Credit exposure: Affiliate transaction rule in sight

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08/06/2013 by Financial services regulatory practice
Credit exposure: Affiliate transaction rule in sight

At a glance

Various provisions of Dodd-Frank require banks to incorporate credit exposures from derivatives and securities financing transactions when calculating prudential limits.

Various provisions of the Dodd-Frank Act require banks to incorporate credit exposures from derivatives and securities financing transactions when calculating prudential limits. The Office of the Comptroller of the Currency (OCC) recently became the first federal regulator to establish final rules in this area – in this instance, for calculating these exposures for Federal lending limit purposes.

The Federal Reserve Board (FRB) has yet to propose how to calculate these same types of credit exposures for purposes of limits on bank transactions with affiliates. It is our view that this rule will be proposed this fall given the FRB’s heightened focus (as evidenced by various recent public pronouncements) on completing an expanded prudential framework for large bank holding companies.

While the OCC’s approach is instructive, it is unclear to what extent the FRB will follow suit. Given the perceived greater risks arising from bank transactions with affiliates and the stricter limits and mandatory collateral requirements of the FRB’s Section 23A and its Regulation W, we expect that the FRB would apply similar methods used by the OCC but will tend to be more conservative in its interpretation, and less flexible in application. As further described below, were the FRB to follow suit in its definition of credit exposure, the result would be a significant change in practice for calculating credit exposure in derivative transactions between a bank and its affiliates.

The OCC final rule itself includes many technicalities, many of which we do not attempt to address, but the rule should prompt some institutions to assess the availability and reliability of their data for limit measurement and monitoring purposes. In addition, the dynamic nature of the OCC rule is important. Several of its key provisions incorporate by reference current provisions of the OCC’s and FDIC’s capital rules. These references will ultimately be updated by the OCC to reflect the new Basel III capital rules that were recently approved by the three agencies, and which contain transition provisions and dynamic qualifying capital elements that may result in volatility when monitoring lending limit compliance.

In this Financial Services Regulatory Brief, we highlight the key decisions made by the OCC that formed its final rule, analyze the rule’s highlights, and link the final rule to some possible expectations for the upcoming FRB affiliate transaction proposal.