I. INTRODUCTION
The Nebraska Department of Banking and Finance (Department) issued an Order (Order) to implement requirements under Section 611 of the Dodd-Frank Act that would otherwise prohibit state chartered banks from engaging in certain derivative transactions and securities-financing transactions on or after January 21, 2013. The Order provides a framework to address credit exposure arising from derivative transactions and securities-financing transactions.
The Order would permit state chartered banks to engage in derivative transactions if the bank is “well-capitalized” as defined in FDIC prompt corrective action rules or has obtained written approval from the Director of the Department prior to commencing derivative transactions. A bank participating in derivative transactions must notify the Department upon becoming less than well-capitalized. Pursuant to the Order, derivative transactions could serve to reduce an institution’s lending limit by adding a “calculated credit exposure amount” to amounts actually advanced to a borrower in determining lending limit restrictions.
The Order includes two methods for calculating derivative credit exposures: the Conversion Factor Matrix Method and the Remaining Maturity Method. The Order closely reflects the interim final rule issued by the Office of the Comptroller of the Currency, except the Department Order does not allow banks to develop their own internal models (Internal Model Method) for measuring credit exposure.
II. KEY DEFINITIONS
Section 611 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 611 of the Dodd-Frank Act, the Department Order contains the following definitions:
Borrower means a person who is named as a borrower or debtor in a loan or extension of credit; a person to whom a bank has credit exposure arising from a derivative transaction or a securities financing transaction, entered into by the bank; or any other person, including a drawer, endorser, or guarantor, who is a direct or indirect borrower.
Credit derivativemeans a financial contract that allows one party (the protection purchaser) to transfer the credit risk of one or more credit exposures (reference exposure) to another party (the protection provider).
Derivative transaction means any 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.
Eligible credit derivative means a single-name credit derivative or a standard, non-tranched index credit derivative, provided that:
(1) The derivative contract is 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 addresses 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 of settlement of the derivative contract are included in the contract;
(5) If the derivative contract allows for cash settlement, the contract incorporates a valuation process to estimate loss with respect to the derivative and specifies a period for obtaining post-credit 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:
(1) Is written and unconditional;
(2) Covers all or a pro rata portion of all contractual payments of the obligor on the
(3) Gives the beneficiary a direct claim against the protection provider;
(4) Is not unilaterally cancelable by the protection provider for reasons other than
(5) Is legally enforceable against the protection provider in a jurisdiction where the
(6) Requires the protection provider to make payment to the beneficiary on the
(7) Does not increase the beneficiary's cost of credit protection on the guarantee in
(8) Is not provided by an affiliate of the bank, unless the affiliate is an insured depository institution, securities broker- dealer, or insurance company that:
(i) Does not control the bank; 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 the Federal Deposit Insurance Act;
(6) A bank holding company, as defined in the Nebraska Bank Holding Company Act of 1995;
(7) A savings and loan holding company, as defined in the Home Owners’ Loan Act;
(8) A securities broker or dealer registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934, or registered by the Department;
(9) An insurance company that is subject to the supervision of a state insurance regulator as defined in 12 CFR Section 211.2;
(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, as defined in the Federal Deposit Insurance Act;
Loans and Extensions of Creditmeans a bank’s direct or indirect advance of funds to or on behalf of a borrower based on an obligation of the borrower to repay the funds or being repayable from specific property pledged by or on behalf of the borrower, and any credit exposure arising from a derivative transaction or a securities-financing transaction, and includes a bank’s purchase of securities subject to an agreement that the seller will repurchase the securities at the end of a stated period. This does not include a bank’s purchase of Type I securities which are subject to a repurchase agreement, where the purchasing bank has assured control over the Type I securities as collateral.
Securities financing transaction means a repurchase agreement, reverse repurchase agreement, securities lending transaction, or securities borrowing transaction.
Single-name derivativesmeans a credit derivative that has a single obligor.
Type 1 securitiesare defined in 12 CFR Section 1.12(j).
III. NONCONFORMING LOANS AND EXTENSIONS OF CREDIT
A loan or extension of credit that is a credit exposure arising from a derivative transaction which was entered into prior to the effective date of the Order or which was within a bank’s legal lending limit when made but increased subsequent to execution, and is no longer in conformity with the bank’s lending limit under the Order, will not be deemed a violation but will be treated as nonconforming.
IV. LOANS NOT SUBJECT TO LENDING LIMITS
The following loans or extensions of credit are not subject to the lending limits of Section 8-141(5):
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 bank for purposes of determining the bank’s lending limit are set forth below:
A. Calculation of Credit Exposure: Non-Credit Derivative Transactions
A bank 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 two following methods. Subject to Section D, below, a bank shall use the same method for calculating counterparty credit exposure arising from all of its derivative transactions.
1. Conversion Factor Matrix Method. Credit exposure calculated with 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 using Table 1, below.
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.”
2. Remaining Maturity Method. Credit exposure calculated with the Remaining Maturity Method shall equal the greater of zero or the sum of the current mark-to-market value of the derivative transaction plus the product of the notional amount of the transaction, the remaining maturity in years of the transaction, and a fixed multiplicative factor determined by Table 2, below.
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
1Transactions not explicitly covered by any other column in the Table are to be treated as “Other.”
B. Calculation of Credit Exposure: Credit Derivative Transactions
A bank shall calculate credit exposure arising from a credit derivative transaction, for purposes of determining compliance with the bank’s lending limit, as follows:
1. A bank shall calculate the credit exposure arising from credit derivatives entered by the bank by adding the net notional value of all protection purchased on the reference entity.
2. Credit exposure to a reference entity shall equal the notional value of all protection sold on the reference entity.
3. A bank may reduce its credit exposure to a reference entity by the amount of any eligible credit derivative purchased on that entity from an eligible protection provider.
C. Calculation of Credit Exposure: Securities-Financing Transactions.
Calculation of credit exposure arising from a securities financing transaction for purposes of determining compliance with the bank’s lending limit shall be made, as follows:
1. Repurchase Agreement. 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.
2. Reverse Repurchase Agreements. The credit exposure arising from a reverse repurchase agreement shall equal, and remain fixed at, the product of the haircut associated with the collateral received, as determined in Table 3 below, and the amount of cash transferred
3. Securities Lending: Cash Collateral Transactions. 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.
4. Securities Lending: Non-Cash Collateral Transactions. Credit exposure arising from a securities lending transaction where the collateral is other securities shall equal, and remain fixed at, 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.
5. Securities borrowing: Cash Collateral Transactions. Credit exposure arising from a securities borrowed transaction where the collateral is cash shall equal, and remain fixed at, 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.
6. Securities borrowing: Non-Cash Collateral Transactions. Credit exposure arising from a securities borrowed transaction where the collateral is other securities shall equal, and remain fixed at, 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.
D. Mandatory Methods.
Notwithstanding Sections A, B, and C, the DEPARTMENT or the bank’s primary federal regulator may require a bank to use a specific method to calculate credit exposure resulting from derivative transactions and securities-financing transactions.
Table 3—Collateral Haircuts
Residual maturity
Haircut without currency mismatch1
SOVEREIGN ENTITIES
OECD Country Risk Classification20–1
<= 1 year
.005
>1 year, <= 5 years
.020
5 years
.040
OECD Country Risk Classification 2–3
.010
.030
>5 years
.060
CORPORATE AND MUNICIPAL BONDS THAT ARE BANK-ELIGIBLE INVESTMENTS
Residual maturity for debt securities
Haircut without currency mismatch
All
.02
> 5 years
OTHER ELIGIBLE COLLATERAL
Main index3 equities (including convertible bonds)
.15
Other publicly traded equities (including convertible bonds)
.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. DOES THE DEPARTMENT’S ORDER REGARDING DERIVATIVE TRANSACTIONS INFLUENCE A BANK’S OPERATIONS?
The Department has provided the chart set forth below to assist in determining if the Department’s Order regarding derivative transactions influence a bank’s operations.
VII. FREQUENTLY ASKED QUESTIONS
The Department has provided frequently asked Questions and Answers regarding its Order, as follows:
1. What is the purpose of the Department Order dated January 21, 2013?
Answer: The Department Order allows banks to enter into derivative transactions. Congress, through the Dodd Frank 2010 Act, mandated that statutory changes be made or banks would be prohibited from entering into derivative transactions after January 21, 2013. The Order determines the manner and extent to which credit exposure from derivative transactions is taken into account with regard to lending limits.
2. What is a derivative?
Answer: A derivative is a risk shifting devise that utilizes a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments are to be made between the parties. Derivatives can be useful tools for banks to effectively manage risk and on a very broad measure are described as either credit or non-credit derivatives.
3. What is a credit derivative?
Answer: Credit derivatives are contracts with which banks buy or sell credit protection against loss on a third-party entity. Common types of credit derivatives include credit default swaps and total return swaps.
4. What is a non-credit derivative?
Answer: Non-credit derivatives are contracts regarding performance at a point in time unrelated to specific credit risk, such as but not limited to interest rates or future delivery. Non-credit derivative transactions include, but are not limited to, forwards, futures, options, caps, or floors.
5. Is the Department's Order on derivatives applicable to every bank?
Answer: The Department's Order is applicable to any bank that enters into derivative or security financing transactions. Please refer to the flow chart found at the end of this document for more detail.
6. Can all banks participate in derivative activities?
Answer: A bank may participate in derivative activities if it is well-capitalized as defined in prompt corrective action rules. A bank not well-capitalized may participate in derivative activities with the prior written approval of the Director.
7. Is a transaction which enables the flow of individual bank-originated one-to-four family real estate loans for sale into the secondary market a derivative?
Answer: If the transaction includes a delivery guarantee, the transaction is a derivative. However, the credit exposure arising from such derivative transaction is not subject to lending limits.
8. How do derivatives impact the calculation of the credit exposure of an entity in regard to compliance with a bank's lending limit?
Answer: The credit exposure resulting from derivative transactions is added to all other credit exposures arising from a customer's or counterparty's promise to perform, such as other loans, bank-issued credit cards, and overdrafts, in determining compliance with the bank's legal lending limit.
9. Are derivatives useful to a bank?
Answer: Derivatives can be effective at managing risk. Banks can gain certainty by locking in an interest rate or use swaps as useful tools to manage risk. However, derivatives can be risky if sound risk management policies, procedures, and goals are not in place. If used in a speculative manner, derivatives increase risk.
10. What are the typical types of derivatives used by banks?
Answer: Interest rate swaps are the most common derivative transactions engaged in by banks. Interest rate swaps provide banks flexibility in managing their interest rate risk, but drastic interest rate movements can still result in an institution suffering substantial losses. Historically, interest rate swaps represent approximately 80% of all derivatives contracts.
11. Can a bank switch between methods used to calculate credit risk?
Answer: With the prior written approval of the Director, a bank may change its method of calculating counterparty credit exposure.
12. When is the credit exposure assigned to a loan customer versus a counterparty for lending limit purposes?
Answer: The entity to which the credit exposure gets assigned for lending limit purposes will depend on the parties involved in the derivative contract. Balance sheet hedges to either convert assets/liabilities from fixed to variable, or variable to fixed, are typically achieved through a swap with a separate counterparty. If these transactions do not directly involve the borrower as a party to the transaction, the calculated exposure for the derivative is allocated to the counterparty for lending limit purposes. However, a bank may enter into a loan with a borrower and then enter into a swap with the borrower to convert to the borrower's payment (from fixed to variable or variable to fixed), and an opposite swap with a counterparty to convert the bank's payment. In this case, there would be credit exposure on the swap with the borrower, which would be added to the borrower's total loans for lending limit purposes, and there would be credit exposure on the swap with the counterparty that would be assigned to the counterparty.
13. In regard to a bank's lending limit, should a bank be monitoring its credit exposure from derivatives transactions any differently than it monitors its credit exposure to an individual loan customer?
Answer: The degree to which management monitors the credit exposure from derivative transactions in regard to the bank's lending limit will depend on the amount of the exposure in relation to the lending limit. For example, loans at or near the lending limit require close monitoring by management so additional loan advances or extension of credit through overdrafts do not put the credit over the lending limit. For loans substantially under a bank's lending limit, little or no monitoring for lending limit purpose is probably needed. The same is true for credit exposure from derivative transactions. For banks with large and/or numerous derivative transactions with one entity, the close monitoring of the total exposure and changes in that exposure in relation to the lending limit will be warranted. The manner as to how this exposure is monitored would be up to each bank.
14. Does the word "credit" have different meanings within the Department's Order?
Answer: The Order addresses eligible credit derivatives, which include non-credit and credit derivatives, and the calculation of credit exposure for both. While there is a significant difference in the calculation of the credit exposure of these two categories, a bank has credit exposure to the parties it contracts with in either type of derivative.
15. How is the credit exposure calculated for an interest rate swap or cap?
Answer: As an example, a bank enters into a $1,000,000, 5-year, interest rate swap with either a loan customer or a separate counterparty. Under the Conversion Factor Matrix Method, the potential future credit factor for the swap is 6% according to Table 1 in Appendix C of the Order. The bank would have exposure of $60,000 ($1,000,000 x 6%) from day one throughout the life of this swap. The same calculation would be done for an interest rate cap with the same terms since both are interest rate transactions.
For an example under the Remaining Maturity Method, a bank enters into the same 5-year, interest rate swap, with either a loan customer or a counterparty, having a notional value of $1,000,000 and a current mark-to-market (MTM) value of zero at execution. On the date of execution, the bank's exposure is $75,000 ($0 + ($1,000,000 x 5 x 1.5%)). The calculation of the credit exposure under this method equals the sum of the current MTM of the derivative transaction added to the product of the notional amount of transaction, the remaining years of the transaction, and the multiplicative factor determined by reference to Table 2 in Appendix C of the Order. The credit exposure cannot be less than zero even though the calculation might be negative due to a negative current MTM. Assume the bank has other loan or derivative activity in year 3, at which time the MTM of the swap is $10,000. The bank's lending limit exposure of the swap would be $40,000 ($10,000 + ($1,000,000 x 2 x 1.5%)). If the MTM of the swap was a negative $10,000 in year 3, the bank's lending limit exposure for the swap is $20,000 (-$10,000 + ($1,000,000 x 2 x 1.5%)). If the MTM of the swap in year 3 had been a negative $40,000, the bank lending limit exposure for the swap is zero since the calculated exposure equaled a negative $10,000 (-$40,000 + ($1,000,000 x 2 x 1.5%)). Zero is the floor for the calculated exposure.
The calculated lending limit exposure of the swap would be added to a loan customer's total borrowings for lending limit purposes if the swap agreement was entered into by the bank and the customer. However, if the contract was entered into by the bank and a separate counterparty, the calculated exposure would be assigned to the counterparty, along with the calculated exposure on any other swaps or derivatives entered into with that particular counterparty.
16. Is the exposure to government-sponsored entities unlimited?
Answer: Nebraska law makes exclusions for lending limit consideration when the borrower or counter party is backed by the full faith and credit of the U.S. Government.