[Federal Register Volume 59, Number 113 (Tuesday, June 14, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-14266]


[[Page Unknown]]

[Federal Register: June 14, 1994]


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DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

12 CFR Part 567

[No. 94-95]
RIN 1550-AA75

 

Risk-Based Capital Standards; Bilateral Netting Requirements

AGENCY: Office of Thrift Supervision (OTS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: The Office of Thrift Supervision (OTS) is proposing to amend 
its risk-based capital standards to recognize the risk-reducing 
benefits of netting arrangements. Under the proposal, savings 
associations 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 OTS is proposing these amendments on the basis of 
proposed revisions to the Basle Accord which would permit the 
recognition of such netting arrangements. These amendments parallel 
recent amendments proposed by the Board of Governors of the Federal 
Reserve System (FRB) and the Office of the Comptroller of the Currency 
(OCC). 59 FR 26456 (May 20, 1994). The effect of the proposed 
amendments would be to allow thrift 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 on or before July 14, 1994.

ADDRESSES: Written comments should be submitted to the Director, 
Information Services Division, Public Affairs, Office of Thrift 
Supervision, 1700 G Street, NW., Washington, DC 20552, Attention Docket 
No. 94-95. These submissions may be hand delivered at 1700 G Street, 
NW., from 9 a.m. to 5 p.m. on business days; they may be sent by 
facsimile transmission to FAX Number (202) 906-7755. Submissions must 
be received by 5 p.m. on the day they are due in order to be considered 
by the OTS. Late filed, misaddressed or misidentified submissions will 
not be considered in this notice of proposed rulemaking. Comments will 
be available for public inspection at 1700 G Street, NW., from 1 p.m. 
until 4 p.m. on business days. Visitors will be escorted to and from 
the Public Reading Room at established intervals.

FOR FURTHER INFORMATION CONTACT: John F. Connolly, Senior Program 
Manager, Capital Policy (202) 906-6455; Lorraine E. Waller, Counsel 
(Banking and Finance) (202) 906-6458, Regulations & Legislation 
Division, Office of Thrift Supervision, 1700 G Street, NW., Washington, 
DC 20552.

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 OTS and the other banking agencies2 each adopted in 1989 
similar frameworks to assess the capital adequacy of the banking 
organizations under their supervision. Banking organizations and 
savings associations (institutions) 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, the Netherlands, Sweden, Switzerland, 
the United Kingdom, and the United States) and Luxembourg.
    \2\The banking agencies are the Office of Thrift Supervision, 
the Office of the Comptroller of the Currency, the Board of 
Governors of the Federal Reserve System and the Federal Deposit 
Insurance Corporation.
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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.3
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    \3\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.4 An institution should 
mark-to-market all of its rate contracts to reflect the current market 
value of the transaction 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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    \4\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.5 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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    \5\For interest rate contracts with a remaining maturity of one 
year or less, the factor is 0% and for those over one year, the 
factor is .5%. For exchange rate contracts with a maturity of one 
year of less, the factor is 1% and for those 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.\6\ 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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    \6\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 banking agencies and the Basle Supervisors' Committee have long 
recognized the importance and encouraged the use of netting 
arrangements as a means of improving interbank efficiency and reducing 
counterparty credit exposure. Netting arrangements 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.\7\ 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.\8\ 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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    \7\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.
    \8\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.\9\ 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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    \9\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 banking agencies' risk-based capital standards provide for the 
same treatment of rate contracts as the Basle Accord, but require that 
institutions 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.\10\ 
Under the proposal, for purposes of determining the current exposure 
amount 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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    \10\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 OTS's public information office.
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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 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 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 transactions 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.11 A banking organization would then add together the 
potential future credit exposure amount (always a positive value) of 
each individual contract subject to the netting arrangement 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\1Under 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. Description of the Proposal

    The banking agencies concur with the Basle Supervisors' Committee 
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 OTS is 
proposing to amend its risk-based capital standards in a manner 
consistent with the Basle Supervisors' Committee's proposed revision to 
the Basle Accord and the recently proposed amendments by the OCC and 
the FRB. These proposed amendments would allow institutions 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 proposed amendments would add provisions 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 sum 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.12 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\2For 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 an institution 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 institution 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.
    Today's proposal requires that a savings association 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.13 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\3The 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 savings association 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, an institution that is active in the international 
financial markets may need opinions covering multiple foreign 
jurisdictions as well as domestic law. The OTS expects 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 savings association 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 savings association 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 savings association must maintain in its files documentation adequate 
to support any particular risk-based capital treatment. In the case of 
a bilateral netting contract, a savings association 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 OTS 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 institutions 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.
    Today's 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 OTS believes 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 OTS is seeking comment on all aspects of its proposed 
amendments to the risk-based capital standards. In addition, the OTS 
notes 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 OTS seeks 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.

F. Regulatory Flexibility Act

    Pursuant to section 605(b) of the Regulatory Flexibility Act, the 
OTS hereby certifies 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 OTS believes 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.

G. Executive Order 12866

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

List of Subjects in 12 CFR Part 567

    Capital, Reporting and recordkeeping requirements, Savings 
associations.

Authority and Issuance

    For the reasons set out in the preamble, part 567, of chapter v, 
title 12 of the Code of Federal Regulations is proposed to be amended 
as set forth below.

SUBCHAPTER D--REGULATIONS APPLICABLE TO SAVINGS ASSOCIATIONS

PART 567--CAPITAL

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

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

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


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

    (a) * * *
    (2) * * *
    (v) Off-balance sheet contracts: interest-rate and foreign exchange 
rate contracts (Group E)--(A) Calculation of credit equivalent amounts. 
The credit equivalent amount of an off-balance sheet interest rate or 
foreign exchange rate contract that is not subject to a qualifying 
bilateral netting contract in accordance with paragraph (a)(2)(v)(B) of 
this section is equal to the sum of the current credit exposure, i.e., 
the replacement cost of the contract, and the potential future credit 
exposure of the off-balance sheet rate contract. The calculation of 
credit equivalent amounts must be measured in U.S. dollars, regardless 
of the currency or currencies specified in the off-balance sheet rate 
contract.
    (1) Current credit exposure. The current credit exposure 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 
credit 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. In 
determining its current credit exposure for multiple off-balance sheet 
rate contracts executed with a single counterparty, a savings 
association may net positive and negative mark-to-market values of off-
balance sheet rate contracts if subject to a bilateral netting contract 
as provided in paragraph (a)(2)(v)(B) of this section.
    (2) Potential future credit exposure. The potential future credit 
exposure on an off-balance sheet rate contract, including contracts 
with negative mark-to-market values, is estimated by multiplying the 
notional principal9 by one of the following credit conversion 
factors, as appropriate:10
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    \9\For purposes of calculating potential future credit exposure 
for foreign exchange contracts and other similar contracts, in which 
notional principal is equivalent to cash flows, total notional 
principal is defined as the net receipts to each party falling due 
on each value date in each currency.
    \1\0No potential future credit exposure is calculated for single 
currency interest rate swaps in which payments are made based upon 
two floating rate indices, so-called floating/floating or basis 
swaps; the credit equivalent amount is measured solely on the basis 
of the current credit exposure.

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

    (B) Off-balance sheet rate contracts subject to bilateral netting 
contracts. In determining its current credit exposure for multiple off-
balance sheet rate contracts executed with a single counterparty, a 
savings association may net off-balance sheet rate contracts subject to 
a bilateral netting contract by offsetting positive and negative mark-
to-market values, provided that:
    (1) The bilateral netting contract is in writing;
    (2) The bilateral netting contract creates a single legal 
obligation for all individual off-balance sheet rate contracts covered 
by the bilateral netting contract, and provides, in effect, that the 
savings association 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 rate 
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;
    (3) The savings association 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 savings association's exposure to be the net amount under:
    (i) The law of the jurisdiction in which the counterparty is 
chartered or the equivalent location in the case of noncorporate 
entities, and if a branch of the counterparty is involved, then also 
under the law of the jurisdiction in which the branch is located;
    (ii) The law that governs the individual off-balance sheet rate 
contracts covered by the bilateral netting contract; and
    (iii) The law that governs the bilateral netting contract;
    (4) The savings association establishes and maintains procedures to 
monitor possible changes in relevant law and to ensure that the 
bilateral netting contract continues to satisfy the requirements of 
this section; and
    (5) The savings association maintains in its files documentation 
adequate to support the netting of an off-balance sheet rate 
contract.11
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    \1\1By netting individual off-balance sheet rate contracts for 
the purpose of calculating its credit equivalent amount, a savings 
association represents that documentation adequate to support the 
netting of an off-balance sheet rate contract is in the savings 
association's files and available for inspection by the OTS. Upon 
determination by the OTS that a savings association's files are 
inadequate or that a bilateral netting contract may not be legally 
enforceable under any one of the bodies of law described in 
paragraph (a)(2)(v)(3)(i) through (iii) of this section, the 
underlying individual off-balance sheet rate contracts may not be 
netted for the purposes of this section.
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    (C) Walkaway clause. A bilateral netting contract that contains a 
walkaway clause is not eligible for netting for purposes of calculating 
the current credit exposure amount. The term ``walkaway clause'' means 
a provision in a bilateral netting contract that permits a 
nondefaulting counterparty to make a lower payment than it would make 
otherwise under the bilateral netting contract, or no payment at all, 
to a defaulter or the estate of a defaulter, even if the defaulter or 
the estate of a defaulter is a net creditor under the bilateral netting 
contract.
    (D) Risk weighting. Once the savings association determines the 
credit equivalent amount for off-balance sheet rate contracts, 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.
    (E) 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 savings association's risk-based capital 
ratio:
    (1) A foreign exchange rate contract with an original maturity of 
14 calendar days or less; and
    (2) Any interest rate or foreign exchange rate contract that is 
traded on an exchange requiring the daily payment of any variations in 
the market value of the contract.
* * * * *
    Dated: June 1, 1994.

    By the Office of Thrift Supervision.
Jonathan L. Fiechter,
Acting Director.
[FR Doc. 94-14266 Filed 6-13-94; 8:45 am]
BILLING CODE 6720-01-P