District Circular Letters

October 19, 2001

BANKING SUPERVISION AND REGULATION:
CAPITAL TREATMENT FOR SOME CAPITAL MARKET TRANSACTIONS

To State Member Banks, Bank
Holding Companies, U.S. Branches
and Agencies of Foreign Banks,
and Others Concerned,
in the Twelfth Federal Reserve District

Capital Treatment for Certain Capital Markets Transactions Affected by the Events of September 11, 2001 (SR 01-24 [GEN])

In the aftermath of the September 11 attacks on the World Trade Center, a number of banking organizations have experienced delays in the clearing and settlement of their capital market transactions, such as repurchase and reverse repurchase transactions, securities lending and borrowing transactions, and securities sales. The delays may expose institutions to short-term credit risks they typically do not have when the clearing and settlement systems are operating normally. These credit risk exposures are often greatly mitigated because they are collateralized, in many cases by cash or government securities.

In order to address the effects of temporary settlement and clearing disruptions, the Federal Reserve Board will allow banking organizations some flexibility in calculating capital ratios for the third quarter of 2001.

Temporary Flexibility for Capital Ratios Calculations

Under the Federal Reserve's risk-based capital guidelines, exposures collateralized by cash or by Organization for Economic Cooperation and Development (OECD) government securities may receive a zero percent risk weight only under limited circumstances. The rules require that a positive margin of collateral be maintained on a daily basis, fully taking into account any change in the banking organization's exposure to the obligor or counterparty under a claim in relation to the market value of the collateral held in support of that claim. If these conditions are not met, the portion of the claim collateralized by the cash or market value of the OECD government securities is assigned to the 20 percent risk category.

Many of the capital market transactions entered into between September 10 and September 28 that were affected by disruptions in the settlement and clearing process were not subject to daily margining, the process that allows an institution to ensure that a positive margin of collateral is always maintained. Daily margining, for example, is not practiced for securities sold and booked under trade date accounting, but for which the cash settlement has not yet been received. Nonetheless, the cash receivable generally is collateralized by the securities sold and held by a third party custodian and would be available to the banking organization in the event of the counterparty's bankruptcy. Similarly, reverse repurchase transactions that have matured but for which the counterparty, due to settlement disruptions, has not made the required cash payment to settle its obligation to repurchase the securities are not subject to daily margining. The securities the counterparty sold subject to repurchase, however, remain available to the banking organization for liquidation in the event of counterparty failure.

In light of the exceptional, but temporary, disruptions in clearing and settlement systems resulting from the events of September 11, the Federal Reserve Board has determined that state member banks and bank holding companies may risk weight at zero percent certain capital markets transactions entered into between September 10 and September 28 whose settlement was affected by these disruptions. The transactions must be collateralized by cash or OECD government securities, and the banking organization must mark daily the collateral and, where applicable, the exposure, to market. In addition, the banking organization must have the unfettered, legally enforceable right to immediately seize and liquidate the collateral for its benefit in the event of the counterparty's insolvency or bankruptcy. In applying this treatment, banking organizations may risk weight at zero percent only the portion of the exposure covered by the market value of the collateral. The uncovered portion would receive the risk weight applicable to the counterparty. The Federal Reserve Board has determined that this exceptional treatment will apply only for purposes of reporting third quarter 2001, risk-based capital ratios.

Additional Information

All circulars and documents are available on the Internet through the Federal Reserve Bank of San Francisco's Internet site, at http://www.frbsf.org/banking/letters. Paper copies of the Board's notice (Docket SR-1-24 [GEN]) are available from our Corporate Services Department. To request copies to be sent by mail, please call (415) 974-2060.

For additional information about the capital treatment of certain capital market transactions in light of the September 11 events, please contact our Banking Supervision and Regulation Department at (415) 974-2225.

FEDERAL RESERVE BANK OF SAN FRANCISCO