[Federal Register Volume 59, Number 97 (Friday, May 20, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-12409]


[[Page Unknown]]

[Federal Register: May 20, 1994]


                                                    VOL. 59, NO. 97

                                               Friday, May 20, 1994

DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 3

[Docket No. 94-08]
RIN 1557-AB14

FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

[Docket No. R-0837]

 

Risk-Based Capital Standards; Bilateral Netting Requirements

AGENCIES: Office of the Comptroller of the Currency (OCC), Department 
of the Treasury; and Board of Governors of the Federal Reserve System 
(Board).

ACTION: Notice of proposed rulemaking.

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SUMMARY: The OCC and the Board (the banking agencies) are proposing to 
amend their risk-based capital standards to recognize the risk reducing 
benefits of netting arrangements. Under the proposal, institutions 
regulated by the OCC and the Federal Reserve would be permitted to net, 
for risk-based capital purposes, interest and exchange rate contracts 
(rate contracts) subject to legally enforceable bilateral netting 
contracts that meet certain criteria. The OCC and the Board are 
proposing these amendments on the basis of proposed revisions to the 
Basle Accord which would permit the recognition of such netting 
arrangements. The effect of the proposed amendments would be to allow 
banks and bank holding companies regulated by the OCC and the Federal 
Reserve (banking organizations, institutions) to net positive and 
negative mark-to-market values of rate contracts in determining the 
current exposure portion of the credit equivalent amount of such 
contracts to be included in risk-weighted assets.

DATES: Comments must be received within 30 days of May 20, 1994.

ADDRESSES: Interested parties are invited to submit written comments to 
either or both of the banking agencies. All comments will be shared by 
the banking agencies.
    OCC: Written comments should be submitted to Docket No. 94-08, 
Communications Division, Ninth Floor, Office of the Comptroller of the 
Currency, 250 E Street, SW., Washington, DC 20219. Attention: Karen 
Carter. Comments will be available for inspection and photocopying at 
that address.
    Board of Governors: Comments, which should refer to Docket No. R-
0837, may be mailed to Mr. William W. Wiles, Secretary, Board of 
Governors of the Federal Reserve System, 20th Street and Constitution 
Avenue, NW., Washington, DC 20551; or delivered to room B-2223, Eccles 
Building, between 8:45 a.m. and 5:15 p.m. weekdays. Comments may be 
inspected in room MP-500 between 9 a.m. and 5 p.m. weekdays, except as 
provided in Sec. 261.8 of the Board's Rules Regarding Availability of 
Information, 12 CFR 261.8.

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 Cantor, Senior Attorney, Securities, 
Investments, and Fiduciary Practices (202/874-5210), or Ronald 
Shimabukuro, Senior Attorney, Bank Operations and Asset Division (202/
874-4460), Office of the Comptroller of the Currency, 250 E Street, 
SW., Washington, DC 20219.
    Board of Governors: Roger Cole, Deputy Associate Director (202/452-
2618), Norah Barger, Manager (202/452-2402), Robert Motyka, Supervisory 
Financial Analyst (202/452-3621), Barbara Bouchard, Senior 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).

SUPPLEMENTARY INFORMATION:

A. Background

    The international risk-based capital standards (Basle Accord)1 
include a framework for calculating risk-weighted assets by assigning 
assets and off-balance sheet items, including interest and exchange 
rate contracts, to broad risk categories based primarily on credit 
risk. The OCC and the Federal Reserve both adopted in 1989 similar 
frameworks to assess the capital adequacy of the banking organizations 
under their supervision. Banking organizations must hold capital 
against their overall credit risk, that is, generally, against the risk 
that a loss will be incurred if a counterparty defaults on a 
transaction.
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    \1\The Basle Accord is a risk-based framework that was proposed 
by the Basle Committee on Banking Supervision (Basle Supervisors' 
Committee) and endorsed by the central bank governors of the Group 
of Ten (G-10) countries in July 1988. The Basle Supervisors' 
Committee is comprised of representatives of the central banks and 
supervisory authorities from the G-10 countries (Belgium, Canada, 
France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, the 
United Kingdom, and the United States) and Luxembourg.
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    Under the risk-based capital framework, off-balance sheet items are 
incorporated into risk-weighted assets by first determining the on-
balance sheet credit equivalent amounts for the items and then 
assigning the credit equivalent amounts to the appropriate risk 
category according to the obligor, or if relevant, the guarantor or the 
nature of the collateral. For many types of off-balance sheet 
transactions, the on-balance sheet credit equivalent amount is 
determined by multiplying the face amount of the item by a credit 
conversion factor. For interest and exchange rate contracts however, 
credit equivalent amounts are determined by summing two amounts: The 
current exposure and the estimated potential future exposure.2
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    \2\Exchange rate contracts with an original maturity of 14 
calendar days or less and instruments traded on exchanges that 
require daily payment of variation margin are excluded from the 
risk-based ratio calculations.
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    The current exposure (sometimes referred to as replacement cost) of 
a contract is derived from its market value. In most instances the 
initial market value of a contract is zero.3 A banking 
organization should mark-to-market all of its rate contracts to reflect 
the current market value of the contracts in light of changes in the 
market price of the contracts or in the underlying interest or exchange 
rates. Unless the market value of a contract is zero, one party will 
always have a positive mark-to-market value for the contract, while the 
other party (counterparty) will have a negative mark-to-market value.
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    \3\An options contract has a positive value at inception, which 
reflects the premium paid by the purchaser. The value of the option 
may be reduced due to market movements but it cannot become 
negative. Therefore, unless an option has zero value, the purchaser 
of the option contract will always have some credit exposure, which 
may be greater than or less than the original purchase price, and 
the seller of the option contract will never have credit exposure.
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    An institution holding a contract with a positive mark-to-market 
value is ``in-the-money,'' that is, it would have the right to receive 
payment from the counterparty if the contract were terminated. Thus, an 
institution that is in-the-money on a contract is exposed to 
counterparty credit risk, since the counterparty could fail to make the 
expected payment. The potential loss is equal to the cost of replacing 
the terminated contract with a new contract that would generate the 
same expected cash flows under the existing market conditions. 
Therefore, the in-the-money institution's current exposure on the 
contract is equal to the market value of the contract.
    An institution holding a contract with a negative mark-to-market 
value, on the other hand, is ``out-of-the-money'' on that contract, 
that is, if the contract were terminated, the institution would have an 
obligation to pay the counterparty. The institution with the negative 
mark-to-market value has no counterparty credit exposure because it is 
not entitled to any payment from the counterparty in the case of 
counterparty default. Consequently, a contract with a negative market 
value is assigned a current exposure of zero. A current exposure of 
zero is also assigned to a contract with a market value of zero, since 
neither party would suffer a loss in the event of contract termination. 
In summary, the current exposure of a rate contract equals either the 
positive market value of the contract or zero.
    The second part of the credit equivalent amount for rate contracts, 
the estimated potential future exposure (often referred to as the add-
on), is an amount that represents the potential future credit exposure 
of a contract over its remaining life. This exposure is calculated by 
multiplying the notional principal amount of the underlying contract by 
a credit conversion factor that is determined by the remaining maturity 
of the contract and the type of contract.4 The potential future 
credit exposure is calculated for all contracts, regardless of whether 
the mark-to-market value is zero, positive, or negative.
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    \4\For interest rate contracts with a remaining maturity of one 
year or less, the factor is 0% and for those with a remaining 
maturity of over one year, the factor is .5%. For exchange rate 
contracts with a remaining maturity of one year or less, the factor 
is 1% and for those with a remaining maturity of over one year, the 
factor is 5%.
    Because exchange rate contracts involve an exchange of principal 
upon maturity and are generally more volatile, they carry a higher 
conversion factor. No potential future credit exposure is calculated 
for single-currency interest-rate swaps in which payments are made 
based on two floating indices (basis swaps).
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    The potential future exposure is added to the current exposure to 
arrive at a credit equivalent amount.5 Each credit equivalent 
amount is then assigned to the appropriate risk category, according to 
the counterparty or, if relevant, the guarantor or the nature of the 
collateral. The maximum risk weight applied to such rate contracts is 
50 percent.
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    \5\This method of determining credit equivalent amounts for rate 
contracts is known as the current exposure method, which is used by 
most international banks. The Basle Accord permits, subject to each 
country's discretion, an alternative method for determining the 
credit equivalent amount known as the original exposure method. 
Under this method, the capital charge is derived by multiplying the 
notional principal amount of the contract by a credit conversion 
factor, which varies according to the original maturity of the 
contract and whether it is an interest or exchange rate contract. 
The conversion factors, which are greater than those used under the 
current exposure method, make no distinction between current 
exposure and potential future exposure.
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B. Netting and Current Risk-Based Capital Treatment

    The OCC, the Board, and the Basle Supervisors' Committee have long 
recognized the importance and encouraged the use of netting contracts 
as a means of improving interbank efficiency and reducing counterparty 
credit exposure. Netting contracts are increasingly being used by 
institutions engaging in rate contracts. Often referred to as master 
netting contracts, these arrangements typically provide for both 
payment and close-out netting. Payment netting provisions permit an 
institution to make payments to a counterparty on a net basis by 
offsetting payments it is obligated to make with payments it is 
entitled to receive and, thus, to reduce its costs arising out of 
payment settlements.
    Close-out netting provisions permit the netting of credit exposures 
if a counterparty defaults or upon the occurrence of another event such 
as insolvency or bankruptcy. If such an event occurs, all outstanding 
contracts subject to the close-out provisions are terminated and 
accelerated, and their market values are determined. The positive and 
negative market values are then netted, or set off, against each other 
to arrive at a single net exposure to be paid by one party to the other 
upon final resolution of the default or other event.
    The potential for close-out netting provisions to reduce 
counterparty credit risk, by limiting an institution's obligation to 
the net credit exposure, depends upon the legal enforceability of the 
netting contract, particularly in insolvency or bankruptcy.6 In 
this regard, the Basle Accord noted that while close-out netting could 
reduce credit risk exposure associated with rate contracts, the legal 
status of close-out netting in many of the G-10 countries was uncertain 
and insufficiently developed to support a reduced capital charge for 
such contracts.7 There was particular concern that a bank's credit 
exposure to a counterparty was not reduced if liquidators of a failed 
counterparty might assert the right to ``cherry-pick,'' that is, demand 
performance on those contracts that are favorable and reject contracts 
that are unfavorable to the defaulting party.
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    \6\The primary criterion for determining whether a particular 
netting contract should be recognized in the risk-based capital 
framework is the enforceability of that netting contract in 
insolvency or bankruptcy. In addition, the netting contract as well 
as the individual contracts subject to the netting contract must be 
legally valid and enforceable under non-insolvency or non-bankruptcy 
law, as is the case with all contracts.
    \7\While payment netting provisions can reduce costs and the 
credit risk arising out of daily settlements with a counterparty, 
such provisions are not relevant to the risk-based capital framework 
since they do not in any way affect the counterparty's gross 
obligations.
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    Concern over ``cherry-picking'' led the Basle Supervisors' 
Committee to limit the recognition of netting in the Basle Accord. The 
only type of netting that was considered to genuinely reduce 
counterparty credit risk at the time the Accord was endorsed was 
netting accomplished by novation.8 Under legally enforceable 
netting by novation ``cherry-picking'' cannot occur and, thus, 
counterparty risk is genuinely reduced. The Accord stated that the 
Basle Supervisors' Committee would continue to monitor and assess the 
effectiveness of other forms of netting to determine if close-out 
netting provisions could be recognized for risk-based capital purposes.
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    \8\Netting by novation is accomplished under a written bilateral 
contract providing that any obligation to deliver a given currency 
on a given date is automatically amalgamated with all other 
obligations for the same currency and value date. The previously 
existing contracts are extinguished and a new contract, for the 
single net amount, is legally substituted for the amalgamated gross 
obligations. Parties to the novation contract, in effect, offset 
their obligations to make payments on individual transactions 
subject to the novation contract with their right to receive 
payments on other transactions subject to the contract.
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    The OCC and the Board's risk-based capital standards provide for 
the same treatment of rate contracts as the Basle Accord, but require 
that banking organizations use the current exposure method. The banking 
agencies, in adopting their standards, generally stated they would work 
with the Basle Supervisors' Committee in its continuing efforts with 
regard to the recognition of netting provisions for capital purposes.

C. Basle Supervisors' Committee Proposal

    Since the Basle Accord was adopted, a number of studies have 
confirmed that close-out netting provisions can serve to reduce 
counterparty risk. In response to the conclusions of these studies, as 
well as to industry support for greater acceptance of netting contracts 
under the risk-based capital framework, the Basle Supervisors' 
Committee issued a consultative paper on April 30, 1993, proposing an 
expanded recognition of netting arrangements in the Basle Accord.9 
Under the proposal, for purposes of determining the current exposure of 
rate contracts subject to legally enforceable bilateral close-out 
netting provisions (that is, close-out netting provisions with a single 
counterparty), an institution could net the contracts' positive and 
negative mark-to-market values.
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    \9\The paper is entitled ``The Prudential Supervision of 
Netting, Market Risks and Interest Rate Risk.'' The section 
applicable to netting is subtitled ``The Supervisory Recognition of 
Netting for Capital Adequacy Purposes.'' This paper is available for 
review through the banking agencies' Freedom of Information Offices 
(FOIA) or through public information offices at the Federal Reserve 
Banks or OCC District Offices.
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    Specifically, the Basle proposal states that a banking organization 
would be able to net rate contracts subject to a legally valid 
bilateral netting contract for risk-based capital purposes if it 
satisfied the appropriate national supervisor(s) that:
    (1) In the event of a counterparty's failure to perform due to 
default, bankruptcy or liquidation, the banking organization's claim 
(or obligation) would be to receive (or pay) only the net value of the 
sum of unrealized gains and losses on included transactions;
    (2) It has obtained written and reasoned legal opinions stating 
that in the event of legal challenge, the netting would be upheld in 
all relevant jurisdictions; and
    (3) It has procedures in place to ensure that the netting 
arrangements are kept under review in light of changes in relevant law.
    The Basle Supervisors' Committee agreed that if a national 
supervisor is satisfied that a bilateral netting contract meets these 
minimum criteria, the netting contract may be recognized for risk-based 
capital purposes without raising safety and soundness concerns. The 
Basle Supervisors' Committee's proposal includes a footnote stating 
that if any of the relevant supervisors is dissatisfied with the status 
of the enforceability of a netting contract under its laws, the netting 
contract would not be recognized for risk-based capital purposes by 
either counterparty.
    In addition, the Basle Supervisors' Committee is proposing that any 
netting contract that includes a walkaway clause be disqualified as an 
acceptable netting contract for risk-based capital purposes. A walkaway 
clause is a provision in a netting contract that permits the non-
defaulting counterparty to make only limited payments, or no payments 
at all, to the defaulter or the estate of the defaulter even if the 
defaulter is a net creditor under the contract.
    Under the proposal, a banking organization would calculate one 
current exposure under each qualifying bilateral netting contract. The 
current exposure would be determined by adding together (netting) the 
positive and negative market values for all individual interest rate 
and exchange rate contracts subject to the netting contract. If the net 
market value is positive, that value would equal the current exposure. 
If the net market value is negative or zero, the current exposure would 
be zero. The add-on for potential future credit exposure would be 
determined by calculating individual potential future exposures for 
each underlying contract subject to the netting contract in accordance 
with the procedure already in place in the Basle Accord.10 A 
banking organization would then add together the potential future 
credit exposure (always a positive value) of each individual contract 
subject to the netting contract to arrive at the total potential future 
exposure it has under those contracts with the counterparty. The total 
potential future exposure would be added to the net current exposure to 
arrive at one credit equivalent amount that would be assigned to the 
appropriate risk category.
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    \1\0Under the proposal, a banking organization could net in this 
manner for risk-based capital purposes if it uses, as all U.S. 
banking organizations are required to use, the current exposure 
method for calculating credit equivalent amounts of rate contracts. 
Organizations using the original exposure method would use revised 
conversion factors until market risk-related capital requirements 
are implemented, at which time the original exposure method will no 
longer be available for netted transactions.
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D. The Banking Agencies' Proposal

    The OCC and the Board concur with the Basle Supervisors' 
Committee's determination that the legal status of close-out netting 
provisions has developed sufficiently to support the expanded 
recognition of such provisions for risk-based capital purposes. 
Therefore, the banking agencies are proposing to amend their respective 
risk-based capital standards in a manner consistent with the Basle 
Supervisors' Committee's proposed revision to the Basle Accord. The 
banking agencies' proposed amendments would allow banking organizations 
regulated by the OCC and the Federal Reserve to net the positive and 
negative market values of interest and exchange rate contracts subject 
to a qualifying, legally enforceable bilateral netting contract to 
calculate one current exposure for that netting contract.
    The banking agencies' proposed amendments would add provisions to 
their standards setting forth criteria for a qualifying bilateral 
netting contract and an explanation of how the credit equivalent amount 
should be calculated for such contracts. The risk-based capital 
treatment of an individual contract that is not subject to a qualifying 
bilateral netting contract would remain unchanged.
    For interest and exchange rate contracts that are subject to a 
qualifying bilateral netting contract under the proposed standards, the 
credit equivalent amount would equal the sum of: (i) The current 
exposure of the netting contract and (ii) the total of the add-ons for 
all individual contracts subject to the netting contract. (As with all 
contracts, mark-to-market values for netted contracts would be measured 
in dollars, regardless of the currency specified in the contract.) The 
current exposure of the bilateral netting contract would be determined 
by adding together all positive and negative mark-to-market values of 
the individual contracts subject to the bilateral netting 
contract.11 The current exposure would equal the sum of the market 
values if that sum is positive, or zero if the sum of the market values 
is zero or negative. The potential future exposure (add-on) for each 
individual contract subject to the bilateral netting contract would be 
calculated in the same manner as for non-netted contracts. These 
individual potential future exposures would then be added together to 
arrive at one total add-on amount.
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    \1\1For regulatory capital purposes, the agencies would expect 
that institutions would normally calculate the current exposure of a 
bilateral netting contract by consistently including all contracts 
covered by that netting contract. In the event a netting contract 
covers transactions that are normally excluded from the risk-based 
ratio calculation--for example, exchange rate contracts with an 
original maturity of fourteen calendar days or less or instruments 
traded on exchanges that require daily payment of variation margin--
institutions may elect to consistently either include or exclude all 
mark-to-market values of such transactions when determining net 
current exposures.
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    The proposed amendments provide that a banking organization may 
net, for risk-based capital purposes, interest and exchange rate 
contracts only under a written bilateral netting contract that creates 
a single legal obligation covering all included individual rate 
contracts and that does not contain a walkaway clause. In addition, if 
a counterparty fails to perform due to default, insolvency, bankruptcy, 
liquidation or similar circumstances, the banking organization must 
have a claim to receive a payment, or an obligation to make a payment, 
for only the net amount of the sum of the positive and negative market 
values on included individual contracts.
    The banking agencies' proposal requires that a banking organization 
obtain a written and reasoned legal opinion(s), representing that an 
organization's claim or obligation, in the event of a legal challenge, 
including one resulting from default, insolvency, bankruptcy, or 
similar circumstances, would be found by the relevant court and 
administrative authorities to be the net sum of all positive and 
negative market values of contracts included in the bilateral netting 
contract.12 The legal opinion normally would cover: (i) The law of 
the jurisdiction in which the counterparty is chartered or the 
equivalent location in the case of noncorporate entities, and if a 
branch of the counterparty is involved, the law of the jurisdiction in 
which the branch is located; (ii) the law that governs the individual 
contracts covered by the bilateral netting contract; and (iii) the law 
that governs the netting contract. The multiple jurisdiction 
requirement is designed to ensure that the netting contract would be 
upheld in any jurisdiction where the contract would likely be enforced 
or whose law would likely be applied in an enforcement action, as well 
as the jurisdiction where the counterparty's assets reside.
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    \1\2The Financial Accounting Standards Board (FASB) has issued 
Interpretation No. 39 (FIN 39) relating to the ``Offsetting of 
Amounts Related to Certain Contracts.'' FIN 39 generally provides 
that assets and liabilities meeting specified criteria may be netted 
under generally accepted accounting principles (GAAP). However, FIN 
39 does not specifically require a written and reasoned legal 
opinion regarding the enforceability of the netting contract in 
bankruptcy and other circumstances. Therefore, under this proposal a 
banking organization might be able to net certain contracts in 
accordance with FIN 39 for GAAP reporting purposes, but not be able 
to net those contracts for risk-based capital purposes.
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    A legal opinion could be prepared by either an outside law firm or 
in-house counsel. If a banking organization obtained an opinion on the 
enforceability of a bilateral netting contract that covered a variety 
of underlying contracts, it generally would not need a legal opinion 
for each individual underlying contract that is subject to the netting 
contract, so long as the individual underlying contracts were of the 
type contemplated by the legal opinion covering the netting contract.
    The complexity of the legal opinions will vary according to the 
extent and nature of the organization's involvement in rate contracts. 
For instance, a banking organization that is active in the 
international financial markets may need opinions covering multiple 
foreign jurisdictions as well as domestic law. The banking agencies 
expect that in many cases a legal opinion will focus on whether a 
contractual choice of law would be recognized in the event of default, 
insolvency, bankruptcy or similar circumstances in a particular 
jurisdiction rather than whether the jurisdiction recognizes netting. 
For example, a U.S. institution might engage in interest rate swaps 
with a non-U.S. institution under a netting contract that includes a 
provision that the contract will be governed by U.S. law. In this case 
the U.S. institution should obtain a legal opinion as to whether the 
netting would be upheld in the U.S. and whether the foreign courts 
would honor the choice of U.S. law in default or in an insolvency, 
bankruptcy, or similar proceeding.
    For a banking organization that engages solely in domestic rate 
contracts, the process of obtaining a legal opinion may be much 
simpler. For example, for an institution that is an end-user of a 
relatively small volume of domestic rate contracts, the standard 
contracts used by the dealer bank may already have been subject to the 
mandated legal review. In this case the end-user institution may obtain 
a copy of the opinion covering the standard dealer contracts, supported 
by the bank's own legal opinion.
    The proposed amendments require a banking organization to establish 
procedures to ensure that the legal characteristics of netting 
contracts are kept under review in the light of possible changes in 
relevant law. This review would apply to any conditions that, according 
to the required legal opinions, are a prerequisite for the 
enforceability of the netting contract, as well as to any adverse 
changes in the law.
    As with all of the provisions of the risk-based capital standards, 
a banking organization must maintain in its files documentation 
adequate to support any particular risk-based capital treatment. In the 
case of a bilateral netting contract, a banking organization must 
maintain in its files documentation adequate to support the bilateral 
netting contract. In particular, this documentation should demonstrate 
that the bilateral netting contract would be honored in all relevant 
jurisdictions as set forth in this rule. Typically, these documents 
would include a copy of the bilateral netting contract, legal opinions 
and any related English translations.
    The banking agencies would have the discretion to disqualify any or 
all contracts from netting treatment for risk-based capital purposes if 
the bilateral netting contract, individual contracts, or associated 
legal opinions do not meet the requirements set out in the applicable 
standards. In the event of such a disqualification, the affected 
individual contracts subject to the bilateral netting contract would be 
treated as individual non-netted contracts under the standards.
    As a general matter, relevant legal provisions for banking 
organizations in the U.S. make it clear that netting contracts with 
close-out provisions enable such organizations to setoff included 
individual transactions and reduce the obligations to a single net 
amount in the event of default, insolvency, bankruptcy, liquidation or 
similar circumstances.
    The banking agencies' proposal provides that netting by novation 
arrangements would not be grandfathered under the standards if such 
arrangements do not meet all of the requirements proposed for 
qualifying bilateral netting contracts. Although netting by novation 
would continue to be recognized under the proposed standards, 
institutions may not have the legal opinions or procedures in place 
that would be required by the proposed amendments. The banking agencies 
believe that holding all bilateral netting contracts to the same 
standards will promote certainty as to the legal enforceability of the 
contracts and decrease the risks faced by counterparties in the event 
of a default.

E. Request for Comment

    The banking agencies are seeking comment on all aspects of their 
proposed amendments to the risk-based capital standards. In addition, 
the agencies note that under current risk-based capital standards for 
individual contracts, the degree to which collateral is recognized in 
assigning the appropriate risk weight is based on the market value of 
the collateral in relation to the credit equivalent amount of the rate 
contract. The agencies are seeking comment on the nature of collateral 
arrangements and the extent to which collateral might be recognized in 
bilateral netting contracts, particularly taking into account legal 
implications of collateral arrangements (e.g., whether the collateral 
pledged for an individual transaction would be available to cover the 
net counterparty exposure in the event of legal challenge) and 
procedural difficulties in monitoring collateral levels.

Regulatory Flexibility Act Analysis

    Pursuant to section 605(b) of the Regulatory Flexibility Act, the 
banking agencies hereby certify that this proposed rule will not have a 
significant impact on a substantial number of small business entities. 
Accordingly, a regulatory flexibility analysis is not required.
    The banking agencies believe that a small institution is more 
likely than a large institution to enter into relatively uncomplicated 
transactions under standard bilateral netting contracts and may need 
only to review a legal opinion that has already been obtained by its 
counterparties.

Executive Order 12866

    It has been determined that this proposal is not a significant 
regulatory action as defined in Executive Order 12866.

Paperwork Reduction Act

    The Federal Reserve has determined that its proposed amendments, if 
adopted, would 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.). The OCC has determined that there are no 
reporting or recordkeeping requirements in its proposed amendments; 
accordingly, the provisions of the Paperwork Reduction Act do not 
apply.

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, Branches, Capital 
adequacy, Confidential business information, Currency, Reporting and 
recordkeeping requirements, Securities, State member banks.

12 CFR Part 225

    Administrative practice and procedure, Banks, Banking, Capital 
adequacy, Holding companies, Reporting and recordkeeping requirements, 
Securities.

Comptroller of the Currency

Authority and Issuance

    For the reasons set out in the preamble, appendix A to part 3 of 
title 12, chapter I of the Code of Federal Regulations is proposed to 
be amended as set forth below.

PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES

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

    Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n 
note, 3907 and 3909.

    2. In appendix A, paragraph (c)(15) of section 1 is removed, 
paragraphs (c)(16) through (c)(28) are redesignated as paragraphs 
(c)(15) through (c)(27), and a new paragraph (c)(28) is added to read 
as follows:

Appendix A--Risk-Based Capital Guidelines

* * * * *

Section 1. Purpose, Applicability of Guidelines, and Definitions

* * * * *
    (c) * * *
    (28) Walkaway clause means a provision in a bilateral netting 
contract that permits a nondefaulting counterparty to make a lower 
payment than it would make otherwise under the bilateral netting 
contract, or no payment at all, to a defaulter or the estate of a 
defaulter, even if a defaulter or the estate of a defaulter is a net 
creditor under the bilateral netting contract.

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

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

* * * * *
    (b) * * *
    (5) Off-Balance Sheet Contracts--Interest Rate and Foreign 
Exchange Rate Contracts.
    (i) Calculation of credit equivalent amounts. The credit 
equivalent amount of an off-balance sheet interest rate or foreign 
exchange rate contract is equal to the sum of the current credit 
exposure (also referred to as the replacement cost) and the 
potential future credit exposure of the off-balance sheet rate 
contract. The calculation of credit equivalent amounts must be 
measured in U.S. dollars, regardless of the currency or currencies 
specified in the off-balance sheet rate contract.
    (A) Current credit exposure. The current credit exposure for a 
single off-balance sheet rate contract is determined by the mark-to-
market value of the off-balance sheet rate contract. If the mark-to-
market value is positive, then the current exposure is equal to that 
mark-to-market value. If the mark-to-market value is zero or 
negative, then the current exposure is zero. However, in determining 
its current credit exposure for multiple off-balance sheet rate 
contracts executed with a single counterparty, a bank may net 
positive and negative mark-to-market values of off-balance sheet 
rate contracts if subject to a bilateral netting contract as 
provided by section 3(b)(5)(ii) of this appendix A. If the net mark-
to-market value is positive, then the current credit exposure is 
equal to that net mark-to-market value. If the net mark-to-market 
value is zero or negative, then the current exposure is zero.
    (B) Potential future credit exposure. The potential future 
credit exposure on an off-balance sheet rate contract, including 
contracts with negative mark-to-market values, is estimated by 
multiplying the notional principal18a by one of the following 
credit conversion factors, as appropriate:\19\
---------------------------------------------------------------------------

    \1\8aFor 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.
    \19\No potential future credit exposure is calculated for single 
currency interest rate swaps in which payments are made based upon 
two floating rate indices, so-called floating/floating or basis 
swaps; the credit equivalent amount is measured solely on the basis 
of the current credit exposure.

------------------------------------------------------------------------
                                                   Interest     Foreign 
                                                     rate      exchange 
               Remaining maturity                  contracts     rate   
                                                  (percents)   contracts
                                                              (percents)
------------------------------------------------------------------------
One year or less................................        0           1.0 
Over one year...................................        0.5         5.0 
------------------------------------------------------------------------

    (ii) Off-balance sheet rate contracts subject to bilateral 
netting contracts. In determining its current credit exposure for 
multiple off-balance sheet rate contracts executed with a single 
counterparty, a bank may net off-balance sheet rate contracts 
subject to a bilateral netting contract by offsetting positive and 
negative mark-to-market values, provided that:
    (A) The bilateral netting contract is in writing;
    (B) The bilateral netting contract creates a single legal 
obligation for all individual off-balance sheet rate contracts 
covered by the bilateral netting contract, and provides, in effect, 
that the bank would have a single claim or obligation either to 
receive or pay only the net amount of the sum of the positive and 
negative mark-to-market values on the individual off-balance sheet 
contracts covered by the bilateral netting contract in the event 
that a counterparty, or a counterparty to whom the bilateral netting 
contract has been validly assigned, fails to perform due to any of 
the following events: default, insolvency, bankruptcy, or other 
similar circumstances.
    (C) The bank obtains a written and reasoned legal opinion(s) 
that represents that in the event of a legal challenge, including 
one resulting from default, insolvency, bankruptcy, or similar 
circumstances, the relevant court and administrative authorities 
would find the bank's exposure to be the net amount under:
    (I) The law of the jurisdiction in which the counterparty is 
chartered or the equivalent location in the case of noncorporate 
entities, and if a branch of the counterparty is involved, then also 
under the law of the jurisdiction in which the branch is located;
    (II) The law that governs the individual off-balance sheet rate 
contracts covered by the bilateral netting contract; and
    (III) The law that governs the bilateral netting contract;
    (D) The bank establishes and maintains procedures to monitor 
possible changes in relevant law and to ensure that the bilateral 
netting contract continues to satisfy the requirements of this 
section; and
    (E) The bank maintains in its files documentation adequate to 
support the netting of an off-balance sheet rate contract.\19\a
---------------------------------------------------------------------------

    \19\aBy netting individual off-balance sheet rate contracts 
for the purpose of calculating its credit equivalent amount, a bank 
represents that documentation adequate to support the netting of an 
off-balance sheet rate contract is in the bank's files and available 
for inspection by the OCC. Upon determination by the OCC that a 
bank's files are inadequate or that a bilateral netting contract may 
not be legally enforceable under any one of the bodies of law 
described in section 3(b)(5)(ii)(C)(I) through (III) of this 
appendix A, the underlying individual off-balance sheet rate 
contracts may not be netted for the purposes of this section.
---------------------------------------------------------------------------

    (F) The bilateral netting contract is not subject to a walkaway 
clause.
    (iii) Risk weighting. Once the bank determines the credit 
equivalent amount for an off-balance sheet rate contract, that 
amount is assigned to the risk weight category appropriate to the 
counterparty, or, if relevant, the nature of any collateral or 
guarantee. However, the maximum weight that will be applied to the 
credit equivalent amount of such off-balance sheet rate contracts is 
50 percent.
    (iv) Exceptions. The following off-balance sheet rate contracts 
are not subject to the above calculation, and therefore, are not 
considered part of the denominator of a national bank's risk-based 
capital ratio:
    (A) A foreign exchange rate contract with an original maturity 
of 14 calendar days or less; and
    (B) Any interest rate or foreign exchange rate contract that is 
traded on an exchange requiring the daily payment of any variations 
in the market value of the contract.
* * * * *
    3. The table title and the introductory text to Table 3 are revised 
to read as follows:

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

    The current exposure method is used to calculate the credit 
equivalent amounts of these off-balance sheet rate contracts. These 
amounts are assigned a risk weight appropriate to the obligor or any 
collateral or guarantee. However, the maximum risk weight is limited 
to 50 percent. Multiple off-balance sheet rate contracts with a 
single counterparty may be netted if those contracts are subject to 
a qualifying bilateral netting contract.
* * * * *
    Dated: April 29, 1994.

Office of the Comptroller of the Currency.
Eugene A. Ludwig,
Comptroller of the Currency.

Federal Reserve System

Authority and Issuance

    For the reasons set out in the preamble, parts 208 and 225 of 
chapter II of title 12 of the Code of Federal Regulations are proposed 
to be amended as set forth below.

PART 208--MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL 
RESERVE SYSTEM (REGULATION H)

    1. The authority citation for part 208 continues to read as 
follows:

    Authority: 12 U.S.C. 36, 248(a) and (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, 781(b), 781(g), 
781(i), 78o-4(c)(5), 78q, 78q-1 and 78w; 31 U.S.C. 5318.

    2. Appendix A to part 208 is amended by revising section III.E.2.; 
section III.E.3.; section III.E.5.; the last sentence of Attachment IV; 
and Attachment V to read as follows:

Appendix A to Part 208--Capital Adequacy Guidelines for State Member 
Banks: Risk-Based Measure

* * * * *

III. Procedures for Computing Weighted Risk Assets and Off-Balance 
Sheet Items

* * * * *

E. Interest Rate and Foreign Exchange Rate Contracts

* * * * *
    2. Calculation of credit equivalent amounts. (a) The credit 
equivalent amount of an off-balance sheet rate contract that is not 
subject to a qualifying bilateral netting contract in accordance 
with section III.E.5. of this appendix A is equal to the sum of (i) 
the current exposure (sometimes referred to as the replacement cost) 
of the contract and (ii) an estimate of the potential future credit 
exposure over the remaining life of the contract.
    (b) The current exposure is determined by the mark-to-market 
value of the contract. If the mark-to-market value is positive, then 
the current exposure is 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 both interest rates and counterparty credit 
quality.
    (c) The potential future credit exposure on a contract, 
including contracts with negative mark-to-market values, is 
estimated by multiplying the notional principal amount of the 
contract by one of the following credit conversion factors, as 
appropriate: 

                              [In percent]                              
------------------------------------------------------------------------
                                                     Interest   Exchange
                                                       rate       rate  
                Remaining maturity                  contracts  contracts
                                                                        
------------------------------------------------------------------------
One year or less..................................        0         1.0 
Over one year.....................................        0.5       5.0 
------------------------------------------------------------------------

    (d) Examples of the calculation of credit equivalent amounts for 
these instruments are contained in Attachment V of this appendix A.
    (e) Because exchange rate contracts involve an exchange of 
principal upon maturity, and exchange rates are generally more 
volatile than interest rates, higher conversion factors have been 
established for foreign exchange rate contracts than for interest 
rate contracts.
    (f) No potential future credit exposure is calculated for single 
currency interest rate swaps in which payments are made based upon 
two floating rate indices, so-called floating/floating or basis 
swaps; the credit exposure on these contracts is evaluated solely on 
the basis of their mark-to-market values.
    3. Risk weights. Once the credit equivalent amount for interest 
rate and exchange rate instruments has been determined, that amount 
is assigned to the risk weight category appropriate to the 
counterparty, or, if relevant, the guarantor or the nature of any 
collateral.49 However, the maximum weight that will be applied 
to the credit equivalent amount of such instruments is 50 percent.
---------------------------------------------------------------------------

    \4\9For interest and exchange rate contracts, sufficiency of 
collateral or guaranties is determined by the market value of the 
collateral or the amount of the guarantee in relation to the credit 
equivalent amount. Collateral and guarantees are subject to the same 
provisions noted under section III.B. of this appendix A.
---------------------------------------------------------------------------

* * * * *
    5. Netting. 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 rate 
contracts is recognized for purposes of calculating the credit 
equivalent amount provided that:
    (a) 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 perform due to any of the following events: default, 
insolvency, bankruptcy, or similar circumstances.
    (b) The bank obtains a written and reasoned legal opinion(s) 
representing that in the event of a legal challenge, including one 
resulting from default, insolvency, liquidation or similar 
circumstances, the relevant court and administrative authorities 
would find the bank's exposure to be such a net amount under:
    (i) The law of the jurisdiction in which the counterparty is 
chartered or the equivalent location in the case of noncorporate 
entities, and if a branch of the counterparty is involved, then also 
under the law of the jurisdiction in which the branch is located;
    (ii) The law that governs the individual contracts covered by 
the netting contract; and
    (iii) The law that governs the netting contract.
    (c) 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.
    (d) The bank maintains in its files documentation adequate to 
support the netting of rate contracts, including a copy of the 
bilateral netting contract and necessary legal opinions.
    (i) A contract containing a walkaway clause is not eligible for 
netting for purposes of calculating the credit equivalent 
amount.50
---------------------------------------------------------------------------

    \5\0For 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.
---------------------------------------------------------------------------

    (ii) By netting individual contracts for the purpose of 
calculating its credit equivalent amount, a bank represents that it 
has met the requirements of this appendix A and all the appropriate 
documents are in the bank's files and available for inspection by 
the Federal Reserve. Upon determination by the Federal Reserve 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 
(b)(i) through (iii) above, underlying individual contracts may be 
treated as though they were not subject to the netting contract.
    (iii) The credit equivalent amount of rate contracts that are 
subject to a qualifying bilateral netting contract is calculated by 
adding (A) the current exposure of the netting contract and (B) the 
sum of the estimates of the potential future credit exposure on all 
individual contracts subject to the netting contract.
    (iv) The current exposure of the netting contract is determined 
by summing all positive and negative mark-to-market values of the 
individual contracts included in the netting contract. If the net 
sum of the mark-to-market values is positive, then the current 
exposure of the netting contract is equal to that sum. If the net 
sum of the mark-to-market values is zero or negative, then the 
current exposure of the netting contract is zero.
    (v)For each individual contract included in the netting 
contract, the potential future credit exposure is estimated in 
accordance with section E.2. of this appendix A.51
---------------------------------------------------------------------------

    \5\1For 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.
---------------------------------------------------------------------------

    (vi) Examples of the calculation of credit equivalent amounts 
for these types of contracts are contained in Attachment V of this 
appendix A.
* * * * *

Attachment IV--Credit Conversion Factors for Off-Balance Sheet Items 
for State Member Banks

* * * * *
    * * * Qualifying netting by novation contracts and other 
qualifying bilateral netting contracts may be recognized.
* * * * *

    Attachment V.--Calculation of Credit Equivalent Amounts for Interest Rate and Foreign Exchange Rate Related Transactions for State Member Banks     
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                             Potential exposure                    +              Current exposure                      
                                                 ----------------------------------------------------------------------------------------     Credit    
     Type of contract (remaining maturity)           Notional             Potential            Potential                       Current      equivalent  
                                                     principal      x     exposure     =       exposure     Mark-to-market    exposure        amount    
                                                    (dollars)            conversion            (dollars)       value\1\     (dollars)\2\                
--------------------------------------------------------------------------------------------------------------------------------------------------------
(1) 120-day forward foreign exchange............       5,000,000              .01                   50,000         100,000       100,000         150,000
(2) 120-day forward foreign exchange............       6,000,000              .01                   60,000        -120,000             0          60,000
(3) 3-year single currency fixed/floating                                                                                                               
 interest rate swap.............................      10,000,000              .005                  50,000         200,000       200,000         250,000
(4) 3-year single currency fixed/floating                                                                                                               
 interest rate swap.............................      10,000,000              .005                  50,000        -250,000             0          50,000
(5) 7-year cross-currency floating/floating                                                                                                             
 interest rate swap.............................      20,000,000              .05                1,000,000      -1,300,000             0       1,000,000
                                                 -------------------------------------------------------------------------------------------------------
      Total.....................................  ..............  .....  ..........  .....       1,210,000  ..............       300,000       1,510,000
--------------------------------------------------------------------------------------------------------------------------------------------------------

    If contracts (1) through (5) above are subject to a qualifying 
bilateral netting contract, then the following applies:


----------------------------------------------------------------------------------------------------------------
                                                   Potential                            Current                 
                                                   exposure            Mark-to-market   exposure      Credit    
                                                   (dollars)             value (from   (dollars)    equivalent  
                                                 (from above)              above)                     amount    
----------------------------------------------------------------------------------------------------------------
(1)...........................................          50,000  .....         100,000                           
(2)...........................................          60,000  .....        -120,000                           
(3)...........................................          50,000  .....         200,000                           
(4)...........................................          50,000  .....        -250,000                           
                                               -----------------------------------------------------------------
(5)...........................................       1,000,000             -1,300,000                           
                                               -----------------------------------------------------------------
      Total...................................       1,210,000      +      -1,370,000         0        1,210,000
----------------------------------------------------------------------------------------------------------------
\1\These numbers are purely for illustration.                                                                   
\2\The larger of zero or a positive mark-to-market value.                                                       

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(b), 1828(o), 1831i, 
1843(c)(8), 1844(b), 1972(1), 3106, 3108, 3310, 3331-3351, 3907, and 
3909.

    2. Appendix A to part 225 is amended by revising section III.E.2., 
section III.E.3.; section III.E.5.; the last sentence of Attachment IV; 
and Attachment V to read as follows:

Appendix A to Part 225--Capital Adequacy Guidelines for Bank Holding 
Companies: Risk-Based Measure

* * * * *

III. Procedures for Computing Weighted Risk Assets and Off-Balance 
Sheet Items

* * * * *

E. Interest Rate and Foreign Exchange Rate Contracts

* * * * *
    2. Calculation of credit equivalent amounts. (a) The credit 
equivalent amount of an off-balance sheet rate contract that is not 
subject to a qualifying bilateral netting contract in accordance with 
section III.E.5. of this appendix A is equal to the sum of (i) the 
current exposure (sometimes referred to as the replacement cost) of the 
contract and (ii) an estimate of the potential future credit exposure 
over the remaining life of the contract.
    (b) The current exposure is determined by the mark-to-market value 
of the contract. If the mark-to-market value is positive, then the 
current exposure is 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 both interest rates and counterparty credit quality.
    (c) The potential future credit exposure on a contract, including 
contracts with negative mark-to-market values, is estimated by 
multiplying the notional principal amount of the contract by one of the 
following credit conversion factors, as appropriate: 

                              [In percent]                              
------------------------------------------------------------------------
                                                     Interest   Exchange
                                                       rate       rate  
                Remaining maturity                  contracts  contracts
                                                                        
------------------------------------------------------------------------
One year or less..................................         0    1.0     
Over one year.....................................       0.5    5.0     
------------------------------------------------------------------------

    (d) Examples of the calculation of credit equivalent amounts for 
these instruments are contained in Attachment V of this appendix A.
    (e) Because exchange rate contracts involve an exchange of 
principal upon maturity, and exchange rates are generally more volatile 
than interest rates, higher conversion factors have been established 
for foreign exchange contracts than for interest rate contracts.
    (f) No potential future credit exposure is calculated for single 
currency interest rate swaps in which payments are made based upon two 
floating rate indices, so-called floating/floating or basis swaps; the 
credit exposure on these contracts is evaluated solely on the basis of 
their mark-to-market values.
    3. Risk weights. Once the credit equivalent amount for interest 
rate and exchange rate instruments has been determined, that amount is 
assigned to the risk weight category appropriate to the counterparty, 
or, if relevant, the guarantor or the nature of any collateral.53 
However, the maximum weight that will be applied to the credit 
equivalent amount of such instruments is 50 percent.
---------------------------------------------------------------------------

    \5\3For interest and exchange rate contracts, sufficiency of 
collateral or guaranties is determined by the market value of the 
collateral or the amount of the guarantee in relation to the credit 
equivalent amount. Collateral and guarantees are subject to the same 
provisions noted under section III.B. of this appendix A.
---------------------------------------------------------------------------

* * * * *
    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 rate contracts 
is recognized for purposes of calculating the credit equivalent amount 
provided that:
    (i) The netting is accomplished under a written netting contract 
that creates a single legal obligation, covering all included 
individual contracts, with the effect that the organization would have 
a claim 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 
perform due to any of the following events: default, insolvency, 
bankruptcy, 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, bankruptcy, or 
similar circumstances, the relevant court and administrative 
authorities would find the organization's exposure to be such a net 
amount under:
    (A) 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;
    (B) the law that governs the individual contracts covered by the 
netting contract; and
    (C) the law that governs the netting contract.
    (iii) The banking organization establishes and maintains procedures 
to ensure that the legal characteristics of netting contracts are kept 
under review in the light of possible changes in relevant law.
    (iv) The banking organization maintains in its files documentation 
adequate to support the netting of rate contracts, including a copy of 
the bilateral netting contract and necessary legal opinions.
    (b) A contract containing a walkaway clause is not eligible for 
netting for purposes of calculating the credit equivalent 
amount.54
---------------------------------------------------------------------------

    \5\4For 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 the 
estate of a defaulter, even if a defaulter or the estate of a 
defaulter is a net creditor under the contract.
---------------------------------------------------------------------------

    (c) By netting individual contracts for the purpose of calculating 
its credit equivalent amount, a banking organization represents that it 
has met the requirements of this appendix A and all the appropriate 
documents are in the organization's files and available for inspection 
by the Federal Reserve. Upon determination by the Federal Reserve that 
a banking organization's files are inadequate or that a netting 
contract may not be legally enforceable under any one of the bodies of 
law described in (a)(ii) (A) through (C) above, underlying individual 
contracts may be treated as though they were not subject to the netting 
contract.
    (d) The credit equivalent amount of rate contracts that are subject 
to a qualifying bilateral netting contract is calculated by adding (i) 
the current exposure of the netting contract and (ii) the sum of the 
estimates of the potential future credit exposure on all individual 
contracts subject to the netting contract.
    (e) The current exposure of the netting contract is determined by 
summing all positive and negative mark-to-market values of the 
individual transactions included in the netting contract. If the net 
sum of the mark-to-market values is positive, then the current exposure 
of the netting contract is equal to that sum. If the net sum of the 
mark-to-market values is zero or negative, then the current exposure of 
the netting contract is zero.
    (f) For each individual contract included in the netting contract, 
the potential future credit exposure is estimated in accordance with 
section E.2. of this appendix A.55
---------------------------------------------------------------------------

    \5\5For 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.
---------------------------------------------------------------------------

    (g) Examples of the calculation of credit equivalent amounts for 
these types of contracts are contained in Attachment V of this appendix 
A.
* * * * *

Attachment IV--Credit Conversion Factors for Off-Balance Sheet Items 
for Bank Holding Companies

* * * * *
    * * * Qualifying netting by novation contracts and other qualifying 
bilateral netting contracts may be recognized.
* * * * *

   Attachment V.--Calculation of Credit Equivalent Amounts for Interest Rate and Foreign Exchange Rate Related Transactions for Bank Holding Companies  
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                      Potential exposure                  +                    Current exposure                         
                                          --------------------------------------------------------------------------------------------------    Credit  
  Type of contract (remaining maturity)       Notional             Potential          Potential                            Current            equivalent
                                              principal      x     exposure     =      exposure     +    Mark-to-market    exposure     =       amount  
                                              (dollars)           conversion          (dollars)             value\1\     (ollars)\2\                    
--------------------------------------------------------------------------------------------------------------------------------------------------------
(1) 120-day forward foreign exchange.....       5,000,000              .01                50,000                100,000     100,000              150,000
(2) 120-day forward foreign exchange.....       6,000,000              .01                60,000               -120,000           0               60,000
(3) 3-year single currency fixed/floating                                                                                                               
 interest rate swap......................      10,000,000              .005               50,000                200,000     200,000              250,000
(4) 3-year single currency fixed/floating                                                                                                               
 interest rate swap......................      10,000,000              .005               50,000               -250,000           0               50,000
(5) 7-year cross-currency floating/                                                                                                                     
 floating interest rate swap.............      20,000,000              .05             1,000,000             -1,300,000           0            1,000,000
                                          --------------------------------------------------------------------------------------------------------------
      Total..............................  ..............  .....  ..........  .....    1,210,000  .....  ..............     300,000   .....    1,510,000
--------------------------------------------------------------------------------------------------------------------------------------------------------

    If contracts (1) through (5) above are subject to a qualifying 
bilateral netting contract, then the following applies:

----------------------------------------------------------------------------------------------------------------
                                                   Potential                                                    
                                                   exposure            Mark-to-market   Current       Credit    
                                                   (dollars)             value (from    exposure    equivalent  
                                                 (from above)              above)      (dollars)      amount    
----------------------------------------------------------------------------------------------------------------
(1)...........................................          50,000                100,000                           
(2)...........................................          60,000               -120,000                           
(3)...........................................          50,000                200,000                           
(4)...........................................          50,000               -250,000                           
(5)...........................................       1,000,000              1,300,000                           
                                               -----------------------------------------------------------------
      Total...................................       1,210,000      +      -1,370,000         0        1,210,000
----------------------------------------------------------------------------------------------------------------
\1\These numbers are purely for illustration.                                                                   
\2\The larger of zero or a positive mark-to-market value.                                                       


    Board of Governors of the Federal Reserve System.

May 17, 1994.
William W. Wiles,
Secretary of the Board.
[FR Doc. 94-12409 Filed 5-19-94; 8:45 am]
BILLING CODE 6210-01-P