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")
Date: 1994-04-27
Institutions: European Commission
Subjects: clearing agreement, competition, credit institution, exchange rate, financial solvency, interest

COMMISSION  OF THE EUROPEAN  COMMUNITIES 

COM(94)  105 final 
Brussels,  27.04.1994 
94/0099(COD) 

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") 

(presented by the Commission) 

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MOTIVATION  OF THE  "CONTRACTUAL NETTING  DIRECTIVE"  IN  RESPECT 
OF THE  PRINCIPLE  OF  SUBSIDIARITY 

The Drective amends a Drective which already exists in the light of developments in another 
international forum  of banking supervisors. These developments are very likely to open to the 
third  country  competitors  of  European  credit  institutions  the  possibility  of  achieving  under 
certain conditions a reduction in capital requirements for their derivatives business.  European 
credit institutions can achieve a similar result only if the Solvency  Ratio Directive is changed 
by the suggested  amendment.  There is no way  by  which  the aim  of  the measure,  namely  to 
achieve a higher degree of legal  safety  in the area concerned  and the maintenance of a level 
playing  field  for  internationally  active  credit  institutions,  can  be  achieved  by  measures  at 
national  level.  Therefore,  Union  legislation  is  indispensable  to  achieve  the  aim  of  this 
measure.  The principle  of  subsidiarity  is therefore  complied  with. 

EXPLANATORY  MEMORANDUM 

I.  Main  objective  of the  proposal 

The  aim  of  this  Directive  is  a  modification  of  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  open  the  possibility  for 
a  broader  supervisory  recognition  of  the  risk  reducing  effect  of  bilateral  netting  than  at 
present. The present text of the Solvency Ratio Directive recognizes only bilateral  netting by 
novation  as  a  risk  reducing  factor.  According  to  the  proposal,  the  national  supervisory 
authorities will  have the possibility  of recognising the risk reducing effect  of further  types of 
bilateral  netting  and,  in  particular,  of  bilateral  close-out  netting,  provided  that  the  legal 
validity  of  the  contractual  netting  is  proven.  The  Directive  mirrors  the  work  of  another 
international  supervisory  forum  on  the  issue  of  bilateral  netting.  Therefore,  the  desirable 
consistency  between  important  international  supervisory  frameworks  is ensured. 

As Council  Directives  93/6/EEC  of  15 March  1993  on  the  capital  adequacy  of  investment 
firms  and  credit  institutions  and  92/121/EEC of  21 December  1992 on  the  monitoring  and 
control  of 
those  provisions  of 
Directive  89/647/EEC  which  are  amended  by  the  Directive,  the  amendments  made  in  this 
Directive will  apply  in the framework  of  Directives  93/6/EEC  and  92/121/EEC  as well. 

large  exposures  of  credit 

institutions 

refer 

to 

II.  EXTENSION  OF THE PROPOSED DIRECTIVE  TO THE EEA 

As  the  Solvency  Ratio  Directive  is  contained  in  the  Annex  to  the  EEA  agreement  (see 
Annex  X,  II  No  18) and  applies to all  countries of the EEA,  the proposed  Directive,  which 
amends the Solvency  Ratio Directive, is to be extended to the EEA. Therefore,  this Directive 
shall  be inserted  in the Annex  IX of the EEA  agreement  under  II  No  19a. 

III.  COMMENTS  ON  INDIVIDUAL  ARTICLES 

Article 1 

Article  1 is confined  to the amendment of the second paragraph  of Annex  II of the  Solvency 
Ratio Directive.  For  editorial  purposes these rules concerning  contractual  netting have been 
placed  below  the general  applicable rules for  the treatment  of off-balance-sheet  transactions 
(point 3). 

The  headings  which  have  been  introduced  will  improve  the  clarity  and  presentation  of 
Annex II. 

Points  I and 2 of the new text correspond  to the former  Annex II with the sole exception  that 
the former  second  paragraph  has been  replaced  by the new point 3. 

Point 3(a) defines the types of netting which are eligible for supervisory  recognition. The draft 
distinguishes  between  netting  by  contracts  for  novation  (point  3(a)(1))  and  by  other  netting 
agreements (point 3(a)(ii)>. The type of netting described in point 3(a)(1) encompasses the type 
of  netting  which  has already  been  eligible for  supervisory  recognition. 

Point  3(b)  fixes  the  minimum  conditions  subject  to  which  the  supervisory  authority  may 
recognize  contractual  netting  as risk reducing. 

A first condition (i) sets a requirement for the content of the agreement of contractual  netting. 
This requirement  ensures  that the  claims and  obligations which  result  from  the  transactions 
included  in the contractual  netting  are amalgamated  into one  single claim  or  obligation. 

In addition, the institution  must furnish  to the supervisor written  and reasoned  legal  opinions 
on  the  enforceability  of  the  contractual  netting  in  the  event  of  legal  challenge  (ii).  The 
supervisor  must  be  satisfied  that  the contractual  netting  in  question  is  legally  binding  in  all 
relevant jurisdictions.  The institution  is held to monitor  permanently  the legal  validity  of its 
contracts for  contractual  netting (iii). 

The  last  but  one  paragraph  of  point  3(b)  prohibits  the  supervisory  recognition  of  netting 
agreements  which  contain  a walkaway  clause. 

The  last  paragraph  of  point  3(b)  obliges  Member  States  to  undertake  a  minimum  of 
coordination  with  respect to the assessment  of the legal  validity  of netting. 

Point  3(c)  deals  with  the  effects  of  the  supervisory  recognition  of  contractual  netting.  The 
Directive draws a strict distinction between  netting by a contract for novation and  netting by 
other netting agreements. The reason for this strict distinction is founded  in the different  legal 
consequences of the two types of netting. The netting by a contract for novation creates a new 
single contract  which  replaces the (old) contracts  included  in the novation  clause.  Compared 
with  that,  the  netting  by  a  netting  agreement  leaves  the  different  contracts  included  in  the 
agreement  legally  untouched. 

The effects  of  contractual  netting  are the  following: 

The effects  of a contract for novation are spelled out in point 3(c) (i): when using method  1, 
netting by a contract for  novation  reduces both the current  replacement  cost and the notional 
amount (sentence  1  of point 3(c)(i)). When using method 2, the contract for novation  reduces 
the notional  amount; the percentages to be used in  step (a) remain  unchanged  (sentence 2 of 
point  3(c)(i)).  These  rules  correspond  to the  treatment  under  the  original  Directive.  As all 
contracts  for  novation  amalgamate  the  included  contracts  into  one  single  new  contract,  the 
legal  consequences  are basically  the  same for  all  contracts  included  in  netting  by  novation. 
Therefore,  it  is  appropriate  to  apply  the  same  method  for  the  reduction  of  the  capital 
requirement  to all  cases of netting by  novation. 

The effects  of other  netting  agreements  are spelled  out  in point  3(c)(ii): 

The  effects  depend  on  the  method  used.  The  first  subparagraph  deals  with  method  I.  In 
principle,  the netting  agreement  can be taken  into account  only  in the calculation  of current 
replacement  costs (step  (a)  of  method  1). Current  replacement  costs can  be  calculated  on a 
net basis (point 3(c)(ii), first sentence of the first paragraph). There is, however, a special rule 
for  foreign  exchange  contracts and  other  similar contracts in which  the notional  principal  is 
equivalent to cash flows. Claims and obligations resulting from  transactions in this category 
can be netted  in the calculation  of  step (b) when they  are denominated  in the same currency 
and  fall  due  on  the  same  value  date  (cases  of  "perfect  matching";  point  3(c)(ii),  second 
sentence of the first paragraph). 

The effects  under the use of method 2 are laid down in point 3(c)(ii) subparagraph 2. The first 
indent  deals with  the cases of  "perfect  matching"  in the case of  foreign  exchange and  other 
similar transactions where the notional  principal  is equal to the cash flows. For this group of 
transactions,  the  netting  agreement  can  be  taken  into  account  by  calculating  the  notional 
amount  on  a  net  basis.  The  credit  conversion  factors  ("percentages")  remain  unchanged 
(point  3(c)(ii), first indent of the second subparagraph). For all other transactions, the netting 
agreement can be taken into account through the application of the reduced credit  conversion 
factors  ("percentages")  set out in table 3. 

Article 2 

The amendment  of  Annex  II  introduces  new detailed  conditions  for  the  confirmation  of the 
legal  validity  of  netting.  Article 2  contains the necessary  grandfathering  provision  for  those 
bilateral  contracts  for  novation  which  have been  concluded  before  these amendments  to  the 
Solvency  Ratio  Directive  are  implemented  by  Member  States.  The  provision  leaves  the 
verification  of the legal  validity  of  these contracts  for  novation  to national  discretion. 

Article 3 

requires 

this  Directive  by 
This  Article 
31 December  1994.  A rapid  implementation  is in  the  interest  of  the  competitiveness  of  the 
European credit institutions and investment firms. It promotes, furthermore,  the  convergence 
of  international  supervisory  frameworks. 

that  Member  States  should 

implement 

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") 

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 the 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, 

(,) 
(2) 

OJ  No L 386, 30.12.1989,  p.  14. 
OJ No  L  HO, 28.4.1992,  p.  52, as rectified  in  OJ No L 280, 24.9.1992,  p. 59. 

HAVE  ADOPTED THIS DIRECTIVE 

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

Article 1 

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 twentieth day following  that of its publication in 
the Official  Journal  of the European Communities. 

This Directive is addressed to the Member States. 

Article 5 

Done at Brussels, 

For the European Parliament 
The President 

For the Council 
The President 

"ANNEX  II 

ANNEX 

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  t:  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(,),  the  notional  principal 
amounts or values underlying  an institution's  aggregate books are multiplied  by 
the following  percentages: 

TABLE 1 

Residual  maturity 

Interest-rate  contracts 

Foreign-exchange 

One year  or less 

More than  one year 

0% 

0.5% 

contracts 

1% 

5% 

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. 

(i) 

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

8 

Method  2:  the  "originai  exposure"  approach 

Step (a): 

the notional  principal amount of each instrument is multiplied  by the percentage 
given  below: 

TABLE  2 

Original  maturity(>> 

One year  or  less 

More than  one year but 
not exceeding  two years 

Additional  allowance  for 
each  additional  year 

Interest-rate  contracts 

Foreign-exchange  contracts 

0.5% 

1% 

1% 

2% 

5% 

3% 

{2) 

In  the  case  of  interest-rate  contracts,  credit  institutions  may,  subject  to the  consent  of 
their  supervisory  authorities,  choose either  original  or residual  maturity. 

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) 

(ii) 

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 
unrealised  gains  and  losses on  included  transactions, 

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  recogzed  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  I  for 

Step (a): 

the current  replacement  cost 

-  Step  (b): 

the notional  principal amounts or values underlying an institution's 
aggregate  books 

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

(ii)  Other  netting  agreements 

In  application  of  method  I  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  tor  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: 

Original  maturity(,) 

One year  or less 

More than  one year  but 
not  exceeding two years 

Additional  allowance  for 
each  additional  year 

TABLE 3 

Interest-rate  contracts 

Foreign-exchange  contracts 

035% 

0.75% 

0.75% 

1.50% 

3.75% 

2.25% 

(I) 

In the case of interest-rate contracts, credit  institutions  may,  subject  to the consent of 
their  supervisory  authorities,  choose  either  original  or  residual  maturity." 

IMPACT  ON  COMPETITIVENESS  AND  EMPLOYMENT 

I  What  is the main justification  for  the  measure? 

The  purpose  of  the  Directive  is  to  recognize  certain  risk  reducing  effects  of  bilateral 
contractual  netting  agreements  between  credit  institutions,  investment  firms  and  their 
counterparties.  The possible achievement  of a reduction  in the capital  charge will  encourage 
the use of  such  netting techniques  and  will  thus contribute  to the safety  and  stability  of  the 
European financial industry. The Directive will place European  institutions on a level  playing 
field with  their  competitors  from  third  countries  whose  authorities  are  likely  to  grant  their 
credit  institutions the same possibility  for  a reduction  in  capital  requirements. 

II  Characteristics  of the enterprises  concerned 

The Directive will  impact  on the business of credit institutions  and investment  firms.  As the 
financial  instruments  concerned  require  a  high  degree  of  managerial  skills,  costly  data-
processing equipment and great knowledge of the markets, the institutions concerned are big 
internationally  active institutions.  Regional  and  small  institutions  are less concerned  as they 
are less active in the relevant business. 

Ill  What  are the obligations  imposed  directly  on  enterprises? 

As  long  as an  institution  does not  want  to take  advantage  of  the envisaged  reductions in 
capital  requirements,  the  Directive  does not  entail  additional  obligations. 

The recognition  of the risk  reducing  effect  of  netting  by  national  supervisors,  however,  is 
subject  to the fulfilment  of  certain  conditions: 

the conclusion  of a legally  binding  netting  contract  which  meets certain  criteria; 

the provision  to the national  supervisor  of  legal  opinions which  prove the  legal 
validity  of the netting  contract; 

permanent  monitoring  of the legal  validity  of the  contract. 

These are indispensable  preconditions which  ensure the  necessary  legal  robustness  of the 
netting contracts. 

IV.  What  obligations  are likely  to be imposed  on  enterprises through  local  authorities? 

The  local  authorities  (in  this  case  the  competent  national  supervisory  authorities)  will  have 
to ensure that the conditions (cf.  III.) for  supervisory  recognition  are met.  As the Directive 
follows the principle of minimum harmonization, the national  supervisory authorities remain 
free  to impose  additional  obligations. 

12 

V. 

Are there  special  measuj es foi; S.MEsTJf  so,  of  what  kind? 

Yes.  As already  foreseen  in the present  text  of  the  Solvency  Ratio Directive  (89/647/EEC), 
the Directive provides for  a less sophisticated  method (the  "method 2" or  "original  exposure 
method") to calculate the  capital  requirement.  This method  will  be used  by  the  smaller  and 
less sophisticated  institutions  and  responds to their  specific  needs. 

VI.  What  is the anticipated  effect  on: 

(a) 

the  competitiveness  of  enterprises? 

(b) 

(a) 

employment? 

The  Directive  will  ensure that  the  European  credit  institutions  are not  competitively 
disadvantaged against their competitors from third countries which are likely to benefit 
from  a  similar  possibility  of a reduction  in  capital  requirements  in the near  future 

(b) 

There is no measurable  effect  on  employment. 

VII.  Have the social  partners been  consulted?  What  are their  views? 

No.  The  measure  proposed  does  not  impact  on  industrial  relationships  and  the  level  of 
employment. 

13 

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COM(94) 105 final 

DOCUMENTS 

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10 09 

Catalogue number : CB-CO-94-113-EN-C 

ISBN 92-77-66944-6 

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