Official Seal of the Board of Governors of the Federal Reserve System 

Official Letterhead Stationery for the 

Division of Banking Supervision and Regulation 

Board of Governors of the Federal Reserve System 

Washington, D.C. 20551 

August 15, 2006 

Gregory J. Lyons 

Goodwin Procter LLP 

Exchange Place 

Boston, MA 02109 

Dear Mr. Lyons: 

This is in response to your letter dated June 19, 2006 (“the request”) on behalf of State 

Street Corporation (“SSC”), Boston, Massachusetts, and its wholly owned subsidiary, 

State Street Bank and Trust Company (“State Street”), Boston, Massachusetts, with 

regard to the regulatory capital treatment of certain securities lending transactions. In 

these transactions, State Street, acting as agent for clients, lends its clients’ securities 

and receives liquid securities collateral in return (the “securities collateral transactions”). 

[Footnote 1. Begin text of Footnote 1. The liquid securities collateral includes government 

agency, government-sponsored entity, corporate debt or equity, or asset-backed or mortgagebacked securities. End Footnote 1.] Each securities loan is marked-to-market daily, and 

State Street calls for additional margin as needed to maintain a positive margin of collateral 

relative to the market value of the securities lent at all times. State Street also agrees to 

indemnify its clients against the risk that, in the event of borrower default, the market 

value of the securities collateral is insufficient to repurchase the amount of securities lent. 

The request states that if the borrower were to default, State Street would be in a position 

to terminate a securities collateral transaction and sell the collateral in order to purchase 

securities to replace the securities that were originally lent. Thus, State Street’s exposure 

under a securities collateral transaction is limited to the difference between the purchase 

price of the replacement securities and the market value of the securities collateral. 

The Federal Reserve Board’s risk-based capital guidelines (“the guidelines”) treat 

indemnifications issued in connection with agency securities lending activities as offbalance sheet guarantees that must be converted at 100 percent to an on-balance sheet 
asset (12 CFR parts 208 and 225, App. A, section III.D.1.c.). The resulting asset is then 

assigned to the lower of the risk-weight category appropriate to the counterparty or the 

collateral (12 CFR parts 208 and 225, App. A, section III.C.). Accordingly, the indemnity 

provided by State Street under the securities collateral transactions would qualify for a 

0 percent risk weight if it were fully collateralized by cash or OECD government 

securities. The indemnity would receive a 20 percent risk weight if State Street’s 

counterparty were an OECD bank or a qualifying securities firm, or if the collateral were 

composed of securities issued or guaranteed by U.S. government-sponsored enterprises. 

If, however, the securities collateral transactions were collateralized by corporate debt or 

equity securities and were entered into with counterparties that are not OECD banks or 

qualifying securities firms, the resulting asset generally would be risk-weighted at 100 

percent. 

In the request, you ask that SSC and State Street receive a risk-based capital treatment for 

the securities collateral transactions similar to that which the Federal Reserve Board (“the 

Board”) extended to State Street in a letter dated May 14, 2003 (“the prior approval”) for 

transactions in which State Street, acting as agent for clients, lends its clients’ securities 

and receives cash collateral in return, then reinvests the cash collateral in a reverse 

repurchase agreement and receives securities collateral in return. In the transactions 

subject to the prior approval (the “cash collateral transactions”), State Street indemnifies 

its client against the risk of default by the securities borrower and the risk of default by 

the reverse repurchase counterparty. 

In support of the request, you note that the current capital treatment for securities 

collateral transactions results in a capital requirement that does not accurately reflect the 

actual risk involved in such transactions. You also argue that the securities collateral 

transactions are economically equivalent to the cash collateral transactions for which the 

Board granted relief in the prior approval. In both cases, State Street, as agent, 

indemnifies its client against counterparty default and effectively holds securities as 

collateral against the obligations of the counterparty. You further argue that the securities 

collateral transactions generally present less operational risk to State Street than the cash 

collateral transactions because of the reduced number of contractual arrangements 

required in the securities collateral transactions. 

In addition, you highlight that the current U.S. bank regulatory capital treatment for the 

securities collateral transactions gives rise to competitive equity issues, given that both 

foreign banks and U.S. non-bank securities lenders generally incur a lower regulatory 

capital requirement for these transactions than U.S. banks. You underscore the 

competitive benefits of greater collateral flexibility by stating that the primary growth 

areas for State Street’s securities lending business are Europe, Asia and Canada, all of 

which are predominantly non-cash collateral markets. Furthermore, you indicate that 

engaging in securities collateral transactions provides income diversification for State 

Street because income through these transactions is fee-based whereas cash collateral 

transactions are based on interest rate spreads. 

Under the treatment outlined in the prior approval for cash collateral transactions, State 

Street is required to determine an unsecured loan equivalent amount for each of the 

2 
counterparties to which State Street, as indemnifying agent, lends securities collateralized 

by cash and/or lends cash collateralized by securities. The unsecured loan equivalent 

amount is determined as the sum of the current exposure to the counterparty and a 

measure for potential future exposure (“PFE”) to the counterparty. The current exposure 

is the sum of the market values of all securities and cash lent to the counterparty under 

State Street’s indemnified arrangements, less the sum of the market values of all 

securities and cash received from the counterparty as collateral under the indemnified 

arrangements. The PFE calculation is based on the market volatilities of the securities 

lent and the securities received, as well as any foreign exchange rate volatilities 

associated with any cash or securities lent or received. The unsecured loan equivalent 

amount, determined as described above, is then assigned a risk weight appropriate to the 

counterparty for risk-based capital purposes. 

The prior approval permits State Street to use a value-at-risk (“VaR”) model for 

incorporating estimates of market volatilities into the calculation of PFE for each 

counterparty. Use of a VaR model allows State Street to take into account correlation of 

market price volatilities among the instruments it lends, as agent, to a counterparty and 

among the instruments it, as agent, takes as collateral from a counterparty, as well as 

correlations between the instruments lent to, and received as collateral from, the 

counterparty. The prior approval noted that State Street would be required to calculate 

daily an unsecured loan equivalent amount, including the VaR PFE component. 

In the request you ask that the Board approve an exception to the guidelines by 

permitting State Street to measure exposure amounts for risk-based capital purposes with 

respect to the securities collateral transactions under the methodology of the prior 

approval. 

After consideration of the request and subject to certain conditions listed below, the 

Board approves an exception to the guidelines that permits SSC and State Street to treat 

the securities collateral transactions described in the request in a manner that differs from 

that set forth in the guidelines. More specifically, the Board grants the request of SSC 

and State Street to use an unsecured loan equivalent amount (calculated as current 

exposure plus a VaR-modeled PFE) for the securities collateral transactions referenced 

above for risk-based capital purposes. The Board approves this exception under the 

reservation of authority provision contained in the guidelines. This provision permits the 

Board, on a case-by-case basis, to determine the appropriate risk weight for any asset or 

off-balance sheet item that imposes risks on a state member bank or bank holding 

company that are incommensurate with the risk weight otherwise specified in the 

guidelines (12 CFR parts 208 and 225, App. A, section III.A.). 

As with the prior approval, State Street must calculate the VaR PFE component using a 

five-business-day holding period and a 99th percentile one-tailed confidence interval 

based on market price data over a one-year historical observation period. The data set 

used should be updated no less frequently than quarterly and should be reassessed 

whenever market prices are subject to material changes. For each counterparty, State 

Street will be required to calculate daily an unsecured loan equivalent amount, including 

the VaR PFE component. These calculations will be subject to supervisory review to 

3 
ensure they are in line with the quarter-end calculations used to determine regulatory 

capital requirements. 

To qualify for the capital treatment outlined above, the securities collateral transactions 

covered by State Street’s indemnification must meet the following conditions: 

1. The transactions are fully collateralized; 

2. Any securities lent or taken as collateral are eligible for inclusion in the trading 

book and are liquid and readily marketable; 

3. Any securities lent or taken as collateral are marked-to-market daily; and 

4. The transactions are subject to a daily margin maintenance requirement. 

Further, the transactions must be executed under a bilateral netting agreement, or an 

equivalent arrangement. These arrangements must: 

1. Provide the non-defaulting party the right to terminate and close-out promptly all 

transactions under the agreement upon an event of default, including in the event 

of insolvency or bankruptcy of the counterparty; 

2. Provide for the netting of gains and losses on transactions (including the value of 

any collateral) terminated and closed out under the agreement so that a single net 

amount is owed by one party to the other; 

3. Allow for the prompt liquidation or setoff of collateral upon the occurrence of an 

event of default; 

4. Be, together with the rights arising from the provisions required in 1) to 3) above, 

conducted under documentation that is legally binding on all parties and legally 

enforceable in each relevant jurisdiction upon the occurrence of an event of 

default and regardless of the counterparty’s insolvency or bankruptcy; and 

5. Be conducted under documentation for which State Street has completed 

sufficient legal review to verify it meets provision 4) above and for which State 

Street has a well-founded legal basis for reaching this conclusion. 

State Street currently has a VaR model that has been approved for purposes of the 

Board’s market risk capital rule (12 CFR parts 208 and 225, App. E). The Board has 

determined that State Street will be permitted to use its VaR model to determine the PFE 

for each of the securities collateral transaction counterparties, subject to ongoing 

supervisory review of the model. State Street must conduct regular and rigorous 

backtesting procedures, which will be subject to supervisory review, on the counterparty 

VaR model the firm uses to ensure the validity of the correlation factors employed in the 

model and the stability of these factors over time. The counterparty VaR model will not 

be subject to a formal backtesting procedure at this time. If supervisory review indicates 

that State Street’s counterparty VaR model or its backtesting procedures have material 

deficiencies and State Street does not take appropriate and expeditious steps to rectify 

those deficiencies, however, the Federal Reserve may take actions to adjust State Street’s 

capital calculations. These actions could range from imposing a multiplier on the VaR 

estimates of PFE calculated by State Street to disallowing the use of its counterparty VaR 

4 
model and requiring use of a simpler, more conservative, own estimates approach to 

determine the PFE component of the unsecured loan equivalent amounts. 

The Board believes that the capital treatment approved above for the securities collateral 

transactions provides a more risk-sensitive treatment for these transactions than that set 

forth under the guidelines. Moreover, the capital treatment approved for State Street in 

this letter is more consistent with best market practices and provides positive incentives 

for State Street to manage collateral actively and prudently. State Street should, however, 

be aware that the Board may in the future impose a regulatory capital treatment for these 

transactions that differs from the treatment described in this letter, depending in part upon 

the outcome of the current efforts to implement Basel II in the United States. 

This determination is conditioned on State Street’s compliance with all the commitments 

and representations it has made in connection with the request. These commitments and 

representations are deemed to be conditions imposed in writing by the Board in 

connection with granting the request and, as such, may be enforced in proceedings under 

applicable law. Further, this determination is based on the specific facts and 

circumstances described in the request and on discussions with Federal Reserve staff. 

Any material change in those facts and circumstances or any failure by State Street to 

observe any of its commitments or representations may result in a different view or in a 

revocation of the regulatory capital treatment permitted under this determination. 

The capital treatment set forth in this letter for these transactions will be made available 

to similarly situated institutions that request and receive Board approval for such 

treatment. 

If you have any questions with regard to this letter, please direct them to Norah Barger, 

Associate Director in the Division of Banking Supervision and Regulation, at 

(202) 452-2402, Juan C. Climent, Supervisory Financial Analyst in the Division of 

Banking Supervision and Regulation, at (202) 872-7526, or Mark Van Der Weide, 

Senior Counsel in the Legal Division, at (202) 452-2263. 

Sincerely yours, 

(signed) 

William G. Spaniel 

Acting Director 

5