On March 4, 2016, the Federal Reserve Board (Board) proposed single-counterparty credit exposure limits (Proposal) as required by Section 165(e) of the Dodd-Frank Act. That section calls for the imposition of limits on net credit exposures to unaffiliated counterparties of nonbank financial companies supervised by the Board and of bank holding companies. It specifically refers to the types of exposures that should count as credit exposures and sets a basic limit of 25 percent of capital and surplus but otherwise leaves further specification of the details to the discretion of the Board.
Despite the fact that Section 165(e) requires the imposition of limits on nonbank financial companies supervised by the Board (commonly referred to as SIFIs), the Proposal does not do so. The preamble to the proposed regulation states that the Board intends to do this at a later time. The Proposal does, however, contain limits on the net credit exposures incurred by foreign banking organizations in their US activities, including special rules for any intermediate holding company that any such banking organization may be required to establish. This client alert will focus on some of the ways the various limits could relate to typical securitizations.
Net credit exposure limits resemble lending limits, but they apply to a wider range of credit extensions and expand the range of such limits beyond banks to US bank holding companies, foreign banking organizations and US intermediate holding companies of foreign banking organizations. The proposed limits, however, only apply to US bank holding companies and foreign banking organizations with total consolidated assets of $50 billion or more, however. Such entities are referred to as “covered companies.” Larger covered companies are subject to stricter limits than smaller ones and must comply within one year of the Proposal’s effectiveness rather than two. In addition, the credit exposure limits only apply to a foreign banking organization’s combined US operations (i.e., any US intermediate holding company, including its subsidiaries, and any US branches or agencies), even though the foreign banking organization’s total consolidated assets on a worldwide basis trigger the application of the credit exposure limits in the first place.
- Exposures of US covered companies with total consolidated assets of $50 billion or more to any single unaffiliated counterparty (and not to all counterparties taken together) are subject to a limit of 25 percent of their consolidated capital stock and surplus;
- Exposures of US covered companies with $250 billion or more in total consolidated assets or $10 billion or more in on-balance-sheet foreign exposures to an unaffiliated counterparty are subject to a limit of 25 percent of their tier 1 capital;
- Exposures of US bank holding companies identified as global systemically important bank holding companies (major covered companies) to an unaffiliated major counterparty are subject to a limit of 15 percent of their tier 1 capital;
- Exposures of the combined US operations of a foreign banking organization with total consolidated assets of $50 billion or more to an unaffiliated counterparty are subject to a limit of 25 percent of the foreign banking organization’s consolidated capital stock and surplus, and exposures of a US intermediate holding company to an unaffiliated counterparty are subject to a limit of 25 percent of the intermediate holding company’s consolidated capital stock and surplus;
- Exposures of the combined US operations of a foreign banking organization that has $250 billion or more in total consolidated assets or $10 billion or more in total on-balance-sheet foreign exposures to an unaffiliated counterparty are subject to a limit of 25 percent of foreign banking organization’s tier 1 capital;
- Exposures of a US intermediate holding company that has $250 billion or more in total consolidated assets or $10 billion or more in total on-balance-sheet foreign exposures to an unaffiliated counterparty are subject to a limit of 25 percent of the intermediate holding company’s tier 1 capital;
- Exposures of the combined US operations of a foreign banking organization with total consolidated assets of $500 billion or more to an unaffiliated major counterparty are limited to 15 percent of the foreign banking organization’s tier 1 capital; and
- Exposures of a US intermediate holding company with total consolidated assets of $500 billion to an unaffiliated major counterparty are subject to a limit of 15 percent of the intermediate holding company’s tier 1 capital.
Operation of the Limits
These credit exposure limits are just limits. They do not impose new capital or liquidity requirements and do not directly affect any counterparties; rather, they could affect deal structures, to the extent some calculations of exposures rely on something other than nominal values, and they could limit relationships with certain counterparties if the volume of transactions with those counterparties is very high. Moreover, the limits are net limits; that is, they apply to exposures after the effects of certain permitted types of hedges, collateralization and netting arrangements have been taken into account. In order to understand these possible effects, it is necessary to understand some of the ways credit exposures are calculated and aggregated. This will be done with regard to the kinds of exposures that are common in securitization transactions.
In doing so, it may be helpful to keep several things in mind. One is the background use of concepts and definitions from the regulations dealing with the calculation of the amount of capital that is required. These provide the basic approach to the concept and calculation of credit exposures. The credit exposure rules themselves then articulate the netting and attribution of exposures in somewhat more detail. Another is the relationship to the lending limits applicable to banks, mentioned above. Those rules aggregate extensions of credit when made to one person for the benefit of another and when a common enterprise is involved. Similar notions (although different percentage values) are found in the Proposal and will be mentioned below. A third is the fundamental importance of attribution. Because the credit exposure rules do not result in the calculation of an amount of required capital but instead seek to limit the amount of potential risk resulting from exposures to persons or linked groups of persons, one fundamental aspect of their operation is the way in which they attribute whatever exposure is calculated. For example, even if a hedge may reduce an exposure to one counterparty, it may create an exposure to another, namely to the provider of the hedge.
A covered company could incur a credit exposure with respect to a securitization in a number of ways. It could own an asset-backed security issued by a securitization vehicle, provide liquidity or credit support to the vehicle, hedge the interest rate or currency positions of the vehicle or fund in various ways the acquisition by a warehouse vehicle of assets that are intended to be securitized. It could also provide credit support or interest rate or currency protection to a holder of an interest in a securitization vehicle, specifically with respect to that interest. When evaluating its credit exposures in such circumstances a covered company will need to determine the identity of the person to whose credit it is exposed, the relationship between that person and others with whom it may be affiliated or on whom it may be economically dependent, the availability of any special rule for calculating the amount of any exposure, and the existence of any hedges, collateral or netting arrangements that are eligible to net out some or all of any such credit exposure. The credit exposures calculated in these circumstances will then need to be added to the other credit exposures the covered company has to the various relevant persons from other sources, since the limits apply to the aggregate net exposure to each person to whose credit the covered company is exposed.
Examples of Potentially Unexpected Exposures
In most cases the person to whose credit the covered company is exposed will be the covered company’s direct counterparty or the other party to a contract. However, this will not always straightforwardly be the case. For example:
- If a gross credit exposure to a borrower is hedged or reduced by an eligible guaranty, the covered company will have a net credit exposure to its borrower (equal to the amount of the borrowing minus the amount of the eligible guaranty) and a gross credit exposure (which could itself be netted) to the eligible guarantor (in the amount of the eligible guaranty).
- If the covered company has less than $250 billion in total consolidated assets and less than $10 billion in total on-balance-sheet foreign exposures, then its exposure to a securitization vehicle, investment fund or other special purpose vehicle will be measured with respect to the obligation or security held, rather than with respect to the assets in the vehicle.
- If, however, the covered company has assets whose value meets or exceeds one or both of such thresholds, then its credit exposures will generally be calculated with respect to the issuers of the assets held by the vehicle (and not to the vehicle itself) unless the covered company can demonstrate that the exposure to each of those issuers that arises by virtue of the covered company’s exposure to the vehicle is less than 0.25 percent of its tier 1 capital. If the look-through requirement would apply except that the covered company cannot identify an issuer of assets held by the vehicle, it must attribute the credit exposure to an “unknown counterparty.” All exposures to unknown counterparties must then be aggregated as if they related to a single counterparty. Exposure to each issuer or counterparty, whether known or unknown, is calculated pursuant to the rule set out in §252.75(b)(3), which differentiates between cases in which the covered company holds interests that are pari passu with the interests held by others and all other cases.
- The covered company must also recognize a credit exposure to any person that has “a contractual or other business relationship” with the vehicle if the “failure or material financial distress” of that person would reduce the value of the covered company’s investment in or exposure to the vehicle. Such a person could, for example, be the fund manager, liquidity provider or a protection provider to the vehicle. Interestingly, the amount of any such exposure required to be recognized would be equal and in addition to the exposure to the vehicle itself.
- If a covered company were to have an aggregate net credit exposure equal to five percent or more of its consolidated capital stock and surplus or its tier 1 capital (depending on its size) to a particular person, the aggregate net credit exposure to that particular person would need to be aggregated with the credit exposures of the covered company to all other persons that are economically interdependent with that particular person. The same is true with regard to control relationships. These are general requirements, but they might conceivably have surprising consequences in connection with securitizations if the economic interdependence or control relationship somehow involves a securitization vehicle.
- Exposures to qualifying central counterparties (e.g., for certain derivatives) are not counted.
- Finally, a special rule governs the size of the credit exposure if a covered party provides credit protection to a counterparty by way of a credit or equity derivative and the issuer of the reference asset is the counterparty.
Ignoring the various attribution issues mentioned above and the possibilities of hedging and netting, the exposure created by a committed credit line (for example, to a securitization warehouse vehicle) would equal the amount of the credit line; the exposure created by a guaranty or letter of credit would equal the maximum potential loss to the guarantor or L/C issuer; and the exposure created by a derivative equals the sum of X and Y, where X equals the greater of the mark-to-market value of the derivative and zero and Y equals the notional principal amount of the derivative times a factor given in a table in Regulation Q of the Board. Repurchase transactions create exposures for the covered company equal to the adjusted market value of the securities transferred by the covered company, whereas reverse repurchase transactions create exposures for the covered company equal to the amount of the cash transferred by the covered company.
Foreign Banking Organizations
The rules sketched above relating to the evaluation of single-counterparty credit exposures deriving from or related to securitizations were phrased, for ease of exposition, in terms applicable to US bank holding companies. The separate rules in the Proposal relating to exposures of foreign banking organizations and their US intermediate holding companies in similar situations are, however, essentially identical. One interesting difference is the exclusion of any US affiliate of a foreign banking organization from the definition of “eligible protection provider.” This exclusion is not found in the definition of “eligible guarantor,” which is the relevant definition for US bank holding companies. Both terms designate a person whose credit support can be used to net out some or all of a credit exposure to a counterparty. In any event, a US bank holding company would not recognize a credit exposure to an affiliated eligible guarantor, since exposures are calculated only for unaffiliated counterparties. On the other hand, such a holding company would have to recognize the exposure of its affiliated guarantor to any unaffiliated counterparty. Presumably the recognition of the exposure created by the affiliated guarantor would allow the netting out of (some of) the credit exposure of the US holding company to its counterparty, the guaranteed entity, just as it would if the credit protection were provided by an unaffiliated guarantor.
As is so often the case, even a relatively abbreviated attempt to sketch the effect of new, complicated rules on the typical array of securitization-related transactions has revealed a number of possible interactions that will require attention in structuring any such deals. Consideration of these possibilities during the comment period for the Proposal could be a valuable exercise in some cases.
 Given the parallels to the methods for computing liquidity requirements (aggregation of the effects of different kinds of financial relationships), also a result of the Dodd-Frank Act, it might be argued that these limits on credit exposures have in effect already been implemented.
 SIFIs do, however, play a role as “major counterparties” in the operation of the Proposal, as discussed below.
 Keeping in mind that, in the US, foreign banking organizations are regulated as if they were bank holding companies.
 To avoid needless repetition for the remainder of this alert the word “proposed" will simply be assumed when talking about the provisions of the Proposal.
 When referring to a single counterparty, it is important to keep in mind that the Proposal requires that the exposures to certain counterparties can be attributed to (and aggregated with) another. For the remainder of this Alert, references to “a counterparty” and the credit exposure limits should be understood as indicating a single counterparty as that counterparty may be created by the various attribution rules.
 A major counterparty is (i) a major covered company together with its subsidiaries, collectively; (ii) any foreign banking organization that the Board determines meets the requirements of the Basel Committee on Banking Supervision for status as a global systemically important banking organization or would meet the Board’s requirements for such status under Regulation Q of the Board; and (iii) any SIFI.
 Note that a foreign banking organization is not required to establish a US intermediate holding company unless it has non-branch US assets worth at least $50 billion.
 How this $10 billion factor relates to the other size factors for foreign banking organizations is unclear, since presumably almost any foreign banking organization with total consolidated assets of $50 billion will have on-balance-sheet foreign exposures of at least $10 billion.
 The nature of an eligible guaranty is one of the concepts borrowed from the credit regulations. Ultimately, the term stands for a number of concepts that relate both to the terms of the guaranty and the nature of the guarantor.
 The rules described in the next bullet point will apply, however, if the Board determines that the covered company is attempting to evade the single-counterparty credit limits that generally apply to the company.
 And not with respect to the covered company’s overall, aggregate exposure to such issuer.
 All references to sections are to sections of the Proposal.
 Section 252.75(c).
 “In making a determination as to whether any two counterparties are economically interdependent, a covered company shall consider the following factors: (i) Whether 50 percent or more of one counterparty’s gross revenue or gross expenditures are derived from transactions with the other counterparty; (ii) Whether one counterparty (counterparty A) has fully or partly guaranteed the credit exposure of the other counterparty (counterparty B), or is liable by other means, and the credit exposure is significant enough that counterparty B is likely to default if presented with a claim relating to the guarantee or liability; (iii) Whether 25 percent or more of one counterparty’s production or output is sold to the other counterparty, which cannot easily be replaced by other customers; (iv) Whether the expected source of funds to repay any credit exposure between the counterparties is the same and at least one of the counterparties does not have another source of income from which the extension of credit may be fully repaid; (v) Whether the financial distress of one counterparty (counterparty A) is likely to impair the ability of the other counterparty (counterparty B) to fully and timely repay counterparty B’s liabilities; (vi) Whether one counterparty (counterparty A) has made a loan to the other counterparty (counterparty B) and is relying on repayment of that loan in order to satisfy its obligations to the covered company, and counterparty A does not have another source of income that it can use to satisfy its obligations to the covered company; and (vii) Any other indicia of interdependence that the covered company determines to be relevant to this analysis.” §252.76(a)(2).
 “(1) A covered company shall assess whether counterparties are connected by control relationships due to the following factors: (i) The presence of voting agreements; (ii) Ability of one counterparty to significantly influence the appointment or dismissal of another counterparty’s administrative, management or governing body, or the fact that a majority of members of such body have been appointed solely as a result of the exercise of the first counterparty’s voting rights; and (iii) Ability of one counterparty to exercise a controlling influence over the management or policies of another counterparty.” §252.76(b).
 The defined term does not contain the word “clearing,” but is clearly intended to refer to entities such as derivatives clearing organizations. Not counting such exposures is intended to support the operations of such organizations but could also create additional concern in the minds of persons who worry that central clearing organizations might actually create systemic risk.
 There is also a special attribution rule, found in §252.73(c), that a credit transaction with one counterparty creates a credit exposure to another counterparty “to the extent that the proceeds of the transaction are used for the benefit of, or transferred to,” the other counterparty. Since this would literally be true of each purchase of an asset-backed security from a securitization vehicle, the relevant counterparty in a securitization could theoretically be the sponsor or depositor. However, the preamble to the Proposal provides as follows: “It is the Board’s intention to avoid interpreting the attribution rule in a manner that would impose undue burden on covered companies by requiring firms to monitor and trace the proceeds of transactions made in the ordinary course of business. In general, credit exposures resulting from transactions made in the ordinary course of business will not be subject to the attribution rule.” Proposal, p. 36.
 Note, however, that if a covered company must recognize an exposure to a counterparty that hedges the covered company’s exposure to another counterparty with which the covered company has entered into a derivative, the derivative exposure is ignored as a source of exposure to the counterparty to the derivative, regardless of whether the derivative exposure is subject to a netting arrangement. Instead, the covered company now has a credit exposure to the counterparty that provided the hedge.
 For repurchase and reverse repurchase transactions that are subject to an appropriate bilateral netting arrangement the resulting net exposure equals the exposure at default amount calculated under the generally applicable capital rules, so long as certain conditions are satisfied. The net exposure relating to eligible guaranties, equity derivatives and credit derivatives also involves the calculation of a maturity mismatch factor.
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