Texas Register, Volume 37, Number 35, Pages 6819-7008, August 31, 2012 Page: 6,839
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The credit exposure arising from a derivative transaction is com-
monly viewed as the sum of the current credit exposure on the
contract or portfolio plus some measure of potential future expo-
sure (PFE). Under proposed new 12.12, the current credit ex-
posure is determined by the mark-to-market value (MTM) of the
derivative contract. The current MTM is generally zero at execu-
tion of the contract. Subsequent to the execution of the contract,
if the MTM value is positive, then the current credit exposure
equals that MTM value. If the MTM value is zero or negative,
then the current credit exposure is zero.
PFE, on the other hand, recognizes the possibility that the MTM
amount may increase over time, based upon changes in mar-
ket factors. The PFE, when added to the MTM amount, can be
viewed as the anticipated ceiling of credit exposure at the exe-
cution of a derivative transaction.
Proposed new 12.12(b) provides three methods for calculating
credit exposure of derivative transactions other than credit
derivatives. Unless required to use a specific method by the
commissioner pursuant to 12.12(b)(3), a state bank may
choose which of these methods it will use. However, a state
bank must use the same method for calculating credit exposure
arising from all derivative transactions.
Under the first method, the "internal model method," state banks
may model their exposures via an internal model. Under this
method, the counterparty credit exposure of a derivative trans-
action would be measured by a model that estimates a credit
exposure amount, inclusive of the current MTM. A bank using
this approach would calculate its exposure by using the inter-
nal model that it considers most appropriate in evaluating the
risk associated with derivative transactions. Like the OCC's rule
for national banks, the proposal requires the bank's model to be
approved for purposes of 53 of the federal capital adequacy
guidelines codified as Appendix C to 12 C.F.R. part 325 (or Ap-
pendix F to 12 C.F.R. part 208 in the case of a bank that is a
member of the Federal Reserve System), or another approved
model. Comments are invited on whether this is an appropriate
standard or whether another standard would be more suitable.
A state bank that elects to calculate its credit exposure by using
the internal model method will be permitted to net credit expo-
sure of derivative transactions arising under the same qualifying
master netting agreement, thereby reducing the bank's exposure
to the borrower to the net exposure under the master netting
Second, a state bank may choose to measure the credit expo-
sure arising from a derivative transaction under the "conversion
factor matrix method." Under this method, the credit exposure
will equal and remain fixed at the PFE of the derivative transac-
tion, as determined at execution of the transaction by reference
to a simple look-up table (Table 1). This approach will be consid-
erably less burdensome than the internal model method because
a state bank would not have to establish statistical simulations
of future PFE calculations.
While the simplicity and stability of the conversion factor matrix
method will make it easy to apply, actual credit exposure can
arise during the life of a derivative contract that is not captured
under this method. The department believes that the potentially
unmeasured risks can be addressed in the supervisory process
by examiners appropriately responding to unsafe and unsound
concentrations, and that the certainty and simplicity of allowing
non-complex banks to "lock in" the attributable exposure at the
execution of the contract balance the possible risks.
Under the third method, the "remaining maturity method," the
measurement of the credit exposure incorporates both the cur-
rent MTM and the transaction's remaining maturity (measured in
years) as well as a fixed add-on for each year of the transaction's
remaining life. Specifically, this method measures credit expo-
sure by adding the current MTM value of the transaction to the
product of the notional amount of the transaction, the remain-
ing maturity of the transaction, and a fixed multiplicative factor.
These multiplicative factors differ based on product type and are
determined by a look-up table (Table 2).
The credit exposure calculated under the remaining maturity
method accounts for the diminishing maturity of the transaction
as well as the current MTM of the transaction. A state bank
may find that any additional burden involved with determining
the MTM under this optional method is balanced by the fact
that, depending on the MTM, as the maturity decreases, the
credit exposure also decreases, thereby permitting additional
extensions of credit under the lending limit.
In the case of credit derivatives, in which a state bank buys or
sells credit protection against loss on a third-party reference
entity, a special rule would apply as set forth in proposed
12.12(b)(2). Specifically, a state bank that uses the conversion
factor matrix method or remaining maturity method, or that uses
the internal model method without entering an effective margin-
ing arrangement with its counterparty as defined in proposed
12.2(6), calculates the counterparty credit exposure arising
from credit derivatives by adding the net notional value of all
protection purchased from the counterparty on each reference
entity. For example, Bank A buys and sells credit protection
from and to Bank B on Firms X, Y and Z. No effective margining
arrangement exists between the banks. Bank A's net notional
protection purchased from Bank B is $50 for Firm X and $100
for Firm Y. Bank A's net protection sold to Bank B is $35 for Firm
Z. The lending limit exposure of Bank A to Bank B is $150.
In addition, a state bank would calculate the credit exposure to
a reference entity arising from credit derivatives by adding the
notional value of all protection sold on the reference entity. For
example, Bank C buys and sells credit protection on Firms 1,
2 and 3. Bank C's notional protection sold is $100 for Firm 1,
$200 for Firm 2 and $300 for Firm 3. The lending limit exposure
of Bank C to Firm 1 is $100, to Firm 2 is $200 and to Firm 3 is
However, the bank may reduce its exposure to a reference en-
tity by the amount of any "eligible credit derivative," defined in
proposed 12.2(7), purchased on that reference entity from an
"eligible protection provider," defined in proposed 12.2(8). In
the last example, if Bank C purchases protection on Firm 3 from
an eligible protection provider in the amount of $25 via an eli-
gible credit derivative, Bank C can reduce its $300 lending limit
exposure to Firm 3 to $275.
Although the internal model method, the remaining maturity
method, and the conversion factor matrix method will generally
be available to all state banks, proposed 12.12(b)(3) provides
that the commissioner may require use of a specific method to
calculate credit exposure based on a finding that such method
is necessary to promote the safety and soundness of the bank.
Securities Financing Transactions
Proposed 12.12(c) would provide state banks with two options
for determining the credit exposure of securities financing trans-
actions, defined as repurchase agreements, reverse repurchase
agreements, securities lending transactions, and securities bor-
PROPOSED RULES August 31, 2012 37 TexReg 6839
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Texas. Secretary of State. Texas Register, Volume 37, Number 35, Pages 6819-7008, August 31, 2012, periodical, August 31, 2012; Austin, Texas. (texashistory.unt.edu/ark:/67531/metapth253227/m1/21/: accessed August 19, 2017), University of North Texas Libraries, The Portal to Texas History, texashistory.unt.edu; crediting UNT Libraries Government Documents Department.