maturity Interest rate and Equity metals, Other

rate gold except gold commodities

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

One year or less............................... 0.0% 1.0% 6.0% 7.0% 10.0%

More than one year to five years............... 0.5% 5.0% 8.0% 7.0% 12.0%

More than five years........................... 1.5% 7.5% 10.0% 8.0% 15.0%

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

(d) For contracts that are structured to settle outstanding

exposure on specified dates and where the terms are reset such that

the market value of the contract is zero on these specified dates,

the remaining maturity is equal to the time until the next reset

date. For interest rate contracts with remaining maturities of more

than one year and that meet these criteria, the conversion factor is

subject to a minimum value of 0.5 percent.

(e) For contracts with multiple exchanges of principal, the

conversion factors are to be multiplied by the number of remaining

payments in the contract. Derivative contracts not explicitly

covered by any of the columns of the conversion factor matrix are to

be treated as ``other commodities.''

(f) No potential future exposure is calculated for single

currency interest rate swaps in which payments are made based upon

two floating rate indices (so called floating/floating or basis

swaps); the credit exposure on these contracts is evaluated solely

on the basis of their mark-to-market values.

4. Risk Weights and Avoidance of Double Counting. (a) Once the

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

derivative contracts subject to a qualifying bilateral netting

agreement, has been determined, that amount is assigned to the risk

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

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

weight that will be applied to the credit equivalent amount of such

contracts is 50 percent.

(b) In certain cases, credit exposures arising from the

derivative contracts covered by these guidelines may already be

reflected, in part, on the balance sheet. To avoid double counting

such exposures in the assessment of capital adequacy and, perhaps,

assigning inappropriate risk weights, counterparty credit exposures

arising from the types of instruments covered by these guidelines

may need to be excluded from balance sheet assets in calculating a

bank's risk-based capital ratio.

(c) The FDIC notes that the conversion factors set forth in

section II.E.3. of appendix A, which are based on observed

volatilities of the particular types of instruments, are subject to

review and modification in light of changing volatilities or market

conditions.

(d) Examples of the calculation of credit equivalent amounts for

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

A.

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

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

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

a credit equivalent amount. Any legally enforceable form of

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

derivative contracts is recognized for purposes of calculating the

credit equivalent amount provided that:

(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 or obligation to receive or pay, respectively, 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

[[Page 46184]]

perform due to default, bankruptcy, 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, bankruptcy 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; and

(iv) The bank maintains in its file documentation adequate to

support the netting of derivative 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.41

\41\For purposes of this section, a walkaway clause means a

provision in a netting contract that permits a non-defaulting

counterparty to make lower payments than it would make otherwise

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

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

defaulter is a net creditor under the contract.

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

inadequate or that a netting contract may not be legally enforceable

under any one of the bodies of law described in paragraphs (ii)(1)

through (3) of section II.E.5.(a) of this appendix A, underlying

individual contracts may be treated as though they were not subject

to the netting contract.

(d) The credit equivalent amount of derivative contracts that

are subject to a qualifying bilateral netting contract is calculated

by adding:

(i) The net current exposure of the netting contract; and

(ii) The sum of the estimates of potential future exposure for

all individual contracts subject to the netting contract, adjusted

to take into account the effects of the netting contract.42

\42\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.

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(e) The net current exposure is the sum of all positive and

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

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

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

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

the net current exposure is zero.

(f) The effects of the bilateral netting contract on the gross

potential future exposure are recognized through application of a

formula, resulting in an adjusted add-on amount (Anet). The

formula, which employs the ratio of net current exposure to gross

current exposure (NGR) is expressed as:

Anet=(0.4 x Agross)+0.6(NGR x Agross)

The effect of this formula is that Anet is the weighted

average of Agross, and Agross adjusted by the NGR.

(g) The NGR may be calculated in either one of two ways--

referred to as the counterparty-by-counterparty approach and the

aggregate approach.

(i) Under the counterparty-by-counterparty approach, the NGR is

the ratio of the net current exposure of the netting contract to the

gross current exposure of the netting contract. The gross current

exposure is the sum of the current exposures of all individual

contracts subject to the netting contract calculated in accordance

with section II.E. of this appendix A.

(ii) Under the aggregate approach, the NGR is the ratio of the

sum of all of the net current exposures for qualifying bilateral

netting contracts to the sum of all of the gross current exposures

for those netting contracts (each gross current exposure is

calculated in the same manner as in section II.E.5.(g)(i) of this

appendix A). Net negative mark-to-market values to individual

counterparties cannot be used to offset net positive current

exposures to other counterparties.

(iii) A bank must use consistently either the counterparty-by-

counterparty approach or the aggregate approach to calculate the

NGR. Regardless of the approach used, the NGR should be applied

individually to each qualifying bilateral netting contract to

determine the adjusted add-on for that netting contract.

3. In appendix A to part 325, Table III is amended by:

a. In the last sentence, removing ``II.E.3.'' and adding in its

place ``II.E.5.''; and

b. Revising the chart and its heading to read as follows:

Table III. * * *

* * * * *

Credit Conversion for Derivative Contracts

* * * * *

Conversion Factor Matrix

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

Exchange Precious

Remaining maturity Interest rate and Equity metals, Other

rate gold except gold commodities

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

One year or less............................... 0.0% 1.0% 6.0% 7.0% 10.0%

More than one year to five years............... 0.5% 5.0% 8.0% 7.0% 12.0%

More than five years........................... 1.5% 7.5% 10.0% 8.0% 15.0%

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

* * * * *

4. Appendix A to part 325, Table IV, is revised to read as follows:

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

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

Potential exposure + Current = Credit equivalent amount

------------------------------------------------ exposure --------------------------------------- Credit

Notional ------------- Potential Mark-to Current equivalent

Type of contract (remaining principal Conversion exposure market exposure amount

maturity) (dollars) factor (dollars) value (dollars)

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

(1) 120-Day Forward Foreign

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

(2) 4-Year Forward Foreign

Exchange......................... 6,000,000 .05 300,000 -120,000 0 300,000

(3) 3-Year Single-Currency Fixed/

Floating Interest Rate Swap...... 10,000,000 .005 50,000 200,000 200,000 250,000

[[Page 46185]]

(4) 6-Month Oil Swap.............. 10,000,000 .10 1,000,000 -250,000 0 1,000,000

(5) 7-Year Cross-Currency Floating/

Floating Interest Rate Swap...... 20,000,000 .075 1,500,000 -1,500,000 0 1,500,000

Total....................... ........... ........... 2,900,000 ........... 300,000 3,200,000

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

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

qualifying bilateral netting contract, then the following applies:

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

Potential

future Credit

exposure Net current equivalent

(from exposure* amount

above)

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

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

(2)....................................... 300,000

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

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

(5)....................................... 1,500,000

Total............................... 2,900,000 + 0 = 2,900,000

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

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

current exposure is zero.

(2) To recognize the effects of netting on potential future

exposure, the following formula applies:

Anet=(0.4 x Agross)+0.6(NGR x Agross)

(3) In the above example:

NGR=0=(0/300,000)

Anet=(0.4 x 2,900,000)+0.6(0 x 2,900,000)

Anet=1,160,000

Credit Equivalent Amount: 1,160,000+0=1,160,000

(4) If the net current exposure was a positive amount, for

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

as follows:

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

Anet=(0.4 x 2,900,000)+0.6(.67 x 2,900,000)

Anet=2,325,800

Credit Equivalent Amount: 2,325,800+200,000=2,525,800

By order of the Board of Directors.

Dated at Washington, D.C. this 25th day of August, 1995.

Federal Deposit Insurance Corporation.

Jerry L. Langley,

Executive Secretary.

[FR Doc. 95-21608 Filed 9-1-95; 8:45 am]

BILLING CODE 4810-33-P, 6210-01-P, 6714-01-P