Last month, the Commodity Futures Trading Commission (CFTC) published a final rule related to the insured depository institution (IDI) exception to the swap dealer de minimis test (the “Final IDI Rule”), effectively allowing community and regional banks to provide greater access to swaps to loan customers without triggering the costly requirement of registering as a swap dealer. The rule went into effect immediately, and modified the eight original criteria that IDIs had to meet in order to rely on the exception from the swap dealer de minimis calculation. Both the original criteria (the “Original IDI Exception”) and the revised criteria (the “Revised IDI Exception”) are discussed and set forth below.
Banks that engage above a certain threshold amount of “swap dealing” activity are required to register with the CFTC and comply with a number of costly regulatory obligations, including business conduct standards, minimum capital requirements, and more. “Swap dealing” activity includes (i) market making, (ii) holding oneself out as a dealer, (iii) regularly entering into swaps with counterparties as an ordinary course of business for one’s own account, or (iv) engaging in activity that causes an entity to be commonly known as a dealer or market maker. Proprietary trading and hedging for one’s own account are outside the scope of swap dealing (but these activities are also subject to a variety of regulatory requirements beyond the scope of this update).
Any entity that engages in swap dealing activity that exceeds an aggregate gross notional amount of $8 billion over the prior 12-month period (the “de minimis” threshold) will be considered a swap dealer under the Dodd-Frank Act and will be subject to registration requirements and the related rules and regulations. However, there are a number of exclusions from the swap dealer de minimis calculation. Notably, under the final rule defining the term “swap dealer,” the CFTC and Securities and Exchange Commission (SEC) allowed for IDIs to exclude certain swaps they enter into with customers in connection with originating loans to that customers. In promulgating the Final IDI Rule, the CFTC acknowledged that the Original IDI Exception criteria were too restrictive, leading a number of IDIs to stop or limit themselves from providing swaps to loan customers, which potentially hampered the ability of bank customers from hedging against the floating rate risk related to their loans. The CFTC stated its belief that increased IDI swap dealing will benefit both IDIs and customers.
Revised IDI Exception
Accordingly, based on feedback received from industry participants, the CFTC revised the Original IDI Exception to make the criteria substantially less onerous. Following the CFTC’s adoption of the Final IDI Rule, the revised criteria for IDIs to exclude swaps from their swap dealer de minimis calculations are as follows:
- The IDI must enter into the swap no earlier than 90 days before execution of the loan agreement or transfer of principal, unless an executed commitment or forward agreement for the applicable loan exists, in which case the 90-day limit does not apply;
- (i) The rate, asset, liability or other item underlying the swap must be tied to the financial terms of the loan (including the loan’s duration, interest rate, currencies, and principal amount) or (ii) the swap is permitted under the IDI’s loan underwriting criteria and is commercially appropriate to hedge risks incidental to a borrower’s business that may affect the borrower’s ability to repay the loan;
- The duration of the swap does not extend beyond maturity of the loan;
- The IDI must be (i) committed to be the source of at least 5% of the maximum loan principal, or (ii) if committed to less than 5% of the maximum loan principal, then the aggregate gross notional amount of all swaps entered into between the IDI and borrower in connection with the loan does not exceed the principal amount of the loan;
- The swap is considered to be “in connection with originating a loan with the customer” if the IDI:
- directly transfers the loan amount to the borrower;
- is part of a syndicate of lenders that is the source of the loan amount that is transferred to the borrower;
- purchases or receives a participation in the loan; or
- under the terms of the agreements related to the loan, is or is intended to be the source of funds for the loan.
- The transaction must not be a sham; and the loan must not be a synthetic loan.
Notably, it is no longer necessary to enter into a swap within 180 days after the loan closes in order for such swaps to be excluded from the de minimis calculation. IDIs also don’t need to enter into a swap with a customer 90 days prior to the loan so long as there is an executed commitment or forward agreement in place for the loan.
The Revised IDI Exception also provides more flexibility to IDIs with respect to providing swaps to customers “in connection with” a loan, meaning that an IDI’s underwriting criteria no longer needs to require that a borrower enter into a swap, and IDIs can make this risk determination based on factors that may not have been apparent at the time the loan was executed.
For IDIs providing hedges to borrowers in a syndicated loan, the IDI now only needs to participate in 5% of the maximum principal amount of the loan, down from 10% in the Original IDI Exception. This is intended to benefit IDIs that participate in large syndications.
Finally, the CFTC clarified in the Final IDI Rule that the revised IDI exception from the swap dealer de minimis test does not apply to the $25 million special entity threshold, and only applies with respect to the $8 billion aggregate gross notional amount threshold, and only applies to swaps executed from and after the effective date of the Final IDI Rule (which was April 1, 2019).
The Final IDI Rule will impact community and regional banks for the better, and will materially change how these institutions calculate which swaps count towards their swap dealer de minimis calculations. The Final IDI Rule may also encourage some banks to expand their swap programs with loan customers, as the regulatory implications may not be as significant as they were when the Original IDI Exception applied.
Questions on how the Final IDI Rule will impact your bank’s swap program and swap dealer de minimis calculations? Contact Alec Fraser or Cheryl Isaac Aaron.