Opinion on the 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 393/06)

The Council decided on 13 July 1994, in accordance with Article 57(2) of the Treaty establishing the European Economic Community, to ask the Economic and Social Committee for an Opinion on the abovementioned proposal.

The Section for Industry, Commerce, Crafts and Services, which was responsible for the preparatory work, adopted its Opinion on 28 July 1994. The Rapporteur was Mr R. Pelletier.

At its 318th Plenary Session (meeting of 14 September 1994) the Economic and Social Committee adopted unanimously the following Opinion.

1. Presentation of the Proposed Directive

The aim of the proposed directive is to amend Annex II of the Solvency Ratio Directive (89/647/EEC). This Annex deals with the treatment of off balance sheet items concerning interest and foreign exchange rates. The intention is to allow a broader supervisory recognition of the risk reducing effect of bilateral netting than at present. Since the present text of the Solvency Ratio Directive recognizes only bilateral netting by novation as a risk reducing factor, the new proposal will enable national supervisory authorities to recognise the risk reducing effect of further types of netting and, in particular, of bilateral close-out netting, provided that the legal validity of the contractual netting is proven.

The proposed changes will also apply to Council Directives 93/6/EEC of 15 March on the capital adequacy of investment firms and credit institutions and 92/121/EEC of 21 December 1992 on the monitoring and control of large exposures of credit institutions.

As the Solvency Ratio Directive is contained in the Annex to the EEA Agreement, the new proposal should also be inserted in Annex IX of the Agreement under II No 19a.

2. Comments

The ESC is pleased that the Commission is proposing amendments to the Solvency Ratio Directive with the aim of maintaining the necessary consistency between EU legislation and the proposals being prepared by the Basle Committee.

This initiative will enable EU financial institutions to benefit from a relaxing of the capital requirements for covering risks associated with dealings in interest rate and foreign exchange contracts. It will prevent the distortion of competition between EU and non-EU institutions. The ESC therefore recommends that the proposed directive be adopted as rapidly as possible, although it would suggest certain changes which it thinks are necessary if the directive is to be applied properly in the different Member States.

These concern the following areas.

2.1. It is desirable to increase the legal security of such contracts throughout the European Union.

In addition to amending the Solvency Ratio, Own Funds and Large Risks Directives, it might well be a good idea for the Commission to put forward some form of binding Community act so that Member States which have no legislation on the validity of contracts for novation or netting agreements take the appropriate steps by 1 January 1996 at the latest. Such an initiative would enable the market in financial derivatives to develop in the EU within the spirit of the Single Market.

In the same spirit, the ESC also thinks it is necessary to adopt rapidly the 1985 draft Directive on the winding-up of credit institutions, amended in 1988.

2.2. The privileged status of netting by novation in the proposed Directive seems excessively influenced by common law and favours the prudential treatment of this type of netting.

For the needs of the present proposal, one can speak of three forms of netting:

2.2.1. Netting by novation:

The effect of netting by novation is to cancel initial commitments by the parties concerned and replace previous gross obligations by a single new obligation equal to the net amount. It assumes the existence of an agreement between the parties concerned.

Netting by novation may be relevant if the claims of parties towards each other are expressed in the same currency and have the same expiry date. So, its scope is fairly limited.

An important feature of netting by novation is that it operates as contracts are concluded. This makes 'cherry picking' impossible (i.e. the process where the liquidator of a bankruptcy differentiates between the claims and obligations concerned by requiring the enactment of those which are advantageous to the mass and refusing to pursue those which are not), except in the case of claims arising from the same contractual relationship, where neither 'cherry picking' nor the exception of non-performance is conceivable.

2.2.2. Netting by payment:

The parties are agreed that if, at any time, one of them has to pay through one of these 'payment centres' in foreign currency, he can amalgamate his debt with all of the sums in foreign currency which the other party owes him and just pay the balance.

2.2.3. Close-out netting:

Netting by close-out or acceleration is when a contract stipulates that the bankruptcy of one of the parties liquidates all current contracts, and results in the calculation of a single payment due by one party to another. The effect of 'netting by close-out' for a non-bankrupt party is to produce a credit or debit balance. But such contracts often contain a 'walkaway clause' allowing the non-bankrupt party not to pay off a net debit balance for which he might be liable following netting. The Basle Committee finds that such a clause introduces an element of instability and uncertainty which does not square with the idea of netting, and therefore proposes that netting contracts containing such a clause should not be taken into consideration when calculating standards for own funds.

But close-out netting, unlike netting by novation, does not have the effect of cancelling initial obligations; it is simply a means of settling payments which are due. This netting-out of payments only comes into effect in the event of a default and the total cancellation of all transactions as a result of this default. It allows current transactions to be paid off, their replacement value to be assessed and amalgamation to take place (the classic case of a default being that of bankruptcy).

2.2.4. Views differ on whether netting-out and amalgamation by contract are really interchangeable concepts. However, one thing seems certain: it is accepted under civil law that amalgamation may apply to third parties in the event of a bankruptcy whenever it concerns associated debts. As a result, amalgamation which is performed, for example, under a current account agreement may be applied to third parties, even if the claims concerned are expressed in another currency, have a different expiry date or have different features.

The proposed directive, which concerns the solvency ratio, only has to question the legal validity of these clauses in the event of the bankruptcy of a counterparty.

2.2.5. In this context close-out netting must see its legal validity fully recognised on the same footing as netting by novation. Anyway, legal systems which have taken account of the amalgamation of foreign exchange transactions - irrespective of whether they belong to the common law countries (USA, ...) or the civil law countries (Belgium, France) - recognize the validity of the close-out netting payment.

2.2.6.

Conclusions

2.2.6.1. The distinction drawn between netting by novation and other forms of netting in the Commission's proposal for a directive has no equivalent in the legislation of countries with a civil law system.

So, the definition of netting by novation contained in the proposal is surprising (a contract 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'). Such a definition appears to be inadequate compared with the law in countries with a civil law system. The Commission should therefore define netting by novation in terms which mean something in different legal systems.

2.2.6.2. In addition, it is possible that, in the eyes of countries with a civil law system, types of netting other than netting by novation may offer the same legal security as netting by novation as understood under common law.

It would therefore seem logical for the proposal to take this into account by granting other forms of netting the same privileged treatment as that given to netting by novation.

2.2.6.3. In some countries (USA, Belgium, France) specific legislation has just been adopted allowing the amalgamation of interbank payments under certain conditions. The aim of this legislation is to grant this particular form of amalgamation legal security at least equal to that given to netting by novation under common law.

One therefore wonders why the proposal should refuse to put payments made under these legislations on an equal footing, as regards prudential treatment, with netting by novation.

2.3.

Application of the proposed directive in practice

Article 1 - Annex (II) - Conditions for the recognition - page 9

The proposal states that amalgamation can only be applied if it is accepted that the claims and obligations of the credit institution are confined to the net value 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.

Such requirements lead to complications, which should be removed. Let us take an example: if a Spanish branch of a French bank concludes a rate swap with a Portuguese branch of a German bank, under an agreement of the British Bankers Association amalgamation would have to be permitted under French, Spanish, German, Portuguese and English law, which is a very severe constraint and leads one to wonder about the legal validity of amalgamation in territories where branches are located.

The proposal stipulates in (b)(ii) that the credit institution should have furnished to the supervisory authorities 'written and reasoned legal opinions...'. This obligation goes beyond the requirements set out by the Basle Committee and necessitates major transfers of documents which are not indispensable. It would suffice to require that the institution should keep its documents at the disposal of the supervisory authorities. In addition, the wording of the last paragraph (b)(iii) of the proposal is ambiguous. With respect to a smooth functioning of the single market, Member States are 'obliged to strive for a uniform assessment of agreements for contractual netting by their competent authorities'; is this an obligation or a recommendation? This freedom of assessment by national authorities must not lead to distortions of competition.

2.4.

Calculation of weightings

The draft directive proposes that the weightings applied for potential future contract risks should be based on the notional total of each contract. Such a method is too strict since in reverse transactions with the same counterparty the risks themselves are reversed. So, weightings should be based solely on the amalgamated amounts of contracts.

But generally the most logical method would be to adjust weightings in the light of the risk in each individual contract.

At the outside it could be proposed for all contracts, whether amalgamated or not, that the market value of contracts be subtracted from the weightings when this is negative. Compared with the current method for calculating solvency ratios, such a change would enable account to be taken of the fact that the appearance of any counterparty risk - assuming that a market value remains positive - is all the more unlikely when a contract portfolio is currently losing money. This could be done by calculating weightings in accordance with the results of the simulation methods used in banks.

2.5.

Multilateral amalgamation

Multilateral amalgamation is designed to extend the advantages of amalgamation to contracts concluded with any group of counterparties taking part in amalgamation arrangements, and not with a single counterparty as in bilateral amalgamation.

Multilateral amalgamation schemes such as ECHO and NACHO-MULTINET are being developed. The proposed directive should be amplified on this point, and indeed the Basle Committee has already given some thought to the matter. Multilateral amalgamation should not be treated as a sedimentation of bilateral amalgamation arrangements, since a claim against a defaulting party may be partially settled by claims held by that counterparty against other, non-defaulting members of the clearing system.

Bearing in mind the standing of the future participants in such schemes (echonetting,...) and the very low probability of several counterparties defaulting at the same time, there is no justification in taking account of a risk in the system, especially as the supervision carried out by the banking authorities on the clearing systems and the management rules applying to the system are safety factors compared with the risk involved in face-to-face transactions.

The reduction of counterparty risk should therefore be taken into account by applying some form of partial exemption geared to the features and quality of the multilateral amalgamation scheme.

It seems sufficient to impose a weighting of 20 % on the clearing system, even if it is not, strictly speaking, a credit institution. The Lamfalussy report envisages making bodies which manage clearing systems subject to a prudential supervisory authority which, irrespective of the legal status of the clearing system, should be sufficient grounds to justify giving it a weighting of 20 % as if it were a credit institution.

Done at Brussels, 14 September 1994.

The President

of the Economic and Social Committee

Susanne TIEMANN