OCC Issues Interim Final Rules Applying the Lending Limit for National Banks and Savings Associations to the Credit Exposure to Derivatives and Securities Financing Transactions SUMMARY On June 20, the Office of the Comptroller of the Currency ( OCC ) issued interim final rules (including both the interim final rule and the preamble, the Lending Limit Release ) to implement Section 610 of the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Dodd-Frank ). Section 610 expands the statutory definition of loans and extensions of credit in the lending limit provisions of the National Bank Act 1 and Home Owners Loan Act 2 to include the credit exposure from repurchase and reverse repurchase transactions and securities lending and borrowing transactions (collectively, securities financing transactions ) and derivative transactions. 3 The Lending Limit Release sets out the procedures and methodologies for calculating the credit exposure for these newly covered transactions. The Lending Limit Release also establishes a single set of lending limit rules applicable to both national banks and federal and state-chartered savings associations. The lending limit rules are effective July 21, 2012, with an exemption until January 1, 2013 for credit exposures from derivatives and securities financing transactions. The Lending Limit Release is the second agency rulemaking to define credit exposure arising from derivative and securities financing transactions. Previously the Board of Governors of the Federal Reserve System ( Federal Reserve ) proposed rules to implement the single-counterparty credit limit in Section 165(e) of Dodd-Frank ( Proposed SCCL Rules ). 4 The Proposed SCCL Rules apply to bank holding companies with $50 billion or more in total consolidated assets and nonbank financial companies that have been designated as systemic by the Financial Stability Oversight Council. The OCC s approach to measuring credit exposure in the Lending Limit Release is less burdensome and provides significantly more flexibility than that in the Proposed SCCL Rules, including by permitting banks to measure credit exposures using supervisor-approved internal models and treating credit exposures that come to exceed New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
the lending limit after inception of the transaction as nonconforming transactions that a bank must bring back into compliance with the lending limit rather than as automatic violations of the limit. In addition, for each type of transaction, the Lending Limit Release includes an alternative streamlined approach to measuring credit exposure that allows a bank to lock in the amount of the credit exposure at inception of the exposure. IMPLEMENTATION OF SECTION 610 The lending limits applicable to national banks and federal and state chartered savings associations (collectively, banks ) generally limit the total loans and extensions of credit from a bank to a person to 15% of the unimpaired capital and unimpaired surplus ( capital ) of the bank, with an increase of 10% of capital available if the exposure over 15% of capital is fully secured by readily marketable collateral. As a result of Dodd-Frank, as of July 21, 2012, a bank must include credit exposures from derivative and securities financing transactions within the applicable limit. In the Lending Limit Release, the OCC states that it reviewed comments received by other agencies in response to rulemakings to implement provisions of Dodd-Frank that raise similar issues, including comments on the Proposed SCCL Rules. Indeed, the OCC s approach to defining credit exposure for this purpose responds to many of the concerns expressed by commenters on the Proposed SCCL Rules. 5 In particular, the OCC has adopted an approach that provides banks with important flexibility in calculating compliance with the lending limit rules rather than imposing a one-size-fits-all approach. By permitting banks to use supervisor-approved internal models, the Lending Limit Release allows banks that have already developed such models to continue to use these more risk-sensitive methods of measuring credit exposure and rely on the systems they currently use for credit risk management purposes to monitor compliance with the lending limit rules as well. Key elements of the Lending Limit Release are a significant departure from the Proposed SCCL Rules. The accompanying chart provides greater detail regarding the calculation methodologies discussed below, as well as a comparison to comparable provisions in the Proposed SCCL Rules. Internal models. In one of the most significant differences between the Lending Limit Release and the Proposed SCCL Rules, a bank may use internal models developed to comply with the banking agencies Basel II capital guidelines for advanced approaches banks or another internal model that has been approved by the bank s primary federal supervisor for establishing the amount of credit exposures under the lending limits. Although the Lending Limit Release provides that the use of an internal model is optional, the appropriate federal banking agency may require that a bank use the internal model method rather than one of the other alternatives discussed below if necessary for safety and soundness purposes. In order to measure credit exposure from credit derivatives under the internal model, the bank must have a margining agreement in place that requires daily posting of variation margin to fully collateralize the bank s net counterparty exposure in excess of $1 million under the agreement. Derivatives transactions. The alternatives to the models approach for calculating credit exposures arising from derivatives transactions include (i) a calculation methodology based only on the estimated potential future exposure ( PFE ) of a transaction, which allows a bank to lock in the -2-
amount of the exposure at inception (the conversion factor matrix approach ) and (ii) a calculation methodology that is performed on an ongoing basis and includes the current mark-to-market value of the transaction plus an additional amount (to account for PFE) that decreases as the time to maturity elapses (the remaining maturity approach ). The conversion factor matrix approach has the benefit of simplicity and certainty because the exposure amount for purposes of the lending limit never changes despite fluctuations in market value, while the remaining maturity approach would allow a bank more room under the lending limit to the extent the mark-to-market value of the transaction decreases over time (but less room if the mark-to-market value increases). Neither approach, however, takes into account netting or collateral and, therefore, may be less workable for a bank with a substantial derivatives portfolio. The appropriate federal banking agency may require that a bank use the internal model method or remaining maturity method if necessary for safety and soundness purposes. 6 Credit derivatives. Similar to the Proposed SCCL Rules, when a bank sells protection on a reference asset in the form of a credit derivative, it must treat the notional protection sold as an exposure to the reference asset. If that same bank purchases a credit derivative that meets certain eligibility criteria on the same reference asset, it may reduce the amount of its exposure to the reference asset. Unlike the Proposed SCCL Rules, a bank may use an eligible credit derivative only to reduce its exposure to a reference asset on which it has sold credit protection rather than to reduce exposures on other transactions (such as a loan or debt security), and the OCC requests comment on whether this is appropriate. If a bank purchases credit derivatives from a counterparty, it must include the net notional value of the protection purchased from that counterparty on all reference entities. Securities financing transactions. The alternative to the models approach for calculating credit exposure arising from securities financing transactions involves measuring exposure only at the inception of the transaction. In general, the methodologies for calculating credit exposure for securities financing transactions are meant to capture either the net current credit exposure of the transaction or, where the bank will be exposed to the fluctuations in the value of a security as part of the transaction, to capture that risk through the application of a market volatility haircut, using the standard supervisory market price volatility haircuts in the general risk-based capital rules. The Lending Limit Release also carries forward the existing exclusion in the lending limit rules from the definition of loan and extension of credit for reverse repurchase transactions where the bank purchases Type I securities (generally, certain government securities) as an exemption and applies the exemption to all securities financing transactions involving Type I securities. Nonconforming transactions. Under the OCC s current lending limit rules, a loan or extension of credit to a borrower that complied with the lending limit at inception and subsequently exceeds the lending limit for certain enumerated reasons, such as that the bank s capital has declined, is considered nonconforming and must be brought into compliance in accordance with the requirements of the rule. Under the Lending Limit Release, if a credit exposure arising from a derivative or securities financing transaction that is measured under the internal model method exceeds the lending limit after inception of the transaction, it also will be treated as nonconforming. A bank must use reasonable efforts to bring such nonconforming transactions into compliance with the lending limit, subject to safety and soundness considerations, but no timeframe is specified. Although the credit exposure of a derivative transaction measured under the remaining maturity approach also may fluctuate over time and, therefore, may exceed the lending limit after inception, such a lending limit excess is not included in the list of nonconforming transactions. While it may not be intentional, it appears, therefore, that credit exposures to derivative transactions measured under the remaining maturity approach could automatically trigger a violation of the lending limit rules if they exceed the lending limits after inception (unless the excess is attributable to a factor that would fit under another prong of the definition of nonconforming transaction, such as a decline in the bank s capital). Under the Proposed SCCL Rules, exceeding the applicable limit in such cases could be an immediate violation, which means that a company subject to the limit may need to maintain a significant buffer at all times to avoid a violation. Intraday exposures. Similar to the Proposed SCCL Rules, intraday exposures arising from derivative or securities financing transactions would be exempt from the lending limit. -3-
Contingent exposure to a derivative clearing house. In the Lending Limit Release, the OCC requests comment on whether a bank s contingent obligation under derivative clearinghouse rules to advance funds to a guaranty fund should be subject to the lending limits and, if so, how it should be measured. Such exposures would be covered under the Proposed SCCL Rules. The Lending Limit Release offers banks a more flexible approach to measuring credit exposure from derivatives and securities financing transactions than the approach in the Proposed SCCL Rules to measuring the same credit exposures. Although the Lending Limit Release seeks to ease the compliance burden on banks subject to the rules, the different approaches to measuring the same credit exposures taken by the OCC and the Federal Reserve may result in a greater overall compliance burden and other complications for banks that are subject to both regimes. Furthermore, in the absence of a fundamental change in approach by the Federal Reserve in its final SCCL rules, banks that are subject to the Lending Limit Release and the single-counterparty credit limit could effectively have a reduced lending limit at the bank because the same exposures would have to be measured under a less risk-sensitive approach under the Proposed SCCL Rules. * * * Copyright Sullivan & Cromwell LLP 2012-4-
ENDNOTES 1 2 3 4 5 6 12 U.S.C. 84. 12 U.S.C. 1464(u). Section 611 of Dodd-Frank provides that an insured state bank may only engage in derivative transactions if the applicable state lending limit takes into consideration credit exposure to derivative transactions but does not address securities financing transactions. Section 611 of Dodd-Frank is effective January 21, 2013 (18 months after the transfer date). 77 Fed. Reg. 594 (Jan. 5, 2012). See our Memorandum to Clients, Systemically Important Financial Companies: Federal Reserve Issues Proposed Rules Implementing Enhanced Prudential Supervision Regime, dated December 22, 2011. See, e.g., letter from The Clearing House, American Bankers Association, The Financial Services Roundtable, Financial Services Forum, and Securities Industry and Financial Markets Association to the Federal Reserve dated April 27, 2012. The appropriate federal banking agency for national banks and federal savings associations is the OCC. The Federal Deposit Insurance Corporation is the appropriate federal banking agency for state savings associations, which are also subject to the Lending Limit Release. -5-
PROPOSED SINGLE COUNTERPARTY CREDIT LIMIT AND LENDING LIMIT RELEASE COMPARISON CHART Transaction Proposed SCCL Rules Lending Limit Release 1 OTC Derivatives (except credit derivatives) Providing credit protection by writing a credit derivative on a reference asset Current exposure methodology used to measure exposure, which is current exposure (greater of mark-to-market or zero) plus potential future exposure (notional x conversion factor) and: Recognition of some netting if transaction is subject to qualifying master netting agreement Permits adjustment for financial collateral This approach is the same as the methodology for calculating the credit equivalent amount for OTC derivative transactions under the general riskbased capital requirements Lesser of the face amount of the transaction or the maximum potential loss on the transaction is treated as an exposure to the reference asset Same treatment applies to equity derivatives Conversion factor matrix method Potential future exposure (notional x conversion factor) Conversion factors are similar to the factors used in the general risk-based capital rules (and under the Proposed SCCL Rules) but increased to reflect the fact that the current market value is not included in the credit exposure amount Measured only at inception of transaction Remaining maturity method Current mark-to-market value (or zero, if greater) + (notional x remaining maturity x conversion factor) Conversion factors differ from the general risk-based capital rules Measured on an ongoing basis Internal models method Bank may use internal model approved for use under the advanced approaches rule or any other model approved by the appropriate federal banking agency for this purpose ( supervisor-approved internal model ) May net exposures of derivative transactions that are subject to the same qualifying master netting agreement Non-model method Full amount of protection treated as an exposure to the reference asset May be reduced by eligible credit derivatives (see below) Internal model method If a bank that uses a supervisor-approved internal model has an effective margining agreement in place, it can measure 1 Where more than one method is mentioned, the choice among them is generally at the bank s option. -6-
Transaction Proposed SCCL Rules Lending Limit Release 1 Purchasing credit derivatives Eligible credit derivative provided by eligible protection provider (to reduce credit exposure) Reverse repurchase agreement (For purposes of the lending limit, transactions involving Type I securities are exempt.) Securities borrowing (For purposes of the lending limit, transactions involving Type I securities are exempt.) Full amount of protection purchased treated as an exposure to the counterparty Same treatment applies to equity derivatives Must be used to reduce exposure to the reference asset and requires shift of face amount of protection to eligible protection provider Same treatment applies to equity derivatives Amount of cash transferred to the counterparty May apply netting if subject to bilateral netting agreement May reduce exposure by the adjusted market value of collateral, subject to a collateral haircut, and shift exposure to collateral issuer Collateral haircut is based on the standard supervisory market volatility haircuts in the general risk-based capital rules Amount of cash collateral plus the market value of securities collateral transferred to the counterparty May apply netting if subject to bilateral netting agreement; and May reduce exposure by the adjusted market value of collateral, which includes the collateral haircut, but must shift exposure to collateral issuer exposure under credit derivatives using its model Non-model method Net notional value of the protection purchased from that counterparty on each reference entity Internal model method If a bank that uses a supervisor-approved internal model has an effective margining agreement in place, it can measure exposure under credit derivatives using its model May be used only to reduce exposure to a reference asset on which the bank has written protection (unless incorporated into a supervisor- approved internal model with an effective margining agreement) Non-model approach Amount of cash transferred x collateral haircut applicable to the collateral Collateral haircut is the same as the Proposed SCCL Rules and the general risk-based capital rules Measured only at inception of transaction Internal models method Bank may use a supervisor-approved internal model Non-model approach (cash collateral only) Same approach as for reverse repos above Non-model approach (securities collateral) The par value of the securities transferred with the higher par value (i.e., either the par value of the securities borrowed or the securities collateral posted) x the higher of the two haircuts that are applicable to the securities transferred Measured only at inception -7-
Transaction Proposed SCCL Rules Lending Limit Release 1 Repurchase agreement (For purposes of the lending limit, transactions involving Type I securities are exempt.) Securities lending (For purposes of the lending limit, transactions involving Type I securities are exempt.) Market value of securities transferred + (market value of securities transferred x collateral haircut) Netted if subject to a bilateral netting agreement May reduce exposure by the adjusted market value of collateral, which includes the collateral haircut, but requires shift of exposure to collateral issuer Same as repurchase transactions Internal models method Bank may use a supervisor-approved internal model Non-model approach Market value of securities transferred less cash received Measured only at inception Internal models method Bank may use a supervisor-approved internal model Non-model approach (cash collateral only) Same approach as for repurchase transactions, above Non-model approach (securities collateral) Same as securities borrowing non-model approach (securities collateral) above Intraday Exempt Intraday exposures related to derivative transactions and securities financing transactions are exempt Default fund contribution to CCP Subject to limit Not currently subject to limit. Lending Limit Release requests comment -8-
ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance, corporate and real estate transactions, significant litigation and corporate investigations, and complex restructuring, regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 800 lawyers on four continents, with four offices in the United States, including its headquarters in New York, three offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future related publications from Jay Plum (+1-212-558-4049; plumj@sullcrom.com) in our New York office. CONTACTS New York H. Rodgin Cohen +1-212-558-3534 cohenhr@sullcrom.com Elizabeth T. Davy +1-212-558-7257 davye@sullcrom.com Mitchell S. Eitel +1-212-558-4960 eitelm@sullcrom.com Michael T. Escue +1-212-558-3721 escuem@sullcrom.com C. Andrew Gerlach +1-212-558-4789 gerlacha@sullcrom.com Andrew R. Gladin +1-212-558-4080 gladina@sullcrom.com Erik D. Lindauer +1-212-558-3548 lindauere@sullcrom.com Mark J. Menting +1-212-558-4859 mentingm@sullcrom.com Camille L. Orme +1-212-558-3373 ormec@sullcrom.com Donald J. Toumey +1-212-558-4077 toumeyd@sullcrom.com Marc Trevino +1-212-558-4239 trevinom@sullcrom.com Mark J. Welshimer +1-212-558-3669 welshimerm@sullcrom.com Michael M. Wiseman +1-212-558-3846 wisemanm@sullcrom.com Wendy M. Goldberg +1-212-558-7915 goldbergw@sullcrom.com Jiang Liu +1-212-558-3093 liujia@sullcrom.com Washington, D.C. Eric J. Kadel Jr. +1-202-956-7640 kadelej@sullcrom.com Samuel R. Woodall III +1-202-956-7584 woodalls@sullcrom.com Andrew S. Baer +1-202-956-7680 baera@sullcrom.com Andrea R. Tokheim +1-202-956-7015 tokheima@sullcrom.com William F. Kroener III +1-202-956-7095 kroenerw@sullcrom.com J. Virgil Mattingly +1-202-956-7028 mattinglyv@sullcrom.com -9-
Los Angeles Patrick S. Brown +1-310-712-6603 brownp@sullcrom.com Stanley F. Farrar +1-310-712-6610 farrars@sullcrom.com Tokyo Keiji Hatano +81-3-3213-6171 hatanok@sullcrom.com DC_LAN:273294.6-10-