May 2006
Guidance Note AGN 112.3
Netting
1.
Netting is a process by which all outstanding transactions between two
counterparties are combined and reduced to a single (net) sum for a party to
either pay or receive. The process is formalised in a netting agreement.
2.
From a prudential viewpoint, the key issue is whether an authorised deposittaking institution's (ADI’s) exposure against a counterparty (or counterparties)
is effectively limited to the net sum determined by a netting agreement ensuring
that the ADI’s credit risk is genuinely reduced.
Scope
3.
An ADI may only net for capital adequacy purposes off-balance sheet marketrelated transactions (across both the “banking” and “trading” books) with a
single counterparty that are subject to a legally valid form of bilateral netting
agreement – e.g. “close-out” netting or “netting by novation” agreement. This
may include netting across different market-related product types.
4.
This does not encompass netting market-related transactions against on-balance
sheet items (e.g. loan receivable against a negative revaluation on a marketrelated transaction) with the same counterparty. However, on-balance sheet
items may qualify as cash collateral for risk weighting the net sum of marketrelated transactions.
5.
The netting provisions set out in this Guidance Note include “credit derivatives”
to the extent that they are recognised as market-related transactions for capital
adequacy reporting purposes. However, they do not include “payments netting”.
Payments netting is designed to reduce operational costs and risks associated
with daily settlement of transactions and is not recognised for capital adequacy
purposes since an ADI’s credit risk arising from a counterparty’s gross
obligations to the ADI is not in any way affected by payments netting.
6.
“Close out netting” (sometimes called contractual netting) is a contractual
process designed to apply on the default of a counterparty when all outstanding
transactions between counterparties subject to the netting agreement are
combined and reduced to a single net payment. There are two stages to this
process:
AGN 112.3 – 1
May 2006
(a)
fixing of obligations on the occurrence of an event (typically insolvency);
and
(b)
calculating the cost to each party in closing out transactions according to a
prescribed formulae (often related to the cost of replacing a transaction by
buying an equivalent position in the market at the prevailing time).
The amounts due to both counterparties may be calculated in one currency or
converted to one currency and then netted to one single payment due by one
party to the other.
7.
“Netting by novation” refers to a “master” contract between two counterparties
under which any obligation between the parties to deliver a given currency (or
equity or debt instrument or commodity) on a given date is automatically
amalgamated with all other obligations under the agreement for the same
currency (pairs) and value date. The result is to legally substitute a single net
amount for the previous gross obligations.
Eligible bilateral netting agreements
8.
An ADI may only net for capital adequacy purposes, claims and obligations
arising from off-balance sheet market-related contracts with a counterparty that
is covered by a legally valid (i.e. eligible) bilateral netting agreement, subject to
the following conditions:
(a)
the bilateral netting agreement is in writing;
(b)
the bilateral netting agreement creates a single legal obligation covering
all transactions included in the agreement such that an ADI would have
either a claim to receive or an obligation to pay only the net sum of the
positive and negative mark-to-market values of individual transactions
covered by the agreement in the event that either party fails to perform
due to the default, liquidation or bankruptcy (or other similar
circumstances); 1
(c)
the ADI has obtained a written and reasoned legal opinion(s) to the effect
that in the event of the default, liquidation or bankruptcy (or other similar
circumstances) of a party to the bilateral netting agreement, the relevant
courts and authorities would find the ADI’s claims and obligations are
limited to the single net sum determined in the eligible bilateral netting
agreement under:
(i)
1
the law of the jurisdiction in which the counterparty is incorporated
and, if a foreign branch of the counterparty is involved, the law of
In some countries there are provisions for the authorities to appoint an administrator/conservator
to a troubled bank. Under statutory provisions applying in those countries, the appointment of
an administrator may not constitute grounds for the triggering of netting agreements. Such
provisions do not prevent the recognition of affected netting agreements for the purposes of
these guidelines provided that a netting agreement can still take effect in the event the bank
under administration does not meet its obligations under market-related transactions as they fall
due.
AGN 112.3 – 2
May 2006
the jurisdiction in which the branch is located;
(ii)
the law that governs the individual market-related transactions
involved; and
(iii) the law that governs any contract or agreement necessary to give
effect to the netting;
9.
2
(d)
the ADI has procedures in place to monitor possible changes in relevant
laws or other legal developments (e.g. court decisions) to ensure that the
bilateral netting agreement continues to be fully effective (in the event
that legal developments adversely affect the enforceability of netting
agreements, an ADI must move promptly to report the transactions
affected on a gross basis rather than as a net sum);
(e)
the ADI has adequate systems and controls in place to record and manage
the transactions covered by the netting arrangements on a net basis in
accordance with the terms of the bilateral netting agreement; and
(f)
the bilateral netting agreement is not subject to a walkaway clause. 2
An ADI which wishes to utilise netting provisions in this Guidance Note must
inform APRA of its intention to do so and provide a copy of the ADI’s netting
policy and a description of its systems and controls covering netting. An ADI
should inform APRA of any material changes in its netting policy and systems
and controls. The description of its systems and controls should include, as a
minimum, the following:
(a)
who has responsibility for setting and reviewing policy on netting (and the
frequency at which netting policy is reviewed);
(b)
types of counterparties and transactions covered by bilateral netting
agreements;
(c)
types of netting being utilised (e.g. close-out, novation, etc);
(d)
who has responsibility for approving the application of an individual
bilateral netting agreement to transactions, to enable calculation of
exposures on a net basis (including determining compliance of individual
agreements with existing legal opinion or whether separate legal opinions
are required for them);
(e)
jurisdictions affecting netting agreements to which the ADI (or a member
of the consolidated group) is a party. The ADI should note any
jurisdictions in which doubt might exist as to the enforceability of netting
and what action the ADI had taken as a result in reporting affected
transactions for capital adequacy purposes;
A walkaway clause is a provision which applies to a netting agreement that permits a nondefaulting counterparty to make only limited payments, or no payments at all, to a defaulting party,
even if the defaulting party is a net creditor.
AGN 112.3 – 3
May 2006
(f)
sources of legal opinions used by the ADI, and the basis of their expertise;
(g)
how the ADI monitors legal developments affecting its netting
agreements, and the need to obtain additional legal opinions for new
jurisdictions;
(h)
procedures for monitoring roll-off of exposures and the impact of this on
the ADI’s credit exposure and capital adequacy; and
(i)
processes for determining and reporting net exposures to individual
counterparties.
10.
It is the responsibility of an ADI to ensure that it has fully complied with all the
requirements set out in this Guidance Note before the netting agreement(s) is
utilised for capital adequacy purposes.
11.
External auditors should include, in their opinion provided to APRA each year
regarding an ADI’s compliance with minimum capital ratios, whether they are
satisfied with the ADI’s compliance with the systems and records requirements
set out in this Guidance Note for netting of transactions.
Legal opinion
12.
An ADI with a general legal opinion covering the enforceability of netting in a
particular jurisdiction, may rely on that opinion when assessing the
enforceability of individual bilateral netting agreements involving the
jurisdiction, provided the ADI has determined that the type of individual
bilateral netting agreement involved is encompassed by the general legal
opinion.
13.
An ADI must satisfy itself that the bilateral netting agreement, and supporting
legal opinions, are applicable to each counterparty, transaction and product type
undertaken with the counterparty, and in all jurisdictions involved in such
transactions (regard should be given to counterparties governed by special rules
relating to insolvency e.g. local authorities, banks and insurance companies).
The ADI should verify the existence of any facts referred to in the bilateral
netting agreement and that all documentation is complete. It should also satisfy
itself that all parties involved in a bilateral netting agreement have the capacity,
power and authority in relation to the agreement and that the agreement has
been properly executed.
14.
If a positive legal opinion regarding enforceability of a bilateral netting
agreement is subject to assumptions and/or qualifications, these must not be
unduly restrictive. They should be specific and of a factual nature and should be
adequately explained in the opinion. An ADI should review and assess all
assumptions, qualifications and omissions in legal opinions on bilateral netting
agreements as to whether they give rise to any material doubts as to the
enforceability of a bilateral netting agreement. Where there is any material
doubt as to the enforceability of a bilateral netting agreement, the agreement
cannot be recognised for capital adequacy purposes.
AGN 112.3 – 4
May 2006
15.
In the event that legal developments adversely affect the enforceability of
netting agreements, an ADI must move promptly to report the transactions
affected on a gross basis rather than as a net sum.
16.
Where a satisfactory legal opinion cannot be obtained regarding the
enforceability of netting transactions involving a specific jurisdiction (e.g. in the
case of transactions done through or with a specific branch), but that the netting
of other transactions under the agreement continues to be enforceable, the
former transactions will need to be excluded from netting in determining the net
sum due to/from the counterparty involved. Transactions excluded from being
netted must be reported on a gross basis.
17.
Where an ADI is aware that a regulator or supervisor of a counterparty has
given notice that it is not satisfied netting is enforceable under the laws of its
country, the netting agreement will not qualify as an eligible bilateral netting
agreement for capital adequacy purposes regardless of any opinion obtained by
the ADI.
18.
An ADI utilising netting for capital adequacy purposes must maintain records
adequate to support the application of an eligible bilateral netting agreement.
This includes records necessary to demonstrate compliance with the
requirements set out in this Guidance Note (e.g. appropriate legal opinions,
assessment of the applicability of netting agreements to counterparties, etc).
Records should incorporate a copy of the netting agreement, and any other
relevant legal documentation (including English translations where appropriate).
Collateral and guarantees
19.
Where a legal agreement with a counterparty contains provisions for applying
collateral and/or guarantees to netted exposures outstanding between an ADI
and the counterparty, the ADI must ensure that the provisions comply with the
requirements set out in Guidance Note AGN 112.1 Risk-Weighted On-Balance
Sheet Exposures with respect to eligible collateral and guarantees.
20.
Collateral and guarantees may be used in calculating the risk weight to be
applied to the net sum calculated under an eligible netting agreement which is
covered by the collateral and/or guarantee. Risk weights may not be assigned
based on collateral and guarantees unless the collateral and/or guarantees have
been posted and are legally available for all individual transactions making up
the net sum of exposures involved. For example, where collateral covers only a
specific class of transactions in a pool of netted transactions (e.g. US/DM
foreign exchange transactions or contracts with a maturity under one year), the
collateral only provides protection against those transactions and not to the net
sum (which may be produced by netting all forms of foreign exchange, interest
rate swaps and other transactions of multiple maturities undertaken with a
counterparty). Consequently, the collateral must not be used in determining the
risk weight to be applied to that net sum.
AGN 112.3 – 5
May 2006
Application of eligible bilateral netting agreements
21.
Where an ADI satisfies all the requirements in this Guidance Note for bilateral
netting, it may report off-balance sheet market-related transactions with a
counterparty on a net basis and calculate the credit equivalent amount of those
transactions in accordance with the methodology outlined below.
Credit equivalent amount
22.
Exposures on transactions falling under netting agreements must be calculated
for capital adequacy purposes using the current exposure method.
23.
The credit equivalent amount (CEA) of transactions subject to an eligible
bilateral netting agreement is calculated as the sum of the net current credit
exposure (NCCE) (i.e. net mark-to-market replacement cost) of all transactions
covered by the netting agreement, if positive, plus an “add-on” (PFCEadj) for
potential future credit exposure based on the notional principal of all the
individual underlying contracts (i.e. the gross potential future credit exposure)
adjusted to reflect the effects of the netting agreement. Thus:
CEA = NCCE (if positive) + PFCEadj
Net current credit exposure
24.
NCCE is the sum of all positive and negative mark-to-market values of all
individual contracts covered by an eligible bilateral netting agreement (i.e.
positive mark-to-market values of transactions may be offset against negative
mark-to-market values on other transactions covered by the netting agreement).
If the net sum of individual mark-to-market values is positive then, the NCCE is
equal to that sum. If the sum of mark-to-market values is zero or negative, then
the NCCE is set equal to zero.
Potential future credit exposure
25.
For the purposes of calculating gross potential future credit exposure, matching
opposing transactions included in a netting agreement may be taken into
account as a single transaction with a notional principal equivalent to the net
receipts on those transactions. Matching transactions are defined to represent
forward foreign exchange and other similar market-related transactions in which
notional principal is equivalent to cash flows, where the cash flows fall due on
the same value date and are in the same currency. Thus, the notional principal
for such transactions would be the net receipts falling due on each value date in
a given currency. The transactions are treated as a single transaction since
offsetting transactions in the same currency maturing on the same date will have
a lower future potential exposure as well as a lower current exposure.
26.
The effects of netting agreements on potential future credit exposure are
recognised through the application of a formula that produces an adjusted “addon” amount for potential future credit exposure on all contracts subject to the
netting agreement (PFCEadj). The formula is:
AGN 112.3 – 6
May 2006
PFCEadj = 0.4(PFCEgross) + 0.6 (NGR x PFCEgross)
27.
The approach makes some allowance for potential fluctuations in net current
exposure arising from future price or rate movements on netted exposures which
are not matched (as defined in paragraph 25).
28.
Gross potential future credit exposure (PFCEgross) is given by the sum of
potential future credit exposure for each individual transaction covered by an
eligible bilateral netting agreement with one counterparty as if no netting would
occur (subject to paragraph 25). Potential future credit exposure for each
transaction is calculated by multiplying the notional principal amount of the
transaction by the appropriate credit conversion factor for that transaction as set
out in Attachment B to Guidance Note AGN 112.2 Risk-Weighted Off-Balance
Sheet Exposures.
29.
NGR is the “net to gross ratio” – i.e. the ratio of the net current exposure of all
transactions included in the bilateral netting agreement (i.e. NCCE to the gross
current credit exposure (GCCE) of these same transactions). GCCE is the sum
of the mark-to-market values of all transactions covered by the netting
agreement with a positive mark-to-market value with no offsetting against any
contracts with negative mark-to-market value (except as allowed under
paragraph 25). NGR reflects the risk reducing portfolio effects of bilaterally
netted transactions with respect to current credit exposure. Thus:
NGR = NCCE/GCCE
30.
NGR may be calculated in two ways:
Counterparty by Counterparty Approach
Under this approach, a unique NGR is applied to each counterparty in
calculating the credit equivalent amount of transactions conducted with that
counterparty.
The NGR is defined as the net current credit exposure of all transactions with an
individual counterparty covered by an eligible bilateral netting agreement (i.e.
NCCEindividual) divided by the gross current credit exposure of all the
transactions with that counterparty covered by the netting agreement
(i.e.GCCEindividual ).
In calculating GCCEindividual, negative mark-to-market values for individual
transactions with the same counterparty may not be used to offset positive markto-market values for other transactions with the same counterparty.
Aggregate Approach
Under this approach, one NGR is calculated and applied to all counterparties in
calculating the credit equivalent amounts for transactions with each
counterparty separately.
AGN 112.3 – 7
May 2006
The NGR is the ratio of the sum of all of the net current credit exposures of all
the transactions of all counterparties subject to eligible bilateral netting
agreements (i.e. NCCEaggregate) to the sum of all of the gross current credit
exposures for all the transactions of all counterparties subject to eligible netting
agreements (i.e. GCCEaggregate).
In calculating GCCEaggregate, negative mark-to-market values of transactions
with one counterparty cannot be used to offset positive mark-to-market values
of transactions with that counterparty or any other counterparty included in the
aggregate calculations.
31.
An ADI must consistently use either the “counterparty by counterparty”
approach or the “aggregate” approach to calculate NGR. An ADI must inform
APRA which approach it intends to use.
Other criteria
32.
An ADI may, with APRA’s prior agreement, elect to include foreign exchange
contracts with an original maturity of fourteen calendar days or less with other
transactions in calculating netted exposures. Where an ADI chooses to include
contracts under fourteen days, it must do so for all counterparties for whom it
calculates net exposures. An ADI cannot selectively include such contracts in
calculating net exposures. All such foreign exchange contracts will need to be
included in calculating current credit exposures and potential future credit
exposures (with a credit conversion factor of 1.0%). Market-related instruments
traded on recognised exchanges where they are subject to daily margining
requirements, are excluded from netting.
Risk weighted amount
33.
Once the CEA has been determined for transactions netted under an eligible
bilateral netting agreement, that amount is then assigned the risk weighting
appropriate to the counterparty, or if relevant, the risk weighting of a guarantor
or collateral. The maximum risk weight applicable to the CEA of netted marketrelated transactions is 50 per cent.
34.
A worked example of the calculation of risk-weighted amount of off-balance
sheet market-related transactions involving eligible bilateral netting agreements
is set out in the Attachment.
AGN 112.3 – 8
May 2006
Attachment
Worked Example for Calculation of Risk-Weighted Amount of OffBalance Sheet Market-Related Transactions Covered by Eligible Bilateral
Netting Agreements
Assumptions
Assume that an ADI has a portfolio of foreign exchange transactions outstanding with
four counterparties. Counterparties A and C are ADIs while counterparties B and D
are corporates. The transactions with each counterparty have the following terms:
Counterparty A
Counterparty B
Counterparty C
Counterparty D
Notional Residual Mark- Notional Residual Mark- Notional Residual Mark- Notional Residual MarkPrincipal Maturity to- Principal Maturity to- Principal Maturity to- Principal Maturity to(Years) Market
(Years) Market
(Years) Market
(Years) Market
(Value)
(Value)
(Value)
(Value)
400
1,500
400
300
200
1000
800
1
2
2
1
3
5
5
5
8
4
1
6
3
-2
200
2,000
200
100
1
2
3
3
5
-5
1
-1
700
200
1,000
800
900
700
500
1
5
4
1
1
2
3
-1
-8
-7
-1
9
2
4
100
800
300
100
500
600
2
2
5
1
1
1
-1
9
5
3
9
-4
Assume in addition that certain transactions with Counterparties A and B involve the
same currencies and have the same value date. In calculating capital requirements, it
is assumed that an ADI has chosen to match transactions in accordance with
paragraph 25 of this Guidance Note and, as a result, these transactions (contracts)
have been effectively replaced by new notional transactions marked with #.
After Matching
Counterparty A
Counterparty B
Counterparty C
Counterparty D
Notional Residual Mark- Notional Residual Mark- Notional Residual Mark- Notional Residual MarkPrincipal Maturity to- Principal Maturity toPrincipal Maturity to- Principal Maturity to(Years) Market
(Years) Market
(Years) Market
(Years) Market
(Value)
(Value)
(Value)
(Value)
400
1
5
200
1
5
700
1
-1
100
2
-1
1,500
2
8
2,000
2
-5
200
5
-8
800
2
9
400
2
4
3
0
1,000
4
-7
300
5
5
100#
300
1
1
800
1
-1
100
1
3
200
3
6
900
1
9
500
1
9
5
1
700
2
2
600
1
-4
200#
500
3
4
Net
25
0
-2
21
NCCE
25
0
0
21
AGN 112.3 – 9
May 2006
If no bilateral netting (or matching of transactions) applied
Counterparty
A
Sum of the mark-to-market value of
transactions with positive
replacement cost
Potential future credit exposure
Credit Equivalent Amount
(CEA = net mark-to-market +
potential future credit exposure)
Risk Weighted Assets
(CEA x Counterparty Risk Weight)
Counterparty Counterparty Counterparty
B
C
D
27
6
15
26
74
202
117
144
72
535
229
123
159
98
609
45.80
61.50
31.80
49.00
188.10
Gross Potential Future Credit Exposure (PFCEgross) Add-on for Each
Individual Transaction:
For the purpose of this example, assume the gross potential future credit exposure for
each individual transaction is obtained by multiplying the transaction’s notional
principal by a credit conversion factor (ccf) of 1% for transactions with a residual
maturity of up to (and including) one year and a ccf of 5% for those transactions with
a remaining term to maturity of greater than one year and up to (and including) 5
years. Thus:
After Matching
Counterparty A
Counterparty B
Counterparty C
Counterparty D
4
2
7
5
75
100
10
40
20
5
50
15
3
8
1
10
9
5
10
35
6
25
PFCEgross
122
Total
107
144
72
AGN 112.3 – 10
May 2006
Calculation of Risk Weighted Amounts
Counterparty Counterparty Counterparty Counterparty
A
B
C
D
Total
Counterparty Risk Weight
20%
50%
20%
50%
Net Current Credit Exposure
(NCCE)
25.00
0.00
0.00
21.00
46.00
Gross Current Credit Exposure
(GCCE)
25.00
5.00
15.00
26.00
71.00
122
107
144
72
1.00
0.00
0.00
0.81
Gross Potential Future Credit
Exposure (PFCEgross)
If bilateral netting applied
Net to Gross Ratio
(NGR = NCCE/GCCE)
0.65∗
Where ∗ indicates the NGR for all
counterparties.
Applying NGR on counterparty by counterparty approach:
122.00
42.80
57.60
63.79
Credit Equivalent Amount
(CEA = NCCE + PFCEadj)
147.00
42.80
57.60
84.79
Risk Weighted Assets
(CEA x Counterparty Risk Weight)
29.40
21.40
11.52
42.40
Potential Future Credit Exposure
(Adjusted)
PFCEadj = 0.4 (PFCEgross) + 0.6
(NGR x PFCEgross)
Where the individual NGR for a
counterparty is applied for that
counterparty
AGN 112.3 – 11
104.72
May 2006
Applying NGR on a aggregate approach:
96.38
84.53
113.76
56.88
Credit Equivalent Amount
(CEA = NCCE + PFCEadj)
121.38
84.53
113.76
77.88
Risk Weighted Assets
(CEA x Counterparty Risk Weight)
24.28
42.27
22.75
38.94
Potential Future Credit Exposure
(Adjusted)
PFCEadj = 0.4 (PFCEgross) + 0.6
(NGR x PFCEgross)
Where NGR = 0.65 for all
counterparties
AGN 112.3 – 12
128.24