Gregory J. Lyons, P.C.
Goodwin Procter LLP
Exchange Place
Boston, MA 02109
Dear Mr. Lyons:
This is in response to your inquiry on behalf of State Street Bank and Trust Company, Boston, Massachusetts, with regard to the risk-based capital treatment of certain European agency securities lending arrangements the bank has recently acquired.
Under these arrangements, the bank, acting as agent, lends out securities of a client and receives cash collateral from the borrower. The transaction is marked-to-market daily and a positive margin of cash collateral relative to the market value of the securities lent is maintained at all times. If the borrowing counterparty defaults on the securities loan through, for example, failure to post margin when required, the transaction is immediately terminated and the cash collateral is used by the bank to repurchase in the market the securities lent, in order to restore them to the client. The bank indemnifies its client against the risk that, in the event of counterparty default, the amount of cash collateral may be insufficient to repurchase the amount of securities lent. Thus, the indemnification is limited to the difference between the value of the cash collateral and the repurchase price of the replacement securities. In addition, the bank, again acting as agent, reinvests on the client�s behalf the cash collateral received from the borrower. The reinvestment transaction takes the form of a cash loan to a counterparty that is fully collateralized by government or corporate securities (through, for example, a reverse repurchase agreement). Like the first transaction, the reinvestment transaction is subject to daily marking-to-market and remargining and is immediately terminable in the event of counterparty default. The bank issues an indemnification to the client against the reinvestment risk, which is similar to the indemnification the bank gives on the original securities lending transaction.
The Federal Reserve Board�s risk-based capital guidelines treat indemnifications issued in connection with agency securities lending activities as off-balance sheet guarantees that are subject to capital charges. Under the guidelines, the bank�s first indemnification would receive the risk weight of the securities borrowing counterparty because of the bank�s indemnification of the client�s reinvestment risk on the cash collateral. See 12 C.F.R. part 208, App. A, � III.D.1.c. The bank�s second indemnification would receive the lower of the risk weight of the reverse repurchase counterparty or the collateral, unless it was fully collateralized with margin by OECD government securities, in which case it would qualify for a zero percent risk weight. See 12 C.F.R. part 208, App. A, � III.D.1.a. and b.
You have inquired about the possibility of assigning a zero percent risk weight for both indemnifications, given the very low risk they pose to the bank. In further support of your request, you have pointed out that the capital treatment outlined in the previous paragraph places the bank at a competitive disadvantage for European agent securities lending activities because most European supervisors allow a zero percent risk weight for both indemnifications. You have stated that the Board�s capital charges for this activity are so high that the bank would find it difficult from a capital perspective to compete against European banks for this high-volume, low-margin, and low-risk business.
The Board agrees that the capital charges for this activity under the Board�s current risk-based capital guidelines do not capture the amount of economic risk it poses to the bank, resulting in a capital charge that is significantly out of proportion to the risk. At the same time, the Board recognizes that the indemnifications do expose the bank to some degree of credit risk, particularly where collateral practices are not tightly monitored and controlled. For this reason and based on all the facts of record, the Board has approved an exception to its risk-based capital guidelines that permits the bank and its holding company to treat these agency securities lending transactions in a manner that differs from that set forth in the guidelines. The Board has approved this exception under the reservation of authority provision contained in the guidelines. This provision permits the Board, on a case-by-case basis, to determine the appropriate risk weight for any asset or off-balance sheet item that imposes risks on a bank or bank holding company that are incommensurate with the risk weight otherwise specified in the guidelines. See 12 C.F.R. part 208, App. A, � III.A; 12 C.F.R. part 225, App. A, � III.A.
This exception will apply to State Street�s agency securities lending transactions collateralized by cash where the bank indemnifies its client against (i) the risk that, in the event of default by the securities borrower, the amount of cash collateral may be insufficient to repurchase the amount of securities lent; and (ii) the reinvestment risk associated with lending the cash collateral in a transaction fully collateralized by securities (for example, in a reverse repurchase transaction).
The capital treatment the Board has approved for these transactions relies upon an economic measurement of the amount of risk exposure the bank has to each of its counterparties. Under the approved approach, the bank will not use the notional amount of underlying transactions that are subject to client indemnifications as the exposure amount for risk-based capital purposes. Rather, the bank must use an economic exposure amount that takes into account the market value of collateral and the market price volatilities of both the instruments delivered by the bank to the counterparty and the instruments received by the bank from the counterparty. This approach builds upon best practices of banks for measuring their credit exposure amounts for purposes of managing internal single-borrower exposure limits, as well as upon existing concepts already incorporated in the Basel Accord and the Federal Reserve�s risk-based capital rules. In particular, the approach embodies some of the principles used for measuring exposure set forth in the Market Risk Amendment.
In essence, under this exception, State Street will be required to determine an unsecured loan equivalent amount for each of the counterparties to which, as agent, the bank lends securities collateralized by cash and/or lends cash collateralized by securities. The unsecured loan equivalent amount, determined as described below, will be assigned the risk weight appropriate to the counterparty.
To determine the unsecured loan equivalent amount, State Street must add together its current exposure to the counterparty and a measure for potential future exposure (PFE) to the counterparty. The current exposure is the sum of the market value of all securities and cash lent to the counterparty under the bank�s indemnified arrangements, less the sum of all securities and cash received from the counterparty as collateral under the indemnified arrangements. The PFE calculation is to be based on the market volatilities of the securities lent and the securities received, as well as any foreign exchange rate volatilities associated with any cash or securities lent or received.
The Board has considered two methods for incorporating market volatilities into the PFE calculation: the bank�s own estimates of those volatilities based on a year�s historical observation of market prices with no recognition of correlation effects or a value-at-risk (VaR) type model. State Street currently calculates daily counterparty VaR estimates for its agency securities lending transactions and already has a VaR model that has been approved for purposes of the Board�s Market Risk Amendment. Accordingly, the Board has determined that State Street will be permitted to use a VaR model to determine the PFE for each of its counterparties. Use of a counterparty VaR model will permit State Street to take into account correlations in market price volatilities among the instruments it lends and among the instruments it takes as collateral, as well as between the instruments lent and received as collateral.
State Street must calculate the VaR using a five-day holding period and a 99th percentile one-tailed confidence interval based on market price data over a one-year historical observation period. The data set used should be updated no less frequently than once every three months and should be reassessed whenever market prices are subject to material changes. For each counterparty, State Street will be required to calculate daily an unsecured loan equivalent amount, including the VaR PFE component. These calculations will be subject to supervisory review to ensure they are in line with the quarter-end calculations used to determine regulatory capital requirements.
To qualify for the capital treatment outlined above, the securities lending and cash loan transactions covered by State Street�s indemnification must meet the following conditions:
- The transactions are fully collateralized;
- Any securities lent or taken as collateral are eligible for inclusion in the trading book and are liquid and readily marketable;
- Any securities lent or taken as collateral are marked-to-market daily; and
- The transactions are subject to a daily margin maintenance requirement.
Further, the transactions must be executed under a bilateral netting agreement, or an equivalent arrangement. These arrangements must:
- Provide the non-defaulting party the right to terminate and close-out promptly all transactions under the agreement upon an event of default, including in the event of insolvency or bankruptcy of the counterparty;
- Provide for the netting of gains and losses on transactions (including the value of any collateral) terminated and closed out under the agreement so that a single net amount is owed by one party to the other;
- Allow for the prompt liquidation or setoff of collateral upon the occurrence of an event of default;
- Be, together with the rights arising from the provisions required in 1) to 3) above, conducted under documentation that is legally binding on all parties and legally enforceable in each relevant jurisdiction upon the occurrence of an event of default and regardless of the counterparty�s insolvency or bankruptcy; and
- Be conducted under documentation for which the bank has completed sufficient legal review to verify it meets provision 4) above and for which the bank has a well-founded legal basis for reaching this conclusion.
With regard to the counterparty VaR model that State Street uses, the bank will be required to conduct regular and rigorous backtesting procedures, which will be subject to supervisory review, to ensure the validity of the correlation factors the bank uses and the stability of these factors over time. State Street will not be subject to a formal backtesting procedure requirement at this time. If supervisory review determines that State Street�s counterparty VaR model or its backtesting procedures have material deficiencies and the bank does not take appropriate and expeditious steps to rectify those deficiencies, however, supervisors may take actions to adjust the bank�s capital calculations. These actions could range from imposing a multiplier on the VaR estimates of PFE calculated by State Street to disallowing the use of its counterparty VaR model and requiring use of the own estimates approach to determine the PFE component of the unsecured loan equivalent amounts.
The Board believes that the capital treatment approved above for State Street�s agent securities lending transactions in which the bank indemnifies its client against the risk of default by the securities borrowing counterparty and against the reinvestment risk of cash collateral pledged by the securities borrowing counterparty provides a more risk-sensitive treatment for these transactions than that set forth under the Board�s risk-based capital guidelines. Moreover, the capital treatment approved for State Street in this letter is more consistent with best market practices and provides positive incentives for the bank to manage its collateral practices actively and prudently. The treatment also is not inconsistent with the current Basel capital framework and is generally in line with the direction that the Basel Committee on Banking Supervision is taking with regard to these transactions as part of its overall efforts to revise the Basel Accord. In this regard, State Street should be aware that the Board may in the future impose a regulatory capital treatment for these transactions that differs from the treatment described in this letter, depending in part upon the outcome of the Basel consultations for a revised capital accord.
The Board�s determination is specifically conditioned on compliance by State Street with all the commitments and representations it made in connection with its request. These commitments and representations are deemed to be conditions imposed in writing by the Board in connection with granting the request and, as such, may be enforced in proceedings under applicable law. This determination is based on the specific facts and circumstances of the agency securities lending program described in your correspondence and this letter. Any material change in those facts and circumstances or any failure by State Street to observe any of its commitments or representations may result in a different view or in a revocation of the exception.
The capital treatment set forth in this letter for these transactions will be made available to similarly situated institutions that request and receive Board approval for such treatment.
If you have any questions with regard to this letter, please direct them to Norah Barger, Deputy Associate Director in the Division of Banking Supervision and Regulation, at (202) 452-2402, or to Mark Van Der Weide, Counsel in the Legal Division, at (202) 452-2263.
Sincerely yours,
(signed) Richard Spillenkothen
Richard Spillenkothen
Director
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