October 9, 2012
Authored by: Jerry Blanchard
On June 20, 2012, the OCC issued an interim final rule (the “Rule”) that amends its existing regulations on legal lending limit in response to Section 610 of the Dodd Frank Act. Section 610 amended the federal lending limits statute, (12 USC § 84) to include credit exposures arising from derivative transactions and repurchase agreements, reverse repurchase agreements, securities lending transactions, and securities borrowing transactions. The Rule also takes into account differences that existed between national banks and saving associations and preserves some of the statutory exceptions that savings associations previously enjoyed. The Rule provides three different methods for calculating credit exposure, one of which will be applicable to larger banks and two that will be more attractive to regional and community banks.
The Rule is relevant to state chartered banks as well since Section 611 of Dodd Frank provides that state banks may only engage in derivative transactions if the law of the sate takes into account credit exposure to derivatives. During the past legislative session many state legislatures passed laws addressing this issue. For example, Georgia amended its legal lending limit statute, GA Code Ann § 7-1-285 to include credit exposure under a derivative when calculating its legal lending limit to any one borrower. The Georgia statute also allows a bank to determine the actual credit exposure pursuant to a methodology acceptable to the Department of Banking and Finance and the bank’s primary federal regulator. One would expect the various state regulators to look very carefully at the three options presented by the OCC when determining the method they will approve for their respective state. The Rule lends itself very well to state regulatory application in that it is devised in a manner that will allow banks to adopt a compliance regimen that fits their size and risk management requirements, subject to an overall requirement that whichever method they choose is always subject to safety and soundness requirements.
Specifically, the Rule provides that banks can choose to measure the credit exposure of derivatives (except credit derivatives) in one of three ways:
- through an OCC-approved internal model,
- by use of a look-up table that fixes the attributable exposure at the execution of the transaction, or
- 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 Rule provides a special process 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 Rule also specifically exempts securities financing transactions relating to U.S. or state government obligations from the lending limits calculations.
Internal Model Method. The calculation of credit exposure on a non-credit derivative such as an interest rate swap is calculated as follows: Credit Exposure equals (Current Credit Exposure plus Potential Credit Exposure)
Under this method national banks and savings associations may model their exposures via an internal model approved by the OCC. The counterparty credit exposure of a derivative transaction will be measured by a model that estimates a credit exposure amount, inclusive of the current mark-to-market value. For example, 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. The calculation of the future potential exposure is based upon the advanced approaches to capital rules adopted by the federal banking regulators for compliance with Basel II capital guidelines.
Conversion Factor Matrix Method. The second method provides for a simpler approach. Under this method, the credit exposure is calculated as follows: Credit Exposure equals (Notional Amount) x (Conversion Factor)
The exposure will remain fixed at the potential future credit exposure of the derivative transaction as determined at the execution of the transaction. The Rule includes a table setting out the conversion matrix. This table reflects the absence of the current mark-to-market component of the credit exposure transactions. It is expected that this approach will be less burdensome than the Internal Model Method because institutions will not have to establish statistical simulations of future potential credit exposure calculations.
Example. Bank A enters a 5-year interest rate swap with a notional value of $100,000 and mark-to-market (“MTM”) of zero at execution. At execution, Bank A’s exposure is $7,500 ($0+ ($100,000 × 5 ×1.5%)). In year 2, Bank A makes loan to counterparty of interest rate swap. At this time, MTM of swap is $1,000. Bank A’s lending limit exposure is $5,500 ($1,000 +($100,000 × 3 ×1.5%)). If the MTM of the swap in year 2 is negative $1,000, Bank A’s lending limit exposure for the swap is $3,500 ($1,000 +($100,000 × 3 ×1.5%)). If the MTM of the swap in year 2 is negative $10,000. Bank A’s lending limit exposure for the swap is zero ($10,000 + ($100,000 × 3 × 1.5%)= negative $5,500 which is less than zero; zero is the floor for the calculated exposure).
Remaining Maturity Method. Under the third method, the Remaining Maturity Method, the credit exposure is calculated as follows: Credit Exposure equals the greater of (i) zero or (ii) the sum of the current mark-to-market value of the derivative transaction plus the [notional amount of the transaction] x [the remaining maturity in years of the transaction] x [the Remaining Maturity Factor]
The Remaining Maturity Factor is set out in the Rule.
The benefit to the third method is that depending on the mark-to-market, as the maturity decreases; the credit exposure also decreases, thereby permitting additional extensions of credit under the lending limit.
Example. Bank A enters a 5¬year interest rate swap with notional value of $100,000 and MTM of zero at execution. At execution, Bank A’s exposure is $7,500 ($0 + ($100,000 x 5 x 1.5%)). In year 2, Bank A makes loan to counterparty of interest rate swap. At this time, MTM of swap is $1,000. Bank A’s lending limit exposure is $5,500 ($1,000 + ($100,000 x 3 x 1.5%)). If the MTM of the swap in year 2 is negative $1,000, Bank A’s lending limit exposure for the swap is $3,500 (¬$1,000 + ($100,000 x 3 x 1.5%)). If the MTM of the swap in year 2 is negative $10,000. Bank A’s lending limit exposure for the swap is zero (-$10,000 + ($100,000 x 3 x 1.5%) = negative $5,500 which is less than zero; zero is the floor for the calculated exposure).
Savings Association Specific Rules. Certain statutory provisions apply only to savings associations and the interim rule addresses those provisions. First, 12 U.S.C. § 1464(u)(2)(A)(i) permits a savings association to make loans to one borrower in an amount not to exceed $500,000, even if its limit as calculated under section 84 would be lower. Second, 12 U.S.C. § 1464(u)(2)(A)(ii) allows a savings association to make loans to one borrower to develop domestic housing units, not to exceed the lesser of $30,000,000 or 30% of the association’s unimpaired capital and unimpaired surplus if certain tests are met, even if its limit as calculated under section 84 would be lower. This latter exception as included in the Rule differs from the provision in existing OTS regulations in that it incorporates a change made by section 404 of the Financial Services Regulatory Relief Act of 2006, which removed from 12 U.S.C. § 1464(u)(2)(A)(ii) the requirement that the final purchase price of each single family dwelling unit not exceed $500,000. Finally, in addition to the amount allowed under the savings association’s combined general limit, a savings association may invest up to 10 percent of unimpaired capital and unimpaired surplus in the obligations of one issuer evidenced by commercial paper or corporate debt securities that are, as of the date of purchase, investment grade.
Nonconforming Loans. National banks have traditionally enjoyed protection from criticism if an existing loan is rendered nonconforming due to a reduction in the bank’s capital position. The Rule continues this protection and now includes credit exposure that increases after execution of the transaction where the institution is using the Internal Model Method to measure credit exposure. In such an event the bank or savings association must use reasonable efforts to bring the loan into a conforming status unless to do so would be inconsistent with safe and sound banking practices.