TO THE OFFICER IN CHARGE OF SUPERVISION AT EACH FEDERAL RESERVE BANK
Over the last several months, the Federal Reserve staff has participated in discussions among countries that have adopted the Basle risk-based capital framework. The purpose of these ongoing discussions is to review questions relating to the implementation of the Accord and to facilitate a broadly consistent approach to implementation of the framework internationally. The attached staff memorandum sets forth a summary of some of the issues that have been raised on the subjects of loan commitments and put options which function like financial guarantees. The memorandum also describes the consensus that has been reached by supervisors from the G-10 countries on these issues. The guidance contained in the memorandum is intended to clarify how the Accord is to be implemented; it does not amend the framework or alter its basic structure.
Associate Director
Attachment
on Questions and Interpretations Relating to the Implementation of the Risk-Based Capital Framework
The following guidelines and interpretations are provided to facilitate implementation of the risk-based capital framework. The clarifications and explanatory information set forth below represent a broad consensus view of supervisors from the G-10 countries which have adopted the risk-based capital framework, and have been endorsed by the Basle Supervisors' Committee. Conversion Factors of Off-Balance Sheet Items 1. Commitments The risk-based capital guidelines issued by the Federal Reserve, in keeping with the Basle Accord, generally require that long-term commitments (those with an original maturity over one year) be subject to a 50 percent conversion factor, and that short-term commitments (those with an original maturity of one year or less) be converted at zero percent. In developing the risk-based capital framework, it was recognized that a maturity break for the credit conversion factors of loan commitments might create an incentive for banks to structure their commitments in such a manner as to avoid a capital requirement. This outcome was considered acceptable provided it led banks to genuinely reduce the duration of their commitments, and thus their potential credit risk, to a maximum of one year from the date on which the commitments were made. As the industry has responded to the incentive to structure commitments on a short-term basis, some questions have been raised concerning 1) the meaning of original maturity and 2) when a commitment must be unconditionally cancelable in order to be eligible for the zero percent conversion factor. The Basle Accord states that "commitments with an original maturity of up to one year, or which can be unconditionally canceled at any time" (emphasis added) are eligible for the zero percent conversion factor. For purposes of determining term to maturity, the Federal Reserve's guidelines define original maturity as, "the length of time between the date the commitment is issued and the earliest date on which (1) the banking organization can, at its option, unconditionally (without cause) cancel the commitment and (2) the banking organization is scheduled to (and as a normal practice actually does) review the facility to determine whether or not it should be extended." Thus, a long-term facility with a nominal maturity of over one year could be converted at zero percent, if, within the first year of the commitment, the bank performs a credit review and at that point can unconditionally cancel the commitment without cause. In other words, after the first year the commitment must be unconditionally cancelable on each and every day. In addition, credit reviews must be conducted at least annually for such facilities to qualify as short-term commitments. Commitments meeting these criteria may be considered to have an original maturity of one year or less for risk-based capital purposes. However, in the cases of commitments nominally meeting the "criteria" for conversion at zero percent but which are in substance long-term facilities, examiners have the right to classify such commitments as long-term. Furthermore, commitments expire in one of two ways: 1) all funds are drawn, and the outstanding commitment is reduced to zero when the resulting loan is booked; or 2) the commitment can reach its stated maturity, in which case it ceases to be binding on either party. A commitment that is structured in such a way that it must expire from either of these two causes within one year is clearly entitled to the zero percent conversion factor. Any commitment which does not expire within one year is subject to the 50 percent conversion factor, unless, as set forth in the Federal Reserve's guidelines, the issuing bank has full and unconditional discretion within a year to withdraw the commitment at any time and conducts a formal review of the commitment, including an assessment of the credit quality of the obligor, at least annually beginning within one year of the date of issuing the commitment. The purpose of this credit review is to give the issuing bank the opportunity to take note of any deterioration in the credit quality of the obligor, thereby enabling it to exercise its right to immediately and unconditionally, i.e., without notice to the customer, revoke the commitment. Thus, so-called evergreen commitments, which require that the bank give advance notice of cancellation to the obligor or which permit the commitment to roll over automatically unless the bank gives notice of its intention not to permit such a rollover, are not unconditionally cancelable and are subject to the 50 percent conversion factor. A commitment that will expire irrevocably within one year is the only exception to this treatment and is converted at zero percent. Some commitments are entered into with the understanding that the issuing bank will renew the commitment within one year subject to a thorough credit review of the obligor. Commitments of this type, so long as they expire within one year, may be accorded a zero percent risk-weight, only if: 1) the renegotiation process is carried out in good faith, involves a full credit assessment of the obligor, and permits the bank the flexibility to alter the terms and conditions of the commitment; 2) the bank has absolute discretion to renew and extend the commitment or to decline to do so; and 3) the renegotiated commitment expires within 12 months from the time it is made. So long as a commitment expires within one year, the maturity of any extension of credit made under it is irrelevant to determining the appropriate conversion factor for the commitment, e.g.,a 90-day commitment to make a 30-year real estate loan would be converted at the zero percent conversion factor. The loan, of course, if made, would then be assigned the risk weight appropriate to the obligor, collateral, or guarantor. A forward commitment is a commitment where, in effect, the bank commits to issue a commitment at a future date. For example, the bank may commit to a customer that, at the end of two years, it will give that customer a firm commitment for a period of ten months. Such a forward commitment should be viewed as a commitment from inception with a maturity of two years and ten months and, accordingly, would be subject to the 50 percent conversion factor for risk-based capital purposes. Sometimes banks issue commitments which can be drawn down in a number of tranches. Some of these tranches may be exercisable within one year while others may be exercisable over longer periods. In such transactions, the full amount of the undrawn commitment would be subject to the 50 percent conversion factor, i.e., the entire commitment would be treated as having a maturity of over one year. In some cases, long-term commitments permit the borrower to draw down different amounts at different times, perhaps reflecting the seasonal credit needs of the borrower. In transactions of this type, the appropriate conversion factor should be applied to the maximum amount that can be drawn under the commitment.
2. Other Off-Balance Sheet Instruments Under certain circumstances, options can be the functional equivalent of direct credit substitutes. Thus, it is appropriate that written put options on specified assets, which have the character of a credit enhancement, i.e., function as a direct credit substitute, be subject to the same 100 percent conversion factor that generally applies to financial guarantees. In addition, these instruments should be assigned a risk weight according to the underlying asset and not the purchaser of the option. In effect, the risk weight should be the same as if the bank had entered directly into the underlying transaction. |
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