[Federal Register Volume 59, Number 141 (Monday, July 25, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-17762]


[[Page Unknown]]

[Federal Register: July 25, 1994]


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FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 325

RIN 3064-AB42

 

Risk-Based Capital Standards; Bilateral Netting Requirements

AGENCY: Federal Deposit Insurance Corporation (FDIC or Corporation).

ACTION: Notice of proposed rulemaking.

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SUMMARY: The FDIC is proposing to amend its risk-based capital 
standards to recognize the risk reducing benefits of netting 
arrangements. Under the proposal, state nonmember banks 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 FDIC is 
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 
state nonmember banks 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 by the FDIC on or before August 24, 
1994.

ADDRESSES: Send comments to Robert E. Feldman, Acting Executive 
Secretary, Federal Deposit Insurance Corporation, 550 17th Street NW., 
Washington, DC 20429. Comments may be hand delivered to room F-402, 
1776 F Street NW., Washington, DC, on business days between 8:30 a.m. 
and 5:00 p.m. [Fax number: (202) 898-3838.] Comments may be inspected 
at the FDIC's Reading Room, room 7118, 550 17th Street NW., Washington, 
DC between 9:00 a.m. and 4:30 p.m. on business days.

FOR FURTHER INFORMATION CONTACT: William A. Stark, Assistant Director, 
(202) 898-6972, Curtis Wong, Capital Markets Specialist, (202) 898-
7327, Division of Supervision, FDIC, 550 17th Street NW., Washington, 
DC 20429; Jeffrey M. Kopchik, Counsel, (202) 898-3872, Christopher 
Curtis, Senior Counsel, (202) 898-3728, FDIC, Legal Division, 550 17th 
Street NW., Washington, DC 20429; Linda L. Stamp, Counsel, (202) 736-
0161, FDIC, Legal Division, 1717 H Street NW., Washington DC 20429.

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 FDIC adopted in 1989 similar frameworks to assess the capital 
adequacy of state nonmember banks. Banks 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 bank 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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    \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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    A bank 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, a bank 
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 over one year, the 
factor is .5%. For exchange rate contracts with a maturity of one 
year or 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.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 FDIC 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.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. The FDIC's 
risk-based capital standards provide for the same treatment of rate 
contracts as the Basle Accord, but require that banks use the 
current exposure method. The FDIC, in adopting its standards, 
generally stated it would work with the Basle Supervisors' Committee 
in its continuing efforts with regard to the recognition of netting 
provisions for capital purposes.
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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 
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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    \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.''
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    Specifically, the Basle proposal states that a bank 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 state nonmember bank 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.10 A bank 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\0Under the proposal, a state nonmember bank 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. 
Banks 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 FDIC concurs 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 FDIC 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. The FDIC's proposed amendments would allow banks 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 FDIC's proposed amendments would add provisions to its 
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 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.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 FDIC 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 bank 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 bank 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 FDIC's proposal requires that a bank 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 a failure to perform due to 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 
bank 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 bank 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 bank's involvement in rate contracts. For 
instance, a bank that is active in the international financial markets 
may need opinions covering multiple foreign jurisdictions as well as 
domestic law. The FDIC 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 bank 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 bank 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 bank must maintain in its files documentation adequate to support any 
particular risk-based capital treatment. In the case of a bilateral 
netting contract, a bank 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 FDIC 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 banks 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 a 
counterparty fails to perform due to default, insolvency, bankruptcy, 
liquidation or similar circumstances. The FDIC notes that pursuant to 
section 11(e) of the Federal Deposit Insurance Act (FDI Act), 12 U.S.C. 
1821(e), the FDIC, in its capacity as conservator or receiver of a 
failed insured depository institution, may transfer all or none of a 
failed institution's qualified financial contracts (QFCs)13 with a 
given counterparty and its affiliates to an assuming insured depository 
institution. Such a transfer by the FDIC as receiver, if accompanied by 
the statutorily mandated notice, overrides any contractual right the 
counterparty might otherwise have to terminate, close-out, and net its 
contracts by reason of the appointment of the FDIC as receiver. 
Further, the FDIC as conservator may, under section 11(e) of the FDI 
Act, enforce continued performance of QFCs without transferring them, 
even if the contracts contain clauses that would otherwise enable the 
counterparty to treat them as in default, and hence to terminate and 
net them, by reason of the appointment of a conservator.14
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    \1\3The scope of this transfer power is established in the FDIC 
Statement of Policy on Qualified Financial Contracts adopted 
December 12, 1989. The term QFC is defined in section 11(e)(8)(D)(i) 
of the FDI Act. It includes securities contracts, commodity 
contracts, forward contracts, repurchase agreements, swap 
agreements, and any similar agreement that the FDIC determines by 
regulation to be a QFC. Interest and exchange rate contracts, as 
specifically referred to in the risk-based capital guidelines, are 
generally QFCs.
    \1\4 The Board of Governors of the Federal Reserve System (Fed), 
the Office of the Comptroller of the Currency (OCC), and the Office 
of Thrift Supervision (OTS) (collectively, the other banking 
agencies) either have published or are in the process of publishing 
notices of proposed rulemaking amending their risk-based capital 
guidelines which are similar to the FDIC's proposal. The other 
banking agencies are not addressing the scope of the FDIC's transfer 
and enforcement powers under section 11 of the FDI Act.
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    The FDIC is of the opinion that its transfer and enforcement powers 
under the FDI Act are consistent with the netting provisions of the 
FDIC Improvement Act of 1991 (FDICIA). Those provisions specifically 
sanction the enforceability of bilateral netting contracts (12 U.S.C. 
4403(a)); so do the FDI Act's QFC provisions (12 U.S.C. 
1821(e)(8)(A)(iii), (E)(iii)). The FDIC's transfer and enforcement 
powers, described in the text, are associated with its power to 
override a different kind of contractual provision--the so-called 
``ipso facto'' clauses that permit a counterparty to terminate a 
contract by reason of the appointment of a receiver or conservator even 
if there has been no default in performance. Although such clauses may 
activate netting clauses, they are not themselves specifically 
addressed in, or protected by, the FDICIA netting provisions. Thus, 
there is no conflict of language between the FDI Act's QFC provisions 
and the FDICIA netting provisions. Nor is there any inconsistency in 
the statutes' underlying policy. The policy of the FDI Act's QFC 
provisions, like that of the FDICIA netting provisions, is to preserve 
a counterparty's net position: If the FDIC does not transfer or enforce 
a counterparty's QFCs, then the contracts may be terminated and netted 
to the extent provided by their terms; and if the contracts are 
transferred or enforced, then the netting provisions continue in force 
as a part of the entire complex of contractual obligations. The 
transfer and enforcement provisions of the FDI Act do no more than to 
preserve the continuity of contractual relationships in cases of 
receivership and conservatorship, an effect that the FDIC believes to 
be consistent with the letter and spirit of the FDICIA netting 
provisions.
    In the event that QFCs are transferred from a failed institution to 
a new depository institution, the amount of credit risk the non-failed 
counterparty is exposed to remains the same. Thus, the netting 
provisions in the contracts may be enforced against or by the assuming 
insured depository institution in the event of a subsequent default. 
Therefore, the FDIC would not regard a netting contract as 
unenforceable, for risk-based capital purposes, simply because the FDIC 
as receiver might transfer it within the limited circumstances 
prescribed in section 11(e) of the FDI Act. In the case of QFCs 
enforced without transfer by the FDIC as conservator, the counterparty 
would continue to enjoy its contractual rights to terminate and net 
such enforced contracts by reason of a default in performance (as 
distinct from a contractually defined default by reason of appointment 
of a conservator). In this regard, the FDIC would not regard a netting 
contract as unenforceable simply because the FDIC as conservator might 
enforce the underlying contracts within the circumstances prescribed in 
section 11(e) of the FDI Act.15
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    \1\5To facilitate the utilization of risk reducing bilateral 
netting contracts which will permit institutions to take advantage 
of the new capital standards prescribed in this proposal, the FDIC 
has determined not to exercise any potential power as a conservator 
selectively to enforce or to repudiate QFCs with the same 
counterparty that are subject to a bilateral netting contract. The 
FDIC would not regard bilateral netting contracts as unenforceable 
solely by reason of the apparent presence of such a power in section 
11(e) of the FDI Act.
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    The FDIC'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 FDIC 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.
    The FDIC is seeking comment on all aspects of its proposed 
amendments to the risk-based capital standards. In addition, the FDIC 
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 FDIC is 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

    The FDIC does not believe adoption of this proposal as a final rule 
would have a significant economic impact on a substantial number of 
small business entities (in this case, small banking organizations), in 
accord with the spirit and purposes of the Regulatory Flexibility Act 
(5 U.S.C. 601 et seq.). In this regard, the final rule would reduce 
certain regulatory burdens on banking organizations as it would reduce 
the capital charge on certain transactions.
    Banks that enter into bilateral netting contracts must obtain a 
legal opinion(s) on the enforceability of those contracts if they wish 
to net for purposes of calculating their capital ratio. A small 
institution may find it more burdensome to obtain a legal opinion(s) 
than a large institution. A small institution, however, 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. The benefits to a small institution of lower capital 
charges after netting will likely outweigh the burdens of obtaining the 
necessary legal opinions.

Paperwork Reduction Act

    The FDIC has determined that the proposed amendments, if adopted, 
would not significantly increase the regulatory burden of state 
nonmember banks pursuant to the Paperwork Reduction Act (44 U.S.C. 3501 
et seq.).

List of Subjects in 12 CFR Part 325

    Bank deposit insurance, Banks, banking, Capital adequacy, Reporting 
and recordkeeping requirements, Savings associations, State nonmember 
banks.

    For the reasons set out in the preamble, the Board of Directors of 
the FDIC proposes to amend 12 CFR part 325 as follows:

PART 325--CAPITAL MAINTENANCE

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

    Authority: 12 U.S.C. 1815(a), 1815(b), 1816, 1818(a), 1818(b), 
1818(c), 1818(t), 1819(Tenth), 1828(c), 1828(d), 1828(i), 1828(n), 
1828(o), 1831o, 3907, 3909; Pub. L. 102-233, 105 Stat. 1761, 1789, 
1790 (12 U.S.C. 1831n note) Pub. L. 102-242, 105 Stat. 2236, 2355, 
2386 (12 U.S.C. 1828 note).

    2. In appendix A to part 325, section II.E. is amended by revising 
the first sentence of the introductory text of II.E.1. and removing the 
footnote in II.E.1.(a); removing the last two sentences of the second 
paragraph of II.E.2.; and adding new II.E.3. to read as follows:

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

* * * * *
    II. * * *
    E. * * *
    1. Credit Equivalent Amounts for Interest Rate and Foreign Exchange 
Rate Contracts. 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.3. of this appendix A is 
equal to the sum of (i) the current exposure (which is equal to the 
mark-to-market value39 and is 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. * * *
---------------------------------------------------------------------------

    \3\9Mark-to-market values should be measured in dollars, 
regardless of the currency or currencies specified in the contract, 
and should reflect changes in both interest (or foreign exchange) 
rates and in counterparty credit quality.
---------------------------------------------------------------------------

* * * * *
    3. Netting. (1) 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 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, bankruptcy, 
liquidation, 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 a failure to perform due to default, insolvency, 
bankruptcy or similar circumstances, the relevant court and 
administrative authorities would find the bank's exposure to be such a 
net amount under:
    (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.
    (2) A contract containing a walkaway clause is not eligible for 
netting for purposes of calculating the credit equivalent 
amount.40
---------------------------------------------------------------------------

    \4\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.
---------------------------------------------------------------------------

    (3) By netting individual contracts for the purpose of calculating 
its credit equivalent amount, a bank represents that it has met the 
requirements of this appendix A and all the appropriate documents are 
in the bank's files and available for inspection by the FDIC. Upon 
determination by the FDIC that a bank's files are inadequate or that a 
netting contract may not be legally enforceable under any one of the 
bodies of law described in paragraphs (b)(i) through (iii) of this 
section, underlying individual contracts may be treated as though they 
were not subject to the netting contract.
    (4) 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.
    (5) 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.
    (6) For each individual contract included in the netting contract, 
the potential future credit exposure is estimated in accordance with 
section II.E.1. of this appendix A.41
---------------------------------------------------------------------------

    \4\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.
---------------------------------------------------------------------------

    (7) Examples of the calculation of credit equivalent amounts for 
these types of contracts are contained in Table IV.
* * * * *
    3. Appendix A to part 325 is amended by revising the last three 
sentences of the last paragraph under the heading ``Credit Conversion 
for Interest Rate and Foreign Exchange Rate Related Contracts'' in 
Table III and adding new Table IV to read as follows:
* * * * *
    III. * * *

Credit Conversion for Interest Rate and Foreign Exchange Rate Related 
Contracts

 * * * * *
    * * * In the event a netting contract covers transactions that are 
normally not included in 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--an institution may elect to consistently 
either include or exclude all mark-to-market values of such 
transactions when determining a net current exposures. Multiple 
contracts with the same counterparty may be netted for risk-based 
capital purposes pursuant to section II.E.3. of this appendix.

     Table IV.--Calculation of Credit Equivalent Amounts for Interest Rate and Foreign Exchange Rate Related Transactions for State Nonmember Banks     
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                            Potential exposure                        Current Exposure                  
                                                         -----------------------------------------------------------------------------------    Credit  
          Type of contract(remaining maturity)              Notional        Potential                 Potential     Mark-to-      Current     equivalent
                                                           principal    x    exposure        =         exposure      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  ............       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  ............       50,000
(5) 7-year cross-currency floating/floating interest                                                                                                    
 rate swap..............................................   20,000,000              .05                 1,000,000   -1,300,000  ............   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         -20,000                                
(3).............................................          50,000         200,000                                
(4).............................................          50,000        -250,000                                
(5).............................................       1,000,000      -1,300,000                                
                                                 ---------------------------------------------------------------
      Total.....................................       1,210,000      -1,370,000  ..............      1,210,000 
----------------------------------------------------------------------------------------------------------------
\1\These numbers are purely for illustration.                                                                   
\2\The larger of zero or a positive mark-to-market value.                                                       

    By order of the Board of Directors.

    Dated at Washington, D.C. this 8th day of June, 1994.

Federal Deposit Insurance Corporation.
Robert E. Feldman
Acting Executive Secretary.
[FR Doc. 94-17762 Filed 7-22-94; 8:45 am]
BILLING CODE 6714-01-P