On June 21, 2012, the OCC published in the Federal Register1 an interim final rule on lending limits for certain credit exposures to derivatives and securities financing transactions. These changes are required by section 610 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).2 The rule amends 12 C.F.R. part 32, and also consolidates the lending limit rules for national banks, and federal and state-chartered savings associations.3 State banks are subject to separate lending limits under section 611 of the Dodd-Frank Act.4
Comments on the rule are due by August 6, 2012, but as an interim final rule, it is effective July 21, 2012. However, in order to allow time for institutions to comply with the new requirements, the OCC has given national banks and savings associations until January 1, 2013 to comply with the requirements for calculating exposures to derivatives and securities financing transactions.
Rather than implementing a one-size-fits-all approach, the rule provides alternative methods for banks to calculate their credit exposures in an attempt to reduce regulatory burden for smaller institutions while giving larger institutions the ability to take a more nuanced approach to their calculations. Those alternative methods are briefly summarized below.
Dodd-Frank Act Section 610 implementation
Section 610 of the Dodd-Frank Act revises the definition of “loans and extensions of credit” for purposes of the lending limit to include certain credit exposures arising from any of a derivative transaction, repurchase agreement, reverse repurchase agreement, securities lending transaction, or securities borrowing transaction. A “derivative transaction” for purposes of both the Dodd-Frank Act and the new rule 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.” Also under the rule, a “credit derivative” is “a financial contract executed under standard industry credit derivative documentation that allows one party (the protection purchaser) to transfer the credit risk of one or more exposures (reference exposure) to another party (the protection provider).”5 Intraday credit exposures arising from a derivative or securities financing transaction are exempted from the lending limit calculation. The rule also amends the scope of certain lending limit provisions applying to loans made to subsidiaries and affiliates of savings associations and national banks, which in part, broadens certain exclusions for loans to certain subsidiaries of national banks.
- Derivative transaction exposure calculation
The interim final rule provides three methods for calculating the credit exposure of derivative transactions, other than credit derivatives.6 An institution choosing one of these methods must consistently use the same method for calculating its exposures. Of course, the rule provides that the OCC may require an institution use a particular method for safety and soundness reasons.
The first method, the “Internal Model Method,” allows institutions to calculate exposures via a model that has been approved for purposes of the federal banking agencies’ advanced approaches capital rules or any other appropriate model approved by the relevant federal banking agency. The “potential future credit exposure” of the derivative transaction is determined by the model. This method will likely be used by the largest and most complex institutions.
The second method, the “Conversion Factor Matrix Model,” measures credit exposure based on the potential future exposure of the derivative transaction, to be determined at the execution of the transaction by reference to a look-up table included in the regulation. The credit exposure under the second approach remains fixed throughout the life of the transaction.
The third method, the “Remaining Maturity Method,” measures the credit exposure by incorporating
both the current mark-to-market value of the derivative contract and the transaction’s remaining maturity as well as a fixed add-on for each year of the transaction’s remaining life. While more complex than the second approach, this method allows for institutions to recognize the diminishing credit exposure over the life of a derivative transaction, thereby allowing for a corresponding increase in an institution’s lending limit. By offering three methods of varying complexity, the OCC hopes to reduce the practical burden of such calculations, particularly for smaller and mid-size banks and savings associations.
2. Securities financing transaction exposure calculation
The interim final rule provides two methods for determining the credit exposure of securities financing transactions, defined as repurchase agreement, reverse repurchase agreements, securities lending transactions, and securities borrowing transactions. These methods take into account the size of an institution and the complexity and volume of the securities financing transactions engaged in by the institution.
The first method, the “Internal Model Method,” provides that an institution may use a model that has been approved for purposes of the federal banking agencies’ advanced approaches capital rules or any other appropriate model approved by the relevant federal banking agency. Again, this model will likely be used by the largest and most complex institutions.
The second method, the “Non-Model Method,” is based upon the type of securities financing transaction at issue. The Non-Method Model also takes into account the type of collateral used in a transaction. Transactions utilizing securities as collateral, rather than cash, will be subject to a haircut that will be determined through the use of a look-up table included in the regulation.
Unless a specific method is required to be used for safety and soundness reasons, an institution may choose either of the two methods to calculate its credit exposure to securities financing transactions, but must use the same method to calculate all such exposures. The rule exempts from lending limit calculation requirements credit exposures arising from securities financing transactions in which the securities being financed are certain government securities, i.e., those securities that the OCC has deemed to be a Type I security for purposes of its investment securities regulation and certain securities enumerated under HOLA in the case of savings associations.7
Integration of savings associations
The rule also incorporates changes to harmonize the treatment of savings associations and national banks. For instance, the OCC has expanded the scope of the previously-existing exception to the lending limit for savings associations for the financed sale of debt previously contracted (DPC) property. When financing a property sale does not put the institution in a worse position than when it held title to the asset, savings associations will now be able to include the financed sale of all bank assets, not just DPC property.
Two lending limit provisions that only apply to savings associations continue to apply with some changes. First, a savings association may make loans to one borrower in an amount not to exceed US$500,000, even if its lending limit as otherwise calculated would be lower. Second, savings associations have specific lending limits with respect to certain loans to develop domestic residential housing units.8 For such loans, the rule expands on the previous regulation’s interpretations and the definition of “residential housing units.”
The OCC’s approach in offering institutions some flexibility in choosing the method they use to calculate credit exposures differs from the approach recently taken by the Federal Reserve in connection with implementing Section 165(e) of the Dodd-Frank Act, which requires large bank holding companies and systematically important nonbank financial companies to calculate and limit their single-counterparty credit exposures.9 In the notice of proposed rulemaking issued by the Federal Reserve implementing those changes, the Federal Reserve took a more prescriptive route with respect to appropriate models to be used in calculating such exposures, but did also seek comment on whether permitting the use of internal models may be appropriate. It will be interesting to see if the Federal Reserve allows institutions similar flexibility in calculating credit exposures under its anticipated amendments to the 23A affiliate transaction rules required by section 606 of the Dodd-Frank Act, which will also require institutions to calculate credit exposures arising from derivative and securities lending or borrowing transactions.10
The interim final rule issued by the OCC may be subject to change based on comments received. Therefore, institutions should consider the impact of the rule, as currently drafted, and consider commenting accordingly.