On March 18, the extended comment period ended for the Standardized Approach for Calculating the Exposure Amount of Derivative Contracts (“SA-CCR”) rule (the “Proposed Rule”) proposed by the Federal Reserve Board (“Board”), the Federal Deposit Insurance Corporation (“FDIC”), and the Office of the Comptroller of the Currency (“OCC” and together with the Board and the FDIC, the “Agencies”). SA-CCR would, in some cases, supplant the calculations currently used by banking organizations for derivatives under the existing regulatory capital rule, and may have significant implications for commercial end-users.
A total of 54 public comments were submitted from a wide range of respondents, including commercial end-users and related trade associations, major banks and industry groups, and the Commodity Futures Trading Commission. A substantial comment letter was also jointly submitted by the International Swaps and Derivatives Association, Inc., the Securities Industry and Financial Markets Association, the American Bankers Association, the Bank Policy Institute, and the Futures Industry Association.
Many of the comment letters focus on the implications of SA-CCR for commercial end-users that rely on the derivatives market to hedge commercial risk. This article provides (i) background on the Proposed Rule, (ii) a summary of certain comment letters submitted by commercial end-users and related trade associations and others, and (iii) a technical section summarizing (A) how the exposure amount of derivative contracts is calculated currently under the regulatory capital rule (the “capital rule”) and (B) how such calculations would be performed under the proposed SA-CCR.
I. Background on the Proposed Rule
The capital rule requires a banking organization to hold an amount of regulatory capital determined by its total risk-weighted assets, which includes, among other factors, the exposure amount of its derivative contracts. SA-CCR, as proposed, would provide an updated approach for calculating that exposure amount. In its current form, the capital rule provides two methods for determining total risk-weighted assets: (i) the standardized approach, applicable to all banking organizations; and (ii) advanced approaches, applicable only to advanced approaches banking organizations. An “advanced approaches banking organization” is a banking organization that has at least $250 billion in total consolidated assets, or has consolidated on-balance sheet foreign exposures of at least $10 billion, or is a subsidiary of a depository institution, bank holding company, savings and loan holding company, or intermediate holding company that is an advanced approaches banking organization.
As explained in Section III below, for advanced approaches banking organizations, SA-CCR would (i) replace the current exposure methodology (“CEM”) and (ii) serve as an alternative to the internal models methodology (“IMM”) for purposes of determining the exposure amount of derivative contracts. Non-advanced approaches banking organizations would continue to use CEM but have the option to use SA-CCR instead. The Agencies describe the purpose of SA-CCR as providing “important improvements to risk-sensitivity and calibration relative to CEM, but also . . . a less complex and non-model-dependent approach than IMM.”
The Proposed Rule would modify other aspects of the capital rule to account for SA-CCR. For example, an advanced approaches banking organization would be required to use SA-CCR (with certain adjustments) to determine the exposure amount of derivative contracts for calculating its total leverage exposure under the supplementary leverage ratio. The Proposed Rule also would incorporate SA-CCR into the cleared transaction framework and make other amendments, generally with respect to cleared transactions.
The Proposed Rule would require banking organizations to comply with its requirements by July 1, 2020.
II. Summary of comment letters
The numerous public comments submitted in response to the Proposed Rule addressed a range of issues, but one of the predominant concerns was the potential for increased costs that would be borne by commercial end-users.
Several comment letters highlighted that the Proposed Rule is expected to generally increase capital requirements for derivatives transactions with end-user counterparties, which could compel banking organizations to pass through any increased costs to such end-users in the form of higher transaction fees. It is also possible that, in some cases, banking organizations may seek to avoid higher capital requirements under SA-CCR by requiring end-user counterparties to post margin, which would be inconsistent with the intent underlying both the end-user margin exemption and the end-user clearing exception. Accordingly, certain respondents argued that SA-CCR should exempt the derivatives of a counterparty that qualifies for the end-user margin exemption or the end-user clearing exception, or, at a minimum, not apply an “alpha factor” (as explained in Section III below) to such transactions.
Commercial end-users often do not collateralize their obligations with cash, but banking organizations frequently require some form of non-cash credit support, such as liens on assets, letters of credit, or parent company guarantees. Under the Proposed Rule, such credit support would not receive any offset recognition against a banking organization’s exposure amount under SA-CCR which, according to certain comment letters, would create an artificially inflated exposure amount. In response, certain comment letters argued that SA-CCR should take into account the credit risk benefits of such non-cash credit support.
Some respondents estimated that SA-CCR would result in substantial increases in total risk-weighted assets with respect to the commodities asset class, as compared to CEM, and argued that the “supervisory factors” that in part determine the SA-CCR calculations with respect to the commodities asset class should be recalibrated. More specifically, these respondents noted that the supervisory factors set by the Basel Committee for the commodities asset class seem to be calibrated to higher volatilities than are justified by historical data for the commodities forward market, and that they should instead reflect the actual volatility of the commodity derivatives market, focusing on contracts that are driven by forward, rather than spot, prices. At a minimum, these respondents argued that the supervisory factors should not exceed the levels set forth in the Basel Committee standards. In addition, the Proposed Rule includes one supervisory factor for both the electricity and the oil/gas components of commodities, rather than distinguishing between the two. Some comment letters noted that this results in the application of a uniform 40% supervisory factor for the entire energy hedging set, whereas the Basel Committee standards apply a 40% supervisory factor to electricity and an 18% supervisory factor to all other energy assets. Therefore, the approach in the Proposed Rule would result in a significantly more conservative calibration for oil/gas in the United States.
Similarly, certain comment letters posited that the supervisory factors for the equities asset class are misaligned with the underlying risks and likely would result in substantial increases in total risk-weighted assets, as compared to CEM. Some of these respondents argued that the Agencies should differentiate based on the quality and associated risks of equities (e.g., differentiating between investment grade and non-investment grade and between developed markets and emerging markets).
III. Exposure amount calculations under (A) current methodologies and (B) SA-CCR as proposed
The capital rule contains risk-based capital ratios in which total risk-weighted assets comprise the denominator and regulatory capital comprises the numerator. The rule provides the following two methodologies for determining total risk-weighted assets:
(i) The standardized approach, applicable to all banking organizations; and
(ii) Advanced approaches, applicable only to advanced approaches banking organizations.
Banking organizations using advanced approaches calculate total risk-weighted assets under both (i) the standardized approach and (ii) advanced approaches; the standardized approach serves as a floor for the denominator. For example, an advanced approaches banking organization’s tier 1 capital ratio is the lower of the ratio of the banking organization’s common equity tier 1 capital to standardized total risk-weighted assets and the ratio of the banking organization’s common equity tier 1 capital to advanced approaches total risk-weighted assets. In other words, advanced approaches banking organizations must calculate total risk-weighted assets under both approaches and use the high of the two in the denominator.
The exposure amount of a banking organization’s noncleared and cleared derivative contracts and the risk-weighted asset amount of its contributions or commitments to mutualized loss sharing agreements with central counterparties (i.e., default fund contributions) are included in total risk-weighted assets under both (i) the standardized approach and (ii) advanced approaches, but measured differently, as summarized below.
Standardized approach. Under the standardized approach, banking organizations are required to use CEM to determine the exposure amount of their derivative contracts, based on formulas provided in the capital rule. Under CEM, the exposure amount of a single derivative contract is equal to the sum of its current credit exposure and potential future exposure (“PFE”), where:
- Current credit exposure equals the on-balance sheet fair value of the derivative contract, subject to a floor of zero.
- PFE, which is meant to approximate the banking organization’s exposure over the remaining maturity of the derivative contract, is equal to:
- the notional amount of the derivative contract, multiplied by
- a conversion factor reflecting the potential volatility in the relevant reference asset for the derivative contract. Conversion factors are based on the derivative contract’s type and remaining maturity, as set forth in a look-up table in the capital rule. (PFE generally increases as volatility and duration of the derivative contract increase.)
A banking organization may measure derivative contracts that are subject to the same qualifying master netting agreement (“QMNA”) on a net basis. Thus, for derivative contracts subject to a QMNA:
- Current credit exposure is the net sum of all positive and negative fair values of the individual derivative contracts, subject to a floor of zero; and
- PFE is calculated as gross PFE adjusted by the net-to-gross ratio. Specifically, the adjusted sum of the PFE amounts equals the sum of (i) the gross PFE amount multiplied by 0.4 and (ii) the gross PFE amount multiplied by the net-to-gross ratio and 0.6.
Additionally, a banking organization may recognize the credit risk-mitigating benefits of financial collateral by applying applicable risk weights according to a formula that includes certain haircuts for collateral.
Advanced approaches. An advanced approaches banking organization may use either CEM or IMM to determine the exposure amount of its derivative contracts, based on its own internal models of exposure. The exposure amount under IMM is calculated as:
- The time-weighted average of the effective expected exposures (“EE”) over a one-year horizon, referred to as the effective expected positive exposure (“EEPE”), multiplied by
- an “alpha factor” of 1.4.
The capital rule also requires an advanced approaches banking organization to meet a supplementary leverage ratio, which includes the exposure amount of its derivative contracts in the denominator. An advanced approaches banking organization must use CEM to determine the exposure amount of its derivative contracts for total leverage exposure.
The Proposed Rule would revise the standardized approach and the advanced approaches by replacing CEM with SA-CCR (the mechanics of which are summarized below) in the following ways:
- Non-advanced approaches banking organizations (i) would have the option to use CEM or SA-CCR to determine the exposure amount for non-cleared derivative contracts (the “counterparty credit risk framework”), (ii) must use the approach selected for purposes of the counterparty credit risk framework (either CEM or SA-CCR) to determine the trade exposure amount for cleared derivative contracts, and (iii) must use the approach selected for purposes of the counterparty credit risk framework (either CEM or SA-CCR) to determine the default fund contribution included in risk-weighted assets.
- Advanced approaches banking organizations:
- In calculating advanced approaches total risk-weighted assets, (i) would have the option to use SA-CCR or IMM to determine the exposure amount for non-cleared derivative contracts, (ii) must use the approach selected for purposes of the counterparty credit risk framework (either SA-CCR or IMM) to determine the trade exposure amount for cleared derivative contracts, and (iii) must use SA-CCR for purposes of the default fund contribution included in risk-weighted assets.
- In calculating standardized approach total risk-weighted assets, must use SA-CCR to determine (i) the exposure amount for non-cleared derivative contracts, (ii) the trade exposure amount for cleared derivative contracts, and (iii) the default fund contribution included in risk-weighted assets.
- Must use a modified version of SA-CCR to determine the exposure amount of derivative contracts for total leverage exposure under the supplementary leverage ratio.
Under the SA-CCR methodology set forth in the Proposed Rule, a banking organization would calculate the exposure amount of its derivative contracts at the “netting set” level, as follows:
- an alpha factor of 1.4 is multiplied by
- the sum of (i) the replacement cost of the netting set and (ii) PFE of the netting set.
Alpha factor. The alpha factor of 1.4 is intended to produce exposure measure outcomes that generally are no lower than those amounts calculated using IMM.
Replacement cost. The replacement cost of a netting set is the greater of: (1) the sum of the fair values (after excluding any valuation adjustments) of the derivative contracts within the netting set less the sum of the net independent collateral amount and, if subject to a variation margin agreement, the variation margin amount applicable to such derivative contracts; (2) if subject to a variation margin agreement, the sum of the variation margin threshold and the minimum transfer amount applicable to the derivative contracts within the netting set less the net independent collateral amount applicable to such derivative contracts; and (3) zero.
PFE. The PFE of a netting set is equal to:
- the PFE multiplier, multiplied by
- aggregated amount.
The PFE multiplier may range in value from 1 to 0.05 and decreases as (i) the value of the financial collateral held exceeds the net fair value of the derivative contracts within the netting set and (ii) the net fair value of the derivative contracts within the netting set decreases below zero (i.e., is out-of-the-money). The aggregated amount is the sum of each “hedging set amount” with in the netting set. To determine the hedging set amounts, a banking organization would: (i) group into separate “hedging sets” derivative contracts that share similar risk factors based on the following asset classes: interest rate, exchange rate, credit, equity, and commodities; and (ii) then determine each hedging set amount using asset-class specific formulas (which depend on, among other factors, the applicable “supervisory factors” as discussed in Section I above).
 Standardized Approach for Calculating the Exposure Amount of Derivative Contracts, 83 Fed. Reg. 64660 (December 17, 2018) (available at https://www.govinfo.gov/content/pkg/FR-2018-12-17/pdf/2018-24924.pdf).
 The regulatory capital rule (the “capital rule”) is codified in various parts of title 12 of the CFR; specifically, part 3 (OCC), part 217 (Board), and part 324 (FDIC).
 Proposed Rule at 64,661-62.
 An advanced approaches banking organization’s supplementary leverage ratio is the ratio of its tier 1 capital to its total leverage exposure. Total leverage exposure includes both on-balance sheet assets and certain off-balance sheet exposures. See 3.10(c)(4)(ii) (OCC); 12 CFR 217.10(c)(4)(ii) (Board); 324.10(c)(4)(ii) (FDIC).
 Under the cleared transactions framework in the capital rule, a banking organization is required to hold risk-based capital for its exposure to, and certain collateral posted in connection with, a derivative contract that is a cleared transaction. In addition, a clearing member banking organization must hold risk-based capital for its default fund contributions. See, e.g., Proposed Rule at 64,680.
 The Proposed Rule provides the following detailed description of the mechanics of calculations under IMM: “A banking organization arrives at the exposure amount by first determining the EE profile for each netting set. In general, EE profile is determined by computing exposure distributions over a set of future dates using Monte Carlo simulations, and the expectation of exposure at each date is the simple average of all Monte Carlo simulations for each date. The expiration of short-term trades can cause the EE profile to decrease, even though a banking organization is likely to replace short-term trades with new trades (i.e., rollover). To account for rollover, a banking organization converts the EE profile for each netting set into an effective EE profile by applying a non-decreasing constraint to the corresponding EE profile over the first year. The non-decreasing constraint prevents the effective EE profile from declining with time by replacing the EE amount at a given future date with the maximum of the EE amounts across this and all prior simulation dates. The EEPE for a netting set is the time-weighted average of the effective EE profile over a one-year horizon. EEPE would be the appropriate loan equivalent exposure in a credit risk capital calculation if the following assumptions were true: There is no concentration risk, systematic market risk, and wrong-way risk (i.e., the size of an exposure is positively correlated with the counterparty’s probability of default). However, these conditions nearly never exist with respect to a derivative contract. Thus, to account for these risks, IMM requires a banking organization to multiply EEPE by 1.4.” Proposed Rule at 64,665, n.20.
 Specifically, such formulas depend on, for each derivative in the hedging set, an adjusted notional amount, an applicable supervisory factor, an applicable supervisory delta adjustment, and a maturity factor. The Proposed Rule provides the following description of each of these four terms: “The adjusted notional amount accounts for the size of the derivative contract and reflects attributes of the most common derivative contracts in each asset class. The supervisory factor would convert the adjusted notional amount of the derivative contract into an EEPE based on the measured volatility specific to each asset class over a one-year horizon. Multiplication by the supervisory delta adjustment accounts for the sensitivity of a derivative contract (scaled to unit size) to the underlying primary risk factor, including the correct sign (positive or negative) to account for the direction of the derivative contract amount relative to the primary risk factor. Finally, multiplication by the maturity factor scales down, if necessary, the derivative contract amount from the standard one-year horizon used for supervisory factor calibration to the risk horizon relevant for a given contract.” Proposed Rule at 64,673 (footnotes omitted).