OPINION OF THE  EUROPEAN MONETARY INSTITUTE
on a consultation from the Council of the European Union under Article 109 f (6) of the Treaty
establishing the European Community as amended by the Treaty on European Union and Article 5.3 of
the Statute of the EMI;
on a Proposal for a European Parliament and Council Directive amending Council Directive 89/647/EEC
with regard to the recognition of contracts for novation and netting agreements (“contractual netting”) by
supervisory authorities (COM (94) 105 final).
CON/94/7
1. The present consultation was initiated on 22 November 1994 by the Council of the European
Union which, for this purpose, transmitted document “COM (94) 105 final” containing the
proposed Directive and various explanatory memorandums to the EMI.
2. The proposed Directive aims at adjusting Community legislation to arrangements already made
within the framework of the Basle Committee on Banking Supervision. These arrangements entail
that not only bilateral netting by novation but also other forms of bilateral netting such as bilateral
netting by close-out are accepted by supervisory authorities as risk reducing, provided that certain
conditions are met, and may therefore be taken into account in the determination of a solvency
ratio for credit institutions. As such determination in the Member States of the European Union is
governed by Council Directive 89/647/EEC, this Directive needs to be changed.
3. Netting, or set-off, is a legal instrument which over the past few years has become increas ingly
important in the foreign exchange markets (for contractual netting) and in payments systems (for
payments netting) with a view to reducing counterparty and systemic risks. This importance was
underlined by the establishment in 1989 of a working group of the G10 countries under the
chairmanship of Mr A. Lamfalussy, at the time General Manager of the Bank for International
Settlements, which undertook an extensive study to netting and laid down its observations in the
so-called Lamfalussy-Report of November 1990. One of the conclusions of this report is that
netting should have a sound legal basis.
4. The present proposal for a Directive deals with bilateral contractual netting of rights and
obligations arising from over-the-counter interest rate and exchange rate derivatives contracts
between two counterparties and its main objective is to bring European Union credit institutions
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with regard to the determination of a solvency ratio in the same position as non-Eur opean Union
credit institutions whose solvency ratios are based on the recommendations of the Basle
Committee on Banking Supervision. In the past, it was already accepted that bilateral netting by
novation may be taken into account in the determination of a solvency ratio, provided that this
form of netting is legally valid in all relevant jurisdi ctions. This has now been extended to other
forms of bilateral netting with the same effect, namely that (at  the latest) at the moment of
insolvency of a party to a netting agreement all mutual rights and obligations covered by the
netting agreement are amalgated in one net amount. This would preclude the liquidating authority
from requi ring fulfilment of contracts which are favourable to the insolvent party, whilst refusing
the fulfilment of unfavourable contracts (also known as “cherry picking”). Provided that such an
arrangement is legally valid in all relevant jurisdictions, it would not only r educe counterparty risk
for the parties to the contract but more in general enhance the stability of the financial markets (a
matter which has been mentioned in Article 4.1, fourth indent, of its Statute as of specific interest
to the EMI). The EMI therefore su pports the use of these forms of netting, agrees with the view
that such forms (provided that they have a sound legal basis) may be taken into account in the
determination of a solvency ratio and consents that this for credit institutions in the Member States
of the European Union indeed requires the proposed adjustment of Directive 89/647/EEC.
16th January 1995