Including Credit Exposure from Derivatives In Total Exposure under the Legal Lending Limit

08/23/2013

 by Suzanne Storm 

Effective October 1, 2013, all banks (regardless of charter) are subject to the revised lending limits rule which includes credit exposures arising from derivative transactions and securities financing transactions. Accordingly, any bank that offers interest rate or currency swaps to its customers, or uses them on its own behalf, must have adequate policies and procedures to assure this exposure is added to aggregate relationship exposures. (This is true for many other types of derivative and securities financing transactions as well, but this article focuses on interest rate and currency as the most likely issues for community banks.)

There are three options for calculating credit exposure arising from interest rate or foreign exchange transactions (although the regulators have reserved the right to require a particular bank to use a particular option in order to ensure its safety and soundness):

  1. Internal Model Method: If a bank has an internal model that has been approved by the appropriate regulator for use, then the bank may add the potential future credit exposure generated by that model to the current credit exposure indicated by the mark-to-market value of the derivative contract to determine credit exposure. It is important to note that this number can change daily.
     
  2. Conversion Factor Matrix Method: Based on the type of derivative and the term of the contract (or underlying loan, if for example an interest rate swap is tied to a term facility), a table* is consulted to determine the appropriate factor, which is multiplied by the notional principal amount of the transaction. Therefore, an interest rate swap on a $2,000,000, five year term loan would carry credit exposure of $2,000,000 x .06 = $120,000. So total credit exposure for this transaction is the loan + the swap = $2,120,000. 
     
  3. Current Exposure Method:  Credit exposure is the sum of the current mark-to-market value plus the potential future exposure calculated by multiplying the notional amount of the transaction by a specified conversion factor taken from Table 4 of the Advanced Approaches Appendix of the capital rules, which varies based on the type and remaining maturity of the contract.

There are costs and benefits to each method outlined above. The simplest and clearest is #2, as the credit exposure is determined at approval by looking up numbers in a table and it remains unchanged throughout the life of the transaction. (It is expected that most community banks will choose this method. ) The trade-off is that this fixed amount may be higher than exposure would be if calculated using one of the other two methods. A bank may choose only one of the methods to calculate exposure on all of its derivative transactions. Therefore, the simplicity vs. exposure size tradeoff must be determined before October 1. The methodology and related tables should be in place in credit policy so that aggregate credit exposures are calculated correctly for any credit approvals after that date.

If you would like to explore this topic further, including a sample testing of existing swap facilities to determine which method would have served you best historically, or if you need help with updating your credit policy, please call Lou Dunham at 847-687-7353 or email him at ldunham@ardmoreadvisors.com