BPI Comments on Derivatives Valuation in Fed’s Regulation O Proposal

Ladies and Gentlemen:

The Bank Policy Institute ("BPI")^[1] is writing in response to the notice of proposed rulemaking issued by the Board of Governors of the Federal Reserve System regarding "Loans to Executive Officers, Directors, and Principal Shareholders of Member Banks; Bank Holding Companies."^[2] This comment addresses the potential adoption of a new valuation methodology for derivative contracts with insiders under Regulation O and with affiliates pursuant to section 23A of the Federal Reserve Act and its implementing regulation, Regulation W, as well as certain other derivative valuation issues. We are submitting a separate comment addressing the other proposed changes to Regulation O.

The proposal would adopt a valuation methodology for credit exposure arising from a bank's derivatives transactions with insiders that would depart significantly from both current practice under Regulation O and the valuation methodology permitted for purposes of section 23A of the Federal Reserve Act and Regulation W for derivatives transactions: the bank's current exposure to the derivative counterparty.^[3] The proposal would instead tie the Regulation O (and potentially, Regulation W) valuation methodology for derivative credit exposure to the valuation methodologies permitted under the risk-based capital rules, which include not only current exposure but also measures of potential future exposure ("PFE").^[4] The proposal would therefore adopt a new standard for valuing derivatives transactions for purposes of Regulation O, and the proposal notes that the Board may consider adopting this new standard for Regulation W. This new standard is likely to unnecessarily increase costs significantly and potentially force significant changes to existing booking models for firms that reflect the current exposure as the relevant credit exposure measure consistent with the 2020 joint prudential regulator final rule establishing Margin and Capital Requirements for Covered Swap Entities ("Uncleared Swaps Margin Rule") for inter-affiliate derivatives transactions.^[5] Under that rule, banks are required to mitigate their derivatives credit exposure by exchanging variation margin equal to the sum of fair values across derivatives payable and receivable less any variation margin received, with variation margin exchanged daily so as to substantially mitigate inter-affiliate credit risk and obviate the need for inclusion of a measure of PFE.

Including PFE when measuring derivative credit exposure is not only inconsistent with current practice and regulatory policy, it is also inconsistent with sections 22(h) and 23A of the Federal Reserve Act and inappropriate for their distinct purposes. Unlike the capital rules, which are designed to ensure banks have capital to absorb unexpected losses under a range of possible future scenarios, these statutes are designed to measure compliance at a specific point in time and for their own specific purposes. In addition, these changes could result in material changes to exposure amounts that, if extended to Regulation O and/or Regulation W, could result in significantly increased compliance and funding costs for banks as well as other negative implications for banking organizations and financial markets that the Federal Reserve has not grappled with in the proposal. Therefore, the Federal Reserve should not adopt these proposed changes to Regulation O or propose similar changes to Regulation W. Instead, the Federal Reserve should explicitly endorse the continued use of current exposure as the appropriate measure of derivative credit exposure for purposes of both Regulation O and Regulation W.

Should the Federal Reserve nevertheless adopt the proposed changes in any final revisions to Regulation O, the Federal Reserve should consider any changes to Regulation W separately and in light of Regulation W's own statutory purpose and only after undertaking empirical analyses of the likely impact of any changes on bank derivatives activities and the markets and customers those activities support. We acknowledge that Regulation O and Regulation W share certain operational concepts and that greater consistency between them can, where appropriate, promote clarity and reduce unnecessary compliance burdens. However, as discussed further in this letter, Regulation O and Regulation W ultimately are rooted in distinct statutory authorities and purposes. Regulation O is designed to prevent insider abuse by limiting preferential extensions of credit to a bank's insiders, whereas Regulation W is focused on protecting the safety and soundness of banks by limiting their exposure to affiliates. Given their distinct purposes and consequences, the application and interpretation of the two regulations should not be automatically linked.

Concepts from one regulation should only be incorporated into the other where there is a sound conceptual basis for doing so, and alignment should not be an end in itself. Otherwise, alignment could lead to unforeseen and unintended consequences with respect to the application of both regulations. Banks have long-standing and separate controls and procedures built around each existing framework, and changing definitions and methodologies in either regulation for the sole purpose of alignment would increase compliance burdens without meaningfully reducing the risks that the frameworks are intended to mitigate. Any changes should be targeted at specific, well-supported enhancements. In addition, the Federal Reserve should ensure that any linkages it codifies between the two regulations enhance clarity of the two regulations, rather than create additional complexity.

To read the full comment letter, please click here, or click on the download button below.

[1] The Bank Policy Institute is a nonpartisan public policy, research and advocacy group that represents universal banks, regional banks, and the major foreign banks doing business in the United States. The Institute produces academic research and analysis on regulatory and monetary policy topics, analyzes and comments on proposed regulations, and represents the financial services industry with respect to cybersecurity, fraud, and other information security issues.

[2] 91 Fed. Reg. 49,526 (Aug. 4, 2026).

[3] See OCC, Federal Reserve Board, FDIC, FCA, FHFA, Final Rule, "Margin and Capital Requirements for Covered Swap Entities," 85 Fed. Reg. 39,754, 39,764 (July 1, 2020).

[4] 91 Fed. Reg. at 49,534.

[5] OCC, Federal Reserve Board, FDIC, FCA, FHFA, Final Rule, "Margin and Capital Requirements for Covered Swap Entities," 85 Fed. Reg. 39,754, 39,759 (July 1, 2020).