Credit Derivatives: A look at the American Regulatory Structure

This paper received high honors for the author's analysis of trading and risk mangement issues.  It is  the opinion, work, and sole responsibility of the author and can not be guaranteed as to completeness or accuracy. Please email the authors c/o authors@rdcb.com.

by Andre' Scheerer,  LLM candidate at the FordhamUniversity School of Law.    

INTRODUCTION

Credit derivatives are often described as "synthetic loans" which reflects only too narrowly their common use and enormous potential. More broadly defined credit derivatives are sophisticated financial instruments that enable the unbundling and intermediation of credit risk.⁽¹⁾

Credit derivatives are financial instruments used to assume or lay off credit risk, sometimes to only a limited extent.⁽²⁾

A risk seller, which is the party seeking credit risk protection, may want to reduce exposures while maintaining relationships that may be endangered by selling their loans, reduce or diversify illiquid exposures, or reduce exposures while avoiding adverse tax or accounting treatment. A risk buyer, the party assuming credit risk, may want to diversify credit exposures, get access to credit markets which are otherwise restricted by corporate statute or off-limits by regulation, or simply arbitrage pricing discrepancies, for example resulting from perceived mispricing between bank loans and subordinated debt of the same issuer. From a more transactional perspective credit derivatives are financial contracts outlining an exchange of payments in which at least one of the cash flows is linked to the performance of a specified underlying credit sensitive asset. Underlying or reference assets may include bank loans, corporate debt, trade receivables, emerging market and municipal debt, and convertible securities, as well as the credit exposure generated from other derivatives linked activities.⁽³⁾ Potential users of credit derivatives are commercial banks, insurance companies, corporations, money managers, mutual funds, hedge funds, and pension funds, which might use these innovative financial products for either investment or risk management purposes. The market for credit derivatives originated in the early 1990s, whereby market participants are speculating whether credit derivatives were first introduced in London or New York. London is said to have taken over the worldwide lead in this derivatives-market segment.⁽⁴⁾

By 1998 most action in the U.S. has been concentrated among a handful of major banks, whereas more regional banks merely participated in credit derivative activities.⁽⁵⁾ The largest current and potential customers of credit derivatives are commercial banks which might use them for risk management purposes. In some institutions, where the opportunities may not line up with the composition of desired portfolios, bankers are using credit derivatives to help redesign their portfolios (i.e., to lay off undesirable concentrations of credit risk, reduce individual borrower risk, or diversify their portfolios).⁽⁶⁾ In the past, common reference assets were corporate bonds and sovereign debts of developing countries. Investment firms with large illiquid bonds use credit derivatives to transfer default risk without selling bonds. Credit derivatives are becoming increasingly more popular among insurance companies.⁽⁷⁾ Since their first occurance in the early 1990s, the volume of notional amounts of credit derivatives in the U.S. has risen to a new record in the first quarter of 1999 to $191 billion. The Office of the Comptroller of the Currency ("OCC") began first tracking the volume of credit derivatives in the forth quarter of 1997 when notional amounts of credit derivatives engaged in by U.S. financial institutions amounted to $55.⁽⁸⁾

The first real test for credit derivatives came with the crisis of the financial markets in Asia in the Fall of 1997 where the first credit derivative related problems on a larger scale occurred.⁽⁹⁾ On the other hand, credit derivatives performed more efficiently in the Asian crisis than the underlying bond market. Between December 1997 and January 1998, credit derivatives allowed investors to recover at least $800 million from the Korean Development Bank and the Industrial Finance Corporation of Thailand.⁽¹⁰⁾ The impact of the turmoil in the Russian financial markets might have reached a different dimension and credit derivatives had to face another even more intense stress test. According to official reports, legal disputes are currently pending over unpaid forward currency contracts and over credit derivatives that were bought as insurance against devaluation of the Ruble and a Russian government default.⁽¹¹⁾ The problems counterparties to credit derivative agreements in the Asian and Russian markets have faced or are currently exposed to are typical of innovative financial products like credit derivatives: lack of effective standard legal documentation; legal uncertainty regarding the enforceability and validity of legal obligations under credit derivative agreements; inconsistencies of the credit derivative agreement and the underlying asset agreement, often rendering credit derivatives credit risk protection mechanisms obsolete; lack of publicly available market and product relevant information and lack of market transparency; legal uncertainty regarding enforceability of closeout-netting provisions and the apparent problem of pricing credit risk. In the recent past not only portfolio managers at large commercial banks have learned to appreciate the benefits of prudently used credit derivatives, but, have also national banking regulators and supervisors recognized the potential and usefulness of credit derivatives to manage and mitigate credit and counterparty risk.⁽¹²⁾

II. COMMON FORMS OF CREDIT DERIVATIVES

At this point, it has become hard to spot all the numerous different types of credit derivative transactions in the market. Regardless the availability of standardized master agreements for some credit derivative products, a large amount of transactions is still negotiated without using standardized documentation. Due to limited market transparency and publicly available information, it seems difficult to keep track with the numerous individualized variations of credit derivatives transactions.⁽¹³⁾ Nevertheless, all have the same unifying feature - the transfer from one party to another of credit risk associated with one or more specific debt obligations of a reference asset.⁽¹⁴⁾ Currently there are three basic categories of credit derivatives: credit swaps, credit options and credit embedded securities.⁽¹⁵⁾

A. Credit Swaps

Two basic types of credit swaps which are used to transfer credit risk are credit default swaps ("CDS") and total rate-of-return swaps ("TROR").⁽¹⁶⁾

1. Credit Default Swaps

The purpose of a CDS is to provide credit protection against credit losses associated with a default on a specified underlying asset. Typically the underlying or reference asset is some form of credit (i.e., a single credit or the first to default in a basket of credits) extended by the party seeking protection ("beneficiary") against a default of its debtor, a third party. The beneficiary swaps the credit risk with the provider of the credit protection, i.e., the guarantor. The transaction is similar to a guarantee or a standby letter of credit: the beneficiary agrees to pay the guarantor a fee typically amounting to a certain number of basis points on the par value of the reference asset, either quarterly, or annually. In return, the guarantor agrees to pay the beneficiary an agreed upon, market-based, post-default amount or a predetermined fixed percentage of the value of the reference asset contingent on the occurrence of a default. The guarantor makes no payment until there is a default as defined in the contract to include, for example, a bankruptcy, cross acceleration, a downgrade of the reference asset or its issuer, repudiation or moratorium, restructuring or payment default, and the event of default must be publicly verifiable. In some instances, the guarantor is not obliged to make any payments to the beneficiary until a pre-established amount of loss has been exceeded in conjunction with a default event (the so called "materiality threshold").⁽¹⁷⁾ The amount owed by the guarantor is the difference between the reference asset's initial principal (or notional) amount and the actual market value of the defaulted reference asset or a predetermined amount or percentage of the reference asset. The guarantor may have the option to purchase the defaulted asset from the beneficiary at a predetermined amount.⁽¹⁸⁾

2. Total Rate-Of-Return Swap

In a TROR the beneficiary agrees to pay the guarantor the total return (i.e., interest plus fees, less the difference of the final price and the original price) on the reference asset (typically a loan or security), which consists of all contractual payments, as well as any appreciation in the market value of the reference asset.⁽¹⁹⁾ Typically, the guarantor agrees to pay a reference interest rate (i.e., LIBOR) plus a spread and any depreciation of the market value of the reference asset to the beneficiary. At each payment exchange date and upon maturity of the TROR or upon default, at which point the TROR may terminate, any depreciation or appreciation in the amortized value of the reference asset is calculated as the difference between the notional principal balance of the reference asset and the dealer price.⁽²⁰⁾ The dealer price may be determined either by referring to a market quotation source, if available, or by polling a group of dealers and reflects changes in the credit profile of the reference obligor and reference asset. If the dealer price is less than the notional amount (i.e., the hypothetical original price of the reference asset) of the contract, then the guarantor must pay the difference to the beneficiary, absorbing any loss caused by a decline in the credit quality of the reference asset.⁽²¹⁾ While no principal amounts are exchanged and no physical change of ownership occurs, the TROR swap allows participants to effectively go long or short the underlying asset.⁽²²⁾ Although the hedger has transferred the risk of the asset without transferring the asset itself, it retains the customer relationship and must continue to fund the earning assets.⁽²³⁾ As such, a TROR swap can be considered a synthetic asset transferring the total economic performance of an asset for the term of the transaction.⁽²⁴⁾ The maturity of the TROR swap need not match that of the reference asset, and the swap can typically be terminated at any time. The guarantor may have the option of purchasing the reference asset.

B. Credit Options and Credit Embedded Securities

The two other main categories of credit derivatives are credit options and credit embedded securities in the form of Credit Default Options ("CDO") and Credit Linked Structured Notes ("CLSN").⁽²⁵⁾

1. Credit Default Options

The basic form of a CDO permits the purchaser to either invest in the reference asset or to hedge against credit default events with respect to the reference asset. A CDO is typically a privately negotiated, over-the-counter option contract. A credit call option gives the purchaser the right, but not the obligation, to purchase the reference asset (i.e., a loan or security or credit spread) at a predetermined price for a prespecified period of time or on a specified exercise date.⁽²⁶⁾ A credit put option gives the purchaser the right, but not the obligation, to sell the reference asset at a predetermined price for a prespecified period of time or on a specified exercise date. A CDO is typically settled by physical delivery of the reference asset.⁽²⁷⁾

2. Credit Embedded Securities

There are many variations of credit embedded securities. The common thread among them is the link between return and credit-related performance of the underlying or reference asset. Credit linked structured notes ("CLSN"), the basic form of credit embedded securities, are loans or securities issued by an investment grade entity or a bankruptcy-remote special purpose vehicle, such as a trust, that has a fixed or floating rate coupon and a highly structured maturity payment provision.⁽²⁸⁾ The note represents a synthetic corporate bond or loan, because a credit derivative (credit default or TROR swap) is embedded in the structure.⁽²⁹⁾ Depending upon the performance of a specified reference asset (i.e., a loan or security), and the type of derivative embedded in the note, the note may not be redeemable at par value. CLSN have principal (par value) at risk depending upon the performance of the reference asset, in addition to the performance of the issuer.⁽³⁰⁾ For example, the investor of a CLSN with an embedded CDS may receive only 60 percent of the original par value if a reference credit defaults. Investors in CLSN assume credit risk of both the reference credit and the underlying collateral. The trust is generally collateralized with high-quality assets to assure payment of contractual amounts due. CLSN may contain leverage that can magnify the risk and return profile of the asset.⁽³¹⁾

III. RISKS AND RISK MANAGEMENT OF CREDIT DERIVATIVES

For the last years, the federal bank regulators in the U.S., principally the Federal Reserve and the OCC, have been promoting the importance of risk management. Inherent in the concept of risk management is the notion that institutions, in order to manage risk effectively, must make conscious decisions about which risks to accept, reject, or transfer and for those risks they accept, the risk reward or price that is necessary.⁽³²⁾ To manage your risks means to know the risks you are exposed to. From a supervisory perspective, the OCC, for example, focused in its initial guidance on seven risks associated with credit derivatives: credit, transaction, liquidity, compliance, strategic, price (or market risk) and reputation risk.⁽³³⁾ In the meantime, since the initial statements by federal banking supervisors on credit derivatives, the list of risks generally associated with OTC derivatives, which is just as applicable to credit derivatives, has been extended to include interconnection (or interrelation) risk, operational risk. Since the near-failure of Long-Term Capital Risk Management, an increasing focus has been on the relevance of systemic risk. Other risks that may affect OTC derivative transactions are interest rate and foreign exchange risk. Which of these risks inhere to a particular credit derivative transaction depends on its individual structuring and must be determined on a case-by-case basis. Federal banking regulators have in the past stressed the importance of analyzing the risks incurred by financial institutions that use them and that banks should have sound risk management policies and procedures, including adequate internal controls, in place for credit derivatives.⁽³⁴⁾

A. Risks for End-Users

The primary risks associated with credit derivatives for end-users are credit, transaction, liquidity, compliance and strategic risks. The OCC defines risk generally as the potential that events, expected or unanticipated, may have an adverse impact on the bank's capital or earnings.⁽³⁵⁾

1. Credit Risk

Credit risk is the risk, that a loss will be incurred if a counterparty defaults on a credit derivatives contract.⁽³⁶⁾ All credit derivative transactions expose a bank to credit risk. Federal banking regulators have stressed over the last years that credit risk management of OTC derivatives should parallel the prudent controls expected in traditional lending activities.⁽³⁷⁾ The credit quality of both the reference asset and the derivative contract counterparty are the principal determinants of credit risk.⁽³⁸⁾ Generally, for the seller of credit protection, the primary credit risk is to a reference credit, similar to loan participations, letters of credit or off-balance sheet guarantees; for the purchaser of credit protection, the credit risk is exposure to the counterparty to the credit derivative contract.⁽³⁹⁾ The purchaser of credit protection suffers a loss when the reference credit and the counterparty, which is the provider of credit protection, default on their obligations. In some cases, such as total rate-of-return swaps, both the guarantor and the beneficiary are exposed to the credit risk of the counterparty, whereas for banks, acting as dealers, that have matching offsetting positions, the counterparty risk could be the primary risk to which the dealer banks are exposed from credit derivative transactions.⁽⁴⁰⁾ Both, banking supervisors and regulators and market participants, since the market disruptions in 1997 and 1998, have focused on the importance of counterparty risk management, especially in the context of reducing systemic risk.⁽⁴¹⁾ Counterparty credit risk should be controlled through a formal and independent credit process. Nonperforming contracts should be treated consistently with institution's policy for nonperforming loans.⁽⁴²⁾ U.S. and international banking regulators have identified credit risk as the most significant risk associated with financial derivatives (respectively credit derivatives) activities of banks. In their latest consultative paper directed to banking regulators and supervisors, the Basle Committee on Banking Supervision proposes common standards for prudent management of credit risk by banks.⁽⁴³⁾ Before banks engage in credit derivative activities, (i) each bank shall establish an appropriate credit risk environment, where the board of directors should have the responsibility for approving and reviewing the bank's credit risk strategy and policies, and, senior management should have the responsibility for implementing the credit risk strategy and for developing policies and procedures for identifying, measuring, monitoring and controlling credit risk inherent in all products and activities; (ii) banks should operate under a sound credit granting process, where banks operate under sound, well-defined credit granting criteria and establish overall credit limits. Banks must have a clearly-established process in place for approving new credits as well as the extension of existing credits, whereby all extensions must be made on an arm's-length basis; (iii) banks should maintain an appropriate credit administration, measurement and monitoring process, whereby banks are encouraged to develop and utilize internal risk rating systems in managing credit risk, and, banks must ensure that they have the information systems and analytical techniques in place, to enable management to measure and monitor credit risk inherent in all on- and off-balance sheet activities; (iv) banks must ensure adequate controls over credit risk, and, should establish a system of independent, ongoing credit review and the results of such reviews should be communicated directly to the board of directors ans senior management. Banks must ensure that the credit-granting function is being properly managed and that credit exposures are within levels consistent with prudential standards and internal limits.⁽⁴⁴⁾

The Basle Committee on Banking Supervision and the Technical Committee of the International Organization of Securities Commissions ("IOSCO")⁽⁴⁵⁾ suggested that the notional amount of derivative contracts does not reflect the actual counterparty risk, whereby credit risk for a derivative contract is best broken into two components, current credit exposure to the counterparty and the potential credit exposure that may result from changes in the market value underlying the derivative contract.⁽⁴⁶⁾ The report stresses, since more organizations are increasingly using credit derivatives to adjust their credit risk exposures, supervisors should be aware of the involvement of institutions with credit derivatives and their impact on institutions' overall credit risk exposure.⁽⁴⁷⁾ Credit risk exposure should include exposure, not only from off-balance sheet credit instruments such as standby letters of credit but also from credit derivatives.⁽⁴⁸⁾ Therefore, before entering into a credit derivative transaction as the buyer of protection, a bank should evaluate the financial condition of the provider of the credit protection, and, likewise, the seller of credit protection, before entering into a credit derivative transaction, and it should conduct a complete review of the reference asset.⁽⁴⁹⁾ Both, the seller and the buyer of the credit protection should continually monitor the condition of their counterparties to the credit derivative transaction. Banks engaged in credit derivative activities should, if appropriate, incorporate exposure from credit derivatives into their Allowance for Loan and Lease Losses (ALLL), and maintain an ALLL at a level that is adequate to absorb estimated losses associated with credit derivatives, as they are generally required for credit losses associated with the loan and lease portfolio.⁽⁵⁰⁾

2. Transaction Risk

Transaction risk is the risk to earnings or capital arising from problems with service or product delivery.⁽⁵¹⁾ Transaction risk occurs when participants to a credit derivative transaction do not fully understand the contract features and the scope and degree of risk transference in a credit derivative product. Other than most traditional credit enhancements, such as letters of credit, the degree of risk transference in a credit derivative depends on the particular design of the product. Bank management should fully understand how the product works and the variables and features that determine its performance.⁽⁵²⁾

3. Liquidity risk

Liquidity risk is the risk to earnings or capital arising from the inability to meet ones obligations when they come due.⁽⁵³⁾ As with cash instruments, there are two basic types of liquidity risk that can be associated with derivative instruments: market (or asset) liquidity risk and funding (or cash flow) liquidity risk.⁽⁵⁴⁾ Funding liquidity risk is the risk of ones ability to fund positions held and to meet, when due the cash and collateral demands of counterparties, other credit providers and investors.⁽⁵⁵⁾ Market liquidity risk is the risk to ones ability to liquidate positions in various asset markets, which ultimately impacts the ability to manage and hedge market risks as well as the capacity to satisfy any shortfall on the funding side. End-users typically measure liquidity risks by evaluating funding (or cash flow) liquidity risk.⁽⁵⁶⁾ Dealers must measure liquidity risk by considering both funding liquidity risk and market (or asset) liquidity risk.⁽⁵⁷⁾ Dealers should consider that the two risks, though separate, are interrelated.⁽⁵⁸⁾ The viability of a financial intermediary or large trading counterparty could be compromised by poor management of its liquidity risk, even if it is solvent on a mark-to-market basis or its leverage is relatively modest.⁽⁵⁹⁾ Banks engaging into credit derivatives transactions should therefore incorporate the impact of these activities on their cash flows into regular liquidity planning and monitoring systems.⁽⁶⁰⁾

4. Compliance (or Legal) Risk

Compliance (or legal) risk is the risk of a loss because a contract cannot be enforced. This includes risks arising from violations of, or non-conformance with, laws, rules, regulations, insufficient capacity or authority of a counterparty (ultra vires), uncertain legality, and unenforceability in bankruptcy or insolvency, and, insufficient documentation.⁽⁶¹⁾ Before engaging in credit derivatives transactions a bank should satisfy itself that it and its counterparties have the legal and necessary regulatory authority to engage in the transactions. In order to ensure that the transaction complies with applicable laws the bank should closely evaluate the legal documentation underlying the transaction (i.e., legal counsel should evaluate the legal documentation of the credit derivative transaction, review the documentation of the underlying or reference asset, and, assure to avoid discrepancies between the terms of the different referenced transactions). Illegality and unenforceability results from the possibility that one counterparty might be legally incapable of entering into the contract (ultra vires) or from an entire class of contracts being declared illegal or unenforceable.⁽⁶²⁾ Both end-users and dealers must ensure that agreements are documented properly and are legally enforceable.⁽⁶³⁾ Participants must ensure that contract documentation is timely executed and maintained.⁽⁶⁴⁾ To reduce legal risk, end-user and dealers should use, to the greatest extent practicable, standardized master agreements that apply to multiple transactions, in order to provide standardized terms governing the transactions and to provide for netting and close-out netting of credit exposures and payment obligations.⁽⁶⁵⁾ Participants should use one master agreement with each counterparty.⁽⁶⁶⁾

5. Strategic Risk

Strategic risk is the risk to earnings or capital arising from adverse business decisions or improper implementation of those decisions. Banks, that plan to engage into the business of credit derivatives, should ensure that the activity is consistent with the overall business strategies and credit risk policies as approved by the board of directors.⁽⁶⁷⁾ The decision to use credit derivatives to manage credit portfolios, to enhance yields, and to use them for arbitrage purposes represents a strategic management decision, which is reserved for senior management and the board of directors.

6. Operational Risk

Operational risk is the risk of losses occurring as a result of inadequate systems and control, human error, or management failure.⁽⁶⁸⁾ The complexity of derivatives requires special emphasis on maintaining adequate human and systems controls to validate and monitor the transactions of end-users and positions of dealers.⁽⁶⁹⁾ Internal controls should include: (i) oversight of informed and involved senior management and the board of directors; (ii) documentation of policies and procedures, listing approved activities and establishing limits and exceptions, credit controls, and management reports; (iii) independent risk management function (as mentioned above analogous to credit review and asset/liability committees) that provides senior management validation of results and utilization of limits; (iv) independent internal audits which verify adherence to the firm's policies and procedures; (v) a back office with the technology and systems for handling confirmations, documentation, payments, and accounting; (vi) a system of independent checks and balances throughout the transaction process from front-office initiation of a transaction to final payment settlement.⁽⁷⁰⁾

B. Risks for Dealers

In addition to the risks as described above, for dealers in credit derivatives the risk spectrum also includes price (or market) risk, and reputation risk.⁽⁷¹⁾

1. Market Risk

Market risk is the exposure arising from adverse changes in the market value (the price) of an instrument or portfolio of instruments.⁽⁷²⁾ In the market for credit derivatives, some participants will enter into credit derivative activities as end-users, while others will act as dealers who will both buy and sell credit protection on the same (or similar) underlying reference assets.⁽⁷³⁾ Dealers and active position-takers are exposed to market risk because, generally, these institutions take positions with the expectation of profiting from price movements. To the extent that end-users enter into credit derivative activities for investment purposes or to manage earnings they are also exposed to market risk.⁽⁷⁴⁾ Market risk can be best broken into two groups: (i) general market risk, which refers to changes in the market value of on-balance sheet assets, and off-balance sheet items resulting from broad market movements; and (ii) specific market risk, which refers to changes in the market value of individual positions due to factors other than broad market movements and includes such risks as the credit risk of an instrument's issuer.⁽⁷⁵⁾ Dealers in credit derivatives should have sound policies, procedures, and systems to ensure that exposures are measured in a timely fashion and are within senior management and board-approved risk limits.⁽⁷⁶⁾ Dealer's risk management system should include stress testing to evaluate the institution's exposure in a highly stressed market scenario.⁽⁷⁷⁾ Dealers should mark their credit derivatives positions to market, on at least a daily basis, for risk management purposes.⁽⁷⁸⁾ Dealers should use a consistent measure to calculate daily the market risk of their derivatives positions and compare it to market risk limits. Generally, market risk is best measured as "value-at-risk" using probability analysis based upon a common confidence interval (e.g., two standard deviations) and time horizon (e.g., a one-day exposure).⁽⁷⁹⁾ Dealers in credit derivatives should also consider for risk management purposes, for example, when establishing internal limits, that liquidity in credit derivatives markets is still limited due to the absence of a deep dealer market, which may make it difficult for dealers to price transactions and hedge cash flow exposures on a timely basis.⁽⁸⁰⁾

2. Reputation Risk

Reputation risk is the risk arising from negative public opinion. Dealers in credit derivatives should not enter into transactions with counterparties that do not fully understand the terms and risks of the transactions as these risks could expose the dealer to litigation, financial loss, or damage to its reputation.⁽⁸¹⁾

IV. Regulatory Initiatives by Federal Banking Agencies

From a regulatory perspective, federal banking agencies, just as banking and securities supervisors and regulators of other nations, have focused their interest on three main elements considered proper means of supervising and regulating the market of OTC derivatives, including credit derivatives, and its participants: (i) risk management, with a major emphasis on credit risk management, (ii) capital adequacy and regulatory capital, and, (iii) disclosure.⁽⁸²⁾ The principles of sound risk management techniques for financial institutions engaging into credit derivatives activities have been described in the previous chapter. Federal banking agencies have, so far, confined themselves to advising financial institutions on risk management of OTC derivatives and related issues rather then imposing regulatory duties and obligations upon them. The agencies, in the past, have relied on the success of market participants' joint efforts and ongoing initiatives for voluntary oversight in the business of OTC derivatives, including credit derivatives, and the promotion of "best practices" among market participants to enhance soundness and market transparency, which would, eventually, be enforced in the market by the pressure of competition. Much different in the context of capital adequacy and regulatory capital and disclosure, where federal banking agencies have not relied on selfregulatory powers, and, therefore, have defined mandatory rules.

A. Regulatory Capital Treatment

Since the early 1980s, international banking supervisors have pooled their efforts to strengthen the soundness and stability of the international banking system. The first major success in the development of risk-based capital rules for banking institutions was achieved with the Basle Capital Accord, issued July 15, 1988, which outlines the basic approach for modern regulatory capital treatment.⁽⁸³⁾ The purpose of the Basle Capital Accord was to establish on an international level minimum capital requirements by assessing capital in relation to on and off-balance sheet credit risk categories, and requiring banking institutions to achieve and maintain a minimum risk-weighted capital ratio of no less than 8 per cent. The provisions of the Basle Capital Accord have been implemented by federal banking agencies in 1989.⁽⁸⁴⁾ Thus, financial institutions have been required to hold capital to support their on and off-balance sheet risk exposures. Since, the Basle Capital Accord has been amended, expanded and refined in various ways to better reflect and incorporate risk exposure of banks including risks inherent in derivative activities. These amendments have been widely adopted by federal banking agencies.

1. General Risk-Based Capital Rules for Derivatives

The initial rules of federal banking agencies on risk-based capital treatment of OTC derivatives have been amended several times since their original implementation in 1989. For example, in 1995, the federal banking agencies and the Department of the Treasury amended their risk-based capital standards to implement revisions to the Basle Capital Accord revising and expanding the set of conversion factors used to calculate the potential future exposure of derivative contracts and recognizing the effects of netting arrangements in the calculation of potential future exposure for derivative contracts subject to qualifying bilateral netting arrangements. In 1996, the agencies issued revisions to their risk-based capital standards to incorporate a measure for market risk arising from derivative trading activities.⁽⁸⁵⁾ The revision is based upon the January 1996 amendments to the Basle Committee's Capital Accord.⁽⁸⁶⁾ Under the revision, a bank must now hold capital to support the general market risk and specific risk associated with its trading activities. Banks with significant trading activities that cause exposure to market risk must maintain adequate capital against that exposure.⁽⁸⁷⁾ In order to calculate risk-based capital for market risk, a bank must first determine its adjusted risk-weighted assets (its risk-weighted assets minus the risk-weighted amounts of the covered positions). In another step, the bank must calculate its measure for market risk, which is the sum of the VAR-based (value-at-risk) capital charge, a specific add-on (for specific market risk), and, at the time, any de minimis charges.⁽⁸⁸⁾ Banks complying with the qualitative and quantitative requirements may use internal models to calculate, on a daily basis, its VAR.⁽⁸⁹⁾ Furthermore, a bank using internal models, must do backtesting, whereas a bank must compare each of its most recent 250 business days' actual net trading profit or loss with the corresponding daily VAR measures generated for internal risk measurement purposes.⁽⁹⁰⁾

Another significant recent amendment to the risk-based capital rules has been implemented by the federal banking agencies in 1997.⁽⁹¹⁾ The federal banking agencies have amended their risk-based capital standards for market risk applicable to banks with significant trading activities to eliminate the requirement, that, when an institution measures specific risk using its internal model, the total capital charge for specific risk must equal at least 50 percent of the standard specific risk capital charge.⁽⁹²⁾

2. Application of the Risk-Based Capital Standards to Credit Derivatives

In their preliminary guidance for the supervisory review of credit derivatives, issued in August, 1996, the federal banking agencies declared the risk-based capital rules generally applicable for credit derivatives.⁽⁹³⁾ Banks must incorporate their credit derivatives into their risk-based capital computation.⁽⁹⁴⁾ Risk-based capital treatment of credit derivatives must be determined on a case-by-case basis, as some of the credit derivatives are functionally equivalent to standby letters of credit or guarantees, while other forms might be treated as interest rate, equity, or other commodity derivatives.⁽⁹⁵⁾ Therefore, banks providing credit protection through a credit derivative must hold capital and reserves against their risk exposure to the reference asset.⁽⁹⁶⁾ An exception to this broad principle is made, where the credit derivative contract incorporates periodic payments for depreciation or appreciation, what is true for most total rate- of-return swaps. The seller of credit protection can deduct the amount of depreciation paid to the beneficiary from the notional amount of the contract to determine the amount of reference exposure subject to a capital charge.⁽⁹⁷⁾ In the case of total rate-of-return swaps, the provider of credit protection is also exposed to the credit risk of the counterparty, which is measured as the replacement cost of the credit derivative transaction plus an add-on factor for the potential future exposure of the credit derivative to market price changes.⁽⁹⁸⁾ For purposes of risk-based capital charges, credit derivatives are generally to be treated as off-balance sheet direct credit substitutes. The notional amount of the contract should be converted at 100 percent to determine the credit equivalent amount to be included in risk weighted assets of the provider of credit protection.⁽⁹⁹⁾ A bank providing a guarantee through a credit derivative transaction should assign its credit exposure to the risk category appropriate to the obligor of the reference asset or any collateral.⁽¹⁰⁰⁾ A bank that owns the underlying asset upon which effective credit protection has been acquired through a credit derivative may, under certain circumstances, assign the unamortized portion of the underlying asset to the risk category appropriate to the provider of credit protection, e.g., the 20 percent risk category if the guarantor is an OECD bank.⁽¹⁰¹⁾ Whether the credit derivative is considered an eligible guarantee for purposes of risk-based capital depends upon the degree of credit protection actually provided, which must be determined on a case-by-case basis. Banks providing credit protection through a credit derivative may mitigate the credit risk associated with the transaction by entering into an offsetting credit derivative with another counterparty, a so called "back-to-back" position.⁽¹⁰²⁾ Banks that have entered into such a position may treat the first credit derivative as guaranteed through the offsetting credit derivative arrangement, e.g., the 20 percent risk category if the counterparty to the offsetting position is an OECD bank.⁽¹⁰³⁾ On June 13, 1997, the Federal Reserve Board issued a supervisory letter explaining how credit derivatives held in trading accounts of banks with significant trading in derivatives will be treated for regulatory capital purposes.⁽¹⁰⁴⁾ Banks should apply the market risk capital rules as in place already for other derivative contracts held in trading accounts of banks with significant trading activities. Dealer banks must include in their risk-based capital computations three risk elements, inherent in credit derivatives held in trading accounts against which banks must hold risk-based capital: (i) counterparty credit risk, (ii) general market risk, and, (iii) specific market risk.⁽¹⁰⁵⁾ The three risk elements correspond three types of open positions: (i) matched positions, which encompass long and short positions in identical credit derivative structures over identical maturities referencing identical assets, whereby matched positions involve counterparty credit risk; (ii) offsetting positions, which encompass long and short credit derivative positions in reference assets of the same obligor with the same level of seniority in bankruptcy, whereby offsetting positions involve counterparty credit risk and some general market risk and some specific risk; (iii) open positions, which are those positions that do not qualify as matched or offsetting, whereby open positions involve counterparty credit risk, general market risk, and, specific risk.⁽¹⁰⁶⁾ Dealer banks must use their internal models to measure their daily value-at-risk (VAR). Counterparty risk is calculated by summing the mark-to-market value of the credit derivative and an add-on factor representing potential future credit exposure.⁽¹⁰⁷⁾ Investment grade credit derivatives, or credit derivatives, where the reference asset is unrated but well-secured by high-quality collateral, qualify for lower add-on factors (equity add-on factors), than credit derivatives, where the reference asset is either below investment grade or is unrated and unsecured (which only qualify for commodity add-on factors), for purposes of calculating the risk-based capital charges. Since their initial guidance on credit derivatives and their regulatory capital treatment by banks in 1996, the federal banking agencies have recognized the risk mitigating effects of certain credit derivatives that effectively transfer credit risk, and, thus, have afforded them preferential risk-based capital treatment, by allowing banks, buying such credit protection, to assign the portion of the underlying asset for which credit protection has been acquired to the risk category appropriate to the guarantor, e.g., the 20 percent risk category if the guarantor is an OECD bank.⁽¹⁰⁸⁾ On November 15, 1999, the agencies issued a joint statement and rules addressing the risk-based capital treatment of certain synthetic securitization transactions involving credit derivatives.⁽¹⁰⁹⁾ The agencies note that credit derivatives are now being used to synthetically replicate collateralized loan obligations (CLOs).⁽¹¹⁰⁾ Banks can utilize CLO's and their synthetic variants to manage their balance sheets and, in some instances, transfer credit risk to the capital markets. A CLO is an asset backed security that is usually supported by a variety of assets, including whole commercial loans, revolving credit facilities, letters of credit, bankers's acceptances, or other asset-backed securities.⁽¹¹¹⁾ In a typical CLO transaction, the sponsoring (or risk selling) bank transfers the loans and other assets to a bankruptcy-remote special purpose vehicle (SPV), which then issues asset-backed securities consisting of one or more classes of debt.⁽¹¹²⁾ This type of transaction represents a so-called "cash flow CLO", which enables the sponsoring (or risk selling) institution to reduce its leverage and risk-based capital requirements, improve its liquidity, and manage credit concentrations.⁽¹¹³⁾ The difference between more traditional credit-linked structured notes and CLO's is, rather than transferring the underlying assets to the SPV, the sponsoring bank issues credit-linked structured notes to the SPV individually referencing the payment obligation of a particular company or the "reference obligor".⁽¹¹⁴⁾ Under a credit-linked structured note transaction, the notional amount of the issued credit-linked structured note equals the dollar amount of the reference asset, that the sponsor was hedging on its balance sheet.⁽¹¹⁵⁾ Other structures may use credit default swaps to transfer credit risk and create different levels of risk exposure, but hedge only a portion of the notional amount of the overall reference portfolio.⁽¹¹⁶⁾ Under a typical CLO structure, assets are actually transferred into the SPV. In synthetic securitizations, the underlying exposures that comprise the reference portfolio remain in the institution's banking book.⁽¹¹⁷⁾ The credit risk is usually transferred into the SPV through credit default swaps or credit-linked structured notes. The Basle Capital Accord in its current form does not contemplate transactions such as securitizations, or synthetically-created securitizations. Under the current risk-based capital guidelines, corporate credits are assigned to the 100 percent risk category and are assessed 8 percent capital. The agencies recognize, that in the case of high quality investment grade corporate exposures, the 8 percent risk-based capital requirement may exceed the economic capital that a bank sets aside to cover the credit risk of the transaction.⁽¹¹⁸⁾ The agencies argue in their statement, that one of the motivations behind CLOs and other securitizations is to more closely align the sponsoring institution's regulatory capital requirements with the economic capital required by the market.⁽¹¹⁹⁾ For purposes of calculating leverage and risk-based capital ratios the agencies discuss in their document three types of transactions, which will be afforded different risk-based capital requirements, depending on the degree of risk transference: (i) a transaction structure, where the sponsoring bank, through a synthetic CLO, hedges the entire notional amount of a reference asset portfolio; (ii) where the sponsoring bank only hedges a portion of the reference portfolio and retains a high quality senior risk position that absorbs only those credit losses in excess of the junior loss positions; and (iii) where the bank retains a subordinated position that absorbs first losses in a reference portfolio.⁽¹²⁰⁾ The agencies note, that these new rules are subject to changes due to the latest Basle Committees suggested amendments to the Basle Capital Accord, which shall more reflect and give effect to the positive impacts of modern innovative risk mitigating techniques to manage credit portfolios, such as credit derivatives.⁽¹²¹⁾ Among others, the Basle Committee notes, that recent development of credit risk mitigating techniques such as credit derivatives has enabled banks to substantially improve their risk management. The Committee recognizes, that the Basle Capital Accord may, in some instances, not have favored the development of specific forms of credit risk mitigation by placing restrictions on both the type of hedges acceptable for receiving capital reduction and the amount of capital relief. According to the Committee, the Accord has also left open the treatment of imperfect credit risk protection (maturity mismatches, asset mismatches, potential future exposure on hedges), resulting in different national policies. The Committee proposes a more consistent and economic approach to credit risk mitigating techniques, covering credit derivatives, collateral, guarantees, and on-balance-sheet netting.⁽¹²²⁾

B. Disclosure and Reporting Requirements

As mentioned before, national and foreign banking and securities supervisors and regulators have identified public disclosure and reporting by market participants as one of the three basic elements or pillars of their approach to supervise and regulate financial derivatives markets and their players. Public disclosure is aimed at promoting safety and soundness of financial derivatives markets by increasing market transparency and thereby reducing systemic risk.⁽¹²³⁾ Regulatory reporting requirements enhance the ability of industry regulators and supervisors to understand of how these activities affect the overall risk profile and profitability of banks and securities firms.⁽¹²⁴⁾

1. Recommendations by Basle Committee and IOSCO

The Basle Committee and IOSCO are recommending that banks engaging into credit derivative activities should provide financial statement users with a clear picture of their trading and derivatives activities.⁽¹²⁵⁾ They should disclose meaningful summary information, both qualitative and quantitative, on the scope and nature of their trading and derivatives activities and disclose how these activities contribute to their earnings profile.⁽¹²⁶⁾ Qualitative information about credit risk should summarize the institutions policies for identifying, measuring and managing credit risk, e.g., institutions should address their mechanisms to reduce credit exposure and if an institution uses credit derivatives, it should discuss how these instruments are used.⁽¹²⁷⁾ Institutions that use credit derivatives should disclose information how they affect the institutions' recognition and measurement of losses.⁽¹²⁸⁾ Quantitative information about credit derivatives should disclose the notional amount of credit derivatives distinguished by protection sold/purchased and by type of instrument (e.g., total rate of return swap, credit default swap, or other credit derivative). If credit derivatives would have a material effect on credit risk concentrations, an institution should also consider disclosing credit derivative exposure by reference asset illustrating their effect. Institutions should disclose information produced by their internal risk measurement systems on their risk exposures and their actual performance in managing these exposures.⁽¹²⁹⁾ The Basle Committee and IOSCO recommend, that supervisors seek to ensure that institutions provide both qualitative and quantitative information on their derivative activities covering four broad areas: (i) credit risk; (ii) liquidity risk; (iii) market risk; and (iv) earnings.⁽¹³⁰⁾

2. Accounting Standards: FAS 133

On June 15, 1998, the Financial Accounting Standards Board (FASB) issued Financial Accounting Standard No. 133, "Accounting for Derivative Instruments and Hedging Activities" (FAS 133).⁽¹³¹⁾ FAS 133 is required for fiscal years beginning after June 15, 1999. For institutions with their fiscal years starting on January 1, FAS 133 will become effective beginning January 1, 2000. Under the previous rules, companies that issued or held derivatives were required to differentiate in their disclosures between derivatives used for trading purposes and those used for risk management or other end-user reasons.⁽¹³²⁾ Before the adoption of FAS 133 institutions were not subject to mandatory accounting rules regarding their derivatives activities. FAS 119 required firms to disclose their objectives in using derivatives and strategies for achieving those objectives.⁽¹³³⁾ The firms were required to describe how they reported derivatives in their financial statements and give details about gains and losses being deferred. End-users and dealers were required to report derivatives at fair value, which is marked-to-market. Under FAS 133, all derivatives, including credit derivatives, must be reported as either assets or liabilities on the balance sheet and must be carried at fair value.⁽¹³⁴⁾ The new accounting standard significantly changes the accounting for derivatives used for hedging purposes and for financial instruments with certain types of embedded derivatives.⁽¹³⁵⁾ An institution may elect to use "hedge accounting", which is a special accounting treatment designed to enable an institution to recognize related fair value gains and losses simultaneously in income.⁽¹³⁶⁾ Hedge accounting is only available for certain derivatives that meet specific qualifying criteria. If certain conditions are met, a derivative may be specifically designated as a "fair value hedge", a "cash flow hedge", or a "foreign currency hedge".⁽¹³⁷⁾ The accounting for changes in the fair value of a derivative (that is gains or losses) depends on the intended use of the derivative and the resulting designation.⁽¹³⁸⁾ FAS 133 changes the previous accounting procedure to the extent that any ineffectiveness in a hedge strategy be recognized in income during the current accounting period.⁽¹³⁹⁾ Derivatives used for trading or not qualifying as a hedge will continue to be marked at fair value, with changes in fair value recognized in the current period's net income.⁽¹⁴⁰⁾ FAS 133 establishes three new classifications of hedges, each subject to its own accounting treatment.⁽¹⁴¹⁾ A fair value hedge seeks to offset the risk resulting from changes in the fair value of a recorded asset, liability, or unrecognized firm commitment (a binding agreement to enter into a transaction with an unrelated party).⁽¹⁴²⁾ Under a fair value hedge, the change in fair value (gain or loss) on the derivative is recognized in net income together with any offsetting change in the fair value of the hedged item. The effect is that changes in fair value on both the hedged item and hedging instrument are recognized in the same period and any ineffectiveness of the hedge is reflected in net income.⁽¹⁴³⁾ A cash flow hedge seeks to offset risk resulting from changes in the amount of future cash flows (e.g., interest payment on debt or interest income on loans) or forecasted transaction. Under FAS 133, all hedges of anticipated transactions are considered cash flow hedges.⁽¹⁴⁴⁾ In a cash flow hedge, to the extent the hedge is effective, the gain or loss on the derivative is not initially reported in net income, but instead in a separate component of equity capital (referred to as "accumulated other comprehensive income" in FAS 133).⁽¹⁴⁵⁾ The gain or loss will subsequently be recognized in net income in the period or periods when the transaction being hedged affects net income. The ineffective portion of the cash flow hedge is reported in net income immediately.⁽¹⁴⁶⁾ A foreign currency hedge seeks to offset the risk resulting from changes in foreign currency values. If specified criteria are met, an institution can use a derivative in a foreign currency fair value hedge or cash flow hedge.⁽¹⁴⁷⁾ The accounting for a foreign currency hedge depends on the transaction, but generally will be treated like a fair value hedge or a cash flow hedge.⁽¹⁴⁸⁾ In all cases, FAS 133 requires derivatives designated for hedge accounting to be linked to the specific asset, liabilities, firm commitments, or forecasted transactions being hedged.⁽¹⁴⁹⁾ This transaction-by-transaction approach does not allow hedge accounting if one or more derivatives are used to hedge diverse groups of asset and liabilities.⁽¹⁵⁰⁾ In addition, FAS 133 requires that institutions separately account for certain types of embedded derivatives.⁽¹⁵¹⁾ Embedded derivatives that are not "clearly and closely related" to the economic characteristics and risk of the instruments in which they reside must be separated from the host instrument and reported separately on the balance sheet as a derivative.⁽¹⁵²⁾ FAS 133 indicates that if a derivative cannot be reliably measured (which may be the case for complex embedded derivatives), the entire instrument should be marked-to-market with changes in fair value recognized in net income.⁽¹⁵³⁾

3. Regulatory Reporting Requirements: Call Reports

In their initial guidance on credit derivatives in August, 1996, the federal banking agencies required banks engaged into credit derivative activities to report credit derivatives in the Reports of Condition and Income (Call Reports).⁽¹⁵⁴⁾ On December 31, 1996, the FDIC issued revisions to the Call Reports for 1997 introducing credit derivatives as new items to be included in the reports by banks.⁽¹⁵⁵⁾ Banks that extend credit protection through credit derivatives are required to include the notional amount of all credit derivatives and the credit equivalent amounts of these contracts on which the reporting bank is the guarantor. Beneficiary banks that purchase credit protection through a credit derivative transaction must report the notional amounts of all credit derivatives on which the bank is the beneficiary. In addition, beneficiary institutions must continue to report the amount and nature of the underlying asset for regulatory reporting purposes, without regard to the credit derivative transaction.⁽¹⁵⁶⁾ All underlying assets must continue to be reported in the category appropriate for that transaction and obligor.⁽¹⁵⁷⁾ The implementation of FAS 133 requires institutions to include changes in fair value of certain derivatives in net income. Under FAS 133, the effective portion of the change in the fair value of derivatives used in certain types of hedges (cash flow hedges) is excluded from net income and reflected on the balance sheet in a separate component of equity (referred to as "accumulated other comprehensive income"). Banks should report these accumulated changes in fair value on the same Call Report.⁽¹⁵⁸⁾ Banks must also report the year-to-date change in these accumulated net gains (or losses).⁽¹⁵⁹⁾ Derivatives held for purposes other than trading must be reported at fair value as appropriate.⁽¹⁶⁰⁾

V. LENDING LIMITS

Federal banking agencies emphasized that entering into a credit derivative transaction as a provider of credit protection is similar to providing a letter of credit or granting a loan.⁽¹⁶¹⁾ A bank providing credit protection through a credit derivative can become as exposed to the credit risk of the reference asset as it would if the asset were on its own balance sheet.⁽¹⁶²⁾ Banking supervisors consider this exposure as if it were a letter of credit or other off-balance sheet guarantee. Banking supervisors are instructed to consider such exposure when evaluating concentrations of credit. Except for this more general risk management guidance federal regulators and federal banking agencies have not addressed the issue of mandatory lending limits for banks providing credit protection through credit derivatives. 12 C.F.R § 32 provides for lending limits applicable to bank loans. Under the current provisions it is not clear, whether a party to a credit derivative transaction buying credit protection through a credit derivative is a "borrower" within the meaning of 12 C.F.R § 32.2 (a), which provides, that borrower is one who is named as a borrower or debtor in a loan extension or credit, or who is deemed to be a borrower if he receives a direct benefit from a loan or extension of credit, or where a common enterprise is deemed to exist.⁽¹⁶³⁾ Credit derivatives could also be deemed loans or extensions of credit under 12 C.F.R. § 32.2 (I), whereas loans and extensions of credit include contractual commitments to advance funds, such as a bank's obligation to guarantee or act as surety for the benefit of a person, or to advance funds under a standby letter of credit, or other similar arrangement. 12. C.F.R. § 32.2 (p) defines standby letters of credit as any letter of credit, or similar arrangement, that represents an obligation to the beneficiary on the part of the issuer. It is not clear whether credit derivatives must be deemed a "guarantee" or "standby letter of credit" or "similar arrangement" within the meaning of 12 C.F.R. §§ 32.2, 32.3, and a bank providing credit protection through a credit derivative be subject to statutory lending limits. Given their similarity to guarantees and standby letters of credit, one could reasonably consider credit derivative agreements as "similar arrangements".

VI. STANDARDIZED DOCUMENTATION

Privately negotiated derivatives such as credit derivatives are largely documented in standard master agreements. The purpose of master agreements is to provide for standard contract forms applicable as a base structure for virtually any OTC derivative product.⁽¹⁶⁴⁾ Standard documentation for derivatives activities has been available in the industry since the late 1980s. Various industry groups have issued standard master agreements.⁽¹⁶⁵⁾ Standardized and generally accepted documentation is useful and important in various ways: it can reduce legal risk, especially in cross-border transactions, e.g., by providing clear and precise terminology and definitions and reducing risk of incompatibility of laws of different jurisdictions; and, it enhances market transparency by reducing confusing variety of documentation. Master agreements are generally perceived as an effective tool to better manage credit risk, which allow for acceleration and close-out netting in the event of default.⁽¹⁶⁶⁾ The credit derivative market is still relatively new and limited compared to more traditional derivative activities. The International Swaps and Derivatives Association (ISDA), which, through various publications, has been considered a trendsetter in the derivatives arena by developing master agreements, has developed standard documentation for some types of credit derivatives.⁽¹⁶⁷⁾ The 1992 ISDA Master Agreements have been amended to cover credit default swap transactions.⁽¹⁶⁸⁾ Another important publication by ISDA is the Credit Derivative Long Form Confirmation (which has been partly reformulated in 1999 to reflect the events in Russia and Korea, where, among others, controversy arose regarding dispute resolution mechanisms contained in the previous version of the Long Form Confirmation and certain credit events, delivery and notice provisions). Standard confirmation documents reduce legal risk of unenforceability of oral contracts (statute of frauds), where recorded telephone conversation may provide insufficient evidence of a contract.⁽¹⁶⁹⁾ The latest publication by ISDA are the 1999 Credit Derivatives Definitions for credit default swaps which were incorporated into the 1999 Confirmation Short Form.⁽¹⁷⁰⁾ The 1999 Credit Derivatives Definitions are intended to primarily apply for contracts between credit default swaps parties written under ISDA Master Agreements. The definitions apply to both sovereign and non-sovereign transactions. ISDA is currently working on definitions for total rate of return swaps and third party dispute resolution mechanisms for all types of credit derivatives.

VII. VIEW TO REGULATION OF CREDIT DERIVATIVES IN GERMANY, THE U.K., AND FRANCE

A major concern of financial institutions when entering into credit derivative activities are the capital implications that come along with the business of credit derivatives. In some markets banks cannot be sure of the regulatory capital treatment until they try a deal.⁽¹⁷¹⁾ In Europe, so far, only in Germany, France and the UK have regulators introduced regulatory capital frameworks.⁽¹⁷²⁾ In these countries credit derivatives are often subject to large exposures and million loans reporting regimes.⁽¹⁷³⁾

A. Regulatory Capital Treatment and Large Exposure and Million Loans Reporting in Germany

In Germany, the banking supervisory authority Bundesaufsichtsamt für das Kreditwesen (BAKred) issued comprehensive rules for credit derivatives in June 1999 with respect to their regulatory capital treatment and reporting under the large exposures and million loans reporting regime.⁽¹⁷⁴⁾ The regulations applicable to credit derivatives are based on the current European and international supervisory framework.⁽¹⁷⁵⁾ The rules prevail on the principle of the counting of each risk asset on an individual basis.⁽¹⁷⁶⁾ Risk-reducing effects are not considered beyond a certain level inherent in the current capital requirements. If the risk structure of individual institutions deteriorates noticeably owing to an concentration of credit risk, higher capital requirements might be imposed.⁽¹⁷⁷⁾ Credit derivatives are to be allocated to the trading or to the banking book. An allocation to the trading book is only possible for those total return or credit default swaps that meet the definition of derivatives as provided in section 1 (11) German Banking Act (KWG), i.e., the reference assets of which are securities or money market instruments, or the reference assets of which are claims meeting the requirements for inclusion in the trading book according to KWG section 1 (12), i.e., which are held with a view to reselling them for profit and are marked to market on a daily basis.⁽¹⁷⁸⁾ Risk mitigating effects of credit derivatives will only be recognized for regulatory capital treatment in risk weighted assets if the terms of the credit derivative lead to a sufficient transfer of credit risks. A general requirement for the recognition of a risk-reducing effect of credit derivatives when weighting the protected risk assets or market risk positions of the protection buyer is that the credit or market risks are transferred to the protection seller in a "verifiable and effective manner", i.e., it must be ensured that the factors which are of importance for the valuation of the asset to be protected, including, e.g., political risks, are considered in the specification of the credit event.⁽¹⁷⁹⁾ As a minimum requirement, the insolvency of the reference debtor must be assigned for credit event. The rules provide for minimum qualitative requirements of the supporting documentation.⁽¹⁸⁰⁾ For the recognition of risk mitigating effects, given the specification of the credit event, the reference asset and the asset to be protected must be identical as regards the credit risk and the market risk.⁽¹⁸¹⁾ For credit derivatives assigned to the banking book a securing effect on a risk asset is only recognized, if the reference asset underlying the derivative (i) is owned by the same person as the risk asset in question; (ii) may not have priority over this risk asset in case of the debtors insolvency; and, (iii) is linked with the risk asset by corresponding contractual clauses in respect of the triggering credit event.⁽¹⁸²⁾ To be recognized for regulatory capital purposes, generally, the risk asset to be protected must be secured by a credit derivative for its entire residual maturity.⁽¹⁸³⁾ In case of maturity mismatches between the underlying asset to be protected and the credit derivative the credit risk for the unprotected future period remains with the protection buyer, and does not lead to a capital relief in these cases.⁽¹⁸⁴⁾ A securing effect is only recognized for the period over which the underlying risk asset is protected, provided the credit derivative has a residual maturity of at least one year.⁽¹⁸⁵⁾ In cases of maturity mismatches, where the residual maturity of the credit derivative is less than one year, no capital relief is available.⁽¹⁸⁶⁾ For credit derivatives assigned to the trading book capital charges are generally calculated for the general and the specific market risk on the basis of net positions.⁽¹⁸⁷⁾ Offsetting positions might be, if specified conditions are met, considered for risk weighting purposes.⁽¹⁸⁸⁾ For credit derivatives held in the banking book, generally, no additional consideration of the counterparty risk is required, with an exception for total rate-of-return swaps.⁽¹⁸⁹⁾ In the case of credit derivatives held in the trading book, both the seller and the buyer of credit protection may be affected by a failure of the counterparty, with varying degree, depending on the particular transaction structure. Therefore, generally, both parties must weight their counterparty risk for credit derivatives held in trading books.⁽¹⁹⁰⁾ Under the provisions governing the large exposures, a buyer of credit protection, different from the seller of credit protection, generally, must not charge his large exposure limits.⁽¹⁹¹⁾ For the protection seller there are two exposures resulting from a total rate-of-return swap, one to the protection buyer, and one to the debtor of the reference asset. The protection seller must charge his large exposure limits in respect of both counterparties correspondingly.⁽¹⁹²⁾ Under the provisions governing million loans reporting, the protection buyer, in contrast to the large exposure regime, must report the loan protected by a credit derivative fully. The exposure to the protection seller from a total rate-of-return or credit default swap must be reported if their securing effect is taken account of in the large exposure regime, i.e., in case of an incomplete hedge, the credit derivative is not considered a loan.⁽¹⁹³⁾ The protection seller must, analogous to the provisions in the large exposure regime in the case of a total rate-of-return swap and credit linked notes, report two exposures: (i) with regard to the protection-buying issuing institution and (ii) to the reference debtor.⁽¹⁹⁴⁾

B. Regulatory Capital Treatment and Large Exposures Reporting in the U.K.

On June 1, 1999, the Bank of England Act 1998 came into force which transferred responsibility for banking supervision in the UK from the Bank of England to the Financial Services Authority (FSA).⁽¹⁹⁵⁾ On June 30, 1998, the FSA introduced comprehensive rules for regulatory capital treatment and large exposure reporting of credit derivatives.⁽¹⁹⁶⁾ The rules and principles, applicable to credit derivatives, may partially differ from the ones issued by the BAKred outlined above (e.g., in establishing risk weights for capital charges). Generally, Credit derivatives must meet the standard criteria applied to other financial instruments in order to be eligible to be held in a bank's trading book. The standard criteria include the ability of the bank to mark-to-market positions on a daily basis, and demonstration of trading intent.⁽¹⁹⁷⁾ Credit derivatives not included in the trading book must be assigned to the banking book.⁽¹⁹⁸⁾ The rules provide a detailed description of the qualitative requirements for recognition of effective risk transfer from the protection buyer to the protection seller of credit derivatives held in the banking book or banks that sell credit risk in the trading book. For credit derivatives held in the banking book, the protection seller of a credit default or total rate-of-return swap acquires exposure to the reference asset only, the exposure resulting thereof is recorded as a direct credit substitute weighted according to the risk weight of the reference asset.⁽¹⁹⁹⁾ Through a credit linked note, the bank providing credit protection acquires exposure to the reference asset, and also to the credit derivative counterparty.⁽²⁰⁰⁾ This exposure is recorded at the higher of the risk weights of the reference obligor and the counterparty.⁽²⁰¹⁾ Section 4 of the Supervisory Chapter on Credit Derivatives sets out the capital treatment applicable to credit derivatives in the trading book. Section 7 provides complex rules regarding the treatment of specific, general market, and counterparty risk exposure from various types of credit derivatives held in the trading book.⁽²⁰²⁾ In the banking book, protection bought using a credit spread option is ignored for capital purposes.⁽²⁰³⁾ Protection sold using credit spread options must be recorded as a direct credit substitute.⁽²⁰⁴⁾ Depending on the risk effectively transferred, banks are subject to large exposures reporting for credit derivatives and the underlying assets.⁽²⁰⁵⁾

C. Regulatory Capital Treatment in France

In April 1998, the French banking supervisory authority Commission Bancaire issued interim rules on the prudent treatment of credit derivatives.⁽²⁰⁶⁾ Under the interim rules, credit derivatives will be allocated to the trading book if the instruments are held with an intention to sell, and are tradeable instruments which are marked-to-market on daily basis.⁽²⁰⁷⁾ Institutions engaging into credit derivative activities must have sufficient expertise on the derivatives markets, and must have sufficient valuation models in place and access to the relevant market and information networks.⁽²⁰⁸⁾ The seller of credit protection reports the exposure as a direct credit substitute weighted according to the risk weight of the underlying asset.⁽²⁰⁹⁾ For the buyer of credit protection the capital charges may be reduced if the institution providing the credit protection is a bank, or an investment firm registered either in France or any other country of the European Economic Area (EEA).⁽²¹⁰⁾ Where the residual maturity of the credit derivative is less than one year the risk mitigating effect will not be recognized for regulatory capital purposes.⁽²¹¹⁾ In case of maturity mismatches between the credit derivative and the protected underlying asset, risk mitigating effects will only be recognized for the time of effective credit protection.⁽²¹²⁾ In the case of credit derivatives held in the trading book, the seller of risk protection is subject to capital charges for general and specific market risk.⁽²¹³⁾ The buyer of credit protection through a credit derivative held in the trading book is generally not eligible for reduced capital charges.⁽²¹⁴⁾ Under certain credit derivative transactions both the seller and the buyer of credit protection may be subject to counterparty risk and therefore subject to additional capital charges ("add-ons").⁽²¹⁵⁾

_________________

1. William F. Kroener III, Federal Deposit Insurance Corporation Washington, D.C., SELECT TOPICS OF CURRENT IMPORTANCE: THE FDIC PERSPECTIVE, published in American Law Institute - American Bar Association Continuing Legal Education ALI-ABA Course of Study, May 15, 1997, Banking and Commercial Law.

2. Federal Deposit Insurance Corporation, FIL-62-96, SUPERVISORY GUIDANCE FOR CREDIT DERIVATIVES, August 19, 1996 (thereafter "FDIC FIL-62-96").

3. Greg Whittaker and Joyce Frost, AN INTRODUCTION TO CREDIT DERIVATIVES, Journal of Lending & Credit Risk Management, Vol. 79, No. 9, May 1, 1997. Credit risk exposure resulting from the extension of credit protection through credit derivatives is often hedged in so called "back-to-back" transactions by means of credit derivatives.

4. Ronit Ghose, MARKET MONITOR, CREDIT DERIVATIVES, TRADING BOOK OR BANKING BOOK?, Euromoney Magazine, February 15, 1997; Joseph Asher, CREDIT DERIVATIVES: A RED-HOT GROWTH AREA, ABA Banking Journal Vol. 90, No. 8, August 1, 1998; though London is said to be the leading market for credit derivatives today the largest U.S. commercial banks and trust companies are among the important market players.

5. Joseph Asher at FN 4: J.P. Morgan reportedly held the market lead among U.S. financial institutions in credit derivatives by midst of 1998, followed, among others, by Nationsbank, Bank of America and Bankers Trust. See Ronit Ghose at FN 4.

6. Carol M. Beaumier, ACTIVE CREDIT PORTFOLIO MANAGEMENT MAY AVERT SERIOUS LOAN PROBLEMS, Banking Policy Report, December 1, 1997 (commenting on the usefulness of credit derivatives in modern active portfolio management).

7. Sangkyun Park, CREDIT RISK, ABA Banking Journal, Vol. 90, No. 8, August 1, 1998.

8. Reliable data on credit derivatives activities became first available to the federal banking supervisors in the forth quarter of 1997 as a result of the Revision of the Reports of Condition and Income (Call Reports) for 1997 in December 1996, which required banks to include qualitative and quantitative information in the quarterly year reports.

9. Christian Porath, German credit derivatives specialist at Credit Suisse Financial Products (CSFP), commenting on the situation among German banks in the aftermath of the meltdown of Asian financial markets in late 1997, and the heavy losses suffered from credit derivatives in risky emerging-market debt, CREDIT DERIVATIVES, GETTING HOOKED ON CREDIT DERIVATIVES, Euromoney Magazine, February 10, 1999. German Landesbanken, for example, diversified loan portfolios which concentrated on regional and public-debt sector borrowers into emerging-market debt in Asia and had to take heavy losses.

10. William F. Kroener. See FN 1.

11. John Finnerty, PricewaterhouseCoopers, COMMENT: RUSSIAN SETTLEMENTS WILL PUT CREDIT DERIVATIVES TO THE TEST, American Banker, Vol. 163, No. 231, December 4, 1998. The author reports as much as $10 billion dollars of credit derivative agreements pending in legal disputes. The two basic structures of credit derivatives used in Russia are credit swaps, which let Western investors get the higher returns of Russian bonds while insulating themselves from the risk of a government default, and credit derivatives in the form of structured notes, combining a credit swap with a conventional bond or note, where the credit swap pays off by reducing the amount the issuer of the note must repay.

12. Susan M. Phillips, LESSONS AND PERSPECTIVES REMARKS BY SUSAN M. PHILLIP MEMBER, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM BEFORE THE INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION 13TH ANNUAL GENERAL MEETING ROME, ITALY, March 26, 1998: "... Credit derivatives are one of the most interesting products developed in the OTC derivative market in quite some time. They offer means for counterparties to directly adjust credit exposures to specific firms or to diversify industry or geographic concentrations. Their potential is enormous because credit risk is the major risk faced by financial service firms. ...". For similar references see: Board of Governors of the Federal Reserve Board: SR 96-17 (GEN): SUPERVISORY GUIDANCE FOR CREDIT DERIVATIVES, issued on August 12, 1996 (thereinafter "FRB SR 96-17"); Office of the Comptroller of the Currency,: OCC Bulletin 96-43, CREDIT DERIVATIVES DESCRIPTION: GUIDELINES FOR NATIONAL BANKS, issued on August 12, 1996 (thereinafter "OCC 96-43"); FDIC FIL-62-96, see at FN 2. Recognition of credit derivatives as modern sophisticated risk management tools in recent publications by the Basle Committee on Banking Supervision and/or the Technical Committee of the International Organization of Securities Commission (IOSCO): FRAMEWORK FOR SUPERVISORY INFORMATION ABOUT DERIVATIVES AND TRADING ACTIVITIES, September, 1998; A NEW CAPITAL ADEQUACY FRAMEWORK, June 1999; PRINCIPLES FOR THE MANAGEMENT OF CREDIT RISK, July, 1999; SOUND PRACTICES FOR LOAN ACCOUNTING AND DISCLOSURE, July, 1999. The reports are available on the Web site of the Bank for International Settlements (BIS), http://www.bis.org, and the Web site of IOSCO, http://www.iosco.org.

13. John Finnerty, PricewaterhouseCoopers, COMMENT: RUSSIAN SETTLEMENTS WILL PUT CREDIT DERIVATIVES TO THE TEST, American Banker, Vol. 163, No. 231, December 4, 1998: "... Nonstandard language is the norm in many Russian-risk credit derivative agreements ..." .

14. Bruce Kayle, WILL THE REAL LENDER PLEASE STAND UP? THE FEDERAL INCOME TAX TREATMENT OF CREDIT DERIVATIVE TRANSACTIONS, Tax Lawyer, Spring, 1997: "... the variations in transactions called credit derivatives are sufficient as to make misleading, particularly from the perspective of tax analysis, the use of a single term to describe them all ...".

15. William F. Kroener III, see at FN 1; see also Bruce Kayle at FN 14. Common forms of credit embedded securities are so called "Credit Linked Structured Notes". Several providers of credit derivatives products maintain Web sites on credit derivative products with more or less comprehensive descriptions of their products (e.g., Rabobank International, Web site: http://www.treasury-management.com).

16. Various authors have described the most common types of credit derivatives in great detail, e.g.,Bruce Kayle, see at FN 14; David S. Miller, AN OVERVIEW OF THE TAXATION OF CREDIT DERIVATIVES, Practicing Law Institute, Tax Law and Estate Planning Course Handbook Series, Tax Law and Practice, PLI Order No. J0-000C, October-November, 1998. Federal banking regulators have described some of the basic forms of credit derivatives in their initial guidance issued in 1996: see Board SR 96-17, OCC 96-43 at FN 12; and FDIC FIL-62-96 at FN 2.

17. Terms and Conditions as suggested in the International Swaps and Derivatives Association, Inc., (ISDA) publications 1999 ISDA Credit Derivatives Definitions ("the Definitions") and Short Form Confirmation For Use With 1999 Credit Derivatives Definitions ("the Confirmation"), both issued in 1999. The Confirmation is available on the ISDA Web site: http://www.isda.org. The Definitions are available from ISDA upon request (order form on ISDA Web site).

18. OCC 96-43. See FN 12.

19. A good description of total rate-of-return swaps is provided in FRB SR96-17 and FDIC FIL-62-96; See at FN 12 and 2.

20. Id.

21. Id.

22. Id.

23. OCC 96-43. See FN 12.

24. See also Gregg Whittaker and Joyce Frost at FN 3.

25. OCC 96-43. See FN 12.

26. Gregg Whittaker and Joyce Frost, see FN 3. The authors describe the difference between a CDO and a Credit Spread Option: A credit spread option may be cash settled: The option seller agrees to pay a final amount which is greater of zero, or the difference between the spread over a reference interest rate (i.e.,LIBOR) of a reference asset on a particular trade date and the spread over a reference interest rate of the reference asset on exercise date. In case of physical settlement the option buyer puts the reference asset to the option seller at par.

27. OCC 96-43. See FN 12.

28. OCC 96-43. See FN. 12.

29. Id.

30. A description of a typical CLSN structure provided by Gregg Whittaker and Joyce Frost introducing the Chase Secured Loan Trust Notes (CSLT), see FN 3: ... The CSLT is an investment-grade debt security of a trust entity that provides high yields and leveraged upside and limited downside returns relative to a diversified bank loan portfolio. The trust uses the note proceeds to purchase Treasury securities that are then used to collateralize the effective purchase of bank loans. From an economic perspective, the note holders are long both the Treasuries and the underlying bank loans. The collateralization may be as low as 14%, allowing investors to achieve an upside leverage of up to 7-to-1, with yields topping 15% per annum. However there are no margin calls with a CSLT, so the investor can lose no more than the initial investment amount ...". The authors give an example suggesting the effectiveness of credit linked structured notes for yield enhancement purposes: "... a bank purchases a $14.3 million note, issued by a trust, which uses the note proceeds to purchase Treasury notes (T-notes) yielding 6.5%. The T-notes are then pledged to the creditor as collateral for a swap paying the total return on a $100 million loan portfolio that yields LIBOR plus 250 basis points assuming seven times leverage. In consideration, the trust makes a swap payment of LIBOR plus 100 basis points to the creditor ... . The swap spread of 150 basis points on $100 million notional is leveraged seven times to 10.5% in respect to the note holder's $14.3 million investment. Add to this the 6.5% T-note yield, and the CSLT generates a yield of 17%. ...".

31. OCC 96-43. See FN 12.

32. Carol M. Beaumier. See FN 6.

33. OCC 96-43. See FN 12.

34. Remarks by Ricki Helfer Chairman Federal Insurance Corporation before a Symposium on Credit Derivatives Sponsored by the FDIC in Arlington, VA, on April 4, 1997 (FDIC Web site: http://www.fdic.gov). In a supervisory letter by the Federal Reserve banks are explicitly required to incorporate the full range of risks of their secondary market credit activities, including credit derivative activities, into their overall risk management systems, Board of Governors of the Federal Reserve SR 97-21, RISK MANAGEMENT AND CAPITAL ADEQUACY OF EXPOSURES FROM SECONDARY MARKET ACTIVITIES, July 11, 1997.

35. OCC 96-43. See FN 12.

36. Global Derivatives Study Group, DERIVATIVES: PRACTICES AND PRINCIPLES, published by the Group of Thirty, Washington, DC, July, 1993 (thereinafter "Group of Thirty Report"). The risk management principles regarding OTC derivatives, which have evolved over the years, are to a great extent equally applicable for credit derivatives transactions.

37. Comptroller of the Currency Banking Circular BC-277, RISK MANAGEMENT OF FINANCIAL DERIVATIVES, issued on October 27, 1993 (thereinafter "OCC BC-277"); since followed by numerous supervisory letters and circulars on the same and related issues.

38. OCC 96-43. See FN 12.

39. FRB SR 96-17. See FN 12.

40. FDIC FIL-62-96. See FN 2.

41. In early 1999 the Counterparty Risk Management Policy Group (CRMPG), upon the endorsement of Chairman Greenspan, Chairman Levitt and Secretary Rubinstein, was formed of 12 major commercial and investment banks to perform a study on enhanced strong practices in counterparty credit and market risk management. CRMPG issued a report, Counterparty Risk Management Policy Group, IMPROVING COUNTERPARTY RISK MANAGEMENT PRACTICES, June, 1999. (thereinafter "CRMPG Report"). The authors note that leverage is not a separate risk category but inherent and interrelated with credit risk and market risk.

42. OCC 96-43. See FN 12.

43. Basle Committee on Banking Supervision, PRINCIPLES FOR THE MANAGEMENT OF CREDIT RISK. See FN 12. Risks inherent in OTC-derivatives activities and their proper management have been described in great detail by various banking and securities regulators and supervisors and in reports issued by industry participants. See, for example, Group of Thirty Report, see FN 36; Treasury Management Association, VOLUNTARY PRINCIPLES AND PRACTICES GUIDELINE FOR END-USERS OF DERIVATIVES, developed by the Government Relations Committee of the Treasury Management Association, October 1995; Derivatives Policy Group, FRAMEWORK FOR VOLUNTARY OVERSIGHT - A FRAMEWORK FOR VOLUNTARY OVERSIGHT OF THE OTC DERIVATIVES ACTIVITIES OF SECURITIES FIRM AFFILIATES TO PROMOTE CONFIDENCE AND STABILITY IN FINANCIAL MARKETS, March 1995; Guidelines of the Federal Reserve, PRINCIPLES AND PRACTICES FOR WHOLESALE FINANCIAL MARKET TRANSACTIONS; CRMPG Report, see FN 41; OCC BC-277, see FN 37.

44. Id.

45. The Technical Committee of IOSCO is a committee of the supervisory authorities for securities firms in major industrialized countries. It consists of senior representatives of the securities regulators from Australia, France, Germany, Hong Kong, Italy, Japan, Mexico, Ontario, the Netherlands, Quebec, Spain, Sweden, Switzerland, the United Kingdom, and the United States.

46. Joint Report by the Basle Committee on Banking Supervision and the Technical Committee of the International Organization of Securities Commissions ("IOSCO"), FRAMEWORK FOR SUPERVISORY INFORMATION ABOUT DERIVATIVES AND TRADING ACTIVITIES, September, 1998. See also FN 12.

47. A significant risk inherent in credit risk is concentration risk, which may occur in large concentrations of credit exposure to individual borrowers, specific areas, or, specific industries. Federal banking agencies have advised, that since nongovernmental guarantees do not reduce credit concentrations, a credit derivative will increase the beneficiary's concentration exposure to the guarantor, or provider of credit protection, without reducing concentration risk of the underlying borrower. FDIC FIL-62-96 and OCC-96-43. See at FN 2 and 12.

48. Id.

49. OCC 96-43. See FN 12.

50. The FDIC's statement suggests such treatment at least as appropriate. FDIC FIL-62-96. See FN 2.

51. OCC 96-43. see FN 12.

52. OCC BC-277. See FN 37.

53. OCC 96-43. See FN 12.

54. Joint Report by the Basle Committee on Banking Supervision and the Technical Committee of the International Organization of Securities Commissions ("IOSCO") FRAMEWORK FOR SUPERVISORY INFORMATION ABOUT DERIVATIVES AND TRADING ACTIVITIES September, 1998. See FN 12. See also CRMPG Report at FN 41.

55. Id.

56. Id.

57. Id.

58. CRMPG Report. See FN 41.

59. Id. The report stresses the awareness of counterparties on leverage as a primary source of problems when engaging with intermediaries in OTC derivative transactions. It furthermore contains a description of the interrelated criteria of leverage: "Leverage is generally considered to exist when: (I) an institution's financial assets exceed its capital; (ii) an institution is exposed to the change in value of a position beyond the amount, if any, initially paid for the position; or (iii) an institution owns a position with "embedded leverage", i.e., a position with a price volatility exceeding that of the underlying market factor."

60. OCC 96-43. See FN 12.

61. CRMPG Report. See FN41.

62. See Group of Thirty Report at FN 36. Legal counsel should review contract terms to determine their legality and enforceability (e.g., some jurisdictions provide for Gaming and so called "Bucket Shop" laws, which might render agreements legally unenforceable). Legal uncertainty remains in the U.S., whether certain types of privately negotiated credit derivatives could be considered "illegal off-exchange futures" contracts, subject to the provisions of the Commodity Exchange Act (CEA) and therefore be unenforceable when challenged. Issues relating to the remaining legal uncertainty of OTC derivatives in the U.S. under the Commodity Exchange Act ("CEA") have been discussed in great detail by Federal Agencies: See United States General Accounting Office, THE COMMODITY EXCHANGE ACT - ISSUES RELATED TO THE COMMODITY FUTURES TRADING COMMISSION'S REAUTHORIZATION, Report to Congressional Committees, Washington, DC, May 5, 1999; and, Report of The President's Working Group on Financial Markets, OVER-THE COUNTER DERIVATIVES MARKETS AND THE COMMODITY EXCHANGE ACT, Washington, DC, November, 1999. Both reports are available under the Treasury Web site, http://www.ustreas.gov.

63. Treasury Management Association, VOLUNTARY PRINCIPLES AND PRACTICES GUIDELINES FOR END-USERS OF DERIVATIVES. See FN 43.

64. Id.

65. Guidelines of the Federal Reserve PRINCIPLES AND PRACTICES FOR WHOLESALE FINANCIAL MARKET TRANSACTIONS. See FN 43.

66. Group of Thirty Report. See FN 36.

67. OCC 96-43. See FN 12.

68. OCC 96-43. See FN 12.

69. Id.

70. CRMPG Report. See FN 41.

71. OCC 96-43. See FN 12.

72. Comptroller of the Currency Comptroller's Handbook, RISK MANAGEMENT OF FINANCIAL DERIVATIVES, Washington, DC, October, 1994.

73. OCC 96-43. See FN 12.

74. Id. See also Basle Committee on Banking Supervision, AMENDMENT TO THE CAPITAL ACCORD TO INCORPORATE MARKET RISKS, January, 1996, identifying general market risk and specific risk inherent both in interest rate risk and equity position risk.

75. Office of the Comptroller of the Currency, Treasury, Board of Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation, RISK-BASED CAPITAL STANDARD: MARKET RISK, September 6, 1996 (61 FR 47358; codified under 12 CFR Part 3, 12 CFR Parts 208 and 225, 12 CFR Part 325).

76. Group of Thirty Report. See FN 36.

77. OCC-96-43. See FN 12. OCC BC-277. See FN 37. CRMPG Report recommends, that institutions, when stress testing, should estimate both market and credit risks. Tests should assess: (I) concentration risk both to a single counterparty and to groups of counterparties; (ii) correlation risks among both market risk factors and credit risk factors; and (iii) risk that liquidating positions could move the market. See FN 41.

78. Group of Thirty Report. See FN 36.

79. Id. See also federal banking agencies rules regarding regulatory capital treatment of credit derivatives and the use of internal risk measurement systems to measure market risk and to calculate value-at-risk (VAR) capital charges 61 FR 47358, see at FN 75; and amendment RISK-BASED CAPITAL STANDARD: MARKET RISK, December 30, 1997 (62 FR 68064).

80. OCC 96-43. See FN 12.

81. Id.

82. Chester B. Feldberg, Executive Vice President in the banking supervision group at the New York Federal Reserve Bank, during a conference in New York on February 24 and 25, 1998, organized by the Fed, the Bank of England and the Bank of Japan, stressing the focus on regulatory capital standards and noting that credit risk is the number one risk for banks and highlighting the significance of risk management and the impact of credit derivatives. See also Laura Mandaro, REGULATORY COMPLIANCE WATCH, American Banker, March 9, 1998, Vol. 9, No. 10; Ricki Helfer, chairman Federal Deposit Insurance Corporation, stressing the importance of sound risk management policies and procedures and the importance of appropriate capital requirements, REMARKS BY RICKI HELFER, CHAIRMAN FEDERAL DEPOSIT INSURANCE CORPORATION BEFORE A SYMPOSIUM ON CREDIT DERIVATIVES BY THE FDIC, Arlington, VA, April 4, 1997; Remarks by senior OCC officials at a EUDA meeting in Washington, D.C., on April 10, 1996, whereas the OCC focuses on three areas of concerns: risk management, information reporting, and capital adequacy, all of which, the OCC finds, are interrelated and must be viewed as a whole, OCC PLANS ADDITIONAL GUIDANCE ON BANK'S USE OF FINANCIAL DERIVATIVES, 66 Banking Rep. (BNA) 627, April 15, 1996; Remarks by James Garner, outlining the Federal Reserve System practices of supervision by risk and implementing risk-focused examinations and that the greater verification of risk management processes will result in less transaction testing by examiners, James Garner, Federal Reserve, and James L. Gertie, Bank of Boston, REGULATORY PERSPECTIVE FROM THE FEDERAL RESERVE AND BANK OF BOSTON, The Journal of Lending & Credit Risk Management, January 1, 1997, Vol. 79, No. 5.

83. Basle Committee on Banking Supervision, INTERNATIONAL CONVERGENCE OF CAPITAL MEASUREMENT AND CAPITAL STANDARDS (BASLE CAPITAL ACCORD), Basle, July, 1988. The Basle Committee on Banking Supervision comprises representatives of the central banks and supervisory authorities of the Group of Ten countries (Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, United Kingdom, United States) and Luxembourg. The Committee meets at the Bank for International Settlements (BIS), Basle, Switzerland.

84. Minimum capital requirements have been codified under 12 CFR Parts 3, 208, 225, and 325.

85. Office of the Comptroller of the Currency, Department of the Treasury, Federal Deposit Insurance Corporation, Board of Governors of the Federal Reserve System, RISK-BASED CAPITAL STANDARDS: DERIVATIVE TRANSACTIONS, September 5, 1995 (60 FR 46,170) (codified at 12 CFR Parts 3, 208, 225, and 325) and amendment, RISK-BASED CAPITAL STANDARDS: MARKET RISK, September 6, 1996 (61 FR 47,358) (codified at 12 CFR Parts 3, 208, 225, and 325). See also FN 75 and 79.

86. Basle Committee on Banking Supervision, AMENDMENT TO THE CAPITAL ACCORD TO INCORPORATE MARKET RISK, Basle, January, 1996. The amendments introduced a measurement for market risk arising from trading activities. Market risk should be measured as general and specific market risk, whereby qualifying financial institutions, upon approval by the bank's supervisory authority, will be permitted to calculate specific risk using an internal model, rather than being subject to standard specific risk capital charge. The report proposes qualitative and quantitative criteria for internal models. Only those banks whose internal models are in full compliance with the qualitative and quantitative criteria shall be eligible for application of the minimum multiplication factor to establish the specific market risk capital charge.

87. Federal banking agencies defined significant trading activities as including any bank whose trading activity on a worldwide consolidated basis equals 10 percent or more of its total assets, or equals $1 billion or more.

88. The agencies risk-based capital guidelines provide for a detailed description of the calculation of the market risk capital charges, 61 FR 47,358. See at FN 85.

89. Id. Qualitative requirements provide for example that a bank's risk control must be independent, and report directly to senior management. A bank's internal risk measurement model must be integrated into its daily management process. A bank's policies and procedures must include stress testing and backtesting. A bank must conduct independent reviews of risk measurement and management systems at least annually. Qualitative requirements provide, for example, that VAR must be calculated daily on a 99%, one-tailed confidence level with a price shock equivalent to a 10-business day movement in prices and rates.

90. Id.

91. Office of the Comptroller of the Currency, Department of Treasury, Board of Governors of the Federal Reserve System, and Federal Deposit Insurance Corporation, RISK-BASED CAPITAL STANDARDS: MARKET RISK, December 30, 1997 (62 FR 68,064) (to be codified at 12 CFR Parts 3, 208, 225, and 325).

92. These amendments incorporate the Basle Committee's determination, that, since the Committee had adopted its market risk amendment, many institutions have significantly improved their risk modeling techniques, and, in particular, their modeling of specific risk. Thus, the use of the minimum specific risk charge and the burden of a separate calculation can be eliminated. Basle Committee on Banking Supervision, EXPLANATORY NOTE: MODIFICATION OF THE BASLE CAPITAL ACCORD OF JULY 1988, AS AMENDED JANUARY 1996, Basle, September 1997.

93. OCC 96-43, FRB SR 96-17, see FN 12; FDIC FIL-62-96 see FN 2.

94. OCC 96-43. See FN 12.

95. Id.

96. FRB SR 96-17. See FN 12.

97. Id.

98. Id.

99. Id.

100. Id.

101. Id.

102. Id.

103. Id. The principles as described above are of a very general nature. FRB SR 96-17 provides a detailed description of other transaction structures involving credit derivatives.

104. Board of Directors of the Federal Reserve SR 97-18, APPLICATION OF MARKET RISK CAPITAL REQUIREMENTS TO CREDIT DERIVATIVES, June 13, 1997 ("FRB SR 97-18").

105. Id.

106. Id.

107. Id.

108. FDIC FIL-62-96. See FN 2. FRB SR 96-17. See FN 12.

109. Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve, RISK BASED CAPITAL INTERPRETATIONS CREDIT DERIVATIVES, Joint Agency Statement, November 15, 1999. Attached is a joint issuance, CAPITAL INTERPRETATIONS SYNTHETIC COLLATERALIZED LOAN OBLIGATIONS NOVEMBER 15, 1999, describing the products eligible for this specific risk-based capital treatment, recognizing the risk mitigating effects, the risk-based capital calculation of three broad categories of Collateralized Loan Obligations (CLO), and, minimum conditions that sponsoring institutions must meet to obtain synthetic securitization capital treatment. The joint agency statement and the attachment are available on the OCC/Treasury Web site: http://www.occ.treas.gov.

110. Id.

111. Id.

112. Id.

113. Id.

114. Id.

115. Id.

116. Id.

117. Id.

118. Id.

119. Id.

120. For exact calculations and a more detailed analysis of the risks for the party buying credit risk protection (the sponsoring bank) and the party selling risk protection, see id.

121. The Basle Committee on Banking Supervision issued a consultative paper in June, 1999, for comment by 31 March 1999, that, if implemented, would result in a comprehensive reform of the Basle Accord and that could affect the treatment of CLOs as described by the OCC and FRB in their joint agency statement, Basle Committee on Banking Supervision, A NEW CAPITAL ADEQUACY FRAMEWORK, consultative paper issued by the Basle Committee on Banking Supervision, Basle, June, 1999. The report is available under the BIS Web site: http://www.bis.org.

122. Id.

123. Various reports have also been issued by private groups of market participants to promote voluntary market oversight of OTC derivatives activities emphasizing the importance of public disclosure and reporting. See FN 36 and also FN 43.

124. Joint Report by the Basle Committee on Banking Supervision and the Technical Committee of the International Organization of Securities Commissions ("IOSCO"), FRAMEWORK FOR SUPERVISORY INFORMATION ABOUT DERIVATIVES AND TRADING ACTIVITIES, September, 1998 (see also at FN 12). The Basle Committee and IOSCO have, since their first joint report in 1995, released reports annually on the subject.

125. Basle Committee on Banking Supervision and Technical Committee of the International Organization of Securities Organizations ("IOSCO"), RECOMMENDATIONS FOR PUBLIC DISCLOSURE OF TRADING AND DERIVATIVES ACTIVITIES OF BANKS AND SECURITIES FIRMS, Basle, October, 1999 (see also at FN 12).

126. Recommendations by the Basle Committee and IOSCO, Basle Committee on Banking Supervision and Technical Committee of the International Organization of Securities Commissions (:IOSCO"), RECOMMENDATIONS FOR PUBLIC DISCLOSURE OF TRADING AND DERIVATIVES ACTIVITIES OF BANKS AND SECURITIES FIRMS, Basle, October, 1999 (see also FN 12). The report states, that qualitative disclosures provide management with an opportunity to elaborate on and provide depth to the quantitative disclosures provided in the annual report. Users of financial statements need qualitative information to have the appropriate perspective necessary to understand the numbers reported in financial statements and schedules.

127. Id.

128. Basle Committee on Banking Supervision, SOUND PRACTICES FOR LOAN ACCOUNTING AND DISCLOSURE, Basle, July 1999 (see also at FN 12).

129. See FN 126. The report states that linking public disclosure to internal risk management process helps ensure that disclosure keeps pace with innovations in risk measurement and management techniques.

130. See FN 124.

131. Financial Accounting Standards Board, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, Statement of Financial Accounting Standards No. 133, June, 1998 (FAS 133).

132. Financial Accounting Standards Board, DISCLOSURE ABOUT DERIVATIVE FINANCIAL INSTRUMENTS AND FAIR VALUE OF FINANCIAL INSTRUMENTS, Statement of Financial Accounting Standards No. 119, October, 1994 (FAS 119).

133. Board of Governors of the Federal Reserve System, OVERVIEW OF DERIVATIVES DISCLOSURES BY MAJOR U.S. BANKS, Federal Reserve Bulletin, September, 1995.

134. Office of the Comptroller of the Currency OCC 98-45, ACCOUNTING FOR DERIVATIVES AND HEDGING ACTIVITIES, October 6, 1998 (thereinafter "OCC 98-45").

135. The FDIC emphasized that under the new accounting standards the existing risk-based capital treatment (see supra) for derivatives remains in effect. According to the FDIC, recording a derivative on the balance sheet under FAS 133 will not change the risk-weighted asset amount for that derivative. The FDIC recognizes, though, that the on-balance-sheet reporting of derivatives may affect the total assets of institutions with derivatives, and directly affect the institution's leverage and regulatory capital ratios. Federal Deposit Insurance Coporation FIL-3-99, REGULATORY REPORTING AND CAPITAL GUIDANCE ON THE FINANCIAL ACCOUNTING STANDARDS BOARD'S STATEMENT NO. 133 - DERIVATIVES AND HEDGING, Financial Institutions Letter, January 14, 1999 (thereinafter "FDIC FIL-3-99").

136. OCC 98-45. See FN 134.

137. FDIC FIL-3-99. See FN 135.

138. Id.

139. OCC 98-45. See FN 134.

140. FDIC FIL-3-99. See FN 135.

141. OCC 98-45. See FN 134.

142. Id.

143. FDIC FIL-3-99. See FN 135.

144. Id.

145. Federal Deposit Insurance Corporation, REVISIONS TO THE REPORTS OF CONDITION AND INCOME (CALL REPORT) FOR 1999, Financial Institution Letter, January 21, 1999.

146. Id.

147. OCC 99-45. See FN 134.

148. FDIC FIL-3-99: Attachment PR-92-98. See FN 135.

149. OCC 99-45. See FN 134.

150. Id.

151. FDIC FIL-3-99: Attachment PR-92-98. See FN 135.

152. Id. FAS 133 provides guidance on determining whether an embedded derivative is "clearly and closely" related and various examples of financial instruments that would be considered to have embedded derivatives, including some structured notes that banks often hold in their investment portfolios.

153. OCC 98-45. See FN 134.

154. See OCC 96-43 and FRB SR 96-17, see FN 12; FDIC FIL-62-96, see FN 2.

155. Federal Deposit Insurance Corporation FIL-109-96, REVISIONS TO THE REPORTS OF CONDITION AND INCOME (CALL REPORTS) FOR 1997, December 31, 1996 ("FIL-109-96").

156. FRB SR 96-17. See FN 12. FDIC FIL-62-96. See FN 2.

157. Id.

158. FDIC FIL-3-99. See FN 135. See also Federal Deposit Insurance Corporation FIL-4-99, REVISIONS TO THE REPORTS OF CONDITION AND INCOME (CALL REPORTS) FOR 1999, Financial Institution s Letter, January 21, 1999 ("FIL-4-99").

159. Id.

160. Id.

161. FDIC FIL-62-96. See FN 2. FRB SR 96-17. See FN 12.

162. Id.

163. See 12 C.F.R. § 32.2 (a) (current through November 2, 1999); 12 C.F.R § 32.5 provides that loans or extensions of credit to one borrower will be attributed to another person and each person will be deemed a borrower when a common enterprise exists between the persons. See also William F. Kroener III at FN 1.

164. Clarence B. Manning, A DERIVATIVES PRIMER FOR CORPORATE COUNSEL, OR DO YOU KNOW WHAT YOUR TREASURER IS DOING?, American Corporate Counsel Association, ACCA Docket March/April, 1995.

165. E.g., the ISDA Master Agreements; the International Foreign Exchange and Options Master Agreement ( "FEOMA"); the International Foreign Exchange Master Agreement ( "IFEMA"); the International Currency Options Market Master Agreement ("ICOM").

166. Remarks by Susan M. Phillips. See FN 12.

167. Daniel P. Cunningham and Dr. Thomas J. Werlen, THE MODEL NETTING ACT: A SOLUTION FOR INSOLVENCY UNCERTAINTY, Futures and Derivatives Law Report, November, 1996. The authors refer to ISDA, who sought to establish the enforceability of the close-out netting provisions of a master agreement by way of reasoned opinions collected from leading counsel in various jurisdictions, which has led to an increased use of master agreements. ISDA obtained legal opinions which confirmed that key jurisdictions will support the netting of trades carried out under ISDA's forms in the event of a counterparty's insolvency. However, netting legislation may have been enacted before credit derivatives appeared and may not embrace them. Under the current version of the U.S. Federal Bankruptcy Act there is some doubt whether close-out netting agreements in credit derivative transactions would be respected. The Bankruptcy Act, in its current version, does not address credit derivatives expressly.

168. The 1992 ISDA Master Agreements include the ISDA Master Agreement (Multicurrency-Cross Border) and the 1992 ISDA Master Agreement (Local Currency-Single Jurisdiction).

169. Warren N. Davis and Kevin I. MacKenzie, CONCERNS OF END-USERS OF DERIVATIVES, Practicing Law Institute, Corporate Law and Practice Course Handbook Series PLI Order No. B4-7122, October, 1996.

170. The ISDA 1999 Credit Derivative Definitions are incorporated into the Confirmation; the 1999 Credit Derivatives Definitions Handbook was issued on June 23, 1999. See also at FN 17.

171. Euromoney Magazine, CREDIT DERIVATIVES, GETTING HOOKED ON CREDIT DERIVATIVES, February 10, 1999.

172. The following outline of the rules governing credit derivatives in Germany, France and the UK is meant to give a rough overview on the subject, only.

173. E.g., in Germany under the Großkredit und Millionenkreditverordnung (GroMiKV) - Regulation Governing Large Exposures and Million Loans Reporting.

174. Bundesaufsichtsamt für das Kreditwesen (BAKred) Circular 10/99, TREATMENT OF CREDIT DERIVATIVES IN PRINCIPLE I ACCORDING TO SECTIONS 10, 10A OF THE GERMAN BANKING ACT (GESETZ ÜBER DAS KREDITWESEN - KWG), AND UNDER THE LARGE EXPOSURES AND MILLION LOAN REPORTING REGIME, Berlin, June, 1999 (thereinafter "Circular 10/99"). The official German version and an unofficial English translation are available on the BAKred web site: http://www.bakred.de.

175. Directives of the Council of the European Communities 89/647/EEC SOLVENCY RATIO DIRECTIVE, 18 December 1989, and 93/6/EEC CAPITAL ADEQUACY DIRECTIVE, 15 March 1993, and the Capital Accord of the Basle Committee on Banking Supervision of July, 1988, as supplemented by the Amendment to incorporate market risks of January, 1996.

176. See FN 174.

177. Id.

178. Id.

179. Id.

180. Id. For a detailed description. See id.

181. Id.

182. Id.

183. Id.

184. Id.

185. Id.

186. Id.

187. Id.

188. Id.

189. Id. A total rate-of-return swap from which the protection buyer receives periodic payments must be allocated as swap to the risk assets, taking account of the counterparty risk.

190. Id.

191. Id. Various exceptions apply depending on the type of credit derivative. Id.

192. Id.

193. Id.

194. Id.

195. The FSA web site features, among others, a Guide to Banking Supervisory Policy containing the Supervisory Chapter on Credit Derivatives. See at http://www.fsa.gov.uk.

196. Id.

197. Id.

198. Id.

199. Id.

200. Id.

201. Id.