I. BACKGROUND
The Office of the Comptroller of the Currency (OCC) has adopted an interim final rule amending its lending limit rule to apply to certain credit exposures arising from derivative transactions and securities financing transactions. Effective July 21, 2012, section 610 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 revised the statutory definition of loans and extensions of credit for purposes of the lending limit to include certain credit exposures arising from a derivative transaction, repurchase agreement, reverse repurchase agreement, securities lending transaction, or securities borrowing transaction. The interim final rule adopted by the OCC implements this statutory change which applies to both national banks and savings associations (state and federally chartered). State chartered banks are subject to separate restrictions under section 611 of the Dodd-Frank Act, with the restrictions applicable to state chartered banks becoming effective on January 21, 2013.
National banks and savings associations have through October 1, 2013, to comply with the rule’s requirements as to derivative transactions and securities financing transactions. The OCC provided a short-term exception under its lending limits authority to allow time for national banks and savings associations to adjust for compliance with the new standard.
To reduce the burden of these new credit exposure calculations, particularly for smaller and mid-size banks and savings associations, the rule provides options for measuring the exposures for each transaction type. This method permits institutions to adopt compliance alternatives that fit their size and risk management requirements, consistent with safety and soundness and the goals of the statute. However, the OCC may require a particular institution to use one of these options for safety and soundness reasons.
Specifically, an institution can choose to measure the credit exposure of derivatives (except credit derivatives) in one of three ways: (1) through an OCC-approved internal model, (2) by use of a look-up table that fixes the attributable exposure at the execution of the transaction, or (3) by use of a look-up table that incorporates the current mark to market and a fixed add-on for each year of the transaction’s remaining life. For credit derivatives (transactions in which banks buy or sell credit protection against loss on a third-party reference entity), the interim final rule provides a special rule for calculating credit exposure, based on exposure to the counterparty and reference entity. With respect to securities financing transactions, institutions can choose to use either an OCC-approved internal model or fix the attributable exposure based on the type of transaction (repurchase agreement, reverse repurchase agreement, securities lending transaction, or securities borrowing transaction).
The interim final rule also specifically exempts securities financing transactions relating to Type I securities (U.S. or state government obligations, etc.) from the lending limits calculations.
The revised lending limit rule continues to provide that loans and extensions of credit, including those that arise from derivative and securities financing transactions, must be consistent with safe and sound banking practices.
II. KEY DEFINITIONS
Section 610 of the Dodd-Frank Act expands the definition of “loans and extensions of credit” to include any credit exposure to a person arising from a derivative transaction, repurchase agreement, reverse repurchase agreement, securities lending transaction, or securities borrowing transaction between a national bank and the person.
To address the additional scope and complexity to the lending limits resulting from Section 610 of the Dodd-Frank Act, the interim final rule has added to or expanded the following definitions under Part 32:
Borrower means a person who is named as a borrower or debtor in a loan or extension of credit; a person to whom a national bank or savings association has credit exposure arising from a derivative transaction or a securities financing transaction, entered by the bank or savings association; or any other person, including a drawer, endorser, or guarantor, who is deemed to be a borrower under the “direct benefit” or the “common enterprise” tests set forth in § 32.5.
Derivative transaction includes any transaction that is a contract, agreement, swap, warrant, note, or option that is based, in whole or in part, on the value of, any interest in, or any quantitative measure or the occurrence of any event relating to, one or more commodities, securities, currencies, interest or other rates, indices, or other assets.
Effective margining arrangement means a master legal agreement governing derivative transactions between a bank or savings association and a counterparty that requires the counterparty to post, on a daily basis, variation margin to fully collateralize that amount of the bank’s net credit exposure to the counterparty that exceeds $1 million created by the derivative transactions covered by the agreement.
Eligible credit derivative means a single-name credit derivative or a standard, non-tranched index credit derivative provided that:
(1) The derivative contract meets the requirements of an eligible guarantee, and has been confirmed by the protection purchaser and the protection provider;
(2) Any assignment of the derivative contract has been confirmed by all relevant parties;
(3) If the credit derivative is a credit default swap, the derivative contract includes the following credit events:
(i) Failure to pay any amount due under the terms of the reference exposure, subject to any applicable minimal payment threshold that is consistent with standard market practice and with a grace period that is closely in line with the grace period of the reference exposure; and
(ii) Bankruptcy, insolvency, or inability of the obligor on the reference exposure to pay its debts, or its failure or admission in writing of its inability generally to pay its debts as they become due and similar events;
(4) The terms and conditions dictating the manner in which the derivative contract is to be settled are incorporated into the contract;
(5) If the derivative contract allows for cash settlement, the contract incorporates a robust valuation process to estimate loss with respect to the derivative reliably and specifies a reasonable period for obtaining postcredit event valuations of the reference exposure;
(6) If the derivative contract requires the protection purchaser to transfer an exposure to the protection provider at settlement, the terms of at least one of the exposures that is permitted to be transferred under the contract provides that any required consent to transfer may not be unreasonably withheld; and
(7) If the credit derivative is a credit default swap, the derivative contract clearly identifies the parties responsible for determining whether a credit event has occurred, specifies that this determination is not the sole responsibility of the protection provider, and gives the protection purchaser the right to notify the protection provider of the occurrence of a credit event.
Eligible Guarantee means a contract that:
a. Is written and unconditional;
b. Covers all or a pro rata portion of all contractual payments of the obligor on the reference exposure;
c. Gives the beneficiary a direct claim against the protection provider;
d. Is not unilaterally cancelable by the protection provider for reasons other than the breach of the contract by the beneficiary;
e. Is legally enforceable against the protection provider in a jurisdiction where the protection provider has sufficient assets against which a judgment may be attached and enforced;
f. Requires the protection provider to make payment to the beneficiary on the occurrence of a default (as defined in the guarantee) of the obligor on the reference exposure in a timely manner without the beneficiary first having to take legal action to pursue the obligor for payment;
g. Does not increase the beneficiary's cost of credit protection on the guarantee in response to deterioration in the credit quality of the reference exposure; and
h. Is not provided by an affiliate of the bank holding company, unless the affiliate is an insured depository institution, bank, securities broker or dealer, or insurance company that:
i. Does not control the bank holding company; and
ii. Is subject to consolidated supervision and regulation comparable to that imposed on U.S. depository institutions, securities broker-dealers, or insurance companies (as the case may be).
Eligible protection provider means:
(1) A sovereign entity (a central government, including the U.S. government; an agency; department; ministry; or central bank);
(2) The Bank for International Settlements, the International Monetary Fund, the European Central Bank, the European Commission, or a multilateral development bank;
(3) A Federal Home Loan Bank;
(4) The Federal Agricultural Mortgage Corporation;
(5) A depository institution, as defined in section 3 of the Federal Deposit Insurance Act, 12 U.S.C. 1813(c);
(6) A bank holding company, as defined in section 2 of the Bank Holding Company Act, as amended, 12 U.S.C. 1841;
(7) A savings and loan holding company, as defined in section 10 of the Home Owners’ Loan Act, 12 U.S.C. 1467a;
(8) A securities broker or dealer registered with the SEC under the Securities Exchange Act of 1934, 15 U.S.C. 78o et seq.;
(9) An insurance company that is subject to the supervision of a State insurance regulator;
(10) A foreign banking organization;
(11) A non-U.S.-based securities firm or a non-U.S.-based insurance company that is subject to consolidated supervision and regulation comparable to that imposed on U.S. depository institutions, securities broker-dealers, or insurance companies; and
(12) A qualifying central counterparty;
Securities financing transaction means a repurchase agreement, reverse repurchase agreement, securities lending transaction, or securities borrowing transaction.
III. NONCONFORMING LOANS AND EXTENSIONS OF CREDIT
A loan or extension of credit that is a credit exposure arising from a derivative transaction and measured by an Internal Model Method, which was within a bank’s legal lending limit when made, will not be deemed a violation but will be treated as nonconforming if the loan or extension of credit is no longer in conformity with the bank’s lending limit because the loan or extension of credit increased after execution of the derivative transaction.
IV. LOANS NOT SUBJECT TO LENDING LIMITS
Added to the existing list of loans excluded from the lending limits restrictions are: (a) credit exposures arising from securities financing transactions in which the securities financed are Type I securities; and (b) intraday credit exposures arising from a derivative transaction or securities financing transaction.
V. CREDIT EXPOSURE ARISING FROM DERIVATIVE AND SECURITIES FINANCING TRANSACTIONS
The rules for calculating the credit exposure arising from a derivative transaction or a securities financing transaction entered into by a national bank or savings association for purposes of determining the bank’s or savings association’s lending limit are set forth below:
A. Calculation of Credit Exposure: Non-Credit Derivative Transactions
A national bank or savings association shall calculate the credit exposure to a counterparty arising from a non-credit derivative transaction, for purposes of determining the bank’s lending limit, by one of the three following methods. Subject to Paragraph (B)(3) below, a bank shall use the same method for calculating counterparty credit exposure arising from all of its derivative transactions.
1. Internal Model Method.
a. Credit exposure. The credit exposure of a derivative transaction under the Internal Model Method shall equal the sum of the current credit exposure of the derivative transaction and the potential future credit exposure of the derivative transaction.
b. Calculation of current credit exposure. A bank or savings association shall determine its current credit exposure by the mark-to-market value of the derivative 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, than the current credit exposure is zero.
c. Calculation of potential future credit exposure. A bank or savings association shall calculate its potential future credit exposure by using an internal model that has been approved by the appropriate Federal banking agency.
d. Net credit exposure. A bank or savings association that calculates its credit exposure by using the Internal Model Method may net credit exposures of derivative transactions arising under the same qualifying master netting agreement.
2. Conversion Factor Matrix Method. The credit exposure arising from a derivative transaction under the Conversion Factor Matrix Method shall equal and remain fixed at the potential future credit exposure of the derivative transaction as determined at the execution of the transaction by reference to Table 1.
Table 1 – Conversion Factor Matrix for Calculating Potential Future Credit Exposure1
Original Maturity2
Interest Rate
Foreign exchange
Rate and gold
Equity
Other3
(includes commodities and precious metals except gold)
1 year or less
.015
.20
.06
Over 1 to 3 years
.03
.18
Over 3 to 5 years
.30
Over 5 to 10 years
.12
.60
Over ten years
1.0
1For an OTC derivative contract with multiple exchanges of principal, the conversion factor is multiplied by the number of remaining payments in the derivative contract.
2For an OTC derivative contract that is structured such that on specified dates any outstanding exposure is settled and the terms are reset so that the market value of the contract is zero, the remaining maturity equals the time until the next reset date. For an interest rate derivative contract with a remaining maturity of greater than one year that meets these criteria, the minimum conversion factor is 0.005.
3 Transactions not explicitly covered by any other column in the Table are to be treated as “Other.”
3. Remaining Maturity Method. The credit exposure arising from a derivative transaction under the Remaining Maturity Method shall equal the greater of zero or the sum of the current mark-to-market value of the derivative transaction added to the product of the notional amount of the transaction, the remaining maturity in years of the transaction, and a fixed multiplicative factor determined by reference to Table 2.
Table 2—Remaining Maturity Factor for Calculating Credit Exposure
Interest rate
Foreign exchange rate and gold
Other1(includes commodities and precious metals except gold)
Multiplicative Factor
1.5%
6%
1Transactions not explicitly covered by any other column in the Table are to be treated as “Other.”
B. Credit Derivatives Transactions
A bank shall calculate credit exposure arising from a credit derivative transaction, for purposes of determining the bank’s lending limit, by one of the three methods found at V. A, items 1, 2 and 3 above, subject to the following:
1. A national bank or savings association that uses the Conversion Factor Matrix Method or Remaining Maturity Method, or that uses the Internal Model Method without entering an effective margining arrangement, shall calculate the counterparty credits exposure arising from credit derivatives entered by the bank or savings association by adding the net notional value of all protection purchased from the counterparty on each reference entity.
2. A national bank or savings association shall calculate the credit exposure to a reference entity arising from credit derivatives entered by the bank or savings association by adding the notional value of all protection sold on the reference entity. However, the bank or savings association may reduce its exposure to a reference entity by the amount of any eligible credit derivative purchased on that reference entity from an eligible protection provider.
3. Mandatory use of Internal Model Method. The appropriate Federal banking agency may require a national bank or savings association to use the Internal Model Method, the Conversion Factor Matrix Method, or the Remaining Maturity Method to calculate the credit exposure of derivative transactions if it finds that such method is necessary to promote the safety and soundness of the bank or savings association.
C. Securities Financing Transactions.
Except as provided by paragraph (C)(3) below, a national bank or savings association shall calculate the credit exposure arising from a securities financing transaction by one of the following methods. A national bank or savings association shall use the same method for calculating credit exposure arising from all of its securities financing transactions.
1. Internal Model Method. A national bank or savings association may calculate the credit exposure of a securities financing transaction by using an internal model approved by the appropriate Federal banking agency.
2. Non-Model Method. A national bank or savings association may calculate the credit exposure of a securities financing transaction as follows:
a. Repurchase agreement. The credit exposure arising from a repurchase agreement shall equal and remain fixed at the market value at execution of the transaction of the securities transferred to the other party less cash received.
b. Securities lending.
(1) Cash collateral transactions. The credit exposure arising from a securities lending transaction where the collateral is cash shall equal and remain fixed at the market value at execution of the transaction of securities transferred less cash received.
(2) Non-cash collateral transactions. The credit exposure arising from a securities lending transaction where the collateral is other securities shall equal and remain fixed as the product of the higher of the two haircuts associated with the two securities, as determined in Table 3 below, and the higher of the two par values of the securities.
c. Reverse repurchase agreements. The credit exposure arising from a reverse repurchase agreement shall equal and remain fixed as the product of the haircut associated with the collateral received, as determined in Table 3 below, and the amount of cash transferred.
d. Securities borrowing.
(1) Cash collateral transactions. The credit exposure arising from a securities borrowed transaction where the collateral is cash shall equal and remain fixed as the product of the haircut on the collateral received, as determined in Table 3 below, and the amount of cash transferred to the other party.
(2) Non-cash collateral transactions. The credit exposure arising from a securities borrowed transaction where the collateral is other securities shall equal and remain fixed as the product of the higher of the two haircuts associated with the two securities, as determined in Table 3 below, and the higher of the two par values of the securities.
3. Mandatory use of Internal Model Method. The appropriate Federal banking agency may require a national bank or savings association to use either the Internal Model Method or the Non-Model Method to calculate the credit exposure of securities financing transactions if the appropriate Federal banking agency finds that such method is necessary to promote the safety and soundness of the bank or savings association.
Table 3—Collateral Haircuts
Residual maturity
Haircut without currency mismatch1
SOVEREIGN ENTITIES
OECD Country Risk Classification20–1
<= 1 year
0.005
>1 year, <= 5 years
0.02
5 years
0.04
OECD Country Risk Classification 2–3
0.01
0.03
0.06
CORPORATE AND MUNICIPAL BONDS THAT ARE BANK-ELIGIBLE INVESTMENTS
Residual maturity for debt securities
Haircut without currency mismatch
All
> 5 years
0.12
OTHER ELIGIBLE COLLATERAL
Main index3equities (including convertible bonds)
0.15
Other publicly traded equities (including convertible bonds)
0.25
Mutual funds
Highest haircut applicable to any security in which the fund can invest
Cash collateral held
0
1In cases where the currency denomination of the collateral differs from the currency denomination of the credit transaction, an addition 8 percent haircut will apply.
2OECD Country Risk Classification means the country risk classification as defined in Article 25 of the OECD's February 2011 Arrangement on Officially Supported Export Credits Arrangement.
3Main index means the Standard & Poor's 500 Index, the FTSE All-World Index, and any other index for which the covered company can demonstrate to the satisfaction of the Federal Reserve that the equities represented in the index have comparable liquidity, depth of market, and size of bid-ask spreads as equities in the Standard & Poor's 500 Index and FTSE All-World Index.
VI. STATE BANK LENDING LIMITS
As noted above, state chartered banks are subject to separate restrictions under Section 611 of the Dodd-Frank Act, with the restrictions applicable to state chartered banks becoming effective on January 21, 2013. The Nebraska Department of Banking and Finance, on October 20, 2015, issued an Order Adopting Consideration Given to Credit Exposure Arising from Derivatives and Securities Financing Transactions which apply the restrictions to state chartered bank lending limits.