[Federal Register Volume 59, Number 163 (Wednesday, August 24, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-20506]


[[Page Unknown]]

[Federal Register: August 24, 1994]


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FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

[Regulations H and Y; Docket No. R-0845]

 

Capital; Capital Adequacy Guidelines

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Notice of Proposed Rulemaking.

SUMMARY: The Board of Governors of the Federal Reserve System is 
proposing to amend its risk-based capital guidelines for state member 
banks and bank holding companies. The proposal would revise and expand 
the set of conversion factors used to calculate the potential future 
exposure of derivative contracts and recognize effects of netting 
arrangements in the calculation of potential future exposure for 
derivative contracts subject to qualifying bilateral netting 
arrangements.
    The Board is proposing these amendments on the basis of proposed 
revisions to the Basle Accord announced on July 15, 1994. The effect of 
the proposed amendments would be twofold. First, long-dated interest 
rate and exchange rate contracts would be subject to new higher 
conversion factors and new conversion factors would be set forth that 
specifically apply to derivative contracts related to equities, 
precious metals, and other commodities. Second, institutions would be 
permitted to recognize a reduction in potential future exposure for 
transactions subject to qualifying bilateral netting arrangements.

DATES: Comments must be received on or before October 21, 1994.

ADDRESSES: Comments should refer to docket No. R-0845 and may be mailed 
to William W. Wiles, Secretary, Board of Governors of the Federal 
Reserve System, 20th Street and Constitution Avenue, N.W., Washington, 
D.C. 20551. Comments may also be delivered to Room B-2222 of the Eccles 
Building between 8:45 a.m. and 5:15 p.m. weekdays, or to the guard 
station in the Eccles Building courtyard on 20th Street, N.W. (between 
Constitution Avenue and C Street) at any time. Comments may be 
inspected in Room MP-500 of the Martin Building between 9:00 a.m. and 
5:00 p.m. weekdays, except as provided in 12 CFR 261.8 of the Board's 
Rules regarding availability of information.

FOR FURTHER INFORMATION CONTACT: Roger Cole, Deputy Associate Director 
(202/452-2618), Norah Barger, Manager (202/452-2402), Robert Motyka, 
Supervisory Financial Analyst (202/452-3621), Barbara Bouchard, Senior 
Financial Analyst (202/452-3072), Division of Banking Supervision and 
Regulation; or Stephanie Martin, Senior Attorney (202/452-3198), Legal 
Division. For the hearing impaired only, Telecommunication Device for 
the Deaf, Dorothea Thompson (202/452-3544).

SUPPLEMENTARY INFORMATION:

I. Background

    The international risk-based capital standards (the Basle 
Accord)1 set forth a framework for measuring capital adequacy 
under which risk-weighted assets are calculated by assigning assets and 
off-balance-sheet items to broad categories based primarily on their 
credit risk, that is, the risk that a loss will be incurred due to an 
obligor or counterparty default on a transaction.2 Off-balance-
sheet transactions are incorporated into risk-weighted assets by 
converting each item into a credit equivalent amount which is then 
assigned to the appropriate credit risk category according to the 
identity of the obligor or counterparty, or if relevant, the guarantor 
or the nature of the collateral.
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    \1\The Basle Accord was proposed by the Basle Committee on 
Banking Supervision (Basle Supervisors' Committee, BSC) 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. In January 1989 the Federal Reserve 
Board adopted a similar framework to be used by state member banks 
and bank holding companies.
    \2\Other types of risks, such as market risks, generally are not 
addressed by the risk-based framework.
---------------------------------------------------------------------------

    The credit equivalent amount of an interest rate or exchange rate 
contract (rate contract) is determined by adding together the current 
replacement cost (current exposure) and an estimate of the possible 
increases in future replacement cost, in view of the volatility of the 
current exposure over the remaining life of the contract (potential 
future exposure, also referred to as the add-on). Each credit 
equivalent amount is then assigned to the appropriate risk category 
generally based on the identity of the counterparty. The maximum risk 
weight applied to interest rate or exchange rate contracts is 50 
percent.3
---------------------------------------------------------------------------

    \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 capital ratio calculations.
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A. Current Exposure

    A banking organization that has a rate contract with a positive 
mark-to-market value has a current exposure to a possible loss equal to 
the mark-to-market value.4 For risk-based capital purposes, if the 
mark-to-market value is zero or negative, then there is no replacement 
cost associated with the contract and the current exposure is zero. The 
sum of current exposures for a defined set of contracts is sometimes 
referred to as the gross current exposure for that set of contracts.
---------------------------------------------------------------------------

    \4\The loss to a banking organization from a counterparty's 
default on a rate contract is the cost of replacing the cash flows 
specified by the contract. The mark-to-market value is the present 
value of the net cash flows specified by the contract, calculated on 
the basis of current market interest and exchange rates.
---------------------------------------------------------------------------

    The Basle Accord, as endorsed in 1988, provided that current 
exposure would be determined individually for every rate contract 
entered into by a banking organization. Generally, institutions were 
not permitted to offset, that is, net, positive and negative mark-to-
market values of multiple rate contracts with a single counterparty to 
determine one current exposure relative to that counterparty.5 In 
April 1993 the Basle Supervisors' Committee (BSC) proposed a revision 
to the Basle Accord, endorsed by the G-10 Governors in July 1994, that 
permits institutions to net positive and negative mark-to-market values 
of rate contracts subject to a qualifying, legally enforceable, 
bilateral netting arrangement. Under the revision to the Accord, 
institutions with qualifying netting arrangements could replace the 
gross current exposure of a set of contracts included in such an 
arrangement with a single net current exposure for purposes of 
calculating the credit equivalent amount for the included contracts. If 
the net market value is positive, then that market value equals the 
current exposure for the netting contract. If the net market value is 
zero or negative, then the current exposure is zero.
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    \5\Netting by novation, however, was recognized. 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.
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    On May 20, 1994, the Board and the Office of the Comptroller of the 
Currency (OCC) issued a joint proposal to amend their respective risk-
based capital guidelines in accordance with the BSC April 1993 
proposal.6 Generally, under the proposal, a bilateral netting 
arrangement would be recognized for risk-based capital purposes only if 
the netting arrangement is legally enforceable. The institution would 
have to have a legal opinion(s) to this effect. The joint Federal 
Reserve/OCC proposal is consistent with the final July 1994 change to 
the Basle Accord. (A detailed discussion of the BSC proposal and the 
Board/OCC proposed amendment to their risk-based capital guidelines can 
be found at 59 FR 26456, May 20, 1994.)
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    \6\The Office of Thrift Supervision issued a similar netting 
proposal on June 14, 1994 and the Federal Deposit Insurance 
Corporation issued its netting proposal on July 25, 1994.
---------------------------------------------------------------------------

B. Potential Future Exposure

    The second part of the credit equivalent amount, potential future 
exposure, is an estimate of the additional exposure that may arise over 
the remaining life of the contract as a result of fluctuations in 
prices or rates. Such changes may increase the market value of the 
contract in the future and, therefore, increase the cost of replacing 
it if the counterparty subsequently defaults.
    The add-on for potential future exposure is estimated by 
multiplying the notional principal amount7 of the underlying 
contract by a credit conversion factor that is determined by the 
remaining maturity of the contract and the type of contract. The 
existing set of conversion factors used to calculate potential future 
exposure, referred to as the add-on matrix, is as follows:
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    \7\The notional principal amount, or value, is a reference 
amount of money used to calculate payment streams between the 
counterparties. Principal amounts generally are not exchanged in 
single-currency interest rate swaps, but generally are exchanged in 
foreign exchange contacts (including cross-currency interest rate 
swaps). 

------------------------------------------------------------------------
                                                     Interest   Exchange
                                                       rate       rate  
                Remaining maturity                  contracts  contracts
                                                       (in        (in   
                                                     percent)   percent)
------------------------------------------------------------------------
One year or less..................................          0        1.0
Over one year.....................................        0.5        5.0
------------------------------------------------------------------------

    The conversion factors were determined through simulation studies 
that estimated the potential volatility of interest and exchange rates 
and analyzed the implications of movements in those rates for the 
replacement costs of various types of interest rate and exchange rate 
contracts. The simulation studies were conducted only on interest rate 
and foreign exchange rate contracts, because at the time the Accord was 
being developed activity in the derivatives market was for the most 
part limited to these types of transactions. The analysis produced 
probability distributions of potential replacement costs over the 
remaining life of matched pairs of rate contracts.8 Potential 
future exposure was then defined in terms of confidence limits for 
these distributions. The conversion factors were intended to be a 
compromise between precision, on the one hand, and complexity and 
burden, on the other.9
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    \8\A matched pair is a pair of contracts with identical terms, 
with the banking organization the buyer of one of the contracts and 
the seller of the other.
    \9\The methodology upon which the statistical analyses were 
based is described in detail in a technical working paper entitled 
``Potential Credit Exposure on Interest Rate and Foreign Exchange 
Rate Related Instruments.'' This paper is available upon request 
from the Board's Freedom of Information Office.
---------------------------------------------------------------------------

    The add-on for potential future exposure is calculated for all 
contracts, regardless of whether the market value is zero, positive, or 
negative, or whether the current exposure is calculated on a gross or 
net basis. The add-on will always be either a positive number or zero. 
The recent revision to the Basle Accord to recognize netting for the 
calculation of current exposure does not affect the calculation of 
potential future exposure, which generally continues to be calculated 
on a gross basis. This means that an add-on for potential future 
exposure is calculated separately for each individual contract subject 
to the netting arrangement and then these individual future exposures 
are added together to arrive at a gross add-on for potential future 
exposure. For contracts subject to a qualifying bilateral netting 
arrangement in accordance with the newly adopted Accord changes, the 
gross add-on for potential future exposure would be added to the net 
current exposure to arrive at one credit equivalent amount for the 
contracts subject to the netting arrangement.
    The original Basle Accord noted that the credit conversion factors 
in the add-on matrix were provisional and would be subject to revision 
if volatility levels or market conditions changed.

II. Basle Proposals for the Treatment of Potential Future Exposure

    Since the original Accord was adopted, the derivatives market has 
grown and broadened. The use of certain types of derivative instruments 
not specifically addressed in the Accord--notably commodity, precious 
metals, and equity-linked transactions10--has become much more 
widespread. As a result of continued review of the method for 
calculating the add-on for potential future exposure, in July 1994 the 
BSC issued two proposals for public consultation.11 The first 
proposal would expand the matrix of add-on factors used to calculate 
potential future exposure to take into account innovations in the 
derivatives market. The second proposal would recognize reductions in 
the potential future exposure of derivative contracts that result from 
entering into bilateral netting arrangements. The second proposal is an 
extension of the recent revision to the Accord recognizing bilateral 
netting arrangements for purposes of calculating current exposure and 
would formally extend the recognition of netting arrangements to 
equity, precious metals and other commodity derivative contracts. The 
consultation period for these BSC proposals is scheduled to end on 
October 10, 1994.
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    \1\0In general terms, these are off-balance-sheet transactions 
that have a return, or a portion of their return, linked to the 
price of a particular commodity, precious metal, or equity or to an 
index of commodity, precious metal, or equity prices.
    \1\1The proposals are contained in a paper from the BSC entitled 
``The Capital Adequacy Treatment of the Credit Risk Associated with 
Certain Off-Balance Sheet Items'' that is available upon request 
from the Board's Freedom of Information Office.
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A. Expansion of Add-on Matrix

    A recently concluded BSC review of the add-on for potential future 
exposure indicated that the current add-on factors used to calculate 
the add-on amount may produce insufficient capital for certain types of 
derivative instruments, in particular, long-dated interest rate 
contracts, commodity contracts, and equity-index contracts. The BSC 
review indicated that the current add-on factors do not adequately 
address the full range of contract structures and the timing of cash 
flows. The review also showed that the conversion factors many 
institutions are using to calculate potential future exposure for 
commodity, precious metals, and equity contracts could result in 
insufficient capital coverage in view of the volatility of the indices 
or prices on the underlying assets from which these contracts derive 
their value.12
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    \1\2While commodity, precious metals, and equity contracts were 
not explicitly covered by the original Accord, as the use of such 
contracts became more prevalent, many G-10 banking supervisors, 
including U.S. banking supervisors, have informally permitted 
institutions to apply the conversion factors for exchange rate 
contracts to these types of transactions pending development of a 
more appropriate treatment.
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    The BSC concluded that it was not appropriate to address these 
problems with a significant departure from the existing methodology 
used in the Accord. The BSC decided that it would be appropriate to 
preserve the conversion factors existing in the Accord and add new 
conversion factors. Consequently, the revision proposed by the BSC 
retains the existing conversion factors for interest and exchange rate 
contracts but applies new higher conversion factors to such contracts 
with remaining maturities of five years and over.13 The proposal 
also introduces conversion factors specifically applicable to 
commodity, precious metals, and equity contracts. The new conversion 
factors were determined on the basis of simulation studies that used 
the same general approach that generated the original add-on conversion 
factors.14
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    \1\3The conversion factors for rate contracts with remaining 
maturities of one to five years are currently applied to contracts 
with a remaining maturity of over one year.
    \1\4The methodology and results of the statistical analyses are 
summarized in a paper entitled ``The Calculation of Add-Ons for 
Derivative Contracts: the ``Expanded Matrix'' Approach'' that is 
available upon request from the Board's Freedom of Information 
Office.
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    The proposed matrix is set forth below: 

                                            Conversion Factor Matrix*                                           
                                              [Amounts in percent]                                              
----------------------------------------------------------------------------------------------------------------
                                                                                          Precious              
                                                   Interest     Foreign                   metals,       Other   
               Residual maturity                    rate        exchange    Equity**    except gold  commodities
                                                               and gold                                         
----------------------------------------------------------------------------------------------------------------
Less than one year.............................         0.0%         1.0%         6.0%         7.0%        12.0%
One to five years..............................         0.5%         5.0%         8.0%         7.0%        12.0%
Five years or more.............................         1.5%         7.5%        10.0%         8.0%       15.0% 
----------------------------------------------------------------------------------------------------------------
*For contracts with multiple exchanges of principal, the factors are to be multiplied by the number of remaining
  payments in the contract.                                                                                     
**For contracts that automatically reset to zero value following a payment, the remaining maturity is set equal 
  to the time remaining until the next payment.                                                                 

    Gold is included within the foreign exchange column because the 
price volatility of gold has been found to be comparable to the 
exchange rate volatility of major currencies. In addition, the BSC 
determined that gold's role as a financial asset distinguishes it from 
other precious metals. The proposed matrix is designed to accommodate 
the different structures of contracts, as well as the observed 
disparities in the volatilities of the associated indices or prices of 
the underlying assets.
    Two footnotes are attached to the matrix to address two particular 
contract structures. The first relates to contracts with multiple 
exchanges of principal. Since the level of potential future exposure 
rises generally in proportion to the number of remaining exchanges, the 
conversion factors are to be multiplied by the number of remaining 
payments (that is, exchanges of principal) in the contract. This 
treatment is intended to ensure that the full level of potential future 
exposure is adequately covered. The second footnote applies to equity 
contracts that automatically reset to zero each time a payment is made. 
The credit risk associated with these contracts is similar to that of a 
series of shorter contracts beginning and ending at each reset date. 
For this type of equity contract the remaining maturity is set equal to 
the time remaining until the next payment.
    While the capital charges resulting from the application of the new 
proposed conversion factors may not provide complete coverage for risks 
associated with any single contract, the BSC believes the factors will 
provide a reasonable level of prudential coverage for derivative 
contracts on a portfolio basis. Like the original matrix, the proposed 
expanded matrix is designed to provide a reasonable balance between 
precision, and complexity and burden.

B. Recognition of the Effects of Netting

    The simulation studies used to generate the conversion factors for 
potential future exposure analyzed the implications of underlying rate 
and price movements on the current exposure of contracts without taking 
into account reductions in exposure that could result from legally 
enforceable netting arrangements. Thus, the conversion factors are most 
appropriately applied to non-netted contracts, and when applied to 
legally enforceable netted contracts, they could in some cases, 
overstate the potential future exposure.
    Comments provided during the consultative process of revising the 
Basle Accord to recognize qualifying bilateral netting arrangements and 
further research conducted by the BSC, have suggested that netting 
arrangements can reduce not only a banking organization's current 
exposure for the transactions subject to the netting arrangement, but 
also its potential future exposure for those transactions.15
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    \1\5While current exposure is intended to cover an 
organization's credit exposure at one point in time, potential 
future exposure provides an estimate of possible increases in future 
replacement cost, in view of the volatility of current exposure over 
the remaining life of the contract. The greater the tendency of the 
current exposure to fluctuate over time, the greater the add-on for 
potential future exposure should be to cover possible fluctuations.
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    As a result, in July 1994 the BSC issued a proposal to incorporate 
into the calculation of the add-on for potential future exposure a 
method for recognizing the risk-reducing effects of qualifying netting 
arrangements. Under the proposal, institutions could recognize these 
effects only for transactions subject to legally enforceable bilateral 
netting arrangements that meet the requirements of netting for current 
exposure as set forth in the recent revision to the Accord.
    Depending on market conditions and the characteristics of a banking 
organization's derivative portfolio, netting arrangements can have 
substantial effects on the organization's potential future exposure to 
multiple derivative contracts it has entered into with a single 
counterparty. Should the counterparty default at some future date, the 
institution's exposure would be limited to the net amount the 
counterparty owes on the date of default rather than the gross current 
exposure of the included contracts. By entering into a netting 
arrangement a bank may reduce not only its current exposure, but 
possibly its future exposure as well. Nevertheless, while in many 
circumstances a netting arrangement can reduce the potential future 
exposure of a counterparty portfolio, this is not always the 
case.16
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    \1\6For purposes of this discussion, a portfolio refers to a set 
of contracts with a single counterparty. A banking organization's 
global portfolio refers to all of the contracts in the institution's 
total derivatives portfolio that are subject to qualifying netting 
arrangements.
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    The most important factors influencing whether a netting 
arrangement will have an effect on potential future exposure are the 
volatilities of the current exposure to the counterparty on both a 
gross and net basis.17 The volatilities of net current exposure 
and gross current exposure of the portfolio may not necessarily be the 
same. Volatility of gross current exposure is influenced primarily by 
the fluctuations of the market values of positively valued contracts. 
Volatility of net current exposure on the other hand, is influenced by 
the fluctuations of the market values of all contracts within the 
portfolio. In those cases where net current exposure has a tendency to 
fluctuate more over time than gross current exposure, a netting 
arrangement will not reduce the potential future exposure. However, in 
those situations where net current exposure has a tendency to fluctuate 
less over time than gross current exposure, a netting arrangement can 
reduce the potential future exposure.
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    \1\7Volatility in this discussion is the tendency of the market 
value of a contract to vary or fluctuate over time. A highly 
volatile portfolio would have a tendency to fluctuate significantly 
over short periods of time. One of the most important factors 
influencing a portfolio's volatility is the correlation of the 
contracts within the portfolio, that is, the degree to which the 
contracts in the portfolio respond similarly to changing market 
conditions.
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    Net current exposure is likely to be less volatile relative to the 
volatility of gross current exposure when the portfolio of contracts as 
a whole is more diverse than the subset of positively valued contracts. 
When a netting arrangement is applied to a diversified portfolio and 
the positively valued contracts within the portfolio as a group are 
less diversified than the overall portfolio, then the effect of the 
netting arrangement will likely be to reduce the potential future 
exposure of the portfolio.
    The BSC has studied and analyzed several alternatives for taking 
into account the effects of netting when calculating the capital charge 
for potential future exposure. In particular, the BSC reviewed one 
general method proposed by commenters to the April 1993 netting 
proposal. This method would reduce the amount of the add-on for 
potential future exposure by multiplying the calculated gross add-on by 
the ratio of the portfolio's net current exposure to gross current 
exposure (the net-to-gross ratio or NGR). The NGR is used as a proxy 
for the risk-reducing effects of the netting arrangement on the 
potential future exposure. The more diversified the portfolio, the 
lower the net current exposure tends to be relative to gross current 
exposure.
    The BSC incorporated this method into its proposal. However, given 
that there are portfolio-specific situations in which the NGR does not 
provide a good indication of these effects, the BSC proposal gives only 
partial weight to the effects of the NGR on the add-on for potential 
future exposure. The proposed method would average the amount of the 
add-on as currently calculated (Agross) and the same amount 
multiplied by the NGR to arrive at a reduced add-on (Anet) for 
contracts subject to qualifying netting arrangements in accordance with 
the requirements set forth in the recently revised Accord. This formula 
is expressed as:
    Anet=.5(Agross+(NGR x Agross)).

For example, a bank with a gross current exposure of 500,000, a net 
current exposure of 300,000, and a gross add-on for potential future 
exposure of 1,200,000, would have an NGR of .6 (300,000/500,000) and 
would calculate Anet as follows:

    .5(1,200,000+(.6 x 1,200,000))
    Anet=960,000

For banking organizations with an NGR of 50 percent, the effect of this 
treatment would be to permit a reduction in the amount of the add-on by 
25 percent. The BSC believes that most dealer banks are likely to have 
an NGR in the vicinity of 50 percent.
    The BSC proposal does not specify whether the NGR should be 
calculated on a counterparty-by-counterparty basis or on an aggregate 
basis for all transactions subject to qualifying, legally enforceable 
netting arrangements. The proposal requests comment on whether the 
choice of method could bias the results and whether there is a 
significant difference in calculation burden between the two methods.
    The BSC proposal also acknowledges that simulations using 
institutions' internal models for measuring credit risk exposure would 
most likely produce the most accurate determination of the effect of 
netting arrangements on potential future exposures. The proposal states 
that the use of such models would be considered at some future date.

III. The Board Proposal

    In light of the BSC proposal, the Board believes that it is 
appropriate to seek comment on proposed revisions to the calculation of 
the add-on for potential future exposure for derivative contracts. 
Therefore, the Board is proposing to amend its risk-based capital 
guidelines for state member banks and bank holding companies to expand 
the matrix of conversion factors, and to permit institutions that make 
use of qualifying netting arrangements to recognize the effects of 
those netting arrangements in the calculation of the add-on for 
potential future exposure. The second part of the proposed amendment is 
contingent on the adoption of a final amendment to the Board's risk-
based capital guidelines to recognize bilateral close-out netting 
arrangements and would formally extend this recognition to commodity, 
precious metals, and equity derivative contracts.
    With regard to the portion of the proposal to expand the conversion 
factor matrix, the Board is proposing the same conversion factors set 
forth in the BSC proposal. The Board agrees with the BSC that the 
existing conversion factors applicable to long-dated transactions do 
not provide sufficient capital for the risks associated with those 
types of contracts. The Board also agrees with the BSC that the 
conversion factors for foreign exchange transactions are significantly 
too low for commodity, precious metals, and equity derivative contracts 
due to the volatility of the associated indices and the prices on the 
underlying assets.18
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    \1\8Similar to the BSC proposal, the Board's proposed amendment 
specifies that for equity contracts that automatically reset to zero 
value following a payment, the remaining maturity is set equal to 
the time remaining until the next payment. Also, for contracts with 
multiple exchanges of principal, the conversion factors are to be 
multiplied by the number of remaining payments in the contract.
---------------------------------------------------------------------------

    The Board is proposing the same formula as the BSC proposal to 
calculate a reduction in the add-on for potential future exposure for 
contracts subject to qualifying netting contracts. The Board recognizes 
several advantages with this formula. First, the formula uses bank-
specific information to calculate the NGR. The NGR is simple to 
calculate and uses readily available information. The Board believes 
the use of the averaging factor of 0.5 is an important aspect of the 
proposed formula because it means the add-on for potential future 
exposure can never be reduced to zero and banking organizations will 
always hold some capital against derivative contracts, even in those 
instances where the net current exposure is zero.
    The Board is seeking comment on all aspects of this proposal. As 
mentioned earlier, the BSC proposal seeks comment on whether the NGR 
should be calculated on a counterparty-by-counterparty basis, or on a 
global basis for all contracts subject to qualifying bilateral netting 
arrangements. The Board's proposed regulatory language would require 
the calculation of a separate NGR for each counterparty with which it 
has a qualifying netting contract. However, the Board is also seeking 
comment as to which method of calculating the NGR would be most 
efficient and appropriate for institutions with numerous qualifying 
bilateral netting arrangements. With either calculation method the NGR 
would be applied separately to adjust the add-on for potential future 
exposure for each netting arrangement. The Board notes that some 
preliminary findings indicate that a global NGR may be less burdensome 
to apply since the same NGR would be used for each counterparty with a 
netting arrangement, but counterparty specific NGRs may provide a more 
accurate indication of the credit risk associated with each 
counterparty.

Regulatory Flexibility Act Analysis

    The Board does not believe that adoption of this proposal 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, while some small institutions 
with limited derivative portfolios may experience an increase in 
capital charges, for most of these institutions the proposal will have 
no effect. For institutions with more developed derivative portfolios 
the overall affect of the proposal will likely be to reduce regulatory 
burden and the capital charge for certain transactions. In addition, 
because the risk-based capital standards generally do not apply to bank 
holding companies with consolidated assets of less than $150 million, 
this proposal will not affect such companies.

Paperwork Reduction Act

    The Federal Reserve has determined that its proposed amendments, if 
adopted, would not increase the regulatory paperwork burden of banking 
organizations pursuant to the provisions of the Paperwork Reduction Act 
(44 U.S.C. 3501 et. seq.).

List of Subjects

12 CFR Part 208

    Accounting, Agriculture, Banks, banking, Capital adequacy, 
Confidential business information, Currency, Federal Reserve System, 
Reporting and recordkeeping requirements, Securities, State member 
banks.

12 CFR Part 225

    Administrative practice and procedure, Banks, banking, Capital 
adequacy, Federal Reserve System, Holding companies, Reporting and 
recordkeeping requirements, Securities.

    For the reasons set forth in the preamble, the Board proposes to 
amend 12 CFR parts 208 and 225 as follows.

PART 208--MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL 
RESERVE SYSTEM (REGULATION H) 
    1. The authority citation for part 208 is revised to read as 
follows:

    Authority: 12 U.S.C. 36, 248(a), 248(c), 321-338a, 371d, 461, 
481-486, 601, 611, 1814, 1823(j), 1828(o), 1831o, 1831p-1, 3105, 
3310, 3331-3351 and 3906-3909; 15 U.S.C. 78b, 78l(b), 78l(g), 
78l(i), 78o-4(c)(5), 78q, 78q-1 and 78w; 31 U.S.C. 5318.

    2. Appendix A to part 208 is amended by revising the last paragraph 
in section III.C.3. and footnote 40 in the introductory text of section 
III.D. to read as follows:
Appendix A to Part 208--Capital Adequacy Guidelines for State Member 
Banks: Risk-Based Measure

* * * * *
    III. * * *
    C. * * *
    3. * * *
    Credit equivalent amounts of derivative contracts involving 
standard risk obligors (that is, obligors whose loans or debt 
securities would be assigned to the 100 percent risk category) are 
included in the 50 percent category, unless they are backed by 
collateral or guarantees that allow them to be placed in a lower 
risk category.
* * * * *
    D. * * * \40\ * * *
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    \40\The sufficiency of collateral and guarantees for off-
balance-sheet items is determined by the market value of the 
collateral or the amount of the guarantee in relation to the face 
amount of the item, except for derivative contracts, for which this 
determination is generally made in relation to the credit equivalent 
amount. Collateral and guarantees are subject to the same provisions 
noted under section III.B of this appendix A.
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* * * * *
    3. Appendix A to part 208 is amended by revising the section III.E. 
heading and section III.E.1. to read as follows:
* * * * *
    III. * * *
    E. Derivative Contracts (Interest Rate, Exchange Rate, Commodity 
(including precious metals), and Equity Contracts)
    1. Scope. (a) Credit equivalent amounts are computed for each of 
the following off-balance-sheet derivative contracts:

I. Interest Rate Contracts

A. Single currency interest rate swaps.
B. Basis swaps.
C. Forward rate agreements.
D. Interest rate options purchased (including caps, collars, and 
floors purchased).
E. Any other instrument that gives rise to similar credit risks 
(including when-issued securities and forward deposits accepted).

II. Exchange Rate Contracts

A. Cross-currency interest rate swaps.
B. Forward foreign exchange contracts.
C. Currency options purchased.
D. Any other instrument that gives rise to similar credit risks.

III. Commodity (including precious metal) or Equity Derivative 
Contracts

A. Commodity or equity linked swaps.
B. Commodity or equity linked options purchased.
C. Forward commodity or equity linked contracts.
D. Any other instrument that gives rise to similar credit risks.

    (b) Exchange rate contracts with an original maturity of 
fourteen calendar days or less and derivative contracts traded on 
exchanges that require daily payment of variation margin may be 
excluded from the risk-based ratio calculation. Over-the-counter 
options purchased, however, are included and treated in the same way 
as other derivative contracts.
* * * * *
    4. In appendix A to part 208, section III.E.2. and section 
III.E.3., as those sections were proposed to be revised at 59 FR 26461, 
May 20, 1994, are revised to read as follows:
* * * * *
    III. * * *
    E. * * *
    2. Calculation of credit equivalent amounts. (a) The credit 
equivalent amount of a derivative contract that is not subject to a 
qualifying bilateral netting contract in accordance with section 
III.E.3. of this appendix A is equal to the sum of (i) the current 
exposure (sometimes referred to as the replacement cost) of the 
contract and (ii) an estimate of the potential future credit 
exposure over the remaining life of the contract.
    (b) The current exposure is determined by the mark-to-market 
value of the contract. If the mark-to-market value is positive, then 
the current exposure is equal to that mark-to market value. If the 
mark-to-market value is zero or negative, then the current exposure 
is zero. Mark-to-market values are measured in dollars, regardless 
of the currency or currencies specified in the contract and should 
reflect changes in both underlying rates, prices, and indices, and 
counterparty credit quality.
    (c) The potential future credit exposure of a contract, 
including contracts with negative mark-to-market values, is 
estimated by multiplying the notional principal amount of the 
contract by one of the following credit conversion factors, as 
appropriate:

                                            Conversion Factor Matrix*                                           
                                              [Amounts in percent]                                              
----------------------------------------------------------------------------------------------------------------
                                                                                          Precious              
                                                   Interest     Exchange                   metals       Other   
               Residual maturity                    rate        rate and    Equity**    except gold  commodities
                                                                 gold                                           
----------------------------------------------------------------------------------------------------------------
Less than one year.............................          0.0          1.0          6.0          7.0         12.0
One to five years..............................          0.5          5.0          8.0          7.0         12.0
Five years or more.............................          1.5          7.5         10.0          8.0         15.0
----------------------------------------------------------------------------------------------------------------
*For contracts with multiple exchanges of principal, the factors are to be multiplied by the number of remaining
  payments in the contract.                                                                                     
**For contracts that reset to zero value following a payment, the remaining maturity is set equal to the time   
  until the next payment.                                                                                       

    (d) No potential future exposure is calculated for single 
currency interest rate swaps in which payments are made based upon 
two floating rate indices (so called floating/floating or basis 
swaps); the credit exposure on these contracts is evaluated solely 
on the basis of their mark-to-market values.
    (e) The Board notes that the conversion factors set forth above, 
which are based on observed volatilities of the particular types of 
instruments, are subject to review and modification in light of 
changing volatilities or market conditions.
    3. Netting. (a) For purposes of this appendix A, netting refers 
to the offsetting of positive and negative mark-to-market values 
when determining a current exposure to be used in the calculation of 
a credit equivalent amount. Any legally enforceable form of 
bilateral netting (that is, netting with a single counterparty) of 
derivative contracts is recognized for purposes of calculating the 
credit equivalent amount provided that:
    (1) The netting is accomplished under a written netting contract 
that creates a single legal obligation, covering all included 
individual contracts, with the effect that the bank would have a 
claim or obligation to receive or pay, respectively, only the net 
amount of the sum of the positive and negative mark-to-market values 
on included individual contracts in the event that a counterparty, 
or a counterparty to whom the contract has been validly assigned, 
fails to perform due to any of the following events: default, 
insolvency, bankruptcy, or similar circumstances.
    (2) The bank obtains a written and reasoned legal opinion(s) 
representing that in the event of a legal challenge, including one 
resulting from default, insolvency, liquidation or similar 
circumstances, the relevant court and administrative authorities 
would find the bank's exposure to be such a net amount under:
    (i) the law of the jurisdiction in which the counterparty is 
chartered or the equivalent location in the case of noncorporate 
entities, and if a branch of the counterparty is involved, then also 
under the law of the jurisdiction in which the branch is located;
    (ii) the law that governs the individual contracts covered by 
the netting contract; and
    (iii) the law that governs the netting contract.
    (3) 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.
    (4) 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.
    (b) A contract containing a walkaway clause is not eligible for 
netting for purposes of calculating the credit equivalent 
amount.49
---------------------------------------------------------------------------

    \4\9For 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.
---------------------------------------------------------------------------

    (c) By netting individual contracts for the purpose of 
calculating its credit equivalent amount, a bank represents that it 
has met the requirements of this appendix A and all the appropriate 
documents are in the bank's files and available for inspection by 
the Federal Reserve. Upon determination by the Federal Reserve that 
a bank's files are inadequate or that a netting contract may not be 
legally enforceable under any one of the bodies of law described in 
section III.E.3.(a)(2) (i) through (iii) of this appendix A, 
underlying individual contracts may be treated as though they were 
not subject to the netting contract.
    (d) The credit equivalent amount of derivative contracts that 
are subject to a qualifying bilateral netting contract is calculated 
by adding (i) the net current exposure for the netting contract and 
(ii) the sum of the estimates of potential future exposure for all 
individual contracts subject to the netting contract, adjusted to 
take into account the effects of the netting contract.
    (e) The net current exposure is the sum of all positive and 
negative mark-to-market values of the individual contracts subject 
to the netting contract. If the net sum of the mark-to-market values 
is positive, then the net current exposure is equal to that sum. If 
the net sum of the mark-to-market values is zero or negative, then 
the net current exposure is zero.
    (f) The sum of the estimates of potential future exposure for 
all individual contracts subject to the netting contract 
(Agross), adjusted to reflect the effects of the netting 
contract (Anet), is determined through application of a 
formula. The formula, which employs the ratio of the net current 
exposure to the gross current exposure (NGR), is expressed as:

    Anet=.5(Agross+(NGR x Agross))

    (g) Gross potential future exposure, or Agross, is 
calculated by summing the estimates of potential future exposure 
(determined in accordance with section III.E.2. of this appendix A) 
for each individual contract subject to the qualifying bilateral 
netting contract.50 The NGR is the ratio of the net current 
exposure of the netting contract to the gross current exposure of 
the netting contract. The gross current exposure is the sum of the 
current exposures of all individual contracts subject to the netting 
contract calculated in accordance with section III.E.2. of this 
appendix A. The effect of this treatment is that Anet is the 
average of Agross and Agross adjusted by the NGR.
---------------------------------------------------------------------------

    \5\0For purposes of calculating gross 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.
---------------------------------------------------------------------------

* * * * *
    5. Appendix A to part 208 is amended by revising section III.E.4. 
to read as follows:
* * * * *
    III. * * *
    E. * * *
    4. Risk weights. (a) Once the credit equivalent amount for a 
derivative contract, or a group of derivative contracts subject to a 
qualifying netting contract, has been determined, that amount is 
assigned to the risk weight category appropriate to the 
counterparty, or, if relevant, the guarantor or the nature of any 
collateral.51 However, the maximum weight that will be applied 
to the credit equivalent amount of such contracts is 50 percent.
---------------------------------------------------------------------------

    \5\1For derivative contracts, sufficiency of collateral or 
guarantees is generally determined by the market value of the 
collateral or the amount of the guarantee in relation to the credit 
equivalent amount. Collateral and guarantees are subject to the same 
provisions noted under section III.B. of this appendix A.
---------------------------------------------------------------------------

* * * * *
    6. In appendix A to part 208, section III.E.5., as that section was 
proposed to be revised at 59 FR 26461, May 20, 1994, is revised to read 
as follows:
* * * * *
    III. * * *
    E. * * *
    5. Avoidance of double counting. (a) In certain cases, credit 
exposures arising from the derivative contracts covered by these 
guidelines may already be reflected, in part, on the balance sheet. 
To avoid double counting such exposures in the assessment of capital 
adequacy and, perhaps, assigning inappropriate risk weights, 
counterparty credit exposures arising from the types of instruments 
covered by these guidelines may need to be excluded from balance 
sheet assets in calculating banks' risk-based capital ratios.
    (b) Examples of the calculation of credit equivalent amounts for 
these types of contracts are contained in Attachment V of this 
appendix A.
* * * * *
    7. In appendix A to part 208, Attachment V, as that attachment was 
proposed to be revised at 59 FR 26462, May 20, 1994, is revised to read 
as follows:
* * * * * 

                Attachment V--Calculation of Credit Equivalent Amounts for Derivative Contracts                 
----------------------------------------------------------------------------------------------------------------
                                       Potential exposure + Current exposure = Credit equivalent amount         
                             -----------------------------------------------------------------------------------
 Type of contract (remaining    Notional                    Potential                    Current                
          maturity)             principal    Conversion     exposure      Mark-to-      exposure                
                                (dollars)      factor       (dollars)   market value    (dollars)               
----------------------------------------------------------------------------------------------------------------
(1) 120-day forward foreign                                                                                     
 exchange...................     5,000,000            01        50,000       100,000       100,000       150,000
(2) 6-year forward foreign                                                                                      
 exchange...................     6,000,000          .075       450,000      -120,000             0       450,000
(3) 3-year interest rate                                                                                        
 swap.......................    10,000,000          .005        50,000       200,000       200,000       250,000
(4) 1-year oil swap.........    10,000,000           .12     1,200,000      -250,000             0     1,200,000
(5) 7-year interest rate                                                                                        
 swap.......................    20,000,000           .05     1,000,000    -1,300,000             0     1,000,000
                             -----------------------------------------------------------------------------------
      Total.................                                 2,750,000                     300,000     3,050,000
----------------------------------------------------------------------------------------------------------------

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

----------------------------------------------------------------------------------------------------------------
                                        Potential                                                               
                                         future                       Net Current                      Credit   
                                        exposure                      exposure\1\                    equivalent 
                                      (from above)                                                     amount   
----------------------------------------------------------------------------------------------------------------
(1).................................        50,000                                                              
(2).................................       450,000                                                              
(3).................................        50,000                                                              
(4).................................     1,200,000                                                              
(5).................................     1,000,000                                                              
                                     ---------------------------------------------------------------------------
      Total.........................     2,750,000              +               0               =     2,750,000 
----------------------------------------------------------------------------------------------------------------
\1\The total of the mark-to-market values from above is -1,370,000. Since this is a negative amount, the net    
  current exposure is zero.                                                                                     
                                                                                                                
To recognize the effects of netting on potential future exposure the following formula applies:                 
  Anet=.5(Agross+(NGR x Agross.)                                                                                
                                                                                                                
In the above example: NGR=0 (0/300,000)Anet=.5(2,750,000+(0 x 2,750,000))Anet=1,375,000.                        
                                                                                                                
Credit equivalent amount: 1,375,000+0=1,375,000.                                                                
                                                                                                                
If the net current exposure was a positive amount, for example $200,000, the credit equivalent amount would be  
  calculated as follows: NGR=.67 (200,000/300,000)Anet=.5(2,750,000+(.67 x 2,750,000))Anet=2,296,250.           
                                                                                                                
Credit Equivalent amount: 2,296,250+200,000=2,496,250.                                                          

* * * * *

PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL 
(REGULATION Y)

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

    Authority: 12 U.S.C. 1817(j)(13), 1818, 1831i, 1843(c)(8), 
1844(b), 1972(l), 3106, 3108, 3310, 3331-3351, 3907, and 3909.

    2. Appendix A to part 225 is amended by revising the last paragraph 
in section III.C.3. and footnote 43 in the introductory text of section 
III.D. to read as follows:

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

* * * * *
    III. * * *
    C. * * *
    3. * * *
    Credit equivalent amounts of derivative contracts involving 
standard risk obligors (that is, obligors whose loans or debt 
securities would be assigned to the 100 percent risk category) are 
included in the 50 percent category, unless they are backed by 
collateral or guarantees that allow them to be placed in a lower 
risk category.
* * * * *
    D. * * * \43\ * * *
---------------------------------------------------------------------------

    \43\The sufficiency of collateral and guarantees for off-
balance-sheet items is determined by the market value of the 
collateral or the amount of the guarantee in relation to the face 
amount of the item, except for derivative contracts, for which this 
determination is generally made in relation to the credit equivalent 
amount. Collateral and guarantees are subject to the same provisions 
noted under section III.B of this Appendix A.
---------------------------------------------------------------------------

* * * * *
    3. Appendix A to part 225 is amended by revising the section III.E. 
heading and section III.E.1. to read as follows:
* * * * *
    III. * * *
    E. Derivative Contracts (Interest Rate, Exchange Rate, Commodity 
(including precious metals) and Equity Derivative Contracts).
    1. Scope. (a) Credit equivalent amounts are computed for each of 
the following off-balance-sheet derivative contracts:

I. Interest Rate Contracts

A. Single currency interest rate swaps.
B. Basis swaps.
C. Forward rate agreements.
D. Interest rate options purchased (including caps, collars, and 
floors purchased).
E. Any other instrument that gives rise to similar credit risks 
(including when-issued securities and forward deposits accepted).

II. Exchange Rate Contracts

A. Cross-currency interest rate swaps.
B. Forward foreign exchange contracts.
C. Currency options purchased.
D. Any other instrument that gives rise to similar credit risks.

III. Commodity (including precious metal) or Equity Derivative 
Contracts

A. Commodity or equity linked swaps.
B. Commodity or equity linked options purchased.
C. Forward commodity or equity linked contracts.
D. Any other instrument that gives rise to similar credit risks.

    (b) Exchange rate contracts with an original maturity of 
fourteen calendar days or less and derivative contracts traded on 
exchanges that require daily payment of variation margin may be 
excluded from the risk-based ratio calculation. Over-the-counter 
options purchased, however, are included and treated in the same way 
as other derivative contracts.
* * * * *
    4. In appendix A to part 225, section III.E.2. and section 
III.E.3., as those sections were proposed to be revised at 59 FR 26463, 
May 20, 1994, are revised to read as follows:
* * * * *
    III. * * *
    E. * * *
    2. Calculation of credit equivalent amounts. (a) The credit 
equivalent amount of a derivative contract that is not subject to a 
qualifying bilateral netting contract in accordance with section 
III.E.3. of this appendix A is equal to the sum of (i) the current 
exposure (sometimes referred to as the replacement cost) of the 
contract and (ii) an estimate of the potential future credit 
exposure over the remaining life of the contract.
    (b) The current exposure is determined by the mark-to-market 
value of the contract. If the mark-to-market value is positive, then 
the current exposure is equal to that mark-to market value. If the 
mark-to-market value is zero or negative, then the current exposure 
is zero. Mark-to-market values are measured in dollars, regardless 
of the currency or currencies specified in the contract and should 
reflect changes in both underlying rates and indices, and 
counterparty credit quality.
    (c) The potential future credit exposure of a contract, 
including contracts with negative mark-to-market values, is 
estimated by multiplying the notional principal amount of the 
contract by one of the following credit conversion factors, as 
appropriate: 

                                            Conversion Factor Matrix*                                           
                                              [Amounts in percent]                                              
----------------------------------------------------------------------------------------------------------------
                                                                                          Precious              
                                                   Interest     Exchange                   metals       Other   
               Residual maturity                    rate        rate and    Equity**    except gold  commodities
                                                                 gold                                           
----------------------------------------------------------------------------------------------------------------
Less than one year.............................          0.0          1.0          6.0          7.0         12.0
One to five years..............................          0.5          5.0          8.0          7.0         12.0
Five years or more.............................          1.5          7.5         10.0          8.0        15.0 
----------------------------------------------------------------------------------------------------------------
*For contracts with multiple exchanges of principal, the factors are to be multiplied by the number of remaining
  payments in the contract.                                                                                     
**For contracts that reset to zero value following a payment, the remaining maturity is set equal to the time   
  until the next payment.                                                                                       

    (d) No potential future exposure is calculated for single 
currency interest rate swaps in which payments are made based upon 
two floating rate indices (so called floating/floating or basis 
swaps); the credit exposure on these contracts is evaluated solely 
on the basis of their mark-to-market values.
    (e) The Board notes that the conversion factors set forth above, 
which are based on observed volatilities of the particular types of 
instruments, are subject to review and modification in light of 
changing volatilities or market conditions.
    3. Netting. (a) For purposes of this appendix A, netting refers 
to the offsetting of positive and negative mark-to-market values 
when determining a current exposure to be used in the calculation of 
a credit equivalent amount. Any legally enforceable form of 
bilateral netting (that is, netting with a single counterparty) of 
derivative contracts is recognized for purposes of calculating the 
credit equivalent amount provided that:
    (1) The netting is accomplished under a written netting contract 
that creates a single legal obligation, covering all included 
individual contracts, with the effect that the organization would 
have a claim or obligation to receive or pay, respectively, only the 
net amount of the sum of the positive and negative mark-to-market 
values on included individual contracts in the event that a 
counterparty, or a counterparty to whom the contract has been 
validly assigned, fails to perform due to any of the following 
events: default, insolvency, bankruptcy, or similar circumstances.
    (2) The banking organization obtains a written and reasoned 
legal opinion(s) representing that in the event of a legal 
challenge, including one resulting from default, insolvency, 
liquidation or similar circumstances, the relevant court and 
administrative authorities would find the organization'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.
    (3) The banking organization establishes and maintains 
procedures to ensure that the legal characteristics of netting 
contracts are kept under review in the light of possible changes in 
relevant law.
    (4) The banking organization maintains in its files 
documentation adequate to support the netting of rate contracts, 
including a copy of the bilateral netting contract and necessary 
legal opinions.
    (b) A contract containing a walkaway clause is not eligible for 
netting for purposes of calculating the credit equivalent 
amount.53
---------------------------------------------------------------------------

    \5\3For 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.
---------------------------------------------------------------------------

    (c) By netting individual contracts for the purpose of 
calculating its credit equivalent amount, a banking organization 
represents that it has met the requirements of this appendix A and 
all the appropriate documents are in the organization's files and 
available for inspection by the Federal Reserve. Upon determination 
by the Federal Reserve that a banking organization's files are 
inadequate or that a netting contract may not be legally enforceable 
under any one of the bodies of law described in section 
III.E.3.(a)(2) (i) through (iii) of this appendix A, underlying 
individual contracts may be treated as though they were not subject 
to the netting contract.
    (d) The credit equivalent amount of derivative contracts that 
are subject to a qualifying bilateral netting contract is calculated 
by adding (i) the net current exposure for the netting contract and 
(ii) the sum of the estimates of potential future exposure for all 
individual contracts subject to the netting contract, adjusted to 
take into account the effects of the netting contract.
    (e) The net current exposure is the sum of all positive and 
negative mark-to-market values of the individual contracts subject 
to the netting contract. If the net sum of the mark-to-market values 
is positive, then the net current exposure is equal to that sum. If 
the net sum of the mark-to-market values is zero or negative, then 
the net current exposure is zero.
    (f) The sum of the estimates of potential future exposure for 
all individual contracts subject to the netting contract 
(Agross), adjusted to reflect the effects of the netting 
contract (Anet), is determined through application of a 
formula. The formula, which employs the ratio of the net current 
exposure to the gross current exposure (NGR), is expressed as:

    Anet=.5(Agross+(NGR x Agross))

    (g) Gross potential future exposure, or Agross, is 
calculated by summing the estimates of potential future exposure 
(determined in accordance with section III.E.2. of this appendix A) 
for each individual contract subject to the qualifying bilateral 
netting contract.54 The NGR is the ratio of the net current 
exposure of the netting contract to the gross current exposure of 
the netting contract. The gross current exposure is the sum of the 
current exposures of all individual contracts subject to the netting 
contract calculated in accordance with section III.E.2. of this 
appendix A. The effect of this treatment is that Anet is the 
average of Agross and Agross adjusted by the NGR.
---------------------------------------------------------------------------

    \5\4For purposes of calculating gross 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.
---------------------------------------------------------------------------

* * * * *
    5. Appendix A to part 225 is amended by revising section III.E.4. 
to read as follows:
* * * * *
    III. * * *
    E. * * *
    4. Risk weights. (a) Once the credit equivalent amount for a 
derivative contract, or a group of derivative contracts subject to a 
qualifying netting contract, has been determined, that amount is 
assigned to the risk weight category appropriate to the 
counterparty, or, if relevant, the guarantor or the nature of any 
collateral.55 However, the maximum weight that will be applied 
to the credit equivalent amount of such contracts is 50 percent.
---------------------------------------------------------------------------

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

* * * * *
    6. In appendix A to part 225, section III.E.5., as that section was 
proposed to be revised at 59 FR 26463, May 20, 1994, is revised to read 
as follows:
* * * * *
    III. * * *
    E. * * *
    5. Avoidance of double counting. (a) In certain cases, credit 
exposures arising from the derivative contracts covered by these 
guidelines may already be reflected, in part, on the balance sheet. 
To avoid double counting such exposures in the assessment of capital 
adequacy and, perhaps, assigning inappropriate risk weights, 
counterparty credit exposures arising from the types of instruments 
covered by these guidelines may need to be excluded from balance 
sheet assets in calculating banks' risk-based capital ratios.
    (b) Examples of the calculation of credit equivalent amounts for 
these types of contracts are contained in Attachment V of this 
appendix A.
* * * * *
    7. In appendix A to part 225, Attachment V, as that attachment 
was proposed to be revised at 59 FR 26464, May 20, 1994, is revised 
to read as follows:
* * * * * 

                Attachment V--Calculation of Credit Equivalent Amounts for Derivative Contracts                 
----------------------------------------------------------------------------------------------------------------
                                       Potential Exposure + Current Exposure = Credit Equivalent Amount         
                             -----------------------------------------------------------------------------------
 Type of contract (remaining    Notional                    Potential                    Current                
          maturity)             principal    Conversion     exposure      Mark-to-      exposure                
                                (dollars)      factor       (dollars)   market value   (dollars)                
----------------------------------------------------------------------------------------------------------------
(1) 120-day forward foreign                                                                                     
 exchange...................     5,000,000           .01        50,000       100,000       100,000       150,000
(2) 6-year forward foreign                                                                                      
 exchange...................     6,000,000          .075       450,000      -120,000             0       450,000
(3) 3-year interest rate                                                                                        
 swap.......................    10,000,000          .005        50,000       200,000       200,000       250,000
(4) 1-year oil swap.........    10,000,000           .12     1,200,000      -250,000             0     1,200,000
(5) 7-year interest rate                                                                                        
 swap.......................    20,000,000           .05     1,000,000    -1,300,000             0    1,000,000 
                             -----------------------------------------------------------------------------------
      Total.................                                 2,750,000                     300,000    3,050,000 
----------------------------------------------------------------------------------------------------------------

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

----------------------------------------------------------------------------------------------------------------
                                        Potential                                                               
                                         future                                                        Credit   
                                        exposure                      Net current                    Equivalent 
                                      (from above)                    exposure\1\                      Amount   
                                                                                                                
----------------------------------------------------------------------------------------------------------------
(1).................................        50,000                                                              
(2).................................       450,000                                                              
(3).................................        50,000                                                              
(4).................................     1,200,000                                                              
(5).................................     1,000,000                                                              
                                     ---------------------------------------------------------------------------
      Total.........................     2,750,000              +               0               =     2,750,000 
----------------------------------------------------------------------------------------------------------------
\1\The total of the mark-to-market values from above is -1,370,000. Since this is a negative amount, the net    
  current exposure is zero.                                                                                     
                                                                                                                
 To recognize the effects of netting on potential future exposure the following formula applies:                
  Anet=.5(Agross+(NGR x Agross).                                                                                
                                                                                                                
In the above example: NGR=0 (0/300,000)Anet=.5(2,750,000+(0 x 2,750,000))Anet=1,375,000.                        
                                                                                                                
Credit equivalent amount: 1,375,000+0=1,375,000.                                                                
                                                                                                                
If the net current exposure was a positive amount, for example, $200,000, the credit equivalent amount would be 
  calculated as follows: NGR=.67 (200,000/300,000)Anet=.5(2,750,000+(.67 x 2,750,000))Anet=2,296,250.           
                                                                                                                
Credit equivalent amount: 2,296,250+200,000=2,496,250.                                                          

* * * * *
    By the order of the Board of Governors of the Federal Reserve 
System, August 16, 1994.
William W. Wiles,
Secretary of the Board.
[FR Doc.94-20506 Filed 8-23-94 8:45am]
BILLING CODE 6210-01-P