[Federal Register Volume 59, Number 169 (Thursday, September 1, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-21642]


[[Page Unknown]]

[Federal Register: September 1, 1994]


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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 3

[Docket No. 94-13]
RIN 1557-AB14

 

Capital Adequacy: Calculation of Credit Equivalent Amounts of 
Off-Balance Sheet Contracts

AGENCY: Office of the Comptroller of the Currency, Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: The Office of the Comptroller of the Currency (OCC) is 
proposing to amend its risk-based capital guidelines for national 
banks. This proposed rule would revise and expand the set of off-
balance sheet credit conversion factors used to calculate the potential 
future exposure of derivative contracts and permit banks to net 
multiple derivative contracts that are subject to a qualifying 
bilateral netting contract when calculating the potential future credit 
exposure.
    This proposed rule is based on the July 15, 1994, proposed 
revisions to the Agreement on International Convergence of Capital 
Measurement and Capital Standards of July 1988 (Basle Accord). The 
effect of this proposed rule would be twofold. First, long-dated 
interest rate and foreign exchange rate contracts would be subject to 
new higher off-balance sheet credit conversion factors and new 
conversion factors would be established specifically for derivative 
contracts related to equities, precious metals, and other commodities. 
Second, national banks generally would recognize a reduction in 
potential future credit exposure for multiple derivative contracts 
subject to a qualifying bilateral netting contract.

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

ADDRESSES: Comments may be submitted to Docket Number 94-13, 
Communications Division, Ninth floor, Office of the Comptroller of the 
Currency, 250 E Street, SW., Washington, DC 20219. Comments will be 
available for inspection and photocopying at that address.

FOR FURTHER INFORMATION CONTACT: Roger Tufts, Senior Economic Advisor, 
Office of the Chief National Bank Examiner, (202) 874-5070; or Ronald 
Shimabukuro, Senior Attorney, Bank Operations and Assets Division, 
(202) 874-4460, Office of the Comptroller of the Currency.

SUPPLEMENTARY INFORMATION:

I. Background

    The Basle Accord\1\ established the international risk-based 
capital standards and 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 contracts 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 and endorsed by 
the central bank governors of the Group of Ten (G-10) countries in 
July 1988. The Basle Supervisors' Committee (BSC) 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.
    \2\Other types of risks, such as market risks, generally are not 
addressed by the risk-based capital framework.
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    The credit equivalent amount of an interest rate or foreign 
exchange rate contract (rate contract) is determined by adding together 
the current replacement cost (current credit exposure) and an estimate 
of the possible increases in future replacement cost, in view of the 
volatility of the current credit exposure over the remaining life of 
the contract (potential future credit exposure--also referred to as the 
add-on). Each credit equivalent amount is then assigned to the 
appropriate risk category. The maximum risk weight applied to rate 
contracts is 50 percent.\3\
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    \3\Exchange rate contracts with an original maturity of 14 
calendar days or less and instruments traded on exchanges that 
require daily payment of variation margin are excluded from the 
risk-based capital ratio calculations.
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A. Current Credit Exposure

    Under the risk-based capital guidelines, the current credit 
exposure of a rate contract with a positive mark-to-market value is 
equal to the mark-to-market value.\4\ If the mark-to-market value is 
zero or negative, then there is no replacement cost associated with the 
rate contract and the current credit exposure is zero. The sum of 
current credit exposures for a defined set of rate contracts is 
referred to as the gross current credit exposure for that set of rate 
contracts.
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    \4\The loss to a bank from a counterparty's default on a rate 
contract is the cost of replacing the cash flows specified by the 
rate contract. The mark-to-market value is the present value of the 
net cash flows specified by the rate contract, calculated on the 
basis of current market interest and foreign exchange rates.
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    As initially adopted in July 1988, the Basle Accord required banks 
to determine the current credit exposure individually for every rate 
contract. Generally, banks 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 a single current credit 
exposure relative to that counterparty.\5\ In April 1993 the BSC 
proposed a revision to the Basle Accord that would permit banks to net 
positive and negative mark-to-market values of rate contracts subject 
to a qualifying, legally enforceable, bilateral netting contract. 
Pursuant to the April 1993 BSC netting proposal, banks with qualifying 
bilateral netting contracts could replace the gross current credit 
exposure of a set of rate contracts covered by the bilateral netting 
contracts with a single net current credit exposure for purposes of 
calculating the credit equivalent amount. If the net market value is 
positive, then that market value equals the current credit exposure for 
the rate contracts under a bilateral netting contract. If the net 
market value is zero or negative, then the current credit 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 OCC and the Board of Governors of the Federal 
Reserve System (FRB) issued a joint notice of proposed rulemaking to 
amend their respective risk-based capital guidelines in accordance with 
the April 1993 BSC netting proposal.\6\ See 59 FR 26456 (May 20, 1994). 
Generally, under the May 1994 joint OCC/FRB proposed rule, a bilateral 
netting contract would be recognized for risk-based capital purposes 
only if the bilateral netting contract is legally enforceable. The May 
1994 joint OCC/FRB proposed rule is consistent with the April 1993 BSC 
netting proposal which was adopted in final form on July 1994. The 
April 1993 BSC netting proposal is discussed in detail in the May 1994 
joint OCC/FRB proposed rule.
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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.
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B. Potential Future Credit Exposure

    The second part of the credit equivalent amount, the add-on for 
potential future credit exposure, is an estimate of the additional 
credit exposure that may arise over the remaining life of the rate 
contract as a result of fluctuations in prices or rates. Such changes 
may increase the market value of the rate contract in the future and, 
therefore, increase the cost of replacing it if the counterparty 
subsequently defaults.
    The add-on for potential future credit exposure is calculated by 
multiplying the notional principal amount\7\ of the underlying rate 
contract by a credit conversion factor that is determined by the 
remaining maturity of the rate contract and the type of rate contract. 
The current credit conversion factors used to calculate potential 
future credit exposure, referred to as the credit conversion factor 
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).

           Table 1.--Current Credit Conversion Factor Matrix            
------------------------------------------------------------------------
                                                  Interest     Exchange 
                                                    rate         rate   
              Remaining maturity                 contracts    contracts 
                                                 (percent)    (percent) 
------------------------------------------------------------------------
One year or less..............................          0.0          1.0
Over one year.................................          0.5          5.0
------------------------------------------------------------------------

    These credit 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 Basle Accord was being developed, activity in the derivatives 
market was for the most part limited to these types of transactions. 
The simulation studies produced distributions of potential replacement 
costs over the remaining life of matched pairs of rate contracts.\8\ 
Potential future credit exposure was then defined in terms of 
confidence limits derived from these distributions. The credit 
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, 
where the bank the buyer of one contract and the seller of the other 
contract.
    \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 OCC's Communications Division.
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    The add-on for potential future credit exposure is calculated for 
all rate contracts, regardless of whether the market value is zero, 
positive, or negative, or whether the current credit exposure is 
calculated on a gross or net basis. Neither the April 1993 BSC netting 
proposal nor the May 1994 joint OCC/FRB proposed rule to recognize 
qualifying bilateral netting contracts for the calculation of the 
current credit exposure affects the calculation of the potential future 
credit exposure, which would continue to be calculated on a gross 
basis. Under the April 1993 BSC netting proposal, this means that an 
add-on for potential future credit exposure is calculated separately 
for each individual rate contract covered by the bilateral netting 
contract and then these individual future credit exposures are added 
together to arrive at a gross add-on for potential future credit 
exposure. The gross add-on for potential future credit exposure would 
then be added to the net current credit exposure to arrive at one 
credit equivalent amount for all of the rate contracts subject to the 
bilateral netting contract.
    When initially adopted, the Basle Accord noted that the credit 
conversion factors in the add-on conversion factor 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 Credit 
Exposure

    Since the original Basle Accord was adopted, the derivatives market 
has grown and broadened. The use of certain types of derivative 
contracts not specifically addressed in the Basle Accord--notably 
equity, precious metals, and commodity-linked transactions\10\--has 
become much more widespread. As a result of continued review of the 
method for calculating the add-on for potential future credit exposure, 
in July 1994 the BSC issued a consultative paper which contained two 
proposals.\11\ The first proposal would expand the matrix of add-on 
credit conversion factors used to calculate potential future credit 
exposure to take into account innovations in the derivatives market. 
The second proposal represents an extension of the April 1993 BSC 
netting proposal and would recognize reductions in the potential future 
credit exposure of derivative contracts that result from entering into 
bilateral netting contracts. The consultation period for the July 1994 
BSC proposal is scheduled to end on October 10, 1994.
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    \10\In 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 equity, precious metals, or commodity or to an 
index of equity, precious metals, or commodity prices.
    \11\The proposals are contained in a paper from the FSC entitled 
``The Capital Adequacy Treatment of the Credit Risk Associated with 
Certain Off-Balance Sheet Items'' that is available upon request 
from the Communications Division of the OCC.
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A. Expansion of Add-On Credit Conversion Factor Matrix

    A recent BSC study of the add-on for potential future credit 
exposure indicated that the current add-on credit conversion 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 study indicated that the current add-on credit 
conversion factors do not adequately address the full range of contract 
structures and the timing of cash flows. The BSC study also showed that 
the credit conversion factors used by many banks to calculate potential 
future credit exposure for equity, precious metals, and commodity 
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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    \12\While equity, precious metals, and commodity contracts were 
not explicitly covered by the original Basle 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 study concluded that it was not appropriate to address 
these problems with a significant departure from the existing 
methodology used in the Basle Accord. The BSC decided that it would be 
appropriate to preserve the credit conversion factors existing in the 
Basle Accord and add new credit conversion factors. Consequently, the 
revision proposed by the BSC retains the existing credit conversion 
factors for interest and exchange rate contracts, but applies new 
higher credit conversion factors to such rate contracts with remaining 
maturities of five years and over.\13\ The BSC proposal also proposes 
credit conversion factors specifically applicable to equity, precious 
metals, and commodity contracts. The new credit conversion factors were 
determined on the basis of simulation studies that used the same 
general approach that generated the original add-on credit conversion 
factors.\14\
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    \13\The 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.
    \14\The 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'' and is 
available upon request from the Communications Division of the OCC.
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    The proposed credit conversion factor matrix is set forth below:

                                  Table 2.--Credit Conversion Factor Matrix\1\                                  
                                                    [Percent]                                                   
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                                                                Foreign                                         
                                                   Interest     exchange                  Precious      Other   
               Remaining maturity                    rate       rate and    Equity\2\      metals    commodities
                                                                  gold                                          
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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
Over five years................................          1.5          7.5         10.0          8.0         15.0
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\1\For derivative contracts with multiple exchanges of principal, the conversion factors are to be multiplied by
  the number of remaining payments in the derivative contract.                                                  
\2\For derivative contracts that automatically reset to zero value following a payment, the remaining maturity  
  is set equal to the time until the next payment.                                                              

    Gold is included within the foreign exchange rate column because 
the price volatility of gold has been found to be comparable to the 
foreign 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 credit conversion factor 
matrix is designed to accommodate the different structures of 
derivative 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 credit conversion factor matrix 
to address two particular derivative contract structures. The first 
relates to derivative contracts with multiple exchanges of principal. 
Because the level of potential future credit exposure rises generally 
in proportion to the number of remaining exchanges of principal, the 
credit conversion factors are multiplied by the number of remaining 
payments (exchanges of principal) in the derivative contract. This 
treatment is intended to ensure that the full level of potential future 
credit exposure is covered adequately. The second footnote applies to 
equity contracts that automatically reset to zero each time a payment 
is made. The credit risk associated with these equity 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 equal to the time remaining until the next payment.
    While the capital charges resulting from the application of the new 
proposed credit conversion factors may not provide complete coverage 
for risks associated with any single derivative contract, the BSC 
believes the credit conversion factors will provide a reasonable level 
of prudential coverage for derivative contracts on a portfolio basis. 
Like the original credit conversion factor matrix, the proposed 
expanded credit conversion factor matrix provides a reasonable balance 
between precision, complexity, and burden.

B. Recognition of the Effects of Netting

    The simulation studies used by the BSC to generate the credit 
conversion factors for potential future credit exposure analyzed the 
implications of underlying rate and price movements on the current 
credit exposure of derivative contracts without taking into account 
reductions in credit exposure that could result from legally 
enforceable bilateral netting contracts. Thus, the credit conversion 
factors are most appropriately applied to non-netted derivative 
contracts, and when applied to derivative contracts subject to a 
legally enforceable bilateral netting contract, they could in some 
cases overstate the potential future credit exposure.
    Comments on the April 1993 BSC netting proposal, as well as further 
research conducted by the BSC, have suggested that bilateral netting 
contracts can reduce not only a bank's current credit exposure for the 
transactions subject to the bilateral netting contracts, but also the 
potential future credit exposure for those transactions.\15\ The July 
1994 BSC proposal reflects these conclusions and proposes to 
incorporate into the calculation of the add-on for potential future 
credit exposure a method for recognizing the risk-reducing effects of 
qualifying bilateral netting contracts. Under the July 1994 BSC 
proposal, banks could recognize these effects only for transactions 
subject to legally enforceable bilateral netting contracts that meet 
the requirements of netting for current credit exposure as set forth in 
the April 1993 BSC netting proposal.
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    \15\While current credit exposure is intended to cover an 
organization's credit exposure at one point in time, potential 
future credit exposure provides an estimate of possible increases in 
future replacement cost, in view of the volatility of current credit 
exposure over the remaining life of the contract. The greater the 
tendency of the current credit exposure to fluctuate over time, the 
greater the add-on for potential future credit exposure should be to 
cover possible fluctuations.
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    Depending on market conditions and the characteristics of a bank's 
derivative portfolio, bilateral netting contracts can have substantial 
effects on the bank's potential future credit exposure to multiple 
derivative contracts it has entered into with a single counterparty. 
Should the counterparty default at some future date, the bank's credit 
exposure would be limited to the net amount the counterparty owes on 
the date of default, rather than the gross current credit exposure of 
the included derivative contracts. By entering into a bilateral netting 
contract, a bank may reduce not only its current credit exposure, but 
possibly its future credit exposure as well. Nevertheless, while in 
many circumstances a bilateral netting contract can reduce the 
potential future credit exposure to a single counterparty portfolio, 
this is not always the case.\16\
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    \16\For purposes of this discussion, a single counterparty 
portfolio refers to a set of contracts with a single counterparty. 
This should be distinguished from a bank's global portfolio, which 
refers to all of the contracts in the bank's derivatives portfolio 
that are subject to qualifying bilateral netting contracts.
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    The most important factors influencing whether a bilateral netting 
contract will have an effect on the potential future credit exposure of 
a single counterparty portfolio are the volatilities of the current 
credit exposure to the counterparty on both a gross and net basis.\17\ 
The volatilities of net current credit exposure and gross current 
credit exposure of a single counterparty portfolio may not necessarily 
be the same. Volatility of gross current credit exposure is influenced 
primarily by the fluctuations of the market values of positively valued 
derivative contracts. On the other hand, volatility of the net current 
credit exposure is influenced by the fluctuations of the market values 
of all derivative contracts within a single counterparty portfolio. In 
those cases where net current credit exposure has a tendency to 
fluctuate more over time than gross current credit exposure, a 
bilateral netting contract will not reduce the potential future credit 
exposure. However, in those situations where net current credit 
exposure has a tendency to fluctuate less over time than gross current 
credit exposure, a bilateral netting contract can reduce the potential 
future credit exposure.
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    \17\Volatility in this discussion is the tendency of the market 
value of a derivative 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 derivative contracts within the portfolio, that is, the degree 
to which the derivative contracts in the portfolio respond similarly 
to changing market conditions.
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    Net current credit exposure is likely to be less volatile relative 
to the volatility of gross current credit exposure when the single 
counterparty portfolio of derivative contracts as a whole is more 
diverse than the subset of positively valued derivative contracts. When 
a bilateral netting contract is applied to a diversified single 
counterparty portfolio and the positively valued derivative contracts 
within that portfolio as a group are less diversified than the overall 
portfolio, then the effect of the bilateral netting contract will 
likely be to reduce the potential future credit exposure of the single 
counterparty 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 credit exposure. In particular, the BSC reviewed 
one general method proposed by commenters to the April 1993 BSC netting 
proposal. This method would reduce the amount of the add-on for 
potential future credit exposure by multiplying the calculated gross 
add-on by the ratio of a single counterparty portfolio's net current 
credit exposure to the gross current credit exposure. This is called 
the net-to-gross ratio (NGR). The NGR is used as a proxy for the risk-
reducing effects of the bilateral netting contract on the potential 
future credit exposure. The more diversified a single counterparty 
portfolio, the lower the net current credit exposure tends to be 
relative to gross current credit exposure.
    This method is incorporated into the July 1994 BSC proposal. 
However, given that there are portfolio-specific situations in which 
the NGR does not provide a good indication of these effects, the July 
1994 BSC proposal gives only partial weight to the effects of the NGR 
on the add-on for potential future credit exposure. The proposed method 
would calculate a weighted average of two amounts. The first amount is 
the add-on as it is currently calculated (Agross). The second 
amount is Agross multiplied by the NGR. This calculation results 
in a reduced add-on (Anet) for derivative contracts subject to a 
qualifying bilateral netting contract. The weights contained in the 
proposed rule are 0.5 and 0.5, respectively, for (1) Agross, and 
(2) NGR times Agross.
    The formula is:

Anet=0.5 x Agross+(0.5 x NGR x Agross).

    For example, a bank with a gross current credit exposure of 
$500,000, a net current credit exposure of $300,000, and a gross add-on 
for potential future credit exposure of $1,200,000, would have an NGR 
of 0.6 ($300,000/$500,000) and would calculate Anet as follows:

Anet=0.5 x $1,200,000+(0.5 x 0.6 x $1,200,000)

Anet=$960,000

    For banks 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 July 1994 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 bilateral netting contracts. The July 1994 BSC 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 July 1994 BSC proposal also acknowledges that simulations using 
banks' internal models for measuring credit risk exposure would most 
likely produce the most accurate determination of the effect of 
bilateral netting contracts on potential future credit exposures. The 
July 1994 BSC proposal states that the use of such models would be 
considered at some future date.

III. The OCC Proposal

    In light of the July 1994 BSC proposal, the OCC believes that it is 
appropriate to seek public comment on proposed revisions to the 
calculation of the add-on for potential future credit exposure for 
derivative contracts. Therefore, the OCC is proposing to (1) Amend its 
risk-based capital guidelines for national banks to expand the matrix 
of credit conversion factors and (2) change the calculation of the add-
on for potential future credit exposure when the derivative contracts 
are subject to a qualifying bilateral netting contract. It is important 
to note that the second part of the proposed rule is contingent on the 
adoption of a final rule to the May 1994 joint OCC/FRB proposed rule to 
recognize qualifying bilateral netting contracts. With regard to the 
portion of this proposed rule to expand the credit conversion factor 
matrix, the OCC is proposing to adopt the same credit conversion 
factors set forth in the July 1994 BSC proposal. The OCC believes that 
the existing credit conversion factors applicable to long-dated 
transactions may not provide sufficient capital for the risks 
associated with those types of contracts. The OCC also believes that 
the credit conversion factors for foreign exchange rate contracts are 
significantly too low for equity, precious metals, and commodity 
derivative contracts due to the volatility of the associated indices 
and the prices on the underlying assets.\18\
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    \18\Similar to the July 1994 BSC proposal, this proposed rule 
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.
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    The OCC is proposing the same weighted average formula as the July 
1994 BSC proposal to calculate a reduction in the add-on for potential 
future credit exposure for derivative contracts subject to qualifying 
bilateral netting contracts. The OCC believes that there may be 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 OCC 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 credit exposure can 
never be reduced to zero and banks will always hold some capital 
against derivative contracts, even in those instances where the net 
current exposure is zero.
    The OCC is seeking comment on all aspects of this proposed rule.
    1. As with the July 1994 BSC proposal, the OCC seeks comment on 
whether the NGR should be calculated on a counterparty-by-counterparty 
basis, or on a global basis for all derivative contracts subject to a 
qualifying bilateral netting contract. The OCC'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 OCC also is seeking comment as to which method of calculating the 
NGR would be most efficient and appropriate for banks with numerous 
qualifying bilateral netting contracts. The OCC notes that some 
preliminary findings indicate that a global NGR may be less burdensome 
to apply, but counterparty specific NGRs may provide a more accurate 
indication of the credit risk associated with each counterparty.
    2. The OCC is also seeking comment on the appropriate weights to 
apply to the two components of the weighted average--Agross and 
NGR x Agross. The proposed values (both set equal to 0.5) allow 
only a partial reduction in the add-on, even when the NGR equals zero. 
Are there other weights, which sum to a value of 1, that better reflect 
the potential risk of a set of netted contracts and which ensure that 
an appropriate level of capital is held for this risk of a potential 
future exposure? Empirical evidence to support any suggested changes to 
the weights used in the calculation would be appreciated.

Regulatory Flexibility Act

    Pursuant to section 605(b) of the Regulatory Flexibility Act, the 
OCC hereby certifies that this proposed rule will not have a 
significant impact on a substantial number of small business entities. 
Accordingly, a regulatory flexibility analysis is not required. The OCC 
believes that, while some banks with limited derivative portfolios may 
experience an increase in capital charges, for most small banks the 
proposal will have little or no affect since small banks typically have 
a limited derivatives portfolio. For banks with more developed 
portfolios the overall affect of the proposal will likely be to reduce 
regulatory burden and a decrease in the capital charge for certain 
derivative contracts.

Executive Order 12866

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

List of Subjects in 12 CFR Part 3

    Administrative practice and procedure, Capital, National banks, 
Reporting and recordkeeping requirements, Risk.

Authority and Issuance

    For the reasons set out in the preamble, appendix A to part 3 of 
title 12, chapter 1 of the Code of Federal Regulations is proposed to 
be amended as set forth below.

PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES

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

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

    2. In appendix A, section 3, paragraph (a)(3)(ii) is revised, the 
fourth sentence in the introductory text of paragraph (b) which begins 
with ``Second,'' is revised, and paragraph (b)(5), as proposed to be 
revised at 59 FR 26460 (May 20, 1994) is revised, to read as follows:

Appendix A to Part 3--Risk-Based Capital Guidelines

* * * * *

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

* * * * *
    (a) * * *
    (3) * * *
    (ii) The credit equivalent amount of derivative contracts 
calculated in accordance with section 3(b)(5) of this appendix A, that 
do not qualify for inclusion in a lower risk category.
* * * * *
    (b) * * * Second, the resulting credit equivalent amount is then 
assigned to the proper risk category using the criteria regarding 
obligors, guarantors, and collateral listed in section 3(a) of this 
appendix A. Collateral and guarantees are applied to the face amount 
of an off-balance sheet item, not the credit equivalent amount of 
such an off-balance sheet item; however, with respect to derivative 
contracts under section 3(b)(5) of this appendix A, collateral and 
guarantees are applied to the credit equivalent amount of such 
derivative contracts. * * *
* * * * *
    (5) Derivative contracts--(i) Calculation of credit equivalent 
amounts. The credit equivalent amount of a derivative contract 
equals the sum of the current credit exposure and the potential 
future credit exposure of the derivative contract. The calculation 
of credit equivalent amounts must be measured in U.S. dollars, 
regardless of the currency or currencies specified in the derivative 
contract.
    (A) Current credit exposure. The current credit exposure for a 
single derivative contract is determined by the mark-to-market value 
of the derivative contract. If the mark-to-market value is positive, 
then the current credit exposure is equal to that mark-to-market 
value. If the mark-to-market value is zero or negative, then the 
current exposure is zero. The current credit exposure for multiple 
contracts executed with a single counterparty and subject to a 
qualifying bilateral netting contract is determined as provided by 
section 3(b)(5)(ii) of this appendix A.
    (B) Potential future credit exposure. The potential future 
credit exposure on a derivative contract, including a derivative 
contract with negative mark-to-market value, is calculated by 
multiplying the notional principal18a of the derivative 
contract by one of the credit conversion factors in Table A 
(Conversion Factor Matrix) of this appendix A, as appropriate.\19\ 
The potential future credit exposure for multiple derivative 
contracts executed with a single counterparty and subject to a 
qualifying bilateral netting contract is determined as provided by 
section 3(b)(5)(ii)(A)(2) of this appendix A.
---------------------------------------------------------------------------

    \1\8aFor purposes of caluclating either the potential future 
credit exposure under section 3(b)(5)(i)(B) of this appendix A or 
the gross potential future credit exposure under section 
3(b)(5)(ii)(A)(2) of this appendix A for foreign exchange contracts 
and other similar contracts in which the notional principal is 
equivalent to the cash flows, total notional principal is the net 
receipts to each party falling due on each value date in each 
currency.
    \19\No potential future credit exposure is calculated for single 
currency interest rate swaps in which payments are made based upon 
two floating rate indices, so-called floating/floating or basis 
swaps; the credit equivalent amount is measured solely on the basis 
of the current credit exposure.

                                      Table A.--Conversion Factor Matrix\1\                                     
                                                   [Percent]                                                    
----------------------------------------------------------------------------------------------------------------
                                                                Foreign                                         
                                                   Interest     exchange                  Precious      Other   
              Remaining maturity                    rate        rate and    Equity\2\     metals     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
Over five years................................          1.5          7.5         10.0          8.0         15.0
----------------------------------------------------------------------------------------------------------------
\1\For derivative contracts with multiple exchanges of principal, the conversion factors are to be multiplied by
  the number of remaining payments in the derivative contract.                                                  
\2\For derivative contracts that automatically reset to zero value following a payment, the remaining maturity  
  is set equal to the time until the next payment.                                                              

    (ii) Derivative contracts subject to a bilateral netting 
contract--(A) Netting Calculation. The credit equivalent amount for 
multiple derivative contracts executed with a single counterparty 
and subject to a qualifying bilateral netting contract as provided 
by section (3)(b)(5)(ii)(B) of this appendix A is calculated by 
adding the net current credit exposure and the adjusted sum of the 
potential future credit exposure for all of the derivative contracts 
subject to the bilateral netting contract.
    (1) The net current credit exposure. The net current credit 
exposure is the net sum of all positive and negative mark-to-market 
values of the individual derivative contracts subject to the 
bilateral netting contract. If the net sum of the mark-to-market 
value is positive, then the net current credit exposure is equal to 
that net sum of the mark-to-market value. If the net sum of the 
mark-to-market value is zero or negative, then the net current 
credit exposure is zero.
    (2) Adjusted sum of the estimates of the potential future credit 
exposure. The adjusted sum of the potential future credit exposure 
is calculated as: Anet = 0.5 x Agross + 
(0.5 x NGR x Agross), where Anet is the adjusted sum of 
the potential future credit exposure, Agross is the gross 
potential future credit exposure, and NGR is the net to gross ratio. 
The NGR is the ratio of the net current credit exposure to the gross 
current credit exposure. The gross potential future credit exposure 
(Agross) is the sum of the potential future credit exposure (as 
determined under section 3(b)(5)(i)(B) of this appendix A) for each 
individual derivative contract subject to the bilateral netting 
contract. In calculating the net gross ratio (NGR), the gross 
current credit exposure is equal to the sum of the current credit 
exposures (as determined under section 3(b)(5)(i)(A) of this 
appendix A) of all individual derivative contracts subject to the 
bilateral netting contract.
    (B) Qualifying Bilateral Netting Contract. In determining the 
current credit exposure for multiple derivative contracts executed 
with a single counterparty, a bank may net derivative contracts 
subject to a bilateral netting contract by offsetting positive and 
negative mark-to-market values, provided that:
    (1) The bilateral netting contract is in writing.
    (2) The bilateral netting contract creates a single legal 
obligation for all individual derivative contracts covered by the 
bilateral netting contract, and provides, in effect, that the bank 
would have a single claim or obligation either to receive or to pay 
only the net amount of the sum of the positive and negative mark-to-
market values on the individual derivative contracts covered by the 
bilateral netting contract in the event that a counterparty, or a 
counterparty to whom the bilateral netting contract has been 
assigned, fails to perform due to any of the following events--
default, insolvency, bankruptcy, or other similar circumstances.
    (3) The bank obtains a written and reasoned legal opinion(s) 
that represents that in the event of a legal challenge, including 
one resulting from default, insolvency, bankruptcy, or similar 
circumstances, the relevant court and administrative authorities 
would find the bank's exposure to be the net amount under:
    (i) The law of the jurisdiction in which the counterparty is 
chartered or the equivalent location in the case of noncorporate 
entities, and if a branch of the counterparty is involved, then also 
under the law of the jurisdiction in which the branch is located;
    (ii) The law of the jurisdiction that governs the individual 
derivative contracts covered by the bilateral netting contract; and
    (iii) The law of the jurisdiction that governs the bilateral 
netting contract;
    (4) The bank establishes and maintains procedures to monitor 
possible changes in relevant law and to ensure that the bilateral 
netting contract continues to satisfy the requirement of this 
section.
    (5) The bank maintains in its files documentation adequate to 
support the netting of a derivative contract.19a
---------------------------------------------------------------------------

    \1\9aBy netting individual derivative contracts for the purpose 
of calculating its credit equivalent amount, a bank represents that 
documentation adequate to support the netting of a derivativ 
contract is in bank's files and available for inspection by the OCC. 
Upon determination by the OCC that a bank's files are inadequate or 
that a bilateral netting contract may not be legally enforceable in 
any one of the bodies of law described in section 3(b)(5)(ii)(B)(3) 
(i) through (iii) of this appendix A the underlying derivative 
contracts may not be netted for the purposes of this section.
---------------------------------------------------------------------------

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

Table 3.--Treatment of Derivative Contracts

    The current exposure method is used to calculate the credit 
equivalent amounts of derivative contracts. These amounts are assigned 
a risk weight appropriate to the obligor or any collateral or 
guarantee. However, the maximum risk weight is limited to 50 percent. 
Multiple derivative contracts with a single counterparty may be netted 
if those contracts are subject to a qualifying bilateral netting 
contract. 

                                      Table A.--Conversion Factor Matrix\1\                                     
                                                    [Percent]                                                   
----------------------------------------------------------------------------------------------------------------
                                                                Foreign                                         
                                                   Interest     exchange                  Precious      Other   
              Remaining maturity                    rate        rate and    Equity\2\     metals     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
Over five years................................          1.5          7.5         10.0          8.0         15.0
----------------------------------------------------------------------------------------------------------------
\1\For derivative contracts with multiple exchanges of principal, the conversion factors are to be multiplied by
  the number of remaining payments in the derivative contract.                                                  
\2\For derivative contracts that automatically reset to zero value following a payment, the remaining maturity  
  is set equal to the time until the next payment.                                                              

    The following derivative contracts will be excluded:
     Exchange rate contracts with an original maturity of 14 
calendar days or less; and
     Derivative contracts traded on exchanges and subject to 
daily margin requirements.

    Dated: August 24, 1994.
Stephen R. Steinbrink,
Acting Comptroller of the Currency.
[FR Doc. 94-21642 Filed 8-31-94; 8:45 am]
BILLING CODE 4810-33-P