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Subject: Risk-Based Capital Interpretations Credit Derivatives
Date: November 15, 1999
To: Chief Executive Officers of All National Banks, Department and Division Heads, and All Examining Personnel
Description: Joint Agency Statement
Attached is a joint issuance by the Office of the Comptroller of the Currency and the Federal Reserve Board addressing the risk-based capital treatment of certain synthetic securitization transactions involving credit derivatives. The objective of these capital interpretations is to recognize the effective transference of the economic risk of loss in these synthetic securitization transactions.
In 1996, the OCC published its initial guidance on national banks' participation in the newly developing market for credit derivatives. OCC Bulletin 96-43 provided background information on the common instruments used in this market (e.g., default swaps, total return swaps and credit-linked notes) and described the risks associated with credit derivatives. This document noted that, if used prudently, credit derivatives can enhance banks' ability to manage risk by hedging credit exposures in ways that would otherwise be unavailable. Additional information and guidance on the risk management of derivatives and loan portfolios is available in the "Risk Management of Financial Derivatives" and "Loan Portfolio Management" sections of the Comptroller's Handbook.
The attached document recognizes in the risk-based capital framework the risk mitigating effects of certain credit derivatives. The capital treatment is available only for banks and transactions that effectively transfer credit risk and satisfy specifically identified safety and soundness-related conditions. Because the qualifying transactions are synthetic securitizations in which the hedged assets remain on the bank's balance sheet, these interpretations do not affect the calculation of a national bank's Tier 1 leverage ratio.
Minimum Conditions for Risk-Based Capital Interpretation
To qualify for the risk-based capital treatment described in the interpretations, the national bank must (1) demonstrate meaningful transfer of credit risk to third parties, (2) adequately measure and manage the credit risk not transferred to third parties (i.e., any retained risk on the hedged portfolio as well as the credit risk of unhedged assets), (3) have adequate capital for its credit risk, and (4) publicly disclose the impact of these transactions on its risk profile and capital adequacy. The bank's risk management process should include a credible internal economic capital assessment process, analysis of any concentrations of credit risk and maturity mismatches, and rigorous and robust forward-looking stress tests. The capital market's assessment of the transaction is also an important condition of the risk-based capital interpretations. The structure must include a senior class of notes that receives the highest possible investment grade rating by a nationally recognized credit rating agency.
For further information about this bulletin, contact Margot Schwadron in the Capital Policy Division at (202) 874 5070 or Kurt Wilhelm in the Treasury and Market Risk Division at (202) 874-4479.
Emory W. Rushton