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)
Date: 1995-01-16
Institutions: European Monetary Institute
Subjects: banking supervision, competition, credit institution, exchange rate, financial derivative, financial solvency

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  increasingly

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-European  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  jurisdictions.  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 requiring 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 reduce 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 supports 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