National bank to establish an operating subsidiary to engage in permissible derivatives-related activities. (05/10/96)

Office of the Comptroller of the Currency

Interpretations - Letter 725

Published in Interpretations and Actions May 1996

Cites:

G 12 C.F.R. 5.34

May 10, 1996

Richard K. Kim, Esquire

Assistant General Counsel

NationsBank Corporation

Legal Department

NationsBank Corporate Center

NC-1-007-20-01

Charlotte, North Carolina 28255

Re: Notification of Intent to Establish an Operating Subsidiary to Engage in Certain Derivatives

Activities

Application Control Number: 96-WO-08-0005

Dear Mr. Kim:

This responds to the NationsBank, N.A. ("Bank") notification ("Notification") of intent to

establish an operating subsidiary to engage in certain derivatives-related activities that are

permissible for national banks and in which the bank is currently engaged. The operating

subsidiary, which will be wholly owned, will be named NationsBanc Financial Products, Inc.

("NFP"). The Bank has committed to structure and operate NFP as set forth in the Notification

and described below.

Based on the commitments and representations made by the Bank, we have no objection to the

Bank's plan to establish NFP to engage in permissible derivatives-related activities, subject to the

condition set forth below.

The Bank's Proposal

The Bank will form NFP for the purpose of entering into interest rate swaps, caps, floors and

swaptions, cross-currency swaps, caps, floors and swaptions, and other derivative transactions

permissible for national banks (collectively the "proposed activities"). The Notification commits

that NFP will engage only in derivatives-related transactions that are permissible for national

banks. The Bank also has represented that it is not establishing NFP to alter or expand the types of

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waps, caps, floors and swaptions, and other derivative transactions

permissible for national banks (collectively the "proposed activities"). The Notification commits

that NFP will engage only in derivatives-related transactions that are permissible for national

banks. The Bank also has represented that it is not establishing NFP to alter or expand the types of

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derivatives transactions in which the Bank engages. Instead, the Bank proposes to establish NFP to

engage in certain types of derivatives transactions in which the Bank currently engages.

The Bank has stated that it is establishing NFP as part of an internal restructuring of the Bank's

current activities. <NOTE: The Notification provides that in July 1993 the Bank purchased substantially all of

the assets of Chicago Research and Trading Group, Ltd., a leading participant in the exchange-traded derivatives

market. The Notification further provides that since then the Bank has become one of the most active U.S. banks in

the derivatives markets with respect to both exchange-traded and OTC instruments.> The Bank will transfer

certain of its existing derivatives-related business to NFP and will structure NFP so that it will be

rated AAA/Aaa by Standard and Poor's Rating Service and Moody's Investors Service, Inc.

<NOTE: NFP will be a continuation structure in that it will continue to exist in the event the Bank becomes

insolvent. If the Bank's long-term senior debt rating falls below A-/A3, a contingent manager will be appointed with

a long-term senior debt rating of at least A-/A3. The duties of the contingent manager will vary depending on the

extent of the downgrading. The Bank has not yet selected a contingent manager but has represented that it will be a

major financial institution with a well developed derivatives business. The Bank will notify the OCC of the identity

of the contingent manager as soon as one is retained.> The Bank will transfer derivatives activities to NFP

in an incremental manner

manager will vary depending on the

extent of the downgrading. The Bank has not yet selected a contingent manager but has represented that it will be a

major financial institution with a well developed derivatives business. The Bank will notify the OCC of the identity

of the contingent manager as soon as one is retained.> The Bank will transfer derivatives activities to NFP

in an incremental manner. Initially, NFP's activities will be limited to interest rate and currency

products. Subsequently, the Bank may transfer other types of derivative products, such as energy

swaps and options, to NFP.

The Bank will initially capitalize NFP with $300 million. The Bank may provide additional funds to

NFP from time to time. NFP will use a sophisticated capital model to ensure that it has sufficient

capital at all times to maintain its credit rating. The model will calculate the appropriate level of

capital by simulating market rate movements and counterparty rating fluctuations over an

extended period of time. The aggregate investment, including loans and advances, by the Bank in

NFP will not exceed 15% of the Bank's capital and surplus. <NOTE: Any collateral posted by the Bank to

NFP will not be counted toward this 15% limitation.>

The Notification states that the Bank currently does not contemplate that any affiliate of the Bank

will make any investments, including loans or advances, in NFP. The Notification also provides,

however, that from time to time NFP may enter into transactions with affiliates of the Bank and

that these transactions will at all times comply with Sections 23A and 23B of the Federal Reserve

Act, 12 U.S.C. 371c and 371c-1.

NFP will generally engage in the proposed activities with counterparties rated A or higher, or of

equivalent creditworthiness. Lower rated counterparties will generally enter into derivative

transactions directly with the Bank and are not expected to comprise a significant portion of the

overall derivatives business of the Bank and NFP

and 23B of the Federal Reserve

Act, 12 U.S.C. 371c and 371c-1.

NFP will generally engage in the proposed activities with counterparties rated A or higher, or of

equivalent creditworthiness. Lower rated counterparties will generally enter into derivative

transactions directly with the Bank and are not expected to comprise a significant portion of the

overall derivatives business of the Bank and NFP.

NFP will transfer market risk to the Bank by entering into transactions with the Bank on mirror

terms as those entered into by NFP with unaffiliated parties. NFP will enter into a mirror

transaction with the Bank at the same time that it enters into a third-party transaction. These

mirror transactions will have exactly opposite terms, except for an intermediation fee, payable by

the Bank to NFP on a monthly basis. <NOTE: The Bank will continue to handle portfolio management of

market risk for all derivative transactions entered into by the Bank and its affiliates, including NFP. Initially, NFP

will not independently hedge its portfolio. Once NFP is fully operational, the Bank will actively explore with the

rating agencies the possibility of NFP independently managing its own risk.> NFP will retain the credit risk of

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its proposed activities but will not bear market risk at any time. If a transaction between NFP and

a third-party is terminated, amended or assigned, the corresponding mirror trade will be

terminated or amended simultaneously.

The Bank will collateralize its obligations to NFP on a net mark-to-market basis in order to

maintain NFP's credit rating. The Bank has represented that posting collateral on behalf of NFP is

more efficient than the Bank's current practice of posting collateral in connection with each

individual transaction and only netting transactions with the same counterparty. Due to its higher

credit rating, NFP will not post collateral on behalf of the Bank

on a net mark-to-market basis in order to

maintain NFP's credit rating. The Bank has represented that posting collateral on behalf of NFP is

more efficient than the Bank's current practice of posting collateral in connection with each

individual transaction and only netting transactions with the same counterparty. Due to its higher

credit rating, NFP will not post collateral on behalf of the Bank. NFP will rarely post collateral to

affiliated or unaffiliated counterparties with a rating of A+/A2 or lower.

The Bank has represented that the fundamental reason it is shifting certain of its derivatives

business into NFP is to attract those counterparties that will only enter into derivatives

transactions with entities with a AA-/Aa3 or higher rating. According to the Bank, market

research indicates that a significant number of derivative users will only trade with entities that

are rated AA or better, particularly with respect to instruments with maturities over one year.

These counterparties include major multinational corporations, domestic and international

institutional investors, and governmental and quasi governmental agencies. The Bank views these

potential counterparties as a highly desirable segment of the market of derivative products

end-users because they actively use derivatives and typically have high credit ratings. In the Bank's

view, attracting these counterparties is essential as the derivatives markets develop and business

becomes increasingly concentrated among large, highly-rated banks and securities firms.

The Bank has represented that the proposal is consistent with safe and sound banking practices

and in fact should enhance the Bank's overall safety and soundness. The Bank believes that

establishing a credit-enhanced derivatives program will increase the Bank's derivatives revenues

and profitability. The program will also increase the proportion of higher-rated counterparties

within the Bank's overall derivatives portfolio and thus improve overall portfolio credit quality

banking practices

and in fact should enhance the Bank's overall safety and soundness. The Bank believes that

establishing a credit-enhanced derivatives program will increase the Bank's derivatives revenues

and profitability. The program will also increase the proportion of higher-rated counterparties

within the Bank's overall derivatives portfolio and thus improve overall portfolio credit quality. In

addition, the Bank expects that the formation of NFP will benefit other lines of business by

providing access to a wider range of potential customers.

The Bank has stated that NFP will treat all business dealings with the Bank and its affiliates in an

arm's length manner. <NOTE: The Bank will provide certain services to NFP including accounting, credit,

documentation, transaction support, risk management and payment services.> According to the Notification,

NFP will be managed by its board of directors, not the Bank, and will have at least one officer and

two directors who are independent from the Bank. The Notification also commits that the assets of

the Bank and NFP will not be commingled, and that NFP will maintain its own corporate records,

financial statements, and accounting records.

Similarly, the Bank represents that both the Bank and NFP will hold out NFP as a separate and

distinct corporate entity in their written and personal contact with outside parties. All written

marketing material will clearly state that NFP is a separate subsidiary of the Bank and the

obligations of NFP are not obligations of the Bank. NFP will put in place derivatives

documentation with its counterparties that prohibits (i) cross-netting by counterparties to NFP and

the Bank, its subsidiaries or affiliates and (ii) cross-default provisions based on a default by the

Bank or an affiliate on any type of contract.

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ubsidiary of the Bank and the

obligations of NFP are not obligations of the Bank. NFP will put in place derivatives

documentation with its counterparties that prohibits (i) cross-netting by counterparties to NFP and

the Bank, its subsidiaries or affiliates and (ii) cross-default provisions based on a default by the

Bank or an affiliate on any type of contract.

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Legal Analysis

The Notification provides that the proposed activities will consist of derivatives transactions in

which national banks are permitted to engage, and in particular, interest rate swaps, caps, floors

and swaptions, and cross-currency swaps, caps, floors and swaptions. The Notification further

provides that the Bank currently engages in all of the proposed activities.

The OCC previously has determined that originating, trading, and making markets in certain

swap products and other derivative instruments such as futures and options, as well as hedging

related risk, are within the legally authorized powers of national banks. See, e.g., OCC

No-Objection Letter No. 90-1 (February 16, 1990), reprinted in Fed. Banking L. Rep. (CCH) 83,095

(bank acting as principal in unmatched commodity price index swaps); OCC Interpretive Letter

No. 494 (December 20, 1989), reprinted in Fed. Banking L. Rep. (CCH) 83,083 (approval for

operating subsidiary to purchase and sell financial futures and options for its own account); OCC

Interpretive Letter No. 462 (December 19, 1988), reprinted in Fed. Banking L. Rep. (CCH) 85,666

(approval for operating subsidiary to keep an inventory in interest rate and currency swap and cap

transactions, as agent commit the parent bank to swap and cap transactions, and engage in related

hedging activities). NFP, as an operating subsidiary, may engage in activities that are permissible

for national banks to engage in directly. 12 C.F.R. 5.34(c)

rinted in Fed. Banking L. Rep. (CCH) 85,666

(approval for operating subsidiary to keep an inventory in interest rate and currency swap and cap

transactions, as agent commit the parent bank to swap and cap transactions, and engage in related

hedging activities). NFP, as an operating subsidiary, may engage in activities that are permissible

for national banks to engage in directly. 12 C.F.R. 5.34(c).

Risk-Based Capital Treatment

The Bank has included with the Notification a memorandum discussing its proposed treatment of

NFP for regulatory capital purposes. The Bank proposes to include NFP's capital for purposes of

calculating the Bank's risk-based capital and leverage ratios. The Bank's proposed treatment of

NFP is consistent with current accounting and regulatory practices and 12 C.F.R. Part 3.

Conclusion

Based upon the Notification submitted by the Bank and the commitments and representations

contained therein, and upon the Bank's compliance with the supervisory condition set forth below,

the OCC does not object to the plan to establish an operating subsidiary to perform the permissible

derivatives activities as set forth in the Notification.

The following supervisory condition is a condition imposed in writing by the agency in connection

with the granting of any application or other request within the meaning of 12 U.S.C. 1818:

The Bank's aggregate direct and indirect investments in and advances to NFP shall not exceed an

amount equal to the Bank's legal lending limit.

If you have any questions, please contact Richard Erb, Licensing Manager (202) 874-4610 or

Robert Sihler, National Bank Examiner (202) 874-5060.

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Sincerely,

/s/

Julie L. Williams

Chief Counsel

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