[Federal Register Volume 59, Number 201 (Wednesday, October 19, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-25662]


[[Page Unknown]]

[Federal Register: October 19, 1994]


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FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 325

RIN 3064-AB43

 

Capital; Capital Adequacy Guidelines

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

ACTION: Notice of proposed rulemaking.

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SUMMARY: The FDIC is proposing to amend its risk-based capital 
guidelines for state nonmember banks. 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 FDIC 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 December 5, 1994.

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

FOR FURTHER INFORMATION CONTACT: William A. Stark, Assistant Director, 
(202) 898-6972, Division of Supervision, FDIC; Sharon K. Lee, Chief, 
Capital Markets Policy and Training, (202) 898-6789, Division of 
Supervision, FDIC; Jeffrey M. Kopchik, Counsel, (202) 898-3872, Legal 
Division, FDIC, 550 17th Street, N.W., Washington, D.C. 20429.

SUPPLEMENTARY INFORMATION:

I. Background

    The international risk-based capital standards (the Basle Accord or 
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 FDIC Board adopted a similar framework to be 
used by state nonmember banks.
    \2\Other types of risks, such as market risks, generally are not 
addressed by the risk-based framework.
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    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 identity of the counterparty. The maximum risk 
weight applied to interest rate or exchange 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 Exposure

    A state nonmember bank that has a rate contract with a positive 
mark-to-market value has a current exposure or 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.
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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 
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.
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    The 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\5\ to determine one 
current exposure relative to that counterparty. In April 1993 the BSC 
proposed a revision to the 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 July 25, 1994, the FDIC issued a notice of proposed rulemaking 
to amend its risk-based capital guidelines in accordance with the BSC 
April 1993 proposal. 59 FR 37726, July 25, 1994.\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 bank would have to have a legal opinion(s) to this 
effect. That proposal is consistent with the final July 1994 change to 
the Accord.
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    \6\The Board of Governors of the Federal Reserve System and the 
Office of the Comptroller of the Currency issued a similar joint 
netting proposal on May 20, 1994 and the OTS issued its netting 
proposal on June 14, 1994.
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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 amount\7\ 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
                                                    (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 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 bank 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 FDIC's Reading Room by calling (202) 898-8785.
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    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 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 
metal, and equity-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 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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    \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 commodity, precious metal, or equity or to an 
index of commodity, precious metal or equity prices.
    \11\The proposals are contained in a paper from the BSC entitled 
``The Capital Adequancy Treatment of the Credit Risk Associated with 
Certain Off-Balance Sheet Items'' that is available upon request 
from FDIC's Reading Room by calling (202) 898--8785.
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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 potential future exposure 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 metal, 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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    \12\While commodity, precious metal, and equity contracts were 
not explicity covered by the original Accord, as the use of such 
contracts became more prevalent, many G-10 bank 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 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 
metal, 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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    \13\The conversion factors for rate contracts with remaining 
maturities of one to five years are currently applied to any 
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'' which is 
available upon request from the FDIC's Reading Room by calling (202) 
898-8785.
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    The proposed matrix is set forth below:

                                            Conversion Factor Matrix*                                           
                                              [Numbers in percent]                                              
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                                                                                         Precious               
                                                        Interest   Foreign               metals,       Other    
                  Residual maturity                      rate      exchange  Equity**     except   commododities
                                                                  and gold                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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    \15\While 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 expected 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 amendment to the Accord.
    Depending on market conditions and the characteristics of a bank's 
derivative portfolio, netting arrangements can have substantial effects 
on a bank'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 bank'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 also 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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    \16\For purposes of this discussion, a portfolio refers to a set 
of contracts with a single counterparty. A bank's global portfolio 
refers to all of the contracts in the institution's 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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    \17\Volatility 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 be to reduce the potential future exposure for 
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 amended Accord. This formula 
is expressed as:
Anet = .5(Agross + (NGR * 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 * 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 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 bank's 
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.

C. The FDIC Proposal

    In light of the BSC proposal, the FDIC 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 FDIC is proposing to amend its risk-based capital 
guidelines for state nonmember banks 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 FDIC'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 FDIC is proposing the same conversion factors set 
forth in the BSC proposal. The FDIC 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 FDIC also agrees with the BSC that the 
conversion factors for foreign exchange transactions are significantly 
too low for commodity, precious metal, and equity contracts due to the 
volatility of the associated indices or the prices on the underlying 
assets.\18\
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    \18\Similar to the BSC proposal, the FDIC'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.
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    The FDIC 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 FDIC 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 FDIC 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 banks will always hold some 
capital against derivative contracts, even in those instances where the 
net current exposure is zero.
    The FDIC 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 FDIC'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 FDIC 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 FDIC 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 FDIC 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 banks), 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 banks with limited derivative portfolios 
may experience an increase in capital charges, for most banks the 
overall effect of the proposal will be to reduce regulatory burden and 
to reduce the capital charge for certain transactions.

Paperwork Reduction Act

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

List of Subjects in 12 CFR Part 325

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

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

PART 325--CAPITAL MAINTENANCE

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

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

    2. In appendix A to part 325, section II is amended by:
    a. Revising the last sentence in section II.C. Category 3;
    b. Redesignating footnotes 36 through 40 as footnotes 37 through 
41;
    c. Adding new footnote 35 at the end of the introductory text of 
section II.D.; and
    d. Revising the heading and the introductory text of section 
II.E. (preceding paragraph E.1.) to read as follows:

APPENDIX A TO PART 325--STATEMENT OF POLICY ON RISK-BASED CAPITAL

* * * * *
    II. * * *
    C. * * *
    Category 3 * * * In addition, the credit equivalent amount of 
derivative contracts that do not qualify for a lower risk weight are 
assigned to the 50 percent risk category.
* * * * *
    D. * * *\35\ * * *
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    \35\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 II.B.
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* * * * *

E. Derivative Contracts (Interest Rate, Exchange Rate, Commodity and 
Equity Derivative Contracts)

    Credit equivalent amounts are computed for each of the following 
off-balance-sheet derivative contracts:

Interest Rate Contracts

    (1) Single currency interest rate swaps.
    (2) Basis swaps
    (3) Forward rate agreements.
    (4) Interest rate options (including caps, collars, and floors 
purchased).
    (5) Any other instrument that gives rise to similar credit risks 
(including when-issued securities and forward deposits accepted).

Exchange Rate Contracts

    (1) Cross-currency interest rate swaps.
    (2) Forward foreign exchange contracts.
    (3) Currency options purchased.
    (4) Any other instrument that gives rise to similar credit 
risks.

Commodity (including precious metal) or Equity Derivative Contracts

    (1) Commodity or equity linked swaps.
    (2) Commodity or equity linked options purchased.
    (3) Forward commodity or equity linked contracts.
    (4) Any other instrument that gives rise to similar credit 
risks.
    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.
* * * * *
    3. In Appendix A to part 325, section II.E.1., as that section 
was proposed to be revised at 59 FR 37726, July 25, 1994, is revised 
to read as follows:
    II. * * *
    E. * * *
    1. Credit Equivalent Amounts for Derivative Contracts. The 
credit equivalent amount of a derivative contract that is not 
subject to a qualifying bilateral netting contract in accordance 
with section II.E.3. of this appendix A is equal to the sum of (i) 
the current exposure (which is equal to the mark-to-market 
value,\41\ if positive, and is sometimes referred to as the 
replacement cost) of the contract and (ii) an estimate of the 
potential future credit exposure over the remaining life of the 
contract.
---------------------------------------------------------------------------

    \41\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.
---------------------------------------------------------------------------

    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.
    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 MatrixA                       
                          [Numbers in percent]                          
------------------------------------------------------------------------
                                                   Precious             
    Residual      Interest   Exchange              metals,      Other   
   maturity        rate      rate and   EquityB     except   commodities
                              gold                  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  
------------------------------------------------------------------------
AFor contracts with multiple exchanges of principal, the factors are to 
  be multiplied by the number of remaining payments in the contract.    
BFor contracts that reset to zero value following a payment, the        
  remaining maturity is set equal to the time until the next payment.   

    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.
    4. In Appendix A to part 325, section II.E.2, as that section 
was proposed to be revised at 59 FR 37726, July 25, 1994, is revised 
to read as follows:
    II. * * *
    E. * * *
    2. Risk Weights and Avoidance of Double Counting. Once the 
credit equivalent amount for a derivative contract, or a group of 
derivative contracts, has been determined, that amount is assigned 
to the risk category appropriate to the counterparty, or, if 
relevant, the guarantor or the nature of any collateral. However, 
the maximum weight that will be applied to the credit equivalent 
amount of such contracts is 50 percent.
    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.
    The FDIC notes that the conversion factors set forth in section 
II.E.1. of appendix A, 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.
    Examples of the calculation of credit equivalent amounts for 
these types of contracts are contained in table IV of this appendix 
A.
    5. In Appendix A to part 325, section II.E.3, as that section 
was proposed to be added at 59 FR 37726, July 25, 1994, is revised 
to read as follows:
    II. * * *
    E. * * *
    3. Netting. For purposes of this appendix A, netting refers to 
the offsetting of positive and negative mark-to-market values when 
determining a current exposure to be used in the calculation of a 
credit equivalent amount. Any legally enforceable form of bilateral 
netting (that is, netting with a single counterparty) of derivative 
contracts is recognized for purposes of calculating the credit 
equivalent amount provided that:
* * * * *
    (d) The bank maintains in its files documentation adequate to 
support the netting of derivative contracts, including a copy of the 
bilateral netting contract and necessary legal opinions.
    A contract containing a walkaway clause is not eligible for 
netting for purposes of calculating the credit equivalent 
amount.\42\
---------------------------------------------------------------------------

    \42\For 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 payments 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.
---------------------------------------------------------------------------

    By netting individual contracts for the purpose of calculating 
its credit equivalent amount, a bank represents that it has met the 
requirements of this appendix A and all the appropriate documents 
are in the bank's files and available for inspection by the FDIC. 
Upon determination by the FDIC that a bank's files are inadequate or 
that a netting contract may not be legally enforceable under any one 
of the bodies of law described in paragraphs (b) (i) through (iii) 
of this section, underlying individual contracts may be treated as 
though they were not subject to the netting contract.
    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 of 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.
    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.
    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 to the gross current exposure 
(NGR), is expressed as:
Anet = .5(Agross + (NGR * Agross))
    Gross potential future exposure, or Agross, is calculated 
by summing the estimates of potential future exposure (determined in 
accordance with section II.E.1. of this appendix A) for each 
individual contract subject to the qualifying bilateral netting 
contract.\43\ The NGR is determined as 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 II.E.1. of this 
appendix A. The effect of this treatment is that Anet is the 
average of Agross and Agross adjusted by the NGR.
---------------------------------------------------------------------------

    \43\For 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.
---------------------------------------------------------------------------

    6. In Appendix A to part 325, the chart in Table III and its 
heading, as that section was proposed to be amended at 59 FR 37726, 
July 25, 1994, is revised to read as follows:
    Table III. * * *
* * * * *

Credit Conversion for Derivative Contracts

* * * * *

                        Conversion Factor MatrixA                       
                          [Numbers in percent]                          
------------------------------------------------------------------------
    Residual      Interest   Exchange              Precious     Other   
   maturity        rate       rate      EquityB    metals    commodities
------------------------------------------------------------------------
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
------------------------------------------------------------------------
AFor contracts with multiple exchanges of principal, the factors are to 
  be multiplied by the number of remaining payments in the contract.    
BFor contracts that reset to zero value following a payment, the        
  remaining maturity is set equal to the time until the next payment.   

* * * * *
    6. In Appendix A to part 325, Table IV, as that table was proposed 
to be added at 59 FR 37726, July 25, 1994, is revised to read as 
follows:

                  Table IV.--Calculation of Credit Equivalent Amounts for Derivative Contracts                  
----------------------------------------------------------------------------------------------------------------
       Potential exposure               +                          =             Credit equivalent amount       
-----------------------------------------------              ---------------------------------------------------
                                     Notional      Current     Potential    Market-to     Current       Credit  
   Type of contract (remaining      principal     exposure      Exposure      market      exposure    equivalent
            maturity)               (dollars)                  (dollars)      value      (dollars)      amount  
----------------------------------------------------------------------------------------------------------------
(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          .015      300,000   -1,300,000            0      300,000
                                  ------------------------------------------------------------------------------
      Total......................  ...........  ............    2,050,000  ...........      300,000    2,350,000
----------------------------------------------------------------------------------------------------------------

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

------------------------------------------------------------------------
                          Potential                                     
                           future          Net current         Credit   
                       exposure (from       exposure*        equivalent 
                           above)                              amount   
------------------------------------------------------------------------
(1)..................          50,000                                   
(2)..................         450,000                                   
(3)..................          50,000                                   
(4)..................       1,200,000                                   
(5)..................        300,000                                    
                      ----------------                                  
      Total..........       2,050,000   +            0   =    2,050,000 
------------------------------------------------------------------------
*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 * Agross))
    In the above example:
NGR = 0 (0/300,000)
Anet = .5 (2,050,000 + (0 * 2,050,000))
Anet = 1,025,000
    Credit Equivalent Amount: 1,025,000 + 0 = 1,025,000
    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(2,050,000 + (.67 * 2,050,000))
Anet = 1,711,750
    Credit Equivalent Amount: 1,711,750 + 200,000 = 1,911,750

    By order of the Board of Directors.

    Dated at Washington, D.C. this 27 day of September, 1994.

Federal Deposit Insurance Corporation
Robert E. Feldman,
Acting Executive Secretary.
[FR Doc. 94-25662 Filed 10-18-94; 8:45 am]
BILLING CODE 6714-01-P