# O

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| ## Comptroller of the Currency                                        |
|                                                                       |
| > Administrator of National Banks                                     |
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Washington, DC 20219

###### Interpretive Letter #1038

August 16, 2005 **September 2005**

> Subject: [Credit Risk and Capital Charge for the Government Card
> Program]{.underline}

Dear **\[ \]**:

**\[ *Mr. A* \]** asked for our views on the appropriate capital
treatment for unused portions of lines of credit (unused lines) on
credit cards issued by the **\[ \]** (**\[ *NB* \]**) to Federal
employees (hereinafter, **\[ *NB* \]** letter).[^1] In the **\[ *NB*
\]** letter, **\[ *Mr. A* \]** suggested that the OCC should not impose
a capital charge on the unused lines because the bank has an
unconditional right to cancel the accounts. In the alternative, he
argued that, even if the cards are not unconditionally cancelable,
historic loss data do not support a 50 percent conversion factor.

We conclude that the unused lines are not unconditionally cancelable,
within the meaning of our risk-based capital rules, but that the OCC
will use its reservation of authority in 12 C.F.R. § 3.4 to assign a
zero percent conversion factor to the lines. This reflects our
conclusion that a zero percent conversion factor more appropriately
reflects the credit risk to **\[ *NB* \]** associated with the unused
lines.

#### DISCUSSION

####  *Background* 

**\[ *NB* \]** is under contract with the General Services
Administration (GSA) to provide purchasing, travel, and fleet charge
cards to government agencies and employees as a payment tool for
official government purchases and travel expenses.[^2] Under this
program, cards held by individual employees are defined as "individual
liability accounts" (ILAs). Liability for all charges and fees incurred
on ILAs rests solely with the cardholder, and the government bears no
secondary liability. Cards held by agencies are "central liability
accounts" (CLAs) and are a liability of the United States.[^3]

Federal employees may use their cards for official travel charges only
and must pay off the balance each billing cycle. As stated in the **\[
*NB* \]** letter, the ILA cards were not intended to be revolving lines
of credit and, therefore, bear no interest. Employees are responsible
for paying their accounts, although the government may offset
delinquencies against an employee's paycheck. [^4] Employees also have
the option to authorize their agency to pay ILA card balances to **\[
*NB* \]** directly under the Federal split disbursement and direct pay
program. For **\[ \]** (***Agency***) employees, the agency must
directly pay all approved invoices to **\[ *NB* \]**. [^5]

Under the GSA contract, **\[ *NB* \]** has the right to cancel an ILA
if: (1) the account has been suspended two times during a 12-month
period because the accountholder failed to timely pay his or her bill
for undisputed amounts and the account is past due for a third time; (2)
the account is past due for 120 days or more from statement closing for
undisputed amounts; or (3) the accountholder uses the card for
unauthorized purchases. **\[ *NB* \]**'s ability to cancel an account,
however, is not absolute; *agencies retain the contractual right to
direct* **\[ *NB* \]** *to keep an employee's account active if the
agency determines that there are "mission-related extenuating
circumstances*." Although the term "mission-related extenuating
circumstances" is not defined in the GSA contract, some agencies have
explained its meaning. For example, according to **\[ *NB* \]**, under
the **\[*Agency*\]** contract, the concept of "mission related" is
defined as "mission critical," which in turn means "travel performed by
**\[*Agency*\]** personnel under competent orders and performing duties
that through no fault of their own, may prohibit the prompt payment of
their outstanding travel charge card bills."[^6]

##### Analysis

The OCC's risk-based capital rules are intended to primarily mitigate
credit risk. Under the capital rules, a bank must convert unused
portions of retail credit lines to an on-balance sheet asset and risk
weight the converted asset. If the unused portion of such a commitment
is "unconditionally cancelable by the bank in accordance with applicable
law," then the unused portion is subject to a 0% on-balance sheet
conversion factor.[^7] As a result, there is no capital charge on the
unused portion. "Unconditionally cancelable*"* means, with respect to a
commitment-type lending arrangement, that the bank may, at any time,
with or without cause, refuse to advance funds or extend credit under
the facility.[^8] If the unused lines are not unconditionally
cancelable, then the bank must apply a 50% conversion factor to the
unused portions of commitments to extend credit.[^9]

In the preamble to the rule adopting this provision, we clarified that
the phrase "in accordance with applicable law" refers to state laws that
require notice before cancellation of credit card accounts. *See* 54
Fed. Reg. 4168, 4174 (January 27, 1989) (discussing treatment of retail
credit arrangements). Our intention, as expressed in the preamble, was
to avoid penalizing banks that operate in states with notice
requirements given that, after notice, the banks could proceed with
cancellation. Specifically, the preamble notes:

Commenters also recommended that open-end credit arrangements should
receive a conversion factor of 0% to the extent they are unconditionally
cancelable "in accordance with applicable law." In an effort to avoid
inequities that could arise in states that have notice requirements
before such credit arrangements can be cancelled, the OCC has adopted
the recommended phraseology. However, to the extent state law makes
open-end retail credit arrangements practically uncancelable, these
items will be treated as long-term commitments and receive a credit
conversion factor of 50%.

*Id*.[^10]

In the **\[ *NB* \]** letter, **\[ *Mr. A* \]** argued that ILA accounts
are "unconditionally cancelable," notwithstanding that the bank must
receive permission from the agency before canceling an ILA account. **\[
*Mr. A* \]** characterized this step as the equivalent of a notice
requirement. As a corollary, he argued that an agency's ability to delay
cancellation of "mission-critical" accounts does not make the accounts
"practically uncancelable."

The contractual language does not support a conclusion that the ILA
accounts are unconditionally cancelable. Under the terms of the
contract, the Federal agencies have the unqualified right to block the
cancellation of an ILA when an employee is on a "mission critical
assignment." The need to obtain agency permission to cancel a contract
is not the equivalent of the notice requirement the OCC contemplated in
drafting the regulation. We understand that notice requirement to be a
procedural step that does not affect the bank's ability to ultimately
cancel an account. In this case, although notice is given to the agency,
the bank cannot proceed unfettered to cancel the contract; the agency
still retains the right to block the cancellation of the account. Also,
under the agreement, **\[ *NB* \]** may cancel an account only *if* one
of three specific circumstances exist: (1) the account has been
suspended two times during a 12-month period for failure to make timely
payments and the account is past due for a third time; (2) the account
is past due for 120 days or more from statement closing; or (3) the
accountholder uses the account for unauthorized purposes. Accordingly,
the right to cancel an account is not "unconditional."

Notwithstanding that the accounts are not unconditionally cancelable,
the OCC may assign a 0% conversion factor to the unused portion of the
ILAs if a 0% factor best reflects the credit risks associated with them.
The OCC's regulations contain a reservation of authority that allows the
OCC to look to the substance of a transaction and depart from the
specific provisions of the risk-based capital guidelines if the assigned
risk weight or credit equivalent amount or conversion factor for any
off-balance sheet item "does not appropriately reflect the risks imposed
on a bank."[^11] In such cases, the OCC "may require another risk
weight, credit equivalent amount, or credit conversion factor that the
OCC deems appropriate."[^12] The use of a 50% conversion factor for an
off-balance sheet item reflects an assessment that a certain amount of
credit risk is associated with the exposure.[^13] We believe the
specific factual circumstances presented in the **\[ *NB* \]** letter
support the conclusion that the credit risk associated with the unused
ILA lines is better reflected by a 0% conversion factor.

In the GSA SmartPay Program, agencies infrequently use their ability to
veto the bank's cancellation of an ILA. As noted in the **\[ *NB* \]**
letter, agencies have historically denied only two or three account
closings per quarter, out of 30 to 45 per quarter closed for default or
unauthorized activity.[^14] That only one or two accounts per quarter
must remain open, notwithstanding the bank's judgment that it should be
closed because of a perceived credit risk or unauthorized activity,
supports the conclusion that the 50% conversion factor does not reflect
the appropriate level of credit risk.

**\[ *Mr. A* \]** also submitted data showing a significantly lower loss
rate for government cards. As a matter of policy, the OCC ordinarily
places only limited reliance on actual, historical loss data as a basis
for assigning a different risk weight or credit conversion factor than
our rules prescribe. Here, however, it appears that demonstrably lower
loss rates are in large part attributable to the unique character of the
GSA Smart Pay program. The key distinguishing features of the program
are: (1) the purpose of the program is to facilitate the operations of
the Federal government; (2) the ILA cards can only be used for
government purposes, in contrast to unsecured consumer credit cards,
which can be used for any purpose and still qualify for a 0% conversion
factor (if they are unconditionally cancelable); and (3) though
individual borrowers are responsible for repayment, the amounts charged
to the card will ordinarily be reimbursable because the charges are
incurred in connection with a Federal employee's performance of his or
her official duties.

The Federal purpose, limited use, and Federal reimbursement features of
the ILA cards distinguish them from ordinary consumer credit cards and
should substantially reduce the credit risk associated with them. The
loss data provided in the attachment to the **\[ *NB* \]** letter bear
out that conclusion.[^15] Given that the Smart Pay program is
distinguishable from all or most other card programs, reliance on loss
data here does not obligate us to consider it for other non-governmental
programs. Moreover, according to the information provided in the **\[
*NB* \]** letter, the reasons for the Federal government to require an
account to remain open when there is a contractual reason to close it do
not necessarily involve deterioration in the Federal borrower's
creditworthiness. For example, under the **\[*Agency*\]** contract as
the **\[ *NB* \]** letter describes it, "mission critical extenuating
circumstances" result from the performance of duties that may preclude
the borrower from making timely payment of his or her bill. No inference
about a change in the creditworthiness of the borrower can necessarily
be drawn from those circumstances.

Further, in the case of **\[ *Agency* \]**, the special government pay
program further substantially reduces the bank's exposure to credit
risk. As noted above, under this program, **\[ *Agency* \]** requires
its employees to use the Federal split disbursement and direct pay
program. In this situation, once an employee submits his or her travel
voucher, the government will pay the amount due directly to **\[ *NB*
\]**. In addition, employees may only use the card for travel purposes
and may not carry a balance beyond one billing period.

In sum, we believe that, based on the facts presented in the **\[ *NB*
\]** letter concerning the credit risk associated with ILAs, the 0%
conversion factor should apply to the unused lines. This determination
is made specifically under the facts presented in the **\[ *NB* \]**
letter and may not be relied on for determining the risk-based capital
treatment of any other scenario or for determining the risk-based
capital treatment of any components of the government card program other
than unused lines. We trust that the foregoing is responsive to **\[
*NB* \]**'s request.

Sincerely,

/s/

Tommy Snow

Director, Capital Policy

[^1]: Letter from **\[ *Mr. A* \]**, Deputy General Counsel, **\[ *NB*
    \]**, to **\[ \]**, Examiner-in-Charge (January 21, 2004).

[^2]: *See* GSA SmartPay Master Contract (SmartPay Contract).

[^3]: As stated in the **\[ *NB* \]** letter, approximately 46% of the
    \$6.5 billion "annual spend" on these cards is through ILAs, while
    54% of this amount is through CLAs. *See* **\[ *NB* \]** Letter at
    2.

[^4]: *See* 31 C.F.R. § 285.7 (describing the salary offset provisions).

[^5]: **\[ \]**

    **\[ \]**

    **\[ \]**.

[^6]: **\[ *NB* \]** letter, *supra,* at 5.

[^7]: 12 C.F.R. Pt. 3, App. A § 3(b)(4)(iii).

[^8]: 12 C.F.R. Pt. 3, App. A § 1(c)(34).

[^9]: *Id.* App. A § 3(b)(2)(ii).

[^10]: The applicability of particular state notice requirements to a
    national bank is not at issue here and, accordingly, we do not
    address it. We note, however, that whether a particular state notice
    requirement applies would be appropriately analyzed under the OCC's
    preemption rules and the underlying Supreme Court precedents. *See*
    12 C.F.R. § 7.4008(d)(2) (non-real estate lending; state law
    limitations concerning the terms of credit).

[^11]: 12 C.F.R. § 3.4(b).

[^12]: *Id.*

[^13]: *See* 53 [Fed. Reg]{.smallcaps}. 8550, 8552 (March 15, 1988)
    (noting that off-balance sheet credit risk weighting is "based
    primarily upon broad judgments of relative credit risk.")

[^14]: **\[ *NB* \]** Letter, *supra,* at 5.

[^15]: *See* **\[ *NB* \]** Letter at Appendix B (comparing annualized
    loss rates per quarter of the government and consumer card
    programs). According to **\[ *Mr. A* \]**'s letter, the annualized
    loss rate for the government card program has been "consistently and
    significantly lower" than the loss rate for its general consumer
    card program. *See id.* at 6. Going forward, **\[*Mr. A*\]** stated
    that **\[ *NB* \]** expects the program to have a credit loss of
    approximately **\[ \]** basis points, which he asserted will
    continue to be below the expected loss rate for **\[ *NB* \]**'s
    general consumer card program. *Id.* As with general consumer card
    programs, we believe the 100% risk weight applicable to *drawn* ILA
    balances should provide a sufficient risk-based capital requirement.