Proposal for a European Parliament and Council Directive amending Council Directive 89/647/EEC with respect to the supervisory recognition of contracts for novation and netting agreements ('Contractual Netting`) (94/C 142/10) (Text with EEA relevance) COM(94) 105 final - 94/0099(COD)

(Submitted by the Commission on 28 April 1994)

THE EUROPEAN PARLIAMENT AND THE COUNCIL OF THE EUROPEAN UNION, Having regard to the Treaty establishing the European Community, and in particular Article 57 (2) thereof,

Having regard to the proposal from the Commission,

Having regard to the opinion of the Economic and Social Committee,

Whereas Annex II to Council Directive 89/647/EEC of 18 December 1989 on a solvency ratio for credit institutions (1), as amended by Directive 92/30/EEC (2), lays down the treatment of off-balance-sheet items concerning interest and foreign exchange rates in the framework of the calculation of capital requirements for credit institutions;

Whereas this Directive is in accordance with the work of another international forum of banking supervisors on the supervisory recognition of bilateral netting, notably the possibility of calculating the own funds requirements for certain transactions on the basis of a net instead of a gross amount provided that legally binding agreements exist which ensure that the credit risk is confined to the net amount;

Whereas the rules envisaged for the supervisory recognition of netting at the wider international level will lead to the possibility of reducing the capital requirements for internationally active credit institutions and groups of credit institutions in a wide range of countries whose credit institutions compete with Community credit institutions;

Whereas for credit institutions incorporated in the Member States, only an amendment of Directive 89/647/EEC can open a similar possibility for the supervisory recognition of bilateral netting and thereby provide them with equal conditions of competition; whereas the rules are both well balanced and suited to further reinforce the application of prudential supervisory measures to the sector of credit institutions;

Whereas, having regard to this situation, this Directive is in line with the principle of subsidiarity, since the aim of this Directive is achievable only by a harmonized amendment of existing Community legislation,

HAVE ADOPTED THIS DIRECTIVE:

Article 1

Annex II to Directive 89/647/EEC is replaced by the Annex hereto.

Article 2

Article 1 leaves without prejudice the supervisory recognition of bilateral contracts for novation which have been concluded before the entry into force of the laws, regulations and administrative provisions necessary for the implementation of this Directive.

Article 3

1. Member States shall bring into force the laws, regulations and administrative provisions necessary to comply with this Directive by 31 December 1994 at the latest. They shall immediately inform the Commission thereof.

When Member States adopt these measures, these shall contain a reference to this Directive or shall be accompanied by such reference at the time of their official publication. The procedure for such reference shall be adopted by Member States.

2. Member States shall communicate to the Commission the text of the main provisions of national law which they adopt in the field covered by this Directive.

Article 4

This Directive shall enter into force on the 20th day following that of its publication in the Official Journal of the European Communities.

Article 5

This Directive is addressed to the Member States.

(1) OJ No L 386, 30. 12. 1989, p. 14.

(2) OJ No L 110, 28. 4. 1992, p. 52, as rectified in OJ No L 280, 24. 9. 1992, p. 59.

ANNEX

'ANNEX II

THE TREATMENT OF OFF-BALANCE-SHEET ITEMS CONCERNING INTEREST AND FOREIGN EXCHANGE/RATES

1. SCOPE AND CHOICE OF THE METHOD

Subject to the consent of their supervisory authorities, credit institutions may choose one of the methods set out below to measure the risks associated with the transactions listed in Annex III. Interest-rate and foreign-exchange contracts traded on recognized exchanges where they are subject to daily margin requirements and foreign-exchange contracts with an original maturity of 14 calendar days or less are excluded.

2. METHODS

Method 1: the "marking to market" approach

Step (a): by attaching current market values to contracts (marking to market) the current replacement cost of all contracts with positive values is obtained.

Step (b): to obtain a figure for potential future credit exposures (1), the notional principal amounts or values underlying an institution's aggregate books are multiplied by the following percentages:

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Step (c): the sum of current replacement cost and potential future credit exposure is multiplied by the risk weightings allocated to the relevant counterparties in Article 6.

Method 2: the "original exposure" approach

Step (a): the notional principal amount of each instrument is multiplied by the percentages given below:

>TABLE>

(1) Except in the case of single-currency "floating/floating interest rate swaps" in which only the current replacement cost will be calculated.

Step (b): the original exposure thus obtained is multiplied by the risk weightings allocated to the relevant counterparties in Article 6.

3. CONTRACTS FOR NOVATION AND NETTING AGREEMENTS ("CONTRACTUAL NETTING")

(a) Supervisory acknowledgeable types of netting

The supervisory authorities may recognize as risk reducing the following types of contracts for novation and netting agreements:

(i) bilateral contracts for novation between a credit institution and its counterparty under which mutual claims and obligations are automatically amalgamated in such a way that this novation fixes one single net amount and thus creates a legally binding, single new contract extinguishing the former contracts;

(ii) other bilateral netting agreements between the credit institution and its counterparty.

(b) Conditions for the recognition

The supervisory authorities may recognize as risk reducing a contract for novation or a netting agreement under the following conditions only:

(i) the credit institution has a contract for novation or a netting agreement with its counterparty which creates a single legal obligation, covering all included transactions, such that, in the event of a counterparty's failure to perform due to default, bankruptcy or liquidation, the credit institution would have a claim or obligation, respectively, to receive or pay only the net value of the sum of unrealized gains and losses on included transactions;

(ii) the credit institution has furnished to the supervisory authorities written and reasoned legal opinions that, in the event of a legal challenge, the relevant Courts and administrative authorities would find that in the cases described under (i) the claims and obligations of the credit institution to be confined to the net value as described in (b) (i) above under:

- the law of the jurisdiction in which the counterparty is incorporated and if a foreign branch of an undertaking is involved, then also under the law of the jurisdiction in which the branch is located,

- the law that governs the individual transactions included, and

- the law that governs any contract or agreement necessary to effect the contract for novation or the netting agreement;

(iii) the credit institution has procedures in place to ensure that the legal validity of contracts for novation and netting agreements are kept under review in the light of possible changes in relevant laws.

The supervisory authorities, after consultation when necessary with other relevant supervisory authorities, must be satisfied that the contractual netting is legally valid under the law of each of the relevant jurisdictions. If one of these supervisory authorities is not convinced of the legal validity of the contractual netting under the law of its country the relevant contract for novation or the relevant netting agreement may not be recognized as risk reducing for either of the counterparties.

Contracts containing a walkaway clause shall not be recognized as risk reducing

With respect to a smooth functioning of the single market, Member States are obliged to strive for a uniform assessment of the agreements for contractual netting by their competent authorities.

(c) Effects of the recognition

(i) Contracts for novation:

The single net amount fixed by contracts for novation may be weighted, rather than the gross amounts involved. Thus, in application of method 1 for;

- Step (a): the current replacement cost,

- Step (b): the notional principal amounts or values underlying an institution's aggregate books,

may be obtained taking account of the contract for novation. In application of method 2 for step (a) the notional principal amount may be calculated taking account of the contract for novation; the percentages of table 2 apply.

(ii) Other netting agreements

In application of method 1 for step (a) the current replacement cost for the contracts included in a netting agreement may be obtained by taking account of the actual hypothetical net replacement cost which result from the agreement. For step (b): the netting agreement may only be taken into account for foreign-exchange contracts and other similar contracts, in which notional principal is equivalent to cash flows, in cases where the amounts to be claimed or delivered fall due on the same value date and in the same currency.

In application of method 2 for step (a)

- or foreign-exchange contracts and other similar contracts, in which notional principal is equivalent to cash flows, in cases where the amounts to be claimed or delivered fall due on the same value date and in the same currency, the notional principal amount may be calculated taking account of the netting agreement; to all these contracts table 2 applies,

- or all other contracts included in a netting agreement, the applicable percentages may be reduced as indicated in table 3:

>TABLE>

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