On June 19, 2013, the OCC issued a final rule (the “Rule”) updating its existing regulations on legal lending limits 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 replaces, and modifies to some extent, the Interim Rule adopted on June 20, 2012. 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. Over the last two years state legislatures passed laws addressing this issue.  [See, e.g.: GA Code Ann § 7-1-285 amended to include credit exposure under a derivative when calculating a bank’s legal lending limit to any one borrower]. State banking departments have also promulgated rules advising state chartered banks on which model they should follow. [See, e.g., California:  “California state chartered banks shall use the Conversion Factor Matrix Method to determine the credit exposure of derivative transactions for purposes of complying with California’s lending limit;” Maryland: “For the purposes of calculating the Derivative-Securities Credit Exposure for compliance with the Maryland Limit, the Commissioner will require state-chartered banking institutions to measure the Derivative-Securities Credit Exposure in accordance with and subject to the limitations and exemptions under the OCC's Interim Final Rule, as amended by the final rule upon issuance.”]  We believe the Georgia Department of Banking and Finance is likely to provide guidance that will provide Georgia state chartered banks with flexibility of which method to adopt, subject, of course, to safety and soundness considerations for any particular institution.

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:

  1. through an OCC-approved internal model (the Model Method),
  2. by use of a look-up table that fixes the attributable exposure at the execution of the transaction (the “Conversion Factor Matrix Method”), or
  3. by use of the current exposure methodology consistent with the regulatory capital rules in use by federal banking agencies (the “Current Exposure Method”).

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. Specifically, a protection purchaser that uses one of the non-model methods for derivative transactions, or that uses a model without entering an effective margining arrangement with its counterparty as defined in 12 CFR § 32.2(l), calculates the counterparty credit exposure arising from credit derivatives by adding the net notional value of all protection purchased from the counterparty across all reference entities. In addition, a protection seller calculates the credit exposure to a reference entity arising from credit derivatives by adding the notional value of all protection sold on that reference entity. However, the protection seller may reduce its exposure to a reference entity by the amount of any eligible credit derivative, which is defined in 12 CFR § 32.2(m) as a single-name credit derivative or standard, non-tranched index credit derivative that meets certain requirements, purchased on that reference entity from an eligible protection provider, as defined in 12 CFR § 32.2(o).

The OCC responded to various comments by adding a provision that will allow national banks to purchase credit protection to reduce all types of credit exposure to a borrower. Under the Interim Rule, the purchase of credit protection could only reduce credit derivative exposure to a reference obligor, not other exposures such as traditional loans and extensions of credit. The final Rule now provides that credit protection purchased should be allowed to offset other types of credit exposures, under certain circumstances but only on a limited basis. [12 CFR § 32.2(q)(2)(vii)]  Specifically, the Rule excludes from the lending limits rule that part of a loan or extension of credit for which a national bank or savings association has purchased protection if:

  1. that protection is by way of a single-name credit derivative that meets the requirements for an eligible credit derivative contained in 12 CFR § 32.2(m)(1) through (7);
  2. the credit derivative is purchased from an eligible protection provider; the reference obligor is the same legal entity as the borrower in the loan or extension of credit; and the amount and maturity of the protection purchased equals or exceeds the amount and maturity of the loan or extension of credit; and

However, even if all of these requirements are satisfied, the total amount of such exclusion may not exceed 10 percent of the bank’s or savings association’s capital and surplus

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 three methods for securities transactions are referred to as the Model Method, the Basic Method and the Collateral Haircut Approach.

Methods to Measure Credit Exposure (Non-Credit Derivatives)

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 Future Exposure [12 CFR § 32.9(b)(1)(i)]

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 III capital guidelines. Any changes to an internal model approved for use by an institution must be approved by the OCC prior to its use. Further, the OCC has indicated that it will not approve the use of a model on a provisional basis.

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  [12 CFR § 32.9(b)(1)(ii)]

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 Model Method because institutions will not have to establish statistical simulations of future potential credit exposure calculations.

Credit Exposure Method. The third method calculates the credit exposure for a single derivative transactions as follows:

Credit Exposure equals Current Exposure (the greater of zero or the MTM value) plus the Potential Future Exposure. [12 CFR § 32.9(b)(1)(iii)]

The Potential Future Exposure is calculated by multiplying the notional amount by a specified conversion factor which varies based on the type and remaining maturity of the contract) of the derivative transactions.  The Credit Exposure Method replaces the Remaining Maturity Method that was included in the Interim Rule. The benefit to the third method is that it incorporates additional calculations for netting arrangements and collateral.

Example (Conversion Factor Method). Bank A enters into a $10 million 5-year interest rate swap with mark-to-market (“MTM”) of zero at execution. Attributable credit exposure is locked-in or fixed at the PFE on day 1 by simply multiplying notional principal amount by a conversion factor provided in table. No requirement to calculate daily mark-to-market or re-calculate PFE. Under the Conversion Factor Matrix Method, the PFE factor for this swap is 6% ($0 + [$10 million x 6%]). Bank A “locks-in” attributable exposure of $600,000 ($10 million × 6%), the day-one PFE amount.

Example (Current Exposure Method).  Bank A enters into a $10 million 5-year interest rate swap with mark-to-market (“MTM”) of zero at execution. Under the Current Exposure Method (CEM), exposure is equal to the current mark-to-market, plus an “add-on” determined by multiplying the notional amount times a factor appropriate for the swap’s maturity. The factor for a 5-year swap is 0.5 percent. Bank A’s attributable exposure would be $50,000 (0 + ($10 million × 0.5%)).

Savings Association Specific Rules.

Certain statutory provisions apply only to savings associations and the 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. These exceptions were noted in the Interim Rule and were left untouched in the final Rule. [12 CFR § 160.93(d)]

The Rule did make some changes to the regulations concerning loans to subsidiaries and their affiliates. The former lending limits rule applicable to savings associations, 12 CFR § 160.93(a), excluded loans made by savings associations and their subsidiaries consolidated in accordance with generally accepted accounting principles (GAAP-consolidated subsidiaries) to all subordinate organizations and savings association affiliates. Rules applicable in these situations were set forth in part 159. Specifically, § 159.5(b) established lending limits for loans by a Federal savings association and its GAAP-consolidated subsidiaries to non-consolidated subsidiaries. Section 159.5(b) did not set a specific lending limit for loans to GAAP-consolidated subsidiaries but provided that such a limit could be established if warranted by safety and soundness considerations.

The Interim Rule carried over the existing exclusion from the lending limits rule for loans to GAAP-consolidated subsidiaries but did not exclude from the coverage of part 32 loans made to non-consolidated subsidiaries. Therefore, loans to non-consolidated subsidiaries of Federal savings associations were made subject to the lending limits in part 32, but no corresponding change was made to the limits set forth in part 159. As a result, the interim final rule subjected loans to non-consolidated subsidiaries of Federal savings associations to the lending limits set forth in both parts 32 and 159, which differ. The Rule corrects this overlap by replacing the lending limits set forth in 12 CFR § 159.5(b) with a cross-reference to part 32; by removing, as unnecessary, the reference to “loans” within 12 CFR § 159.5(c); and by making a conforming change to 12 CFR § 159.3(k)(2). This amendment also removes the provision in 12 CFR § 159.5(b)(2) that provides that the OCC may limit the amount of loans to GAAP-consolidated subsidiaries where safety and soundness considerations warrant such action.

Nonconforming Credit.

National banks have traditionally enjoyed protection from criticism if an existing extension of credit 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 Model Method or the Current Exposure Method to measure credit exposure.  It is not necessary to include the Conversion Factor Matrix method for derivative transactions or the Basic Method for securities financing transactions in 12 CFR § 32.6(a)(3) because the measured credit exposure of a transaction for lending limits purposes remains fixed under these methods. If an extension of credit becomes non-conforming, the bank or savings association must use reasonable efforts to bring the credit into a conforming status unless to do so would be inconsistent with safe and sound banking practices. [12 CFR § 32.6(a)(3)]

Timing.

Institutions are expected to be in compliance with the new Rule by October 1, 2013.