In the last sentence of the first paragraph on page 28 (Annex 3) of the 1988 Capital Accord the word "are" is replaced with "may be". The language below replaces page 30 (Annex 3) of the 1988 Capital Accord in respect of the recognition of bilateral netting for the purpose of calculating capital requirements. The footnote numbers are as they would appear in the revised Capital Accord. "Careful consideration has been given to the issue of bilateral netting, i.e., weighting the net rather than the gross claims with the same counterparties arising out of the full range of forwards, swaps, options and similar derivative contracts.6 The Committee is concerned that if a liquidator of a failed counterparty has (or may have) the right to unbundle netted contracts, demanding performance on those contracts favourable to the failed counterparty and defaulting on unfavourable contracts, there is no reduction in counterparty risk. Accordingly, it has been agreed for capital adequacy purposes that: - Banks may net transactions subject to novation under which any obligation between a bank and its counterparty to deliver a given currency on a given value date is automatically amalgamated with all other obligations for the same currency and value date, legally substituting one single amount for the previous gross obligations.
- Banks may also net transactions subject to any legally valid form of bilateral netting not covered in (a), including other forms of novation.
- In both cases (a) and (b), a bank will need to satisfy its national supervisor that it has:7
- a netting contract or agreement with the counterparty which creates a single legal obligation, covering all included transactions, such that the bank would have either a claim to receive or obligation to pay only the net sum of the positive and negative mark-to-market values of included individual transactions in the event a counterparty fails to perform due to any of the following: default, bankruptcy, liquidation or similar circumstances;
- written and reasoned legal opinions that, in the event of a legal challenge, the relevant courts and administrative authorities would find the bank's exposure to be such a net amount under:
- the law of the jurisdiction in which the counterparty is chartered and, if the foreign branch of a counterparty is involved, then also under the law of the jurisdiction in which the branch is located;
- the law that governs the individual transactions; and
- the law that governs any contract or agreement necessary to effect the netting.
The national supervisor, after consultation when necessary with other relevant supervisors, must be satisfied that the netting is enforceable under the laws of each of the relevant jurisdictions;8 - procedures in place to ensure that the legal characteristics of netting arrangements are kept under review in the light of possible changes in relevant law.
Contracts containing walkaway clauses will not be eligible for netting for the purpose of calculating capital requirements pursuant to this Accord. A walkaway clause is a provision which permits a non-defaulting counterparty to make only limited payments, or no payment at all, to the estate of a defaulter, even if the defaulter is a net creditor. For banks using the current exposure method, credit exposure on bilaterally netted forward transactions will be calculated as the sum of the net mark-to-market replacement cost, if positive, plus an add-on based on the notional underlying principal.9 The scale of add-ons to apply will be the same as those for non-netted transactions as set out in this Annex. The Committee will continue to review the scale of add-ons to make sure they are appropriate. For purposes of calculating potential future credit exposure to a netting counterparty for forward foreign exchange contracts and other similar contracts in which notional principal is equivalent to cash flows, notional principal is defined as the net receipts falling due on each value date in each currency. The reason for this is that offsetting contracts in the same currency maturing on the same date will have lower potential future exposure as well as lower current exposure. The original exposure method may also be used for transactions subject to netting agreements which meet the above legal requirements until market risk-related capital requirements are implemented, at which time the original exposure method will cease to be available for banks supervised according to this Accord10 . The conversion factors to be used during the transitional period when calculating the credit exposure of bilaterally netted transactions will be as follows:
| Maturity | Interest rate contracts | Exchange rate contracts | | Less than one year | 0.35% | 1.5% | | One year and less than two years | 0.75% | 3.75%
(i.e. 1.5% + 2.25%) | | For each additional year | 0.75% | 2.25% |
These factors represent a reduction of approximately 25% from those on page 29 of the Accord. For purposes of calculating the credit exposure to a netting counterparty during the transitional period for forward foreign exchange contracts and other similar contracts in which notional principal is equivalent to cash flows, the credit conversion factors on page 29 of the Accord could be applied to the notional principal, which would be defined as the net receipts falling due on each value date in each currency. In no case could the reduced factors above be applied to net notional amounts."
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