Financial Institutions Commission Releases Guidelines for Commodity Contracts
The Republic of Palau’s Financial Institutions Commission has issued new guidelines for calculating capital adequacy requirements for commodity contracts, including equity forward and swap agreements.
Calculating Capital Adequacy Requirements
According to the guidelines, banks that engage in these types of instruments must calculate credit equivalent amounts by adding:
- The total replacement cost of all contracts with positive value
- An add-on factor based on the notional principal amount
The add-on factor varies depending on the residual maturity of the contract, ranging from 0% for one-year or less to 15% for over five years.
Bilateral Netting
The guidelines also provide for bilateral netting, which allows banks to net transactions subject to valid and binding agreements with counterparties. To qualify for netting, banks must demonstrate that they have:
- A legally enforceable agreement in place
- Procedures in place to ensure that legal characteristics of the netting arrangement are kept under review
Risk Weighting
In addition, the guidelines provide for risk weighting, which requires credit equivalent amounts to be weighted based on the category of counterparty. The weightings vary depending on the type of guarantee or collateral provided by the counterparty, including:
- Cash and government securities: 0% weighting
- Local government guarantees: 50% weighting
Walk-Away Clauses
The guidelines clarify that contracts containing walk-away clauses are not eligible for netting when calculating capital requirements. Walk-away clauses permit non-defaulting counterparties to make limited payments or no payment even if the defaulter is a net creditor.
Purpose of the Guidelines
The Financial Institutions Commission’s guidelines aim to ensure that banks maintain adequate capital levels to cover potential losses from commodity contract exposures, while also promoting:
- Transparency in risk management practices
- Consistency in risk management practices