OCC 95-50 Subject: Risk-Based Capital; Derivative Transactions Description: Transmits Final Rule TO: Chief Executive Officers of National Banks, Department and Division Heads, Examining Personnel and Other Interested Parties PURPOSE On September 5, 1995, the Office of the Comptroller of the Currency, the Federal Reserve Board, and the Federal Deposit Insurance Corporation published an amendment to their respective risk-based capital guidelines to a) revise and expand the set of conversion factors used to calculate the potential future exposure of derivative contracts, and b) recognize the effect that qualifying bilateral netting arrangements will have on the potential future exposure for derivative contracts. BACKGROUND In the current risk-based capital (RBC) guidelines, capital requirements on the credit exposure for derivative contracts are the sum of two parts. The first is the current mark-to-market value (often referred to as the "replacement cost") of a contract. The second part is the "add-on" for the possibility that the contract will move further in-the-money over the remaining life of the contract. Capital is held for the combined credit exposure of these two parts. This amendment makes two changes to the second component -- i.e., the potential risk add-on calculation. a) Revise and Expand the Conversion Factors Long-dated interest rate and foreign exchange rate (FX) contracts (i.e., those with over 5-years remaining maturity) are now subject to new, higher conversion factors. Also, new conversion factors are established that specifically apply to derivative contracts related to equities, precious metals, and other commodity contracts. The conversion factors are shown in the table below, with the new factors shown in bold. Conversion Factors Interest Foreign Precious Other Maturity Rate Exchange Equity Metals Commodities Less than 1 year 0.0% 1.0% 6.0% 7.0% 10.0% 1- to 5-years 0.5 5.0 8.0 7.0 12.0 Over 5 years 1.5 7.5 10.0 8.0 15.0 b) Alter the Calculation of the Potential Risk Add-On The agencies recognize that netting arrangements can reduce not only a banking organization's current exposure for the transactions subject to the netting arrangement, but also its potential future exposure. The amendment provides a measure that can be used as a proxy for the risk-reducing effects of the netting arrangement on the potential future exposure. That is, the replacement costs -- both the "net" and "gross" replacement costs -- are used to form an indicator called the net-to-gross ratio [NGR]. This ratio may be used in the calculation of the potential future exposure for nettable transactions. This revised measure recognizes the effects that netting arrangements have on the potential future exposure for derivative contracts in most cases, when those contracts are subject to qualifying bilateral netting arrangements. The revised method calculates a weighted average of two amounts. The first amount is the add-on as it is currently calculated (labeled Agross). The second amount is Agross multiplied by the NGR. This calculation results in a reduced add-on (Anet) for derivative contracts subject to a qualifying bilateral netting contract. The weights contained in the amended regulation are .4 and .6, respectively, for 1) Agross and, 2) NGR times Agross. The formula is : Anet = .4 Agross + (.6 NGR Agross). For banks with an NGR of 50 percent, the effect is to permit a reduction in the amount of the add-on by 30 percent. Thus, for all values of the NGR less than 1, the amendment results in a partial reduction in the add-on as it is currently calculated. FOR FURTHER INFORMATION CONTACT Roger Tufts, Senior Economic Advisor, Office of the Chief National Bank Examiner (202) 874-5070. Questions may also be addressed to Ron Shimabukuro, Senior Attorney, Legislative and Regulatory Activities Division, (202) 874-5090. Jimmy F. Barton Chief National Bank Examiner Attachments September 11, 1995 Fed. Reg., 60, No. 171, pg. 46170, September 5, 1995