Texas Register, Volume 37, Number 35, Pages 6819-7008, August 31, 2012 Page: 6,837

this manner, both the bank and its customer get what they want,
risks are contained, and mismatches are avoided.
Thus, derivative investments can be highly useful in managing
or hedging existing risk in a bank's loan or investment portfolio.
However, because a derivative product can be created by means
of an agreement, the types of derivative products that can be
developed are limited only by the imagination. Many derivative
products available today possess a bewildering complexity and
lack of transparency that can result in poor investment decisions
by the occasional user. In some instances, a derivative contract
may appear to hedge a particular risk but actually increase risk
to the institution. Even "plain vanilla" derivatives carry potentially
excessive risk if a bank relies too heavily on a single counter-
party.
The past decade revealed a series of serious financial losses
suffered by county and municipal governments, well-known cor-
porations, banks and mutual funds that had invested in these
products. As the prevalence and complexity of the derivatives
market ballooned, unexpected shifts in derivative values played
a major role in the downturn of the world's financial system, lead-
ing to the recent recession.
The Dodd-Frank Wall Street Reform and Consumer Protection
Act, Public Law 111-203, 124 Stat. 1376 (2010) (Dodd-Frank)
was aimed at a financial regulatory overhaul that, among other
matters, established a more regulated environment for deriva-
tives trading. Because most insured banks use deposits to fund
their lending and investment activities, and because catastrophic
mistakes by banks can end up costing taxpayers, Dodd-Frank
imposes additional requirements on banks to identify the risks
being assumed in derivative transactions, evaluate and compre-
hend those risks, and continuously monitor and manage those
risks. Part of the risk identification and management process is
determining the potential monetary exposure of the parties under
the terms of the derivative instrument, a step sometimes over-
looked in the past because money is typically not due until the
specified date of performance of a derivative contract. The pro-
posed rules will require a state bank to make up-front determina-
tions of potential credit exposure from a derivative transaction,
as well as from a securities financing transaction. Federal rules
will impose similar requirements on national banks.
Securities Financing Transactions
A securities financing transaction is collateralized lending or bor-
rowing in the form of a repurchase agreement, reverse repur-
chase agreement, securities lending transaction, or securities
borrowing transaction. Each of these transaction types are de-
fined and described in connection with discussion of 12.12(c)
as proposed.
Both parties to a securities financing transaction are subject to
credit risk because the market value of the collateral can change
during the life of the loan. In addition, the lender must consider
both the creditworthiness of the counterparty and the quality of
the underlying collateral. Banks are already expected to main-
tain a risk management process to ensure that credit risk is ef-
fectively identified, measured, monitored, and controlled, but re-
quiring that the aggregate credit exposure to a single counter-
party be compared to the lending limit is anticipated to help in
controlling this risk.
Dodd-Frank Requirements
Effective January 21, 2013, Section 611 of Dodd-Frank prohibits
state banks from engaging in derivative transactions unless "the

law with respect to lending limits of the State in which the insured
State bank is chartered takes into consideration credit exposure
to derivative transactions." Banks have long been encouraged to
quantify and limit the off-balance sheet credit risk inherent in a
derivative contract, or to avoid over-reliance on a limited number
of counterparties, but have not previously been required by law
to compare that credit exposure to the lending limit.
Effective July 21, 2012, national banks are subject to similar but
broader requirements. Section 610 of Dodd-Frank expanded
the statutory definition of "loans and extensions of credit" in 12
U.S.C. 84 to include credit exposure arising from repurchase
and reverse repurchase transactions and securities lending and
borrowing transactions (collectively, securities financing transac-
tions), as well as derivative transactions.
The problem with adding these transactions to lending limit con-
siderations is that they do not fit squarely into any lending prod-
uct category. For example, derivative transactions are not loans,
do not arise from an advance of funds, and are not extensions
of credit. Neither Section 610 nor Section 611 of Dodd-Frank
provides guidance on how to measure the fluctuating credit ex-
posure of derivative transactions and securities financing trans-
actions for purposes of the lending limit.
Measuring and quantifying the potential credit exposure under a
derivative transaction or a securities financing transaction is typ-
ically accomplished through the use of sophisticated computer
models and simulations that only large banks can afford to pur-
chase or develop. Because the department does not have the
depth of capital markets expertise that the Office of the Comp-
troller of the Currency (OCC) possesses, these difficulties led the
department to conclude that state action to implement Section
611 of Dodd-Frank should be postponed until the OCC issued
its regulations implementing similar requirements under Section
610.
On June 20, 2012, the OCC released its interim final rule to im-
plement Section 610 of Dodd-Frank. Published in the June 21,
2012, edition of the Federal Register (77 Fed. Reg. 37265), the
rule sets out procedures and methodologies for calculating the
credit exposure under these newly covered transactions and re-
quests comments in response to a series of questions regarding
how best to address certain ambiguities and difficulties raised by
the requirements of Section 610. In order to reduce the practi-
cal burden of these calculations, particularly for smaller banks,
the OCC commendably provided different options for measur-
ing credit exposures in new 12 C.F.R 32.9. These alternatives
would appear to implement the statutory changes, consistent
with safety and soundness and the goals of the statute, but in
a manner that should reduce unnecessary new regulatory bur-
den.
Section 610 of Dodd-Frank became effective on July 21, 2012.
The interim final rule adopted by the OCC is also effective on
July 21, 2012. However, in recognition that national banks will
need time to conform their operations to the amendments imple-
menting Section 610, the OCC added a temporary exemption to
the interim final rule (codified at 12 C.F.R. 32.1(d)) for the trans-
actions covered by Section 610 until January 1, 2013, in order to
allow institutions a sufficient period to make adjustments to as-
sure compliance with the new requirements.
The 45-day comment period on the OCC interim final rule closes
on August 6, 2012. The OCC may thereafter amend the interim
final rule based on comments received. If the OCC determines
that amendments are required, the OCC is anticipated to issue a

PROPOSED RULES August 31, 2012 37 TexReg 6837