[Federal Register Volume 59, Number 248 (Wednesday, December 28, 1994)]
[Unknown Section]
[Page ]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-31730]


[Federal Register: December 28, 1994]


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DEPARTMENT OF THE TREASURY
12 CFR Part 3

[Docket No. 94-24]
RIN 1557-AB14
Office of Thrift Supervision

12 CFR Part 567

[Docket No. 94-258]
RIN 1550-AA75


Risk-Based Capital Standards; Bilateral Netting Requirements

AGENCIES: Office of the Comptroller of the Currency (OCC), Department 
of the Treasury and the Office of Thrift Supervision (OTS), Department 
of the Treasury.

ACTION: Final rule.

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SUMMARY: The OCC and the OTS (the banking agencies) are amending their 
respective risk-based capital standards to recognize the risk-reducing 
benefits of qualifying bilateral netting contracts. On December 7, 
1994, the Board of Governors of the Federal Reserve System (Board) 
issued a similar final rule. This final rule implements a recent 
revision to the Basle Accord permitting the recognition of such netting 
arrangements. The effect of the final rule is that banks, thrifts and 
savings associations (institutions or banking institutions) may net 
positive and negative mark-to-market values of interest and exchange 
rate contracts in determining the current exposure portion of the 
credit equivalent amount of such contracts to be included in risk-
weighted assets.

EFFECTIVE DATE: December 31, 1994.

FOR FURTHER INFORMATION CONTACT:

    OCC: For issues relating to netting and the calculation of risk-
based capital ratios, Roger Tufts, Senior Economic Advisor (202/874-
5070), Office of the Chief National Bank Examiner. For legal issues, 
Eugene H. Cantor, Senior Attorney, Securities & Corporate Practices 
(202/874-5210), or Ronald Shimabukuro, Senior Attorney, Legislative and 
Regulatory Activities Division (202/874-4460), Office of the 
Comptroller of the Currency, 250 E Street, SW., Washington, DC 20219.
    OTS: John F. Connolly, Senior Program Manager, Capital Policy (202/
906-6465); Vicki Hawkins-Jones, Senior Attorney (202/906-7034), 
Regulations and Legislation Division, Office of Thrift Supervision, 
1700 G Street, NW., Washington, DC 20552.

SUPPLEMENTARY INFORMATION:

Background

    The Basle Accord\1\ established a risk-based capital framework 
which was implemented in the United States by the banking agencies in 
1989. Under this framework, off-balance-sheet interest rate and 
exchange rate contracts (rate contracts) are incorporated into risk 
weighted assets by converting each contract into a credit equivalent 
amount. This amount is then assigned to the appropriate credit risk 
weight category according to the identity of the obligor or 
counterparty or, if relevant, the guarantor or the nature of the 
collateral. The credit equivalent amount of an interest or exchange 
rate contract can be assigned to a maximum credit risk category of 50 
percent.
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    \1\The Basle Accord is a risk-based framework that was proposed 
by the Basle Accord Committee on Banking Supervison (Basle 
Supervisors' Committee) and endorsed by the central bank governors 
of the Group of Ten (G-10) countries in July 1988. The Basle 
Supervisors' Committee is comprised of representatives of the 
central banks and supervisory authorities from the G-10 countries 
(Belgium, Canada, France, Germany, Italy, Japan, Netherlands, 
Sweden, Switzerland, the United Kingdom, and the United States) and 
Luxembourg.
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    The credit equivalent amount of a rate contract is determined by 
adding together the current replacement cost (current exposure) and an 
estimate of the possible increase 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).\2\
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    \2\This method of determining credit equivalent amounts for rate 
contracts is identified in the Basle Accord as the current exposure 
method, which is used by most international banks.
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    For risk-based capital purposes, a rate contract with a positive 
mark-to-market value has a current exposure equal to that market value. 
If the mark-to-market value of a rate contract is zero or negative, 
then there is no replacement cost associated with the contract and the 
current exposure is zero. The original Basle Accord and U.S. banking 
agency standards provided that current exposure would be determined 
individually for each rate contract entered into by an institution; 
institutions generally were not permitted to offset, that is, net, 
positive and negative market values of multiple rate contracts with a 
single counterparty to determine one current credit exposure relative 
to that counterparty.\3\
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    \3\It was noted in the Basle Accord that the legal 
enforceability of certain netting arrangements was unclear in some 
jurisdictions. The legal status of netting by novation, however, was 
determined to be settled and this limited type of netting 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, in effect, legally replaces the amalgamated gross 
obligations.
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    In April 1993 the Basle Supervisors' Committee proposed a revision 
to the Basle Accord, endorsed by the G-10 Governors in July 1994, that 
permits institutions to net positive and negative market values of rate 
contracts subject to a qualifying, legally enforceable, bilateral 
netting arrangement. Under the revision, institutions with qualifying 
netting arrangements may calculate a single net current exposure for 
purposes of determining the credit equivalent amount for the included 
contracts.\4\ If the net market value of the contracts included in such 
a netting arrangement 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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    \4\The revision to the Basle Accord notes that national 
supervisors must be satisfied about the legal enforceability of a 
netting arrangement under the laws of each jurisdiction relevant to 
the arrangement. The Basle Accord also states that, if any 
supervisor is dissatisfied about enforceability under its own laws 
the netting arrangement does not satisfy this condition and neither 
counterparty may obtain supervisory benefit.
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The Banking Agencies' Proposals

    On May 20, 1994, the OCC issued a joint proposal with the Board to 
amend their respective risk-based capital standards (59 FR 26456) in 
accordance with the Basle Supervisors' Committee's April 1993 proposal. 
The OTS and the Federal Deposit Insurance Corporation (FDIC) issued 
their parallel netting proposals on June 14, 1994 (59 FR 30538) and 
July 25, 1994 (59 FR 37726), respectively. The banking agencies each 
proposed that for capital purposes the institutions under their 
supervision could net the positive and negative market values of 
interest and exchange rate contracts subject to a qualifying, legally 
enforceable, bilateral netting contract to calculate one current 
exposure for that master netting contract.
    The proposals provided that the net current exposure would be 
determined by adding together all positive and negative market values 
of individual contracts subject to the netting contract. The net 
current exposure would equal the sum of the market values if that sum 
is a positive value, or zero if the sum of the market values is zero or 
a negative value. The proposals did not alter the calculation method 
for potential future exposure.\5\
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    \5\Potential future exposure is estimated by multiplying the 
effective notional amount of a contract by a credit conversion 
factor which is based on the type of contract and the remaining 
maturity of the contract. Under the proposals, a potential future 
exposure amount would be calculated for each individual contract 
subject to the netting contract. The individual potential future 
exposures would then be added together to arrive at one total add-on 
amount.
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    Under the proposals, institutions would be able to net for risk-
based capital purposes only with a written bilateral netting contract 
that creates a single legal obligation covering all included individual 
rate contracts and does not contain a walkaway clause.\6\ The proposals 
required an institution to obtain a written and reasoned legal 
opinion(s) stating that under the master netting contract the 
institution would have a claim to receive, or an obligation to pay, 
only the net amount of the sum of the positive and negative market 
values of included individual contracts if a counterparty failed to 
perform due to default, insolvency, bankruptcy, liquidation, or similar 
circumstances.
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    \6\A walkaway clause is a provision in a netting contract that 
permits a non-defaulting counterparty to make lower payments than it 
would make otherwise under the contract, or no payment at all, to a 
defaulter or to the estate of a defaulter, even if the defaulter or 
the estate of the defaulter is a net creditor under the contract.
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    The proposals indicated that the legal opinion must normally cover: 
(i) The law of the jurisdiction in which the counterparty is chartered, 
or the equivalent location in the case of noncorporate entities, and if 
a branch of the counterparty is involved, the law of the jurisdiction 
in which the branch is located; (ii) the law that governs the 
individual contracts covered by the netting contract; and (iii) the law 
that governs the netting contract.
    The proposals provided that an institution must maintain in its 
files documentation adequate to support the bilateral netting contract. 
Documentation would typically include a copy of the bilateral netting 
contract, legal opinions and any related translations. In addition, the 
proposals required an institution to establish and maintain procedures 
to ensure that the legal characteristics of netting contracts would be 
kept under review.
    Under the proposals, the banking agencies could disqualify any or 
all contracts from netting treatment for risk-based capital purposes if 
the requirements of the proposals were not satisfied. In the event of 
disqualification, the affected contracts would be treated as though 
they were not subject to the master netting contract. The proposals 
indicated that outstanding netting by novation arrangements would not 
be grandfathered, that is, such arrangements would have to meet all of 
the proposed requirements for qualifying bilateral netting contracts.
    The proposals requested general comments as well as specific 
comments on the nature of collateral arrangements and the extent to 
which collateral might be recognized in conjunction with bilateral 
netting contracts. On December 7, 1994, the Board which worked with the 
banking agencies on the proposal, issued its version of the final rule 
in 59 FR 62987 (December 7, 1994).

Comments Received

    The banking agencies together received 21 public comments on their 
proposed amendments. Thirteen comments were from banks, thrifts, and 
bank and thrift holding companies and five were from industry trade 
associations and organizations. In addition, there were three comments 
from law firms. All commenters supported the expanded recognition of 
bilateral netting contracts for risk-based capital purposes. Several 
commenters encouraged recognition of such contracts as quickly as 
possible. Many of the commenters concurred with one of the principal 
underlying tenets of the proposals, that is, that legally enforceable 
bilateral netting contracts can provide an efficient and desirable 
means for institutions to reduce or control credit exposure. A few 
commenters noted that, in their view, the recognition of bilateral 
netting contracts would create an incentive for market participants to 
use such arrangements and would encourage lawmakers to clarify the 
legal status of netting arrangements in their jurisdictions. One 
commenter noted that the expanded recognition of bilateral netting 
contracts would help keep U.S. banking institutions competitive in 
global derivatives markets.
    While generally expressing their endorsement for the expanded 
recognition of bilateral netting contracts, nearly all commenters 
offered suggestions or requested clarification regarding details of the 
proposals. In particular, the commenters raised issues concerning 
specifics of the required legal opinions, the treatment of collateral, 
and the grandfathering of walkaway clauses and novation agreements.

Legal Opinions

    Almost all commenters addressed the proposed requirement that 
institutions obtain legal opinions concluding that their bilateral 
netting contracts would be enforceable in all relevant jurisdictions. 
Commenters did not object to the general requirement that they secure 
legal opinions, rather they raised a number of questions about the form 
and substance of an acceptable opinion.

Form

    Several commenters requested clarification as to the specific form 
of the legal opinion. Commenters wanted to know if a memorandum of law 
would satisfy the requirement or if a legal opinion would be required. 
They questioned whether a memorandum or opinion could be addressed to, 
or obtained by, an industry group, and whether a generic opinion or 
memorandum relating to a standardized netting contract would satisfy 
the legal opinion requirement.
    Several commenters suggested that an opinion secured on behalf of 
the banking industry by an institution should be sufficient so long as 
the individual institution's counsel concurs with the opinion and 
concludes that the opinion applies directly to the institution's 
specific netting contract and to the individual contracts subject to 
it. A few commenters requested confirmation that legal opinions would 
not have to follow a predetermined format.

Scope

    Several commenters identified two possible interpretations of the 
proposed language with regard to the scope of the legal opinions. They 
asked the banking agencies to clarify whether the opinions would be 
required to discuss only whether all relevant jurisdictions would 
recognize the contractual choice of law, or whether they must also 
discuss the enforceability of netting in bankruptcy or other instances 
of default. One commenter suggested deleting the requirement for a 
choice of law analysis.
    A number of commenters objected to the proposed requirement that 
the legal opinion for a multibranch netting contract (that is, a 
netting contract between multinational banks that includes contracts 
with branches of the parties located in various jurisdictions) address 
the enforceability of netting under the law of the jurisdiction where 
each branch is located. These commenters stated that it should be 
sufficient for the legal opinion to conclude that netting would be 
enforced in the jurisdiction of the counterparty's home office if the 
master netting contract provides that all transactions are considered 
obligations of the home office and the branch jurisdictions recognize 
that provision.

Severability

    Several commenters expressed concern about the proposed treatment 
for netting contracts that include contracts with branches in 
jurisdictions where the enforceability of netting is unclear. In such 
circumstances, commenters asserted, unenforceability or uncertainty in 
one jurisdiction should not invalidate the entire netting contract for 
risk-based capital netting treatment. These commenters contended that 
contracts with branches of a counterparty in jurisdictions that 
recognize netting arrangements should be netted and contracts with 
branches in jurisdictions where the enforceability of netting is not 
supported by legal opinions should, for risk-based capital purposes, be 
severed, or removed from the master netting contract and treated as 
though they were not subject to that contract. These commenters noted 
that this treatment should only be available to the extent it is 
supported by legal opinion.

Conclusions

    The proposals required a legal opinion to conclude that ``relevant 
court and administrative authorities would find'' the netting to be 
effective. Many commenters that discussed this aspect of the proposals 
expressed concern that this standard was too high. They suggested, 
instead, that the opinions be required to conclude that netting 
``should'' be effective.
    A few commenters requested clarification regarding the proposed 
requirement that the netting contract must create a single legal 
obligation.

Collateral

    Twelve commenters addressed the proposals' specific request for 
comment on the nature of collateral and the extent to which collateral 
might be recognized in conjunction with bilateral netting contracts. 
All of these commenters believed collateral should be recognized as a 
means of reducing credit exposure. A few commenters noted that 
collateral arrangements are increasingly being used with derivative 
transactions.
    Several commenters stated that for netting contracts that call for 
the use of collateral, the amount of required collateral is determined 
from the net mark-to-market value of the master netting contract. A few 
commenters added that mark-to-market collateral often is used in 
conjunction with a collateral ``add-on'' based on such things as the 
notional amount of the underlying contracts, the maturities of the 
contracts, the credit quality of the counterparty, and volatility 
levels.
    A number of commenters offered their opinions as to how collateral 
should be recognized for risk-based capital purposes. Some suggested 
that the existing method of recognizing collateral for purposes of 
assigning credit equivalent amounts to risk categories is applicable to 
derivative transactions as well. Other commenters expressed the view 
that collateral should be recognized when assigning risk weights to the 
extent it is legally available to cover the total credit exposure for 
the bilateral netting contract in the event of default and that this 
availability should be addressed in the legal opinions.
    Several other commenters suggested separating the net current 
exposure and potential future exposure of bilateral netting contracts 
for determining collateral coverage and appropriate risk weights. One 
commenter favored recognizing collateral for capital purposes by 
allowing an institution to offset net current exposure by the amount of 
the collateral to further reduce the credit equivalent amount.
    Two commenters requested clarification that contracts subject to 
qualifying netting contracts could be eligible for a zero percent risk 
weight if the transaction is properly collateralized in accordance with 
the collateralized transactions rule proposed by the OCC in August 
1993, when it is issued as a final rule. \7\
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    \7\In August 1993, the OCC issued a proposed amendment to its 
risk-based capital guidelines permitting certain collateralized 
transactions to qualify for a zero percent risk weight (58 FR 43822, 
August 18, 1993). In order to qualify for a zero percent risk 
weight, an institution would need to maintain a positive margin of 
qualifying collateral at all times. The collateral arrangement 
should provide for immediate liquidation of the claim in the event 
that a positive margin of collateral is not maintained. The Board 
issued a final rule with similar provisions in December 1992 (57 FR 
62180, December 30, 1992).
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Walkaway Clauses

    Several commenters addressed the proposed prohibition against 
walkaway clauses in contracts qualifying for netting for risk-based 
capital purposes. While most of these commenters agreed that, 
ultimately, walkaway clauses should be eliminated from master netting 
contracts, they favored a phase-out period, during which outstanding 
bilateral netting contracts containing walkaway clauses could qualify 
for capital netting treatment. Several commenters contended that if a 
defaulter is a net debtor under the contract, the existence of a 
walkaway clause would not affect the amount owed to the non-defaulting 
creditor.

Novation

    A few commenters expressed concern that the banking agencies' 
proposals did not grandfather outstanding novation agreements. These 
commenters suggested a phase-in period during which novation agreements 
would not be required to be supported by legal opinions.

Other Issues

    One commenter requested greater detail on the nature and extent of 
examination review procedures. Two commenters stated that in some 
situations obtaining translations might be burdensome. Another 
commenter suggested assurance that the banking agencies would not 
disqualify netting contracts in an unreasonable manner.
    Approximately one-half of the commenters expressed concern that the 
banking agencies' proposals specifically were limited to interest rate 
and exchange rate contracts. All of these opposed limiting the range of 
products that could be included under qualifying netting contracts. In 
this regard, one commenter noted that where there is sufficient legal 
support confirming the enforceability of cross-product netting it 
should be recognized for capital purposes.
    A number of commenters used the proposal as an opportunity to 
discuss the manner in which the add-on for potential future exposure is 
calculated. They suggested netting contracts should be recognized not 
only as a way to reduce the current exposure to a counterparty, but 
also the effects of such netting contracts should be taken into account 
to reduce the amount of capital institutions must hold against the 
potential future exposure to the counterparty.

Final Rule

    After considering the public comments received and further 
deliberating the issues involved, the banking agencies are adopting a 
final rule recognizing, for capital purposes, qualifying bilateral 
netting contracts. This final rule is substantially the same as 
proposed.

Legal opinions

Form

    The final rule affirms the usual and customary industry practice by 
providing that institutions obtain a written and reasoned legal 
opinion(s) concluding that the netting contract is enforceable in all 
relevant jurisdictions. The legal opinion provisions of the final rule 
are aimed at ensuring there is a substantial legal basis supporting the 
legal enforceability of a netting contract before reducing a banking 
institution's capital requirement based on that netting contract. A 
legal opinion, as that phrase is commonly understood by the legal 
community in the United States, can provide such a legal basis. A 
memorandum of law may be consistent with prudent banking practices 
provided it addresses all of the relevant issues in a credible manner 
and represents that netting is enforceable in all relevant 
jurisdictions.
    As discussed in the proposals, legal opinions on bilateral netting 
contracts are prepared by either an outside law firm or an 
institution's in-house counsel, and need to (i) address all relevant 
jurisdictions, and (ii) conclude with a high degree of certainty that 
in the event of a legal challenge the banking institution's claim or 
obligation would be determined by the relevant court or administrative 
authority to be the net sum of the positive and negative mark-to-market 
values of all individual contracts subject to the bilateral netting 
contract. The subject matter and complexity of required legal opinions 
will vary.
    Institutions sometimes use general, standardized opinions to help 
support the legal enforceability of their bilateral netting contracts. 
For example, a banking institution may have obtained a memorandum of 
law addressing the enforceability of netting provisions in a particular 
foreign jurisdiction. This opinion may be used as the basis for 
recognizing netting generally in that jurisdiction. However, with 
regard to an individual master netting contract, the memorandum of law 
is supplemented by an opinion that addresses issues such as the 
enforceability of the underlying contracts, choice of law, and 
severability.
    For example, a generic opinion prepared for a trade association 
with respect to the effectiveness of netting under the standard form 
agreement issued by the trade association, by itself is generally 
inadequate to support a netting contract. Banking institutions 
supplement the generic opinion with a review of the terms of the 
specific netting contract that the institution is executing.

Scope

    With regard to the scope of the legal opinions, institutions 
following prudent banking practices insure that legal opinions address 
the validity and enforceability of the entire netting contract. This 
generally involves a legal conclusion that under the applicable state 
or other jurisdictional law the netting contract is a legal, valid, and 
binding contract, enforceable in accordance with its terms, even in the 
event of insolvency, bankruptcy, or similar proceedings. Opinions 
provided on the law of jurisdictions outside of the U.S. should include 
a discussion and conclusion that netting provisions do not violate the 
public policy or the law of that jurisdiction.
    A critical aspect of a qualified netting contract is the contract's 
enforceability in any jurisdiction whose law would likely be applied in 
an enforcement action, as well as the jurisdiction where the 
counterparty's assets reside. In this regard, and in light of the 
policy in some countries to liquidate branches of foreign banking 
institutions independent of the head office, prudent banking practices 
include ensuring that legal opinions address the netting contract's 
enforceability 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, 
the law of the jurisdiction in which the branch is located; (ii) the 
law that governs the individual contracts subject to the bilateral 
netting contract; and (iii) the law that governs the netting contract.

Severability

    The banking agencies recognize that for some multibranch netting 
contracts an institution may not be able to obtain a legal opinion(s) 
concluding that netting would be enforceable in every jurisdiction 
where branches covered under the master netting contract are located. 
The banking agencies concur with commenters that in such situations it 
may be inefficient for institutions to renegotiate netting contracts to 
ensure they cover only those jurisdictions where netting is clearly 
enforceable. In certain circumstances for capital purposes, banking 
institutions may use master bilateral netting contracts that include 
contracts with branches across all jurisdictions. Banking institutions 
should calculate their net current exposure for the contracts in those 
jurisdictions where netting clearly is enforceable as supported by 
legal opinion(s). The remaining contracts subject to the netting 
contract are severed from the netting contract and treated as though 
they were not subject to the netting contract for capital and credit 
purposes. This approach of essentially dividing contracts subject to 
the netting contact into two categories--those that clearly may be 
netted and those that may not--is consistent with prudent banking 
practices provided that the banking institution's legal opinions 
conclude that the contracts that do not qualify for netting treatment 
are legally severable from the master netting contract and that such 
severance will not undermine the enforceability of the netting contract 
for the remaining qualifying contracts.

Conclusions

    The banking agencies have retained the proposed language concerning 
legal opinions, which is consistent with the prudent industry practice 
of obtaining legal opinions representing that netting is enforceable in 
all relevant jurisdictions. In response to commenters' assertions that 
the standard for this type of legal opinion is too high, the banking 
agencies note that use of the word ``would'' in the capital rules does 
not necessarily mean that the legal opinions must also use the word 
``would'' or that enforceability must be determined to be an absolute 
certainty. The intent, rather, is for banking institutions to continue 
to secure a legal opinion indicating with a high degree of certainty 
that a netting contract will survive a legal challenge in any 
applicable jurisdiction. The degree of certainty should be apparent 
from the reasoning set out in the opinion.
    As discussed above, a netting contract may include individual 
contracts that do not qualify for netting treatment, provided that 
these individual contracts are legally severable from the contracts to 
be netted for capital purposes. Legal opinions obtained by banking 
institutions under this final rule will address only those individual 
contracts that are covered by, and included under, the netting contract 
for capital purposes, e.g., not severed contracts.
    Institutions generally must include all contracts covered by a 
qualifying netting contract in calculating the current exposure of that 
netting contract. In the event a netting contract covers transactions 
that are normally excluded from the risk-based ratio calculation, an 
institution may choose to either include or exclude all mark-to-market 
values of such contracts when determining net current exposure, but 
this choice must be followed consistently. Examples of such contracts 
include exchange rate contracts with an original maturity of fourteen 
calendar days or less or instruments traded on exchanges that require 
daily payment of variation margin.

Collateral

    The final rule permits, subject to certain conditions, institutions 
to take into account qualifying collateral when assigning the credit 
equivalent amount of a netting contract to the appropriate risk weight 
category in accordance with the procedures and requirements currently 
set forth in each banking agencies' risk-based capital standards. The 
banking agencies have added language to the final rule clarifying that 
collateral must be legally available to cover the credit exposure of 
the netting contract in the event of default. For example, the 
collateral may not be pledged solely against one individual contract 
subject to the master netting contract. The legal availability of the 
collateral must be addressed in the legal opinions.

Walkaway Clauses

    The banking agencies have considered the suggestion made by some 
commenters of a phase-out period for outstanding contracts with 
walkaway clauses. The banking agencies continue to believe that 
walkaway clauses do not reduce credit risk. Accordingly, the final rule 
retains the provision that bilateral netting contracts with walkaway 
clauses are not eligible for netting treatment for risk-based capital 
purposes and does not provide for a phase-out period.

Novation

    The proposal required all netting contracts, including netting by 
novation agreements, to be supported by written legal opinions. The 
banking agencies do not agree with commenters that a grandfathering 
period for outstanding novation agreements is needed. Rather, the 
banking agencies continue to believe that all netting contracts must be 
held to the same standards in order to promote certainty as to the 
legal enforceability of the contracts and to decrease the risks faced 
by counterparties in the event of default. Under the final rule, a 
netting by novation agreement must meet the requirements for a 
qualifying bilateral netting contract.

Other Issues

    The banking agencies have considered all of the other issues raised 
by commenters. With regard to documentation, the banking agencies 
reiterate that, as with all provisions of risk-based capital, a banking 
institution must maintain in its files appropriate documentation to 
support any particular capital treatment including netting of rate 
contracts. Appropriate documentation typically would include a copy of 
the bilateral netting contract, supporting legal opinions, and any 
related translations. The documentation should be available to 
examiners for their review.
    The banking agencies recognize commenters' concerns that the 
proposed rule was limited specifically to interest and exchange rate 
contracts. The banking agencies note that both the Basle Accord and 
their risk-based capital standards currently do not address derivatives 
contracts other than rate contracts. This final rule does not attempt 
to go beyond the scope of the existing risk-based capital framework and 
applies only to netting contracts encompassing interest rate and 
foreign exchange rate contracts. The banking agencies, however, note 
that the Basle Supervisors' Committee issued a proposal for public 
comment in July 1994 to amend the Basle Accord which explicitly would 
set forth the risk-based capital treatment for other types of 
derivative transactions, such as commodity, precious metal, and equity 
contracts. In this regard, the OCC issued a similar proposal, based on 
the Basle Supervisors' Committee proposal, to amend its risk-based 
capital standards (59 FR 45243, September 1, 1994).\8\ The OTS intends 
to issue a similar proposal in the near future.
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    \8\The Board and the FDIC have issued similar proposed rules (59 
FR 43508, August 24, 1994 and 59 FR 52714, October 19, 1994, 
respectively).
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    Until the Basle Accord has been revised and the banking agencies' 
risk-based capital rules have been amended to encompass commodity, 
precious metal, and equity derivative contracts, the banking agencies, 
rather than automatically disqualifying from capital netting treatment 
an entire netting contract that includes non-rate-related transactions, 
will permit institutions to apply the following treatment. In 
determining the current exposure of otherwise qualifying netting 
contracts that include non-rate-related contracts, institutions will be 
permitted to net the positive and negative mark-to-market values of the 
included interest and exchange rate contracts, while severing the non- 
rate-related contracts and treating them for risk-based capital 
purposes as individual contracts that are not subject to the master 
netting contract. (This treatment is similar to the treatment applied 
to a netting contract that includes contracts in jurisdictions where 
the enforceability of netting is not supported by legal opinion. With 
non-rate-related contracts, however, legal opinions on severability are 
not required.)
    The banking agencies note that the regulatory language with regard 
to the calculation of potential future exposure remains essentially the 
same as that proposed. The banking agencies have clarified an 
underlying premise of the current exposure method for calculating 
credit exposure as set forth in the Basle Accord, that is, the add-on 
for potential future exposure must be calculated based on the 
effective, rather than the apparent, notional principal amount and the 
notional amount an institution uses will be subject to examiner 
review.\9\
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    \9\The notional amount is, generally, a stated reference amount 
of money used to calculate payment, streams between the 
counterparties. In the event that the effect of the notional amount 
is leveraged or enhanced by the structure of the transaction, 
institutions must use the actual, or effective, notional amount when 
determining potential future exposure. For example, a stated 
notional amount of one million dollars with payments calculated at 
2X Libor, would have an effective notional amount of two million 
dollars.
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Regulatory Flexibility Act Analysis

    Pursuant to section 605(b) of the Regulatory Flexibility Act, the 
banking agencies hereby certify that this final rule will not have a 
significant impact on a substantial number of small business entities. 
Accordingly, a regulatory flexibility analysis is not required.

Executive Order 12866

    The OCC and the OTS have determined that this final rule is not a 
significant regulatory action as defined in Executive Order 12866.

Effective Date

    Section 302 of the Riegle Community Development and Regulatory 
Improvement Act of 1994 (Pub. L. 103-325, 108 Stat. 2160) provides that 
the federal banking agencies must consider the administrative burdens 
and benefits of any new regulations that impose additional requirements 
on insured depository institutions. Section 302 also requires such a 
rule to take effect on the first day of the calendar quarter following 
final publication of the rule, unless the agency, for good cause, 
determines an earlier effective date is appropriate. Similarly, the 
Administrative Procedure Act requires a 30-day delayed effective date, 
unless the rule either relieves a restriction or the agency finds good 
cause. 5 U.S.C. 553(d) (1) and (3).
    This final rule imposes certain requirements on depository 
institutions that wish to net the current exposures of their rate 
contracts for purposes of calculating their risk-based capital 
requirements. For these institutions, any burden of complying with the 
requirements of netting under a legally enforceable netting contract 
and obtaining the necessary legal opinions should be outweighed by the 
benefits associated with a lower capital requirement. This final rule 
will not affect institutions that do not wish to net for capital 
purposes. For these reasons, the banking agencies have determined that 
there is sufficient good cause to provide for an effective date of 
December 31, 1994. A year-end effective date allows banking 
institutions to take advantage of netting in their year-end statements, 
if they so desire. Delay in implementation of this final rule to the 
next calendar quarter would be unnecessary and contrary to the public 
interest because compliance would be more difficult and costly, and 
could require additional accounting adjustments and disclosures.

List of Subjects

12 CFR Part 3

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

12 CFR Part 567

    Capital, Reporting and recordkeeping requirements, Savings 
associations.

Comptroller of the Currency

12 CFR Chapter I

Authority and Issuance

    For the reasons set out in the preamble, part 3 of title 12, 
chapter I of the Code of Federal Regulations is amended as set forth 
below.

PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES

    1. The authority citation for part 3 is revised 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 to part 3, paragraph (c)(15) of section 1 is 
removed, paragraphs (c)(16) through (c)(29) are redesignated as 
paragraphs (c)(15) through (c)(28), and a new paragraph (c)(29) is 
added to read as follows:

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

Section 1. Purpose, Applicability of Guidelines, and Definitions.

* * * * *
    (c) * * *
    (29) Walkaway clause means a provision in a bilateral netting 
contract that permits a nondefaulting counterparty to make a lower 
payment than it would make otherwise under the bilateral netting 
contract, or no payment at all, to a defaulter or the estate of a 
defaulter, even if the defaulter or the estate of the defaulter is a 
net creditor under the bilateral netting contract.
* * * * *
    3. In appendix A, paragraph (b)(5) of section 3 is revised to read 
as follows:
* * * * *

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

* * * * *
    (b) * * *
    (5) Off-balance sheet contracts--interest rate and foreign 
exchange rate contracts. (i) Calculation of credit equivalent 
amount. The credit equivalent amount of an off-balance sheet 
interest rate or foreign exchange rate contract equals the sum of 
the current credit exposure (also referred to as the replacement 
cost) and the potential future credit exposure of the off-balance 
sheet rate contract. The calculation of credit equivalent amounts is 
measured in U.S. dollars, regardless of the currency or currencies 
specified in the off-balance sheet rate contract.
    (A) Current credit exposure. The current credit exposure for a 
single off-balance sheet rate contract is determined by the mark-to-
market value of the off-balance sheet rate contract. If the mark-to-
market value is positive, then the current exposure equals that 
mark-to-market value. If the mark-to-market value is zero or 
negative, the current exposure is zero. However, in determining its 
current credit exposure for multiple off-balance sheet rate 
contracts executed with a single counterparty, a bank may net 
positive and negative mark-to-market values of off-balance sheet 
rate contracts if subject to a bilateral netting contract as 
provided by section 3(b)(5)(ii) of this appendix A. If the net mark-
to-market value is positive, the current credit exposure equals that 
net mark-to-market value. If the net mark-to-market value is zero or 
negative, the current exposure is zero.
    (B) Potential future credit exposure. The potential future 
credit exposure of an off-balance sheet rate contract, including a 
contract with a negative mark-to-market value, is estimated by 
multiplying the notional principal\19\ by a credit conversion 
factor. Banks, subject to examiner review, should use the effective 
rather than the apparent or stated notional amount in this 
calculation. The credit conversion factors are:\20\
---------------------------------------------------------------------------

    \19\For purposes of calculating potential future credit exposure 
for foreign exchange contracts and other similar contracts, in which 
notional principal is equivalent to cash flows, total notional 
principal is defined as the net receipts to each party falling due 
on each value date in each currency.
    \20\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.

------------------------------------------------------------------------
                                                               Foreign  
                                                  Interest     exchange 
              Remaining maturity                    rate         rate   
                                                 contracts    contracts 
                                                 (percents)   (percents)
------------------------------------------------------------------------
One year or less..............................          0.0          1.0
Over one year.................................          0.5          5.0
------------------------------------------------------------------------

    (ii) Off-balance sheet rate contracts subject to bilateral 
netting contracts. In determining its current credit exposure for 
multiple off-balance sheet rate contracts executed with a single 
counterparty, a bank may net off-balance sheet rate contracts 
subject to a bilateral netting contract by offsetting positive and 
negative mark-to-market values, provided that:
    (A) The bilateral netting contract is in writing;
    (B) The bilateral netting contract is not subject to a walkaway 
clause;
    (C) The bilateral netting contract creates a single legal 
obligation for all individual off-balance sheet rate contracts 
covered by the bilateral netting contract. In effect, the bilateral 
netting contract provides that the bank has a single claim or 
obligation either to receive or pay only the net amount of the sum 
of the positive and negative mark-to-market values on the individual 
off-balance sheet contracts covered by the bilateral netting 
contract. The single legal obligation for the net amount is 
operative in the event that a counterparty, or a counterparty to 
whom the bilateral netting contract has been validly assigned, fails 
to perform due to any of the following events: default, insolvency, 
bankruptcy, or other similar circumstances;
    (D) The bank obtains a written and reasoned legal opinion(s) 
representing, with a high degree of certainty, 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 that governs the individual off-balance sheet rate 
contracts covered by the bilateral netting contract; and
    (III) The law that governs the bilateral netting contract;
    (E) 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 requirements of this 
section; and
    (F) The bank maintains in its files documentation adequate to 
support the netting of an off-balance sheet rate contract.\21\
---------------------------------------------------------------------------

    \21\By netting individual off-balance sheet rate contracts for 
the purpose of calculating its credit equivalent amount, a bank 
represents that documentation adequate to support the netting of an 
off-balance sheet rate contract is in the 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 under any one of the bodies of law 
described in sections 3(b)(5)(ii)(D) (I) through (III) of this 
appendix A, the underlying individual off-balance sheet rate 
contracts may not be netted for the purpose of this section.
---------------------------------------------------------------------------

    (iii) Risk weighting. Once the bank determines the credit 
equivalent amount for an off-balance sheet rate contract, it assigns 
that amount to the counterparty's appropriate risk weight category 
or, if relevant, to the nature of any collateral or guarantee. 
Collateral held against a netting contract is not recognized for 
capital purposes unless it is legally available for all contracts 
included in the netting contract. However, the maximum risk weight 
for the credit equivalent amount of such an off-balance sheet rate 
contract is 50 percent.
    (iv) Exceptions. The following off-balance sheet rate contracts 
are not subject to the above calculation, and therefore, are not 
part of the denominator of a national bank's risk-based capital 
ratio:
    (A) A foreign exchange rate contract with an original maturity 
of 14 calendar days or less; and
    (B) Any interest rate or foreign exchange rate contract that is 
traded on an exchange requiring the daily payment of any variations 
in the market value of the contract.
* * * * *
    4. The table title and the introductory text to Table 3 to appendix 
A are revised to read as follows:
* * * * *

Table 3--Treatment of Interest Rate and Foreign Exchange Rate Contracts

    The current exposure method is used to calculate the credit 
equivalent amounts of these off-balance sheet rate 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 off-balance sheet rate contracts with a 
single counterparty may be netted if those contracts are subject to 
a qualifying bilateral netting contract.
* * * * *

Office of Thrift Supervision

 12 CFR Chapter V

Authority and Issuance

    For the reasons set out in the preamble, part 567, of chapter V, 
title 12 of the Code of Federal Regulations is amended as set forth 
below:

SUBCHAPTER D--REGULATIONS APPLICABLE TO ALL SAVINGS ASSOCIATIONS

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

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

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


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

    (a) * * *
    (2) * * *
    (v) Off-balance sheet contracts; interest-rate and foreign exchange 
rate contracts (Group E)--(A) Calculation of credit equivalent amounts. 
The credit equivalent amount of an off-balance sheet interest rate or 
foreign exchange rate contract that is not subject to a qualifying 
bilateral netting contract in accordance with paragraph (a)(2)(v)(B) of 
this section is equal to the sum of the current credit exposure, i.e., 
the replacement cost of the contract, and the potential future credit 
exposure of the off-balance sheet rate contract. The calculation of 
credit equivalent amounts is measured in U.S. dollars, regardless of 
the currency or currencies specified in the off-balance sheet rate 
contract.
    (1) Current credit exposure. The current credit exposure of an off-
balance sheet rate contract is determined by the mark-to-market value 
of the contract. If the mark-to-market value is positive, then the 
current credit exposure equals that mark-to-market value. If the mark-
to-market value is zero or negative, then the current exposure is zero. 
In determining its current credit exposure for multiple off-balance 
sheet rate contracts executed with a single counterparty, a savings 
association may net positive and negative mark-to-market values of off-
balance sheet rate contracts if subject to a bilateral netting contract 
as provided in paragraph (a)(2)(v)(B) of this section.
    (2) Potential future credit exposure. The potential future credit 
exposure of an off-balance sheet rate contract, including a contract 
with a negative mark-to-market value, is estimated by multiplying the 
notional principal\9\ by a credit conversion factor. Savings 
associations, subject to examiner review, should use the effective 
rather than the apparent or stated notional amount in this calculation. 
The conversion factors are:\10\
---------------------------------------------------------------------------

    \9\For purposes of calculating potential future credit exposure 
for foreign exchange contracts and other similar contracts, in which 
notional principal is equivalent to cash flows, total notional 
principal is defined as the net receipts to each party falling due 
on each value date in each currency.
    \10\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.

------------------------------------------------------------------------
                                                               Foreign  
                                                  Interest     exchange 
              Remaining maturity                    rate         rate   
                                                 contracts    contracts 
                                                 (percents)   (percents)
------------------------------------------------------------------------
One year or less..............................          0.0          1.0
Over one year.................................          0.5          5.0
------------------------------------------------------------------------

    (B) Off-balance sheet rate contracts subject to bilateral netting 
contracts. In determining its current credit exposure for multiple off-
balance sheet rate contracts executed with a single counterparty, a 
savings association may net off-balance sheet rate contracts subject to 
a bilateral netting contract by offsetting positive and negative mark-
to-market values, provided that:
    (1) The bilateral netting contract is in writing;
    (2) The bilateral netting contract creates a single legal 
obligation for all individual off-balance sheet rate contracts covered 
by the bilateral netting contract. In effect, the bilateral netting 
contract provides that the savings association has a single claim or 
obligation either to receive or pay only the net amount of the sum of 
the positive and negative mark-to-market values on the individual off-
balance sheet rate contracts covered by the bilateral netting contract. 
The single legal obligation for the net amount is operative in the 
event that a counterparty, or a counterparty to whom the bilateral 
netting contract has been validly assigned, fails to perform due to any 
of the following events: default, insolvency, bankruptcy, or other 
similar circumstances;
    (3) The savings association obtains a written and reasoned legal 
opinion(s) representing, with a high degree of certainty, that in the 
event of a legal challenge, including one resulting from default, 
insolvency, bankruptcy or similar circumstances, the relevant court and 
administrative authorities would find the savings association's 
exposure to be the net amount under:
    (i) The law of the jurisdiction in which the counterparty is 
chartered or the equivalent location in the case of noncorporate 
entities, and if a branch of the counterparty is involved, then also 
under the law of the jurisdiction in which the branch is located;
    (ii) The law that governs the individual off-balance sheet rate 
contracts covered by the bilateral netting contract; and
    (iii) The law that governs the bilateral netting contract;
    (4) The savings association establishes and maintains procedures to 
monitor possible changes in relevant law and to ensure that the 
bilateral netting contract continues to satisfy the requirements of 
this section; and
    (5) The savings association maintains in its files documentation 
adequate to support the netting of an off-balance sheet rate 
contract.\11\
---------------------------------------------------------------------------

    \11\By netting individual off-balance sheet rate contracts for 
the purpose of calculating its credit equivalent amount, a savings 
association represents that documentation adequate to support the 
netting of an off-balance sheet rate contract is in the savings 
association's files and available for inspection by the OTS. Upon 
determination by the OTS that a savings association's files are 
inadequate or that a bilateral netting contract may not be legally 
enforceable under any one of the bodies of law described in 
paragraphs (a)(2)(v)(B)(3) (i) through (iii) of this section, the 
underlying individual off-balance sheet rate contracts may not be 
netted for the purposes of this section.
---------------------------------------------------------------------------

    (C) Walkaway clause. A bilateral netting contract that contains a 
walkaway clause is not eligible for netting for purposes of calculating 
the current credit exposure amount. The term ``walkaway clause'' means 
a provision in a bilateral netting contract that permits a 
nondefaulting counterparty to make a lower payment than it would make 
otherwise under the bilateral netting contract, or no payment at all, 
to a defaulter or the estate of a defaulter, even if the defaulter or 
the estate of the defaulter is a net creditor under the bilateral 
netting contract.
    (D) Risk weighting. Once the savings association determines the 
credit equivalent amount for an off-balance sheet rate contract, that 
amount is assigned to the risk-weight category appropriate to the 
counterparty, or, if relevant, to the nature of any collateral or 
guarantee. Collateral held against a netting contract is not recognized 
for capital purposes unless it is legally available for all contracts 
included in the netting contract. However, the maximum risk weight for 
the credit equivalent amount of such off-balance sheet rate contracts 
is 50 percent.
    (E) Exceptions. The following off-balance sheet rate contracts are 
not subject to the above calculation, and therefore, are not part of 
the denominator of a savings association's risk-based capital ratio:
    (1) A foreign exchange rate contract with an original maturity of 
14 calendar days or less; and
    (2) Any interest rate or foreign exchange rate contract that is 
traded on an exchange requiring the daily payment of any variations in 
the market value of the contract.
* * * * *
    Dated: December 7, 1994.
Eugene A. Ludwig,
Comptroller of the Currency.
    Dated: December 1, 1994.
Jonathan L. Fiechter,
Acting Director, Office of Thrift Supervision.
[FR Doc. 94-31730 Filed 12-27-94; 8:45 am]
BILLING CODE 4810-33-P AND 6720-01-P